**UNITED STATESSECURITIES 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 June  30, 2003**                                                                                                                                                                                                                                                                                                                                                                                                     |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| **o**      |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                                                                         |
|       |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|       |   | **For the transition period from                                     to                                  ** |

 

| **Commission  File No.  000 – 22207**         |
|---------------------------------------------------------|
|                                                    |   |   |
| **GUITAR  CENTER, INC.**                                |
| (Exact Name of Registrant  as Specified in its Charter) |

 

|                                                     |   | **DELAWARE**                                                    |   | **95-4600862**                           |
|----------------------------------------------------------|--------|-----------------------------------------------------------------|--------|------------------------------------------|
|                                                     |   | (State or other jurisdiction of  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 August 4, 2003, 23,206,643 shares of our Common Stock, $.01par value, were outstanding.

 

 

----

 

**Guitar Center, Inc. and subsidiaries**

 

#### INDEX

 
| Part I.      |   | Financial Information                                                                                         |   |   |
|--------------|--------|---------------------------------------------------------------------------------------------------------------|--------|--------|
|         |   |                                                                                                          |   |   |
|         |   | **Item  1. Consolidated Financial Statements (Unaudited)**                                                    |   |   |
|         |   |                                                                                                          |   |   |
|         |   | Consolidated Balance Sheets – June 30, 2003 and  December 31, 2002                                       |   | 3      |
|         |   |                                                                                                          |   |   |
|         |   | Consolidated Statements of Income – Three months  ended  June 30, 2003 and 2002                          |   | 4      |
|         |   |                                                                                                          |   |   |
|         |   | Consolidated Statements of Income – Six months ended  June 30, 2003 and 2002                             |   | 5      |
|         |   |                                                                                                          |   |   |
|         |   | Consolidated Statements of Cash Flows – Six months  ended  June 30, 2003 and 2002                        |   | 6      |
|         |   |                                                                                                          |   |   |
|         |   | Notes to Consolidated Financial Statements                                                                    |   | 7      |
|         |   |                                                                                                          |   |   |
|         |   | **Item 2.  Management’s Discussion and Analysis of  Financial Condition and Results of Operations** |   | 10     |
|         |   |                                                                                                          |   |   |
|         |   | **Item  3.  Quantitative and Qualitative  Disclosures About Market Risk**                                |   | 26     |
|         |   |                                                                                                          |   |   |
|         |   | **Item  4.  Controls and Procedures**                                                                    |   | 26     |
|         |   |                                                                                                          |   |   |
| **Part II.** |   | **Other Information**                                                                                         |   |   |
|         |   |                                                                                                          |   |   |
|         |   | Item 4.   Submission of Matters to a Vote of Security Holders                                            |   | 27     |
|         |   |                                                                                                          |   |   |
|         |   | Item 6.   Exhibits                                                                                       |   | 27     |

 

2

----

 

**Guitar Center, Inc. and subsidiariesConsolidated Balance Sheets**

(In thousands, except pershare amounts)

(Unaudited)

 
|                                                                                                                                            |   | **June 30,****2003** |    | **December 31,  2002** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|---------|------------------------|--------|
| **Assets**                                                                                                                                      |   |                 |    |                   |   |
| Current assets:                                                                                                                                 |   |                 |    |                   |   |
| Cash and cash equivalents                                                                                                                       |   | $                    | 72,909  |                   | $      | 5,931 |   |
| Accounts receivable, net                                                                                                                        |   | 15,155               |    | 19,762                 |   |
| Merchandise inventories                                                                                                                         |   | 283,582              |    | 292,075                |   |
| Prepaid expenses and deposits                                                                                                                   |   | 7,842                |    | 8,626                  |   |
| Deferred income taxes                                                                                                                           |   | 6,077                |    | 6,077                  |   |
| Total current assets                                                                                                                            |   | 385,565              |    | 332,471                |   |
|                                                                                                                                            |   |                 |    |                   |   |
| Property and equipment, net                                                                                                                     |   | 91,022               |    | 89,702                 |   |
| Goodwill                                                                                                                                        |   | 25,995               |    | 25,995                 |   |
| Deposits and other assets, net                                                                                                                  |   | 7,179                |    | 4,231                  |   |
|                                                                                                                                            |   | $                    | 509,761 |                   | $      | 452,399 |   |
|                                                                                                                                            |   |                 |    |                   |   |
| **Liabilities  and stockholders’ equity**                                                                                                  |   |                 |    |                   |   |
| Current liabilities:                                                                                                                            |   |                 |    |                   |   |
| Accounts payable                                                                                                                                |   | $                    | 47,534  |                   | $      | 70,745 |   |
| Accrued expenses and other current liabilities                                                                                                  |   | 45,520               |    | 54,211                 |   |
| Merchandise advances                                                                                                                            |   | 13,176               |    | 13,882                 |   |
| Borrowings under line of credit                                                                                                                 |   | 55,584               |    | 82,690                 |   |
| Current portion of long-term debt                                                                                                               |   | 66,667               |    | 118                    |   |
| Total current liabilities                                                                                                                       |   | 228,481              |    | 221,646                |   |
|                                                                                                                                            |   |                 |    |                   |   |
| Other long-term liabilities                                                                                                                     |   | 5,715                |    | 5,691                  |   |
| Deferred income taxes                                                                                                                           |   | 3,352                |    | 3,352                  |   |
| Long-term debt                                                                                                                                  |   | 100,000              |    | 66,782                 |   |
| Total liabilities                                                                                                                               |   | 337,548              |    | 297,471                |   |
|                                                                                                                                            |   |                 |    |                   |   |
| Stockholders’ equity:                                                                                                                      |   |                 |    |                   |   |
| Preferred Stock; 5,000 authorized, none issued  and outstanding                                                                                 |   | —               |    | —                 |   |
| Common Stock, $0.01 par value, authorized  55,000 shares, issued and outstanding  23,174 at June 30, 2003 and 22,746 at  December 31, 2002 |   | 232                  |    | 227                    |   |
| Additional paid in capital                                                                                                                      |   | 259,716              |    | 253,863                |   |
| Accumulated deficit                                                                                                                             |   | (87,735              | )       | (99,162                | )      |
| Net stockholders’ equity                                                                                                                   |   | 172,213              |    | 154,928                |   |
|                                                                                                                                            |   |                 |    |                   |   |
|                                                                                                                                            |   | $                    | 509,761 |                   | $      | 452,399 |   |

 

See accompanying notes toconsolidated financial statements.

 

3

----

 

**Guitar Center, Inc. and subsidiariesConsolidated Statements of Income**

(In thousands, except pershare data)

(Unaudited)

 
|                                         |   | **Three months ended June 30,** |       |
|----------------------------------------------|--------|---------------------------------|------------|
|                                         |   | **2003**                        |       | **2002** |   |
|                                         |   |                            | ** ** |   | ** ** |
| Net sales                                    |   | $                               | 291,600    |   | $ | 253,887 |   |
| Cost of goods sold, buying and occupancy     |   | 216,050                         |       | 188,512 |   |
| Gross profit                                 |   | 75,550                          |       | 65,375 |   |
|                                         |   |                            |       |   |   |
| Selling, general and administrative expenses |   | 62,666                          |       | 55,757 |   |
| Operating income                             |   | 12,884                          |       | 9,618 |   |
|                                         |   |                            |       |   |   |
| Interest expense, net                        |   | 2,956                           |       | 2,998 |   |
|                                         |   |                            |       |   |   |
| Income before income taxes                   |   | 9,928                           |       | 6,620 |   |
|                                         |   |                            |       |   |   |
| Income taxes                                 |   | 3,778                           |       | 2,520 |   |
|                                         |   |                            |       |   |   |
| Net income                                   |   | $                               | 6,150      |   | $ | 4,100 |   |
|                                         |   |                            |       |   |   |
| Net income per share                         |   |                            |       |   |   |
| Basic                                        |   | $                               | 0.27       |   | $ | 0.18 |   |
| Diluted                                      |   | $                               | 0.25       |   | $ | 0.18 |   |
|                                         |   |                            |       |   |   |
| Weighted average shares outstanding          |   |                            |       |   |   |
| Basic                                        |   | 22,995                          |       | 22,430 |   |
| Diluted                                      |   | 24,173                          |       | 23,169 |   |

 

See accompanying notes toconsolidated financial statements.

 

4

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**Guitar Center, Inc. and subsidiariesConsolidated Statements of Income**

(In thousands, except pershare data)

(Unaudited)

 
|                                         |   | **Six months ended June 30,** |       |
|----------------------------------------------|--------|-------------------------------|------------|
|                                         |   | **2003**                      |       | **2002** |   |
|                                         |   |                          | ** ** |   | ** ** |
| Net sales                                    |   | $                             | 579,142    |   | $ | 508,710 |   |
| Cost of goods sold, buying and occupancy     |   | 428,936                       |       | 379,174 |   |
| Gross profit                                 |   | 150,206                       |       | 129,536 |   |
|                                         |   |                          |       |   |   |
| Selling, general and administrative expenses |   | 125,664                       |       | 111,219 |   |
| Operating income                             |   | 24,542                        |       | 18,317 |   |
|                                         |   |                          |       |   |   |
| Interest expense, net                        |   | 6,095                         |       | 6,150 |   |
|                                         |   |                          |       |   |   |
| Income before income taxes                   |   | 18,447                        |       | 12,167 |   |
|                                         |   |                          |       |   |   |
| Income taxes                                 |   | 7,020                         |       | 4,631 |   |
|                                         |   |                          |       |   |   |
| Net income                                   |   | $                             | 11,427     |   | $ | 7,536 |   |
|                                         |   |                          |       |   |   |
| Net income per share                         |   |                          |       |   |   |
| Basic                                        |   | $                             | 0.50       |   | $ | 0.34 |   |
| Diluted                                      |   | $                             | 0.48       |   | $ | 0.33 |   |
|                                         |   |                          |       |   |   |
| Weighted average shares outstanding          |   |                          |       |   |   |
| Basic                                        |   | 22,894                        |       | 22,393 |   |
| Diluted                                      |   | 23,928                        |       | 23,020 |   |

 

See accompanying notes toconsolidated financial statements.

 

5

----

 

**Guitar Center, Inc. and subsidiariesConsolidated Statements of Cash Flows**

(In thousands)

(Unaudited)

 
|                                                                                         |   | **Six months ended June 30,** |   |
|----------------------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                                         |   | **2003**                      |   | **2002** |   |
| **Operating  activities**                                                                    |   |                          |   |   |   |
| Net income                                                                                   |   | $                             | 11,427 |   | $ | 7,536 |   |
| Adjustments to reconcile net income to net cash provided by (used in)  operating activities: |   |                          |   |   |   |
| Depreciation and amortization                                                                |   | 9,962                         |   | 7,943 |   |
| Amortization of deferred financing fees                                                      |   | 351                           |   | 328 |   |
| Changes in operating assets and liabilities:                                                 |   |                          |   |   |   |
| Accounts receivable                                                                          |   | 4,607                         |   | 816 |   |
| Merchandise inventories                                                                      |   | 8,512                         |   | (17,129 | ) |
| Prepaid expenses and deposits                                                                |   | 784                           |   | (1,671 | ) |
| Other assets                                                                                 |   | (189                          | )      | (80 | ) |
| Accounts payable                                                                             |   | (23,211                       | )      | (10,250 | ) |
| Accrued expenses and other current liabilities                                               |   | (8,776                        | )      | (9,524 | ) |
| Other long-term liabilities                                                                  |   | 24                            |   | 642 |   |
| Merchandise advances                                                                         |   | (706                          | )      | (855 | ) |
| Net cash provided by (used in) operating activities                                          |   | 2,785                         |   | (22,244 | ) |
|                                                                                         |   |                          |   |   |   |
| **Investing  activities**                                                                    |   |                          |   |   |   |
| Purchase of property and equipment                                                           |   | (11,283                       | )      | (13,655 | ) |
| Acquisitions of businesses                                                                   |   | —                        |   | (5,932 | ) |
| Net cash used in investing activities                                                        |   | (11,283                       | )      | (19,587 | ) |
|                                                                                         |   |                          |   |   |   |
| **Financing  activities**                                                                    |   |                          |   |   |   |
| Net change in revolving debt facility                                                        |   | (27,106                       | )      | 27,695 |   |
| Proceeds from exercise of stock options                                                      |   | 5,436                         |   | 1,901 |   |
| Proceeds from stock issued under employee purchase plan                                      |   | 422                           |   | — |   |
| Proceeds from senior convertible notes                                                       |   | 96,875                        |   | — |   |
| Payments under capital lease                                                                 |   | (151                          | )      | (420 | ) |
| Net cash provided by financing activities                                                    |   | 75,476                        |   | 29,176 |   |
|                                                                                         |   |                          |   |   |   |
| Net change in cash and cash equivalents                                                      |   | 66,978                        |   | (12,655 | ) |
| Cash and cash equivalents at beginning of year                                               |   | 5,931                         |   | 17,480 |   |
|                                                                                         |   |                          |   |   |   |
| Cash and cash equivalents at end of period                                                   |   | $                             | 72,909 |   | $ | 4,825 |   |
|                                                                                         |   |                          |   |   |   |
| **Non-cash activities**                                                                      |   |                          |   |   |   |
| Acquisition of businesses:                                                                   |   |                          |   |   |   |
| Fair value of assets acquired                                                                |   |                          |   | $ | 4,774 |   |
| Liabilities assumed                                                                          |   |                          |   | (1,463 | ) |
| Debt incurred                                                                                |   |                          |   | (2,400 | ) |
| Goodwill                                                                                     |   |                          |   | 5,021 |   |
| Cash paid for acquisitions                                                                   |   |                          |   | $ | 5,932 |   |

 

See accompanying notes toconsolidated financial statements.

 

6

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**Guitar Center, Inc. and subsidiariesNotes to Consolidated FinancialStatements**

 

1.                                       Natureof Business and Basis of Presentation

 

Nature of Business

 

Guitar Center, Inc., and subsidiaries (“GuitarCenter,” the “Company,” “we,” “us” or “our”) is the nation’s leading retailerof guitars, amplifiers, percussion instruments, keyboards and pro-audio andrecording equipment. As of June 30, 2003, we operated 115 Guitar Center retailstores, with 102 stores in 42 major markets and 13 stores in secondary marketsacross the United States. In addition, our American Music division, whichserves the student and family market, operated 19 stores as of June 30, 2003.Musician’s Friend, Inc., a wholly owned subsidiary of Guitar Center, Inc., isthe largest direct response retailer of musical instruments in the UnitedStates through the Musician’s Friend catalog and web site,www.musiciansfriend.com.

 

Basis of Presentation

 

In the opinion of management, the accompanyingunaudited consolidated financial statements contain all adjustments necessaryto present fairly the financial position of Guitar Center, Inc. andsubsidiaries as of June 30, 2003 and December 31, 2002, and the results ofoperations and cash flows for the three and six months ended June 30, 2003 and2002. The accompanying consolidated financial statements should be read inconjunction with the audited consolidated financial statements and notesthereto contained in our Annual Report on Form 10-K for the year ended December31, 2002.

 

The results of operations for the three and six monthsended June 30, 2003 are not necessarily indicative of the results to beexpected for the full year.

 

2.                                       Acquisitions

 

In February 2002, we acquired the inventory andassumed the customer credit liabilities of Music Loft East, Inc., a singlestore located in Raleigh, North Carolina. In connection with the purchase we paid $488,000 in cash, acquiredassets with a fair value of $369,000, and assumed liabilities of $146,000.  Goodwill in the amount of $265,000 wasrecorded.

 

On June 14, 2002, we acquired M&M Music, afive-store band instrument retailer headquartered in Valdosta, Georgia. Underthe terms of the agreement, we acquired the stock of M&M Music for totalconsideration of $6.0 million in cash and stock.  We acquired assets with a fair value of $4.4 million and assumedliabilities and paid expenses of $1.3 million. Goodwill in the amount of $2.9million was recorded. Under the terms of the purchase agreement, during thesecond quarter of 2002 we paid $3.6 million in cash and during the thirdquarter of 2002 we issued 90,602 shares of Guitar Center stock, representing$1.5 million.  As part of the terms ofthe purchase agreement, there was a $0.9 million holdback on the transaction,pending the M&M Music business meeting certain balance sheetrequirements.  During the fourth quarterof 2002, it was determined that the requirements subject to the holdback were satisfiedand we issued an additional 54,360 shares of common stock in consideration forthe remaining $0.9 million of the purchase price.

 

The results of operations and the assets of the MusicLoft East, Inc. and M&M Music were not material to Guitar Center’spreviously presented consolidated financial statements and, as such, pro-formafinancial information is not presented. The results of operations for each ofthese entities are included in Guitar Center’s consolidated financialstatements from the dates of the acquisition.

 

Goodwill was recorded on Music Loft and M&M Musicacquisitions in the amount of the total consideration paid in excess of thefair value of the identifiable assets acquired.  In accordance with SFAS 142 we no longer amortize goodwill andintangible assets with an indefinite useful life on a stated basis but ratherdo annual testing of the goodwill for impairment, with no charge to incomeexcept to the extent of any such impairment.

 

7

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3.                                       EarningsPer Share

 

The following table summarizes the reconciliation ofBasic to Diluted Weighted Average Shares for the three and six months endingJune 30, 2003 and 2002:

 
|                                                              |   | **For the  three months  ended June 30,** |   | **For the six  months  ended June 30,** |   |
|-------------------------------------------------------------------|--------|-------------------------------------------|--------|-----------------------------------------|--------|
|                                                              |   | **2003**                                  |   | **2002**                                |   | **2003** |   | **2002** |   |
|                                                              |   | **(in  thousands)**                       |   |
| Basic shares                                                      |   | 22,995                                    |   | 22,430                                  |   | 22,894 |   | 22,393 |   |
|                                                              |   |                                      |   |                                    |   |   |   |   |   |
| Common stock equivalents - dilutive effect of options outstanding |   | 1,178                                     |   | 739                                     |   | 1,034 |   | 627 |   |
|                                                              |   |                                      |   |                                    |   |   |   |   |   |
| Diluted shares                                                    |   | 24,173                                    |   | 23,169                                  |   | 23,928 |   | 23,020 |   |

 

For the three and six months ended June 30, 2003 and2002, the only common stock equivalents outstanding with the Company are stockoptions.  The 2.9 million conversionshares related to the Convertible Senior Notes issued in June 2003 are not commonstock equivalents as of June 30, 2003. For the three and six months ended June 30, 2003, all optionsoutstanding had a dilutive effect. Options to purchase 701,000 shares of Common Stock at prices rangingfrom $19.24 to $28.56 and options to purchase 712,000 shares of Common Stock atprices ranging from $20.75 to $28.56 were outstanding during the three and sixmonths ended June 30, 2002, respectively, but were not included in thecomputation of diluted earnings per share because the exercise price of theseoptions was greater than the average market price of our Common Stock.

 

4.                                       Segment Information

 

For financial reportingpurposes, we classify our business interests into two reportable segments,retail and direct response. The retail segment includes revenue and expenseassociated with our 115 Guitar Center and 19 American Music retail locations.Our direct response segment consists of Musician’s Friend. We evaluate segmentperformance based primarily on net sales and income before income taxes. Accountingpolicies of the segments are the same as the accounting policies for theconsolidated Company. There are no differences between the measurements ofprofits or losses or assets of the reportable segments and those of the Companyon a consolidated basis.

 

Net sales, gross margin,depreciation and amortization, selling, general and administrative expense,income before income taxes, capital expenditures and total assets for the threeand six months ended June 30, 2003 and 2002 and total assets as of June 30,2003 and 2002 are summarized as follows (in thousands):

** **
|                                          |   | **Three  Months Ended June 30,  2003** |    | **Six Months  Ended June 30,  2003** |   |
|-----------------------------------------------|--------|----------------------------------------|---------|--------------------------------------|--------|
|                                          |   | **Retail**                             |    | **Direct  Response**                 |   | **Total** |   | **Retail** |   | **Direct  Response** |   | **Total** |   |
| Net sales                                     |   | $                                      | 231,153 |                                 | $      | 60,447 |   | $ | 291,600 |   | $ | 458,754 |   | $ | 120,388 |   | $ | 579,142 |   |
| Gross profit                                  |   | 56,169                                 |    | 19,381                               |   | 75,550 |   | 112,054 |   | 38,152 |   | 150,206 |   |
| Depreciation and amortization                 |   | 4,415                                  |    | 690                                  |   | 5,105 |   | 8,605 |   | 1,357 |   | 9,962 |   |
| Selling, general and  administrative expenses |   | 49,654                                 |    | 13,012                               |   | 62,666 |   | 99,019 |   | 26,645 |   | 125,664 |   |
| Income before income taxes                    |   | 3,659                                  |    | 6,269                                |   | 9,928 |   | 7,220 |   | 11,227 |   | 18,447 |   |
| Capital expenditures                          |   | 5,603                                  |    | 201                                  |   | 5,804 |   | 10,433 |   | 850 |   | 11,283 |   |
| Total assets                                  |   |                                   |    |                                 |   |   |   | 473,384 |   | 36,377 |   | 509,761 |   |
|                                               |        |                                        |         |                                      |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

8

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|                                         |   | **Three Months Ended June 30,  2002** | ** ** | **Six Months Ended June 30,  2002** | ** ** |
|----------------------------------------------|--------|---------------------------------------|------------|-------------------------------------|------------|
|                                         |   | **Retail**                            |       | **Direct  Response**                |       | **Total** |   | **Retail** |   | **Direct  Response** |   | **Total** |   |
| Net sales                                    |   | $                                     | 207,385    |                                | $          | 46,502 |   | $ | 253,887 |   | $ | 412,862 |   | $ | 95,848 |   | $ | 508,710 |   |
| Gross profit                                 |   | 51,293                                |       | 14,082                              |       | 65,375 |   | 101,787 |   | 27,749 |   | 129,536 |   |
| Depreciation and amortization                |   | 3,629                                 |       | 481                                 |       | 4,110 |   | 7,021 |   | 922 |   | 7,943 |   |
| Selling, general and administrative expenses |   | 44,407                                |       | 11,350                              |       | 55,757 |   | 88,305 |   | 22,914 |   | 111,219 |   |
| Income before income taxes                   |   | 4,228                                 |       | 2,392                               |       | 6,620 |   | 8,030 |   | 4,137 |   | 12,167 |   |
| Capital expenditures                         |   | 7,165                                 |       | 613                                 |       | 7,778 |   | 12,685 |   | 970 |   | 13,655 |   |
| Total assets                                 |   |                                  |       |                                |       |   |   | 384,739 |   | 40,505 |   | 425,244 |   |
|                                              |        |                                       |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

5.                                       Stock-BasedCompensation

 

In December 2002, the FASB issued S*tatement of Financial Accounting Standards*(“*SFAS*”)No. 148, *“Accountingfor Stock-Based Compensation - Transition and Disclosure.”* SFAS No. 148 amends SFAS No. 123, *“Accounting for Stock-Based Compensation,”*to provide alternative methods of transition for a voluntary change to the fairvalue based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of Statement No.123 to require prominent disclosures in both annual and interim financialstatements about the method of accounting for stock-based employee compensationand the effect of the method used on reported results.  SFAS No. 148 iseffective for interim and annual periods beginning after December 15, 2002.

 

We apply the provisions of 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**Compensation,”*and related interpretations and provide pro forma net income and proforma earnings per share disclosures for employee stock option grants made in 1995and future years as if the fair-value-based method defined in SFAS No. 123 hadbeen applied.  We have elected tocontinue to apply the provisions of APB Opinion No. 25 and provide the proforma disclosure provisions of SFAS No. 123. As such, compensation expense forstock options issued to employees is recorded on the date of grant only if thecurrent market price of the underlying stock exceeded the exercise price.  Had we determined compensation cost basedupon the fair value at the grant date for our stock options under SFAS No. 123using the Black Scholes option pricing model, pro forma net income and proforma net income per share, including the following weighted averageassumptions used in these calculations, would have been as follows:

 
|                                                                                                                                                 |   | **For the  three months  ended June 30,** |   | **For the six  months ended  June 30,** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|-----------------------------------------|--------|
|                                                                                                                                                 |   | **2003**                                  |   | **2002**                                |   | **2003** |   | **2002** |   |
| Net income, as reported                                                                                                                              |   | 6,150                                     |   | 4,100                                   |   | 11,427 |   | 7,536 |   |
| Deduct:  Total stock-based  employee compensation expense determined under fair value based methods for all  awards, net of related tax effects |   | 2,356                                     |   | 1,495                                   |   | 4,031 |   | 2,873 |   |
| Pro forma net income                                                                                                                                 |   | 3,794                                     |   | 2,605                                   |   | 7,396 |   | 4,663 |   |
| Earnings per share:                                                                                                                                  |   |                                      |   |                                    |   |   |   |   |   |
| Basic - as reported                                                                                                                                  |   | 0.27                                      |   | 0.18                                    |   | 0.50 |   | 0.34 |   |
| Basic - pro forma                                                                                                                                    |   | 0.16                                      |   | 0.12                                    |   | 0.32 |   | 0.21 |   |
| Diluted - as reported                                                                                                                                |   | 0.25                                      |   | 0.18                                    |   | 0.48 |   | 0.33 |   |
| Diluted - pro forma                                                                                                                                  |   | 0.16                                      |   | 0.11                                    |   | 0.31 |   | 0.20 |   |
| Risk free interest rate                                                                                                                              |   | 2.8                                       | %      | 4.6                                     | %      | 2.8 | % | 4.6 | % |
| Expected life of options                                                                                                                             |   | 7.09                                      |   | 7.13                                    |   | 7.09 |   | 7.13 |   |
| Expected volatility                                                                                                                                  |   | 63.8                                      | %      | 69.9                                    | %      | 63.8 | % | 69.9 | % |
| Expected dividends                                                                                                                                   |   | —                                    |   | —                                  |   | — |   | — |   |

 

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*6.*                                       Vendor Payments

 

EITF Issue No. 02-16, *“Accounting by a Reseller for CashConsideration Received from a Vendor,”* provides that cashconsideration received from a vendor is presumed to be a reduction of theprices of the vendor’s products or services and should, therefore, becharacterized as a reduction in cost of sales unless it is a payment for assetsor services delivered to the vendor, in which case the cash considerationshould be characterized as revenue, or unless it is a reimbursement of costsincurred to sell the vendor’s products, in which case the cash considerationshould be characterized as a reduction of that cost. EITF No. 02-16 becameeffective for us in the first quarter of 2003, and had no impact on ourfinancial statements, as we have historically accounted for vendor payments inaccordance with the provisions of this standard.

 

7.                                       ConvertibleNotes Offering and Subsequent Events

 

In June 2003, we issued $100 million in 4% convertiblesenior notes due 2013.  In July 2003, weused $67,889 of the proceeds to retire all of our 11% Senior Notes of $66,667and pay the associated redemption premium of $1,222.  In July 2003, we also wrote-off $722 of deferred financing costsattributed to the 11% Senior Notes.  Theredemption premium and deferred financing costs will be charged to our incomestatement in the quarter ending September 30, 2003.

 

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

 

### **OVERVIEW**

 

We operated 115 Guitar Center retail locations as ofJune 30, 2003, with 102 stores in 42 major markets and 13 stores in secondarymarkets across the United States. In addition, our American Music division,which serves the student and family market, operated 19 stores as of June 30,2003.  We also operate the largestdirect response channel (Musician’s Friend catalog and Internet) in the musicalinstruments industry in the United States.

 

From 1998 to 2002, our net sales grew at an annualcompound growth rate of 22.5%, principally due to the comparable store salesgrowth of our retail stores averaging 8% per year, the opening of new stores,and a 27.9% per year increase in the direct response channel. We believe suchvolume increases are the result of the continued success of the implementationof our business strategy, continued growth in the music products industry andincreasing consumer awareness of the Guitar Center, Musician’s Friend andAmerican Music brand names. We do not expect total or comparable store sales tocontinue to increase at historical rates, as Guitar Center already maintainsoperations in most major domestic markets for our industry, and a higherpercentage of our new stores opened will be in secondary markets.  We expect that these secondary market storeswill contribute lower sales per store than historically achieved from ourstores operating in major markets. When we refer to “comparable sales,” thatcalculation compares net sales for the comparable periods, excluding net salesattributable to stores not open for 13 months. All references in this report tocomparable store sales results are based on this calculation methodology. Inany given period, the set of stores comprising comparable stores may bedifferent from the set of the comparable stores in the previous period,depending on when stores were opened. Other companies may use different methods to calculate this statistic.

 

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We opened a total of 12 Guitar Center stores in2002.  During the six months ended June30, 2003, we have opened four large format Guitar Center stores, those being inScottsdale, Arizona, Warwick, Rhode Island, Cerritos, California, and Memphis,Tennessee, as well as three small format stores in Gary, Indiana, Lakeland,Florida, and Fredericksburg, Virginia. We plan to open three additional largeformat stores and one small format store in the third quarter of 2003.  Our development plan for 2003 also includeslarge, “flagship” Guitar Center stores to be located in Manhattan andNashville.  For the remainder of 2003,we do not plan to open any additional American Music stores organically,however we may identify acquisition opportunities.  We will continue to pursue our strategy of clustering stores inmajor markets to take advantage of operating and advertising efficiencies andto build awareness of the Guitar Center and American Music brand names in newmarkets.  In some markets thisclustering strategy results in some transfer of sales from existing stores tonew locations.

 

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 businesses, including  additional acquisitions if suitable candidatescan be located for reasonable prices.

 

**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. On an ongoing basis, we evaluate our estimates,including those related to product returns, bad debt, inventories, goodwill andtaxes on income. We base our estimates on historical experience and on variousassumptions that are believed to be reasonable under the circumstances, theresults of which form the basis for making judgments about the carrying valuesof assets and liabilities that are not readily apparent from other sources.Actual results could differ significantly from those estimates under differentassumptions and conditions. We believe that the following discussion addressesour most critical accounting policies, which are those that in our opinion aremost important to the portrayal of our financial condition and results andrequire management’s most difficult, subjective and complex judgments, often asa result of the need to make estimates about the effect of matters that areinherently uncertain.  Additionally, thepolicy described below regarding credits and other vendor allowances is uniqueto our industry and deserves the attention of a reader of our financial statements.

 

*Valuationof Inventory*

 

We value our inventories at the lower of cost ormarket using the first-in, first-out (FIFO) method.  Rentalinventories are valued at the lower of cost or market using the specificidentification method and are depreciated on a straight-line basis over the termof the associated rental agreement for rent-to-own sales, or over the estimateduseful life of the rented instrument for rental only items.  We record adjustments to the value ofinventory 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 misunderstanding of these conditions anduncertainties in the future outlook of our industry or the economy, or otherfailure to estimate correctly, could result in inventory valuation changes comparedto the requirement determined to be appropriate as of any given balance sheetdate.

 

*Valuationof Long-Lived Assets*

 

Long-lived assets such as property and equipment andidentifiable intangibles are reviewed for impairment whenever events or changesin circumstances indicate that the carrying amount of an asset may not berecoverable. Goodwill and other intangibles are required to be reviewed forimpairment on an annual

 

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basis, or more frequently when triggering events occur. Factors weconsider important, which could trigger impairment, include, among otherthings:

 

•                  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 assets other than intangibles, thedetermination of whether impairment has occurred is based on an estimate ofundiscounted future cash flows attributable to the assets at the store level,as compared to the carrying value of the assets.  Assumptions used in these cash flows are consistent with internalforecasts and consider current and future expected sales volumes and relatedoperating costs and any anticipated increases or declines based on expectedmarket conditions and local business environment factors. If a potentialimpairment is identified, the amount of the impairment loss recognized would bedetermined by estimating the fair value of the assets and recording a loss ifthe fair value was less than the book value. Fair value will be determinedbased on appraisal values assessed by third parties, if deemed necessary, orthe undiscounted future cash flows as determined above. For goodwill and otherintangibles, impairment to be recognized is measured as the amount by which thecarrying amount of the assets exceeds the fair value of the related assets.

 

Our assessment regarding the existence of impairmentfactors is based on market conditions and the operational performance of ourbusiness. Our review of factors present and the resulting appropriate carryingvalue of our goodwill, intangibles and other long-lived assets are subject tojudgments and estimates that management is required to make.

 

*SalesReturns*

 

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 the competitiveenvironment differ from our expectations.

 

*Creditsand 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 toin-stock inventory if the vendor subsequently lowers their wholesale price forsuch products) 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$2.3 million and $2.2 million in the six months ended June 30, 2003 and 2002,respectively, recorded as an offset to selling, general and administrativeexpense.  Price protection credits andvendor rebates are accounted for as a reduction of the cost of merchandiseinventory and are recorded at the time the credit or rebate is earned.  The effect of price protection credits andvendor rebates is recognized in the income statement at the time the relatedinventory is sold, as a reduction in cost of goods sold.

 

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**ResultsOf Operations**

 

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

 
|                                        |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|---------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                        |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Net sales                                   |   | 100.0                            | %      | 100.0                          | %      | 100.0 | % | 100.0 | % |
| Gross profit                                |   | 25.9                             | %      | 25.8                           | %      | 25.9 | % | 25.5 | % |
| Selling, general and administrative expense |   | 21.5                             | %      | 22.0                           | %      | 21.7 | % | 21.9 | % |
| Operating income                            |   | 4.4                              | %      | 3.8                            | %      | 4.2 | % | 3.6 | % |
| Interest expense, net                       |   | 1.0                              | %      | 1.2                            | %      | 1.0 | % | 1.2 | % |
| Income before income tax expense            |   | 3.4                              | %      | 2.6                            | %      | 3.2 | % | 2.4 | % |
| Income tax expense                          |   | 1.3                              | %      | 1.0                            | %      | 1.2 | % | 0.9 | % |
| Net income                                  |   | 2.1                              | %      | 1.6                            | %      | 2.0 | % | 1.5 | % |

 

**ThreeMonths Ended June 30, 2003 Compared to the Three Months Ended June 30, 2002**

 

Net sales increased to $291.6 million for the threemonths ended June 30, 2003, from $253.9 million for the comparable priorperiod, a 14.9% increase.  Net salesfrom retail stores totaled $231.2 million, an increase of $23.8 million, or11.5%. Sales from new stores contributed $12.9 million, or 54% of the increase.Comparable store sales increased 5%, which was in line with our expectations.Our management is presently anticipating comparable store sales growth of 5% to7% for the immediate future, although fluctuations will undoubtedly take placefrom period to period.  The foregoingstatement is a forward-looking statement and is subject to the qualificationsset forth below under “Forward-Looking Statements.”  Net sales from the direct response channel totaled $60.4 million,a $13.9 million increase from the second quarter of 2002.  This increase reflects the improvedperformance of catalog circulation strategies. Sales from the contact center,which represents sales placed via phone, live chat, mail and e-mail, increased16.6% to $28.7 million from $24.6 million for the three months ended June 30,2003 compared to 2002. Internet sales from orders placed over the Musician’sFriend and Giardinelli web sites increased 45.1% to $31.7 million from $21.9million for the same period last year. The web site growth reflects the recenttrend of our catalog customers’ preference in using the web to place theirorders, the success of web-based promotions and that the website includes amore complete inventory presentation than our catalog.

 

Gross profit for the threemonths ended June 30, 2003 compared to 2002 increased 15.6% to $75.6 millionfrom $65.4 million.  Gross profit as apercentage of net sales for the three months ended June 30, 2003 compared to2002 increased to 25.9% from 25.8%. Gross profit percentage for the retailstores decreased to 24.3% from 24.7% for the three months ended June 30, 2003.The decrease is due to the new costs associated with operating the distributioncenter (1.2% of sales) and higher freight costs associated with starting up thedistribution center (0.7% of sales), offset by improved selling margins.  The gross profit percentage for the directresponse division was 32.1% for the quarter compared to 30.3% in the secondquarter of 2002. The increase is due to a higher selling margin.

 

Selling, general andadministrative expenses for the three months ended June 30, 2003 compared to2002 increased 12.4% to $62.7 million from $55.8 million.  Selling, general and administrativeexpenses, as a percentage of sales, for the three months ended June 30, 2003compared to 2002 decreased to 21.5% from 22.0%. Selling, general andadministrative expenses for the retail stores in the second quarter were 21.5%of sales compared to 21.4% in last year’s second quarter. The increase is dueto higher corporate expenses related to our infrastructure build-out atAmerican Music (0.6% of sales), an increase in bad debt expense at AmericanMusic (0.1% of sales), higher credit card fees incurred for promotionalactivities (0.3% of sales), principally offset by the decrease in start-upcosts associated with our Guitar Center distribution center which we

 

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incurred prior to it becoming operational inthe third quarter of 2002.  Selling,general and administrative expenses for the direct response division were 21.5%of sales in the second quarter compared to 24.4% in the same period last year.The improvement is primarily due to savings in catalog and postage costs (1.3%of sales) and contract labor in the Kansas City warehouse (0.5% of sales), aswell as a reduction in telephone costs (0.2% of sales), travel & meetings(0.3% of sales) and bad debt expense (0.4% of sales).

 

Operating income increased from $9.6 million to $12.9million, or 34.0% for the three months ended June 30, 2003.  This increase reflects performance of theGuitar Center and Musician’s Friend businesses at or above expected levels,offset somewhat by continued spending on systems and infrastructure and certainmerchandising and operational challenges at the American Music stores resultingin an operating loss of approximately $1.5 million for these stores for thequarter.

 

Interest expense, net for the three months ended June30, 2003 and 2002 remained consistent at $3.0 million, which consisted ofhigher borrowings at lower interest rates. Although we issued $100 million of convertible notes during the quarter,the redemption of our Senior Notes was not completed until July 14, 2003.  Accordingly, during the third quarter wewill recognize a charge to interest expense in our income statement ofapproximately $2.0 million (approximately $1.2 million after-tax, or $0.05 perdiluted share) representing the redemption premium and the write-off ofdeferred financing costs associated with the retirement of the SeniorNotes.  This write-off of the redemptionpremium and deferred financing costs will roughly offset the benefit of lowerinterest rates in the third quarter and thus the full benefit of therefinancing will first be reflected in interest expense in the fourth quarterof this year.

 

In the three months ended June 30, 2003, a $3.8million provision for income taxes was recorded compared to $2.5 million forthe same period last year, both based on an annualized tax rate ofapproximately 38%, which is subject to ongoing review and evaluation bymanagement.

 

Net income for the three months ended June 30, 2003increased to $6.2 million from $4.1 million in the second quarter of 2002 as aresult of the combinations of factors described above.

### ** **

**SixMonths Ended June 30, 2003 Compared to the Six Months Ended June 30, 2002**

 

Net sales increased to $579.1 million for the sixmonths ended June 30, 2003, from $508.7 million for the comparable priorperiod, a 13.8% increase.  Net salesfrom retail stores totaled $458.8 million, an increase of $45.9 million, or11.1%. Sales from new stores contributed $26.5 million, or 58% of the increase.Comparable store sales increased 5%, which was in line with our expectations.Our management is presently anticipating comparable store sales growth of 5% to7% for the immediate future, although fluctuations will undoubtedly take placefrom period to period.  The foregoingstatement is a forward-looking statement and is subject to the qualificationsset forth below under “Forward-Looking Statements.”  Net sales from the direct response channel totaled $120.4million, a $24.5 million increase from the same period of 2002. This increasereflects the improved performance of catalog circulation strategies. Sales fromthe contact center, which represents sales placed via phone, live chat, mailand e-mail, increased 10.3% to $57.4 million from $52.0 million for the sixmonths ended June 30, 2003 compared to 2002. Internet sales from orders placedover the Musician’s Friend and Giardinelli web sites increased 43.8% to $63.0million from $43.8 million for the same period last year. The web site growthreflects the recent trend of our catalog customers’ preference in using the webto place their orders, the success of web-based promotions and that the websiteincludes a more complete inventory presentation than our catalog.

 

Gross profit for the sixmonths ended June 30, 2003 compared to 2002 increased 16.0% to $150.2 millionfrom $129.5 million.  Gross profit as apercentage of net sales for the six months ended June 30, 2003 compared to 2002increased to 25.9% from 25.5%. Gross profit percentage for the retail storesdecreased to 24.4% from 24.7% for the six months ended June 30, 2003.  The decrease is due to an increase indistribution center expenses (1.3% of sales) and an increase in freightexpenses of (0.3% of sales), offset by improved selling margins. The grossprofit percentage for the direct response division was 31.7% for the six monthscompared to 29.0% in the same period of 2002. The increase is due to a higherselling margin. The categories contributing to better margin are percussion,recording, live sound, and B&O.

 

Selling, general and administrative expenses for thesix months ended June 30, 2003 compared to 2002 increased 13.0% to $125.7million from $111.2 million.  Selling,general and administrative expenses, as a percentage of sales, for the sixmonths ended June 30, 2003 compared to 2002 decreased to 21.7% from 21.9%.Selling, general and administrative expenses for the retail stores for the sixmonths were

 

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21.6% of sales compared to 21.4% in the prior year.  The increase was due to increasedpromotional expenses (0.1% of sales), higher corporate expenses related to ourinfrastructure build-out at American Music (0.5% of sales), an increase in baddebt expense at American Music (0.1% of sales), higher credit card fees incurredfor promotional activities (0.2% of sales), principally offset by the decreasein start up costs associated with our distribution center which we incurredprior to it becoming operational in the third quarter of 2002.  Selling, general and administrative expensesfor the direct response division were 22.1% of sales for the six monthscompared to 23.9% in the same period last year. The improvement is primarilydue to a reduction in catalog and postage costs (1.0% of sales), telephonecosts (0.2% of sales), and reduced packing supply costs due to efficiencies atthe fulfillment center as a result of improvements to our “marry up” software(0.2% of sales).

 

Operating income increased from $18.3 million to $24.5million, or 34.0% for the six months ended June 30, 2003. This increasereflects performance of the Guitar Center and Musician's Friend businesses ator above expected levels, offset somewhat by continued spending on systems andinfrastructure and certain merchandising and operational challenges at theAmerican Music stores resulting in an operating loss of approximately $1.9million for these stores for the quarter.

 

Interest expense, net for the six months ended June30, 2003 decreased to $6.1 million from $6.2 million in the same period of2002, which consisted of higher borrowings at lower interest rates.

 

In the six months ended June 30, 2003, a $7.0 millionprovision for income taxes was recorded compared to $4.6 million for the sameperiod last year, both based on an annualized tax rate of approximately 38%,which is subject to ongoing review and evaluation by management.

 

Net income for the six months ended June 30, 2003increased to $11.4 million from $7.5 million in the same period of 2002 as aresult of the combinations of factors described above.

 

### **Liquidity andCapital Resources**

 

Our need for liquidity will arise primarily from thefunding of capital expenditures, working capital requirements and payments onour indebtedness, as well as possible acquisitions. We have historicallyfinanced our operations primarily through internally generated funds andborrowings under our credit facilities. As of June 30, 2003, we had $55.6million outstanding under the credit facility, excluding $2.5 millionoutstanding on letters of credit, and had available borrowings of $69.8million.

 

The credit facility permits borrowings up to $200million, subject to borrowing base limitations. 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.  A fee of 0.375% is assessed on the unusedportion of the credit facility. Borrowings bear interest at either the primerate plus an applicable margin rate (4.25% at June 30, 2003), or LIBOR plus anapplicable margin rate (2.77% at June 30, 2003), subject to a minimum interestrate of 4.0%. The applicable margin rate is based upon a quarterly calculationof average daily availability at the end of each fiscal quarter.  At June 30, 2003, we were subject to the minimuminterest rate of 4.0%. 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, makeinvestments or acquisitions, engage in transactions with affiliates and incurcapital expenditures, and also require that we satisfy specified financialrequirements including a tangible net worth test and a minimum availabilitytest.  Under the tangible net worthtest, we are required to maintain, as of each quarter end, a minimum level oftangible net worth which, under the agreement, is defined as stockholders’equity, less goodwill, plus $3.5 million (or $149.7 million at June 30,2003).  The minimum amounts required bythe agreement increase on a quarterly basis and are $118.0 million at June 30,2003, $122.0 million at September 30, 2003, $134.0 million at December 31, 2003and $155.0 million at March 31, 2004 and thereafter. The minimum availabilitytest requires that we maintain $10.0 million of reserved availability under theagreement based on its borrowing base limitations. The amount we disclose inour public reports from time to time as available to borrow under the agreement($69.8 million at June 30, 2003) is already reduced by this required reserveand thus represents a net amount available under the agreement.  The agreement also includes representationsand warranties which must be true each time we borrow funds under the creditfacility and affirmative covenants.  Thefull text of the contractual requirements imposed by this financing is setforth in the Amended and Restated Loan and Security Agreement, as amended,which has been filed with the Securities and Exchange Commission.  We were in compliance with such requirementsas of June 30, 2003.  Subject to limitedcure periods, the lenders under

 

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our credit facility may demand repayment of these borrowings prior tostated maturity upon the occurrence of specified events, including if we breachthe terms of the agreement, suffer a material adverse change, engage in achange in control transaction, suffer a significant adverse legal judgment,default on other significant obligations, or in the event of specified eventsof insolvency.  The credit agreementmatures in December 2005.

 

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 designatedperiod.  The final maturity of the notesis July 2013, although holders may require us to repurchase the notes at theirelection in July 2008, July 2010 or upon the occurrence of a change in control,in each case for a purchase price equal to the original principal amount plusaccrued interest.  We may call the notesfor redemption commencing in July 2006 subject to the payment of a redemptionpremium of 1.6% if redeemed prior to July 2007 and 0.8% if redeemed prior toJuly 2008 (thereafter there is no redemption premium).  The indenture governing the notes does notlimit our ability to incur indebtedness or otherwise substantively restrict theoperation of our business to any significant degree.  Subject to limited cure periods, the holders of the notes maydemand repayment of these borrowings prior to the stated maturity upon the occurrenceof specified events, including if we fail to pay interest or principal whendue, fail to satisfy our conversion obligation, if another obligation of ourshaving an outstanding principal amount in excess of $15 million is acceleratedprior to stated maturity and upon the occurrence of specified events ofinsolvency.

 

At June 30, 2003, we had completed the issuance of theconvertible notes and had called for redemption the remaining $66.7 million ofSenior Notes still outstanding, but the redemption of the Senior Notes had notbeen completed resulting in both issues of debt being outstanding on thebalance sheet date.  For a pro formapresentation of our June 30, 2003 balance sheet adjusted assuming that the redemptionof the Senior Notes actually took place as of June 30, please see Exhibit 99.2to our Current Report on Form 8-K dated July 29, 2003.

 

During 2002 we entered into master operating leaseagreements with General Electric Capital Corporation and US Bank to leaseequipment and other property primarily to support the operations of the newcentral distribution 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 to General Electric CapitalCorporation of $138,000 for a term of 36 months through September 1, 2005, andmonthly payments to US Bank of $48,000 for a term of 12 months through December28, 2003. The leases have options to extend through September 30, 2009 and December28, 2005, respectively.

 

The terms of our significant financing agreements,including those related to our credit facility, the convertible notes and theequipment lease facilities described above are not dependent on any change inour credit rating. We believe that the key company-specific factors affectingour ability to maintain our existing debt and lease financing relationships andto access such capital in the future are our present and expected levels ofprofitability and cash flow from operations, our working capital and fixedasset collateral bases, our expected level of capital expenditures, the levelof equity capital of the company relative to the level of debt obligations and,in the case of convertible instruments, the related perceived attractiveness ofan investment in our common stock. In addition, as noted above, our existingagreements include significant restrictions on future financings, includingamong others, limits on the amount of indebtedness that we may incur andwhether or not such indebtedness may be secured by any of our assets.

 

As is the case with most multi-unit retailers,substantially all of the real property used in our business is leased underoperating lease agreements.  Please see,Item 2. Properties, “—Disclosures About Contractual Obligations and CommercialCommitments” and Note 8 in our Annual Report on Form 10-K for the year endedDecember 31, 2002.

 

For the six months ended June 30, 2003, net cashprovided by operating activities was $2.8 million, which principally consistedof a decrease in accounts payable and accrued expenses, offset by cash incomefrom

 

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operations. Cash used in investing activities totaled $11.3 million,used for capital expenditures principally for our store expansion program. Cashprovided by financing activities totaled $75.5 million, which principallyconsisted of proceeds from the Senior Convertible Note offset by the paydown ofthe credit facility.

 

We intend to pursue an aggressive growth strategy byopening additional stores in new and existing markets. During the six monthsended June 30, 2003, we opened seven new Guitar Center stores. Each new largeformat Guitar Center store typically has required approximately $1.6 to $1.8million for gross inventory. Historically, our cost of capital improvements fora large format Guitar Center store has been approximately $850,000, consistingof leasehold improvements, fixtures and equipment. We incur higher costs insome geographic areas, particularly the Northeast and with respect to large,“flagship” stores such as those we plan to open in Manhattan andNashville.  We have developed smallerGuitar Center stores to build in secondary markets or sites that we do notbelieve will support our large format units. The first of these units wasopened in late 2000 and a total of 13 were opened as of June 30, 2003. Oursmall format stores have typically incurred approximately $560,000 in capitalexpenditures 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.

 

We started operations of our distribution center inthe Indianapolis, Indiana area to support our Guitar Center retail storeoperations in July 2002. We have entered into a 10-year agreement to lease thefacility and we also have entered into numerous additional commitmentsnecessary to support the operations of the facility. By the end of 2002, nearlyall products were flowing through the distribution facility, with the exceptionof special orders which will continue, for the most part, to be drop shipped toour stores. Migration from our former “drop-ship” model to a centralizeddistribution model is an important development in our operating strategy andhas required the allocation of significant financial and managerial resources.In accordance with generally accepted accounting principles, a portion of thecosts of operating this facility are absorbed into our Guitar Centermerchandise inventories and recognized as an element of cost of goods sold whenthe related inventory is sold. This can result in a slight decrease in reportedgross margin depending on our success in defraying these additional costs,although we also expect to realize efficiencies involving other costs such asselling, general and administrative and interest expense.

 

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 12 GuitarCenter stores in 2002 and 13 stores in 2001, and currently anticipate openingapproximately 14 to 16 Guitar Center stores in 2003. Some of these stores willbe smaller format units designed for secondary markets and two are expected to belarge, “flagship” stores. We opened a total of eight American Music stores in2002, five of the eight by acquisition of M&M Music, a band instrument andretail merchandise retailer.  For theremainder of 2003, we do not plan to open any additional American Music storesorganically, however we may identify acquisition opportunities.  We believe there exists a number ofacquisition opportunities in the relatively fragmented band instruments marketthat could be a good fit into our American Music platform.

 

We also believe there may be attractive opportunitiesto expand by selectively acquiring existing music products retailers or othercomplimentary businesses, if attractive opportunities can be identified. Whilewe cannot provide assurance that we will complete any further acquisitiontransactions, in the ordinary course of our business we investigate and engagein negotiations regarding such opportunities. Acquisitions will be financedwith drawings under our existing credit facilities, expansion of our creditfacilities, issuance of debt or equity securities, or a combination, dependingupon transaction size and market conditions, among other things.

 

Our additional capital resources and liquidity for2003 are presently expected to be primarily provided by net cash flow fromoperations and additional borrowings under our credit facility. Depending uponmarket conditions, we may also elect or be required to raise additional capitalin the form of common

 

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or preferred equity, debt or convertible securities for the purpose ofproviding additional capital to fund working capital needs or continued growthof our existing business, or to refinance our Senior Notes or other existingobligations. Any such financing activity will be dependent upon many factors,including our liquidity needs, market conditions and prevailing market terms,and we cannot assure you that future external financing for us will beavailable on attractive terms or at all.

 

### **New AccountingPronouncements**

 

In August 2001, the Financial Accounting StandardsBoard issued Statement No. 143, “*Accountingfor Asset Retirement Obligations” (SFAS No. 143).* This newpronouncement establishes financial accounting and reporting standards forobligations associated with the retirement of tangible long-lived assets andthe associated asset retirement costs. The provisions of SFAS No. 143 apply to legal obligations associatedwith the retirement of long-lived assets that result from the acquisition,construction, development and/or the normal operation of a long-lived asset,except for obligations of lessees. The standard was effective for financialstatements issued for fiscal years beginning after June 15, 2002.  We adopted this standard effective January1, 2003, and it did not have a material effect on our consolidated financialstatements.

 

In January 2003, the Financial Accounting StandardsBoard issued FASB Interpretation No. 46, “*Consolidation of Variable Interest Entities*”(*FIN 46*).  This interpretation clarifies theapplication of Accounting Research Bulletin No. 51, “*Consolidated Financial Statements*”(*ARB 51*),and requires companies to evaluate variable interest entities for specificcharacteristics to determine whether additional consolidation and disclosurerequirements apply.  This interpretationis immediately applicable for variable interest entities created after January31, 2003, and applies to fiscal periods beginning after June 15, 2003 forvariable interest entities acquired prior to February 1, 2003. The adoption ofthis interpretation did not have any impact on our financial position orresults of operations.

 

EITF Issue No. 02-16, *“Accounting by a Reseller for CashConsideration Received from a Vendor,”* provides that cashconsideration received from a vendor is presumed to be a reduction of theprices of the vendor’s products or services and should, therefore, becharacterized as a reduction in cost of sales unless it is a payment for assetsor services delivered to the vendor, in which case the cash considerationshould be characterized as revenue, or unless it is a reimbursement of costsincurred to sell the vendor’s products, in which case the cash considerationshould be characterized as a reduction of that cost.  EITF No. 02-16 became effective for us in the first quarterof 2003, and had no impact on our financial statements, as we have historicallyaccounted for vendor payments in accordance with the provisions of thisstandard.

 

In December 2002, the FASB issued SFAS No. 148 *“Accountingfor Stock-Based Compensation-Transition and Disclosure,”* anamendment of FASB Statement No. 123, which provides guidance for transition tothe fair value based method of accounting for stock-based employee compensationand the required financial statement disclosure. The adoption of SFAS No. 148expanded the disclosure in our interim financial statements, and is notexpected to impact our annual disclosure of stock-based compensation.  See Note 5 to the interim financialstatements.

 

### **Seasonality**

 

Our operating results are not highly seasonal, exceptfor the effect of the holiday selling season in November and December.  Sales in the fourth quarter are typicallysignificantly higher on a per store basis and through the direct response unitthan in any other quarter.

 

### **Inflation**

 

We believe that the relatively moderate rates ofinflation experienced in recent years have not had a significant impact on ournet sales or profitability.

 

### **Forward-LookingStatements**

 

This report contains forward-looking statements relatingto, among other things, future results of operations, growth and investmentplans, sales, trends in gross margin, growth in the Internet business and

 

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other factors affecting growth in sales and earnings.  Specific forward-looking statements areprovided regarding our management’s current views regarding comparable storesales, new store openings and capital expenditure levels.  Statements regarding new store openings arebased largely on our current expectations and are necessarily subject toassociated business risks related to, among other things, the identification ofsuitable sites or acquisition opportunities, the timely construction, staffingand merchandising of those stores and other matters, some of which are outsideof 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.  TheAmerican Music business was only recently acquired by us and has in the pastand may in the future given rise to significant fluctuations from period toperiod as we integrate these activities with the other Guitar Centerbusinesses, reformat their store model and build-out the information technologyand management structure.

 

Sales and earnings trends are also affected by manyother factors including, among others, world and national political events,general economic conditions, which recently have been weak, particularly interms of consumer demand and general retail sales, the effectiveness of ourpromotion and merchandising strategies, changes in the music products industry,retail sales trends and the emergence of new or growing specialty retailers ofmusic products.  In light of theserisks, there can be no assurance that the forward-looking statements containedin this report will in fact be realized. The statements made by us in this report represent our views as of thedate of this report, and it should not be assumed that the statements madeherein remain accurate as of any future date. We do not presently intend to update these statements and undertake noduty to any person 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.”

 

All forward-looking statements are provided in expressreliance on the safe harbor provisions contained in Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.

 

**RisksRelated 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 existing locations.  As of June 30, 2003, we operated 115 GuitarCenter stores and 19 American Music stores. We opened a total of 12 Guitar Center stores in 2002, and currentlyexpect to open approximately 14 to 16 additional Guitar Center stores in2003.  Some of these Guitar Centerstores will be smaller format units designed for secondary markets, and two areexpected to be large, “flagship” stores.

 

We opened a total of eight American Music stores in2002, five of which were acquired in connection with American Music’sacquisition of M&M Music, a band instrument retailer.  For the remainder of 2003, we do not plan toopen any additional American Music stores organically, however we may identifyacquisition opportunities.  We believethere exists a number of acquisition opportunities in the relatively fragmentedband instruments market that could be a good fit into our American Musicplatform.

 

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

 

•                  identificationof suitable retail sites and appropriate acquisition candidates;

 

•                  negotiationof acceptable lease terms;

 

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•                  hiring,training and retention of skilled personnel;

 

•                  availabilityof adequate capital;

 

•                  sufficientmanagement and financial resources to support the new locations;

 

•                  vendorsupport; and

 

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

 

A number of these factors are, to a significantextent, beyond our control. As a result, we do not know whether we will be ableto continue to open and/or acquire additional Guitar Center and American Musicstores at the rates currently anticipated. If we are unable to achieve ourretail store expansion goals, or the new stores underperform our expectations,our results of operations could be adversely affected.

 

*We faceunique competitive and merchandising challenges in connection with our plans toopen additional Guitar Center and American Music retail stores in new markets.*

 

As part of our retail growth strategy, we plan to openand/or acquire additional Guitar Center and American Music stores in newmarkets. 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;

 

•                  managementof stores in distant locations;

 

•                  availabilityof desirable product lines; and

 

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

 

Any of these factors may lead to a shortfall inrevenues or an increase in costs with respect to the operation of thesestores.  If we are not able to operatethese stores profitably, our results of operations would be adversely affected.

 

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

 

Historically, we have achieved significant salesgrowth in existing stores. Our quarterly comparable store sales results havefluctuated significantly in the past. Sales growth for comparable periods, excluding net sales attributable tostores not open for 13 months, was as follows for our retail stores:

 
|      |   | **2003** |   | **2002** |   | **2001** |   | **2000** |   |
|-----------|--------|----------|--------|----------|--------|----------|--------|----------|--------|
| Quarter 1 |   | 4        | %      | 5        | %      | 7        | %      | 8        | %      |
| Quarter 2 |   | 5        | %      | 8        | %      | 5        | %      | 7        | %      |
| Quarter 3 |   | —   | %      | 5        | %      | 3        | %      | 6        | %      |
| Quarter 4 |   | —   | %      | 7        | %      | 6        | %      | 7        | %      |
|      |   |     |   |     |   |     |   |     |   |
| Full Year |   | —   | %      | 6        | %      | 6        | %      | 7        | %      |

 

We do not know whether our new stores will achievesales or profitability levels similar to our existing stores. Our expansionstrategy includes clustering stores in existing markets. Clustering has in the

 

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past and may in the future result in the transfer of sales to the newstore and a reduction in the profitability of an existing store. In addition, avariety of factors affect our comparable store sales results, including:

 

•                  competition;

 

•                  economicconditions, including  in particular,discretionary consumer spending;

 

•                  consumerand music trends;

 

•                  changesin our merchandise mix;

 

•                  productdistribution; and

 

•                  timingand effectiveness of our promotional events.

 

Our management is presently planning for annualcomparable store sales growth of 5% to 7% for the immediate future, althoughfluctuations will undoubtedly take place from period to period. This rate wasnot reached in the first quarter of 2003. A shortfall in comparative salesgrowth in any period will likely cause a shortfall in earnings, and result infinancial performance below that for which we have planned or the investmentcommunity expects.

 

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

 

We believe that our expansion may be accelerated bythe acquisition of existing music product retailers. For example, in April 2001we acquired the business of American Music Group, a New York-based retailer ofband instruments, a business in which we were not previously engaged. Ourgrowth plans for the American Music business contemplate a significant number ofrelatively small acquisitions. For example, in June 2002 American Musicacquired M&M Music, a band instrument retailer. We also regularlyinvestigate acquisition opportunities complimentary to our Guitar Center andMusician’s Friend businesses. Accordingly, in the ordinary course of ourbusiness, we regularly consider, evaluate and enter into negotiations relatedto potential acquisition opportunities. We may pay for these acquisitions incash or securities, including equity securities, or a combination of both. Wecannot assure you that attractive acquisition targets will be available atreasonable prices or that we will be successful in any such transaction.  Acquisitions involve a number of specialrisks, including:

 

•                  diversionof our management’s attention;

 

•                  integrationof the acquired business with our business; and

 

•                  unanticipatedlegal liabilities and other circumstances or events.

 

*We depend on a relatively smallnumber of manufacturers and suppliers who may not be able or desire to supplyour requirements.*

 

Brand recognition is of significant importance in theretail music products business. As a result, we depend on a relatively smallnumber of manufacturers and suppliers for both our existing stores and thedirect response unit as well as our expansion goals for each of these units. Wedo not have any long-term contracts with our suppliers, and any failure tomaintain our relationships with our key brand name vendors would have amaterial adverse effect on our business. A number of the manufacturers of theproducts we sell are limited in size and manufacturing capacity and havesignificant capital or other constraints. These manufacturers may not be ableor willing to meet our increasing requirements for inventory, and we cannotassure you that sufficient quantities or the appropriate mix of products willbe available in the future to supply our existing stores and expansion plans.These capacity restraints could lead to extended lead times and shortages ofdesirable products. The risk is especially prevalent in new markets where ourvendors have existing agreements with other dealers and thereby may beunwilling or unable for contractual or other reasons to meet our requirements.The efficient operation of our new distribution center for the Guitar Centerstores is also highly dependent upon compliance by our vendors with preciserequirements as to the timing, format and composition of shipments, which inmany instances requires changes and upgrades to the operational procedures andlogistics and supply chain management capabilities of vendors, all of which areoutside of our control. Additionally, many of our vendors receive product fromoverseas and depend on

 

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an extensive supply chain including common carriers to transportmerchandise into the country. We also rely on common carriers to transportproduct from our vendors to our central distribution center in Indiana, andfrom the distribution facility to our Guitar Center stores. Any disruption inthe services of common carriers due to employee strikes or other unforeseenevents could impact our ability to maintain sufficient quantities of inventoryin our retail locations.  In addition,the recent outbreak of severe acute respiratory syndrome, or SARS, in Asiacould have an adverse effect on our ability to source manufacturers or receivetimely shipments of certain of our products and could result in delayedshipments and have an adverse effect on our business.

 

*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 othercompetitive advantages as compared to our company. Our expansion to new marketswill be inhibited by these and other established competitors. In addition, oneor more of our competitors may adopt a new, innovative store format or retailselling method. If we are not able to compete effectively, we may fail toachieve market position gains or may lose market share.

 

*We mustefficiently integrate American Music and grow its band instrument business inorder to earn an acceptable 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 new managementinformation systems at American Music, which has proven to be a challengingproject requiring more time and resources than originally anticipated. Thisimplementation is an important project to facilitate further integrating ofAmerican Music with our other businesses and to provide a systems backbone topermit growth of this division. In addition, in 2002 we started marketingthrough the American Music stores some Guitar Center products not previouslycarried by American Music. This change in merchandising strategy from thehistoric focus of American Music on band instruments is in process and is animportant element of our family music store concept for this brand.  This remerchandising strategy is not yetproven.  Failure to execute on therequirements and initiatives described above could result in a poor or noreturn on our investment, constitute a distraction of the efforts of our managementteam from the core Guitar Center and Musician’s Friend brands and potentiallyrequire us to recognize an impairment in the significant amount of goodwillrecorded in the acquisitions of American Music and M&M Music.

 

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

 

Our success depends to asignificant extent on the services of Larry Thomas, our Chairman and Co-CEO,Marty Albertson, our President and Co-CEO, Robert Eastman, the CEO of our wholly-ownedsubsidiary, Musician’s Friend, Inc., and David Fleming, President andChief Operating Officer of American Music,as well as our ability to attract and retain additional key personnel with theskills necessary to manage our existing business and growth plans. 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. During 2001, we entered into a five-year employment contract witheach of Mr. Thomas and Mr. Albertson. 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 promote existing personnel to seniormanagement, and we must attract and

 

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retain new personnel with the skills andexpertise to manage our business. If we cannot hire, retain and promotequalified personnel, our business, results of operations, financial conditionand prospects could be adversely affected.

 

*Theimplementation of our new distribution center for the Guitar Center retailstores presents operational risks and represents a significant investment.*

 

During 2001, we began construction of a distribution center in theIndianapolis, Indiana area to support our Guitar Center retail storeoperations. The conveyor systems, the warehouse management system, and allother technology systems and infrastructure commenced operations in July 2002.Migration from our former “drop-ship” model to a centralized distribution modelis an important development in our operating strategy and will continue torequire significant financial and managerial resources for the next severalquarters. The efficient operation of the distribution center is also dependentupon the performance of third parties that we do not control, such as vendorswho must comply with new operating procedures and common carriers who must deliverproduct on time. This program involves financial and operating risks that couldinclude the need to expend greater funds than presently budgeted or disruptionsin retail store operations and the loss of sales if inventory is not timelyprovided in the required quantities. Further, one of the key underlyingeconomic assumptions of our distribution center project is that this programwill permit us to reduce overall inventory levels as a percentage of salesthereby resulting in significantly reduced working capital requirements. Anyfailure to reach our inventory reduction targets will adversely affect ourfuture financial performance and capital needs, potentially in a materialmanner. Failure to execute on these requirements could result in a poor or no returnon our investment, disruption of our retail store business and a distraction ofthe efforts of our management team.

 

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

 

As of December 31, 2002, our corporate headquarters aswell as 22 of our 108 Guitar Center stores were located in California andstores located in that state generated 27.5% and 28.3% of our retail sales for2002 and 2001, respectively. Although we have opened and acquired stores inother areas of the United States, a significant percentage of our net sales andresults of operations will likely remain concentrated in California for theforeseeable future. As a result, our results of operations and financialcondition are heavily dependent upon general consumer trends and other generaleconomic conditions in California and are subject to other regional risks,including earthquakes. We do maintain earthquake insurance, but such policiescarry significant deductibles and other restrictions.

 

*Economicconditions or changing consumer 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. Recent weak economicconditions have created uncertainty as to the future direction of the economywhich is likely to continue to impact hobbyists and other general consumers whopurchase from Musician’s Friend and our American Music and Guitar Centerstores.  Although we attempt to stay informedof consumer preferences for musical products and accessories typically offeredfor sale in our stores, any sustained failure on our part to identify andrespond to trends would have a material adverse effect on our results ofoperations, financial condition, business and prospects.

 

*We mayneed to change the manner in which we conduct our business if governmentregulation or taxation imposes additional costs and adversely affects ourfinancial results.*

 

The adoption or modification oflaws or regulations, or revised interpretations of existing laws, relating tothe direct response industry could adversely affect the manner in which wecurrently conduct our catalog and e-commerce business and the results ofoperations of that unit. For example, laws related to the taxation of catalog,telephone and online commercial activity, including direct response sales,remain in flux. In addition, the growth and development of the market foronline commerce may lead to more stringent consumer protection laws, both inthe United States and abroad, that may impose additional burdens on us. Lawsand regulations directly applicable to communications or commerce over theInternet are becoming more prevalent. The law of the Internet, however, remainslargely unsettled, even in areas

 

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where there has been some legislative action. Itmay take years to determine whether and how existing laws such as thosegoverning intellectual property, consumer privacy, sales-based and othertaxation of e-commerce transactions and the like are interpreted and enforced.Any adverse change in any of these laws or in the enforcement, interpretationor scope of existing laws could have a material adverse effect on our resultsof operations, financial condition or prospects.

 

*We 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.

 

*Netsales of our e-commerce business could decrease if our online security measuresfail.*

 

Our relationships with our e-commerce customers may beadversely affected if the security measures that we use to protect theirpersonal information, such as credit card numbers, are ineffective.  If, as a result, we lose customers, our netsales could decrease. We rely on security and authentication technology that welicense from third parties. With this technology, we perform real-time creditcard authorization and verification with our bank. We cannot predict whetherevents or developments will result in a compromise or breach of the technologywe use to protect a customer’s personal information.  Furthermore, our servers may be vulnerable to computer viruses,physical or electronic break-ins and similar disruptions. We may need to expendsignificant additional capital and other resources to protect against asecurity breach or to alleviate problems caused by any breaches. We cannotassure that we can prevent all security breaches.

 

*If wedo not respond to rapid technological changes, our services could becomeobsolete and we could lose customers.*

 

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 our computer hardware and software systemsfor the efficient operation of our retail stores and direct response business.Our information systems provide our management with real-time inventory, salesand cost information that is essential to the operation of our business. Due toour number of stores, geographic diversity and other factors, we would beunable to generate this information in a timely

 

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and accurate manner in the event our hardware or software systems wereunavailable. These systems are vulnerable to damage or interruption from anumber of factors, including:

 

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

 

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

 

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 provide for our“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 event of a disaster, our directresponse business would most likely experience delays in processing andshipping orders until we executed our failure recovery plans.

 

In addition, we are in the process of upgrading someof our accounting systems.  Theseactivities will require higher than typical expenses for operations during theupgrade installation phase, and no assurance can be given that the upgrades andconversions will not cause disruption of our business or our financialreporting.

 

*The results of operations of ourDirect Response business could be materially adversely affected should thedistribution of catalogs and other direct mail become more costly or lesseffective*

 

# **OurDirect Response business, Musician’s Friend, relies on the United States PostalService to distribute its catalogs and other direct mail communications toconsumers. Should the United States Postal Service significantly tightensecurity guidelines or impose additional processes on mail to detect or respondto contamination, the expected result would be increased costs to shippers andlengthened delivery times, each of which will impose greater costs on us. Weare also concerned that some consumers may dispose of direct mail pieces, suchas catalogs, if fears of contamination in the mail system are heightened. Anytrend of this sort would reduce the number of catalogs in circulation, reduceresponse rates, raise costs and decrease margins.**

 

*Ourstock price could be volatile.*

 

The market price of our common stock has been subjectto significant fluctuations in response to our operating results and otherfactors, including announcements by our competitors, and those fluctuationswill likely continue in the future. In addition, the stock market in recentyears has experienced significant price and volume fluctuations that often havebeen unrelated or disproportionate to the operating performance of particularcompanies. These fluctuations, as well as a shortfall in sales or earningscompared to public market analysts’ expectations, changes in analysts’expectations, changes in analysts’ recommendations or projections, and generaleconomic and market conditions, may adversely affect the market price of ourcommon stock.

 

*Our actual operating results may differ significantly fromour projections.*

 

From time to time, we release projections regardingour future performance that represent our management’s estimates as of the dateof release. These projections, which are forward looking-statements, areprepared by our management and are qualified by, and subject to, theassumptions and the other information contained in the release. Our projectionsare not prepared with a view toward compliance with published guidelines of theAmerican Institute of Certified Public Accountants, and neither our independentpublic accountants nor any other independent expert or outside party compilesor examines the projections and, accordingly, no such person expresses anyopinion or any other form of assurance with respect thereto.

 

Projections are based upon a number of assumptions andestimates that, while presented with numerical specificity, are inherentlysubject to significant business, economic and competitive uncertainties

 

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and contingencies, many of which are beyond our control and are basedupon specific assumptions with respect to future business decisions, some ofwhich will change. We generally state possible outcomes as high and low rangeswhich are intended to provide a sensitivity analysis as variables are changedbut are not intended to represent that actual results could not fall outside ofthe suggested ranges.  The principalreason that we release this data is to provide a basis for our management todiscuss our business outlook with analysts and investors. We do not accept anyresponsibility for any projections or reports published by any such persons.

 

Projections are necessarily speculative in nature, andit can be expected that some or all of the assumptions of the projectionsfurnished by us will not materialize or will vary significantly from actualresults. Accordingly, our projections are only an estimate of what managementbelieves is realizable as of the date of release. Actual results will vary fromthe projections and the variations may be material.  Investors should also recognize that the reliability of anyforecasted financial data diminishes the farther in the future that the data isprojected. In light of the foregoing, investors are urged to put theprojections in context and not to place undue reliance on them.

 

Any failure to successfully implement our operatingstrategy or the occurrence of any of the events or circumstances set forth inthis report could result in the actual operating results being different thanthe projections, and such differences may 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 $100.0 million principal amount of SeniorConvertible Notes due 2013 with a fixed interest rate of 4% (subject tocontingent interest) and our credit facility which has a variable rate ofinterest generally consisting of stated premiums above the London InterbankOffered Rate, or LIBOR.  At June 30,2003, we had $55.6 million outstanding under our credit facility.  To the extent prevailing short-term interestrates fluctuate the interest expense we incur on our credit facility willchange with a resulting effect (positive or negative) on our financialposition, results of operations and cash flows.  However, based on the balances outstanding under our creditfacility at June 30, 2003, such a fluctuation would have to be relativelysignificant to have a material financial impact on us.  We do not use derivative financialinstruments in our investment portfolio. We do not carry significant cash balances, except for the cash on handrelated to the proceeds from the Senior Convertible Notes which wassubsequently used to pay off the 11% Senior Notes.  Generally, any cash in excess of our daily operating needs is usedto reduce our borrowings.

 

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

 

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in ourExchange Act reports is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to ourmanagement, including our Co-Chief Executive Officers and Chief FinancialOfficer, as appropriate, to allow for timely decisions regarding requireddisclosure. In designing and evaluating the disclosure controls and procedures,management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving thedesired control objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

 

As required by SEC Rule 13a-15(b), we carried out anevaluation, under the supervision and with the participation of our management,including our Co-Chief Executive Officers and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the quarter covered by this report.  Based onthe foregoing, our Co-Chief Executive Officers and Chief Financial Officerconcluded that our disclosure controls and procedures were effective at thereasonable assurance level.

 

There has been no change in our internal controls overfinancial reporting during our most recent fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, our internal controlsover financial reporting.

 

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

 

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

 

Information regarding our annual meeting ofstockholders held April 30, 2003 was previously provided in our QuarterlyReport on Form 10-Q for the quarter ended March 31, 2003.

 

**Item 6.****                                                        Exhibitsand Reports on Form 8-K**

 

(a)                                  Exhibits:

 

4.4                                 Formof Officer’s Certificate pursuant to Section 2.02 of the Indenture governingthe Senior Convertible Notes due 2013 (incorporated by reference to Exhibit 4.1to the Company’s Current Report on Form 8-K dated June 13, 2003).

 

4.5                                 Formof Global Note relating to the Senior Convertible Notes due 2013 (incorporatedby reference to Exhibit 4.2 to the Company’s Current Report on Form 8-K datedJune 13, 2003).

 

10.41                     Amendment to Commercial Lease byand between CarrAmerica Realty, LP as lessor and Musician’s Friend, Inc. aslessee relating to 180 West ElectionRoad, Suite #100, Draper, Utah 84020.

 

10.42                     Consent and Amendment, dated as ofJune 9, 2003, by and among, Wells Fargo Retail Finance, LLC, as the arrangerand administrative agent, the lenders named therein, and Guitar Center, Inc.,Guitar Center Stores, Inc. and Musician’s Friend, Inc., as borrowers.

 

31                                    Certificationsof the Company’s Co-Chief Executive Officers and Chief Financial Officerpursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

32                                    Certificationsof the Company’s Co-Chief Executive Officers and Chief Financial Officerpursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

(b)                                 Reportson Form 8-K:

 

We filed a Current Report on Form 8-K on April 24,2003 disclosing, under caption of Items 5 and 9, revenue and related financialinformation for the quarter ended March 31, 2003.

 

We filed a Current Report on Form 8-K on June 10, 2003disclosing, under caption of Items 5 and 7, earnings guidance for the quarterended June 30, 2003.

 

We filed a Current Report on Form 8-K on June 12, 2003disclosing, under caption of Item 7, specified documentation related to theissuance of Senior Convertible Notes.

 

We filed a Current Report on Form 8-K on June 13, 2003disclosing, under caption of Item 7, specified documentation related to theissuance of Senior Convertible Notes.

 

 

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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 8th day ofAugust 2003.

 
|   |   | 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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