**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 September  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 itsCharter)

 

| **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 November 10, 2003, 23,814,053 shares of our Common Stock, $.01par value, were outstanding.

 

 

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**GuitarCenter, Inc. and subsidiaries**

 

#### INDEX

 
| Part I.      | Financial Information                                                                                          |   |
|--------------|----------------------------------------------------------------------------------------------------------------|--------|
|         |                                                                                                           |   |
|         | **Item 1.  Consolidated Financial Statements (Unaudited)**                                                     |   |
|         |                                                                                                           |   |
|         | Consolidated Balance Sheets – September 30, 2003 and December 31,  2002                                   | 3      |
|         |                                                                                                           |   |
|         | Consolidated Statements of Income – Three  months ended September 30, 2003 and 2002                       | 4      |
|         |                                                                                                           |   |
|         | Consolidated Statements of Income – Nine months ended September 30,  2003 and 2002                        | 5      |
|         |                                                                                                           |   |
|         | Consolidated Statements of Cash Flows –  Nine months ended September 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**                                                                                          | **27** |
|         |                                                                                                           |   |
|         | **Item 6.   Exhibits**                                                                                    |   |

 

2

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**GuitarCenter, Inc. and subsidiaries**

# **ConsolidatedBalance Sheets**

(In thousands, except per share amounts)

(Unaudited)

 
|                                                                                                                                               |   | **September 30,****2003** |    | **December 31,  2002** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------|---------|------------------------|--------|
|                                                                                                                                               |   |                      |    |                   |   |
| **Assets**                                                                                                                                         |   |                      |    |                   |   |
| Current  assets:                                                                                                                                   |   |                      |    |                   |   |
| Cash                                                                                                                                               |   | $                         | 4,701   |                   | $      | 5,931 |   |
| Accounts  receivable, net                                                                                                                          |   | 19,103                    |    | 19,762                 |   |
| Merchandise  inventories                                                                                                                           |   | 290,610                   |    | 292,075                |   |
| Prepaid  expenses and deposits                                                                                                                     |   | 9,354                     |    | 8,626                  |   |
| Deferred  income taxes                                                                                                                             |   | 6,077                     |    | 6,077                  |   |
| Total current  assets                                                                                                                              |   | 329,845                   |    | 332,471                |   |
|                                                                                                                                               |   |                      |    |                   |   |
| Property and  equipment, net                                                                                                                       |   | 91,509                    |    | 89,702                 |   |
| Goodwill                                                                                                                                           |   | 25,995                    |    | 25,995                 |   |
| Deposits and  other assets, net                                                                                                                    |   | 6,468                     |    | 4,231                  |   |
|                                                                                                                                               |   | $                         | 453,817 |                   | $      | 452,399 |   |
|                                                                                                                                               |   |                      |    |                   |   |
| **Liabilities and  stockholders’ equity**                                                                                                     |   |                      |    |                   |   |
| Current  liabilities:                                                                                                                              |   |                      |    |                   |   |
| Accounts  payable                                                                                                                                  |   | $                         | 52,863  |                   | $      | 70,745 |   |
| Accrued  expenses and other current liabilities                                                                                                    |   | 51,164                    |    | 54,211                 |   |
| Merchandise advances                                                                                                                               |   | 13,196                    |    | 13,882                 |   |
| Revolving line  of credit                                                                                                                          |   | 42,345                    |    | 82,690                 |   |
| Current  portion of long-term debt                                                                                                                 |   | —                    |    | 118                    |   |
| Total current  liabilities                                                                                                                         |   | 159,568                   |    | 221,646                |   |
|                                                                                                                                               |   |                      |    |                   |   |
| Other  long-term liabilities                                                                                                                       |   | 5,923                     |    | 5,691                  |   |
| Deferred  income taxes                                                                                                                             |   | 3,352                     |    | 3,352                  |   |
| Long-term debt                                                                                                                                     |   | 100,000                   |    | 66,782                 |   |
| Total  liabilities                                                                                                                                 |   | 268,843                   |    | 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  23,625  at September 30, 2003 and 22,746 at  December 31, 2002 |   | 236                       |    | 227                    |   |
| Additional  paid in capital                                                                                                                        |   | 266,692                   |    | 253,863                |   |
| Accumulated  deficit                                                                                                                               |   | (81,954                   | )       | (99,162                | )      |
| Net  stockholders’ equity                                                                                                                     |   | 184,974                   |    | 154,928                |   |
|                                                                                                                                               |   | $                         | 453,817 |                   | $      | 452,399 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

3

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**GuitarCenter, Inc. and subsidiaries**

# **ConsolidatedStatements of Income**

(In thousands, except per share data)

(Unaudited)

 
|                                          |   | **Three months ended September 30,** |       |
|-----------------------------------------------|--------|--------------------------------------|------------|
|                                          |   | **2003**                             |       | **2002** |   |
|                                          |   |                                 | ** ** |   | ** ** |
| Net sales                                     |   | $                                    | 300,112    |   | $ | 257,356 |   |
| Cost of goods  sold, buying and occupancy     |   | 220,261                              |       | 191,258 |   |
| Gross profit                                  |   | 79,851                               |       | 66,098 |   |
|                                          |   |                                 |       |   |   |
| Selling,  general and administrative expenses |   | 66,182                               |       | 55,662 |   |
| Operating  income                             |   | 13,669                               |       | 10,436 |   |
|                                          |   |                                 |       |   |   |
| Interest  expense, net                        |   | 4,335                                |       | 3,393 |   |
|                                          |   |                                 |       |   |   |
| Income before  income taxes                   |   | 9,334                                |       | 7,043 |   |
|                                          |   |                                 |       |   |   |
| Income taxes                                  |   | 3,553                                |       | 2,681 |   |
|                                          |   |                                 |       |   |   |
| Net income                                    |   | $                                    | 5,781      |   | $ | 4,362 |   |
|                                          |   |                                 |       |   |   |
| Net income per  share                         |   |                                 |       |   |   |
| Basic                                         |   | $                                    | 0.25       |   | $ | 0.19 |   |
| Diluted                                       |   | $                                    | 0.23       |   | $ | 0.19 |   |
|                                          |   |                                 |       |   |   |
| Weighted  average shares outstanding          |   |                                 |       |   |   |
| Basic                                         |   | 23,430                               |       | 22,810 |   |
| Diluted                                       |   | 24,944                               |       | 23,388 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

4

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**GuitarCenter, Inc. and subsidiaries**

# **ConsolidatedStatements of Inco**me

(In thousands, except per share data)

(Unaudited)

 
|                                          |   | **Nine months ended September 30,** |       |
|-----------------------------------------------|--------|-------------------------------------|------------|
|                                          |   | **2003**                            |       | **2002** |   |
|                                          |   |                                | ** ** |   | ** ** |
| Net sales                                     |   | $                                   | 879,254    |   | $ | 766,066 |   |
| Cost of goods  sold, buying and occupancy     |   | 649,197                             |       | 570,432 |   |
| Gross profit                                  |   | 230,057                             |       | 195,634 |   |
|                                          |   |                                |       |   |   |
| Selling,  general and administrative expenses |   | 191,846                             |       | 166,866 |   |
| Operating  income                             |   | 38,211                              |       | 28,768 |   |
|                                          |   |                                |       |   |   |
| Interest  expense, net                        |   | 10,430                              |       | 9,556 |   |
|                                          |   |                                |       |   |   |
| Income before  income taxes                   |   | 27,781                              |       | 19,212 |   |
|                                          |   |                                |       |   |   |
| Income taxes                                  |   | 10,573                              |       | 7,312 |   |
|                                          |   |                                |       |   |   |
| Net income                                    |   | $                                   | 17,208     |   | $ | 11,900 |   |
|                                          |   |                                |       |   |   |
| Net income per  share                         |   |                                |       |   |   |
| Basic                                         |   | $                                   | 0.75       |   | $ | 0.53 |   |
| Diluted                                       |   | $                                   | 0.71       |   | $ | 0.51 |   |
|                                          |   |                                |       |   |   |
| Weighted  average shares outstanding          |   |                                |       |   |   |
| Basic                                         |   | 23,075                              |       | 22,523 |   |
| Diluted                                       |   | 24,329                              |       | 23,133 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

5

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**GuitarCenter, Inc. and subsidiaries**

**ConsolidatedStatements of Cash Flows**

(In thousands)

(Unaudited)

 
|                                                                                         |   | **Nine months ended September 30,** |   |
|----------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|
|                                                                                         |   | **2003**                            |   | **2002** |   |
| **Operating  activities**                                                                    |   |                                |   |   |   |
| Net income                                                                                   |   | $                                   | 17,208 |   | $ | 11,900 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |   |                                |   |   |   |
| Depreciation and  amortization                                                               |   | 15,056                              |   | 12,167 |   |
| Amortization  of deferred financing fees                                                     |   | 650                                 |   | 496 |   |
| Write down of  deferred financing fees                                                       |   | 722                                 |   | — |   |
| Changes in  operating assets and liabilities:                                                |   |                                |   |   |   |
| Accounts  receivable, net                                                                    |   | 659                                 |   | 1,641 |   |
| Merchandise  inventories                                                                     |   | 1,485                               |   | (39,347 | ) |
| Prepaid  expenses and deposits                                                               |   | (728                                | )      | (3,728 | ) |
| Deposits and  other assets, net                                                              |   | (509                                | )      | (28 | ) |
| Accounts  payable                                                                            |   | (17,882                             | )      | (10,529 | ) |
| Accrued  expenses and other current liabilities                                              |   | (3,132                              | )      | (7,392 | ) |
| Merchandise  advances                                                                        |   | (686                                | )      | (129 | ) |
| Other long  term liabilities                                                                 |   | 232                                 |   | 1,829 |   |
| Net cash  provided by (used in) operating activities                                         |   | 13,075                              |   | (33,120 | ) |
|                                                                                         |   |                                |   |   |   |
| **Investing  activities**                                                                    |   |                                |   |   |   |
| Purchase of  property and equipment                                                          |   | (16,855                             | )      | (17,035 | ) |
| Acquisition of  businesses                                                                   |   | —                              |   | (5,932 | ) |
| Net cash used  in investing activities                                                       |   | (16,855                             | )      | (22,967 | ) |
|                                                                                         |   |                                |   |   |   |
| **Financing  activities**                                                                    |   |                                |   |   |   |
| Net change in  revolving line of credit                                                      |   | (40,345                             | )      | 41,683 |   |
| Proceeds from  exercise of stock options                                                     |   | 12,416                              |   | 1,427 |   |
| Proceeds from  stock issued under employee purchase plan                                     |   | 422                                 |   | 705 |   |
| Proceeds from  senior convertible note                                                       |   | 96,875                              |   | — |   |
| Payments for  senior note                                                                    |   | (66,667                             | )      | — |   |
| Payments under  capital lease                                                                |   | (151                                | )      | (688 | ) |
| Net cash  provided by financing activities                                                   |   | 2,550                               |   | 43,127 |   |
|                                                                                         |   |                                |   |   |   |
| Net decrease  in cash                                                                        |   | (1,230                              | )      | (12,960 | ) |
| Cash at  beginning of year                                                                   |   | 5,931                               |   | 17,480 |   |
|                                                                                         |   |                                |   |   |   |
| Cash at end of  period                                                                       |   | $                                   | 4,701  |   | $ | 4,520 |   |
|                                                                                         |   |                                |   |   |   |
| Non-cash activities                                                                          |   |                                |   |   |   |
| Acquisition of  businesses:                                                                  |   |                                |   |   |   |
| Fair value of  assets acquired                                                               |   |                                |   | $ | 4,774 |   |
| Liabilities  assumed                                                                         |   |                                |   | (1,515 | ) |
| Goodwill                                                                                     |   |                                |   | 5,021 |   |
| Common Stock  issued                                                                         |   |                                |   | (1,500 | ) |
| Debt incurred                                                                                |   |                                |   | (848 | ) |
| Cash paid for  acquisitions                                                                  |   |                                |   | $ | 5,932 |   |
| Cash acquired  in acquisitions                                                               |   |                                |   | — |   |
| Net cash paid  for acquisitions                                                              |   |                                |   | $ | 5,932 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

6

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**GuitarCenter, Inc. and subsidiaries**

**Notesto Consolidated Financial Statements**

 

1.                                       Natureof Business and Basis of Presentation

 

Nature of Business

 

Guitar Center, Inc., and subsidiaries (“Guitar Center,” the “Company,”“we,” “us” or “our”) is the nation’s leading retailer of guitars, amplifiers,percussion instruments, keyboards and pro-audio and recording equipment. As ofSeptember 30, 2003, our subsidiaries operated 119 Guitar Center retail stores,with 105 stores in 44 major markets and 14 stores in secondary markets acrossthe United States. In addition, our American Music division, which serves thestudent and family market, operated 19 stores as of September 30, 2003. Musician’sFriend, Inc., a wholly owned subsidiary of Guitar Center, Inc., is the largestdirect response retailer of musical instruments in the United States throughthe Musician’s Friend catalog and web site, www.musiciansfriend.com.

 

Basis of Presentation

 

In the opinion of management, the accompanying unaudited consolidatedfinancial statements contain all adjustments necessary to present fairly thefinancial position of Guitar Center, Inc. and subsidiaries as of September 30,2003 and December 31, 2002, and the results of operations and cash flows forthe three and nine months ended September 30, 2003 and 2002. The accompanyingconsolidated financial statements should be read in conjunction with theaudited consolidated financial statements and notes thereto contained in ourAnnual Report on Form 10-K for the year ended December 31, 2002.

 

The results of operations for the three and nine months ended September30, 2003 are not necessarily indicative of the results to be expected for thefull year.

 

2.                                       Acquisitions

 

In February 2002, we acquired the inventory and assumed the customercredit liabilities of Music Loft East, Inc., a single store located in Raleigh,North Carolina.  In connection with thepurchase we paid $488,000 in cash, acquired assets with a fair value of$369,000, and assumed liabilities of $146,000. Goodwill in the amount of $265,000 was recorded.

 

On June 14, 2002, we acquired M&M Music, a five-store bandinstrument retailer headquartered in Valdosta, Georgia. Under the terms of theagreement, we acquired the stock of M&M Music for total consideration of$6.0 million in cash and stock.  Weacquired assets with a fair value of $4.4 million and assumed liabilities andpaid expenses of $1.3 million. Goodwill in the amount of $2.9 million was recorded.Under the terms of the purchase agreement, during the second quarter of 2002 wepaid $3.6 million in cash and during the third quarter of 2002 we issued 90,602shares of Guitar Center stock, representing $1.5 million.  As part of the terms of the purchaseagreement, there was a $0.9 million holdback on the transaction, pending theM&M Music business meeting certain balance sheet requirements.  During the fourth quarter of 2002, it wasdetermined that the requirements subject to the holdback were satisfied and weissued an additional 54,360 shares of common stock in consideration for theremaining $0.9 million of the purchase price.

 

The results of operations and the assets of the Music Loft East, Inc.and M&M Music were not material to Guitar Center’s previously presentedconsolidated financial statements and, as such, pro-forma financial informationis not presented. The results of operations for each of these entities areincluded in Guitar Center’s consolidated financial statements from the dates ofthe acquisition.

 

Goodwill was recorded on Music Loft andM&M Music acquisitions in the amount of the total consideration paid inexcess of the fair value of the identifiable assets acquired.  In accordance with SFAS 142 we no longeramortize goodwill and intangible assets with an indefinite useful life on astated basis but rather do annual testing of the goodwill for impairment, withno charge to income except to the extent of any such impairment.

 

7

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3.                                       EarningsPer Share

 

The following table summarizes the reconciliation of Basic to DilutedWeighted Average Shares for the three and nine months ending September 30, 2003and 2002:

 
|                                                               |   | **For the  three months  ended September 30,** |   | **For the  nine months  ended September 30,** |   |
|--------------------------------------------------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                               |   | **2003**                                       |   | **2002**                                      |   | **2003** |   | **2002** |   |
|                                                               |   | **(in  thousands)**                            |   |
| Basic shares                                                       |   | 23,430                                         |   | 22,810                                        |   | 23,075 |   | 22,523 |   |
| Common stock equivalents - dilutive effect of  options outstanding |   | 1,514                                          |   | 578                                           |   | 1,254 |   | 610 |   |
| Diluted shares                                                     |   | 24,944                                         |   | 23,388                                        |   | 24,329 |   | 23,133 |   |

 

For the three and nine months ended September 30, 2003 and 2002, theonly common stock equivalents outstanding with the Company are stock options.For the quarter ended September 30, 2003, the 2.9 million shares of commonstock issuable upon conversion of the 4% Senior Convertible Notes issued inJune 2003 (reflecting an effective conversion price of $34.58) were not deemedto be common stock equivalents and thus not considered in the calculation ofearnings per share.  At such time thatthose notes become convertible (generally involving trading prices above $41.50per share for a specified period and designated corporate events), the securitywill be treated under the as-if converted method, whereby for earnings pershare purposes the 2.9 million conversion shares will be deemed outstanding andthe after-tax interest expense for the period will be added back to net income.For the three and nine months ended September 30, 2003, all options outstandinghad a dilutive effect.  During the threeand nine months ended September 30, 2002, options to purchase 702,000 sharesand 709,000 shares of Common Stock, respectively, at prices ranging from $19.24to $28.56, were outstanding but were not included in the computation of dilutedearnings per share because the exercise prices of these options were greaterthan the average market price of our Common Stock.

 

**4.**                                      **SegmentInformation**

 

For financial reporting purposes, we classify our business interestsinto two reportable segments, retail and direct response. The retail segmentincludes revenue and expense associated with our 119 Guitar Center and 19American Music retail locations. Our direct response segment consists ofMusician’s Friend. We evaluate segment performance based primarily on net salesand income before income taxes. Accounting policies of the segments are thesame as the accounting policies for the consolidated Company. There are nodifferences between the measurements of profits or losses or assets of thereportable segments and those of the Company on a consolidated basis.

 

Net sales, gross margin, depreciation and amortization, selling,general and administrative expense, income before income taxes and capitalexpenditures for the three and nine months ended September 30, 2003 and 2002and total assets as of September 30, 2003 and 2002 are summarized asfollows (in thousands):

 
|                                          |   | **Three  Months Ended September  30, 2003** |    | **Nine  Months Ended September  30, 2003** |   |
|-----------------------------------------------|--------|---------------------------------------------|---------|--------------------------------------------|--------|
|                                          |   | **Retail**                                  |    | **Direct  Response**                       |   | **Total** |   | **Retail** |   | **Direct  Response** |   | **Total** |   |
| Net sales                                     |   | $                                           | 241,114 |                                       | $      | 58,998 |   | $ | 300,112 |   | $ | 699,868 |   | $ | 179,386 |   | $ | 879,254 |   |
| Gross profit                                  |   | 60,787                                      |    | 19,064                                     |   | 79,851 |   | 172,841 |   | 57,216 |   | 230,057 |   |
| Depreciation  and amortization                |   | 4,438                                       |    | 656                                        |   | 5,094 |   | 13,043 |   | 2,013 |   | 15,056 |   |
| Selling,  general and administrative expenses |   | 53,467                                      |    | 12,715                                     |   | 66,182 |   | 152,485 |   | 39,361 |   | 191,846 |   |
| Income before  income taxes                   |   | 3,032                                       |    | 6,302                                      |   | 9,334 |   | 10,254 |   | 17,527 |   | 27,781 |   |
| Capital  expenditures                         |   | 5,087                                       |    | 485                                        |   | 5,572 |   | 15,520 |   | 1,335 |   | 16,855 |   |
| Total assets                                  |   | 415,010                                     |    | 38,807                                     |   | 453,817 |   | 415,010 |   | 38,807 |   | 453,817 |   |
|                                               |        |                                             |         |                                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

8

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|                                          |   | **Three  Months Ended September  30, 2002** |    | **Nine  Months Ended September  30, 2002** |   |
|-----------------------------------------------|--------|---------------------------------------------|---------|--------------------------------------------|--------|
|                                          |   | **Retail**                                  |    | **Direct  Response**                       |   | **Total** |   | **Retail** |   | **Direct  Response** |   | **Total** |   |
| Net sales                                     |   | $                                           | 210,506 |                                       | $      | 46,850 |   | $ | 257,356 |   | $ | 623,368 |   | $ | 142,698 |   | $ | 766,066 |   |
| Gross profit                                  |   | 52,421                                      |    | 13,677                                     |   | 66,098 |   | 154,208 |   | 41,426 |   | 195,634 |   |
| Depreciation  and amortization                |   | 3,726                                       |    | 498                                        |   | 4,224 |   | 10,747 |   | 1,420 |   | 12,167 |   |
| Selling,  general and administrative expenses |   | 44,763                                      |    | 10,899                                     |   | 55,662 |   | 133,052 |   | 33,814 |   | 166,866 |   |
| Income before  income taxes                   |   | 4,588                                       |    | 2,455                                      |   | 7,043 |   | 12,621 |   | 6,591 |   | 19,212 |   |
| Capital  expenditures                         |   | 2,403                                       |    | 977                                        |   | 3,380 |   | 15,090 |   | 1,945 |   | 17,035 |   |
| Total assets                                  |   | 407,142                                     |    | 40,345                                     |   | 447,487 |   | 407,142 |   | 40,345 |   | 447,487 |   |
|                                               |        |                                             |         |                                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

5.**                                      **Stock-BasedCompensation

 

InDecember 2002, the FASB issued S*tatement ofFinancial Accounting Standards* (“*SFAS*”) No. 148, *“Accounting for Stock-BasedCompensation - Transition and Disclosure.”*  SFAS No. 148 amendsSFAS No. 123, *“Accounting for Stock-Based Compensation,”* to providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation.  Inaddition, 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.

 

The provisions of SFAS No. 123,“*Accountingfor Stock-Based Compensation,”* permits entities to recognize as expense over the vesting periodthe fair value of all stock-based awards on the date of grant.  Alternatively, SFAS No. 123 also allowsentities to continue to apply the provisions of Accounting Principles Board (“*APB”*)Opinion No. 25 “*Accounting for Stock Issuedto**Compensation,”*and related interpretations and provide proforma net income and pro forma earnings per share disclosures for employeestock option grants made in or after 1995 as if the fair-value basedmethod defined in SFAS No. 123 had been applied.  We have elected to continue to apply the provisions of APBOpinion No. 25 and provide the pro forma disclosures required by SFAS No. 123.As such, compensation expense for stock options issued to employees is recordedon the date of grant only if the current market price of the underlying stockexceeds the exercise price.  Had wedetermined compensation cost based upon the fair value at the grant date forour stock options under SFAS No. 123 using the Black Scholes option pricingmodel, pro forma net income and pro forma net income per share, including thefollowing assumptions used in these calculations, would have been as follows(in thousands except per share data) :

 
|                                                                                                                                                 |   | **For the  three months  ended September 30,** |   | **For the  nine months  ended September 30,** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------|--------|-----------------------------------------------|--------|
|                                                                                                                                                 |   | **2003**                                       |   | **2002**                                      |   | **2003** |   | **2002** |   |
| Net income, as reported                                                                                                                              |   | 5,781                                          |   | 4,362                                         |   | 17,208 |   | 11,900 |   |
| Deduct:   Total stock-based employee compensation expense determined under fair  value based methods for all awards, net of related tax effects |   | 2,173                                          |   | 1,299                                         |   | 4,741 |   | 3,090 |   |
| Pro forma net income                                                                                                                                 |   | 3,608                                          |   | 3,063                                         |   | 12,467 |   | 8,810 |   |
|                                                                                                                                                 |   |                                           |   |                                          |   |   |   |   |   |
| Earnings per share:                                                                                                                                  |   |                                           |   |                                          |   |   |   |   |   |
| Basic - as reported                                                                                                                                  |   |                                           | 0.25   |                                          | 0.19   |   | 0.75 |   | 0.53 |   |
| Basic - pro forma                                                                                                                                    |   |                                           | 0.15   |                                          | 0.13   |   | 0.54 |   | 0.39 |   |
| Diluted - as reported                                                                                                                                |   |                                           | 0.23   |                                          | 0.19   |   | 0.71 |   | 0.51 |   |
| Diluted - pro forma                                                                                                                                  |   |                                           | 0.14   |                                          | 0.13   |   | 0.51 |   | 0.38 |   |
| Risk free interest rate                                                                                                                              |   |                                           | 3.7    | %                                             | 3.5    | % | 3.7 | % | 3.5 | % |
| Expected life of options                                                                                                                             |   |                                           | 6.41   |                                          | 6.46   |   | 6.41 |   | 6.46 |   |
| Expected volatility                                                                                                                                  |   |                                           | 63.1   | %                                             | 69.0   | % | 63.1 | % | 69.0 | % |
| Expected dividends                                                                                                                                   |   |                                           | — |                                          | — |   | — |   | — |   |

 

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6.                                       VendorPayments

 

EITF Issue No. 02-16, *“Accounting by a Reseller for Cash ConsiderationReceived from a Vendor,”* provides that cash consideration receivedfrom a vendor is presumed to be a reduction of the prices of the vendor’sproducts or services and should, therefore, be characterized as a reduction incost of sales unless it is a payment for assets or services delivered to thevendor, in which case the cash consideration should be characterized asrevenue, or unless it is a reimbursement of costs incurred to sell the vendor’sproducts, in which case the cash consideration should be characterized as areduction of that cost. EITF No. 02-16 became effective for us in thefirst quarter of 2003, and had no impact on our financial statements, as wehave historically accounted for vendor payments in accordance with theprovisions of this standard.

 

7.                                       ConvertibleNotes Offering

 

In June 2003, we issued $100million principal amount of 4% Senior Convertible Notes due 2013. We incurred$3.6 million of issuance costs which have been deferred and are being amortizedover five years on a straight-line basis. In July 2003, we used $67,889 of theproceeds to retire the $66,667 principal amount of 11% Senior Notes remainingoutstanding and pay the associated redemption premium of $1,222. In July 2003,we also wrote-off $762 of deferred financing costs attributed to the 11% SeniorNotes.  The redemption premium anddeferred financing costs were charged to our income statement in the quarterending September 30, 2003.

 

**Item 2****.****                                                          ****Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

**Overview**

 

We operated 119 Guitar Center retail locations as of September 30,2003, with 105 stores in 44 major markets and 14 stores in secondary marketsacross the United States. In addition, our American Music division, whichserves the student and family market, operated 19 stores as of September 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 annual compound growth rateof 22.5%, principally due to the comparable store sales growth of our retailstores averaging 8% per year, the opening of new stores, and a 27.9% per yearincrease in the direct response channel. We believe such volume increases arethe result of the continued success of the implementation of our businessstrategy, continued growth in the music products industry and increasingconsumer awareness of the Guitar Center, Musician’s Friend and American Musicbrand names. We do not expect total or comparable store sales to continue toincrease at historical rates, as Guitar Center already maintains operations inmost major domestic markets for our industry, and a higher percentage of ournew stores opened will be in secondary markets.  We expect that these secondary market stores will contributelower sales per store than historically achieved from our stores operating inmajor markets. When we refer to “comparable sales,” that calculation comparesnet sales for the comparable periods, excluding net sales attributable tostores not open for 13 months. All references in this report to comparablestore sales results are based on this calculation methodology. In any givenperiod, the set of stores comprising comparable stores may be different fromthe set of the comparable stores in the previous period, depending on whenstores were opened.  Other companies mayuse different methods to calculate this statistic.

 

We opened a total of 12 Guitar Center stores in 2002.  During the nine months ended September 30,2003, we have opened seven large format Guitar Center stores, those being inScottsdale, Arizona,

 

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Warwick, Rhode Island, Cerritos,California, Memphis, Tennessee, Tampa, Florida, Albany New York and Richmond,Virginia, as well as four small format stores in Gary, Indiana, Lakeland,Florida,  Fredericksburg, Virginia andHarrisburgh, Pennsylvania. We plan to open three stores in the fourth quarterof 2003, two very large “flagship” stores and one small format store. The“flagship” Guitar Center stores planned for the fourth quarter are located inManhattan and Nashville.  For theremainder of 2003, we do not plan to open any additional American Music storesorganically, however we may identify acquisition opportunities.  We will continue to pursue our strategy ofclustering stores in major markets to take advantage of operating andadvertising efficiencies and to build awareness of the Guitar Center andAmerican Music brand names in new markets. In some markets this clustering strategy results in some transfer ofsales from existing stores to new locations.

 

As we enternew markets, we expect that we will initially incur higher administrative andpromotional costs per store than is currently experienced in establishedmarkets.  We expect competition tocontinue to increase as other music product retailers attempt to executenational growth strategies.  Ourbusiness strategy will also emphasize opportunities to continue to grow each ofour businesses, including additional acquisitions if suitable candidates can belocated for reasonable prices.

 

### **Discussionof Critical Accounting Policies**

### ** **

In the ordinary course of our business, we have made a number ofestimates and assumptions relating to the reporting of results of operationsand financial condition in the preparation of our financial statements inconformity with accounting principles generally accepted in the United Statesof America. On an ongoing basis, we evaluate our estimates, including thoserelated to product returns, bad debt, inventories, goodwill and taxes onincome. 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 future events andsimilar matters that are inherently uncertain. Additionally, the policy described below regarding credits and other vendorallowances is unique to our industry and deserves the attention of a reader ofour financial statements.

 

*Valuation of Inventory*

 

We value ourinventories at the lower of cost or market using the first-in, first-out (FIFO)method.  Rental inventories are valuedat the lower of cost or market using the specific identification method and aredepreciated on a straight-line basis over the term of the associated rentalagreement for rent-to-own sales, or over the estimated useful life of therented instrument for rental only items. We record adjustments to the value of inventory based upon obsolescenceand changes in market value.  Applicablecosts associated with bringing inventory through our Guitar Center retaildistribution center are capitalized to inventory.  The amounts are expensed to cost of goods sold as the associatedinventory is sold.  Management hasevaluated the current level of inventories considering future customer demandfor our products, taking into account general economic conditions, growthprospects within the marketplace, competition, market acceptance of current andupcoming products, and management initiatives. Based on this evaluation, we have recorded impairment adjustments tocost of goods sold for estimated decreases in net realizable value.  These judgments are made in the context ofour customers’ shifting needs, product and technological trends, and changes inthe demographic mix of our customers. A misinterpretation or misunderstandingof these conditions and uncertainties in the future outlook of our industry orthe economy, or other failure to estimate correctly, could result in inventoryvaluation changes compared to the requirement determined to be appropriate asof any given balance sheet date.

 

*Valuation of Long-Lived Assets*

 

Long-lived assets such as property and equipment and identifiableintangibles are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Goodwill and other intangibles are required to be reviewed forimpairment on an annual basis, or more frequently when triggering events occur.Factors we consider important, which could trigger impairment, include, amongother things:

 

•                  Significantunderperformance relative to historical or projected operating results;

 

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•                  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, the determination ofwhether impairment has occurred is based on an estimate of undiscounted futurecash flows attributable to the assets at the store level, as compared to thecarrying value of the assets. Assumptions used in these cash flows are consistent with internalforecasts and consider current and future expected sales volumes and relatedoperating costs and any anticipated increases or declines based on expectedmarket conditions and local business environment factors. If a potentialimpairment is identified, the amount of the impairment loss recognized would bedetermined by estimating the fair value of the assets and recording a loss 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 impairment factors is basedon market conditions and the operational performance of our business. Ourreview of factors present and the resulting appropriate carrying value of ourgoodwill, intangibles and other long-lived assets are subject to judgments andestimates that management is required to make.

 

*Sales Returns*

 

As part of our “satisfaction guaranteed” policy, we allow Guitar Centercustomers to return product generally within 30 days after the date ofpurchase, and we allow Musician’s Friend customers to return product within 45days. American Music customers have ten business days from the date of purchaseto return product. We regularly review and revise, when deemed necessary, ourestimates of sales returns based upon historical trends. While our estimatesduring the past few years have closely approximated actual results, actualreturns may differ significantly, either favorably or unfavorably, fromestimates if factors such as economic conditions or the competitive environmentdiffer from our expectations.

 

*Credits and Other Vendor Allowances*

 

We receive cooperative advertising allowances (*i.e*., an allowance from themanufacturer to subsidize qualifying advertising and similar promotionalexpenditures we make relating to the vendor’s products), price protectioncredits (*i.e*.,credits from vendors with respect to in-stock inventory if the vendorsubsequently lowers their wholesale price for such products) and vendor rebates(*i.e*.,credits or rebates provided by vendors based on the purchase of specifiedproducts and paid at a later date). Cooperative advertising allowances arerecognized as a reduction to selling, general, and administrative expense whenwe incur the advertising expense eligible for the credit. We recognizedcooperative advertising allowances of $3.6 million and $3.5 million in the ninemonths ended September 30, 2003 and 2002, respectively, recorded as an offsetto selling, general and administrative expense.  Price protection credits and vendor rebates are accounted for asa reduction of the cost of merchandise inventory and are recorded at the timethe credit or rebate is earned.  Theeffect of price protection credits and vendor rebates is recognized in theincome statement at the time the related inventory is sold, as a reduction incost of goods sold.

 

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**Results of Operations**

 

The following table presents our consolidated statements of income, asa percentage of sales, for the periods indicated.

 
|                                          |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|-----------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                          |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
| Net sales                                     |   | 100.0                                 | %      | 100.0                                | %      | 100.0 | % | 100.0 | % |
| Gross profit                                  |   | 26.6                                  |   | 25.7                                 |   | 26.2 |   | 25.5 |   |
| Selling,  general, and administrative expense |   | 22.1                                  |   | 21.6                                 |   | 21.8 |   | 21.8 |   |
| Operating  income                             |   | 4.5                                   |   | 4.1                                  |   | 4.4 |   | 3.8 |   |
| Interest  expense, net                        |   | 1.4                                   |   | 1.4                                  |   | 1.2 |   | 1.2 |   |
| Income before  income tax expense             |   | 3.1                                   |   | 2.7                                  |   | 3.2 |   | 2.5 |   |
| Income tax  expense                           |   | 1.2                                   |   | 1.0                                  |   | 1.2 |   | 1.0 |   |
| Net income                                    |   | 1.9                                   |   | 1.7                                  |   | 2.0 |   | 1.6 |   |

 

### **Three Months Ended September 30, 2003 Compared to theThree Months Ended September 30, 2002**

 

Net sales increased to $300.1 million for the three months endedSeptember 30, 2003, from $257.4 million for the comparable prior period, a16.6% increase. Net sales from retail stores totaled $241.1 million, anincrease of $30.6 million, or 14.5%. Sales from new stores contributed $16.0million, or 52.3% of the increase. Comparable store sales for our Guitar Centerstores increased 7%, which was in line with our expectations. Our management ispresently anticipating comparable store sales growth of 5% to 7% for the fourthquarter of 2003. The foregoing statement is a forward-looking statement and issubject to the qualifications set forth below under “Forward-LookingStatements.”  Net sales from the directresponse channel totaled $59.0 million, a $12.1 million or 25.9% increase fromthe third quarter of 2002. This increase reflects the improved performance ofcatalog circulation strategies. Sales from the contact center, which representssales placed via phone, live chat, mail and e-mail, increased 13.8% to $27.3million from $24.0 million for the three months ended September 30, 2003compared to 2002. Internet sales from orders placed over the Musician’s Friendand Giardinelli web sites increased 38.4% to $31.7 million from $22.9 millionfor the same period last year. The web site growth reflects the recent trend ofour catalog customers’ preference in using the web to place their orders, thesuccess of web-based promotions, and that the website includes a more completeinventory presentation than our catalog.

 

Gross profitfor the three months ended September 30, 2003 compared to 2002 increased 20.8%to $79.9 million from $66.1 million. Gross profit as a percentage of sales for the three months endedSeptember 30, 2003 compared to 2002 increased to 26.6% from 25.7%. Gross profitpercentage for the retail stores increased to 25.2% from 24.9% for the threemonths ended September 30, 2003. The increase is principally due to improvedselling margins (1.0%) and lower shrink expense (0.3%), offset by costsassociated with the distribution center (0.9%), higher freight expense (0.2%)and reduced occupancy costs (0.1%). The gross profit percentage for the directresponse division was 32.3% for the quarter compared to 29.2% in the thirdquarter of 2002. The increase is primarily due to a shift in our product mixtoward higher margin products (1.8%), better than expected margin on the sellthrough of slow moving products (0.7%) and lower return rates (0.5%).

 

Selling,general and administrative expenses for the three months ended September 30,2003 compared to 2002 increased 18.9% to $66.2 million from $55.7 million.  Selling, general and administrativeexpenses, as a percentage of sales, for the three months ended September 30,2003 compared to 2002 increased to 22.1% from 21.6%. Selling, general andadministrative expenses for the retail stores in the third quarter were 22.2%of sales compared to 21.3% in last year’s third quarter. The increase isprincipally due to higher promotional activity (0.2%), increased salary costs(0.2%), higher bad debt (0.2%) and infrastructure build-out costs at AMG(0.2%). We also experienced higher grand opening costs (0.1%), and increasedinsurance expense (0.1%) and a decline in credit card processing rates (0.1%).Selling, general and administrative expenses for the direct response divisionwere 21.6% of sales in the third quarter compared to 23.3% in the same periodlast year. The improvement is primarily due to reduction in catalog and postagecosts due to lower, more targeted circulation (1.1%), and reduced labor costs inour contact center (0.3%) and distribution center (0.5%).

 

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Operatingincome increased from $10.4 million to $13.7 million, or 31.0% for the threemonths ended September 30, 2003.  Thisincrease reflects performance of the Guitar Center and Musician’s Friendbusinesses at or above expected levels, offset somewhat by continued spendingon systems and infrastructure and merchandising and operational challenges atthe American Music stores resulting in an operating loss of approximately $1.8million for these stores for the quarter.

 

Interest expense, net for the three months ended September 30, 2003increased to $4.3 million from $3.4 million in the same period of 2002.Included in the interest expense is the previously disclosed redemption premiumand the write-off of deferred financing costs associated with the senior notesredeemed in July 2003 of $1.9 million ($1.2 million after-tax, or $0.05 perdiluted share). This write-off of the redemption premium and deferred financingcosts approximately offset the benefit of lower interest rates in the thirdquarter and thus the full benefit of the refinancing will first be reflected ininterest expense in the fourth quarter of this year.

 

In the three months ended September 30, 2003, a $3.6 million provisionfor income taxes was recorded compared to $2.7 million for the same period lastyear, both based on an annualized tax rate of approximately 38%, which issubject to ongoing review and evaluation by management.

 

Net income for the three months ended September 30, 2003 increased to$5.8 million from $4.4 million in the third quarter of 2003 as a result of thecombinations of factors described above.

 

**NineMonths Ended September 30, 2003 Compared To The Nine Months Ended September 30,2002**

 

Net sales increased to $879.3 million for the nine months endedSeptember 30, 2003, from $766.1 million for the comparable prior period, a14.8% increase.  Net sales from retailstores totaled $699.9 million, an increase of $76.5 million, or 12.3%. Salesfrom new stores contributed $42.5 million, or 55.5% of the increase. Comparablestore sales increased 6%, which was in line with our expectations. Ourmanagement is presently anticipating comparable store sales growth of 5% to 7%for the fourth quarter of 2003.  Theforegoing statement is a forward-looking statement and is subject to thequalifications set forth below under “Forward-Looking Statements.”  Net sales from the direct response channeltotaled $179.4 million, a $36.7 million increase from the same period of 2002.This increase reflects the improved performance of catalog circulationstrategies. Sales from the contact center, which represents sales placed viaphone, live chat, mail and e-mail, increased 11.3% to $84.6 million from $76.0million for the nine months ended September 30, 2003 compared to 2002. Internetsales from orders placed over the Musician’s Friend and Giardinelli web sitesincreased 42.1% to $94.8 million from $66.7 million for the same period lastyear. The web site growth reflects the recent trend of our catalog customers’preference in using the web to place their orders, the success of web-basedpromotions, and that the website includes a more complete inventorypresentation than our catalog.

 

Gross profitfor the nine months ended September 30, 2003 compared to 2002 increased 17.6%to $230.1 million from $195.6 million. Gross profit as a percentage of net sales for the nine months endedSeptember 30, 2003 compared to 2002 increased to 26.2% from 25.5%. Gross profitpercentage for the retail stores remained consistent at 24.7% for the ninemonths ended September 30, 2003 and 2002. The gross profit percentage for thedirect response division was 31.9% for the nine months compared to 29.0% in thesame period of 2002. The increase is due to a higher selling margin resultingfrom better buying performance and favorable product mix (1.3%), better thanexpected margin on the sell through of slow moving products (0.8%), reductionin return rate (0.4%) and reduced shipping (0.2%) and inbound freight (0.2%)costs.

 

Selling, general and administrative expenses for the nine months endedSeptember 30, 2003 compared to 2002 increased 15.0% to $191.8 million from$166.9 million.  Selling, general andadministrative expenses, as a percentage of sales, for the nine months endedSeptember 30, 2003 compared to 2002 remained consistent at 21.8%. Selling,general and administrative expenses for the retail stores for the nine monthswere 21.8% of sales compared to 21.3% in the prior year.  The increase was due to increasedpromotional expenses (0.2%), increased salary costs (0.3%), higher bad debt(0.1%), offset by a slight decrease in grand opening costs (0.1%). Selling,general and administrative expenses for the direct response division were 21.9%of sales for the nine months compared to 23.7% in the same period last year.The improvement is primarily due to a reduction in catalog and postage costs(1.0% of sales), labor costs at the contact center (0.4%) and distribution center(0.2%) and credit card expense (0.3%).

 

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Operatingincome increased from $28.8 million to $38.2 million, or 32.8% for the ninemonths ended September 30, 2003.  Thisincrease reflects performance of the Guitar Center and Musician’s Friendbusinesses at or above expected levels, offset somewhat by continued spendingon systems and infrastructure and merchandising and operational challenges atthe American Music stores resulting in an operating loss of approximately $3.7million for these stores for the nine months ending September 30, 2003.

 

Interest expense, net for the nine months ended September 30, 2003increased to $10.4 million from $9.6 million in the same period of 2002.Included in the interest expense is the redemption premium and the write-off ofdeferred financing costs associated with the senior notes redeemed in July 2003of $1.9 million ($1.2 million after-tax, or $0.05 per diluted share). Thiswrite-off of the redemption premium and deferred financing costs approximatelyoffset the benefit of lower interest rates in the third quarter and thus thefull benefit of the refinancing will first be reflected in interest expense inthe fourth quarter of this year.

 

In the nine months ended September 30, 2003, a $10.6 million provisionfor income taxes was recorded compared to $7.3 million for the same period lastyear, both based on an annualized tax rate of approximately 38%, which issubject to ongoing review and evaluation by management.

 

Net income for the nine months ended September 30, 2003 increased to$17.2 million from $11.9 million in the same period of 2002 as a result of thecombinations of factors described above.

 

### **Liquidityand Capital Resources**

 

Our need forliquidity will arise primarily from the funding of capital expenditures,working capital requirements and payments on our indebtedness, as well aspossible acquisitions. We have historically financed our operations primarilythrough internally generated funds and borrowings under our credit facilities.As of September 30, 2003, we had $42.3 million outstanding under our creditfacility, excluding $4.5 million outstanding on letters of credit, and hadavailable borrowings of $83.9 million.

 

The credit facility permits borrowings up to $200 million, subject toborrowing base limitations. The actual amount available is tied to ourinventory and receivable base, and repayment obligations under the creditfacility 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 September 30, 2003), or LIBORplus an applicable margin rate (2.88% at September 30, 2003), subject to aminimum interest rate of 4.0%. The applicable margin rate is based upon aquarterly calculation of average daily availability at the end of each fiscalquarter.  At September 30, 2003, we weresubject to the minimum interest rate of 4.0%. The agreement underlying the creditfacility includes significant restrictive negative covenants. Among otherthings, these covenants restrict our ability to incur debt and issue specifiedequity instruments, incur liens on our assets, make any significant change inour corporate structure or the nature of our business, dispose of assets, makeguaranties, prepay debt, engage in a change in control transaction, paydividends, make investments or acquisitions, engage in transactions withaffiliates and incur capital expenditures, and also require that we satisfyspecified financial requirements including a tangible net worth test and aminimum availability test.  Under thetangible net worth test, we are required to maintain, as of each quarter end, aminimum level of tangible net worth which, under the agreement, is defined asstockholders’ equity, less goodwill, plus $3.5 million (or $162.5 million atSeptember 30, 2003). The minimum amounts required by the agreement increase ona quarterly basis and are $122.0 million at September 30, 2003, $134.0 millionat December 31, 2003 and $155.0 million at March 31, 2004 and thereafter. Theminimum availability test requires that we maintain $10.0 million of reservedavailability under the agreement based on its borrowing base limitations. Theamount we disclose in our public reports from time to time as available toborrow under the agreement ($83.9 million at September 30, 2003) is alreadyreduced by this required reserve and thus represents a net amount availableunder the agreement.  The agreement alsoincludes representations and warranties which must be true each time we borrowfunds under the credit facility and affirmative covenants.  The full text of the contractualrequirements imposed by this financing is set forth in the Amended and RestatedLoan and Security Agreement, as amended, which has been filed with theSecurities and Exchange Commission.  Wewere in compliance with such requirements as of September 30, 2003.  Subject to limited cure periods, the lendersunder 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.

 

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On June 16, 2003, we completed the issuance of $100 million principalamount of 4.00% Senior Convertible Notes due 2013.  Of the net proceeds from the offering, approximately $68.2million was used in July 2003 to retire all outstanding Senior Notes and paythe related redemption premium, and the balance was used to reduce the amountoutstanding under our credit agreement and pay offering expenses.  The notes bear interest at the rate of 4.00%per annum, subject to the payment of contingent interest under certaincircumstances, and are convertible into shares of common stock at a conversionprice of $34.58 per share, subject to adjustment under specified circumstances.Under the contingent conversion feature of the notes, subject to certainexceptions, they are not convertible into common stock unless and until thetrading price of the common stock reaches at least $41.50 for a specifiedperiod or designated corporate events occur. The final maturity of the notes is July 2013, although holders mayrequire us to repurchase the notes at their election in July 2008, July 2010 orupon the occurrence of a change in control, in each case for a purchase priceequal to the original principal amount plus accrued interest.  We may call the notes for redemption commencingin July 2006 subject to the payment of a redemption premium of 1.6% if redeemedprior to July 2007 and 0.8% if redeemed prior to July 2008 (thereafter there isno redemption premium).  The indenturegoverning the notes does not limit our ability to incur indebtedness orotherwise substantively restrict the operation of our business to anysignificant degree.  Subject to limitedcure periods, the holders of the notes may demand repayment of these borrowingsprior to the stated maturity upon the occurrence of specified events, includingif we fail to pay interest or principal when due, fail to satisfy ourconversion obligation, if another obligation of ours having an outstandingprincipal amount in excess of $15 million is accelerated prior to statedmaturity and upon the occurrence of specified events of insolvency.

 

In July 2003, we completed the issuance of the convertible notes andcalled for the redemption of $66.7 million of Senior Notes outstanding.Interest expense related to the redemption premium and the write-off ofdeferred financing costs associated with the senior notes redeemed was $1.9million ($1.2 million after-tax, or $0.05 per diluted share).

 

During 2002 we entered into master operating lease agreements withGeneral Electric Capital Corporation and US Bank to lease equipment and otherproperty primarily to support the operations of the new central distributioncenter for our Guitar Center retail stores. Under these agreements, we leased atotal of $10.5 million in equipment and other property. The agreement calls formonthly payments to General Electric Capital Corporation of $138,000 for a termof 36 months through September 1, 2005, and monthly payments to US Bank of$48,000 for a term of 12 months through December 28, 2003. The leases haveoptions to extend through September 30, 2009 and December 28, 2005,respectively.

 

The terms of our significant financing agreements, including thoserelated to our credit facility, the convertible notes and the equipment leasefacilities described above are not dependent on any change in our creditrating. We believe that the key company-specific factors affecting our abilityto maintain our existing debt and lease financing relationships and to accesssuch capital in the future are our present and expected levels of profitabilityand cash flow from operations, our working capital and fixed asset collateralbases, our expected level of capital expenditures, the level of equity capitalof the company relative to the level of debt obligations and, in the case ofconvertible instruments, the related perceived attractiveness of an investmentin our common stock. In addition, as noted above, our existing agreementsinclude significant restrictions on future financings, including among others,limits on the amount of indebtedness that we may incur and whether or not suchindebtedness may be secured by any of our assets.

 

As is the case with most multi-unit retailers, substantially all of thereal property used in our business is leased under operating leaseagreements.  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 nine months ended September 30, 2003, net cash provided byoperating activities was $13.1 million, which principally consisted of adecrease in accounts payable and accrued expenses, offset by cash income fromoperations and improved inventory utilization. Cash used in investingactivities totaled $16.9 million, used for capital expenditures principally forour store expansion program. Cash provided by financing activities totaled $2.6million, which principally consisted of proceeds from the Senior ConvertibleNotes offset by the redemption of the senior notes and the paydown of thecredit facility.

 

We intend to pursue an aggressive growth strategy by opening additionalstores in new and existing markets. During the nine months ended September 30,2003, we opened eleven new Guitar Center stores. Each new large format GuitarCenter store typically has required approximately $1.6 to $1.8 million

 

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for gross inventory.Historically, our cost of capital improvements for a large format Guitar Centerstore has been approximately $850,000, consisting of leasehold improvements,fixtures and equipment. We incur higher costs in some geographic areas,particularly the Northeast, and with respect to large, “flagship” stores suchas those we plan to open in Manhattan and Nashville.  We have developed smaller Guitar Center stores to build insecondary markets or sites that we do not believe will support our large formatunits. The first of these units was opened in late 2000 and a total of 14 hadbeen opened as of September 30, 2003. Our small format stores have typicallyincurred approximately $560,000 in capital expenditures and requireapproximately $1.1 million to $1.2 million in inventory.

 

We are also anticipating additional capital and strategic requirementsrelated to improving our fulfillment facilities, upgrading our technology andsystems, and pursuing new opportunities in the e-commerce activities of ourretail and direct response divisions as well as related businesses.

 

We started operations of our distribution center in the Indianapolis,Indiana area to support our Guitar Center retail store operations in July 2002.We have entered into a 10-year agreement to lease the facility and we also haveentered into numerous additional commitments necessary to support theoperations of the facility. By the end of 2002, nearly all products wereflowing through the distribution facility, with the exception of special orderswhich will continue, for the most part, to be drop shipped to our stores.Migration from our former “drop-ship” model to a centralized distribution modelis an important development in our operating strategy and has required theallocation of significant financial and managerial resources. In accordancewith generally accepted accounting principles, a portion of the costs ofoperating this facility are absorbed into our Guitar Center merchandiseinventories and recognized as an element of cost of goods sold when the relatedinventory is sold. This can result in a slight decrease in reported grossmargin depending on our success in defraying these additional costs, althoughwe also expect to realize efficiencies involving other costs such as selling,general and administrative and interest expense.

 

We also continue to make significant investments in informationtechnology across our businesses and to incur costs and make investmentsdesigned to expand the reach of our businesses on the Internet.  The costs of these initiatives and otherinvestments related to our businesses will continue to be significant.

 

Our expansion strategy is to continue to increase our market share inexisting markets and to penetrate strategically selected new markets.  We opened a total of 12 Guitar Center storesin 2002 and 13 stores in 2001, and currently anticipate opening 14 GuitarCenter stores in 2003. Some of these stores are smaller format units designedfor secondary markets and two are expected to be large, “flagship” stores. Weopened a total of eight American Music stores in 2002, five of the eight byacquisition of M&M Music, a band instrument and retail merchandiseretailer.  For the remainder of 2003, wedo not plan to open any additional American Music stores organically, howeverwe may identify acquisition opportunities. We have slowed our planned growth ofthe American Music division because our infrastructure and remerchandisingprojects at this business have to date required more time and resources thanoriginally anticipated. We believe there exists a number of acquisitionopportunities in the relatively fragmented band instruments market that could bea good fit into our American Music platform.

 

We also believe there may be attractive opportunities to expand byselectively acquiring existing music products retailers or other complimentarybusinesses, if attractive opportunities can be identified. While we cannotprovide assurance that we will complete any further acquisition transactions,in the ordinary course of our business we investigate and engage innegotiations regarding such opportunities. Acquisitions will be financed withdrawings 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 for 2003 are presentlyexpected to be primarily provided by net cash flow from operations andadditional borrowings under our credit facility. Depending upon marketconditions, we may also elect or be required to raise additional capital in theform of common or preferred equity, debt or convertible securities for thepurpose of providing additional capital to fund working capital needs orcontinued growth of our existing business, or to refinance existingobligations. Any such financing activity will be dependent upon many factors,including our liquidity needs, market conditions and prevailing market terms,and we cannot assure you that future external financing for us will beavailable on attractive terms or at all.

 

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### **NewAccounting Pronouncements**

 

In August 2001, the Financial Accounting Standards Board issuedStatement No. 143, “*Accounting for AssetRetirement Obligations” (SFAS No. 143).* This new pronouncementestablishes financial accounting and reporting standards for obligationsassociated with the retirement of tangible long-lived assets and the associatedasset retirement costs.  The provisionsof SFAS No. 143 apply to legal obligations associated with the retirement of long-livedassets that result from the acquisition, construction, development and/or thenormal operation of a long-lived asset, except for obligations of lessees. Thestandard was effective for financial statements issued for fiscal yearsbeginning after June 15, 2002.  Weadopted this standard effective January 1, 2003, and it did not have a materialeffect on our consolidated financial statements.

 

In January2003, the Financial Accounting Standards Board issued FASB Interpretation No.46, “*Consolidationof Variable Interest Entities*” (*FIN 46*). This interpretation clarifies the application of Accounting ResearchBulletin No. 51, “*Consolidated Financial Statements*” (*ARB 51*), and requirescompanies to evaluate variable interest entities for specific characteristicsto determine whether additional consolidation and disclosure requirementsapply.  This interpretation isimmediately applicable for variable interest entities created after January 31,2003, and applies to fiscal periods beginning after December 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 Cash ConsiderationReceived from a Vendor,”* provides that cash consideration receivedfrom a vendor is presumed to be a reduction of the prices of the vendor’sproducts or services and should, therefore, be characterized as a reduction incost of sales unless it is a payment for assets or services delivered to thevendor, in which case the cash consideration should be characterized asrevenue, or unless it is a reimbursement of costs incurred to sell the vendor’sproducts, in which case the cash consideration should be characterized as areduction of that cost.  EITFNo. 02-16 became effective for us in the first quarter of 2003, and had noimpact on our financial statements, as we have historically accounted forvendor payments in accordance with the provisions of this standard.

 

In December 2002, the FASB issued SFAS No. 148 *“Accounting for Stock-BasedCompensation-Transition and Disclosure,”* an amendment of FASBStatement No. 123, which provides guidance for transition to the fair valuebased method of accounting for stock-based employee compensation and the requiredfinancial statement disclosure. The adoption of SFAS No. 148 expanded thedisclosure in our interim financial statements, and does not significantlyimpact our disclosures of stock-based compensation.  See Note 5 to the interim financial statements.

 

InMay 2003, the Financial Accounting Standards Board issued Statement No. 150, “A*counting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity.” Th*e Statementestablishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity. Itrequires that an issuer classify a financial instrument that is within itsscope as a liability (or an asset in some circumstances). It is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003.  We adopted thisstandard effective July 1, 2003, and it did not have a material effect on ourconsolidated statements.

 

### **Seasonality**

 

Our operating results are not highly seasonal, except for the effect ofthe holiday selling season in November and December.  Sales in the fourth quarter are typically significantly higher ona per store basis and through the direct response unit than in any otherquarter.

 

### **Inflation**

 

We believe that the relatively moderate rates of inflation experiencedin recent years have not had a significant impact on our net sales orprofitability.

 

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### **Forward-LookingStatements**

 

This report contains forward-looking statements relating to, amongother things, future results of operations, growth and investment plans, sales,trends in gross margin, growth in the Internet business and other factorsaffecting growth in sales and earnings. Specific forward-looking statements are provided regarding ourmanagement’s current views regarding comparable store sales, new store openingsand capital expenditure levels. Statements regarding new store openings are based largely on our currentexpectations and are necessarily subject to associated business risks relatedto, among other things, the identification of suitable sites or acquisitionopportunities, the timely construction, staffing and merchandising of thosestores and other matters, some of which are outside of our control.  Comparable store sales growth is highlydependent upon the state of the economy, the effectiveness of our sales andpromotion strategies and the effect of competition, including other nationaloperators of music products stores attempting to implement national growthstrategies.  The American Music businesswas only recently acquired by us and has in the past and may in the futuregiven rise to significant fluctuations from period to period as we integratethese activities with the other Guitar Center businesses, reformat their storemodel and build-out the information technology and management structure. TheAmerican Music stores have incurred significant operating losses in recentquarters and we presently expect this situation to continue at least for thefourth quarter of 2003.

 

Sales and earnings trends are also affected by many other factorsincluding, among others, world and national political events, general economicconditions, which recently have been weak, the effectiveness of our promotionand merchandising strategies, changes in the music products industry, retailsales trends and the emergence of new or growing specialty retailers of musicproducts.  In light of these risks,there can be no assurance that the forward-looking statements contained in thisreport will in fact be realized.  Thestatements made by us in this report represent our views as of the date of thisreport, and it should not be assumed that the statements made herein remainaccurate as of any future date.  We donot presently intend to update these statements and undertake no duty to anyperson to affect any such update under any circumstances.

 

For further discussion of risks associated with our business, pleasesee the discussion under the caption “Risks Related to the Business.”

 

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

 

**RisksRelated to the Business**

 

An investment in our securities involves a high degree of risk.  Described below are some of the risks anduncertainties facing our company.  Theremay be additional risks that we do not presently know of or that we currentlyconsider immaterial.  Any of these riskscould adversely affect our business, results of operations, liquidity andfinancial position.  A shortfall incomparative sales growth in any period will likely cause a shortfall inearnings, and result in financial performance below that for which we haveplanned or the investment community expects.

 

*We may be unable to meet our Guitar Centerand American Music retail store growth strategy, which could adversely affectour results of operations.*

 

Our retail store growth strategy includes opening new stores in new andexisting markets and increasing sales at existing locations.  As of September 30, 2003, we operated 119Guitar Center stores and 19 American Music stores.  We opened a total of 12 Guitar Center stores in 2002, andcurrently expect to open approximately 14 to 16 additional Guitar Center storesin 2003.  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 in 2002, five of whichwere acquired in connection with American Music’s acquisition of M&M Music,a band instrument 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. However, we haveslowed our planned growth of the American Music division because ourinfrastructure

 

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and remerchandising projects atthis business have to date required more time and resources than originallyanticipated.  As a result of thesefactors, the American Music stores have incurred significant operating lossesin recent quarters and we presently expect this situation to continue at leastfor the fourth quarter of 2003.

 

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

 

•                  identificationof suitable retail sites and appropriate acquisition candidates;

 

•                  negotiationof acceptable lease terms;

 

•                  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 ofthese factors are, to a significant extent, beyond our control. As a result, wedo not know whether we will be able to continue to open and/or acquireadditional Guitar Center and American Music stores at the rates currentlyanticipated. If we are unable to achieve our retail store expansion goals, orthe new stores underperform our expectations, our results of operations couldbe adversely affected.

 

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

 

As part of our retail growth strategy, we plan to open and/or acquireadditional Guitar Center and American Music stores in new markets. Thisexpansion into new markets will present unique competitive and merchandisingchallenges, including:

 

•                  significantstart-up costs, including promotion and advertising;

 

•                  higheradvertising and other administrative costs as a percentage of sales than is experiencedin mature markets that are served by multiple stores, particularly in largeurban 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 thesefactors may lead to a shortfall in revenues or an increase in costs withrespect to the operation of these stores. If we are not able to operate these stores profitably, our results ofoperations would be adversely affected.

 

*Our retail storeexpansion strategy, including our strategy of clustering retail stores, mayadversely impact our comparable store sales.*

 

Historically,we have achieved significant sales growth in existing stores. Our quarterlycomparable store sales results have fluctuated significantly in the past.  Sales growth for comparable periods,excluding net sales attributable to stores not open for 13 months, was asfollows for our retail stores:

 

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

 

We do not know whether our new stores will achieve sales orprofitability levels similar to our existing stores. Our expansion strategyincludes clustering stores in existing markets. Clustering has in the past andmay in the future result in the transfer of sales to the new store and areduction in the profitability of an existing store. In addition, a variety offactors 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 managementis presently planning for annual comparable store sales growth of 5% to 7% forthe fourth quarter of 2003.  A shortfallin comparative sales growth in any period will likely cause a shortfall inearnings, and result in financial performance below that for which we haveplanned or the investment community expects.

 

*Our growth plans depend on our completion ofacquisitions, and these transactions involve special risks.*

 

We believethat our expansion may be accelerated by the acquisition of existing musicproduct retailers. For example, in April 2001 we acquired the business ofAmerican Music Group, a New York-based retailer of band instruments, a businessin which we were not previously engaged. Our growth plans for the AmericanMusic business contemplate a significant number of relatively smallacquisitions. For example, in June 2002 American Music acquired M&M Music,a band instrument retailer. We also regularly investigate acquisitionopportunities complimentary to our Guitar Center and Musician’s Friendbusinesses. Accordingly, in the ordinary course of our business, we regularlyconsider, evaluate and enter into negotiations related to potential acquisitionopportunities. We may pay for these acquisitions in cash or securities,including equity securities, or a combination of both. We cannot assure youthat attractive acquisition targets will be available at reasonable prices orthat we will be successful in any such transaction.  Acquisitions involve a number of special risks, 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 small number ofmanufacturers and suppliers who may not be able or desire to supply ourrequirements.*

 

Brand recognition is of significant importance in the retail musicproducts business. As a result, we depend on a relatively small number ofmanufacturers and suppliers for both our existing stores and the directresponse unit as well as our expansion goals for each of these units. We do nothave any long-term contracts with our suppliers, and any failure to maintainour relationships with our key brand name vendors would have a material adverseeffect on our business. A number of the manufacturers of the products we sellare limited in size and manufacturing capacity and have significant capital orother constraints. These manufacturers may not be able or willing to meet ourincreasing requirements for inventory, and we cannot

 

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assure you that sufficientquantities or the appropriate mix of products will be available in the futureto supply our existing stores and expansion plans. These capacity constraintscould lead to extended lead times and shortages of desirable products. The riskis especially prevalent in new markets where our vendors have existingagreements with other dealers and thereby may be unwilling or unable forcontractual or other reasons to meet our requirements. The efficient operationof our new distribution center for the Guitar Center stores is also highlydependent upon compliance by our vendors with precise requirements as to thetiming, format and composition of shipments, which in many instances requireschanges and upgrades to the operational procedures and logistics and supplychain management capabilities of vendors, all of which are outside of ourcontrol. Additionally, many of our vendors receive product from overseas anddepend on 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.

 

*We face significant competition, and ourefforts 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 and highlycompetitive. We compete with many different types of music product retailers,including conventional retailers, as well as other catalog and e-commerceretailers, who sell many or most of the items we sell. We believe that largeformat music product retailers such as our company will seek to expand in partthrough the acquisition of small, independently owned stores or franchises, andwe anticipate increased competition in our existing markets and planned newmarkets from these consolidating retailers. These retailers may identify targetcompanies or execute their acquisition strategies more effectively than ourcompany.  In addition, these retailersmay have greater financial resources or other competitive advantages ascompared to our company. Our expansion to new markets will be inhibited bythese and other established competitors. In addition, one or more of ourcompetitors may adopt a new, innovative store format or retail selling method.If we are not able to compete effectively, we may fail to achieve marketposition gains or may lose market share.

 

*We must efficientlyintegrate American Music and grow its band instrument business in order to earnan acceptable return on that investment.*

 

In April 2001, we completed our acquisition of American Music Group, aNew York-based retailer of band instruments. We had not previously participatedin the band instruments segment of the music products business and had no priorexperience in this distribution channel. We intend to use the acquired AmericanMusic business as a platform to develop and grow a family music store conceptthat will emphasize band instruments and also sell selected “combo” products soldby our Guitar Center stores, such as guitars, drums and the like. Thus, we facethe normal challenges of any acquisition, such as integration of personnel andsystems as well as the need to learn, understand and further develop thisbusiness. We are installing new management information systems at AmericanMusic, which has proven to be a challenging project requiring more time andresources than originally anticipated. This implementation is an importantproject to facilitate further integrating of American Music with our otherbusinesses and to provide a systems backbone to permit growth of this division.In addition, in 2002 we started marketing through the American Music storessome Guitar Center products not previously carried by American Music. Thischange in merchandising strategy from the historic focus of American Music onband instruments is in process and is an important element of our family musicstore concept for this brand.  Thisremerchandising strategy is not yet proven. Further, we have slowed our plannedgrowth of the American Music division because the challenges posed by ourinfrastructure and remerchandising projects. As a result of these factors, the American Music stores have incurredsignificant operating losses in recent quarters and we presently expect thissituation to continue at least for the fourth quarter of 2003. Failure toexecute on the requirements and initiatives described above could result in apoor or no return on our investment, constitute a distraction of the efforts ofour management team from the core Guitar Center and Musician’s Friend brandsand potentially require us to recognize an impairment in the significant amountof goodwill recorded in the acquisitions of American Music and M&M Music,which totaled $20.6 million at September 30, 2003..

 

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

 

Our success depends to a significant extent on the services of LarryThomas, our Chairman and Co-CEO, Marty Albertson, our President and Co-CEO,Robert Eastman, the CEO of our wholly-owned

 

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subsidiary,Musician’s Friend, Inc., and David Fleming, President and ChiefOperating Officer of American Music, aswell 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 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.

 

*The implementationof our new distribution center for the Guitar Center retail stores presentsoperational 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 mustdeliver product on time. This program involves financial and operating risksthat could include the need to expend greater funds than presently budgeted ordisruptions in retail store operations and the loss of sales if inventory isnot timely provided in the required quantities. Further, one of the keyunderlying economic assumptions of our distribution center project is that thisprogram will permit us to reduce overall inventory levels as a percentage ofsales thereby resulting in significantly reduced working capital requirements.Any failure 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 noreturn on our investment, disruption of our retail store business and adistraction of the efforts of our management team.

 

*Our retail operations are concentrated inCalifornia, which ties our financial performance to events in that state.*

 

As of December 31, 2002, our corporate headquarters as well as 22 ofour 108 Guitar Center stores were located in California and stores located inthat state generated 27.5% and 28.3% of our retail sales for 2002 and 2001,respectively. Although we have opened and acquired stores in other areas of theUnited States, a significant percentage of our net sales and results ofoperations will likely remain concentrated in California for the foreseeablefuture. As a result, our results of operations and financial condition areheavily dependent upon general consumer trends and other general economicconditions in California and are subject to other regional risks, includingearthquakes. We do maintain earthquake insurance, but such policies carrysignificant deductibles and other restrictions.

 

*Economic conditionsor changing consumer preferences could also adversely impact us.*

 

Our business is sensitive to consumer spending patterns, which can beaffected by prevailing economic conditions. A downturn in economic conditionsin one or more of our markets, such as occurred after September 11, 2001, couldhave a material adverse effect on our results of operations, financialcondition, business and prospects. Recent weak economic conditions have createduncertainty as to the future direction of the economy which is likely tocontinue to impact hobbyists and other general consumers who purchase fromMusician’s Friend and our American Music and Guitar Center stores.  Although we attempt to stay informed ofconsumer preferences for musical products and accessories typically offered forsale in our stores, any sustained failure on our part to identify and respondto trends would have a material adverse effect on our results of operations,financial condition, business and prospects.

 

*We may need tochange the manner in which we conduct our business if government regulation ortaxation imposes additional costs and adversely affects our financial results.*

 

The adoption or modification of laws or regulations, or revisedinterpretations of existing laws, relating to the direct response industrycould adversely affect the manner in which we currently conduct our

 

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

 

*We must manage efficiently the expansion ofour direct response business, including the musiciansfriend.com website, oursystems that process orders in our direct response business, and ourfulfillment resources in order to service our customers properly.*

 

Our direct response business, particularly our e-commerce business,will require significant investments to respond to anticipated growth andcompetitive pressures. If we fail to rapidly upgrade our website in order toaccommodate increased traffic, we may lose customers, which would reduce ournet sales. Furthermore, if we fail to expand the computer systems that we useto process and ship customer orders and process payments and the fulfillmentfacilities we use to manage and ship our inventory, we may not be able tosuccessfully distribute customer orders. We experienced some delays of thissort in 2001 in connection with the consolidation of our fulfillment centers. Asa result, we could incur excessive shipping costs due to the need to splitdelayed shipments, increased marketing costs in the form of special offers toaffected customers or the loss of customers altogether. We may experiencedifficulty in improving and maintaining such systems if our employees orcontractors that develop or maintain our key systems become unavailable tous.  We have experienced periodicservice disruptions and interruptions, which we believe will continue to occur,while enhancing and expanding these systems.

 

*Net sales of oure-commerce business could decrease if our online security measures fail.*

 

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

 

*If we do not respondto rapid technological changes, our services could become obsolete and we couldlose customers.*

 

If we face material delays in introducing new services, products andenhancements, our e-commerce customers may forego the use of our services anduse those of our competitors. To remain competitive, we must continue toenhance and improve the functionality and features of our online store.  The Internet and the online commerceindustry are rapidly changing. If competitors introduce new products andservices embodying new technologies, or if new industry standards and practicesemerge, our existing website and proprietary technology and systems may becomeobsolete. To develop our website and other proprietary technology entailssignificant technical and business risks. We may use new technologiesineffectively or we may fail to adapt our website, our transaction processingsystems and our computer network to meet customer requirements or emerging industrystandards. In addition, the success of e-commerce may result in greaterefficiency and lower prices, which could have an adverse effect on sellingprices and margins in our retail store business and in our catalog business andgenerally constrain profitability in the specialty retail business.

 

*Our hardware and software systems are vitalto the efficient operation of our retail stores and direct response business,and damage to these systems could harm our business.*

 

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We rely on ourcomputer hardware and software systems for the efficient operation of ourretail stores and direct response business. Our information systems provide ourmanagement with real-time inventory, sales and cost information that isessential to the operation of our business. Due to our number of stores,geographic diversity and other factors, we would be unable to generate thisinformation in a timely and accurate manner in the event our hardware orsoftware systems were unavailable. These systems are vulnerable to damage orinterruption from a number of factors, including:

 

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

 

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

 

A significant information systems failure could reduce the quality orquantity of operating data available to our management. If this informationwere unavailable for any extended period of time, our management would beunable to efficiently run our business, which would result in a reduction inour net sales.

 

To attempt to mitigate these risks we have contracted services fromthird parties to provide backup systems for our Guitar Center retail stores inthe event of a disaster. These services provide for our “mission critical”systems to be online within 48 hours following most disasters. Our directresponse business does not have redundant Internet or operating systems andwould be vulnerable to catastrophic events. In the event of a disaster, ourdirect response business would most likely experience delays in processing andshipping orders.

 

In addition, we are in the process of upgrading some of our accountingsystems.  These activities will requirehigher than typical expenses for operations during the upgrade installationphase, and no assurance can be given that the upgrades and conversions will notcause disruption of our business or our financial reporting.

 

*The results of operations of our Direct Response business could bematerially adversely affected should the distribution of catalogs and otherdirect mail become more costly or less effective*

 

# **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.**

 

*Our stock pricecould be volatile.*

 

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

 

*Our actual operating results may differ significantly from ourprojections.*

 

From time totime, we release projections regarding our future performance that representour management’s estimates as of the date of release. These projections, whichare forward looking-statements, are prepared by our management and arequalified by, and subject to, the assumptions and the other informationcontained or referred to in the release. Our projections are not prepared witha view toward compliance with published guidelines of the American Institute ofCertified Public Accountants, and neither our independent public accountantsnor any other independent expert or outside party compiles or examines theprojections and, accordingly, no such person expresses any opinion or any otherform of assurance with respect thereto.

 

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

 

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

 

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

 

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

 

We do not haveany assets or liabilities which, in our view, impose upon us significant marketrisk except for our outstanding indebtedness represented by $100.0 millionprincipal amount of Senior Convertible Notes due 2013 with a fixed interestrate of 4% (subject to contingent interest) and our credit facility which has avariable rate of interest generally consisting of stated premiums above theLondon Interbank Offered Rate, or LIBOR. At September 30, 2003, we had $42.3 million outstanding under our creditfacility.  To the extent prevailingshort-term interest rates fluctuate the interest expense we incur on our creditfacility will change 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 September 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 and any cash in excess of ourdaily operating needs is used to reduce our borrowings.

 

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

 

We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in our Exchange Act reports isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms and that suchinformation is accumulated and communicated to our management, including ourCo-Chief Executive Officers and Chief Financial Officer, as appropriate, toallow for timely decisions regarding required disclosure. In designing and evaluatingthe disclosure controls and procedures, management recognizes that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement is required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

 

As required by SEC Rule 13a-15(b), we carried out an evaluation, underthe supervision and with the participation of our management, including ourCo-Chief Executive Officers and Chief Financial Officer, of the effectivenessof the design and operation of our disclosure controls and procedures as of theend of the quarter covered by this report.  Based on the foregoing, ourCo-Chief Executive Officers and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective at the reasonable assurancelevel.

 

There has beenno change in our internal controls over financial reporting during our mostrecent fiscal quarter that has materially affected, or is reasonably likely tomaterially affect, our internal controls over financial reporting.

 

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

 

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

 

(a)                                  Exhibits:

 

10.43                     AmendmentNo. 2 dated July 1, 2003 to Amended and Restated Employment Agreement betweenGuitar Center, Inc. and Larry Thomas.

 

10.44                     AmendmentNo. 2 dated July 1, 2003 to Amended and Restated Employment Agreement betweenGuitar Center, Inc. and Marty Albertson.

 

10.45                     ThirdAmended and Restated Employment Agreement dated July 1, 2003 between GuitarCenter, Inc. and Bruce Ross.

 

10.46                     SeparationAgreement dated as of August 5, 2003 between Guitar Center, Inc. and BarrySoosman.

 

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

 

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

 

 

(b)                                 Reports on Form 8-K:

 

We filed a Current Report on Form 8-K on July 29, 2003 disclosing,under caption of Items 5 and 12, financial information for the quarter endedJune 30, 2003.

 

 

Pursuant to the requirements of the Securities and Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized as of the 10th day of November 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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