**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**
| **x**  | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                                                                      |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |       | **For the quarterly period ended September 30,  2006**                                                                                                                                                                                                                                                                                                                                                                                            |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| **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**

**GUITARCENTER, INC.**

(Exact Name of Registrant as Specified in its Charter)

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

 

**(818) 735-8800**

Registrant’stelephone number, including area code

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

Yes   x     No   o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 
| Large accelerated  filer   x | Accelerated  filer   o | Non-accelerated  filer   o |
|---------------------------------------------|---------------------------------------|-------------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

 

Yes   o     No   x

 

As of November 3, 2006, therewere 29,325,361 shares of our common stock, $.01 par value, outstanding.

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES**

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

 

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**GUITARCENTER, INC. AND SUBSIDIARIES**

**CONSOLIDATED BALANCE SHEETS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                                                                                                                                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                    | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **Assets**                                                                                                                                                                                                    |       |                   |       |                  |       |
| Current assets:                                                                                                                                                                                               |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                                                                    |       | $                      | 10,211     |                  | $          | 14,529 |   |
| Accounts  receivable, less allowance for doubtful accounts of $3,200 and $2,844,  respectively                                                                                                                |       | 43,677                 |       | 40,844                |       |
| Merchandise  inventories                                                                                                                                                                                      |       | 558,463                |       | 445,771               |       |
| Prepaid expenses  and other current assets                                                                                                                                                                    |       | 21,402                 |       | 15,533                |       |
| Deferred income  taxes                                                                                                                                                                                        |       | 14,324                 |       | 13,492                |       |
| Total current assets                                                                                                                                                                                          |       | 648,077                |       | 530,169               |       |
| Property and equipment,  net of accumulated depreciation and amortization of $147,944 and $125,440,  respectively                                                                                             |       | 186,978                |       | 149,209               |       |
| Goodwill                                                                                                                                                                                                      |       | 96,627                 |       | 85,929                |       |
| Intangible assets, net                                                                                                                                                                                        |       | 7,535                  |       | 9,142                 |       |
| Other assets, net                                                                                                                                                                                             |       | 4,014                  |       | 5,741                 |       |
| Total assets                                                                                                                                                                                                  |       | $                      | 943,231    |                  | $          | 780,190 |   |
|                                                                                                                                                                                                          |       |                   |       |                  |       |
| **Liabilities and Stockholders’  Equity**                                                                                                                                                                |       |                   |       |                  |       |
| Current liabilities:                                                                                                                                                                                          |       |                   |       |                  |       |
| Accounts payable                                                                                                                                                                                              |       | $                      | 110,937    |                  | $          | 79,497 |   |
| Accrued expenses  and other current liabilities                                                                                                                                                               |       | 67,653                 |       | 106,181               |       |
| Merchandise  advances                                                                                                                                                                                         |       | 20,138                 |       | 25,127                |       |
| Borrowings under  revolving line of credit                                                                                                                                                                    |       | 147,440                |       | 32,266                |       |
| Total current  liabilities                                                                                                                                                                                    |       | 346,168                |       | 243,071               |       |
| Other long-term  liabilities                                                                                                                                                                                  |       | 15,039                 |       | 11,995                |       |
| Deferred income taxes                                                                                                                                                                                         |       | 13,113                 |       | 20,307                |       |
| Long-term debt                                                                                                                                                                                                |       | —                 |       | 100,000               |       |
| Total liabilities                                                                                                                                                                                             |       | 374,320                |       | 375,373               |       |
| Stockholders’ equity:                                                                                                                                                                                    |       |                   |       |                  |       |
| Preferred stock,  5,000 authorized, none issued and outstanding                                                                                                                                               |       | —                 |       | —                |       |
| Common stock,  $0.01 par value, authorized 100,000 shares at September 30, 2006 and 55,000  shares at December 31, 2005, issued and outstanding 29,307 at September 30, 2006  and 26,092 at December 31, 2005 |       | 293                    |       | 261                   |       |
| Additional  paid-in capital                                                                                                                                                                                   |       | 450,360                |       | 326,755               |       |
| Retained  earnings                                                                                                                                                                                            |       | 118,258                |       | 77,801                |       |
| Total stockholders’  equity                                                                                                                                                                              |       | 568,911                |       | 404,817               |       |
| Total liabilities and stockholders’ equity                                                                                                                                                               |       | $                      | 943,231    |                  | $          | 780,190 |   |

 

*See accompanyingnotes to consolidated financial statements.*

1

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**GUITARCENTER, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF INCOME**

**(Inthousands, except per share data)**

**(Unaudited)**

 
| ** **                                                             | ** ** | **Three months ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                             | ** ** | **2006**                                                 | ** ** | **2005** | ** ** |
| Net sales                                                              |       | $                                                        | 472,732    |   | $ | 421,061 |   |
| Cost of goods  sold, buying and occupancy                              |       | 339,465                                                  |       | 297,243 |   |
| Gross profit                                                           |       | 133,267                                                  |       | 123,818 |   |
| Selling, general  and administrative expenses                          |       | 114,022                                                  |       | 98,366 |   |
| Operating income                                                       |       | 19,245                                                   |       | 25,452 |   |
| Interest  expense, net of interest income of $68 and $26, respectively |       | 2,173                                                    |       | 2,021 |   |
| Gain on sale of  property                                              |       | 2,115                                                    |       | — |   |
| Income before  income taxes                                            |       | 19,187                                                   |       | 23,431 |   |
| Income taxes                                                           |       | 7,866                                                    |       | 9,022 |   |
| Net income                                                             |       | $                                                        | 11,321     |   | $ | 14,409 |   |
|                                                                   |       |                                                     |       |   |   |
| Net income per  share:                                                 |       |                                                     |       |   |   |
| Basic                                                                  |       | $                                                        | 0.39       |   | $ | 0.55 |   |
| Diluted                                                                |       | $                                                        | 0.38       |   | $ | 0.51 |   |
|                                                                   |       |                                                     |       |   |   |
| Weighted average  shares outstanding:                                  |       |                                                     |       |   |   |
| Basic                                                                  |       | 28,874                                                   |       | 25,975 |   |
| Diluted                                                                |       | 29,924                                                   |       | 29,946 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

2

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**GUITARCENTER, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(In thousands, except per share data)**

**(Unaudited)**

 
| ** **                                                               | ** ** | **Nine months ended September 30,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| Net sales                                                                |       | $                                                       | 1,401,457  |   | $ | 1,219,743 |   |
| Cost of goods  sold, buying and occupancy                                |       | 1,000,327                                               |       | 869,413 |   |
| Gross profit                                                             |       | 401,130                                                 |       | 350,330 |   |
| Selling, general  and administrative expenses                            |       | 331,120                                                 |       | 275,266 |   |
| Operating income                                                         |       | 70,010                                                  |       | 75,064 |   |
| Interest  expense, net of interest income of $216 and $675, respectively |       | 6,399                                                   |       | 4,811 |   |
| Gain on sale of  property                                                |       | 2,115                                                   |       | — |   |
| Income before  income taxes                                              |       | 65,726                                                  |       | 70,253 |   |
| Income taxes                                                             |       | 25,269                                                  |       | 27,049 |   |
| Net income                                                               |       | $                                                       | 40,457     |   | $ | 43,204 |   |
|                                                                     |       |                                                    |       |   |   |
| Net income per  share:                                                   |       |                                                    |       |   |   |
| Basic                                                                    |       | $                                                       | 1.49       |   | $ | 1.67 |   |
| Diluted                                                                  |       | $                                                       | 1.41       |   | $ | 1.52 |   |
|                                                                     |       |                                                    |       |   |   |
| Weighted average  shares outstanding:                                    |       |                                                    |       |   |   |
| Basic                                                                    |       | 27,119                                                  |       | 25,819 |   |
| Diluted                                                                  |       | 29,911                                                  |       | 29,836 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

3

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**GUITARCENTER, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

 

 
| ** **                                                                                   | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| **Operating  activities:**                                                                   |       |                                                    |       |   |   |
| Net income                                                                                   |       | $                                                       | 40,457     |   | $ | 43,204 |   |
| Adjustments to  reconcile net income to net cash (used in) provided by operating activities: |       |                                                    |       |   |   |
| Depreciation and amortization                                                                |       | 26,634                                                  |       | 20,630 |   |
| (Gain) loss on disposal of property and equipment                                            |       | (2,115                                                  | )          | 1,849 |   |
| Amortization of deferred financing fees                                                      |       | 539                                                     |       | 784 |   |
| Stock-based compensation                                                                     |       | 14,941                                                  |       | — |   |
| Tax benefit from exercise of stock options                                                   |       | —                                                  |       | 7,175 |   |
| Deferred income taxes                                                                        |       | (7,139                                                  | )          | 350 |   |
| Changes in  operating assets and liabilities, net of effect of acquisitions:                 |       |                                                    |       |   |   |
| Accounts receivable                                                                          |       | (2,250                                                  | )          | 5,653 |   |
| Merchandise inventories                                                                      |       | (104,185                                                | )          | (82,193 | ) |
| Prepaid expenses and other current assets                                                    |       | (5,869                                                  | )          | (4,703 | ) |
| Other assets, net                                                                            |       | (297                                                    | )          | (725 | ) |
| Accounts payable                                                                             |       | 31,330                                                  |       | 34,977 |   |
| Accrued expenses and other current liabilities                                               |       | (39,088                                                 | )          | (18,271 | ) |
| Merchandise advances                                                                         |       | (5,038                                                  | )          | 3,817 |   |
| Other long-term liabilities                                                                  |       | 3,044                                                   |       | (8,289 | ) |
| Net cash (used  in) provided by operating activities                                         |       | (49,036                                                 | )          | 4,258 |   |
| **Investing  activities:**                                                                   |       |                                                    |       |   |   |
| Purchase of property and equipment                                                           |       | (61,542                                                 | )          | (60,305 | ) |
| Proceeds from sale of property and equipment                                                 |       | 2,565                                                   |       | — |   |
| Purchase of available-for-sale securities                                                    |       | —                                                  |       | (27,305 | ) |
| Proceeds from sale of available-for-sale securities                                          |       | —                                                  |       | 47,460 |   |
| Acquisition of businesses, net of cash acquired                                              |       | (20,815                                                 | )          | (101,925 | ) |
| Net cash used in  investing activities                                                       |       | (79,792                                                 | )          | (142,075 | ) |
| **Financing  activities:**                                                                   |       |                                                    |       |   |   |
| Net change in borrowings under revolving line of  credit                                     |       | 115,174                                                 |       | 74,004 |   |
| Proceeds from exercise of stock options                                                      |       | 6,086                                                   |       | 10,175 |   |
| Proceeds from stock issued under employee purchase  plan                                     |       | 1,220                                                   |       | 953 |   |
| Excess tax benefit from exercise of stock options                                            |       | 2,033                                                   |       | — |   |
| Repayment of long-term debt                                                                  |       | (3                                                      | )          | — |   |
| Net cash  provided by financing activities                                                   |       | 124,510                                                 |       | 85,132 |   |
| Net decrease in  cash and cash equivalents                                                   |       | (4,318                                                  | )          | (52,685 | ) |
| Cash and cash  equivalents at beginning of period                                            |       | 14,529                                                  |       | 60,453 |   |
| Cash and cash  equivalents at end of period                                                  |       | $                                                       | 10,211     |   | $ | 7,768 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

4

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**GUITARCENTER, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                                      | ** ** | **Nine months ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| **Non-cash  investing and financing activities:**                                               |       |                                                    |       |   |   |
| Acquisition of  businesses, in which the fair value of assets and liabilities were as  follows: |       |                                                    |       |   |   |
| Accounts receivable                                                                             |       | $                                                       | 583        |   | $ | 5,745 |   |
| Merchandise inventories                                                                         |       | 8,507                                                   |       | 59,424 |   |
| Prepaid expenses and other current assets                                                       |       | —                                                  |       | 677 |   |
| Property and equipment                                                                          |       | 597                                                     |       | 3,775 |   |
| Goodwill                                                                                        |       | 10,698                                                  |       | 49,663 |   |
| Intangible assets                                                                               |       | 1,107                                                   |       | — |   |
| Other assets                                                                                    |       | —                                                  |       | 5,299 |   |
| Total assets acquired                                                                           |       | 21,492                                                  |       | 124,583 |   |
| Current liabilities                                                                             |       | (1,564                                                  | )          | (19,779 | ) |
| Other long-term liabilities                                                                     |       | —                                                  |       | (460 | ) |
| Deferred income taxes                                                                           |       | 887                                                     |       | (2,419 | ) |
| Total liabilities assumed                                                                       |       | (677                                                    | )          | (22,658 | ) |
| Net assets acquired                                                                             |       | $                                                       | 20,815     |   | $ | 101,925 |   |
|                                                                                            |       |                                                    |       |   |   |
| Conversion of debt to  common stock                                                             |       | $                                                       | 98,512     |   | $ | — |   |

 

*See accompanying notes toconsolidated financial statements.*

5

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

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

*Nature ofBusiness*

Guitar Center, Inc.(the “Company”) is the leading United States retailer of guitars, amplifiers,percussion instruments, keyboards and pro-audio and recording equipment. As ofSeptember 30, 2006, our retail subsidiary operated 194 Guitar Center storesacross the United States consisting of 132 primary format stores, 59 secondaryformat stores and 3 tertiary format stores. In addition, as ofSeptember 30, 2006, our Music & Arts Center division operatedmore than 90 stores specializing in band instruments for sale and rental,serving teachers, band directors, college professors and students. We are alsothe largest direct response retailer of musical instruments in the UnitedStates through our wholly owned subsidiary, Musician’s Friend, Inc., andits catalog and website, www.musiciansfriend.com.

*Basis ofPresentation*

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

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

*Use of Estimatesin the Preparation of Financial Statements*

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

*Reclassifications*

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

**2.**Acquisitionof Businesses**

During the second quarterof 2006, our Guitar Center division acquired four retail locations in Texas andrelated net assets from Hermes Trading Company, Inc., a musical instrumentsretailer, for approximately $11.0 million.

During the nine monthsended September 30, 2006, our Music & Arts Center division acquired a totalof 13 stores and related net assets for an aggregate purchase price ofapproximately $9.8 million.

The aggregate purchaseprice for the acquisitions in the nine months ended September 30, 2006(including purchase price adjustments of $0.4 million) totaled approximately$20.8 million, which was principally allocated to merchandise inventories of$8.5 million and goodwill of $10.7 million.

The acquisitions wereaccounted for under the purchase method of accounting in accordance withStatement of Financial Accounting Standards (“SFAS”) No. 141, “*Business Combinations*.” The results of operations of theacquisitions were not material to the current period consolidated financialstatements and, as such, pro forma financial information is not presented forthese acquisitions. The results of operations of the acquired businesses areincluded in the consolidated financial statements from the respective dates ofacquisition.

6

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

**3.**Goodwilland Intangible Assets**

Goodwill represents theexcess of the purchase price over the fair value of identifiable net assetsacquired resulting from business acquisitions accounted for under the purchasemethod. The changes in the carrying amount of goodwill by reportable segmentfor the nine months ended September 30, 2006 were as follows (in thousands):
|                                       | ** ** | **Guitar** | ** ** | **Music &** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|----------------------|------------|---------------------|------------|------------|------------|
| ** **                            | ** ** | **Center** | ** ** | **Arts**             | ** ** | **Friend**          | ** ** | **Total**  | ** ** |
| Balance at  December 31, 2005         |       | $          | 5,382      |                 | $          | 77,106              |       | $          | 3,441      |   | $ | 85,929 |   |
| Goodwill  resulting from acquisitions |       | 8,160      |       | 2,106                |       | —              |       | 10,266     |       |
| Goodwill  adjustments                 |       | —     |       | 432                  |       | —              |       | 432        |       |
| Balance at September 30,  2006        |       | $          | 13,542     |                 | $          | 79,644              |       | $          | 3,441      |   | $ | 96,627 |   |

 

Intangible assets withdefinite useful lives are amortized over their respective estimated usefullives. The following is a summary of intangible assets as of September 30, 2006and December 31, 2005 (dollars in thousands, life in years):
|                          | ** ** | ** **              | ** ** | **September 30, 2006** | ** ** |
|--------------------------|------------|-------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **Weighted-**           | ** ** | **Gross**                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Average Useful** | ** ** | **Carrying**                     | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Life**                | ** ** | **Amount**                       | ** ** | **Amortization** | ** ** | **Total** | ** ** |
| Unamortized  trademark   |       | —                  |       | $                                | 5,367      |   | $ | — |   | $ | 5,367 |   |
| Amortized                |       |                    |       |                             |       |   |   |   |   |
| Customer contracts       |       | 1.4                     |       | 4,003                            |       | (3,640 | ) | 363 |   |
| Covenants not to compete |       | 3.9                     |       | 2,674                            |       | (1,133 | ) | 1,541 |   |
| Other                    |       | 2.6                     |       | 852                              |       | (588 | ) | 264 |   |
| Intangible assets, net   |       |                    |       | $                                | 12,896     |   | $ | (5,361 | ) | $ | 7,535 |   |

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

 

Amortization ofintangible assets is included in selling, general and administrative expenses.The estimated amortization expense related to intangible assets for each of thefive years and thereafter as of September 30, 2006 is as follows (inthousands):

7

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| Year ending December 31, | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
|                                    |       |       |       |
| Remainder of  2006                      |       | $          | 387        |   |
| 2007                                    |       | 983        |       |
| 2008                                    |       | 409        |       |
| 2009                                    |       | 247        |       |
| 2010                                    |       | 97         |       |
| 2011                                    |       | 45         |       |
| Thereafter                              |       | —     |       |
| Total                                   |       | $          | 2,168      |   |

 

**4. Net Income Per Share**

The following tablesummarizes the calculation of diluted weighted average shares and diluted netincome per share for the periods presented below (in thousands, except pershare data):
|                                                                                | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                     | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                     | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net income, as  reported                                                       |       | $                                | 11,321     |                            | $          | 14,409 |   | $ | 40,457 |   | $ | 43,204 |   |
| Add back  interest, net of tax, on 4% Senior Convertible Notes (a)             |       | 118                              |       | 727                             |       | 1,722 |   | 2,181 |   |
| Net income,  excluding interest expense on 4% Senior Convertible Notes         |       | $                                | 11,439     |                            | $          | 15,136 |   | $ | 42,179 |   | $ | 45,385 |   |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Basic weighted  average shares outstanding                                     |       | 28,874                           |       | 25,975                          |       | 27,119 |   | 25,819 |   |
| Dilutive effect  of stock options outstanding                                  |       | 650                              |       | 1,079                           |       | 740 |   | 1,125 |   |
| Shares issuable  on assumed conversion of 4% Senior Convertible Notes (b) |       | 400                              |       | 2,892                           |       | 2,052 |   | 2,892 |   |
| Diluted weighted  average shares outstanding                                   |       | 29,924                           |       | 29,946                          |       | 29,911 |   | 29,836 |   |
|                                                                           |       |                             |       |                            |       |   |   |   |   |
| Basic net income  per share                                                    |       | $                                | 0.39       |                            | $          | 0.55 |   | $ | 1.49 |   | $ | 1.67 |   |
| Diluted net income per  share                                                  |       | $                                | 0.38       |                            | $          | 0.51 |   | $ | 1.41 |   | $ | 1.52 |   |

 

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(a)   Represents theinterest expense for the period the 4% Senior Convertible Notes (the “Notes”)were outstanding, including contingent interest and amortization of deferredfinancing costs, net of tax, using an effective tax rate of 41.0% and 37.7% forthe three and nine months ended September 30, 2006 and 38.5% for the three andnine months ended September 30, 2005.

(b)   Represents theweighted-average number of common shares issuable upon the conversion of theNotes, up to the date of actual conversion.

For the three and ninemonths ended September 30, 2006 and 2005, the only potential additionalshares of common stock that could become outstanding were shares issuable uponexercise of stock options and conversion of the Notes up to the date of actualconversion.

For the three and ninemonths ended September 30, 2006, options to acquire weighted-averageshares of 1,059,000 and 869,000, respectively, were outstanding but wereexcluded from the computation of diluted net income per share because theireffect was anti-dilutive. For the three and nine months endedSeptember 30, 2005, options to acquire weighted-average shares of 77,000and 177,000, respectively, were outstanding but were excluded from thecomputation of diluted net income per share because their effect wasanti-dilutive.

For the three and ninemonths ended September 30, 2006, 0.4 million and 2.1 million shares,respectively, of common stock issuable upon conversion of the Notes issued inJune 2003 (reflecting an effective conversion price of $34.58) were deemedto be potential common stock and were deemed to be outstanding for the purposesof calculating diluted net income per share under the “if-converted” method ofaccounting under which the after-tax interest expense, including

8

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contingentinterest and amortization of deferred financing costs, for the period is addedback to net income. For the three and nine months ended September 30, 2005, thecommon stock issuable upon conversion of the Notes amounted to 2.9 millionshares. The Notes were called for redemption by the Company on June 15, 2006and substantially all of the outstanding Notes were converted into common stockprior to the July 15, 2006 redemption date. See Note 9 for further discussionof the Notes.

**5. Segment Information**

Our reportable businesssegments are Guitar Center stores, Music & Arts Center and Musician’sFriend direct response. Management evaluates segment performance basedprimarily on net sales, operating income (loss) and income (loss) before incometaxes. Accounting policies of the segments are the same as the accountingpolicies for the consolidated company. There are no differences between themeasurements of profits or losses or assets of the reportable segments andthose of the Company on a consolidated basis.

The following tablesummarizes financial information for our operating segments as of September 30,2006 and December 31, 2005 and for the three and nine months endedSeptember 30, 2006 and 2005 (in thousands):
|                                                | ** ** | **Three Months Ended September 30, 2006** | ** ** | **Nine Months Ended September 30, 2006** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Guitar**                                                         | ** ** | **Music &**                                              | ** ** | **Musician’s** | ** ** | ** ** | ** ** | **Guitar** | ** ** | **Music &** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Center**                                                         | ** ** | **Arts**                                                          | ** ** | **Friend** | ** ** | **Total** | ** ** | **Center** | ** ** | **Arts** | ** ** | **Friend** | ** ** | **Total** | ** ** |
| Net Sales                                      |       | $                                                                  | 352,470    |                                                              | $          | 34,190 |   | $ | 86,072 |   | $ | 472,732 |   | $ | 1,031,601 |   | $ | 99,180 |   | $ | 270,676 |   | $ | 1,401,457 |   |
| Gross Profit                                   |       | 94,123                                                             |       | 13,331                                                            |       | 25,813 |   | 133,267 |   | 277,327 |   | 42,667 |   | 81,136 |   | 401,130 |   |
| Depreciation and amortization                  |       | 7,228                                                              |       | 1,331                                                             |       | 883 |   | 9,442 |   | 20,167 |   | 4,111 |   | 2,356 |   | 26,634 |   |
| Selling, general  and adiministrative expenses |       | 75,616                                                             |       | 17,411                                                            |       | 20,995 |   | 114,022 |   | 219,731 |   | 46,884 |   | 64,505 |   | 331,120 |   |
| Operating income  (loss)                       |       | 18,507                                                             |       | (4,080                                                            | )          | 4,818 |   | 19,245 |   | 57,596 |   | (4,217 | ) | 16,631 |   | 70,010 |   |
| Income (loss)  before income tax (benefit)     |       | 20,984                                                             |       | (7,062                                                            | )          | 5,265 |   | 19,187 |   | 60,495 |   | (12,808 | ) | 18,039 |   | 65,726 |   |
| Capital expenditures                           |       | 21,164                                                             |       | 679                                                               |       | 1,653 |   | 23,496 |   | 53,498 |   | 2,609 |   | 5,435 |   | 61,542 |   |
|                                                |            |                                                                    |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                                                | ** ** | **Three Months Ended September 30, 2005** | ** ** | **Nine Months Ended September 30, 2005** | ** ** |
|------------------------------------------------|------------|--------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **Guitar**                                                         | ** ** | **Music &**                                              | ** ** | **Musician’s** | ** ** | ** ** | ** ** | **Guitar** | ** ** | **Music &** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Center**                                                         | ** ** | **Arts**                                                          | ** ** | **Friend** | ** ** | **Total** | ** ** | **Center** | ** ** | **Arts (1)** | ** ** | **Friend** | ** ** | **Total** | ** ** |
| Net Sales                                      |       | $                                                                  | 310,130    |                                                              | $          | 30,121 |   | $ | 80,810 |   | $ | 421,061 |   | $ | 904,410 |   | $ | 65,032 |   | $ | 250,301 |   | $ | 1,219,743 |   |
| Gross Profit                                   |       | 87,014                                                             |       | 13,299                                                            |       | 23,505 |   | 123,818 |   | 247,139 |   | 27,413 |   | 75,778 |   | 350,330 |   |
| Depreciation and amortization                  |       | 5,388                                                              |       | 1,295                                                             |       | 630 |   | 7,313 |   | 15,902 |   | 3,017 |   | 1,711 |   | 20,630 |   |
| Selling, general  and adiministrative expenses |       | 64,120                                                             |       | 14,611                                                            |       | 19,635 |   | 98,366 |   | 186,310 |   | 34,437 |   | 54,519 |   | 275,266 |   |
| Operating income  (loss)                       |       | 22,894                                                             |       | (1,312                                                            | )          | 3,870 |   | 25,452 |   | 60,829 |   | (7,024 | ) | 21,259 |   | 75,064 |   |
| Income (loss)  before income tax (benefit)     |       | 22,867                                                             |       | (3,715                                                            | )          | 4,279 |   | 23,431 |   | 60,145 |   | (12,264 | ) | 22,372 |   | 70,253 |   |
| Capital expenditures                           |       | 21,335                                                             |       | 315                                                               |       | 826 |   | 22,476 |   | 56,016 |   | 810 |   | 3,479 |   | 60,305 |   |
|                                                |            |                                                                    |            |                                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                                     | ** ** | **Guitar** | ** ** | **Music &** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------|------------|----------------------|------------|---------------------|------------|------------|------------|
| ** **                          | ** ** | **Center** | ** ** | **Arts**             | ** ** | **Friend**          | ** ** | **Total**  | ** ** |
| Total assets at  September 30, 2006 |       | $          | 628,913    |                 | $          | 230,686             |       | $          | 83,632     |   | $ | 943,231 |   |
| Total assets at December  31, 2005  |       | $          | 512,802    |                 | $          | 197,045             |       | $          | 70,343     |   | $ | 780,190 |   |

 

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

9

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**6. Stock-BasedCompensation**

Effective January 1,2006, the Company adopted the provisions of, and accounts for stock-basedcompensation in accordance with, SFAS No. 123—revised 2004 (“SFAS No. 123(R)”),“*Share–Based Payment*,” which replacedSFAS No. 123, “*Accounting for Stock–Based Compensation*,”and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “*Accounting for Stock Issued to Employees*.” Under the fairvalue recognition provisions of this statement, stock*–*basedcompensation cost for option awards is measured at the grant date based on thefair value of the award and is recognized as expense on a straight-line basisover the requisite service period of the award. For performance share awards,stock-based compensation expense is measured at the market price of the Company’sstock on the date the underlying plan receives compensation committee approval,or other form of a mutual understanding of the key terms and conditions ofperformance. The Company elected the modified prospective method, under whichprior periods are not restated for comparative purposes. The valuationprovisions of SFAS No. 123(R) apply to new grants subsequent to theeffective date. Estimated compensation for unvested grants that wereoutstanding as of the effective date will be recognized over the remainingservice period using the compensation cost estimated for the SFAS No. 123pro forma disclosures.

Stock-based compensationexpense for all stock award plans included in our consolidated statement ofincome for the three months ended September 30, 2006 was $3.0 million ($1.8million, net of tax), or $0.06 per diluted share. Stock-based compensationexpense for all stock award plans included in our consolidated statement ofincome for the nine months ended September 30, 2006 was $14.9 million ($9.2million, net of tax), or $0.31 per diluted share. Stock-based compensationexpense for all stock award plans included in our consolidated statement ofincome for the three and nine months ended September 30, 2005 was $1.4million ($0.8 million, net of tax), or $0.03 per diluted share. As a result ofadopting SFAS No. 123(R) on January 1, 2006, income before income taxesfor the three and nine months ended September 30, 2006 was $2.8 million and$10.7 million lower, respectively, and net income for the three and nine monthsended September 30, 2006 was $1.7 million and $6.6 million lower, respectively,than if we had continued to account for stock-based compensation under APBNo. 25. If we had not adopted SFAS No. 123(R), our basic and dilutednet income per share for the three months ended September 30, 2006 would havebeen increased by $0.06 and for the nine months ended September 30, 2006, basicand diluted income per share would have been increased by $0.25 and $0.22,respectively. Under the APB No. 25 intrinsic value method, the Company wouldnot have recorded stock-based compensation expense in 2006 related to stockoption awards, but would have recorded stock-based compensation expense relatedto awards of performance shares, restricted stock and deferred stock.

Prior to the adoption ofSFAS No. 123(R), we presented all tax benefits for deductions resultingfrom the exercise of stock options as operating cash flows on our consolidatedstatement of cash flows. SFAS No. 123(R) requires the benefits of taxdeductions in excess of recognized compensation expense to be reported as afinancing cash flow, rather than as an operating cash flow. This requirementwill reduce net operating cash flows and increase net financing cash flows inperiods after adoption. Total cash flow will remain unchanged from what wouldhave been reported under prior accounting rules. For the nine months endedSeptember 30, 2006, $2.0 million of excess tax benefits from the exercise ofstock options reported in financing cash flows would have been reported asoperating cash flows had SFAS No. 123(R) not been adopted.

The following tabledetails the effect on net income and net income per share as if we had appliedthe fair value recognition provisions of SFAS No. 123 to stock-basedcompensation during the three and nine months ended September 30, 2005 (in thousands,except per share data):

10

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|                                                                                                                                                | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| Net income, as  reported                                                                                                                       |       | $                                | 14,409     |                             | $          | 43,204 |   |
| Add: Total  stock-based employee compensation expense, net of related tax effects                                                              |       | 883                              |       | $                                | 883        |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  methods for all awards, net of related tax effects |       | 2,765                            |       | 5,541                            |       |
| Pro forma net  income                                                                                                                          |       | $                                | 12,527     |                             | $          | 38,546 |   |
|                                                                                                                                           |       |                             |       |                             |       |
| Net income per  share:                                                                                                                         |       |                             |       |                             |       |
| Basic - as reported                                                                                                                            |       | $                                | 0.55       |                             | $          | 1.67 |   |
| Basic - pro forma                                                                                                                              |       | $                                | 0.48       |                             | $          | 1.49 |   |
| Diluted - as reported                                                                                                                          |       | $                                | 0.51       |                             | $          | 1.52 |   |
| Diluted - pro forma                                                                                                                            |       | $                                | 0.44       |                             | $          | 1.37 |   |

 

*IncentiveCompensation Plans*

Our 2004 Incentive StockAward Plan (as amended, the “2004 Plan”) provides for the issuance of stockoptions, stock appreciation rights, restricted stock, deferred stock, dividendequivalents, performance awards and stock payments, or any combination thereof.Substantially all stock awards are currently issued under the 2004 Plan.

Prior to fiscal 2004, theCompany had adopted various stock option plans (the “Prior Plans”). A smallnumber of grants are expected to be made under the Prior Plans, and outstandingawards under the Prior Plans will continue to be in effect.

Under the 2004 Plan andthe Prior Plans, an aggregate of 1.3 million shares of common stock wereavailable for issuance as of September 30, 2006, which includes 0.7 millionadditional shares approved by our stockholders on April 28, 2006. The Companygenerally issues new shares for stock option exercises, performance shareawards and restricted stock awards.

*StockOptions*

Option grants are issuedat fair market value on the date of grant and generally vest over four years.Option grants generally expire ten years after the date of grant.

In the second quarter of2005, we converted to a lattice-based binomial model from a Black-Scholesmodel. The conversion was implemented beginning with grants issued during thesecond quarter of 2005. The fair value of our grants issued prior to the secondquarter of 2005 was determined using the Black-Scholes model.

Using the lattice-basedbinomial model, the fair value of each option award is estimated based on theassumptions noted in the following table. Because lattice-based binomial modelsincorporate ranges of assumptions for inputs, those ranges are disclosed.Expected volatilities are based on historical volatility of the Company’s stockand implied volatilities for open market exchange-traded options issued “near-the-money”.The Company uses historical data to estimate option exercise and employeedeparture behavior. Assumptions were developed separately for our seniormanagement from the other participants of our stock plans, since seniormanagement’s exercise behavior is expected to differ materially from the otherparticipants. The expected term of share options granted is derived from theoutput of the option pricing model and represents the period of time thatoptions granted are expected to be outstanding. The range in expected termresults from the different post-vesting behaviors exhibited by seniormanagement and the other participants. The risk free interest rate is based onUS Treasury zero-coupon issues with remaining terms similar to the expectedterm of the options.

The assumptions used tovalue option grants under the lattice-based binomial model for the three monthsand nine months ended September 30, 2006 and 2005 are as follows:

11

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|                                       | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Expected  volatility range            |       | 40-43                                                    | %          | 32-52                                                   | %          | 35-49 | % | 32-52 | % |
| Weighted-average  expected volatility |       | 41.3                                                     | %          | 42.0                                                    | %          | 41.6 | % | 42.0 | % |
| Expected term  (in years)             |       | 4.38                                                     |       | 7.38                                                    |       | 4.38-5.75 |   | 7.38 |   |
| Risk-free  interest rate              |       | 4.3-4.7                                                  | %          | 3.5-4.0                                                 | %          | 4.3-4.9 | % | 3.5-4.0 | % |
| Expected  dividends                   |       | —                                                   |       | —                                                  |       | — |   | — |   |

 

Stock option activity forall plans during the nine months ended September 30, 2006 is as follows:
|                                    | ** ** | ** **                  | ** ** | ** **    | ** ** | **Weighted-**             | ** ** | ** **               | ** ** |
|------------------------------------|------------|-----------------------------|------------|---------------|------------|---------------------------|------------|--------------------------|------------|
| ** **                         | ** ** | ** **                  | ** ** | **Weighted-** | ** ** | **Average**               | ** ** | ** **               | ** ** |
| ** **                         | ** ** | ** **                  | ** ** | **Average**   | ** ** | **Remaining**             | ** ** | **Aggregate**            | ** ** |
| ** **                         | ** ** | ** **                  | ** ** | **Exercise**  | ** ** | **Contractual Term** | ** ** | **Intrinsic Value** | ** ** |
| ** **                         | ** ** | **No. of Shares** | ** ** | **Price**     | ** ** | **(in years)**       | ** ** | **(in thousands)**  | ** ** |
| Outstanding at  December 31, 2005  |       | 2,802,394                   |       | $             | 31.94      |                      |       |                     |       |   |
| Granted                            |       | 558,400                     |       | 43.60         |       |                      |       |                     |       |
| Exercised                          |       | (290,485                    | )          | 20.95         |       |                      |       |                     |       |
| Forfeited                          |       | (92,647                     | )          | 49.82         |       |                      |       |                     |       |
| Expired                            |       | —                      |       | —        |       |                      |       |                     |       |
| Outstanding at  September 30, 2006 |       | 2,977,662                   |       | $             | 34.63      |                      | 6.85       |                     | $          | 38,404 |   |
|                               |       |                        |       |          |       |                      |       |                     |       |
| Exercisable at  September 30, 2006 |       | 1,736,811                   |       | $             | 26.11      |                      | 5.43       |                     | $          | 34,302 |   |

 

The weighted-averagegrant-date fair value of options granted during the three and nine months endedSeptember 30, 2006 was $18.07 and $18.85. The weighted-average grant-date fairvalue of options granted during the three and nine months ended September 30,2005 was $32.91 and 27.09. The aggregate intrinsic value of options (the amountby which the stock price on the date of exercise exceeded the stock price ofthe option on the date of grant) exercised during the nine months endedSeptember 30, 2006 and 2005 was $8.3 million and $25.6 million, respectively.

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

*Employee StockPurchase Plan*

Our Employee StockPurchase Plan (the “ESPP”) is a tax-qualified employee stock purchase planunder which options are permitted to purchase our common stock at a price whichis eighty-five percent of the stock’s fair market value on either the first orlast day of the offering period, whichever price is lower. The options are thenautomatically exercised on the last business day of the offering periods, whichend in June and December. The participants purchase the shares through payrolldeductions.

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

12

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|                                         | ** ** | **Three months ended** | ** ** | **Nine months ended**  | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **September 30, 2006** | ** ** | **September 30, 2006** | ** ** |
| Expected  volatility range              |       | 34-40                            | %          | 32-40                            | %          |
| Weighted-average  expected volatility   |       | 36.9                             | %          | 36.5                             | %          |
| Expected term                           |       | 6 months                         |       | 6 months                         |       |
| Risk-free  interest rate                |       | 5.0                              | %          | 4.4-5.0                          | %          |
| Weighted-average grant-date  fair value |       | $                                | 11.62      |                             | $          | 12.20 |   |
|                                         |            |                                  |            |                                  |            |  |  |

 

Total stock-basedcompensation expense recognized for ESPP options was $0.2 million and $0.6million, respectively, for the three and nine months ending September 30, 2006.

*Long TermIncentive Plan*

In July 2005, the Companyadopted the Long Term Incentive Plan (the “LTIP”), which provides equityincentives to senior management that include not only stock options or similargrants, but also a performance share program that measures performance on amulti-year basis. The performance period under the LTIP began on July 1,2005 and ends on December 31, 2007. Awards under the LTIP are made underthe 2004 Plan or any successor plan. It is expected that each participant willreceive an annual grant of stock options under the 2004 Plan, pursuant to itsterms. Performance shares in the form of common stock are earned by theparticipants based upon specified objective performance goals during theperformance period of the LTIP. The number of shares issuable could change ifwe add or subtract executives to or from the plan. The compensation committeealso has the discretion to make cash payments in lieu of performance shares.Any subsequent long-term incentive plans established during the performanceperiod for inclusion of new participants are combined for reporting purposeswith the LTIP.

The target number ofperformance shares potentially issuable under the LTIP is expected to be250,912, with the actual number of shares ultimately issuable to be betweenzero and twice such amount, depending on actual performance and number ofparticipants. Included in the target performance shares are 21,382 shares fortwo new executives added to the plan effective April 1, 2006. The performanceperiod for these new participants began on April 1, 2006 and ends on December31, 2007. The number of target shares was reduced in the third quarter of 2006by 15,273 shares due to the departure of a participant. The previously recordedstock compensation expense related to this participant was reversed in thethird quarter of 2006.

Stock-based compensationexpense related to the LTIP is estimated based on forecasted performance duringthe performance period compared to plan targets. At the end of each reportingperiod, we reevaluate our assessment of performance under the plan and makeadjustments to the expense as necessary based on the latest estimatesavailable. The fair value of performance share awards is based on the marketprice of the Company’s stock on the date the underlying plan receivescompensation committee approval, or other form of a mutual understanding of thekey terms and conditions of performance.

For the three monthsended September 30, 2006, the Company recorded a $0.1 million reduction tostock-based compensation expense related to the LTIP. For the nine months endedSeptember 30, 2006, the Company recorded stock-based compensation expenserelated to the LTIP of $5.0 million ($3.1 million net of tax), or $0.10 perdiluted share. Included in the $5.0 million expense is $1.8 million ofstock-based compensation expense recorded in the first quarter of 2006 relatedto the LTIP that should have been recorded in the fourth quarter of 2005 underthe variable plan accounting method established by APB No. 25. The Companydoes not believe that this misstatement is material to our current orpreviously issued consolidated financial statements.

*Restricted Stock Awards/DeferredStock Awards*

Awards of restrictedstock and deferred stock are generally made to the non-employee directors ofthe Company and are measured on the date of grant. These time-based awards vestover three to five years and are forfeitable under certain conditions.

A summary of the Company’sawards of performance shares, restricted stock, and deferred stock as of andfor the nine months ended September 30, 2006 is presented below:

13

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|                                          | ** ** | ** **                  | ** ** | **Weighted-Average**     | ** ** |
|------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                               | ** ** | **No. of Shares** | ** ** | **Grant-Date Fair** | ** ** |
| ** **                               | ** ** | **(1)**                     | ** ** | **Value**                | ** ** |
| Nonvested  balance at December 31, 2005  |       | 506,848                     |       | $                        | 55.94      |   |
| Granted                                  |       | 63,051                      |       | 48.88                    |       |
| Vested                                   |       | (2,014                      | )          | 49.93                    |       |
| Forfeited                                |       | (30,546                     | )          | 56.32                    |       |
| Nonvested balance at  September 30, 2006 |       | 537,339                     |       | $                        | 55.12      |   |

 

----

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

*The total fair value of restricted stock anddeferred stock vested during the nine months ended September 30, 2006 wasimmaterial. Based on our latest estimates, there was $6.7 million ($4.0 millionnet of tax) of total unrecognized compensation cost for nonvested shares, as ofSeptember 30, 2006, that is expected to be recognized over a weighted averageperiod of 1.5 years.*

**7. Legal Proceedings**

On November 29, 2005, acase was filed against the Company and other defendants, including our ChiefExecutive Officer, in the United States District Court for the Southern Districtof Florida. The amended complaint asserts, among other things, violations ofthe Federal Racketeering Influenced and Corrupt Organization Act (RICO) and acorresponding Florida statute, Sections 1 and 2 of the Sherman Antitrust Act,Section 2 of the Clayton Act (as amended by the Robinson-Patman Act), theFlorida Antitrust Act of 1980, and the Florida Deceptive and Unfair TradePractices Act, as well as tortious interference with business relationshipunder Florida law, various common law claims and civil conspiracy under Floridalaw by some or all of the identified defendants in connection with the claimedinability of Ace Pro Sound and Recording, L.L.C. to obtain vendor lines for itsstore. The complaint purports to be made as a class action on behalf of allcurrent and former retail sellers of musical instruments and/or sound equipmentand/or recording equipment with stores located in geographical regions in theUnited States wherein some or all of the defendants have carried on business,and seeks compensatory damages, treble damages, punitive damages, injunctiverelief and attorneys’ fees.

The Company and the otherdefendants, under a joint defense agreement, have filed motions to dismiss allclaims and the plaintiff has filed reply briefs.

While we believe thislawsuit is without merit and intend to defend it vigorously, it may, regardlessof the outcome, result in substantial expenses and damages to us and maysignificantly divert the attention of our management. There can be no assurancethat we will be able to achieve a favorable settlement of this lawsuit orobtain a favorable resolution of this lawsuit if it is not settled. Anunfavorable resolution of this lawsuit could have a material adverse effect onour business, financial condition and results of operations. Regardless of theoutcome, the costs and expenses incurred by us to defend this lawsuit couldadversely impact our financial condition.

On October 13, 2004, aputative class action lawsuit entitled Carlos Rodriguez v. The Guitar Center,Inc. [sic], Case No. GC322958, was filed in the Superior Court of the State ofCalifornia for the County of Los Angeles. The lawsuit was filed by anindividual purporting to represent all hourly retail store employees employedby us within the State of California. On December 15, 2004, a putative classaction lawsuit entitled James McClain et. al. v. Guitar Center Stores, Inc.,Case No. BC326002, was filed in the Superior Court of the State of Californiafor the County of Los Angeles. The lawsuit was filed by three individualspurporting to represent all hourly retail store employees employed by us withinthe State of California. Among other things, the lawsuits alleged that weimproperly failed to document and enforce break-time and lunch-time periods forsuch employees and sought an unspecified amount of damages, penalties andattorneys’ fees. In July 2006, the court approved a final class actionsettlement. Pursuant to the settlement, the Company made payments to the classmembers in October 2006 of approximately $2.9 million to fully resolve claimsby eligible class members.

In addition to thelawsuits described above, we are involved in various claims and legal actionsarising in the ordinary course of our business and, while the results of thoseproceedings cannot be predicted with certainty, we believe that the finaloutcome of those matters will not have a material adverse effect on ourbusiness, financial condition and results of operations.

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**8. Common Stock**

On April 28, 2006, theCompany’s stockholders approved an amendment to the Restated Certificate ofIncorporation to increase the number of authorized shares of common stock from55 million to 100 million.

**9. Conversion of Notes**

On June 15, 2006, theCompany called for redemption all of the outstanding Notes due 2013. The Noteswere originally issued on June 13, 2003 in the aggregate principal amount of$100 million. Holders were able to convert the Notes into shares of commonstock at an effective conversion price of approximately $34.58 per share, inlieu of accepting redemption. Prior to the redemption date of July 15, 2006, holdersof substantially all of the remaining outstanding Notes elected to converttheir Notes into shares of the Company’s common stock. As a result of theseconversions, approximately 2.9 million shares of common stock were issued tothe holders that elected to convert their Notes. In connection with theredemption of the unconverted Notes, the Company paid approximately $3,000 incash, which includes the redemption and premium payments and cash paid in lieuof fractional shares. In conjunction with the redemption, the Companyreclassified approximately $1.5 million of unamortized debt issuance costs fromother assets to additional paid-in capital in the third quarter of 2006.

**Item 2. MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**General**

Guitar Center, Inc.is the leading United States retailer of guitars, amplifiers, percussion instruments,keyboards and pro-audio and recording equipment.  As of September 30, 2006, our retailsubsidiary operated 194 Guitar Center stores across the United Statesconsisting of 132 primary format stores, 59 secondary format stores and 3tertiary format stores. In addition, as of September 30, 2006, ourMusic & Arts Center division operated more than 90 stores specializingin band instruments for sale and rental, serving teachers, band directors,college professors and students. We are also the largest direct responseretailer of musical instruments in the United States through our wholly ownedsubsidiary, Musician’s Friend, Inc., and its catalog and website,www.musiciansfriend.com.

During the third quarter,we opened a total of ten Guitar Center stores, including three primary format storesin Fairview Heights, Illinois, Fayetteville, Georgia and Lewisville, Texas, sixsecondary format stores in Allentown, Pennsylvania, Beaumont, Texas, Davenport,Iowa, Greensboro, North Carolina, Lubbock, Texas and Reno, Nevada and atertiary format store in Sioux Falls, South Dakota . The new stores added 113,000square feet of retail space and increased the retail space for Guitar Centerstores to a total of 2.8 million square feet at the end of the third quarter of2006.

As we enter new markets,we expect that we will initially incur higher administrative and promotionalcosts per store than is currently experienced in established markets. We expectcompetition to continue to increase as other music product retailers attempt toexecute national growth strategies. Our business strategy will also emphasizeopportunities to continue to grow each of our brands, including furtheracquisitions if attractive candidates can be located for reasonable prices.

**FinancialReporting Change**

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123 (revised 2004), *Share–Based Payment*(“SFAS No. 123(R)”),effective for a company’s first fiscal year beginning after June 15, 2005. SFASNo. 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*.SFAS No. 123(R) requires all share–based compensation to employees,including grants of employee stock options, to be recognized in the consolidatedstatements of income based on fair values rather than pro forma footnotedisclosure.

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Effective January 1,2006, we adopted SFAS No. 123(R), and elected the modified prospectivetransition method. This method permits us to apply the new requirements on aprospective basis. For additional information on our adoption of SFAS No. 123(R),see Note 6, Stock–Based Compensation, of the Notes toConsolidated Financial Statements in this Quarterly Report on Form 10–Q.

**Executive Summary**

Consolidated net sales forthe quarter ended September 30, 2006 increased 12.3%, or $51.7 million, to$472.7 million compared to $421.1 million in the third quarter of 2005.Consolidated net income for the quarter was $11.3 million, a decrease of 21.4%compared to the third quarter of 2005. Net income per diluted share decreasedto $0.38 from $0.51 in the third quarter of 2005.

For the third quarter of2006, our Guitar Center stores generated 2.9% comparable store sales growth andan increase of 13.7% in total net sales compared to the third quarter of 2005.Sales from new stores totaled $33.3 million and represented 78.8% of theoverall increase in net sales. We opened ten new Guitar Center stores in thequarter. We continue to face a more challenging retail environment, which mayimpact sales and operating margins trends for the foreseeable future.

Musician’s Friend, ourdirect response unit, generated an increase in net sales for the third quarterof 6.5% to $86.1 million compared to $80.8 million in the third quarter of 2005.Gross profit margins increased by 0.9% of net sales compared to the thirdquarter of 2005, reflecting a higher selling margin offset somewhat by reducedshipping and handling revenue resulting from the competitive environment.

For the three monthsended September 30, 2006, net sales for our Music & Arts Center segmentincreased 13.5% to $34.2 million from $30.1 million for the same period in 2005.The increase was generated primarily from newly acquired businesses. Comparablesales for the third quarter were down slightly by 0.2%. Gross profit marginsdeclined by 5.2% of net sales compared to the third quarter of 2005. Thedecrease was primarily the result of lower selling margin, increased occupancycosts, and higher shrink expense.

**Discussion ofCritical Accounting Policies**

In the ordinary course ofbusiness, we have made a number of estimates and assumptions relating to thereporting of results of operations and financial condition in the preparationof our financial statements in conformity with accounting principles generallyaccepted in the United States. Actual results could differ significantly fromthose estimates under different assumptions and conditions. We believe that thefollowing discussion addresses our most critical accounting policies, which arethose that are most important to the portrayal of our financial condition andresults and require management’s most difficult, subjective and complexjudgments, often as a result of the need to make estimates about the effect ofmatters that are inherently uncertain. Additionally, the policy described belowregarding credits and other vendor allowances is unique to our industry anddeserves the attention of a reader of our financial statements.

*Valuation ofInventory*

We value our merchandiseinventory at the lower of cost, using the weighted-average method, or market.Rental inventories are valued at the lower of cost or market using the specificidentification method and are depreciated on a straight-line basis while outunder a rental agreement for rent-to-own sales. We record adjustments to thevalue of inventory based upon obsolescence and changes in market value.Applicable costs associated with bringing inventory through our Guitar Centerretail distribution center are capitalized to inventory. The amounts areexpensed to cost of goods sold as the associated inventory is sold. Managementhas evaluated the current level of inventories considering future customerdemand for our products, taking into account general economic conditions,growth prospects within the marketplace, competition, market acceptance ofcurrent and upcoming products, and management initiatives. Based on thisevaluation, we have recorded impairment adjustments to inventory and to cost ofgoods sold for estimated decreases in net realizable value. These judgments aremade in the context of our customers’ shifting needs, product and technologicaltrends, and changes in the demographic mix of our customers. Amisinterpretation or misunderstanding of these conditions and uncertainties inthe future outlook of our industry or the economy, or other failure to estimatecorrectly, could result in inventory valuation changes as of any given balancesheet date.

*Valuation ofLong-Lived Assets*

Long-lived assets such asproperty and equipment and identifiable intangibles with finite lives arereviewed for

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impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Goodwill and other intangibles withindefinite lives that are not amortized 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;

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

·              Significantnegative industry or economic trends; and

·              Significantdecline in stock value for a sustained period.

For long-lived assetsother than goodwill and intangibles that are not amortized, the determinationof whether impairment has occurred is based on an estimate of undiscountedfuture cash flows attributable to the assets, as compared to the carrying valueof the assets. Assumptions used in these cash flows are consistent withinternal forecasts and consider current and future expected sales volumes andrelated operating costs and any anticipated increases or declines based onexpected market conditions and local business environment factors. If apotential impairment is identified, the amount of the impairment lossrecognized would be determined by estimating the fair value of the assets andrecording a loss if the fair value was less than the book value. Fair valuewill be determined based on appraisal values assessed by third parties, ifdeemed necessary, or a discounted future cash flows analysis. For goodwill andother intangibles that are not amortized, impairment to be recognized ismeasured as the amount by which the carrying amount of the assets exceeds thefair value of the related assets of the underlying reporting unit to which thegoodwill relates.

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

*Sales Returns*

As part of our “satisfactionguaranteed” policy, we allow Guitar Center customers to return productgenerally within 30 days after the date of purchase, and we allow Musician’sFriend customers to return product within 45 days. Music & Arts Centercustomers have 30 business days from the date of purchase to return product. Weregularly review and revise, when deemed necessary, our estimates of salesreturns based upon historical trends. While our estimates during the past fewyears have approximated actual results, actual returns may differ significantlyfrom estimate, either favorably or unfavorably, if factors such as economicconditions or the competitive environment differ from our expectations.

*Credits and OtherVendor Allowances*

We receive cooperativeadvertising allowances (i.e., an allowance from the manufacturer to subsidizequalifying advertising and similar promotional expenditures we make relating tothe vendor’s products), price protection credits (i.e., credits from vendorswith respect to in-stock inventory if the vendor subsequently lowers theirwholesale price for such products) and vendor rebates (i.e., credits or rebatesprovided by vendors based on the purchase of specified products and paid at alater date). Cooperative advertising allowances are recognized as a reductionto selling, general, and administrative expense when we incur the advertisingexpense eligible for the credit. We recognized cooperative advertisingallowances of $2.8 million and $2.6 million for the three months ended September30, 2006 and 2005, respectively. For the nine months ended September 30, 2006and 2005, we recognized $8.4 million and $6.5 million of cooperativeadvertising allowances. Price protection credits and vendor rebates areaccounted for as a reduction of the cost of merchandise inventory and arerecorded at the time the credit or rebate is earned. The effect of priceprotection credits and vendor rebates is recognized in the income statement atthe time the related inventory is sold as a reduction in cost of goods sold.The reserves against cooperative advertising and rebate receivables aredetermined by specifically identifying uncollectible accounts through an agingreview and an analysis of vendor relationships. We received payments for vendorrebates of $7.0 million and $6.1 million for the three months ended September 30,2006 and 2005 and $24.6 million and $23.1 million for the nine months ended September30, 2006 and 2005, respectively. We earned and recognized vendor rebates of $7.4million and $7.7 million for the three months ended September 30, 2006 and2005 and $23.4 million and $21.2 million for the nine months ended September30, 2006 and 2005, respectively. None of these credits are recorded as revenue.

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*Stock-basedCompensation*

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

Under SFASNo. 123(R), we determine the fair value of stock options, includingoptions granted under our Employee Stock Purchase Plan (the “ESPP”), using alattice-based binomial model. Assumptions used in the model were developed inconsultation with an outside valuation specialist. The model requires the inputof several assumptions including expected volatility, dividend yield, andrisk-free rate of return, as well as certain assumptions regarding exercisebehavior. Assumptions were developed separately for our senior management fromthe other participants of our stock plans, since senior management’s exercisebehavior is expected to differ materially from the other participants. Theseassumptions reflect management’s best estimates, but they involve inherentuncertainties based on market conditions, generally outside of our control. Asa result, if other assumptions were used, total stock-based compensation cost,as determined in accordance with SFAS No. 123(R) could have beenmaterially impacted. Furthermore, if different assumptions are used for futuregrants, stock-based compensation could be materially impacted in futureperiods.

Also, under SFASNo. 123(R), stock-based compensation expense is recorded net of estimatedforfeitures. The forfeiture rate assumption used in determining stock-basedcompensation expense is estimated based on historical data. The actualforfeiture rate could differ from these estimates.

Stock-based compensationexpense related to performance share awards issued under our Long TermIncentive Plan (the “LTIP”) is estimated based on our forecasted performancecompared to plan targets. At the end of each reporting period, we reevaluateour assessment of performance under the plan and make adjustments to theexpense as necessary based on the latest estimates available. Under SFASNo. 123(R), the fair value of performance share awards is based on themarket price of the Company’s stock on the date the underlying plan receivescompensation committee approval, or other form of a mutual understanding of thekey terms and conditions of performance.

*Gift Cards*

We sell gift cards to ourcustomers in our Guitar Center retail stores. Revenue from gift card sales isrecognized at redemption of the gift card. Our gift cards do not haveexpiration dates. Based on historical redemption rates, a certain percentage ofgift cards will never be redeemed, which is referred to as “breakage.”Estimated breakage income is recognized as the remaining gift card values areredeemed and is recorded as a reduction of cost of goods sold.

**Results ofOperations**

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

 
| ** **                                    | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                     |       | 100.0                                                    | %          | 100.0                                                   | %          | 100.0 | % | 100.0 | % |
| Gross profit                                  |       | 28.2                                                     |       | 29.4                                                    |       | 28.6 |   | 28.7 |   |
| Selling, general and administrative  expenses |       | 24.1                                                     |       | 23.4                                                    |       | 23.6 |   | 22.6 |   |
| Operating income                              |       | 4.1                                                      |       | 6.0                                                     |       | 5.0 |   | 6.1 |   |
| Interest expense, net                         |       | 0.5                                                      |       | 0.5                                                     |       | 0.5 |   | 0.4 |   |
| Gain on sale of  property                     |       | 0.5                                                      |       | 0.0                                                     |       | 0.2 |   | 0.0 |   |
| Income before income  tax expense             |       | 4.1                                                      |       | 5.5                                                     |       | 4.7 |   | 5.7 |   |
| Income taxes                                  |       | 1.7                                                      |       | 2.1                                                     |       | 1.8 |   | 2.2 |   |
| Net income                                    |       | 2.4                                                      | %          | 3.4                                                     | %          | 2.9 | % | 3.5 | % |

 

**ThreeMonths Ended September 30, 2006 Compared to the Three Months Ended September 30,2005**

Consolidated net sales for the three months ended September30, 2006 increased 12.3% to $472.7 million, compared 

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to$421.1 million for the same period in 2005.

Net sales from Guitar Center stores for the threemonths ended September 30, 2006 totaled $352.5 million, a 13.7% increase from$310.1 million for the same period in 2005. Sales from new stores were $33.3million and represented 78.8% of the total increase in Guitar Center retailstore sales. Comparable Guitar Center store sales for the third quarterincreased 2.9%. Comparable store sales achieved this level despite experiencinga more challenging retail environment throughout the quarter. Comparable storesales are defined as sales for the comparable periods, excluding net salesattributable to stores not open for 14 months as of the end of the reportingperiod. We believe that comparable store sales are a more useful indicator ofstore performance than the change in total net sales, since comparable storesales exclude the effects of changes in the number of stores open. We continueto face a more challenging retail environment, which may impact sales andoperating margin trends for the foreseeable future.

Net sales from the Music & Arts Center segment forthe three months ended September 30, 2006 increased 13.5% to $34.2 million from$30.1 million for the same period in 2005. Substantially all of the salesgrowth for the third quarter of 2006 was generated from new locations,primarily acquired businesses and new affiliates. Comparable sales declinedslightly by 0.2% in the third quarter of 2006.

Net sales from the Musician’s Friend channel totaled$86.1 million for the three months ended September 30, 2006, an increase of$5.3 million, or 6.5%, from the same period in 2005. The increase in salesprimarily reflects the improved leveraging of an expanding buyer file andadvertising strategies. We continue to face increased competition in the directresponse channel, which we expect to impact that segment’s net sales and grossmargin for the foreseeable future.

Consolidated gross profit for the three months endedSeptember 30, 2006 compared to 2005 increased 7.6% to $133.3 million from$123.8 million. Gross profit as a percentage of net sales for the three monthsended September 30, 2006 declined to 28.2% from 29.4% in the same period in2005. As discussed below, we define selling margin as net sales less the costof the associated merchandise charged by the vendor plus the associatedinventory costs from fulfilling inventory through our distribution center. Thecost of merchandise inventory is net of all associated vendor discounts andrebates. Freight is not included in selling margin.

Gross profit as a percentage of net sales for GuitarCenter stores was 26.7% in the third quarter of 2006 compared with 28.1% in thethird quarter of 2005. The decrease in gross margin was primarily due to higheroccupancy costs of 0.8% and lower selling margin of 0.6%. The higher occupancycosts were primarily due to higher store rent and higher depreciation andamortization expense. The selling margin in the prior year period was impactedby the reduction in inventory reserves and benefits associated with unclaimedmerchandise advances.

Gross profit for the Music & Arts Center segmentwas 39.0% for the three months ended September 30, 2006 compared to 44.2% forthe same period in 2005. The decline in gross margin was primarily due toreduced selling margin of 3.1%, higher occupancy costs of 1.5% and highershrink expense of 0.6%. The reduced selling margin was primarily due toadjustments in the prior year period to record higher vendor rebates of 1.7%and higher rental margins on the acquired contracts from the Music & ArtsCenter, Inc. acquisition of 1.0%. The higher occupancy costs were primarily dueto higher rent expense. The higher shrink expense was impacted by higherinstrument recoveries in the prior year period.

Gross profit for the Musician’s Friend segment was30.0% for the three months ended September 30, 2006 compared to 29.1% in thethird quarter of 2005. The increased gross margin was primarily due to higherselling margin of 1.2% partially offset by reduced shipping and handlingrevenue of 0.3%. Reduced shipping and handling revenue resulted from expandedfree freight offers due to increased online competition.

Consolidated selling, general and administrative (SG&A)expenses for the three months ended September 30, 2006 increased 15.9% to$114.0 million from $98.4 million for the same period in 2005. As apercentage of net sales, SG&A expenses were 24.1% for the third quarter in2006 compared to 23.4% in the third quarter of 2005. The increase was primarilydue to higher stock-based compensation and increased promotional costs.

SG&A expenses for the Guitar Center division inthe third quarter of 2006 were 21.5% as a percentage of net sales compared to20.7% in the third quarter of 2005. The increase was primarily due to higheradvertising costs of 0.6% and stock-based compensation expense of 0.2%. Thehigher advertising costs resulted primarily from increased promotional effortsto drive sales in the current quarter. The higher stock-based compensationconsisted of expense for options and other stock awards of 0.5% offset by adecrease in expense under the LTIP of 0.3%.

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SG&A expenses for Music & Arts Center were50.9% of net sales in the third quarter of 2006 compared to 48.5% in the thirdquarter of 2005. The increase was primarily due to higher salary expense of2.0% and higher stock-based compensation expense of 0.8%. The salary expensewas impacted by costs of expansion into Texas resulting from the closure of acompetitor. The higher stock-based compensation consisted of expense foroptions and other stock awards of 0.5% and an increase in expense under theLTIP of 0.3%.

SG&A expenses for the Musician’s Friend division were24.4% of sales in the third quarter of 2006 compared to 24.3% in the thirdquarter of 2005. The increase was primarily due to higher expenses fordepreciation and amortization of 0.3%, computer maintenance of 0.2%, insuranceof 0.2% and stock-based compensation of 0.3% offset by a reduction inadvertising costs of 1.1%. The higher depreciation and amortization wasprimarily related to capital purchases for equipment and building improvements.The higher stock-based compensation consisted of expense for options and otherstock awards of 1.3% offset by a decrease in expense under the LTIP of 1.0%. Thelower advertising was primarily the result of reduced catalog circulation,offset somewhat by higher web-based marketing.

Consolidated operating income decreased 24.4% to $19.2million for the three months ended September 30, 2006 from $25.5 million in thecomparable 2005 period. As a percentage of net sales, consolidated operatingincome declined to 4.1% from 6.0% in the third quarter of 2005.

Interest expense, net for the three months endedSeptember 30, 2006 increased to $2.2 million from $2.0 million in thethird quarter of 2005. The increase was principally due to higher borrowingsunder the revolving credit facility used primarily to fund working capitalrequirements offset by reduced interest resulting from the conversion of the 4%senior notes in July 2006.

The gain on sale of property of $2.1 million in thethird quarter of 2006 resulted from the disposition of real estate madeavailable by the relocation of a Guitar Center store.

For the three months ended September 30, 2006, incometax expense was $7.9 million compared to $9.0 million for the same period in2005. The effective tax rate in the third quarter increased to 41.0% comparedto 38.5% in the prior year quarter. The rate increase was primarily due to the treatmentof incentive stock options, or ISO’s, under SFAS 123(R). In addition, the ratewas impacted by a partial reversal, amounting to $0.2 million, of the valuationallowance decrease recorded in the second quarter of 2006. The effective taxrate is subject to ongoing review and evaluation and may fluctuate in futurequarters.

Consolidated net income for the three months endedSeptember 30, 2006 decreased 21.4% to $11.3 million, compared to $14.4 millionin the same period in 2005 as a result of the combinations of factors describedabove.

**NineMonths Ended September 30, 2006 Compared to the Nine Months Ended September 30,2005**

Consolidated net sales for the nine months ended September30, 2006 increased 14.9% to $1,401 million, compared to $1,220 million for thesame period in 2005.

Net sales from Guitar Center stores for the ninemonths ended September 30, 2006 totaled $1,032 million, a 14.1% increase from $904.4million for the same period in 2005. Sales from new stores were $84.5 millionand represented 66.5% of the total increase in Guitar Center retail storesales. Comparable Guitar Center store sales increased 4.7% for the nine monthperiod. We continue to face a more challenging retail environment, which mayimpact sales and operating margin trends for the foreseeable future.

On April 15, 2005, we completed our acquisition ofMusic & Arts Center, Inc., a Maryland-based musical instrumentretailer with an emphasis on the beginning musician. The acquired business wascombined with our former American Music business into a new division of ourretail store subsidiary that operates under the Music & Arts Centername. Financial results for the period of January 1, 2005 through April 15,2005 reflect only our former American Music stores and do not include resultsfrom the acquired business. However, comparable sales for the periods arecomputed using the combined comparable sales of Music & ArtsCenter, Inc. and American Music stores. Net sales from theMusic & Arts Center division for the nine months ended September 30,2006 totaled $99.2 million compared to $65.0 million for the same period in2005. The increase in net sales is primarily due to the acquisition of Music& Arts Center, Inc. on April 15, 2005. Combined comparable sales increased1.3% for the nine month period.

Net sales from the Musician’s Friend segment totaled $270.7million for the nine months ended September 30, 2006, a $20.4 million, or 8.1%,increase from the same period in 2005. The increase in sales primarily reflectsthe improved

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leveragingof an expanding buyer file and advertising strategies. We continue to faceincreased competition in the direct response channel, which we expect to impactthat segment’s net sales and gross margin for the foreseeable future.

Consolidated gross profit for the nine months endedSeptember 30, 2006 compared to 2005 increased 14.5% to $401.1 million from$350.3 million. Gross profit as a percentage of net sales for the nine monthsended September 30, 2006 was 28.6% compared to 28.7% in the prior year period.As discussed below, we define selling margin as net sales less the cost of theassociated merchandise charged by the vendor plus the associated inventorycosts from fulfilling inventory through our distribution center. The cost ofmerchandise inventory is net of all associated vendor discounts and rebates.Freight is not included in selling margin.

Gross profit as a percentage of net sales for GuitarCenter stores was 26.9% in the nine month period ended September 30, 2006compared with 27.3% in the same period in 2005. The decline in gross profit wasprimarily due to higher occupancy costs of 0.5% partially offset by higherselling margin of 0.1%. The higher occupancy costs were primarily due to higherstore rent and higher depreciation and amortization expense.

The gross profit margin for the Music & ArtsCenter division was 43.0% for the nine months ended September 30, 2006 comparedto 42.2% for the same period in 2005. The margin improvement was primarily dueto the write-down in the prior year period of $0.6 million, or 0.9% of sales,of inventory carried at American Music resulting from a change in productassortment. Excluding this prior year inventory write-down, the gross marginwas 43.0% for both periods. In 2006, higher occupancy costs of 0.8% were offsetby higher selling margin of 0.6% and lower shrink of 0.2%. The higher occupancycosts were primarily due to higher rent expense and higher telecommunicationscosts. The improved selling margin was driven by a change in product mix andbetter pricing under the Music & Arts business as compared to the AmericanMusic business in 2005. During 2005, we discontinued our low margininstitutional business sales which are not part of our ongoing Music & ArtsCenter strategy. The lower shrink expense was due to higher instrumentrecoveries in the current period.

Gross profit margin for the Musician’s Friend divisionwas 30.0% for the nine months ended September 30, 2006 compared to 30.3% in thesame period in 2005. The decrease resulted primarily from reduced shipping andhandling revenue of 1.3%, higher freight costs of 0.2% and increased purchasingcosts of 0.1%, partially offset by higher selling margin of 1.3%. Reducedshipping and handling revenue resulted from expanded free freight offers due toincreased online competition.

ConsolidatedSG&A expenses for the nine months ended September 30, 2006 increased 20.3%to $331.1 million from $275.3 million for the same period in 2005. Asa percentage of net sales, SG&A expenses were 23.6% for the nine monthperiod in 2006 compared to 22.6% in the same period in 2005. The increase wasprimarily due to the recognition of $14.9 million of stock-based compensationexpenses in the current year consisting of expenses for stock options and otherawards totaling $9.9 million, or 0.7% of sales, and expense under the LTIPtotaling $5.0 million, or 0.4% of sales. This was an increase in stock-based compensation expense of 0.9% ofsales over the prior year period, which included $1.4 million of expense underthe LTIP. The components of stock-based compensation for the nine months endedSeptember 30, 2006 consisted of the following:

 
|                                                                                                                        | ** ** | ** **         | ** ** | **As a % of** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------------|------------|
| ** **                                                                                                             | ** ** | **Amount in** | ** ** | **consolidated**             | ** ** |
| ** **                                                                                                             | ** ** | **millions**       | ** ** | **net sales**           | ** ** |
| **Stock-based  compensation expense for the nine months ended September 30, 2006:**                                    | ** ** | ** **         | ** ** | ** **                   | ** ** |
| Stock options and other awards for the nine months  ended September 30, 2006                                           |       | $                  | 9.1        |                         | 0.6        | % |
| Acceleration of stock option vesting related to the  retirement of our former Chief Financial Officer in February 2006 |       | 0.8                |       | 0.1                          | %          |
| Total expense from options and other awards                                                                            |       | 9.9                |       | 0.7                          | %          |
| LTIP performance related to the fourth quarter of  2005                                                                |       | 1.8                |       | 0.1                          | %          |
| LTIP performance related to the nine months ended  September 30, 2006                                                  |       | 3.2                |       | 0.2                          | %          |
| Total expense from LTIP                                                                                                |       | 5.0                |       | 0.4                          | %          |
| Total  stock-based compensation expense                                                                                |       | $                  | 14.9       |                         | 1.1        | % |

 

The stock-based compensation related to stock options,including the ESPP, and other awards was recorded as a 

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resultof the adoption of SFAS No. 123(R) effective January 1, 2006. Upon theretirement of our former Chief Financial Officer announced in February 2006,all of his remaining unvested options totaling 32,002 shares immediatelyvested. Pursuant to SFAS No. 123(R), stock-based compensation expense inthe amount of $0.8 million was recorded due to the vesting acceleration. Atotal of $5.0 million of stock-based compensation expense related to the LTIPwas recorded in the nine months ended September 30, 2006. Included in thisfigure was $1.8 million of expense that should have been recorded in theconsolidated financial statements in the fourth quarter of 2005. The error wasdiscovered subsequent to the issuance of the 2005 consolidated financialstatements. We do not believe that this misstatement is material to our currentor previously issued consolidated financial statements. The remaining LTIPexpense of $3.2 million relates to the initial adoption of SFAS No. 123(R)and recognition of performance under the LTIP provisions for the nine monthsended September 30, 2006.

SG&A expenses for the Guitar Center division forthe nine months ended September 30, 2006 were 21.3% as a percentage of netsales compared to 20.6% in same period in 2005. The increase was primarily dueto higher expenses for stock-based compensation of 0.7%, advertising costs of0.1%, store opening costs of 0.1% and credit card expenses of 0.1% offset bylower equipment rent costs of 0.2% and lower payroll and benefits of 0.2%.

SG&A expenses for Music & Arts Center were47.3% of sales for the nine months ended September 30, 2006 compared to 53.0%in the same period in 2005. The reduction in expenses was primarily due toexpenses totaling $2.8 million, or 4.3% of sales, recorded in the prior yearperiod related to the acquisition of Music & Arts Center, Inc. consistingof the elimination of a redundant point of sales system, severance costs, andmoving costs to relocate certain American Music employees to the Music &Arts corporate office in Maryland. Excluding the prior year acquisition-relatedexpenses, the SG&A expenses decreased by 1.4% of sales compared to theprior year period, which is primarily due to improved leveraging on the higherrevenue base of the combined businesses of Music & Arts Center, Inc.and American Music partially offset by stock-based compensation expenses of 1.4%.

SG&A expenses for the Musician’s Friend divisionwere 23.8% of sales for the nine months ended September 30, 2006 compared to21.8% for the same period in 2005. The increase was primarily due to higherexpenses for stock-based compensation of 1.7%, payroll costs of 0.6%, insuranceof 0.3% and depreciation and amortization of 0.2%, partially offset by loweradvertising expense of 1.3%. Higher payroll costs were driven by higher officeand warehouse salaries. The lower advertising was primarily the result ofreduced catalog circulation, offset somewhat by higher web-basedmarketing.  Other smaller increases wereexperienced related to computer maintenance expense, bad debt expense andconsulting expense.

Consolidated operating income decreased 6.7% to $70.0million for the nine months ended September 30, 2006 from $75.1 million in thecomparable 2005 period. As a percentage of net sales, consolidated operatingincome declined to 5.0% from 6.1% in the prior year period. This declinereflects the higher SG&A expenses resulting primarily from the recognitionof stock-based compensation expenses in the current year period and a slightdecrease in consolidated gross profit margin compared to the prior year period.

Interest expense, net for the nine months endedSeptember 30, 2006 increased to $6.4 million from $4.8 million in thecomparable 2005 period. The increase was due to higher borrowings under therevolving credit facility used primarily to fund the acquisition of Music &Arts Center, Inc. on April 15, 2005 and increased working capital requirementsoffset somewhat by reduced interest resulting from the conversion of the 4%senior notes in July 2006.

The gain on sale of property of $2.1 million recordedin the third quarter of 2006 resulted from the disposition of real estate madeavailable by the relocation of a Guitar Center store.

For the nine months ended September 30, 2006, incometax expense was $25.3 million compared to $27.0 million for the same period in2005. The effective tax rate for the nine months ended September 30, 2006 was38.4%, compared to 38.5% in the prior year period. The slightly lower rate wasthe result of a $0.8 million, or $0.03 per diluted share, reduction in thecurrent period of a valuation allowance related to a capital loss recorded in2001. Substantially offsetting this was a rate increase associated with the treatmentof incentive stock options, or ISO’s, under SFAS 123(R).

Consolidated net income for the nine months endedSeptember 30, 2006 decreased 6.4% to $40.5 million, compared to $43.2 millionin the same period in 2005 as a result of the combinations of factors describedabove.

### **Liquidity and Capital Resources**

Our need for liquidity will arise primarily from thefunding of capital expenditures, working capital requirements and payments onour indebtedness, as well as possible acquisitions. We have historically financedour operations primarily

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throughinternally generated funds and borrowings under our credit facilities. Pleasesee “Risk Factors” in our Annual Report on Form 10-K filed for the year endedDecember 31, 2005 for a discussion of factors which could reasonably likelyresult in a decrease in the amount of internally generated funds available tofinance capital expenditures and working capital requirements. As of September30, 2006, we had $147.4 million in borrowings outstanding under our creditfacility and had available borrowings of $46.3 million (net of $6.2 million ofoutstanding letters of credit).

Our credit facility with a syndicate of banks led byWells Fargo Retail Finance, as amended through April 26, 2006, permitsborrowings up to $200 million (which may be increased to $250 million at ouroption), subject to borrowing base limitations. The actual amount available istied to our inventory and receivable base, and our obligations under the creditfacility are secured by liens on our principal assets. Borrowing options areprime rate plus applicable prime margin, or London Interbank Offered Rate (“LIBOR”),plus applicable LIBOR margin. The applicable prime and LIBOR margins are basedupon levels of excess availability and adjusted quarterly. If excessavailability is greater than $30 million, the applicable prime margin is -0.25%and applicable LIBOR margin is 0.75%. If excess availability is less than orequal to $30 million and greater than $15 million, the applicable prime marginis 0.00% and the applicable LIBOR margin is 1.00%. If excess availability isless than or equal to $15 million, the applicable prime margin is 0.00% and theapplicable LIBOR margin is 1.25%. An unused fee of 0.25% is assessed on theunused portion of the credit facility. The agreement underlying the creditfacility includes significant restrictive negative covenants. Among otherthings, these covenants restrict or prohibit our ability to incur debt andissue specified equity instruments, incur liens on our assets, make anysignificant changes in our corporate structure or the nature of our business,dispose of assets, make guaranties, prepay debt, engage in a change in controltransaction, pay dividends, make investments or acquisitions, engage intransactions with affiliates and incur capital expenditures. 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 thecontractual requirements imposed by this financing is set forth in the Amendedand Restated Loan and Security Agreement and related amendments which have beenfiled with the Securities and Exchange Commission (SEC). Subject to limitedcure periods, the lenders under our credit facility may demand repayment ofthese borrowings prior to stated maturity upon the occurrence of specifiedevents, including if we breach the terms of the agreement, suffer a materialadverse change, engage in a change in control transaction, suffer a significantadverse legal judgment, default on other significant obligations, or in theevent of specified events of insolvency. The credit agreement matures inDecember 2011.

During 2002 we entered into master operating leaseagreements with General Electric Capital Corporation and US Bank to leaseequipment and other property primarily to support the operations of thedistribution center for our Guitar Center retail stores. Under theseagreements, we leased a total of $10.5 million in equipment and other property.

The terms of our significant financing agreements,including those related to our credit facility and the equipment leasefacilities described above, are not dependent on any change in our creditrating. We believe that the key company-specific factors affecting our abilityto maintain our existing debt and lease financing relationships and to accesssuch capital in the future are our present and expected levels of profitabilityand cash flow from operations, our working capital and fixed asset collateralbases, our expected level of capital expenditures, and the level of our equitycapital relative to the level of debt obligations. In addition, as noted above,our existing agreements include significant restrictions on future financings,including among others, limits on the amount of indebtedness that we may incurand whether or not such indebtedness may be secured by any of our assets.

As is the case with most multi-unit retailers,substantially all of the real property used in our business is leased underoperating lease agreements. Please see Item 2. Properties, “—Disclosures AboutContractual Obligations and Commercial Commitments” and Note 8 to theConsolidated Financial Statements in our Annual Report on Form 10-K for theyear ended December 31, 2005. We anticipate making additional capitalinvestments of $4.0 million to $5.0 million in the fourth quarter of 2006 inconnection with the expansion of our Guitar Center distribution center and thenew corporate office build out, and we expect to incur increased rent expensefor the expanded distribution center starting during the fourth quarter of2006. On March 30, 2006, our Musician’s Friend division executed a leaseagreement for a new distribution center for our direct response business thatwill have a capacity significantly exceeding the capacity of the currentdistribution center that it will replace. This lease is treated as an operatinglease for accounting purposes. Details of the lease agreement were included inthe Current Report on Form 8-K we filed on March 30, 2006. In August2006, we entered into a master operating lease agreement to lease equipmenttotaling approximately $13 million to support the operations of thedistribution center for our Musician’s Friend division.

Net cash used in operating activities was $49.0million for the nine months ended September 30, 2006 compared to net cash providedby operating activities of $4.3 million for the same period in 2005. Theprimary uses of cash during the nine months ended September 30, 2006 were anincrease in merchandise inventories of $104.2 million and a decrease in accruedexpenses and other current liabilities of $39.1 million. The increase inmerchandise inventories was primarily due to

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the 29Guitar Center stores opened in the current period and an increase in businessvolumes across all segments.  Thereduction of accrued expenses and other current liabilities was primarily dueto payments of income taxes and sales taxes. The primary sources of cash weregenerated from the current period earnings and an increase in accounts payable of$31.3 million due mostly to higher business volumes and timing of vendorpayments.

Cash used in investing activities was $79.8 millionfor the nine months ended September 30, 2006 compared to $142.1 millionfor the same period in 2005. The cash used in investing activities for the ninemonths ended September 30, 2006 included $61.5 million of capital expenditures,comprised primarily of $34.4 million on new stores and remodels, $11.0 millionon computer equipment purchases and $7.4 million related to the expansion ofour distribution center facilities. Also, our acquisition of businesses for theMusic & Arts Center division totaled $9.8 million for the nine months endedSeptember 30, 2006. During the second quarter of 2006, we also acquired fourretail locations of Hermes Trading Company, Inc. for approximately $11.0million.

Cash provided by financing activities totaled $124.5million for the nine months ended September 30, 2006 compared to $85.1 millionin the same period in 2005. The cash provided by financing activities in thenine months ended September 30, 2006 was due to increased borrowings under therevolving line of credit to support business acquisitions, capital expendituresand working capital requirements.  Inaddition, proceeds from the exercise of stock options provided $8.1 million(including $2.0 million in excess tax benefits that are reflected in cash flowsfrom financing activities) and employee purchases of our common stock under theESPP provided $1.2 million.

We believe that our current operating cash flows,working capital, cash on hand, borrowings available under our credit facilityand other sources of liquidity will be sufficient to meet our obligations inthe ordinary course of business over the next twelve months, including capitalexpenditures and new store openings. We anticipate our capital expenditureswill be between $26.0 million and $30.0 million for the fourth quarter offiscal 2006.

Our known capital resource and liquidity requirementsfor 2006 are expected to be primarily provided by net cash flow from operationsand borrowings available under our credit facility. Traditionally, we haveexperienced the largest use of cash from operating activities in the latterpart of the third quarter and in the fourth quarter due to the build up ofinventory to support the holiday season, resulting in additional borrowingsunder our line of credit. We believe that our borrowing ability under ouramended credit facility will be sufficient to provide the seasonal liquidity webelieve will be required during the 2006 fiscal year.

Depending upon market conditions, we may also elect orbe required to raise additional capital in the form of common or preferredequity, debt or convertible securities for the purpose of providing additionalcapital to fund working capital needs or continued growth of our existingbusiness or to refinance existing obligations. Any such financing activity willbe dependent upon many factors, including our liquidity needs, marketconditions and prevailing market terms, and we cannot assure you that futureexternal financing for us will be available on attractive terms or at all. Ifwe require but are unable to obtain additional liquidity on favorable terms, wemay be required to curtail our growth plans and our financial condition andresults of operations would likely be materially adversely impacted.

In 2006, we are pursuing an aggressive growth strategyby opening additional stores in new and existing markets. During the ninemonths ended September 30, 2006, we opened a total of 29 new Guitar Centerstores, consisting of 10 primary format stores, 17 secondary format stores and 2tertiary format stores. We expect our cost of capital improvements for aprimary format Guitar Center store to average approximately $1.2 million consistingof leasehold improvements, fixtures and equipment. A new primary format storeis also expected to require approximately $2.0 to $2.5 million in grossinventory. We have developed secondary format Guitar Center stores to build insites that we do not believe will support our primary format units. For oursecondary market stores, we expect to require an average of approximately $0.9million in capital improvements and approximately $1.7 to $2.0 million in grossinventory. Our first tertiary format store to serve smaller population centerswas opened in late 2005 and we have opened two more stores in 2006. For ourtertiary format stores, we expect to require an average of approximately $0.6million in capital improvements and approximately $1.0 million in grossinventory. These capital expenditures reflect the increasing construction coststhat we have been experiencing. We expect these increases to continue for theforeseeable future, and these costs may increase above our expectations.

We are also anticipating additional capital andstrategic investments related to improving our fulfillment facilities andupgrading our technology and systems, including an enterprise data warehouse,retail point of sale system replacement, retail inventory management systemsimprovements, and enterprise systems replacement for our direct responsedivision. 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 ofthese initiatives and other

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investmentsrelated to our businesses will continue to be significant.

Throughout our history, we have primarily grownorganically. However, we also believe there may be attractive opportunities toexpand by selectively acquiring existing music products retailers or othercomplimentary businesses, if attractive opportunities can be identified. Webelieve that our growth at Music & Arts Center will in large part bedriven through many small acquisitions. While we cannot provide assurance thatwe will complete any further acquisition transactions, in the ordinary courseof our business we investigate and engage in negotiations regarding suchopportunities. Acquisitions will be financed with cash on hand, drawings underour existing credit facilities, expansion of our credit facilities, issuance ofdebt or equity securities, or a combination, depending upon transaction sizeand market conditions, among other things.

**Recently IssuedAccounting Pronouncements**

In June 2006, the FASB issued FASB InterpretationNo. 48 (FIN 48), “*Accounting for Uncertaintyin Income Taxes*.” FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with SFAS No. 109, “*Accounting for IncomeTaxes*.” This Interpretation defines the minimum recognitionthreshold a tax position is required to meet before being recognized in thefinancial statements. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. We are currently evaluating the effect that theadoption of FIN 48 will have on our financial position and results ofoperations.

In June 2006, the FASB ratified Emerging IssuesTask Force issued Issue 06-3, “*How Sales Taxes CollectedFrom Customers and Remitted to Governmental Authorities Should Be Presented inthe Income Statemen*t” (EITF 06-3). EITF 06-3 requires a company todisclose its accounting policy (i.e., gross or net presentation) regarding thepresentation of taxes within the scope of EITF 06-3. If taxes are significant,a company should disclose the amount of such taxes for each period for which anincome statement is presented. The guidance is effective for periods beginningafter December 15, 2006. We are currently evaluating the effect that theadoption of EITF 06-3 will have on our financial position and results ofoperations.

In September 2006, the SEC issued Staff AccountingBulletin No. 108, “*Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*” (SAB 108), to address diversity in practice inquantifying financial statement misstatements. SAB 108 requires that wequantify misstatements based on their impact on each of our financialstatements and related disclosures. SAB 108 is effective as of the end of our2006 fiscal year, allowing a one-time transitional cumulative effect adjustmentto retained earnings as of January 1, 2006 for errors that were not previouslydeemed material, but are material under the guidance in SAB 108. We arecurrently evaluating the impact, if any, adopting SAB 108 will have on our consolidatedfinancial statements.

In September 2006, the FASB issued SFAS No. 157, “*Fair Value Measurements*.” SFAS No. 157defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles and expands disclosures about fairvalue measurements. This Statement applies under other accountingpronouncements that require or permit fair value measurements, the FASB havingpreviously concluded in those accounting pronouncements that fair value is therelevant measurement attribute. Accordingly, this Statement does not requireany new fair value measurements. SFAS No. 157 is effective for fiscal yearsbeginning after November 15, 2007. We are currently evaluating the impact, ifany, the adoption of SFAS No. 157 will have on our operating income or netincome.

**Seasonality**

Our business follows a seasonal pattern, peakingduring the holiday selling season in November and December. Sales in thefourth quarter are typically significantly higher on a per store basis andthrough the direct response unit than in any other quarter. In addition, bandrental season for our Music & Arts Center business starts inAugust and carries through mid-October, but that seasonality does not havea significant impact on our consolidated results.

**Inflation**

We believe that the relatively moderate rates ofinflation experienced in recent years have not had a significant impact on ournet sales or profitability. However, in 2006, we have been experiencing risingsteel, lumber, concrete, labor, fuel and freight costs related to opening,remodeling, operating and relocating our stores, expanding our distributioncenters and operating our business.

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**Forward-LookingStatements; Business Risks**

This report containsforward-looking statements relating to, among other things, future results ofoperations, growth and investment plans, sales, trends in gross margin, growthin the Internet portion of our direct response business and other factorsaffecting growth in sales and earnings. Specific forward-looking statements areprovided regarding our management’s current views regarding new store openings,capital expenditure levels and the dates new facilities and systems will becomeoperational. Statements regarding new store openings are based largely on ourcurrent expectations and are necessarily subject to associated business risksrelated to, among other things, the identification of suitable sites oracquisition opportunities, the timely construction, staffing and merchandisingof those stores and other matters, some of which are outside of our control.Statements regarding the dates new facilities and systems will becomeoperational are dependent upon third parties and events beyond our control,such as the availability of third party consulting resources, construction delays,technology development delays and other events. Sales and earnings trends arealso affected by many other factors including, among others, world and nationalpolitical events, including general economic conditions, the effectiveness ofour promotion and merchandising strategies, our ability to integrate andprofitably operate acquired businesses, the efficient operation of our supplychain, including the continued support of our key vendors, our effectivemanagement of business risks, including litigation, and competitive factorsapplicable to our retail and direct response markets.

In light of these risks,there can be no assurance that the forward-looking statements contained in thisreport will in fact be realized. The statements made by us in this reportrepresent our views as of the date of this report, and it should not be assumedthat the statements made herein remain accurate 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.

**Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

We do not have any assetsor liabilities which, in our view, impose upon us significant market riskexcept for our credit facility which has a variable rate of interest generallyconsisting of stated premiums above LIBOR. At September 30, 2006, we had $147.4million in outstanding borrowings under our credit facility. As short-terminterest rates fluctuate, the interest expense we incur on our credit facilitywill change resulting in either a positive or negative effect on our financialposition, results of operations and cash flows. At this borrowing level for ourcredit facility, a one percentage point increase in interest rates would havean unfavorable impact on pre-tax earnings of $1.5 million on an annual basis.The primary interest rate exposure on the credit facility is based on LIBOR. Wedo not use derivative financial instruments in our investment portfolio.Historically, we have not carried significant cash balances and any cash inexcess of our daily operating needs has been used to reduce our borrowings.Excess cash is generally invested in short-term, high quality interest bearinginvestments.

**Item 4. CONTROLS AND PROCEDURES**

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our reports filed pursuant to the Exchange Act is recorded,processed, summarized and reported within the time periods specified in the SEC’srules and forms and that such information is accumulated and communicatedto our management, including our Chief Executive Officer and Chief FinancialOfficer, as appropriate, to allow for timely decisions regarding requireddisclosure. In designing and evaluating the disclosure controls and procedures,management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving thedesired control objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

As required by SECRule 13a-15(b), we carried out an evaluation, under the supervision andwith the participation of our management, including our Chief Executive Officerand Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures as of the end of the period coveredby this report. Based on the foregoing, our Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures wereeffective to provide reasonable assurance that information relating to us andour subsidiaries that we are required to disclose in the reports that we fileor submit to the SEC is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms.

**PartII.  OTHER INFORMATION**

**Item 1. Legal Proceedings**

For information on legalproceedings, see Note 7 of Notes to Consolidated Financial Statements “LegalProceedings”, which is incorporated by reference in response to this Item 1.

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**Item 1A. Risk Factors**

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

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

We are in the process ofsignificantly expanding our Guitar Center and direct response distributioncenters to increase our capacity to support continued expansion. We have made,and expect to continue to make, significant capital investments in thesefacilities. We expect to incur increased rent starting during the fourthquarter of 2006 for our new Guitar Center distribution center. The lease forour direct response distribution center expires in the third quarter of 2007.We are in the process of constructing a larger replacement distribution centerfor our direct response business, and expect to complete that facility prior tothe expiration of the lease on our existing facility. Our failure to complete ourexpansions and replacements on time and on budget may result in the need for usto expend additional capital and may impair the efficient operation of ourdistribution system, which could materially adversely impact our business,results of operations, financial condition and prospects.

*We dependon key personnel including our senior management who are important to thesuccess of our business.*

Our success depends to asignificant extent on the services of members of our senior management. Theloss of one or more of these individuals or other key personnel could have amaterial adverse effect on our business, results of operations, liquidity andfinancial position. In particular, two members of senior management at ourdirect response business have left the company in 2006. The departure of theseindividuals has increased the strain on management capacity, and the departureof further senior management at our direct response business could furtherstrain management capacity. The departures that have occurred in 2006, orfuture departures, may adversely impact the results of our direct responsebusiness.

Historically, we havepromoted employees from within our organization to fill senior operations,sales and store management positions. In order to achieve our growth plans, wedepend 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.

**Item 6. Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                              |
|---------------------|------------|------------------------------------------------------------------------------------------------------------------------------|
| 31.1                |       | Certification of the Company’s Chief Executive  Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31.2                |       | Certification of the Company’s Chief Financial  Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32.1                |       | Certification of the Company’s Chief Executive  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2                |       | Certification of the Company’s Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized as of the 7th day of November 2006.

 
|        | Guitar Center, Inc.                       |
|--------|-------------------------------------------|
|   |                                      |
|   | /s/ ERICK MASON                           |   |
|   |                                      |
|   | Erick Mason, Executive Vice President and |
|   | Chief Financial Officer                   |
|   |                                      |

 

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