**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

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

 

**Commission File No.  000– 22207**

 

**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’s telephone number, including area code |

 

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

 

Yes    ý                 No    o

 

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

 

Yes    ý                 No    o

 

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

 

Yes    o                 No    ý

 

As of November 4, 2005,26,014,567 shares of our Common Stock, $.01 par value, were outstanding.

 

 

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**Guitar Center, Inc. and subsidiaries**

 

#### INDEX

 
| Part I.      | Financial  Information                                                                                  |       |
|-------------------|---------------------------------------------------------------------------------------------------------|------------|
|              |                                                                                                    |       |
|              | **Item 1.  Consolidated Financial Statements (Unaudited)**                                              |       |
|              |                                                                                                    |       |
|              | Consolidated Balance Sheets – September 30,  2005 and December 31, 2004                  |       |
|              |                                                                                                    |       |
|              | Consolidated Statements of  Income – Three months ended  September 30, 2005 and 2004          |       |
|              |                                                                                                    |       |
|              | Consolidated Statements of Income – Nine  months ended  September 30, 2005 and 20045          |       |
|              |                                                                                                    |       |
|              | Consolidated Statements of  Cash Flows – Nine months ended  September 30, 2005 and 2004       |       |
|              |                                                                                                    |       |
|              | Notes to Consolidated  Financial Statements                                                             |       |
|              |                                                                                                    |       |
| ** **        | **Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations** |       |
|              |                                                                                                    |       |
|              | **Item 3. Quantitative  and Qualitative Disclosures About Market Risk**                                 |       |
|              |                                                                                                    |       |
|              | **Item 4. Controls and Procedures**                                                                     |       |
|              |                                                                                                    |       |
| **Part II.** | **Other Information**                                                                                   | ** ** |
| ** **        | ** **                                                                                              | ** ** |
|              | **Item 1. Legal  Proceedings**                                                                     |       |
|              |                                                                                                    |       |
|              | **Item 6. Exhibits**                                                                                    |       |

 

2

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

# **ConsolidatedBalance Sheets**

(In thousands, except per share data)

(Unaudited)

 
| ** **                                                                                                                                                                   | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                   |       |                         |       |                        |       |
| Current assets:                                                                                                                                                              |       |                         |       |                        |       |
| Cash and cash equivalents                                                                                                                                                    |       | $                            | 7,768      |                        | $          | 60,453 |   |
| Investments in marketable securities                                                                                                                                         |       | —                       |       | 3,810                       |       |
| Accounts receivable, less allowance for doubtful  accounts $2,349 and $3,489, respectively                                                                                   |       | 28,326                       |       | 27,627                      |       |
| Merchandise inventories                                                                                                                                                      |       | 456,384                      |       | 314,961                     |       |
| Prepaid expenses and deposits                                                                                                                                                |       | 18,747                       |       | 13,367                      |       |
| Deferred income taxes                                                                                                                                                        |       | 5,137                        |       | 5,552                       |       |
| Total current  assets                                                                                                                                                        |       | 516,362                      |       | 425,770                     |       |
|                                                                                                                                                                         |       |                         |       |                        |       |
| Property and equipment, net of accumulated  depreciation of $117,674 and $99,915, respectively                                                                               |       | 140,471                      |       | 97,349                      |       |
| Investments in marketable securities                                                                                                                                         |       | —                       |       | 16,997                      |       |
| Goodwill                                                                                                                                                                     |       | 76,138                       |       | 26,474                      |       |
| Deposits and other assets, net                                                                                                                                               |       | 11,960                       |       | 8,003                       |       |
|                                                                                                                                                                         |       | $                            | 744,931    |                        | $          | 574,593 |   |
|                                                                                                                                                                         |       |                         |       |                        |       |
| **Liabilities  and Stockholders’ equity**                                                                                                                               |       |                         |       |                        |       |
| Current  liabilities:                                                                                                                                                        |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                             |       | $                            | 98,259     |                        | $          | 49,771 |   |
| Accrued expenses and other current liabilities                                                                                                                               |       | 67,305                       |       | 83,606                      |       |
| Merchandise advances                                                                                                                                                         |       | 18,543                       |       | 22,534                      |       |
| Revolving line of credit                                                                                                                                                     |       | 74,004                       |       | —                      |       |
| Total current  liabilities                                                                                                                                                   |       | 258,111                      |       | 155,911                     |       |
|                                                                                                                                                                         |       |                         |       |                        |       |
| Other long-term  liabilities                                                                                                                                                 |       | 11,220                       |       | 6,943                       |       |
| Deferred income  taxes                                                                                                                                                       |       | 7,411                        |       | 5,057                       |       |
| Long-term debt                                                                                                                                                               |       | 100,000                      |       | 100,000                     |       |
| Total  liabilities                                                                                                                                                           |       | 376,742                      |       | 267,911                     |       |
|                                                                                                                                                                         |       |                         |       |                        |       |
| Stockholders’  equity:                                                                                                                                                  |       |                         |       |                        |       |
| Preferred stock; 5,000 authorized, none issued and  outstanding                                                                                                              |       | —                       |       | —                      |       |
| Common Stock, $0.01 par value,  authorized  55,000 shares, issued  and outstanding  25,992 at September 30,  2005 and 25,359 at  December 31,  2004 |       | 260                          |       | 254                         |       |
| Additional paid-in capital                                                                                                                                                   |       | 323,602                      |       | 305,305                     |       |
| Retained earnings                                                                                                                                                            |       | 44,327                       |       | 1,123                       |       |
| Stockholders’  equity                                                                                                                                                   |       | 368,189                      |       | 306,682                     |       |
|                                                                                                                                                                         |       | $                            | 744,931    |                        | $          | 574,593 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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**Guitar Center, Inc. and subsidiaries**

# **ConsolidatedStatements of Income**

(In thousands, except per share data)

(Unaudited)

 
| ** **                                   | ** ** | **Three  months ended September 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                   | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | ** **                                 | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                                          | 421,061    |   | $ | 354,909 |   |
| Cost of goods sold, buying and occupancy     |       | 297,243                                    |       | 256,968 |   |
| Gross profit                                 |       | 123,818                                    |       | 97,941 |   |
|                                         |       |                                       |       |   |   |
| Selling, general and administrative expenses |       | 98,366                                     |       | 76,628 |   |
| Operating income                             |       | 25,452                                     |       | 21,313 |   |
|                                         |       |                                       |       |   |   |
| Interest expense, net                        |       | 2,021                                      |       | 1,294 |   |
|                                         |       |                                       |       |   |   |
| Income before income taxes                   |       | 23,431                                     |       | 20,019 |   |
|                                         |       |                                       |       |   |   |
| Income taxes                                 |       | 9,022                                      |       | 7,608 |   |
|                                         |       |                                       |       |   |   |
| Net income                                   |       | $                                          | 14,409     |   | $ | 12,411 |   |
|                                         |       |                                       |       |   |   |
| Net income per share:                        |       |                                       |       |   |   |
| Basic                                        |       | $                                          | 0.55       |   | $ | 0.49 |   |
| Diluted                                      |       | $                                          | 0.51       |   | $ | 0.45 |   |
|                                         |       |                                       |       |   |   |
| Weighted average shares outstanding:         |       |                                       |       |   |   |
| Basic                                        |       | 25,975                                     |       | 25,211 |   |
| Diluted                                      |       | 29,946                                     |       | 29,235 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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**Guitar Center, Inc. and subsidiaries**

# **Consolidated Statementsof Income**

(In thousands, except per share data)

(Unaudited)

 
| ** **                                   | ** ** | **Nine  months ended September 30,** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                   | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                                         | 1,219,743  |   | $ | 1,044,234 |   |
| Cost of goods sold, buying and occupancy     |       | 869,413                                   |       | 757,397 |   |
| Gross profit                                 |       | 350,330                                   |       | 286,837 |   |
|                                         |       |                                      |       |   |   |
| Selling, general and administrative expenses |       | 275,266                                   |       | 224,146 |   |
| Operating income                             |       | 75,064                                    |       | 62,691 |   |
|                                         |       |                                      |       |   |   |
| Interest expense, net                        |       | 4,811                                     |       | 4,082 |   |
|                                         |       |                                      |       |   |   |
| Income before income taxes                   |       | 70,253                                    |       | 58,609 |   |
|                                         |       |                                      |       |   |   |
| Income taxes                                 |       | 27,049                                    |       | 22,274 |   |
|                                         |       |                                      |       |   |   |
| Net income                                   |       | $                                         | 43,204     |   | $ | 36,335 |   |
|                                         |       |                                      |       |   |   |
| Net income per share:                        |       |                                      |       |   |   |
| Basic                                        |       | $                                         | 1.67       |   | $ | 1.47 |   |
| Diluted                                      |       | $                                         | 1.52       |   | $ | 1.34 |   |
|                                         |       |                                      |       |   |   |
| Weighted average shares outstanding:         |       |                                      |       |   |   |
| Basic                                        |       | 25,819                                    |       | 24,698 |   |
| Diluted                                      |       | 29,836                                    |       | 28,833 |   |

 

See accompanying notes to consolidated financial statements.

 

5

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**Guitar Center, Inc. and subsidiaries**

**Consolidated Statements of CashFlows**

(In thousands)

(Unaudited)

 
| ** **                                                                           | ** ** | **Nine  months ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                           | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **Operating activities:**                                                            |       |                                      |       |   |   |
| Net income                                                                           |       | $                                         | 43,204     |   | $ | 36,335 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities:   |       |                                      |       |   |   |
| Depreciation and amortization                                                        |       | 20,630                                    |       | 16,640 |   |
| Loss on disposal of property  and equipment                                          |       | 1,849                                     |       | — |   |
| Amortization of deferred  financing fees                                             |       | 784                                       |       | 784 |   |
| Tax benefit from exercise of  stock options                                          |       | 7,175                                     |       | 9,686 |   |
| Deferred income taxes                                                                |       | 350                                       |       | — |   |
| Changes in operating assets  and liabilities, net of effects of acquired businesses: |       |                                      |       |   |   |
| Accounts receivable                                                                  |       | 5,653                                     |       | 695 |   |
| Merchandise inventories                                                              |       | (82,193                                   | )          | (31,263 | ) |
| Prepaid expenses and deposits                                                        |       | (4,703                                    | )          | (9,018 | ) |
| Deposits and other assets                                                            |       | (725                                      | )          | (2,781 | ) |
| Accounts payable                                                                     |       | 34,977                                    |       | 2,304 |   |
| Accrued expenses and other  current liabilities                                      |       | (18,271                                   | )          | (14,198 | ) |
| Other long-term liabilities                                                          |       | (8,289                                    | )          | (331 | ) |
| Merchandise advances                                                                 |       | 3,817                                     |       | 623 |   |
| Net cash provided by operating activities                                            |       | 4,258                                     |       | 9,476 |   |
|                                                                                 |       |                                      |       |   |   |
| **Investing activities:**                                                            |       |                                      |       |   |   |
| Purchase of property and equipment                                                   |       | (60,305                                   | )          | (18,289 | ) |
| Acquisition of businesses, net of cash acquired                                      |       | (101,925                                  | )          | (2,775 | ) |
| Purchase of available-for-sale-securities                                            |       | (27,305                                   | )          | — |   |
| Proceeds from the sale of available-for-sale-securities                              |       | 47,460                                    |       | — |   |
| Net cash used in investing activities                                                |       | (142,075                                  | )          | (21,064 | ) |
|                                                                                 |       |                                      |       |   |   |
| **Financing activities:**                                                            |       |                                      |       |   |   |
| Net increase in revolving debt facility                                              |       | 74,004                                    |       | — |   |
| Proceeds from exercise of stock options                                              |       | 10,175                                    |       | 17,336 |   |
| Proceeds from stock issued under employee stock purchase plan                        |       | 953                                       |       | 706 |   |
| Net cash provided by financing activities                                            |       | 85,132                                    |       | 18,042 |   |
|                                                                                 |       |                                      |       |   |   |
| Net (decrease) increase in cash and cash equivalents                                 |       | (52,685                                   | )          | 6,454 |   |
| Cash and cash equivalents at beginning of period                                     |       | 60,453                                    |       | 5,350 |   |
|                                                                                 |       |                                      |       |   |   |
| Cash and cash equivalents at end of period                                           |       | $                                         | 7,768      |   | $ | 11,804 |   |

 

See accompanying notes to consolidated financial statements.

 

6

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| ** **                                                                                      | ** ** | **Nine  months ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **Non-cash  investing activities**                                                              | ** ** | ** **                                | ** ** | ** ** | ** ** |
| ** **                                                                                      | ** ** | ** **                                | ** ** | ** ** | ** ** |
| Acquisition of  businesses, in which the fair value of assets and liabilities were as  follows: |       |                                      |       |   |   |
|                                                                                            |       |                                      |       |   |   |
| Current assets                                                                                  |       | $                                         | 7,492      |   | $ | 1,988 |   |
| Receivables held in escrow                                                                      |       | —                                    |       | 540 |   |
| Inventory                                                                                       |       | 59,424                                    |       | — |   |
| Property and equipment                                                                          |       | 3,775                                     |       | — |   |
| Other assets                                                                                    |       | 5,299                                     |       | — |   |
| Goodwill                                                                                        |       | 49,663                                    |       | 404 |   |
| Total assets acquired                                                                           |       | 125,653                                   |       | 2,932 |   |
| Current liabilities                                                                             |       | (19,779                                   | )          | (157 | ) |
| Deferred tax liability                                                                          |       | (2,419                                    | )          | — |   |
| Other long-term liabilities                                                                     |       | (460                                      | )          | — |   |
| Total liabilities assumed                                                                       |       | (22,658                                   | )          | (157 | ) |
| Net assets acquired                                                                             |       | $                                         | 102,995    |   | $ | 2,775 |   |

 

See accompanying notes to consolidated financial statements.

 

7

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**Guitar Center, Inc. and subsidiaries**

**Notes to Consolidated FinancialStatements**

 

1.             Natureof Business and Basis of Presentation

 

Natureof Business

 

Guitar Center is the nation’s leading retailer ofguitars, amplifiers, percussion instruments, keyboards, live-sound/DJ andrecording equipment based on annual revenue. As of September 30, 2005, weoperated 156 Guitar Center retail stores, with 123 stores in 50 major marketsand 33 stores in secondary markets across the United States. Included in the 156Guitar Center retail stores are 121 large format stores (square footage ofapproximately 16,000 to 20,000) and 35 small format stores (square footage ofapproximately 10,000 to 12,000).  Thefirst of these small format units was opened in late 2000 and 34 more had beenopened as of September 30, 2005. In addition, as of September 30,2005, our Music & Arts division operated 79 retail locations and eighteducational support centers specializing in band instruments for sale andrental, serving thousands of teachers, band directors, college professors andstudents. We are also the largest direct response retailer of musicalinstruments in the United States through our wholly-owned subsidiary, Musician’sFriend, Inc., and its catalog and web site, www.musiciansfriend.com.

 

Basisof Presentation

 

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

 

The results of operations for the three and ninemonths ended September 30, 2005 are not necessarily indicative of theresults to be expected for the full year.

 

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

 

Use ofEstimates in the Preparation of Financial Statements

 

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

 

2.             Acquisitionof Businesses

 

On April 15, 2005, we completedthe acquisition of Music & Arts Center, Inc., a Maryland-based musicalinstruments retailer with an emphasis on the beginning musician. At the time ofthe acquisition, Music & Arts Center, Inc. operated 61 retaillocations, primarily located in the Northeast, Mid-Atlantic and Southernregions of the U.S. The acquired business and our existing American Musicbusiness have been combined into a new division under the Music & Artsname.

 

OnJune 10, 2005, our Musician’s Friend unit completed the asset acquisitionof Harmony-Central.com, an Internet content and information site.  The acquired company is separately maintainedand operated by Musician’s Friend as Harmony Central Group, LLC. The results ofoperations and the assets of Harmony-Central.com were not material to GuitarCenter’s historical consolidated financial statements and, as such, pro-formafinancial information is not presented. The results of operations are includedin Guitar Center’s consolidated financial statements from the date of theacquisition.

 

On July 18, 2005, our Music & Arts divisioncompleted the asset acquisition of John W. Coffey Music Co., Inc., asingle warehouse, school delivery business in Norwood, Massachusetts. CoffeyMusic services the greater Boston, Massachusetts metropolitan area. The resultsof operations and the assets of Coffey Music were not material to Guitar Center’shistorical consolidated financial statements

 

8

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and, as such, pro-forma financial information is notpresented. The results of operations are included in Guitar Center’sconsolidated financial statements from the date of the acquisition.

 

The aggregate purchaseprice of the three acquisitions was approximately $103 million and was fundedfrom cash on hand and drawings under our line of credit. The aggregate purchaseprice was allocated to the following assets acquired and liabilities assumed attheir estimated fair value (in thousands):

 
| Current assets                |   | $       | 7,492   |   |
|-------------------------------|--------|---------|---------|--------|
| Inventory                     |   | 59,424  |    |
| Property & equipment |   | 3,775   |    |
| Other assets                  |   | 5,299   |    |
| Goodwill                      |   | 49,663  |    |
| Total assets acquired         |   | 125,653 |    |
| Current liabilities           |   | (19,779 | )       |
| Deferred tax liability        |   | (2,419  | )       |
| Other long-term liabilities   |   | (460    | )       |
| Total liabilities assumed     |   | (22,658 | )       |
| Total purchase price          |   | $       | 102,995 |   |

 

The purchaseprice allocation described above resulted in our recording approximately $50 millionin goodwill, which is not being amortized, but will be evaluated for impairmentannually or when a triggering event occurs which may require an impairmenttest.

 

Results of operations for the Music & Arts divisionare included in the consolidated financial statements since April 15,2005, the date of acquisition. The following table summarizes pro formafinancial information assuming the Music & Arts Center, Inc. acquisitionhad occurred as of the beginning of the periods presented below:

 
| ** **        | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **        | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **        | ** ** | **(in thousands, except per  share data)** | ** ** |
| Net sales         |       | $                                          | 421,061    |                                      | $          | 375,187 |   | $ | 1,246,198 |   | $ | 1,102,167 |   |
|              |       |                                       |       |                                      |       |   |   |   |   |
| Net income        |       | 14,409                                     |       | 12,472                                    |       | 39,657 |   | 36,624 |   |
|              |       |                                       |       |                                      |       |   |   |   |   |
| Income per share: |       |                                       |       |                                      |       |   |   |   |   |
| Basic             |       | 0.55                                       |       | 0.49                                      |       | 1.54 |   | 1.48 |   |
| Diluted           |       | 0.51                                       |       | 0.45                                      |       | 1.40 |   | 1.35 |   |
|                   |            |                                            |            |                                           |            |  |  |  |  |  |  |  |  |

 

Included in pro forma net income for the nine monthsended September 30, 2005 are after-tax charges of $5.9 million ($0.12 perdiluted per share) for bonus payments and legal fees associated with theacquisition. These charges were incurred prior to the acquisition on April 15,2005. In addition, in conjunction with the acquisition, after-tax charges of$3.4 million ($0.07 per diluted per share) were incurred primarily from theelimination of a redundant point of sales system, severance costs, moving coststo relocate certain American Music employees to the Music & Arts divisioncorporate office in Maryland and the write down of inventory carried at AmericanMusic resulting from a change in inventory assortment. These charges wereincurred during the period of April 15, 2005 through June 30, 2005.

 

The purchase price accounting related to the Music &Arts Center, Inc. acquisition is being finalized and, as a result, theremay be a subsequent reclassification of certain items presented on the balancesheet as of September 30, 2005. During the third quarter of 2005, goodwillwas reduced by $5.1 million to adjust income tax obligations to fair value aspart of the Music & Arts Center, Inc. purchase price accounting. Thepro forma information is not necessarily indicative of the operating resultsthat would have occurred had the acquisition been made at the beginning of theperiods presented nor are they necessarily indicative of any future operatingresults.

 

9

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3.             EarningsPer Share

 

The following table summarizes the reconciliation of thenumerator and denominator for basic and diluted earnings per share for thethree and nine months ended September 30, 2005 and 2004:

 
| ** **                                                            | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                            | ** ** | **(in thousands, except per  share data)** | ** ** |
| Net income                                                            |       | $                                          | 14,409     |                                      | $          | 12,411 |   | $ | 43,204 |   | $ | 36,335 |   |
| Add: Interest, net of tax on 4% Senior Convertible  Notes             |       | 727                                        |       | 733                                       |       | 2,181 |   | 2,199 |   |
| Net income excluding interest expense on 4% Senior  Convertible Notes |       | 15,136                                     |       | 13,144                                    |       | 45,385 |   | 38,534 |   |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Basic shares                                                          |       | 25,975                                     |       | 25,211                                    |       | 25,819 |   | 24,698 |   |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Dilutive effect  of options outstanding                               |       | 1,079                                      |       | 1,132                                     |       | 1,125 |   | 1,243 |   |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Dilutive effect of assumed conversion of 4% Senior  Convertible Notes |       | 2,892                                      |       | 2,892                                     |       | 2,892 |   | 2,892 |   |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Diluted shares                                                        |       | 29,946                                     |       | 29,235                                    |       | 29,836 |   | 28,833 |   |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Basic net income  per share                                           |       | $                                          | 0.55       |                                      | $          | 0.49 |   | $ | 1.67 |   | $ | 1.47 |   |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Diluted net  income per share                                         |       | $                                          | 0.51       |                                      | $          | 0.45 |   | $ | 1.52 |   | $ | 1.34 |   |

 

For the three and nine months ended September 30, 2005and 2004, the only common stock equivalents deemed outstanding are stockoptions.  For the three and nine monthsended September 30, 2005, options to purchase 77,000 shares and 177,000 shares,respectively, at exercise prices ranging from $58.83 to $64.66 were outstandingand not included in the computation of diluted earnings per share because theexercise price of these options was greater than the average market price ofour common stock. For the three months ended September 30, 2004, all optionsoutstanding had a dilutive effect. For the nine months ended September 30,2004, 381,000 options with an exercise price of $39.98 per share wereoutstanding and not included in the computation of diluted earnings per sharebecause the exercise price of these options was greater than the average marketprice of our common stock.

 

For the three and nine months ended September 30,2005 and 2004, the 2.9 million shares of common stock issuable upon conversionof the 4.00% Senior Convertible Notes as described in Liquidity and CapitalResources and referred to as the convertible notes (reflecting an effectiveconversion price of $34.58) are potential shares of common stock and are deemedto be outstanding for the purposes of calculating diluted earnings per shareunder the if-converted method of accounting which also provides that therelated after-tax interest expense, including amortization of deferredfinancing costs, is added back to net income.

 

In November 2004, the Emerging Issues Task Force(“EITF”) reached a consensus that contingently convertible debt instruments,such as our convertible notes, should be included in the computation of dilutedearnings per share under the if-converted method regardless of whether themarket price trigger has been met. The consensus must be applied by retroactiverestatement of financial statements issued for periods ending after December 15,2004. Accordingly, we retroactively restated all earnings per share measuresfor the three and nine months ended September 30, 2004 to reflect theconsensus.

 

**4.**             Segment Information

** **

**Our reportable business segmentsare Guitar Center stores, the Music & Arts division and Musician’sFriend direct response (contact center and Internet). Prior to the acquisitionof Music & Arts Center, Inc., that segment was referred to as AmericanMusic stores. Both brands have similar operations and there has been no changeto the internal structure of the overall organization. Therefore there has beenno change in the nature of the company segment reporting. Management evaluatessegment performance based primarily on net sales and income (loss) beforeincome taxes.  Accounting policies of thesegments are the same as the accounting policies for the consolidated company.  There are no differences between themeasurements of profits or losses or assets of the reportable segments andthose of the company on a consolidated basis.**

** **

**10**

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** **

**Our business segments under Statement of FinancialAccounting Standards (“SFAS”) No. 131, “*Disclosuresabout Segments of an Enterprise and Related Information*,” areconsistent with our reporting units under SFAS No. 142, *“Goodwill and Other Intangible Assets.” *SFAS No. 131 establishes standards for the reporting ofoperating segment information in annual financial statements and in interimfinancial reports issued to shareholders. SFAS No. 142 requires thatgoodwill no longer be amortized, reclassifications between goodwill and otherintangible assets be made based upon certain criteria, and, once allocated toreporting units (the business segment level, or one level below), that testsfor impairment of goodwill be performed at least annually. We will continue toevaluate goodwill annually or whenever events and circumstances indicate thatthere may be an impairment of the asset value.**

** **

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

 
| ** **                                    | ** ** | **Three Months Ended September 30, 2005** | ** ** | **Nine Months Ended September 30, 2005** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                    | ** ** | **Guitar  Center**                             | ** ** | **Music &  Arts**                    | ** ** | **Direct  Response** | ** ** | **Total** | ** ** | **Guitar  Center** | ** ** | **Music &  Arts** | ** ** | **Direct  Response** | ** ** | **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  administrative expenses |       | 64,120                                         |       | 14,611                                        |       | 19,635 |   | 98,366 |   | 186,310 |   | 34,437 |   | 54,519 |   | 275,266 |   |
| Income (loss) before income  taxes            |       | 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 |   |
| Total assets                                  |       |                                           |       |                                          |       |   |   |   |   | 460,292 |   | 189,313 |   | 95,326 |   | 744,931 |   |
|                                          |       |                                           |       |                                          |       |   |   |   |   |   |   |   |   |   |   |   |   |
| ** **                                    | ** ** | **Three Months Ended September 30, 2004** | ** ** | **Nine Months Ended September 30, 2004** | ** ** |
| ** **                                    | ** ** | **Guitar  Center**                             | ** ** | **Music &  Arts (1)**                | ** ** | **Direct  Response** | ** ** | **Total** | ** ** | **Guitar  Center** | ** ** | **Music &  Arts (1)** | ** ** | **Direct  Response** | ** ** | **Total** | ** ** |
| Net sales                                     |       | $                                              | 272,338    |                                          | $          | 10,727 |   | $ | 71,844 |   | $ | 354,909 |   | $ | 798,725 |   | $ | 28,697 |   | $ | 216,812 |   | $ | 1,044,234 |   |
| Gross profit                                  |       | 71,838                                         |       | 3,606                                         |       | 22,497 |   | 97,941 |   | 206,906 |   | 9,837 |   | 70,094 |   | 286,837 |   |
| Depreciation and amortization                 |       | 4,568                                          |       | 364                                           |       | 499 |   | 5,431 |   | 13,912 |   | 1,082 |   | 1,646 |   | 16,640 |   |
| Selling, general and  administrative expenses |       | 56,538                                         |       | 4,896                                         |       | 15,194 |   | 76,628 |   | 164,251 |   | 13,583 |   | 46,312 |   | 224,146 |   |
| Income (loss) before income  taxes            |       | 14,516                                         |       | (1,939                                        | )          | 7,442 |   | 20,019 |   | 40,071 |   | (5,682 | ) | 24,220 |   | 58,609 |   |
| Capital expenditures                          |       | 5,996                                          |       | 242                                           |       | 1,216 |   | 7,454 |   | 15,194 |   | 804 |   | 2,291 |   | 18,289 |   |
| Total assets                                  |       |                                           |       |                                          |       |   |   |   |   | 377,930 |   | 65,699 |   | 69,703 |   | 513,332 |   |

 

 

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**(1) The information includedfor the Music & Arts division included only the operation of AmericanMusic prior to April 15, 2005.**

** **

**11**

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** **

5.             Stock-BasedCompensation

 

On July 28, 2005, our Board ofDirectors approved the Guitar Center, Inc. 2005 Long-Term Incentive Plan,effective July 1, 2005.  Historically, we have provided equity-basedincentives to our senior management solely in the form of stock options issuedunder stockholder approved plans.  The purpose of the long-term incentiveplan is to provide equity incentives to senior management that include not onlystock options or similar grants, but also a performance share program thatmeasures performance on a multi-year basis. The performance period under the long-termincentive plan began on July 1, 2005 and ends on December 31, 2007.The target number of performance shares potentially issuable under the plan isexpected to be approximately 260,000, with the actual number of shares beingbetween zero and 520,000, depending on the Company’s actual performance. Underthe terms of the plan, there may be stock option grants to the participants ofthe plan that will be for a term of ten years and will vest over three to fouryears in equal annual installments.  UntilDecember 31, 2005, we will account for the long-term incentive plan usingthe variable plan accounting method established by Accounting Principles BoardOpinion No. 25, *Accounting for StockIssued to Employees* and related interpretations. Details of the planwere included in the 8-K we filed on July 28, 2005.

 

We have adopted SFAS No. 123, *“Accounting for Stock-Based Compensation,”* which permitsentities to recognize as expense over the vesting period the fair value of allstock-based awards on the date of grant. Alternatively, SFAS No. 123 allows entities to continue to applythe provisions of Accounting Principles Board (“APB”) Opinion No. 25 *“Accounting for Stock Issued to Employees,”* and relatedinterpretations and provide pro forma net income and pro forma income per sharedisclosures for employee stock options as if the fair-value-based methoddefined in SFAS No. 123 had been applied. We have elected to continue to apply the provisions of APB Opinion No. 25and provide the pro forma disclosure provisions of SFAS No. 123.

 

In December 2004, the Financial AccountingStandards Board issued SFAS No. 123 (revised 2004) *Share-BasedPayment* (“SFAS No. 123R”). SFAS No. 123R requires that thecost from all share-based payment transactions, including stock options, berecognized in the financial statements at fair value. SFAS No. 123R iseffective for public companies in the first fiscal year beginning after June 15,2005. We will adopt the provisions of this statement effective January 1,2006. We anticipate adopting SFAS No. 123R using the modified prospectivemethod, pursuant to which we will not restate any prior periods.

 

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

 

We granted 109,000 options in the third quarter.Assumptions used to determine the fair value of options granted during the thirdquarter of 2005 using the lattice-based binomial model were developed inconsultation with an outside valuation specialist.  The lattice-based binomial model requires theinput of several assumptions including expected volatility, the dividend yield,and risk-free rate of return, as well as certain assumptions regarding exercisebehavior.  Unlike the Black-Scholes modelwhere the expected term is an input assumption, the expected-term is an outputvariable of the lattice-based binomial model. For fiscal year 2004 the company reflected a volatility assumption of61.3% for stock options granted during the fiscal year.  This was based on the historical price of ourstock over the expected life of the option. Using the lattice model the expected volatility assumption was developedbased on an analysis of historical prices of our stock and open marketexchanged options.  The volatility ofhistorical prices for fiscal year 2005 was 52% while the volatility for openmarket exchanged options issued “near-the-money” was 32%.  Therefore, a best-estimate range of 32% to52% was developed.  When no point in arange is more or less likely to be the best estimate, FAS123(R) directs the useof an average.  This implies that 42% isthe best estimate volatility assumption for us. The risk free interest rate varies by duration, from 3.5% to 4.0%.

 

Assumptions were developed separately for our seniormanagement from the other participants of our stock plans, since seniormanagements’ exercise behavior is expected to differ materially from the otherparticipants.

 

Compensation expense for stock options issued to employeesis recorded on the date of grant only if the current market price of theunderlying stock exceeds the exercise price. Had we determined compensation cost based upon the fair value at thegrant date for our stock options using the methodologies described above, proforma net income and pro forma net income per share, including the following

 

12

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weightedaverage assumptions used in these calculations, would have been as follows forthe three and nine months ended September 30, 2005 and 2004:

 

| ** **                                                                                                                                     | ** ** | **For the three months  ended September 30,** | ** ** | **For the nine months  ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **2005**                                      | ** ** | **2004**                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net income, as  reported                                                                                                                       |       | $                                             | 14,409     |                                         | $          | 12,411 |   | $ | 43,204 |   | $ | 36,335 |   |
| 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                                         |       | 1,878                                        |       | 5,541 |   | 4,198 |   |
| Pro forma net  income                                                                                                                          |       | $                                             | 12,527     |                                         | $          | 10,533 |   | $ | 38,546 |   | $ | 32,137 |   |
|                                                                                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Income per  share:                                                                                                                             |       |                                          |       |                                         |       |   |   |   |   |
| Basic - as  reported                                                                                                                           |       | 0.55                                          |       | 0.49                                         |       | 1.67 |   | 1.47 |   |
| Basic - pro  forma                                                                                                                             |       | 0.48                                          |       | 0.42                                         |       | 1.49 |   | 1.30 |   |
| Diluted - as  reported                                                                                                                         |       | 0.51                                          |       | 0.45                                         |       | 1.52 |   | 1.34 |   |
| Diluted - pro  forma                                                                                                                           |       | 0.44                                          |       | 0.39                                         |       | 1.37 |   | 1.19 |   |
| Risk free  interest rate                                                                                                                       |       | 3.5% - 4                            | %          | 4.4                                          | %          | 3.5% - 4 | % | 4.4 | % |
| Expected life of  options                                                                                                                      | ** ** | 7.38                                          |       | 6.74                                         |       | 7.38 |   | 6.74 |   |
| Expected  volatility                                                                                                                           |       | 42.0                                          | %          | 61.3                                         | %          | 42.0 | % | 61.3 | % |
| Expected  dividends                                                                                                                            |       | —                                        |       | —                                       |       | — |   | — |   |

 

6.             LegalProceedings

 

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

 

On May 6,2005, a lawsuit entitled Farnam Street Financial, Inc. v. Guitar Center, Inc.,Case No. CT 05-6546, was filed in the Fourth Judicial District in theState of Minnesota for the County of Hennepin. The lawsuit, which was filed by a Minnesota corporation, alleges breachof contract in connection with the lease of certain equipment located in ourcorporate office and retail stores. Among other things, the lawsuit alleges that we have breached thecontract by our failure to comply with the terms and conditions in connectionwith the return of the equipment and seeks approximately $4.5 million ofdamages and attorneys’ fees.  We havefiled an answer to the complaint and are in the process of propoundingdiscovery on the plaintiff as well as responding to plaintiff’s requests fordiscovery.

 

While we intendto defend these claims vigorously, there can be no assurance that we will beable to achieve a favorable settlement of these lawsuits or obtain a favorableresolution of such lawsuits if they are not settled.  An unfavorable resolution of these lawsuitscould have a material adverse effect on our business, financial condition andresults of operations.  Regardless of theoutcome, the costs and expenses incurred by us to defend these lawsuits couldalso have a material adverse effect on our business, financial condition andresults of operations.

 

In additionto the lawsuits described above, we are involved in various claims and legalactions arising in the ordinary course of our business and, while the resultsof those proceedings cannot be predicted with certainty, we believe that thefinal outcome of those matters will not have a material adverse effect on ourbusiness, financial condition and results of operations.

 

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

** **

### **General**

### ** **

GuitarCenter is the nation’s leading retailer of guitars, amplifiers, percussioninstruments, keyboards and live-sound/DJ and recording equipment based onannual revenue. As of September 30, 2005, we operated 156 Guitar Centerretail stores, with 123 stores in 50 major markets and 33 stores in secondarymarkets across the United States. In addition, as of September 30, 2005,our Music & Arts division operated 79 retail locations and eighteducational support centers specializing in band instruments for sale andrental, serving thousands of teachers, band directors, college professors andstudents. We are also the largest direct response retailer of musicalinstruments in the United States through our wholly-owned subsidiary, Musician’sFriend, Inc., and its catalog and web site, www.musiciansfriend.com.

 

Duringthe third quarter, we opened two large format Guitar Center stores in OverlandPark, Kansas and Independence, Missouri and five small format stores in Greenville,South Carolina, Wichita, Kansas, Charleston, South Carolina, Fort Wayne,Indiana and Pensacola, Florida.  Thesestores added 79,000 square feet of Guitar Center retail space and brought us toa total of 2.33 million square feet of Guitar Center retail space at the end ofthe quarter.

 

As weenter new markets, we expect that we will initially incur higher administrativeand promotional costs per store than is currently experienced in establishedmarkets.  We expect competition tocontinue to increase as other music product retailers attempt to executenational growth strategies including expansion of their direct responseoperations.  Our business strategy willalso emphasize opportunities to continue to grow each of our brands, includingfurther acquisitions if attractive candidates can be located for reasonableprices.

 

From2000 to 2004, our consolidated net sales grew at an annual compound growth rateof 17%, principally due to the comparable store sales growth of our retailstores averaging 7% per year, the opening of new stores, and a 22% per yearincrease in the direct response channel. We believe such volume increases arethe result of the continued success of the implementation of our businessstrategy, continued growth in the music products industry and increasingconsumer awareness of the Guitar Center, Musician’s Friend and Music &Arts brand names. We achieved comparable store sales growth for Guitar Center storesof 5%, 7% and 7% for the first three quarters of 2005, compared to 11%, 8% and9% for the first three quarters of 2004. Comparable store sales compares net salesfor the comparable periods, excluding net sales attributable to stores not openfor 14 months as of the end of the latter reporting period.  All references in this report to comparablestores sales are based on this calculation methodology.

 

**Executive Summary**

 

Consolidatednet sales for the quarter ended September 30, 2005 increased 18.6%, or $66.2million, to $421.1 million compared to $354.9 million in the third quarter of2004. Net income for the quarter was $14.4 million, which is a 16.1% increase overthe $12.4 million we reported in the third quarter of 2004.

 

OurGuitar Center retail division turned in a strong performance for the quarter.Net sales from our Guitar Center stores increased 13.9% to $310.1 million from$272.3 million in last year’s third quarter. Sales from new stores contributed$19.2 million and accounted for 50.9% of the increase. Guitar Center retail’scomparable store sales increased 7%. In addition, we successfully opened sevennew stores during the quarter including our 150th store grandopening in July.

 

Musician’sFriend, our direct response division, generated a net sales increase of 12.5%for the quarter to $80.8 million compared to $71.8 million in the third quarterof 2004. As has been the case in recent quarters, we are continuing toexperience a higher level of competition in the direct response business andthat trend continued in the third quarter. Among other things, we are experiencing a continuing shift of businessto the internet and are spending much more on internet search engineadvertising than we have in the past. For the quarter, we achieved an initialorder fill rate of 93% down from 94% in the same quarter of 2004. Initial orderfill rate reflects the percentage of items ordered by our customers that we areable to supply in the initial shipment to that customer.

 

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Wecompleted the acquisition of Music & Arts Center, Inc. on April 15,2005 and the acquired business and our former American Music business werecombined into a new division that operates under the Music & Artsname. Financial statements prior to April 15, 2005 only reflect results forour former American Music stores and do not include results from the acquiredbusiness. However, comparable stores sales for the quarter is computed usingthe combined comparable store sales of Music & Arts Center, Inc. stores andAmerican Music stores. Net sales from our Music & Arts division were $30.1million compared to $10.7 million in the third quarter of 2004. Comparablestore sales for only American Music stores decreased 25.0%, while comparablestore sales for only Music and Arts Center, Inc. stores increased 3.2%,resulting in the combined comparable store sales decrease of 6%. Comparablestore sales decreased at the American Music stores principally due to the reductionin institutional sales which will not be a part of our ongoing Music & Artsstrategy.  We decided to no longer pursuethese sales due to their low selling margins.

 

**Discussion of Critical Accounting Policies**

 

In theordinary course of business, we have made a number of estimates and assumptionsrelating to the reporting of results of operations and financial condition inthe preparation of our financial statements in conformity with accountingprinciples generally accepted in the United States of America.  Actual results could differ significantlyfrom those estimates under different assumptions and conditions.  We believe that the following discussionaddresses our most critical accounting policies, which are those that are mostimportant to the portrayal of our financial condition and results and requiremanagement’s most difficult, subjective and complex judgments, often as aresult of the need to make estimates about the effect of matters that areinherently uncertain.  Additionally, thepolicy described below regarding credits and other vendor allowances is uniqueto our industry and deserves the attention of a reader of our financialstatements.

 

*Valuationof Inventory*

 

Wevalue our merchandise at the lower of cost using the weighted average method ormarket. Rental inventories are valued at the lower of cost or market using thespecific identification method and are depreciated on a straight-line basiswhile out under a rental agreement for rent-to-own sales. We record adjustmentsto the value of inventory based upon obsolescence and changes in marketvalue.  Applicable costs associated withbringing inventory through our Guitar Center retail distribution center arecapitalized to inventory.  The amountsare expensed to cost of goods sold as the associated inventory is sold.  Management has evaluated the current level ofinventories considering future customer demand for our products, taking intoaccount general economic conditions, growth prospects within the marketplace,competition, market acceptance of current and upcoming products, and managementinitiatives.  Based on this evaluation,we have recorded impairment adjustments to cost of goods sold for estimateddecreases in net realizable value.  Thesejudgments are made in the context of our customers’ shifting needs, product andtechnological trends, and changes in the demographic mix of our customers. Amisinterpretation or misunderstanding of these conditions and uncertainties inthe future outlook of our industry or the economy, or other failure to estimatecorrectly, could result in inventory valuation changes as of any given balancesheet date.

 

*Valuationof Long-Lived Assets*

 

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

 

•      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.

 

Forlong-lived assets other than goodwill and intangibles that are not amortized,the determination of whether impairment has occurred is based on an estimate ofundiscounted future cash flows attributable to the assets, as compared to thecarrying value of the assets. Assumptions used in these cash flows are consistent with internalforecasts and consider current and future expected sales volumes and relatedoperating costs and any

 

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anticipated increases ordeclines based on expected market conditions and local business environmentfactors. If a potential impairment is identified, the amount of the impairmentloss recognized would be determined by estimating the fair value of the assetsand recording 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.

 

Ourassessment regarding the existence of impairment factors is based on marketconditions and the operational performance of our business. Our review offactors present and the resulting appropriate carrying value of our goodwill,intangibles and other long-lived assets are subject to judgments and estimatesthat management is required to make.

 

*SalesReturns*

 

Aspart of our “satisfaction guaranteed” policy, we allow Guitar Center customersto return product generally within 30 days after the date of purchase, and weallow Musician’s Friend customers to return product within 45 days. Music &Arts division customers have 14 business days from the date of purchase toreturn product. We regularly review and revise, when deemed necessary, ourestimates of sales returns based upon historical trends. While our estimatesduring the past few years have approximated actual results, actual returns maydiffer significantly from estimates, either favorably or unfavorably, iffactors such as economic conditions or the competitive environment differ fromour expectations.

 

*Creditsand Other Vendor Allowances*

 

Wereceive cooperative advertising allowances (i.e., an allowance from themanufacturer to subsidize qualifying advertising and similar promotionalexpenditures we make relating to the vendor’s products), price protection credits(i.e., credits from vendors with respect to in-stock inventory if the vendorsubsequently lowers their wholesale price for such products) and vendor rebates(i.e., credits or rebates provided by vendors based on the purchase ofspecified products and paid at a later date). Cooperative advertisingallowances are recognized as a reduction to selling, general, andadministrative expense when we incur the advertising expense eligible for thecredit. We recognized cooperative advertising allowances of $2.6 million and $1.6million in the three months ended September 30, 2005 and 2004,respectively. For the nine months ended September 30, 2005 and 2004 werecognized $6.5 million and $4.5 million of cooperative advertising allowances,recorded as an offset to selling, general and administrative expense.  Price protection credits and vendor rebatesare accounted for as a reduction of the cost of merchandise inventory and arerecorded at the time the credit or rebate is earned.  The effect of price protection credits andvendor rebates is recognized in the income statement at the time the relatedinventory is sold as a reduction in cost of goods sold. The reserve againstrebates receivable is determined by specifically identifying uncollectibleaccounts through an aging review and an analysis of vendor relationships. Wereceived vendor rebate payments of $6.1 million and $4.1 million for the threemonths ended September 30, 2005 and 2004 and $23.1 million and $16.1 millionfor the nine months ended September 30, 2005 and 2004, respectively. Weearned vendor rebates of $7.7 million and $6.3 million for the three monthsended September 30, 2005 and 2004 and $21.2 million and $17.4 million forthe nine months ended September 30, 2005 and 2004, respectively. None of thesecredits are recorded as revenue.

 

**Results ofOperations**

 

Thefollowing table presents our consolidated statements of income, as a percentageof sales, for the periods indicated.

 
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | **2005**                                   | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                    |       | 100.0                                      | %          | 100.0                                     | %          | 100.0 | % | 100.0 | % |
| Gross profit                                 |       | 29.4                                       | %          | 27.6                                      | %          | 28.7 | % | 27.5 | % |
| Selling, general and  administrative expense |       | 23.4                                       | %          | 21.6                                      | %          | 22.6 | % | 21.5 | % |
| Operating income                             |       | 6.0                                        | %          | 6.0                                       | %          | 6.1 | % | 6.0 | % |
| Interest expense, net                        |       | 0.5                                        | %          | 0.4                                       | %          | 0.4 | % | 0.4 | % |
| Income before income tax expense             |       | 5.5                                        | %          | 5.6                                       | %          | 5.7 | % | 5.6 | % |
| Income tax expense                           |       | 2.1                                        | %          | 2.1                                       | %          | 2.2 | % | 2.1 | % |
| Net income                                   |       | 3.4                                        | %          | 3.5                                       | %          | 3.5 | % | 3.5 | % |

 

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

 

Netsales for the three months ended September 30, 2005, increased 18.6% to $421.1million, compared to $354.9 million for the same period last year. Net salesfrom Guitar Center stores for the three months ended September 30, 2005totaled $310.1 million, a 13.9% increase from $272.3 million for the sameperiod in 2004.  Sales from new storescontributed $19.2 million and represent 50.9% of the total increase in retailstore sales.  Comparable store sales forGuitar Center division increased 7%.  Webelieve that comparable store sales are a more useful indicator of storeperformance than the change in total net sales, since comparable store salesexclude the effects of changes in the number of stores open.

 

Wecompleted our acquisition of Music & Arts Center, Inc. on April 15,2005, and the acquired business and our former American Music business werecombined into a new division that operates under the Music & Artsname. Third quarter 2005 financial statement results reflect the combinedoperations of the Music & Arts division and American Music while thirdquarter 2004 results only include results from American Music. However,comparable stores sales for the quarter is computed using the combinedcomparable store sales of Music & Arts Center, Inc. stores and AmericanMusic stores. Net sales from Music & Arts for the quarter ended September 30,2005 totaled $30.1 compared to $10.7 million in 2004 primarily due to the acquisition.Comparable store sales for only American Music stores decreased 25.0%, whilecomparable store sales for only Music & Arts Center, Inc. stores increased3.2%, resulting in the combined comparable store sales decrease of 6%.Comparable store sales decreased at the American Music stores principally dueto the reduction in institutional sales which will not be a part of our ongoingMusic & Arts strategy.  We decided tono longer pursue these sales due to their low selling margins. Sales were alsolower than expected due to a later school calendar shifting some sales to thefourth quarter.

 

Netsales from the direct response channel totaled $80.8 million for the threemonths ended September 30, 2005, a $9.0 million, or 12.5%, increase from2004. This increase primarily reflects the improved leveraging of an expandingbuyer file and advertising strategies offset somewhat by expanded free shippingprograms and increased competition. We continued to face increased competition.Weexpect this trend of increased competition in the direct response channel andits negative impact on that segment’s net sales and gross margin to continue forthe foreseeable future. Sales from the contact center, whichrepresent sales placed via phone, live chat, mail and e-mail, decreased 6.2% to$31.0 million for the three months ended September 30, 2005 from $33.1million for the comparable 2004 period. Internet sales from orders placed viathe Musician’s Friend and Giardinelli web sites increased 28.4% to $49.8million from $38.8 million for the same period last year.  The growth of web-based sales reflects thecontinued trend of our catalog customers’ preference in using the web to placetheir orders, the success of web-based promotions, and that the web siteincludes a more complete inventory presentation than our catalogs.

 

Gross profit for thethree months ended September 30, 2005 compared to 2004 increased 26.4% to$123.8 million from $97.9 million.  Grossprofit as a percentage of net sales for the three month period ended September 30,2005 compared to 2004 increased to 29.4% from 27.6%.  Gross profit as a percentage of net sales forGuitar Center retail was 28.1% compared with 26.4% in the third quarter of2004. The increase is primarily due to higher selling margin (1.1%) and areduction in inventory and other reserves of $1.8 million (0.6%), partiallyoffset by increased freight costs (0.1%) which was affected by higher fuel costs.We realized higher selling margin principally from expansion of sales of ourproprietary product, items marketed and sold under brand names owned by GuitarCenter, which yield a higher margin, a change in product mix and better pricingfrom vendors. We define selling margin as net sales less the cost of themerchandise charged by the vendor plus the associated inventory costs from fulfillinginventory through our distribution center, less all associated vendor discountsand rebates. Freight is not included in selling margin. Gross profit for theMusic & Arts division increased to 44.2% from 33.6%, or 10.6%, due toimproved selling margin (14.1%) and a reduction in freight (0.8%), offset byincreased shrink (2.6%) and occupancy costs (1.7%).  Selling margin improved due to a shift inproduct mix towards higher profit margin categories as well as improved marginsdelivered by the Music & Arts Center business compared to American Music.The primary changes in product mix were a decrease in instruments sales as apercentage of total mix, while increasing sales of instruments for rent andprint as a percentage of total mix. Instruments for rent margins and printsales margins are significantly higher than instrument sales margins.  We were able to reduce our emphasis oninstrument sales by eliminating certain institutional sales that were at verylow margins. Gross profit margin for the direct response division was 29.1% forthe quarter compared to 31.3% in the third quarter of 2004. The decrease wasprimarily due to reduced shipping and handling revenue which is a direct resultof the competitive environment over the Internet (2.4%), partially offset by adecrease in freight costs (0.1%) and shrink (0.1%).

 

Selling,general and administrative expenses for the three months ended September 30,2005 increased 28.4% to $98.4 million from $76.6 million for the sameperiod in 2004. As a percentage of net sales, selling,

 

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general andadministrative expense was 23.4% for the third quarter in 2005 compared to 21.6%for the same period in 2004. This increase includes a charge for stock-basedcompensation of approximately $1.4 million resulting from our new long-termincentive plan. On July 28, 2005 our Board of Directors approved ourlong-term incentive plan, which includes issuance of Guitar Center stock andstock options. Grants of stock under the long-term incentive plan are based onthe attainment of a specified level of cumulative diluted earnings per shareduring a performance period that began on July 1, 2005 and ends December 31,2007.

 

Selling,general and administrative expenses for the Guitar Center stores in the thirdquarter were 20.7% as a percentage of net sales compared to 20.8% in last year’sthird quarter. The decrease is primarily due to a decrease in advertising andpromotional costs (0.6%), partially offset by an increase in salary costs(0.4%), inclusive of stock-based compensation costs resulting from thelong-term incentive plan.

 

Selling, general and administrative expenses for the Music &Arts division were 48.5% of sales in the third quarter compared to 45.6% in thesame period last year. We did not record any material charges related to theacquisition of Music & Arts Center, Inc. in the third quarter. The increase is primarily due to anincrease in advertising and promotional costs (3.7%), depreciation andamortizations costs (1.2%) due to the amortization of intangibles acquired fromMusic & Arts Center, Inc., partially offset by a decrease in salary costs(1.7%), inclusive of stock-based compensation costs resulting from thelong-term incentive plan and travel and entertainment (0.3%).

 

Selling,general and administrative expenses for the direct response division were 24.3%of sales compared to 21.1% for the three month periods ended September 30,2005 and 2004, respectively. The increase is primarily due to increased on-lineadvertising expense (1.6%), and increased payroll costs (1.4%) which includesthe accrual for the new long-term incentive plan, partially offset by adecrease in legal fees (0.2%).

 

Operatingincome increased 19.4% to $25.5 for the three months ended September 30,2005 from $21.3 million in the comparable 2004 period. This resulted in anoperating income percentage of 6.0% for both the third quarter of 2005 and2004. We achieved these results due to an increased operating income percentageat our Guitar Center stores of 7.4% for the third quarter of 2005 compared to5.6% for the third quarter of 2004, offset by a decline in Musician’s Friendoperating income percentage of 4.8% for the third quarter of 2005 compared to10.2% in the third quarter of 2004. Music &****Art’soperating income percentage improved to a negative 4.4% for the third quarterof 2005 compared to a negative 12.0% for the third quarter of 2004.

 

Interestexpense, net for the three months ended September 30, 2005, increased to $2.0 millionfrom $1.3 million in the third quarter of 2004. The increase is primarilydue to interest on borrowings related to the acquisition of Music & ArtsCenter, Inc., increased inventory levels at our Guitar Center retail stores andpurchases of property and equipment.

 

In thethree months ended September 30, 2005, a $9.0 million provision for incometaxes was recorded compared to $7.6 million for the same period last year,based on effective tax rates of approximately 38.5% and 38%, respectively.There was a change in the effective tax rate as a result of higher blendedstate income tax rates.

 

Netincome for the three months ended September 30, 2005 increased 16.1% to $14.4million, compared to $12.4 million in the same period last year as a result ofthe combinations of factors described above.

 

**NineMonths Ended September 30, 2005 Compared to the Nine Months Ended September 30,2004**

 

Netsales for the nine months ended September 30, 2005 increased 16.8% to $1.2billion, compared to $1.0 billion in the same period last year. Net sales fromGuitar Center stores for the nine months ended September 30, 2005 totaled$904.4 million, a 13.2% increase from $798.7 million for the same period in2004.  Sales from new stores contributed$54.9 million and represent 52.0% of the total increase in retail store sales. Comparablestore sales from our Guitar Center stores increased 6%. We believe that comparablestore sales are a more useful indicator of store performance than the change intotal net sales, since comparable store sales exclude the effects of changes inthe number of stores open. 

 

The financialstatements of American Music and Music & Arts Center, Inc. forthe nine months ended September 30, 2005 reflect the combined results ofAmerican Music for the entire period and Music & Arts Center, Inc.from April 15, 2005 through September 30, 2005, while third quarter2004 results include results from American Music only. However, comparablestores sales for the period ended September 30, 2005 is computed using thecomparable store sales of American Music stores for the nine month period endedSeptember 30, 2005 combined with comparable store sales for the Music &Arts Center, Inc. stores for the period from April 15, 2005 through September30, 2005. Net sales from Music & Arts for the nine months ended September 30,2005 totaled $65.0 million compared to $28.7 million in 2004 due to theacquisition. Comparable Music & Arts stores sales decreased 2%.

 

Netsales from the direct response channel totaled $250.3 million for the nine monthsended September 30, 2005, a $33.5 million, or 15.4%, increase from 2004. Thisincrease primarily reflects the improved leveraging of an expanding buyer fileand advertising strategies offset somewhat by expanded free shipping

 

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programs and increasedcompetition. We expect this trend of increased competition in the directresponse channel and its negative impact on that segment’s net sales and grossmargin to continue for the foreseeable future. Sales from the contact center,which represent sales placed via phone, live chat, mail and e-mail, increased4.2% to $101.8 million from $97.7 million for the nine months ended September 30,2005 compared to 2004. Internet sales from orders placed via the Musician’sFriend and Giardinelli web sites increased 24.6% to $148.5 million from $119.2million for the same period last year. The growth of web-based sales reflectsthe continued trend of our catalog customers’ preference in using the web toplace their orders, the success of web-based promotions, and that the web siteincludes a more complete inventory presentation than our catalogs.

 

Grossprofit for the nine months ended September 30, 2005 compared to 2004increased 22.1% to $350.3 million from $286.8 million.  Gross profit as a percentage of net sales forthe nine months ended September 30, 2005 compared to 2004 increased to 28.7%from 27.5%. Gross profit as a percentage of net sales for Guitar Center retailwas 27.3% compared with 25.9% for the nine months ended September 30, 2004.The increase is due to a higher selling margin (1.2 %) and reduced inventoryand other reserves of $1.8 million (0.2%). We realized higher selling marginprincipally from expansion of our proprietary product which yield a highermargin, a change in product mix and better pricing from our vendors. Grossprofit for the Music and Arts division increased to 42.2% from 34.3%, or 7.9%,due to improved selling margin (9.6%) and a reduction in freight (0.5%), lowershrink (0.1%) offset by the write down of inventory carried at American Musicresulting from a change in inventory assortment with the acquisition of Music& Arts Center, Inc. (0.9%), and occupancy costs (1.4%).  Selling margin improved due to a shift inproduct mix towards higher profit margin categories as well as improved marginsdelivered by the Music & Arts Center business compared to American Music.The primary changes in product mix were a decrease in instruments sales as apercentage of total mix, while increasing sales of instruments for rent andprint as a percentage of total mix. Instruments for rent margins and printsales margins are significantly higher than instrument sales margins.  We were able to reduce our emphasis on instrumentsales by eliminating certain institutional sales that were at low margins. Grossprofit margin for the direct response division was 30.3% for the nine monthsended September 30, 2005 compared to 32.3% in the same period last year.The decrease was primarily due to increased activity by competitors over theInternet which led to pricing pressure (2.4%), partially offset by a decreasein freight costs (0.3%) and shrink (0.1%).

 

Selling,general and administrative expenses for the nine months ended September 30,2005 increased 22.8% to $275.3 million from $224.1 million for thesame period in 2004. Selling, general and administrative expenses as apercentage of net sales, for the nine months ended September 30, 2005compared to 2004, increased to 22.6% from 21.5%. As a percentage of net sales,selling, general and administrative expenses for Guitar Center stores was 20.6%for the nine months ended September 30, 2005 and 2004, respectively. The resultsinclude an increase in salary costs (0.2%), and an increase in accounting fees(0.1%), partially offset by decreased bad debt expense (0.1%) due to bettercollections and a decrease in advertising and promotional costs (0.1%).

 

Selling,general and administrative expenses for the Music & Arts division were53.0% of sales for the nine months ended September 30, 2005 compared to 47.3%in the same period last year. Excluding the acquisition charges of $2.9 million,selling, general and administrative expense were 48.5% of sales compared to 47.3%for the same period last year. The increase is primarily due to anincrease in advertising and promotional costs (2.4%), depreciation andamortizations costs (1.4%) due to the amortization of intangibles acquired fromMusic & Arts Center, Inc., partially offset by decreases in auto expense(0.6%), travel and entertainment (0.4%), supplies expense (0.4%), bad debtexpense (0.4%) and general insurance expense (0.4%).

 

Selling,general and administrative expenses for the direct response division were 21.8%of sales compared to 21.4% for the nine months ended September 30, 2005and 2004, respectively. The increase was driven by advertising expense relatedto programs to increase web traffic (0.8%), and was offset by decrease in baddebt expense (0.1%), in credit card expense (0.1%), and general insuranceexpense (0.2%).

 

Operating income increased 19.7% to $75.1 million from $62.7million for the nine months ended September 30, 2005. Thisresulted in an operating income percentage of 6.2% for the nine months endedSeptember 30, 2005 compared to 6.0% for the same period in 2004. We achievedthese results due to an increased operating income percentage at our GuitarCenter stores of 6.7% for the nine months ended September 30, 2005 compared to5.3% for the same period in 2004, offset by a decline in Musician’s Friend operatingincome percentage of 8.5% for the nine months ended September 30, 2005 comparedto 11.0% for the same period in 2004. Music & Art’s operating income percentage improved to a negative10.8% for the nine months ended September 30, 2005 compared to a negative13.1%for the same period in 2004. The Music & Arts operating loss includes $2.9 million ofacquisition charges resulting primarily from the elimination of a redundantpoint of sales system, severance costs and moving costs to relocate certainAmerican Music employees to the Music & Arts corporate office in Maryland,and $0.6 million from the write down of inventory carried at American Musicresulting from a change in inventory assortment.

 

Interestexpense, net for the nine months ended September 30, 2005 increased to$4.8 million from $4.1 million for the same period in 2004. The increase is primarilydue to interest on borrowings related to the acquisition of Music & ArtsCenter, Inc., increased inventory levels at our Guitar Center retail stores andpurchases of property and equipment.

 

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In thenine months ended September 30, 2005, a $27.0 million provision for incometaxes was recorded compared to $22.3 million for the same period last year,based on an effective tax rate of approximately 38.5% and 38%, respectively.There was an increase in the effective tax rate as a result of higher blendedstate income tax rates.

 

Netincome for the nine months ended September 30, 2005 increased 18.9% to $43.2million, compared to $36.3 million in the same period last year as a result ofthe factors described above.

 

### **Liquidity and Capital Resources**

### ** **

Ourneed for liquidity will arise primarily from the funding of capitalexpenditures, working capital requirements and payments on our indebtedness, aswell as possible acquisitions. We have historically financed our operationsprimarily through internally generated funds and borrowings under our creditfacilities. As of September 30, 2005, we had $74.0 million outstanding in borrowingsunder our credit facility and had available borrowings of $34.7 million (net of$6.3 million of outstanding letters of credit).

 

In February of2005, we amended our credit facility with a syndicate of banks led by WellsFargo Retail Finance. The credit facility permits borrowings up to $125 million(which may be increased to $150 million at our option), subject to borrowingbase limitations. The actual amount available is tied to our inventory andreceivable base, and our obligations under the credit facility are secured byliens on our principal assets. Borrowing options are prime rate (6.75% at September 30,2005) plus applicable prime margin, or London Interbank Offered Rate (“LIBOR”),or LIBOR (nine month rate at September 30, 2005 was 4.4%) plus applicableLIBOR margin. The applicable prime and LIBOR margins are based upon levels ofexcess availability and adjusted quarterly. If excess availability is greaterthan $20 million, the applicable prime margin is 0.00% and applicable LIBORmargin is 1.0%. If excess availability is less than or equal to $20 million andgreater than $10 million, the applicable prime margin is 0.00% and theapplicable LIBOR margin is 1.25%. If excess availability is less than or equalto $10 million, the applicable prime margin is 0.00% and the applicable LIBORmargin is 1.5%. An unused fee of 0.25% is assessed on the unused portion of thecredit facility. The agreement underlying the credit facility includessignificant restrictive negative covenants. Among other things, these covenantsrestrict our ability to incur debt and issue specified equity instruments,incur liens on our assets, make any significant changes in our corporatestructure or the nature of our business, dispose of assets, make guaranties, prepaydebt, engage in a change in control transaction, pay dividends, makeinvestments or acquisitions, engage in transactions with affiliates and incurcapital expenditures, and also require that we satisfy a minimum availabilitytest. The minimum availability test requires that we maintain $10 million ofreserved availability under the agreement based on its borrowing baselimitations.  The amount we disclose inour public reports from time to time as available to borrow under the agreementis already reduced by this required reserve and outstanding letters of credit,and thus represents a net amount available under the agreement. The agreementalso includes representations and warranties which must be true each time weborrow funds under the credit facility and affirmative covenants.  The full text of the contractual requirementsimposed by this financing is set forth in the Amended and Restated Loan andSecurity Agreement and related amendments which have been filed with theSecurities and Exchange Commission.  Wewere in compliance with such requirements as of September 30, 2005.  Subject to limited cure periods, the lendersunder our credit facility may demand repayment of these borrowings prior tostated maturity upon the occurrence of specified events, including if we breachthe terms of the agreement, suffer a material adverse change, engage in achange in control transaction, suffer a significant adverse legal judgment,default on other significant obligations, or in the event of specified eventsof insolvency.  The credit agreementmatures in December 2010.

 

On June 16,2003, we completed the issuance of $100 million principal amount of 4.00%Senior Convertible Notes due 2013. The convertible notes bear interest at therate of 4.00% per annum, subject to the payment of contingent interest undercertain circumstances commencing January 15, 2006, and are convertibleinto shares of common stock at a conversion price of $34.58 per share, subjectto adjustment under specified circumstances. Under the contingent conversionfeature of the convertible notes, subject to certain exceptions, they are notconvertible into common stock unless and until the trading price of the commonstock reaches at least $41.50 for a specified period in advance of eachquarterly conversion period or designated corporate events occur. As of September 30,2005, the convertible notes were convertible for the current quarterlyconversion period. The convertible notes will also become convertible upon theoccurrence of specified corporate transactions and other events described inthe indenture. The final maturity of the convertible notes is July 2013,although holders may require us to repurchase the Notes at their election in July 2008,July 2010 or upon the occurrence of a change in control, in each case fora purchase price equal to the original principal amount plus accrued interest.

 

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We may call theconvertible notes for redemption commencing in July 2006.  The premium is not payable upon bonds thatare converted. The indenture governing the convertible notes does not limit ourability to incur indebtedness or otherwise substantively restrict the operationof our business to any significant degree. Subject to limited cure periods, the holders of the convertible notesmay demand repayment of these borrowings prior to the stated maturity upon theoccurrence of specified events, including if we fail to pay interest orprincipal when due, if we fail to satisfy our conversion obligation, if anotherobligation of ours having an outstanding principal amount in excess of $15million is accelerated prior to stated maturity and upon the occurrence ofspecified events of insolvency.

 

During2002 we entered into master operating lease agreements with General ElectricCapital Corporation and US Bank to lease equipment and other property primarilyto support the operations of the distribution center for our Guitar Centerretail stores. Under these agreements, we leased a total of $10.5 million in equipmentand other property. The agreements call for monthly payments of $138,000 for aterm of 36 months through September 30, 2009 and monthly payments of$48,000 for a term of 36 months through December 28, 2005.

 

Theterms of our significant financing agreements, including those related to ourcredit facility, the convertible notes and the equipment lease facilitiesdescribed above, are not dependent on any change in our credit rating. Webelieve that the key company-specific factors affecting our ability to maintainour existing debt and lease financing relationships and to access such capitalin the future are our present and expected levels of profitability and cashflow from operations, our working capital and fixed asset collateral bases, ourexpected level of capital expenditures, and the level of our equity capitalrelative to the level of debt obligations. In addition, as noted above, ourexisting 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 isthe case with most multi-unit retailers, substantially all of the real propertyused in our business is leased under operating lease agreements.  Please see Item 2. Properties, “—DisclosuresAbout Contractual Obligations and Commercial Commitments” and Note 9 to theConsolidated Financial Statements in our Annual Report on Form 10-K forthe year ended December 31, 2004.

 

Netcash provided by operating activities was $4.3 million for the nine monthsended September 30, 2005 compared to $9.5 million for the same period lastyear. The largest use of cash was an increase in inventoriesof $82.2 million. The increase in inventories was due to the opening of 20 newGuitar Center retail stores of $26.6 million and an increase in existing storeinventory level of $55.6 million. Accounts payable also increased $35.0 millionfrom the inventory build and timing of vendor payments.

 

Cashused in investing activities increased to $142.1 million for the nine monthsended September 30, 2005 compared to $21.1 million for the same periodlast year. The investing activities for the nine months ended September 30,2005 consisted primarily of the purchase of Music & Arts Center, Inc.for approximately $93.0 million, a corporate airplane for $10.6 million, newcorporate office building for $12.2 million, capital expenditures for storeexpansions and remodels of $27.9 million compared to $11.8 million in the priorperiod, and computer equipment purchases of $7.0 million in the current periodcompared to $5.3 million in the same period last year. Additionally, we receivednet proceeds from the sale of available-for-sale securities of $20.1 million.

 

Cashprovided by financing activities totaled $85.1 million for the nine monthsended September 30, 2005 compared to $18.0 million used in the same periodlast year. The cash provided by financing activities consists primarily of the borrowingsunder our credit facility of $74.0 million and remaining from the net proceedsreceived from the exercise of stock options and other employee purchases of ourcommon stock. The increase in borrowings was required to support the Music &Arts Center, Inc. acquisition and the capital spending described above.

 

Webelieve that our current operating cash flow, working capital, and cash andcash equivalents on hand will be sufficient to meet our obligations in theordinary course of business, including capital expenditures and new store openings.

 

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Weintend to pursue an aggressive growth strategy by opening additional stores innew and existing markets.  During the ninemonths ended September 30, 2005, we opened 20 new Guitar Center stores (ninelarge format and 11 small format stores). Each new large format Guitar Centerstore typically has required approximately $1.3 to $1.5 million for grossinventory.  Historically, our cost ofcapital improvements for a large format Guitar Center store has beenapproximately $900,000, consisting of leasehold improvements, fixtures andequipment. We incur higher costs in some geographic areas, particularly theNortheast, and when we build a larger flagship store.  The first of the small format units wasopened in late 2000 and 34 more have been opened as of September 30, 2005.Our small format stores have typically required approximately $700,000 incapital expenditures and require approximately $1.0 million to $1.2 million ininventory. We expect the future costs to build new Guitar Center stores to risefrom these historical amounts as we have recently begun to experiencesignificant increases in the cost of steel, lumber concrete, labor, fuel andfreight.

 

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

 

Ourdistribution center in the Indianapolis, Indiana area supports our Guitar Centerretail store operations. Nearly all product flows through thedistribution facility, with the exception of special orders which, for the mostpart, are drop shipped to our stores. A portion of the costs of operating thisfacility are absorbed into our Guitar Center merchandise inventories andrecognized as an element of cost of goods sold when the related inventory issold. We have numerous commitments necessary to support the operations of thefacility, including a lease on the facility. On November 2, 2005, we enteredinto an amendment to our lease agreement for our distribution center in orderto expand the facility.  The amendmentextends the term of the lease for a period of 12 years from the substantialcompletion of construction of the expansion to the facility.

 

Inconnection with the amendment of the lease for the distribution facility, weare in the process of expanding our Guitar Center distribution center from 505,000square feet to approximately 713,000 square feet. We anticipate this expansionto be completed in 2006. The larger facility will increase our capacity tosupport continued expansion in 2006 and beyond. We anticipate making additionalcapital investments of $8.0 to $10.0 million and we expect to incur increasedrent starting during the third quarter of 2006.

 

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

 

Ourexpansion strategy is to continue to increase our market share in existingmarkets and to penetrate strategically selected new markets.  We opened a total of 14 Guitar Center storesin each of 2004 and 2003, and currently anticipate opening 25 Guitar Centerstores in 2005. This includes 12 large format stores and 12 small formatstores. In addition to the planned large and small format store openings, weexpect to open our first tertiary market store in December.  On April 15, 2005 we completed theacquisition of Music & Arts Center, Inc. and we combined ourAmerican Music business and Music & Arts, with the combined businessoperating under the Music & Arts name, and since then have opened twonew Music & Arts stores and completed one small acquisition. We continue tobelieve that there exists a number of additional acquisition opportunities in therelatively fragmented band instruments market that could be a good fit with ourcompany and continue to pursue acquisition opportunities.

 

Throughoutour history, we have primarily grown organically. However, we also believethere may be attractive opportunities to expand by selectively acquiringexisting music products retailers or other complimentary businesses, ifattractive opportunities can be identified. While we cannot provide assurancethat we will complete any further acquisition transactions, in the ordinarycourse of our business we investigate and engage in negotiations regarding suchopportunities. Acquisitions will be financed with cash on hand, drawings underour existing credit facilities, expansion of our credit facilities, issuance ofdebt or equity securities, or a combination, depending upon transaction sizeand market conditions, among other things.

 

Ourknown capital resource and liquidity requirements for 2005 are presentlyexpected to be primarily provided by cash on hand, net cash flow fromoperations and borrowings under our credit facility. Depending upon marketconditions, we may also elect or be required to raise additional capital in theform of common or preferred equity, debt or convertible securities for thepurpose of providing additional capital to fund working capital needs orcontinued growth of our existing business, or to refinance existingobligations. Any such

 

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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.

 

### **New Accounting Pronouncements**

 

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

 

In November 2004, the FASB issued SFAS No. 151,“Inventory Costs - An Amendment of ARB No. 43, Chapter 4”. SFAS No. 151amends the guidance in ARB No. 43, Chapter 4, “Inventory Pricing”, toclarify the accounting for abnormal amounts of idle facility expense, freight,handling costs, and wasted material (spoilage). SFAS No. 151 is effectivefor fiscal years beginning after June 15, 2005 and is required to beadopted in the first quarter of fiscal 2006. We do not expect the adoption ofSFAS No. 151 to have a material impact on our consolidated financialstatements.

 

In December 2004, the FASB issued SFAS No. 123(revised 2004) Share-Based Payment (“SFAS No. 123R”). SFAS No. 123Rrequires that the fair value from all share-based payment transactions,including stock options, be recognized in the financial statements at fairvalue. SFAS No. 123R is effective for public companies in the first fiscalyear beginning on or after January 1, 2006. We will adopt the provisionsof this statement in the first quarter of 2006. We anticipate adopting SFAS No. 123Rusing the modified prospective method, pursuant to which we will not restateany prior periods.  We are currentlyevaluating the effect of adoption of SFAS No. 123R will have on ourconsolidated financial statements and have not determined whether the adoptionwill result in amounts that are similar to the current pro forma disclosureunder SFAS No. 123.

 

### **Seasonality**

### ** **

Ourbusiness follows a seasonal pattern, peaking during the holiday selling seasonin November and December.  Sales inthe fourth 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 the Music & Arts division starts in August andcarries through mid-October, but that seasonality does not have a significantimpact on our consolidated results.

 

### **Inflation**

### ** **

Webelieve that the relatively moderate rates of inflation experienced in recentyears have not had a significant impact on our net sales or profitability.However, we anticipate that rising steel, lumber, concrete, labor, fuel andfreight costs may increase expenses related to opening, remodeling andrelocating our stores, expanding our distribution center and operating ourbusiness.

 

### **Forward-Looking Statements**

### ** **

Thisreport contains forward-looking statements relating to, among other things,future results of operations, growth and investment plans and related expenses,sales, trends in gross margin, growth and competition in the Internet businessand other factors affecting growth in sales and earnings.  Specific forward-looking statements areprovided regarding our management’s current views regarding comparable storesales, new store openings, and capital expenditure levels.  Statements regarding new store openings arebased largely on our current expectations and are necessarily subject toassociated business risks related to, among other things, the

 

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identification ofsuitable sites or acquisition opportunities, the timely construction, staffingand merchandising of those stores and other matters, some of which are outsideof our control. Comparable store sales growth is highly dependent upon thestate of the economy, the effectiveness of our sales and promotion strategies,and the effect of competition, including other national operators of musicproducts stores attempting to implement national growth strategies.

 

Salesand earnings trends are also affected by many other factors including, amongothers, world and national political events, general economic conditions, theeffectiveness of our promotion and merchandising strategies, changes in themusic products industry, retail sales trends, the emergence of new or growingspecialty retailers of music products, our ability to integrate and profitablyoperate acquired businesses, the efficient operation of our supply chain,including the continued support of our key vendors, our effective management ofbusiness risks, including litigation, and competitive factors applicable to ourretail and direct response markets. In light of these risks, there can be no assurancethat the forward-looking statements contained in this report will in fact berealized.  The statements made by us inthis report represent our views as of the date of this report, and it shouldnot be assumed that the statements made herein remain accurate as of any futuredate.  We do not presently intend toupdate these statements and undertake no duty to any person to affect any suchupdate under any circumstances.

 

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

 

**RisksRelated to the Business**

 

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

 

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

* *

Ourretail store growth strategy includes opening new stores in new and existingmarkets and increasing sales at existing locations.  As of September 30, 2005 we operated 156Guitar Center stores.  We opened a totalof 14 Guitar Center stores in 2004, have opened a total of 20 Guitar CenterStores as of September 30, 2005, and currently expect to open total ofapproximately five additional Guitar Center stores in 2005. This includes 12large format stores, 12 small format stores and our first tertiary market storein December. Our planned store opening schedule may be affected by anyacquisitions we may transact during a given period. If we complete any suchtransactions, our planned organic store openings may be reduced.

 

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

 

•      identificationof suitable retail sites and appropriate acquisition candidates;

 

•      negotiationof acceptable lease terms;

 

•      hiring,training and retention of skilled personnel;

 

•      availabilityof adequate capital;

 

•      sufficientmanagement and financial resources to support the new locations; and

 

•      vendorsupport.

 

Anumber of these factors are, to a significant extent, beyond our control.  As a result, we do not know whether we willbe able to continue to open and/or acquire additional Guitar Center stores atthe rates currently

 

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anticipated.  If we are unable to achieve our retail storeexpansion goals, or the new stores under perform our expectations, our resultsof operations could be adversely affected.

 

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

 

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

 

•      significantstart-up costs, including promotion and advertising;

 

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

 

•      managementof stores in distant locations or foreign countries;

 

•      availabilityof desirable product lines; and

 

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

 

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

 

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

 

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

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

 

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

 

•      competition;

 

•      economicconditions, including in particular, discretionary consumer spending;

 

•      consumerand music trends;

 

•      changesin our merchandise mix;

 

•      productdistribution; and

 

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•      timingand effectiveness of our promotional events.

 

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

 

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

* *

Webelieve that our expansion may be accelerated by the acquisition of existingmusic product retailers. For example, we completed the acquisition of Music &Arts Center, Inc. on April 15, 2005, and since then have completedone small acquisition. Acquisitions such as the Music & Arts Center, Inc.transaction involve a number of special risks, including:

 

•      diversionof our management’s attention;

 

•      integrationof the acquired business with our business; and

 

•      unanticipatedlegal liabilities and other circumstances or events.

 

Any failure to successfully complete the integrationof the Music & Arts Center, Inc. business with our American Musicbusiness could adversely affect our business, results of operations, liquidityand financial position. Further, we expect to incur significant costs andexpenses in the initial integration of these two businesses.

 

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

 

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

* *

Brand recognitionis of significant importance in the retail music products business. As aresult, we depend on a relatively small number of manufacturers and suppliersfor both our existing retail stores and the direct response unit as well as ourexpansion goals for each of these units. We do not have any long-term contractswith our suppliers, and any failure to maintain our relationships with our keybrand name vendors would have a material adverse effect on our business. Anumber of the manufacturers of the products we sell are limited in size andmanufacturing capacity and have significant capital or other constraints. Thesemanufacturers may not be able or willing to meet our increasing requirementsfor inventory, and we cannot assure you that sufficient quantities or theappropriate mix of products will be available in the future to supply ourexisting stores and expansion plans. These capacity constraints could lead toextended lead times and shortages of desirable products. The risk is especiallyprevalent in new markets where our vendors have existing agreements with otherdealers and thereby may be unwilling or unable for contractual or other reasonsto meet our requirements. The efficient operation of our distribution centerfor the Guitar Center stores is also highly dependent upon compliance by ourvendors with precise requirements as to the timing, format and composition ofshipments, which in many instances requires changes and upgrades to theoperational procedures and logistics and supply chain management capabilitiesof vendors, all of which are outside of our control. Additionally, many of ourvendors receive product from overseas and depend on an extensive supply chainincluding common carriers and port access to transport merchandise into thecountry. Foreign manufacturing is subject to a number of risks, includingpolitical and economic disruptions, the imposition of tariffs, quotas and otherimport or export controls, and changes in governmental policies. We rely oncommon carriers to transport product from our vendors to our centraldistribution center in Indiana, and from the distribution facility to ourGuitar Center stores. Similarly, Musician’s Friend relies on common carriers totransport product to its fulfillment center in Kansas City, Missouri and onwardto consumers. Any disruption in the services of common carriers due to employeestrikes or other unforeseen events could impact our ability to maintainsufficient quantities of inventory in our retail locations or to fulfill ordersby direct response customers.

 

*We face products liability risk.*

 

Products that we developor sell may expose us to liability from claims by users of such products fordamages including, but not limited to, bodily injury or property damage. Thisrisk is expected to increase as we use

 

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the capabilities of our Guitar Center and Musician’sFriend distribution centers to increase the private label and other proprietaryproduct that we offer. Much of this product is manufactured by small companieslocated overseas. We currently maintain products liability insurance coveragein amounts that we believe are adequate. However, there can be no assurancethat we will be able to maintain such coverage or obtain additional coverage onacceptable terms in the future, or that such insurance will provide adequatecoverage against all potential claims.

 

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

* *

Theretail music products industry is fragmented and highly competitive. We competewith many different types of music product retailers, including conventionalretailers, as well as other catalog and e-commerce retailers, who sell many ormost of the items we sell. We believe that large format music product retailerssuch as our company will seek to expand in part through the acquisition ofsmall, independently owned stores or franchises, and we anticipate increasedcompetition in our existing markets and planned new markets from theseconsolidating retailers. These retailers may identify target companies orexecute their acquisition strategies more effectively than our company.  The expansion of the sale of musicalinstruments on the internet also exposes us to competition from search engineadvertisers such as Google, auction companies such as Ebay, and others who havedeveloped the ability to aggregate web traffic and forward it to competitors ofour Musician’s Friend unit. In any of these new markets, we will likely competewith companies that may have greater financial resources or other competitiveadvantages as compared to our company. Our expansion will be inhibited by theseand other established competitors. In addition, one or more of our competitorsmay adopt a new, innovative store format or retail selling method. If we arenot able to compete effectively, we may fail to achieve market position gainsor may lose market share.

 

Severallarge mass merchants, including Wal-Mart, Target, Best-Buy and Costco, sellmusical instruments in categories that we compete in, including entry-levelguitars, electronic keyboards and band instruments, and thus could represent asignificant source of future competition for our retail and direct responsebusinesses, particularly if these retailers expand their product lines beyondentry-level merchandise.

 

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

 

In April 2001,we completed our acquisition of American Music Group, a New York-based retailerof band instruments. We had not previously participated in the band instrumentssegment of the music products business and had no prior experience in thisdistribution channel. The American Music division incurred significantoperating losses in 2003 and 2004. In April 2005, we completed ouracquisition of Music & Arts Center, Inc.  Thus, we face the normal challenges of anyacquisition, such as integration of personnel and systems as well as the needto learn, understand and further develop this business. During 2005, we willface further significant challenges as we attempt to combine the Music &Arts business with our existing American Music business. Failure to execute onthe requirements and initiatives described above could result in a poor or noreturn on our investments in American Music and Music & Arts,constitute a distraction of the efforts of our management team from the GuitarCenter and Musician’s Friend brands and potentially require us to recognize animpairment in the significant amount of goodwill recorded in the acquisitionsof American Music, Music & Arts and several other smaller companies,which totaled $76.1 million at September 30, 2005.

 

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

 

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

* *

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

* *

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

 

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

* *

As of September 30,2005, our corporate headquarters as well as 23 of our 156 Guitar Center storeswere located in California, and stores located in that state generated 23.3%and 24.6% of our Guitar Center retail sales for the third quarter of 2005 and2004, respectively.  Although we haveopened and acquired stores in other areas of the United States, a significantpercentage of our net sales and results of operations will likely remainconcentrated in California for the foreseeable future.  As a result, our results of operations andfinancial condition are heavily dependent upon general consumer trends andother general economic conditions in California and are subject to otherregional risks, including earthquakes. We do maintain earthquake insurance, but such policies carry significantdeductibles and other restrictions.

 

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

 

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

 

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

 

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

 

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

 

We are involved in anumber of litigation matters, as discussed more fully in Part II, Item 1 “LegalProceedings”.  Current and futurelitigation that we may face may result in substantial costs and expenses andsignificantly divert the attention of our management regardless of the outcomeand an unfavorable resolution could have a material adverse effect on ourbusiness, financial condition and results of operations. In addition, currentand future litigation, governmental proceedings, labor disputes orenvironmental matters could lead to increased costs or interruptions of ournormal business operations.

 

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

* *

Ourdirect response business, particularly our e-commerce business, will requiresignificant investments to respond to anticipated growth and competitivepressures. If we fail to rapidly upgrade our website in order to accommodateincreased traffic, we may lose customers, which would reduce our net sales.Furthermore, if we fail to expand the computer systems that we use to processand ship customer orders and process payments and the fulfillment facilities weuse to manage and ship our inventory, we may not be able to successfullydistribute customer orders. We experienced some delays of this sort in 2001 inconnection with the consolidation of our

 

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fulfillment centers. As aresult, we could incur excessive shipping costs due to the need to splitdelayed shipments, increased marketing costs in the form of special offers toaffected customers or the loss of customers altogether. We may experiencedifficulty in improving and maintaining such systems if our employees orcontractors that develop or maintain our key systems become unavailable to us.  We have experienced periodic servicedisruptions and interruptions, which we believe will continue to occur, whileenhancing and expanding these systems.

 

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

 

Ourrelationships with our e-commerce customers may be adversely affected if thesecurity measures that we use to protect their personal information, such ascredit card numbers, are ineffective. If, as a result, we lose customers, our net sales could decrease. We relyon security and authentication technology that we license from third parties.With this technology, we perform real-time credit card authorization andverification with our bank and we are subject to the customer privacy standardsof credit card companies. We cannot predict whether events or developments willresult in a compromise or breach of the technology we use to protect a customer’spersonal information, and such breaches could lead to loss of confidence ofcustomers or significant fines from credit card companies.  Furthermore, our servers may be vulnerable tocomputer viruses, physical or electronic break-ins and similar disruptions. Wemay need to expend significant additional capital and other resources toprotect against a security breach or to alleviate problems caused by anybreaches. We cannot assure that we can prevent all security breaches.

 

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

 

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

 

*Ourhardware and software systems are vital to the efficient operation of our retailstores and direct response business, and damage to these systems could harm ourbusiness.*

 

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

 

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

 

•      power loss,computer systems failure, or security breaches, Internet and telecommunicationsor data network failure.

 

Asignificant information systems failure could reduce the quality or quantity ofoperating data available to our management. If this information were unavailablefor any extended period of time, our management would be unable to efficientlyrun our business, which would result in a reduction in our net sales.

 

Toattempt to mitigate these risks we have contracted services from third partiesto provide backup systems for our Guitar Center retail stores in the event of adisaster. These services are designed to permit our “mission critical” systemsto be online within 48 hours following most disasters. Our Music &Arts and direct

 

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response business do nothave redundant systems and would be vulnerable to catastrophic events. In theevent of a disaster, our businesses would most likely experience delays inprocessing and shipping orders.

 

*Our stock price could be volatile.*

 

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

 

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

** **

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

 

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

 

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

 

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

 

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

 

We donot have any assets or liabilities which, in our view, impose upon us significantmarket risk except for our outstanding indebtedness represented by $100 millionprincipal amount of our convertible notes with a fixed interest rate of 4%(subject to contingent interest commencing January 15, 2006) and ourcredit facility which has a variable rate of interest generally consisting ofstated premiums above LIBOR.  At September 30,2005, we had $74.0 million outstanding borrowings under our creditfacility.  To the extent prevailingshort-term interest rates fluctuate, the interest expense we incur on ourcredit facility will change with a resulting effect (positive or negative) onour financial position, results of operations and cash flows. We do not usederivative financial instruments in our investment portfolio.  Historically, we have not carried significantcash balances and any cash in excess of our daily operating needs has been usedto reduce our borrowings.  Excess cash isinvested in short-term, high quality interest bearing investments.

 

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

 

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our reports filed pursuant to the Securities Exchange Act of1934, as amended, is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

 

As required by Securitiesand Exchange Commission Rule 13a-15(b), we carried out an evaluation,under the supervision and with the participation of our management, includingour Chief Executive Officer and Chief Financial Officer, of the effectivenessof the design and operation of our disclosure controls and procedures as of theend of the period covered by this report.  Based on the foregoing, ourChief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls and procedures were effective.

 

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

 

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

 

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

 

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

 

On May 6, 2005, a lawsuitentitled Farnam Street Financial, Inc. v. Guitar Center, Inc., Case No. CT05-6546, was filed in the Fourth Judicial District in the State of Minnesotafor the County of Hennepin.  The lawsuit,which was filed by a Minnesota corporation, alleges breach of contract inconnection with the lease of certain equipment located in our corporate officeand retail stores.  Among other things,the lawsuit alleges that we have breached the contract by our failure to complywith the terms and conditions in connection with the return of the equipmentand seeks approximately $4.5 million of damages and attorneys’ fees.  We have filed an answer to the complaint andare in the process of propounding discovery on the plaintiff as well asresponding to plaintiff’s requests for discovery.

 

While we intend to defend theseclaims vigorously, there can be no assurance that we will be able to achieve afavorable settlement of these lawsuits or obtain a favorable resolution of suchlawsuits if they are not settled.  Anunfavorable resolution of these lawsuits could have a material adverse effecton our business, financial condition and results of operations.  Regardless of the outcome, the costs andexpenses incurred by us to defend these lawsuits could also have a materialadverse effect on our business, financial condition and results of operations.

 

In addition to the lawsuitsdescribed above, we are involved in various claims and legal actions arising inthe ordinary course of our business and, while the results of those proceedingscannot be predicted with certainty, we believe that the final outcome of thosematters will not have a material adverse effect on our business, financialcondition and results of operations.

 

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

 

(a)           Exhibits:

 

31.1         Certificationof the Company’s Chief Executive Officer pursuant to Section 302 of theSarbanes-Oxley Act of 2002.

 

31.2         Certificationof the Company’s Chief Financial Officer pursuant to Section 302 of theSarbanes-Oxley Act of 2002.

 

32.1         Certificationof the Company’s Chief Executive Officer pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

32.2         Certificationof the Company’s Chief Financial Officer pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

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Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized as of the 8th day of November 2005.

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

 

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