**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

**FORM 10-Q**

 

| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                             |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                                                                                                                                          |
|       |       | **For the quarterly period ended  June 30, 2004**                                                                                                                                                                                                                                                                                                        |
|       |       |                                                                                                                                                                                                                                                                                                                                                          |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**                                                                                                                                                                                                                                                           |
|       |       |                                                                                                                                                                                                                                                                                                                                                          |
|       |       | **For the transition period  from                          to                          ** |

 

**Commission File No.  000 – 22207**

 

**GUITAR CENTER, INC.**

(Exact Name of Registrant as Specified in itsCharter)

 

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 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 mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).

 

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

 

As of August 2, 2004, 25,156,146 shares of our Common Stock, $.01par value, were outstanding.

 

 

----

 

**Guitar Center, Inc. and subsidiaries**

 

#### INDEX

 
| Part I.      | Financial Information                                                                                   |       |
|--------------|---------------------------------------------------------------------------------------------------------|------------|
|         |                                                                                                    |       |
|         | **Item 1. Consolidated Financial Statements (Unaudited)**                                               |       |
|         |                                                                                                    |       |
|         | Consolidated Balance Sheets  – June 30, 2004 and December 31, 2003                       |       |
|         |                                                                                                    |       |
|         | Consolidated Statements of Income – Three  months ended June 30, 2004 and 2003                |       |
|         |                                                                                                    |       |
|         | Consolidated Statements of Income – Six  months ended June 30, 2004 and 2003                  |       |
|         |                                                                                                    |       |
|         | Consolidated  Statements of Cash Flows – Six months ended June 30, 2004 and 2003              |       |
|         |                                                                                                    |       |
|         | 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  4.  Submission of Matters to a Vote of  Security Holders**                                 |       |
|         | ** **                                                                                              |       |
|         | **Item 6.  Exhibits and Reports on Form 8-K**                                                      |       |

 

2

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**Guitar Center, Inc. and subsidiaries**

# **Consolidated Balance Sheets**

(In thousands, except per share amounts)

(Unaudited)

 
| ** **                                                                                                                                                             | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                             |       |                    |       |                        |       |
| Current  assets:                                                                                                                                                       |       |                    |       |                        |       |
| Cash and cash  equivalents                                                                                                                                             |       | $                       | 3,817      |                        | $          | 5,350 |   |
| Accounts  receivable, net                                                                                                                                              |       | 18,642                  |       | 23,814                      |       |
| Merchandise  inventories                                                                                                                                               |       | 313,208                 |       | 288,873                     |       |
| Prepaid  expenses and deposits                                                                                                                                         |       | 18,803                  |       | 11,543                      |       |
| Deferred  income taxes                                                                                                                                                 |       | 5,631                   |       | 5,631                       |       |
| Total current  assets                                                                                                                                                  |       | 360,101                 |       | 335,211                     |       |
|                                                                                                                                                                   |       |                    |       |                        |       |
| Property and  equipment, net                                                                                                                                           |       | 92,991                  |       | 93,347                      |       |
| Goodwill                                                                                                                                                               |       | 25,995                  |       | 25,995                      |       |
| Deposits and  other assets, net                                                                                                                                        |       | 5,698                   |       | 6,318                       |       |
|                                                                                                                                                                   |       | $                       | 484,785    |                        | $          | 460,871 |   |
|                                                                                                                                                                   |       |                    |       |                        |       |
| **Liabilities  and stockholders’ equity**                                                                                                                         |       |                    |       |                        |       |
| Current  liabilities:                                                                                                                                                  |       |                    |       |                        |       |
| Accounts  payable                                                                                                                                                      |       | $                       | 44,952     |                        | $          | 47,778 |   |
| Accrued  expenses and other current liabilities                                                                                                                        |       | 50,167                  |       | 71,616                      |       |
| Merchandise  advances                                                                                                                                                  |       | 16,593                  |       | 17,104                      |       |
| Total current  liabilities                                                                                                                                             |       | 111,712                 |       | 136,498                     |       |
|                                                                                                                                                                   |       |                    |       |                        |       |
| Other  long-term liabilities                                                                                                                                           |       | 6,428                   |       | 5,982                       |       |
| Deferred  income taxes                                                                                                                                                 |       | 4,220                   |       | 4,220                       |       |
| Long-term debt                                                                                                                                                         |       | 100,000                 |       | 100,000                     |       |
| Total  liabilities                                                                                                                                                     |       | 222,360                 |       | 246,700                     |       |
|                                                                                                                                                                   |       |                    |       |                        |       |
| Stockholders’  equity:                                                                                                                                            |       |                    |       |                        |       |
| Preferred  Stock; authorized 5,000 shares at  June 30, 2004 and December 31, 2003,  none issued and outstanding                                    |       | —                  |       | —                      |       |
| Common Stock,  $0.01 par value, authorized  55,000  shares, issued and outstanding  25,145  at June 30, 2004 and 23,998 at  December 31, 2003 |       | 251                     |       | 240                         |       |
| Additional  paid in capital                                                                                                                                            |       | 300,552                 |       | 276,233                     |       |
| Accumulated  deficit                                                                                                                                                   |       | (38,378                 | )          | (62,302                     | )          |
| Net  stockholders’ equity                                                                                                                                         |       | 262,425                 |       | 214,171                     |       |
|                                                                                                                                                                   |       | $                       | 484,785    |                        | $          | 460,871 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

3

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

# **Consolidated Statements of Income**

(In thousands, except per share data)

(Unaudited)

 
| ** **                                    | ** ** | **Three months ended  June 30,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2004**                              | ** ** | **2003** | ** ** |
|                                          |       |                                  |       |   |   |
| Net sales                                     |       | $                                     | 339,622    |   | $ | 291,600 |   |
| Cost of goods  sold, buying and occupancy     |       | 245,409                               |       | 216,050 |   |
| Gross profit                                  |       | 94,213                                |       | 75,550 |   |
|                                          |       |                                  |       |   |   |
| Selling,  general and administrative expenses |       | 73,200                                |       | 62,666 |   |
| Operating  income                             |       | 21,013                                |       | 12,884 |   |
|                                          |       |                                  |       |   |   |
| Interest  expense, net                        |       | 1,425                                 |       | 2,956 |   |
|                                          |       |                                  |       |   |   |
| Income before  income taxes                   |       | 19,588                                |       | 9,928 |   |
|                                          |       |                                  |       |   |   |
| Income taxes                                  |       | 7,444                                 |       | 3,778 |   |
|                                          |       |                                  |       |   |   |
| Net income                                    |       | $                                     | 12,144     |   | $ | 6,150 |   |
|                                          |       |                                  |       |   |   |
| Net income per  share                         |       |                                  |       |   |   |
| Basic                                         |       | $                                     | 0.49       |   | $ | 0.27 |   |
| Diluted                                       |       | $                                     | 0.47       |   | $ | 0.25 |   |
|                                          |       |                                  |       |   |   |
| Weighted  average shares outstanding          |       |                                  |       |   |   |
| Basic                                         |       | 24,676                                |       | 22,995 |   |
| Diluted                                       |       | 25,967                                |       | 24,173 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

4

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

# **Consolidated Statements of Income**

(In thousands, except per share data)

(Unaudited)

 
| ** **                                    | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------|------------|------------------------------------|------------|
| ** **                                    | ** ** | **2004**                           | ** ** | **2003** | ** ** |
|                                          |       |                               |       |   |   |
| Net sales                                     |       | $                                  | 689,325    |   | $ | 579,142 |   |
| Cost of goods  sold, buying and occupancy     |       | 500,429                            |       | 428,936 |   |
| Gross profit                                  |       | 188,896                            |       | 150,206 |   |
|                                          |       |                               |       |   |   |
| Selling,  general and administrative expenses |       | 147,518                            |       | 125,664 |   |
| Operating  income                             |       | 41,378                             |       | 24,542 |   |
|                                          |       |                               |       |   |   |
| Interest  expense, net                        |       | 2,788                              |       | 6,095 |   |
|                                          |       |                               |       |   |   |
| Income before  income taxes                   |       | 38,590                             |       | 18,447 |   |
|                                          |       |                               |       |   |   |
| Income taxes                                  |       | 14,666                             |       | 7,020 |   |
|                                          |       |                               |       |   |   |
| Net income                                    |       | $                                  | 23,924     |   | $ | 11,427 |   |
|                                          |       |                               |       |   |   |
| Net income per  share                         |       |                               |       |   |   |
| Basic                                         |       | $                                  | 0.98       |   | $ | 0.50 |   |
| Diluted                                       |       | $                                  | 0.93       |   | $ | 0.48 |   |
|                                          |       |                               |       |   |   |
| Weighted  average shares outstanding          |       |                               |       |   |   |
| Basic                                         |       | 24,432                             |       | 22,894 |   |
| Diluted                                       |       | 25,744                             |       | 23,928 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

5

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**Guitar Center, Inc. and subsidiaries**

**Consolidated Statements of Cash Flows**

(In thousands)

(Unaudited)

 
| ** **                                                                                   | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                   | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| **Operating  activities**                                                                    |       |                               |       |   |   |
| Net income                                                                                   |       | $                                  | 23,924     |   | $ | 11,427 |   |
| Adjustments to  reconcile net income to net cash (used in) provided by operating activities: |       |                               |       |   |   |
| Depreciation  and amortization                                                               |       | 11,209                             |       | 9,962 |   |
| Amortization  of deferred financing fees                                                     |       | 522                                |       | 351 |   |
| Tax benefit  from exercise of stock options                                                  |       | 8,481                              |       | — |   |
| Changes in  operating assets and liabilities:                                                |       |                               |       |   |   |
| Accounts  receivable                                                                         |       | 5,172                              |       | 4,607 |   |
| Merchandise  inventories                                                                     |       | (24,334                            | )          | 8,512 |   |
| Prepaid  expenses and deposits                                                               |       | (7,260                             | )          | 784 |   |
| Other assets                                                                                 |       | 78                                 |       | (189 | ) |
| Accounts  payable                                                                            |       | (2,826                             | )          | (23,211 | ) |
| Accrued  expenses and other current liabilities                                              |       | (21,448                            | )          | (8,776 | ) |
| Other  long-term liabilities                                                                 |       | 446                                |       | 24 |   |
| Merchandise  advances                                                                        |       | (511                               | )          | (706 | ) |
| Net cash (used  in) provided by operating activities                                         |       | (6,547                             | )          | 2,785 |   |
|                                                                                         |       |                               |       |   |   |
| **Investing  activities**                                                                    |       |                               |       |   |   |
| Purchase of  property and equipment                                                          |       | (10,835                            | )          | (11,283 | ) |
| Net cash used in investing activities                                                        |       | (10,835                            | )          | (11,283 | ) |
|                                                                                         |       |                               |       |   |   |
| **Financing  activities**                                                                    |       |                               |       |   |   |
| Net increase  in revolving debt facility                                                     |       | —                             |       | (27,106 | ) |
| Proceeds from  exercise of stock options                                                     |       | 15,143                             |       | 5,436 |   |
| Proceeds from  stock issued under employee purchase plan                                     |       | 706                                |       | 422 |   |
| Proceeds from  senior convertible notes                                                      |       | —                             |       | 96,875 |   |
| Payments under  capital leases                                                               |       | —                             |       | (151 | ) |
| Net cash  provided by financing activities                                                   |       | 15,849                             |       | 75,476 |   |
|                                                                                         |       |                               |       |   |   |
| Net (decrease)  increase in cash and cash equivalents                                        |       | (1,533                             | )          | 66,978 |   |
| Cash and cash  equivalents at beginning of year                                              |       | 5,350                              |       | 5,931 |   |
|                                                                                         |       |                               |       |   |   |
| Cash and cash  equivalents at end of period                                                  |       | $                                  | 3,817      |   | $ | 72,909 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

6

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**Guitar Center, Inc. and subsidiaries**

**Notes to Consolidated Financial Statements**

 

1.                                       Nature ofBusiness and Basis of Presentation

 

Nature of Business

 

Guitar Center, Inc., and subsidiaries(“Guitar Center,” the “Company,” “we,” “us” or “our”) is the nation’s leadingretailer of guitars, amplifiers, percussion instruments, keyboards andpro-audio and recording equipment based on annual revenue. As of June 30,2004, our retail subsidiary operated 130 Guitar Center retail stores, with 111stores in 46 major markets and 19 stores in secondary markets across the UnitedStates.  In addition, as of June 30,2004, our American Music division operated 19 family music stores specializingin band and orchestral instruments for sale and rental, serving teachers, banddirectors, college professors and students. We are also the largest directresponse retailer of musical instruments in the United States through our wholly-ownedsubsidiary, Musician’s Friend, Inc., and its catalog and web site,www.musiciansfriend.com.

 

Basis of Presentation

 

In the opinion of management, theaccompanying unaudited consolidated financial statements contain alladjustments necessary to present fairly the financial position of GuitarCenter, Inc. and subsidiaries as of June 30, 2004 and December 31,2003, and the results of operations and cash flows for the three and six monthsended June 30, 2004 and 2003. The accompanying consolidated financialstatements should be read in conjunction with the audited consolidatedfinancial statements and notes thereto contained in our Annual Report on Form10-K for the year ended December 31, 2003.

 

The results of operations for the three andsix months ended June 30, 2004, are not necessarily indicative of theresults to be expected for the full year.

 

2.                                       Earnings PerShare

 

The following table summarizes thereconciliation of basic to diluted weighted average shares for the three andsix months ended June 30, 2004 and 2003:

 
| ** **                                                         | ** ** | **For the three months  ended June 30,** | ** ** | **For the six months ended  June 30,** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                         | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                         | ** ** | **(in thousands)**                            | ** ** |
| Basic shares                                                       |       | 24,676                                        |       | 22,995                                      |       | 24,432 |   | 22,894 |   |
| Common stock equivalents - dilutive effect  of options outstanding |       | 1,291                                         |       | 1,178                                       |       | 1,312 |   | 1,034 |   |
| Diluted shares                                                     |       | 25,967                                        |       | 24,173                                      |       | 25,744 |   | 23,928 |   |

 

For the three and six months endedJune 30, 2004 and 2003, the only common stock equivalents deemedoutstanding are stock options.  For thethree months ended June 30, 2004, all options outstanding had a dilutiveeffect.  For the six months endedJune 30, 2004, 183,000 options with an exercise price of $39.98 per sharewere outstanding but were not included in the computation of diluted earningsper share because the exercise price of these options was greater than theaverage market price of our common stock. For the three and six months ended June 30, 2003, options topurchase 15,000 shares and 79,000 shares, respectively, at exercise pricesranging from $21.96 to $28.56 were outstanding but were not included in thecomputation of diluted earnings per share because the exercise price of theseoptions was greater than the average market price of our common stock.

 

As of June 30, 2004,our common stock closed at or above $41.50 per share for twenty trading dayswithin the thirty trading day period prior to the next conversion period. As a result, holders of Guitar Center 4.0% Senior Convertible Notes due 2013may, if they elect, convert the notes into common stock during the conversionperiod commencing July 16, 2004 and continuing through and includingOctober 14, 2004. The notes are convertible at an effective conversionprice of $34.58 per share. As the notes will be convertible during a portion ofat least the third and fourth fiscal quarters of

 

7

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2004, during such periods our earnings per share underapplicable generally accepted accounting principles will be determined pursuantto the “if-converted” method (see below).

 

Whether or not the notesare convertible after October 14 will be determined based on the tradingprice of the common stock during the thirty trading days ending onOctober 15, 2004.  If during at least twenty such trading days thelast reported sales price is at or above $41.50, the notes will remainconvertible for the next quarterly conversion period.  The notes will alsobecome convertible upon the occurrence of specified corporate transactions andother events described in the indenture.  There is currently outstanding$100 million principal amount of the notes.

 

Because the notes will be convertible during a portion of atleast the third and fourth fiscal quarters of 2004, during such periods ourearnings per share under presently applicable generally accepted accountingprinciples will be determined pursuant to the “if-converted” method. Under this method, for the calculation of diluted earnings per share duringsuch quarterly periods:

 

•                  Netafter-tax interest expense related to the notes for the period will be addedback to net income (we estimate that after-tax interest expense for the notesis and will be approximately $733,000 per quarter for 2004 and 2005, includingamortization of deferred financing costs); and

 

•                  The fullnumber of shares (2,892,000) issuable upon conversion of the notes will bedeemed outstanding for the entire quarter.

 

Under GAAP, this method will not apply to our financialstatements until the quarter ending September 30, 2004.

 

For the year ending December 31, 2004, diluted earningsper share will reflect the following:

 

•                  The add-backof net after tax interest expense related to the notes for the third and fourthquarters (estimated to be $1,466,000 in the aggregate, including amortizationof deferred financing costs); and

 

•                  The weightedaverage shares outstanding for the year will assume that the shares issuableupon conversion of the notes are outstanding only for the third and fourthquarters (representing 1,446,000 shares on a weighted average basis).

 

**3.**                                       Segment Information

 

**Our reportable business segments are Guitar Center stores,American Music stores and direct response (Musician’s Friend’s catalog andInternet).  Management evaluates segmentperformance based primarily on net sales and income (loss) before incometaxes.  Accounting policies of thesegments are the same as the accounting policies for the consolidatedCompany.  There are no differencesbetween the measurements of profits or losses or assets of the reportablesegments and those of the Company on a consolidated basis. Our operating andreportable segments under SFAS No. 131 are consistent with our reporting unitsunder SFAS No. 142.**

 

**Net sales, gross margin, depreciation and amortization,selling, general and administrative expenses, income before income taxes andcapital expenditures for the three and six months ended June 30, 2004 and2003 and total assets as of June 30, 2004 and 2003 are summarized asfollows (in thousands):**

 

8

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| ** **                                    | ** ** | **Three Months Ended June 30, 2004** | ** ** | **Six Months Ended June 30, 2004** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **Guitar  Center**                        | ** ** | **American  Music**                     | ** ** | **Direct  Response** | ** ** | **Total** | ** ** | **Guitar  Center** | ** ** | **American  Music** | ** ** | **Direct  Response** | ** ** | **Total** | ** ** |
| Net sales                                     |       | $                                         | 262,879    |                                    | $          | 8,592 |   | $ | 68,151 |   | $ | 339,622 |   | $ | 526,387 |   | $ | 17,970 |   | $ | 144,968 |   | $ | 689,325 |   |
| Gross profit                                  |       | 68,380                                    |       | 2,846                                   |       | 22,987 |   | 94,213 |   | 135,068 |   | 6,231 |   | 47,597 |   | 188,896 |   |
| Depreciation  and amortization                |       | 4,980                                     |       | 327                                     |       | 544 |   | 5,851 |   | 9,343 |   | 718 |   | 1,148 |   | 11,209 |   |
| Selling,  general and administrative expenses |       | 54,254                                    |       | 4,362                                   |       | 14,584 |   | 73,200 |   | 107,713 |   | 8,687 |   | 31,118 |   | 147,518 |   |
| Income (loss)  before income taxes            |       | 13,212                                    |       | (2,156                                  | )          | 8,532 |   | 19,588 |   | 25,555 |   | (3,743 | ) | 16,778 |   | 38,590 |   |
| Capital  expenditures                         |       | 5,173                                     |       | 445                                     |       | 434 |   | 6,052 |   | 9,198 |   | 563 |   | 1,074 |   | 10,835 |   |
| Total assets                                  |       |                                      |       |                                    |       |   |   |   |   | 365,565 |   | 57,984 |   | 61,236 |   | 484,785 |   |
|                                               |            |                                           |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                    | ** ** | **Three Months Ended June 30, 2003** | ** ** | **Six Months Ended June 30, 2003** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                    | ** ** | **Guitar  Center**                        | ** ** | **American  Music**                     | ** ** | **Direct  Response** | ** ** | **Total** | ** ** | **Guitar  Center** | ** ** | **American  Music** | ** ** | **Direct  Response** | ** ** | **Total** | ** ** |
| Net sales                                     |       | $                                         | 223,134    |                                    | $          | 8,019 |   | $ | 60,447 |   | $ | 291,600 |   | $ | 441,481 |   | $ | 17,273 |   | $ | 120,388 |   | $ | 579,142 |   |
| Gross profit                                  |       | 52,964                                    |       | 3,205                                   |       | 19,381 |   | 75,550 |   | 105,408 |   | 6,646 |   | 38,152 |   | 150,206 |   |
| Depreciation  and amortization                |       | 4,142                                     |       | 273                                     |       | 690 |   | 5,105 |   | 8,057 |   | 548 |   | 1,357 |   | 9,962 |   |
| Selling,  general and administrative expenses |       | 44,963                                    |       | 4,691                                   |       | 13,012 |   | 62,666 |   | 90,512 |   | 8,507 |   | 26,645 |   | 125,664 |   |
| Income (loss)  before income taxes            |       | 5,904                                     |       | (2,245                                  | )          | 6,269 |   | 9,928 |   | 10,595 |   | (3,375 | ) | 11,227 |   | 18,447 |   |
| Capital  expenditures                         |       | 4,738                                     |       | 865                                     |       | 201 |   | 5,804 |   | 9,218 |   | 1,215 |   | 850 |   | 11,283 |   |
| Total assets                                  |       |                                      |       |                                    |       |   |   |   |   | 412,491 |   | 60,893 |   | 36,377 |   | 509,761 |   |
|                                               |            |                                           |            |                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

4.                                       Stock-BasedCompensation

 

We 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 also allows entities to continue to applythe provisions of Accounting Principles Board (“*APB”*)Opinion No. 25, “*Accounting for Stock Issuedto Employees**,”*and relatedinterpretations and provide pro forma net income and pro forma earnings pershare disclosures 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.25 and provide the pro forma disclosures of SFAS No. 123.  As such, compensation expense for stockoptions issued to

 

9

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employees is recorded on the date of grant only if the then-currentmarket price of the underlying stock exceeded the exercise price.  Had we determined compensation cost basedupon the fair value at the grant date for our stock options under SFAS No. 123using the Black Scholes option pricing model, pro forma net income and proforma net income per share, including the following weighted averageassumptions used in these calculations, would have been as follows ($ inthousands, except per share amounts):

 
| ** **                                                                                                                                           | ** ** | **For the three months  ended June 30,** | ** ** | **For the six months  ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                           | ** ** | **2004**                                      | ** ** | **2003**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income, as reported                                                                                                                              |       | $                                             | 12,144     |                                        | $          | 6,150 |   | $ | 23,924 |   | $ | 11,427 |   |
| Deduct:   Total stock-based employee compensation expense determined under fair  value based methods for all awards, net of related tax effects |       | 925                                           |       | 1,521                                       |       | 2,003 |   | 2,566 |   |
| Pro forma net income                                                                                                                                 |       | $                                             | 11,219     |                                        | $          | 4,629 |   | $ | 21,921 |   | $ | 8,861 |   |
|                                                                                                                                                 |       |                                          |       |                                        |       |   |   |   |   |
| Earnings per share:                                                                                                                                  |       |                                          |       |                                        |       |   |   |   |   |
| Basic - as  reported                                                                                                                                 |       | 0.49                                          |       | 0.27                                        |       | 0.98 |   | 0.50 |   |
| Basic - pro  forma                                                                                                                                   |       | 0.45                                          |       | 0.20                                        |       | 0.90 |   | 0.39 |   |
| Diluted - as  reported                                                                                                                               |       | 0.47                                          |       | 0.25                                        |       | 0.93 |   | 0.48 |   |
| Diluted -  pro forma                                                                                                                                 |       | 0.43                                          |       | 0.19                                        |       | 0.85 |   | 0.37 |   |
| Risk free  interest rate                                                                                                                             |       | 4.4                                           | %          | 2.8                                         | %          | 4.4 | % | 2.8 | % |
| Expected  life of options                                                                                                                            |       | 6.74                                          |       | 6.76                                        |       | 6.74 |   | 6.76 |   |
| Expected  volatility                                                                                                                                 |       | 61.3                                          | %          | 63.8                                        | %          | 61.3 | % | 63.8 | % |
| Expected  dividends                                                                                                                                  |       | —                                        |       | —                                      |       | — |   | — |   |

 

5.             ConvertibleNotes Offering

 

On June 16, 2003, we completed theissuance of $100 million principal amount of 4.00% Senior Convertible Notes due2013. Of the net proceeds from the offering, approximately $68.2 million wasused in July 2003 to retire all $66.7 million principal amount of SeniorNotes outstanding and pay the related redemption premium, and the balance wasused to reduce the amount outstanding under our credit agreement and payoffering expenses.  In July 2003, wecompleted the redemption of all Senior Notes outstanding. Interest expenserelated to the redemption premium and the write-off of deferred financing costsassociated with the Senior Notes redeemed was $1.9 million.

 

**Item 2.**                                                           Management’s Discussion and Analysis of FinancialCondition and Results of Operations

 

### **General**

 

Guitar Center is the nation’s leading retailer of guitars, amplifiers,percussion instruments, keyboards and pro-audio and recording equipment basedon annual revenue. Our retail subsidiary operated 130 Guitar Center retaillocations as of June 30, 2004, with 111 stores in 46 major markets and 19stores in secondary markets across the United States. In addition, atJune 30, 2004 our American Music division operated 19 family music storesspecializing in band and orchestral instruments for sale and rental, servingteachers, band directors, college professors and students. We are also thelargest direct response retailer of musical instruments in the United Statesthrough our wholly-owned subsidiary, Musician’s Friend, Inc., and its catalogand web site, www.musiciansfriend.com.

 

During the second quarter, we opened a small format Guitar Center storein Nashua, New Hampshire and two large format stores in Ft. Worth, Texas andLawrenceville, Georgia. These stores added 37,800 square feet of Guitar Centerretail space and brought us to a total of 1.997 million square feet of GuitarCenter retail space at the end of the quarter.

 

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As we enter new markets, we expect that we will initially incur higheradministrative and promotional costs per store than is currently experienced inestablished markets.  We expectcompetition to continue to increase as other music product retailers attempt toexecute national growth strategies.  Ourbusiness strategy will also emphasize opportunities to continue to grow each ofour brands, including further acquisitions if attractive candidates can belocated for reasonable prices.

 

From 1999 to 2003, our net sales grew at an annual compound growth rateof 19%, principally due to the comparable store sales growth of our retailstores averaging 7% per year, the opening of new stores, and a 31% per yearincrease in the direct response channel. We believe such volume increases arethe result of the continued success of the implementation of our businessstrategy, continued growth in the music products industry and increasingconsumer awareness of the Guitar Center, Musician’s Friend and American Musicbrand names. We achieved comparable store sales growth of 11% and 8% for thefirst and second quarters of 2004 compared to 4% and 5% for the same periods in2003. We believe this growth reflects the strength of our merchandiseselection, effective advertising and promotion, and well-trained and committedpersonnel. Comparable store sales compares net sales for the comparableperiods, excluding net sales attributable to stores not open for 14 months asof the end of the latter reporting period. All references in this report to comparable stores sales are based onthis calculation methodology.

 

**ExecutiveSummary**

 

Consolidated net sales for the quarter ended June 30, 2004increased 16.5%, or $48.0 million, to $339.6 million compared to $291.6 millionin the second quarter of 2003. Net income for the second quarter was $12.1million, which is a 97.5% increase over the $6.2 million we reported in thesecond quarter of 2003. Earnings per diluted share increased to $0.47 comparedto $0.25 in the second quarter of 2003.

 

Our Guitar Center retail division turned in a strong performance forthe quarter. Our stores experienced strong traffic during the quarter which webelieve reflects interest in the music market and good responses to ourpromotions. Net sales from our Guitar Center stores increased 17.8% to $262.9million from $223.1 million in last year’s second quarter. Sales from newstores contributed $21.2 million and accounted for 53.4% of the increase.Guitar Center comparable store sales increased 8%.

 

Musician’s Friend, our direct response division, generated a net salesincrease of 12.7% for the quarter to $68.2 million compared to $60.4 million inthe second quarter of 2003. Operating income was above our expectations. Forthe second quarter, we achieved an initial fill rate of 95%, up from 93% in thesecond quarter of 2003. Initial order fill rate reflects the percentage ofitems ordered by our customers that we are able to supply in the initialshipment to that customer. Inventory turn improved to 5.7 times on a trailingtwelve-month basis compared to 4.7 times in the second quarter of 2003. Theimprovements that were made to the Musician’s Friend web site over the lastyear, as well as the infrastructure and systems at the direct response callcenter and fulfillment center, permitted us to capitalize on high demand.

 

We continued to focus on remerchandising, systems execution andinfrastructure build out at American Music during the quarter. American Musicincurred an operating loss of $1,516,000 for the second quarter on a pre-taxbasis, which was greater than what we had expected. Failure to execute on theinitiatives described above could potentially require us to recognize animpairment related to the significant amount of goodwill recorded in theacquisitions of American Music and M&M Music, which totaled $20.6 millionat June 30, 2004. No such impairment has been recognized throughJune 30, 2004.

 

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

 

**Discussionof Critical Accounting Policies**

 

In the ordinary course of business, we have made a number of estimatesand assumptions relating to the reporting of results of operations andfinancial condition in the preparation of our financial statements inconformity with accounting principles generally accepted in the United Statesof America.  Actual results could differsignificantly from those estimates under different assumptions andconditions.  We believe that thefollowing discussion addresses our most critical accounting policies, which arethose that are most important to the portrayal of our financial condition andresults and require management’s most difficult, subjective and complexjudgments, often as a result of the need to make estimates about the effect ofmatters that are inherently

 

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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.

 

*Valuation of Inventory*

 

We value our inventoriesat the lower of cost or market using the first-in, first-out (FIFO)method.  Rental inventories are valued atthe lower of cost or market using the specific identification method and aredepreciated on a straight-line basis over the term of the associated rentalagreement for rent-to-own sales, or over the estimated useful life of therented instrument for rental only items. We record adjustments to the value of inventory based upon obsolescenceand changes in market value.  Applicablecosts associated with bringing inventory through our Guitar Center retaildistribution center are capitalized to inventory.  The amounts are expensed to cost of goodssold as the associated inventory is sold. Management has evaluated the current level of inventories considering futurecustomer demand for our products, taking into account general economicconditions, growth prospects within the marketplace, competition, marketacceptance of current and upcoming products, and management initiatives.  Based on this evaluation, we have recordedimpairment adjustments to cost of goods sold for estimated decreases in netrealizable value.  These judgments aremade in the context of our customers’ shifting needs, product and technologicaltrends, and changes in the demographic mix of our customers. Amisinterpretation or misunderstanding of these conditions and uncertainties inthe future outlook of our industry or the economy, or other failure to estimateaccurately, could result in inventory valuation changes in the future.

 

*Valuation of Long-Lived Assets*

 

Long-lived assets such as property and equipment and identifiableintangibles are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Goodwill is required to be reviewed for impairment on an annualbasis, or more frequently when triggering events occur. Factors we considerimportant, which could trigger impairment, 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.

 

For long-lived assets other than goodwill and intangibles that are notamortized, the determination of whether impairment has occurred is based on anestimate of undiscounted future cash flows attributable to the assets, ascompared to the carrying value of the assets. Assumptions used in these cash flows are consistent with internalforecasts and consider current and future expected sales volumes and relatedoperating costs and any anticipated increases or declines based on expectedmarket conditions and local business environment factors. If a potentialimpairment is identified, the amount of the impairment loss recognized would bedetermined by estimating the fair value of the assets and recording a loss ifthe fair value was less than the book value. Fair value will be determinedbased on appraisal values assessed by third parties, if deemed necessary, or adiscounted future cash flows analysis. For goodwill and other intangibles thatare not amortized, impairment to be recognized is measured as the amount bywhich the carrying amount of the assets exceeds the fair value of the relatedassets of the underlying segment to which the goodwill relates.

 

Our assessment regarding the existence of impairment factors is basedon market conditions and the operational performance of our business. Ourreview of factors present and the resulting appropriate carrying value of ourgoodwill, intangibles and other long-lived assets are subject to judgments andestimates that management is required to make.

 

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*Sales Returns*

 

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

 

*Credits and Other Vendor Allowances*

 

We receive cooperative advertising allowances (i.e., an allowance fromthe manufacturer to subsidize advertising and similar promotional expenditureswe 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 $2.9 million and$2.3 million in the six months ended June 30, 2004 and 2003,respectively.  Price protection creditsand vendor rebates are accounted for as a reduction of the cost of merchandiseinventory and are recorded at the time the credit or rebate is earned.  The effect of price protection credits andvendor rebates is recognized in the income statement at the time the relatedinventory is sold, as a reduction in cost of goods sold. None of these creditsare recorded as revenue.

 

**Results of Operations**

 

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

 
| ** **                                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                   | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                                    |       | 100.0                                 | %          | 100.0                               | %          | 100.0 | % | 100.0 | % |
| Gross profit                                 |       | 27.7                                  | %          | 25.9                                | %          | 27.4 | % | 25.9 | % |
| Selling,  general and administrative expense |       | 21.5                                  | %          | 21.5                                | %          | 21.4 | % | 21.7 | % |
| Operating  income                            |       | 6.2                                   | %          | 4.4                                 | %          | 6.0 | % | 4.2 | % |
| Interest  expense, net                       |       | 0.4                                   | %          | 1.0                                 | %          | 0.4 | % | 1.0 | % |
| Income before  income tax expense            |       | 5.8                                   | %          | 3.4                                 | %          | 5.6 | % | 3.2 | % |
| Income tax  expense                          |       | 2.2                                   | %          | 1.3                                 | %          | 2.1 | % | 1.2 | % |
| Net income                                   |       | 3.6                                   | %          | 2.1                                 | %          | 3.5 | % | 2.0 | % |

 

**Three Months Ended June 30, 2004 Compared to the Three MonthsEnded June 30, 2003**

 

Net sales for the three months ended June 30, 2004 increased 16.5%to $339.6 million, compared to $291.6 million same period last year.  Comparable store sales increased 8%. 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.

 

Net sales from Guitar Center stores for the three months endedJune 30, 2004 totaled $262.9 million, a 17.8% increase from $223.1 millionfor the same period in 2003.  Sales fromnew stores contributed $21.2 million and represent 53.4% of the total increasein retail store sales.  Comparable GuitarCenter store sales for the quarter increased 8%.  The increase in comparable store sales was dueto good response to our advertising and marketing strategy for our Guitar Centerstores. Total advertising and marketing expense increased from $6.8 million to$8.6 million for second quarter of 2003. Our management is presently anticipating comparable store sales growth

 

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for the Guitar Center stores of 6% to 8% for the third quarter in2004.  Please see “Forward-LookingStatements; Business Risks,” below. Net sales from American Music stores forthe three months ended June 30, 2004 totaled $8.6 compared to $8.0 millionin 2003.  Comparable American Musicstores sales for the quarter increased 6%. Net sales from the direct responsechannel totaled $68.2 million for the three months ended June 30, 2004, a$7.7 million, or 12.7%, increase from 2003. This increase primarily reflectsthe improved performance of catalog circulation strategies.  Sales from the contact center, whichrepresent sales placed via phone, live chat, mail and e-mail, increased 7.3% to$30.8 million from $28.7 million for the three months ended June 30, 2004compared to 2003. Internet sales from orders placed via the Musician’s Friendand Giardinelli web sites increased 18.0% to $37.4 million from $31.7 millionfor the same period last year.  Thegrowth of web-based sales reflects the continued trend of our catalogcustomers’ preference in using the web to place their orders, the success ofweb-based promotions, and that the web site includes a more complete inventorypresentation than our catalogs.

 

Gross profit for the three months ended June 30, 2004 compared to2003 increased 24.7% to $94.2 million from $75.6 million.  Gross profit as a percentage of net sales forthe quarter ended June 30, 2004 compared to 2003 increased to 27.7% from25.9%.  Gross profit as a percentage ofnet sales for Guitar Center was 26.0% compared with 23.7% in the second quarterof 2003. The increase is due to higher selling margin 1.1%, decreased freight1.0%, lower inventory shrink expense 0.1%, and leveraged occupancy costs 0.1%due to the strong comparable store sales increase. We define selling margin asnet sales less the cost of the associated merchandise charged by the vendorplus the associated inventory costs from fulfilling inventory through ourdistribution center.  The cost of merchandiseinventory is net of all associated vendor discounts and rebates. Freight is notincluded in selling margin. The gross profit margin for the American Musicstores was 33.1% compared to 40.0% for the same period last year.  The decrease is primarily due to lowerselling margin and a change in product mix 7.2%, offset by decreased freight0.3%. Gross profit margin for the direct response division was 33.7% for thequarter compared to 32.1% in the second quarter of 2003.  The increase is due to higher selling marginresulting from better buying performance and favorable product mix 2.0%, lowerinventory shrink 0.1%, partially offset by higher freight costs 0.4% andoccupancy costs 0.1%.

 

Selling, general and administrative expenses for the three months endedJune 30, 2004 increased 16.8% to $73.2 million from$62.7 million for the same period in 2003. Selling, general andadministrative expenses were 21.5% as a percentage of sales in the three monthsended June 30, 2004 and 2003. Selling, general and administrative expensesfor the Guitar Center stores in the second quarter were 20.6% as a percentageof net sales compared to 20.2% in last year’s second quarter. The increase isdue to increased salary costs 0.3%, advertising expense 0.2%, medical insuranceexpense 0.2% and consulting fees 0.1%, partially offset by decreased travel0.1% and credit card expense 0.2%. Selling, general and administrative expensesfor the American Music stores were 50.8% of sales in the second quartercompared to 58.5% in the same period last year. The decrease is primarily dueto decreased salary costs 3.7%, bad debt expense 1.4%, advertising expense1.1%, travel 0.9%, and medical insurance expense 0.9%, partially offset byincrease in consulting 0.1%. Selling, general and administrative expenses forthe direct response division were 21.4% of sales compared to 21.5% for thethree month ended June 30, 2004 and 2003, respectively. The improvement isprimarily due to leveraging on sales and increased operational efficiencies.

 

Operating income increased 63.1% to $21.0 million from $12.9 millionfor the three months ended June 30, 2004. This increase reflectsperformance of the Guitar Center and Musician’s Friend businesses at or aboveexpected levels, offset somewhat by weaker than expected sales and continuedspending on our remerchandising efforts and systems and infrastructure buildout at the American Music stores resulting in an operating loss ofapproximately $1.5 million for this segment for the period ending June 30,2004.

 

Interest expense, net for the three months ended June 30, 2004,decreased to $1.4 million from $3.0 million in the second quarter of2003. The reduction in interest expense is due primarily to the retirement of$67 million in 11% senior notes through a $100 million 4% convertible bondoffering completed in June 2003.

 

In the three months endedJune 30, 2004, a $7.4 million provision for income taxes was recordedcompared to $3.8 million for the same period last year, both based on aneffective tax rate of approximately 38%. There were no significant changes inour operation that resulted in a change to the effective tax rate.

 

Net income for the three months ended June 30, 2004 increased97.5% to $12.1 million, compared to $6.2 million in the same period last yearas a result of the factors described above.

 

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**Six Months Ended June 30, 2004 Compared to the Six Months EndedJune 30, 2003**

 

Net sales for the six months ended June 30, 2004 increased 19.0%to $689.3 million, compared to $579.1 million same period last year.  Comparable store sales increased 9%.  We believe that comparable store sales are amore useful indicator of store performance than the change in total net sales,since comparable store sales exclude the effects of changes in the number of storesopen.

 

Net sales from Guitar Center stores for the six months endedJune 30, 2004 totaled $526.4 million, a 19.2% increase from $441.5 millionfor the same period in 2003.  Sales fromnew stores contributed $42.4 million and represent 49.9% of the total increasein retail store sales.  Comparable GuitarCenter store sales increased 10%.  Theincrease in comparable store sales was due to good response to our advertisingand marketing strategy for our Guitar Center stores. Total advertising andmarketing expense increased from $14.1 million in 2003 to $16.4 million in2004. Net sales from American Music stores for the six months endedJune 30, 2004 totaled $18.0 compared to $17.3 million in 2003.  Comparable American Music stores sales was3%. Net sales from the direct response channel totaled $145.0 million for thesix months ended June 30, 2004, a $24.6 million, or 20.4%, increase from2003. This increase primarily reflects the improved performance of catalogcirculation strategies.  Sales from thecontact center, which represent sales placed via phone, live chat, mail ande-mail, increased 12.5% to $64.6 million from $57.4 million for the six monthsended June 30, 2004 compared to 2003. Internet sales from orders placedvia the Musician’s Friend and Giardinelli web sites increased 27.6% to $80.4million from $63.0 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 the six months ended June 30, 2004 compared to2003 increased 25.8% to $188.9 million from $150.2 million.  Gross profit as a percentage of net sales forthe six months ended June 30, 2004 compared to 2003 increased to 27.4%from 25.9%.  Gross profit as a percentageof net sales for Guitar Center was 25.7% compared with 23.9% for the six monthsended June 30, 2003. The increase is due to higher selling margin 1.4%,lower inventory shrink expense 0.1%, and leveraged occupancy costs 0.3%. Thegross profit margin for the American Music stores was 34.7% compared to 38.5%for the same period last year.  Thedecrease is primarily due to lower selling margin and a change in product mix3.3% and increased occupancy costs 0.6%. Gross profit margin for the directresponse division was 32.8% for the six months ended June 30, 2004compared to 31.7% in the same period last year. The increase is due to higher selling margin resulting from betterbuying performance and favorable product mix 1.2%, decrease in inventory shrink0.2%, partially offset by increased freight costs 0.2%.

 

Selling, general and administrative expenses for the six months endedJune 30, 2004 increased 17.4% to $147.5 million from$125.7 million for the same period in 2003. Selling, general andadministrative expenses as a percentage of sales, for the six months endedJune 30, 2004 compared to 2003, decreased to 21.4% from 21.7%. Selling,general and administrative expenses for the Guitar Center stores were 20.5% asa percentage of sales for the six months ended June 30, 2004 and 2003.Selling, general and administrative expenses for the American Music stores were48.3% of sales for the six months compared to 49.3% in the same period lastyear. The decrease is primarily due to decreased advertising expense 1.5%,medical insurance 0.7%, decreased supplies 0.3% and decreased travel expense0.1%, offset by increases in general insurance expense 0.8%, consulting fees0.2% and depreciation and amortization expense 0.5%. Selling, general andadministrative expenses for the direct response division were 21.5% of salescompared to 22.1% for the six months ended June 30, 2004 and 2003, respectively.The improvement is primarily due to leveraging on better than expected salesand increased operational efficiencies as indicated by a reduction in payrollcosts 1.0%, offset by an increase in advertising expense primarily related toprograms to increase web traffic 0.5%,and an increase in consulting fees 0.1%.

 

Operating income increased 68.6% to $41.4 million from $24.5 millionfor the six months ended June 30, 2004. This increase reflects performanceof the Guitar Center and Musician’s Friend businesses at or above expectedlevels, offset somewhat by weaker than expected sales and continued spending onour remerchandising efforts and systems and infrastructure build out at theAmerican Music stores resulting in an operating loss of approximately $2.5million for this segment for the period ending June 30, 2004.

 

Interest expense, net for the six months ended June 30, 2004,decreased to $2.8 million from $6.1 million in the same period lastyear. The reduction in interest expense is due primarily to the retirement of$67 million in 11% senior notes through a $100 million 4% convertible bondoffering completed in June 2003 and the use of cash flow from operationsto pay off our line of credit borrowings.

 

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In the six months endedJune 30, 2004, a $14.7 million provision for income taxes was recordedcompared to $7.0 million for the same period last year, both based on aneffective tax rate of approximately 38%. There were no significant changes inour operation that resulted in a change to the effective tax rate.

 

Net income for the six months ended June 30, 2004 increased 109.4%to $23.9 million, compared to $11.4 million in the same period last year as aresult of the factors described above.

 

### **Liquidity andCapital Resources**

 

Our need for liquiditywill arise primarily from the funding of capital expenditures related toinfrastructure improvements and retail store expansion, working capitalrequirements and payments on our indebtedness, as well as possibleacquisitions. We have historically financed our operations primarily throughinternally generated funds and borrowings under our credit facilities. As ofJune 30, 2004, we had no borrowings under our credit facility and hadavailable borrowings of $111.4 million (net of $3.6 million of outstandingletters of credit).

 

In the fourth quarter of2003, we amended our credit facility with a syndicate of banks led by WellsFargo Retail Finance. The credit facility permits borrowings up to $125million, subject to borrowing base limitations ($115 million at June 30,2004).  The actual amount available istied to our inventory and receivable base, and repayment obligations under thecredit facility are secured by liens on our principal assets. Borrowing optionsare prime rate (4.25% at June 30, 2004) plus applicable prime margin, orLondon Interbank Offered Rate, or LIBOR (six month rate at June 30, 2004was 1.94%), plus applicable LIBOR margin. The applicable prime and LIBORmargins are fixed for the first six months of the amended agreement were 0.00%and 1.50%, respectively. After the initial six months, the applicable prime andLIBOR margins are based upon levels of excess availability and adjustedquarterly. If excess availability is greater than $20 million, the applicableprime margin is 0.00% and applicable LIBOR margin is 1.50%. If excessavailability is less than or equal to $20 million and greater than $10 million,the applicable prime margin is 0.00% and the applicable LIBOR margin is 1.75%.If excess availability is less than or equal to $10 million, the applicableprime margin is 0.25% and the applicable LIBOR margin is 2.00%. An unused linefee is assessed on the unused portion of the credit facility based upon levelsof excess availability. If excess availability is greater than $10 million, theunused line fee is 0.25%. If excess availability is less than or equal to $10million, the unused line fee is 0.375%. The agreement underlying the creditfacility includes significant restrictive negative covenants. Among otherthings, these covenants restrict our ability to incur debt and issue specifiedequity instruments, incur liens on our assets, make any significant change inour corporate structure or the nature of our business, dispose of assets, makeguaranties, prepay debt, engage in a change in control transaction, paydividends, make investments or acquisitions, engage in transactions withaffiliates and incur capital expenditures, and also require that we satisfy aminimum availability test. The minimum availability test requires that wemaintain $10 million of reserved availability under the agreement based on itsborrowing base limitations.  The amountwe disclose in our public reports from time to time as available to borrowunder the agreement ($111.4 million at June 30, 2004) is already reducedby this required reserve and outstanding letters of credit, and thus representsa net amount available under the agreement. The agreement also includesrepresentations and warranties which must be true each time we borrow fundsunder the credit facility and affirmative covenants.  The full text of the contractual 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 June 30, 2004.  Subject to limited cure periods, the lendersunder our credit facility may demand repayment of any 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 2007.

 

On June 16, 2003, we completed the issuance of $100 millionprincipal amount of 4.00% Senior Convertible Notes due 2013.  Of the net proceeds from the offering,approximately $68.2 million was used in July 2003 to retire alloutstanding Senior Notes and pay the related redemption premium, and thebalance was used to reduce the amount outstanding under our credit agreementand pay offering expenses.  The Notesbear interest at the rate of 4.00% per annum, subject to the payment ofcontingent interest under certain circumstances, and are convertible intoshares of common stock at a conversion price of $34.58 per share, subject toadjustment under specified circumstances. Under the contingent conversionfeature of the Notes, subject to certain exceptions, they are not convertibleinto common stock unless and until the trading price of the common stockreaches at least $41.50 for a specified period or designated corporate eventsoccur. As of June 30, 2004, Guitar Center’s common stock closed at orabove $41.50 per share for twenty trading days within the thirty trading dayperiod prior to the next conversion period.  As a result, holders ofGuitar Center 4.0% Senior Convertible Notes due

 

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2013 may, if they elect, convert the notes into common stock during theconversion period commencing July 16, 2004 and continuing through andincluding October 14, 2004. Whether or not the notes are convertible afterOctober 14, 2004 will be determined based on the trading price of thecommon stock during the thirty trading days ending on October 15,2004.  If during at least twenty such trading days the last reported salesprice is at or above $41.50, the notes will remain convertible for the nextquarterly conversion period.  The notes will also become convertible uponthe occurrence of specified corporate transactions and other events describedin the indenture. The final maturity of the Notes is July 2013, althoughholders may require us to repurchase the Notes at their election inJuly 2008, July 2010 or upon the occurrence of a change in control,in each case for a purchase price equal to the original principal amount plusaccrued interest.  We may call the Notesfor redemption commencing in July 2006 subject to the payment of aredemption premium of 1.6% if redeemed prior to July 2007 and 0.8% ifredeemed prior to July 2008 (thereafter there is no redemption premium).The indenture governing the Notes does not limit our ability to incurindebtedness or otherwise substantively restrict the operation of our businessto any significant degree.  Subject tolimited cure periods, the holders of the Notes may demand repayment of theseborrowings prior to the stated maturity upon the occurrence of specifiedevents, including if we fail to pay interest or principal when due, fail tosatisfy our conversion obligation, if another obligation of ours having anoutstanding principal amount in excess of $15 million is accelerated prior tostated maturity and upon the occurrence of specified events of insolvency.

 

During 2002 we entered into master operating lease agreements withGeneral Electric Capital Corporation and US Bank to lease equipment and otherproperty primarily to support the operations of the new central distributioncenter for our Guitar Center retail stores. Under these agreements, we leased atotal of $10.5 million in equipment and other property. The agreements call formonthly payments of $138,000 for a term of 36 months through September 1,2005 with an option to extend through September 30, 2009 and monthlypayments of $48,000 for a term of 24 months through December 28, 2005.

 

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

 

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

 

Net cash used in operating activities was $6.5 million for the sixmonths ended June 30, 2004 compared to net cash provided by operatingactivities of $2.8 million for the same period last year. We used cashgenerated from our improved operations during the six months endedJune 30, 2004 to increase inventories by $24 million and reduce accruedexpenses by $21 million. The increase in merchandise inventory is required tosupport the continuing growth of the Company.

 

Cash used in investing activities decreased to $10.8 million for thesix months ended June 30, 2004 compared to $11.3 million for the sameperiod last year. The current period capital expenditures consisted primarilyof capital expenditures for store expansions of $6.1 million compared to $5.7million in the prior period and computer equipment purchases of $3.4 million inthe current period compared to $3.9 million in the same period last year.

 

Cash provided by financing activities totaled $15.8 million for the sixmonths ended June 30, 2004 compared to $75.5 million for the same period lastyear. The cash provided by financing activities for the current periodprimarily includes the proceeds received from the exercise of stock options$15.1 compared to the prior period when we received $96.9 from the SeniorConvertible Notes.

 

We believe that our current operating cash flow, working capital, andcash and cash equivalents on hand will be sufficient to meet our obligations inthe ordinary course of business, including capital expenditures and new storeopenings.

 

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We intend to pursue an aggressive growth strategy by opening additionalstores in new and existing markets. During the six months ended June 30, 2004, we opened eight newGuitar Center stores (three large format and five small format stores). Eachnew large format Guitar Center store typically has required approximately $1.6to $1.8 million for gross inventory. Historically, our cost of capital improvements for a large format GuitarCenter store has been approximately $850,000, consisting of leaseholdimprovements, fixtures and equipment. We incur higher costs in some geographicareas, particularly the Northeast, and when we build a larger flagshipstore.  We have developed smaller GuitarCenter stores to build in secondary markets or sites that we do not believewill support our large format units. The first of these units was opened inlate 2000 and 18 more had been opened as of June 30, 2004. Our smallformat stores have typically incurred approximately $560,000 in capital expendituresand require approximately $1.1 million to $1.2 million in inventory.

 

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

 

Our distribution center in the Indianapolis, Indiana area supports ourGuitar Center retail store operations. We have a 10-year agreement to lease thefacility and we also have numerous additional commitments necessary to supportthe operations of the facility. In 2003, nearly all products flowed through thedistribution facility, with the exception of special orders which willcontinue, for the most part, to be drop shipped to our stores. Migration fromour former “drop-ship” model to a centralized distribution model is animportant development in our operating strategy and has required the allocationof significant financial and managerial resources. In accordance with generallyaccepted accounting principles, 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. This can result in a slight decrease in reported gross margin dependingon our success in defraying these additional costs, although we also expect torealize efficiencies involving other costs such as selling, general andadministrative expense and interest expense.

 

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

 

Our expansion strategy is to continue to increase our market share inexisting markets and to penetrate strategically selected new markets.  We opened a total of 14 Guitar Center storesin 2003 and 12 stores in 2002, and currently anticipate opening 13 to 15 GuitarCenter stores in 2004. Approximately half of the stores planned for 2004 aresmaller format units designed for secondary markets. We opened a total of eightAmerican Music stores in 2002, five of the eight by acquisition of M&MMusic, a band instrument and retail merchandise retailer. In 2003, we openedone and closed two American Music stores. As of June 30, 2004, we have 19American Music stores. For the remainder of 2004, we do not presently plan toopen any American Music stores. We have slowed our planned growth of theAmerican Music division because our infrastructure and remerchandising projectsat this business have to date required more time and resources than originallyanticipated. We do, however, believe there exists a number of acquisitionopportunities in the relatively fragmented band instruments market that couldbe a good fit into our American Music platform and we continue to pursueacquisition opportunities. For an example, in July 2004, we acquired theassets of the band and orchestra instrument business of Karnes Music in theChicago area. Total purchase consideration was approximately $3.0 million,subject to a working capital adjustment.

 

Throughout our history, we have primarily grown organically, and we donot expect this to change. However, we also believe there may be attractiveopportunities to expand by selectively acquiring existing music productsretailers or other complimentary businesses, if attractive opportunities can beidentified. While we cannot provide assurance that we will complete any furtheracquisition transactions, in the ordinary course of our business we investigateand engage in negotiations regarding such opportunities. Acquisitions will befinanced with cash on hand, drawings under our existing credit facilities,expansion of our credit facilities, issuance of debt or equity securities, or acombination, depending upon transaction size and market conditions, among otherthings.

 

Our known capital resource and liquidity requirements for 2004 arepresently expected to be primarily provided by cash on hand, net cash flow fromoperations and, possibly, borrowings under our credit facility. Depending uponmarket conditions, we may also elect or be required to raise additional capitalin the form of

 

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common or preferred equity, debt or convertible securities for thepurpose of providing additional capital to fund working capital needs orcontinued growth of our existing business, or to refinance existingobligations. Any such financing activity will be dependent upon many factors,including our liquidity needs, market conditions and prevailing market terms,and we cannot assure you that future external financing for us will beavailable on attractive terms or at all.

 

### **New AccountingPronouncements**

 

InJanuary 2003, the Financial Accounting Standards Board issued FASBInterpretation No. 46, *“Consolidation of VariableInterest Entities” (FIN 46).* This interpretation clarifies the application of Accounting ResearchBulletin No. 51, *“Consolidated Financial Statements” (ARB51),* and requires companies to evaluate variable interest entitiesfor specific characteristics to determine whether additional consolidation anddisclosure requirements apply.  Thisinterpretation was immediately applicable for variable interest entitiescreated after January 31, 2003, and applies to the first fiscal year orinterim period beginning after June 15, 2003 for variable interestentities acquired prior to February 1, 2003. The adoption of thisinterpretation did not have any impact on our financial position or results ofoperations. In December 2003, the FASB revised FIN 46 to exempt certain entitiesfrom its requirements and to clarify certain issues arising during theimplementation of FIN 46. The adoption of this revised interpretation in thefirst quarter of 2004 did not have any impact on our consolidated financialstatements.

 

In May 2003, the FinancialAccounting Standards Board issued Statement No. 150, *“Accounting for Certain Financial Instrumentswith Characteristics of both Liabilities and Equity” (SFAS No. 150). *The statement establishes standards for how an issuer classifiesand measures certain financial instruments with characteristics of bothliabilities and equity. It requires that an issuer classify a financialinstrument that is within its scope as a liability (or an asset in somecircumstances). It is effective for financial instruments entered into ormodified after May 31, 2003, and otherwise is effective at the beginning of thefirst interim period beginning after June 15, 2003.   We adopted this standard effectiveJuly 1, 2003, and it did not have a material effect on our consolidatedfinancial statements.

 

### **Seasonality**

 

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

 

### **Inflation**

 

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

 

### **Forward-LookingStatements**

 

This report contains forward-looking statements relating to, amongother things, future results of operations, growth and investment plans, sales,trends in gross margin, growth in the Internet business and other factorsaffecting growth in sales and earnings. Specific forward-looking statements are provided regarding ourmanagement’s current views regarding comparable store sales, new storeopenings, and capital expenditure levels. Statements regarding new store openings are based largely on our currentexpectations and are necessarily subject to associated business risks relatedto, among other things, the identification of suitable sites or acquisitionopportunities, the timely construction, staffing and merchandising of thosestores and other matters, some of which are outside of our control. Comparablestore sales growth is highly dependent upon the state of the economy, theeffectiveness of our sales and promotion strategies, and the effect ofcompetition, including other national operators of music products storesattempting to implement national growth strategies. The American Music businesshas in the past and may in the future give rise to significant fluctuationsfrom period to period as we reformat their store model and build-out theinformation technology and management structure. The American Music storesincurred significant operating losses in 2003 and for the first six months of2004, and are expected to incur operating losses for the last six months of2004.

 

Sales and earnings trends are also affected by many other factorsincluding, among others, world and national political events, general economicconditions, the effectiveness of our promotion and merchandising strategies,changes in the music products industry, retail sales trends and the emergenceof new or growing

 

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specialty retailers of music products. In light of these risks, there can be no assurance that theforward-looking statements contained in this report will in fact be realized.  The statements made by us in this reportrepresent our views as of the date of this report, and it should not be assumedthat the statements made herein remain accurate as of any future date.  We do not presently intend to update thesestatements and undertake no duty to any person to affect any such update underany circumstances.

 

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

 

**Risks Related to the Business**

 

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

 

*Wemay be unable to meet our Guitar Center and American Music retail store growthstrategy, which could adversely affect our results of operations.*

 

Our retail store growth strategy includes opening new stores in new andexisting markets and increasing sales at existing locations.  As of June 30, 2004, we operated 130Guitar Center stores and 19 American Music stores.  We opened a total of 14 Guitar Center storesin 2003, and currently expect to open approximately 13 to 15 additional GuitarCenter stores in 2004.  Approximatelyhalf of the Guitar Center stores planned for 2004 are expected to be smallerformat units designed for secondary markets. Our planned store openingschedule for 2004 may be affected by any acquisitions we may transactduring the year.  If we complete any suchtransactions, our planned organic store openings may be reduced.

 

We opened a total of eight American Music stores in 2002, five of whichwere acquired in connection with American Music’s acquisition of M&M Music,a band instrument retailer. In 2003, we opened one American Music store andclosed two. In 2004, we do not plan to open any additional American Musicstores.  We do, however, believe thereexist a number of acquisition opportunities in the relatively fragmented bandinstruments market that could be a good fit into our American Music platform.For an example, in July 2004 we acquired the assets of the band andorchestra instrument business of Karnes Music located in the Chicago area.However, we have slowed our planned growth of the American Music divisionbecause our infrastructure and remerchandising projects at this business haveto date required more time and resources than originally anticipated.  As a result of these factors, the AmericanMusic stores incurred significant operating losses in 2003 and for the firstsix months of 2004, and are expected to incur operating losses for the last sixmonths of 2004.

 

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

 

•                  identificationof suitable retail sites and appropriate acquisition candidates;

 

•                  negotiation ofacceptable lease terms;

 

•                  hiring, trainingand retention of skilled personnel;

 

•                  availability ofadequate capital;

 

•                  sufficientmanagement and financial resources to support the new locations;

 

•                  vendor support;and

 

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

 

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A number of these factors are, to a significant extent, beyond ourcontrol.  As a result, we do not knowwhether we will be able to continue to open and/or acquire additional GuitarCenter and American Music stores at the rates currently anticipated.  If we are unable to achieve our retail storeexpansion goals, or the new stores underperform our expectations, our resultsof operations could be adversely affected.

 

*We face unique competitive and merchandising challenges in connectionwith our plans to open additional Guitar Center and American Music retailstores in new markets.*

 

As part of our retailgrowth strategy, we plan to open and/or acquire additional Guitar Center andAmerican Music stores in new markets, which could include internationalmarkets. This expansion into new markets will present unique competitive andmerchandising challenges, including:

 

•                  significantstart-up costs, including promotion and advertising;

 

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

 

•                  management ofstores in distant locations or foreign countries;

 

•                  availability ofdesirable product lines; and

 

•                  our expansionmay involve acquisitions, including acquisitions in business segments in whichwe have limited or no experience.

 

Any of these factors maylead to a shortfall in revenues or an increase in costs with respect to theoperation of these stores.  If we are notable to operate these stores profitably, our results of operations would beadversely affected.

 

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

 

Historically, we haveachieved significant sales growth in existing 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 retail stores:

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

 

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

 

•                  competition;

 

•                  economicconditions, including in particular, discretionary consumer spending;

 

•                  consumer andmusic trends;

 

•                  changes in ourmerchandise mix;

 

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•                  productdistribution; and

 

•                  timing andeffectiveness of our promotional events.

 

Our management ispresently anticipating comparable store sales growth of 6% to 8% for the GuitarCenter stores’ third quarter of 2004. A shortfall in comparative sales growthin any period will likely cause a shortfall in earnings, and result infinancial performance below that for which we have planned or the investmentcommunity expects.

 

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

 

We believe that ourexpansion may be accelerated by the acquisition of existing music productretailers. For example, in April 2001 we acquired the business of AmericanMusic Group, a New York-based retailer of band instruments, a business in whichwe were not previously engaged and in July 2004, we acquired the assets ofthe band and orchestra instrument business of Karnes Music located in theChicago area. Our growth plans for the American Music business contemplate asignificant number of relatively small acquisitions. We also regularlyinvestigate acquisition opportunities complimentary to our Guitar Center andMusician’s Friend businesses. Accordingly, in the ordinary course of ourbusiness, we regularly consider, evaluate and enter into negotiations relatedto potential acquisition opportunities. We may pay for these acquisitions incash or securities, including equity securities, or a combination of both. Wecannot assure you that attractive acquisition targets will be available atreasonable prices or that we will be successful in any such transaction.  Acquisitions involve a number of specialrisks, including:

 

•                  diversion of ourmanagement’s attention;

 

•                  integration ofthe acquired business with our business; and

 

•                  unanticipatedlegal liabilities and other circumstances or events.

 

*Wedepend on a relatively small number of manufacturers, suppliers and commoncarriers who may not be able or desire to supply our requirements.*

 

Brand recognition is ofsignificant importance in the retail music products business. As a result, wedepend on a relatively small number of manufacturers and suppliers for both ourexisting retail stores and the direct response unit as well as our expansiongoals for each of these units. We do not have any long-term contracts with oursuppliers, and any failure to maintain our relationships with our key brandname vendors would have a material adverse effect on our business. A number ofthe manufacturers of the products we sell are limited in size and manufacturingcapacity and have significant capital or other constraints. These manufacturersmay not be able or willing to meet our increasing requirements for inventory,and we cannot assure you that sufficient quantities or the appropriate mix ofproducts will be available in the future to supply our existing stores andexpansion plans. These capacity constraints could lead to extended lead timesand shortages of desirable products. The risk is especially prevalent in newmarkets where our vendors have existing agreements with other dealers andthereby may be unwilling or unable for contractual or other reasons to meet ourrequirements. The efficient operation of our distribution center for the GuitarCenter stores is also highly dependent upon compliance by our vendors withprecise requirements as to the timing, format and composition of shipments,which in many instances requires changes and upgrades to the operationalprocedures and logistics and supply chain management capabilities of vendors,all of which are outside of our control. Additionally, many of our vendorsreceive product from overseas and depend on an extensive supply chain includingcommon carriers and port access to transport merchandise into the country.Foreign manufacturing is subject to a number of risks, including political andeconomic disruptions, the imposition of tariffs, quotas and other import orexport controls, and changes in governmental policies. We also rely on commoncarriers to transport product from our vendors to our central distributioncenter in Indiana, and from the distribution facility to our Guitar Centerstores. Similarly, Musician’s Friend relies on common carriers to transportproduct to its fulfillment center in Kansas City, Missouri and onward toconsumers. 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 thatwe develop or sell may expose us to liability from claims by users of suchproducts for damages including, but not limited to, bodily injury or propertydamage. This risk is expected to increase as we use

 

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thecapabilities of our Guitar Center distribution center to increase the privatelabel and other proprietary product that we offer. Much of this product ismanufactured by small companies located overseas. We currently maintain productliability insurance coverage in amounts that we believe are adequate. However,there can be no assurance that we will be able to maintain such coverage orobtain additional coverage on acceptable terms in the future, or that suchinsurance will provide adequate coverage 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 nationalexpansion strategies.*

 

The retail music products industry is fragmented and highlycompetitive. We compete with many different types of music product retailers,including conventional retailers, as well as other catalog and e-commerceretailers, who sell many or most of the items we sell. We believe that largeformat music product retailers such as our company will seek to expand in partthrough the acquisition of small, independently owned stores or franchises, andwe anticipate increased competition in our existing markets and planned newmarkets from these consolidating retailers. These retailers may identify targetcompanies or execute their acquisition strategies more effectively than ourcompany.  In addition, these retailersmay have greater financial resources or other competitive advantages ascompared to our company. Our expansion to new markets will be inhibited 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.

 

Recently, several large mass merchants, including Wal-Mart and Costco,have begun to sell musical instruments in categories that we compete in,including entry-level guitars, electronic keyboards and band instruments, andthus could represent a significant source of future competition for our retailand direct response businesses, particularly if these retailers expand theirproduct lines beyond entry-level merchandise.

 

*We must efficiently integrate American Music andgrow its family music business in order to earn an acceptable return on thatinvestment.*

 

In April 2001, we completed our acquisition of American MusicGroup, a New York-based retailer of band instruments. We had not previouslyparticipated in the band instruments segment of the music products business andhad no prior experience in this distribution channel. We intend to use theacquired American Music business as a platform to develop and grow a familymusic store concept that will emphasize band instruments and also sell selected“combo” products sold by our Guitar Center stores, such as guitars, drums andthe like. Thus, we face the normal challenges of any acquisition, such asintegration of personnel and systems as well as the need to learn, understandand further develop this business. We are installing a new managementinformation system at American Music, which has proven to be a challengingproject requiring more time and resources than originally anticipated. Thisimplementation is an important project to provide a systems backbone to permitgrowth of this division. In addition, we have begun marketing through theAmerican Music stores some Guitar Center products not previously carried byAmerican Music and offering lessons. This change in merchandising strategy fromthe historic focus of American Music on band instruments is in process and isan important element of our family music store concept for this brand.  This remerchandising strategy is not yetproven. Further, we have slowed our planned growth of the American Music divisionbecause the challenges posed by our infrastructure and remerchandisingprojects.  As a result of these factors,the American Music stores incurred significant operating losses in 2003 and thefirst six months of 2004, and are expected to incur operating losses for thelast six months of 2004.  Failure toexecute on the requirements and initiatives described above could result in apoor or no return on our investment, constitute a distraction of the efforts ofour management team from the core Guitar Center and Musician’s Friend brandsand potentially require us to recognize an impairment in the significant amountof goodwill recorded in the acquisitions of American Music and M&M Music,which totaled $20.6 million at June 30, 2004.

 

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

 

Oursuccess depends to a significant extent on the services of Larry Thomas, ourChairman and Co-CEO, Marty Albertson, our President and Co-CEO, Robert Eastman,the CEO of our wholly-owned subsidiary, Musician’s Friend, Inc., and David Fleming, President and ChiefOperating Officer of American Music, aswell as our ability to attract and retain additional key personnel with theskills necessary to manage our existing business and growth plans. The loss ofone or more of our key personnel could have a material adverse effect on ourbusiness, results of operations, liquidity and financial position.

 

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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.

 

*The implementation of our distribution center forthe Guitar Center retail stores presents operational risks and represents asignificant investment.*

 

Our distribution center in the Indianapolis, Indiana area supports ourGuitar Center retail store operations. The conveyor systems, the warehouse managementsystem, and all other technology systems and infrastructure commencedoperations in July 2002. Migration from our former “drop-ship” model to acentralized distribution model is an important development in our operatingstrategy. The efficient operation of the distribution center is also dependentupon the performance of third parties that we do not control, such as vendorswho must comply with new operating procedures and common carriers who mustdeliver product on time. This program involves financial and operating risksthat could include the need to expend greater funds than presently budgeted ordisruptions in retail store operations and the loss of sales if inventory isnot timely provided in the required quantities. Further, one of the key underlyingeconomic assumptions of our distribution center project is that this programwill permit us to reduce overall inventory levels as a percentage of salesthereby resulting in significantly reduced working capital requirements. Anyfailure to reach our inventory reduction targets will adversely affect ourfuture financial performance and capital needs, potentially in a materialmanner. Failure to execute on these requirements could result in a poor or noreturn on our investment, disruption of our retail store business and adistraction of the efforts of our management team.

 

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

 

As of June 30, 2004, our corporate headquarters as well as 23 ofour 130 Guitar Center stores were located in California, and stores located inthat state generated 24.9% and 26.0% of our retail sales for the second quarterof 2004 and 2003, respectively.  Althoughwe have opened and acquired stores in other areas of the United States, asignificant percentage of our net sales and results of operations will likelyremain concentrated 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 changing consumerpreferences could also adversely impact us.*

 

Our business is sensitive to consumer spending patterns, which can beaffected by prevailing economic conditions. A downturn in economic conditionsin one or more of our markets, such as occurred after September 11, 2001,could have a material adverse effect on our results of operations, financialcondition, business and prospects. Although we attempt to stay informed of consumer preferences for musicalproducts and accessories typically offered for sale in our stores, anysustained failure on our part to identify and respond to trends would have amaterial adverse effect on our results of operations, financial condition,business and prospects.

 

*We may need to change the manner in which weconduct our business if government regulation or taxation imposes additionalcosts 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 direct response sales, remain in flux. In addition, thegrowth and development of the market for online commerce may lead to morestringent consumer protection laws, both in the United States and abroad, thatmay impose additional burdens on us. Laws and regulations directly applicableto communications or commerce over the Internet are becoming more prevalent.The law of the Internet, however, remains largely unsettled, even in areaswhere there has been some legislative action. It may take years to determinewhether and how existing laws such as those governing intellectual property,consumer privacy, sales-based and other taxation of e-commerce transactions andthe like are interpreted and enforced. Any

 

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adversechange in any of these laws or in the enforcement, interpretation or scope ofexisting laws could have a material adverse effect on our results ofoperations, financial condition or prospects.

 

*We face risks created by litigation, governmental proceedings, labordisputes or environmental matters.*

 

We are involved in a number of litigation matters. Litigation mayresult in substantial costs and expenses and significantly divert the attentionof our management regardless of the outcome. In addition, current and future litigation, governmental proceedings,labor disputes or environmental matters could lead to increased costs orinterruptions of our normal 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.*

 

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

 

*Net sales of our e-commerce business could decreaseif our online security measures fail.*

 

Our relationships with our e-commerce customers may be adverselyaffected if the security measures that we use to protect their personalinformation, such as credit card numbers, are ineffective.  If, as a result, we lose customers, our netsales could decrease. We rely on security and authentication technology that welicense from third parties. With this technology, we perform real-time creditcard authorization and verification with our bank. We cannot predict whetherevents or developments will result in a compromise or breach of the technologywe use to protect a customer’s personal information.  Furthermore, our servers may be vulnerable 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 rapid technologicalchanges, our services could become obsolete and we could lose customers.*

 

If we face material delays in introducing new services, products andenhancements, our e-commerce customers may forego the use of our services anduse those of our competitors. To remain competitive, we must continue toenhance and improve the functionality and features of our online store.  The Internet and the online commerce industryare rapidly changing. If competitors introduce new products and servicesembodying new technologies, or if new industry standards and practices emerge,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.

 

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

 

We rely on our computerhardware and software systems for the efficient operation of our retail storesand direct response business. Our information systems provide our managementwith real-time inventory, sales

 

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and cost information thatis essential to the operation of our business. Due to our number of stores,geographic diversity and other factors, we would be unable to generate thisinformation in a timely and accurate manner in the event our hardware orsoftware systems were unavailable. These systems are vulnerable to damage orinterruption from a number of factors, including:

 

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

 

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

 

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

 

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

 

*Our stock price could be volatile.*

 

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

 

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

 

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

 

Projections are basedupon a number of assumptions and estimates that, while presented with numericalspecificity, are inherently subject to significant business, economic andcompetitive 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.

 

Projections arenecessarily speculative in nature, and it can be expected that some or all ofthe assumptions of the projections furnished by us will not materialize or willvary significantly from actual results. Accordingly, our projections are onlyan estimate of what management believes is realizable as of the date ofrelease. Actual results will vary from the projections and the variations maybe material.  Investors should 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.

 

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

 

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

 

We do not have any assets or liabilities which, in our view, imposeupon us significant market risk except for our outstanding indebtednessrepresented by $100 million principal amount of Senior Convertible Notes due2013 with a fixed interest rate of 4% (subject to contingent interest) and ourcredit facility which has a variable rate of interest generally consisting ofstated premiums above LIBOR.  AtJune 30, 2004, we had no outstanding borrowings under our credit facility.  To the extent prevailing short-term interestrates fluctuate, the interest expense we incur on our credit facility willchange with a resulting effect (positive or negative) on our financialposition, results of operations and cash flows. We do not use derivativefinancial 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.

 

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

 

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

 

As required by SEC Rule13a-15(b), we carried out an evaluation, under the supervision and with theparticipation of our management, including our Co-Chief Executive Officers andChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures as of the end of the period covered bythis report.  Based on the foregoing, our Co-Chief Executive Officers andChief Financial Officer concluded that our disclosure controls and procedureswere effective at the reasonable assurance level.

 

There has been no changein our internal controls over financial reporting during our most recent fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

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

 

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

 

(a)                                  Our annual meeting ofstockholders (the “Annual Meeting”) was held on April 29, 2004.  At that time there were present, in person orby proxy, 22,097,590 shares of our common stock.

 

(b)                                 At the annual meeting,two items were submitted to a vote of stockholders: (1) the election ofdirectors; and (2) the approval of the 2004 Guitar Center, Inc. Incentive StockAward Plan.

 

(c)                                  (1)                                  The results of votingfor the election of ten directors at the Annual Meeting were as follows:

 

 
| **Nominee**           | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|-----------------------|------------|------------|------------|--------------|------------|
|                  |       |       |       |         |       |
| Larry Thomas          |       | 21,207,177 |       | 890,413      |       |
| Marty Albertson       |       | 21,855,044 |       | 242,546      |       |
| Wm. Christopher Gorog |       | 21,846,424 |       | 251,166      |       |
| Wayne Inouye          |       | 21,818,606 |       | 278,984      |       |
| George Jones          |       | 21,853,824 |       | 243,766      |       |
| Larry Livingston      |       | 21,848,421 |       | 249,169      |       |
| George Mrkonic        |       | 20,803,301 |       | 1,294,289    |       |
| Kenneth Reiss         |       | 21,084,841 |       | 1,012,749    |       |
| Walter Rossi          |       | 21,119,853 |       | 977,737      |       |
| Peter Starrett        |       | 21,570,204 |       | 527,386      |       |

 

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(2)                                  Theresults of voting for the approval of the 2004 Guitar Center, Inc. IncentiveStock Award Plan were as follows:

 
| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker  Non-Votes** |
|------------|------------|-------------|------------|-------------|------------|-----------------------|
| 15,876,851 |       | 2,476,495   |       | 13,736      |       | 0                     |

 

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

 

(a)                                  Exhibits:

 

3.1                                 Amendedand Restated Bylaws (Filed herewith).

 

10.1                           AmendmentNo.3 dated January 1, 2004 to Third Amended and Restated EmploymentAgreement between Guitar Center, Inc. and Larry Thomas (Filed herewith).

 

10.2                           AmendmentNo.3 dated January 1, 2004 to Third Amended and Restated EmploymentAgreement between Guitar Center, Inc. and Marty Albertson (Filed herewith).

 

10.3                           AmendmentNo.1 dated January 1, 2004 to Third Amended and Restated EmploymentAgreement between Guitar Center, Inc. and Bruce Ross (Filed herewith).

 

10.4                           Formof Executive Severance Benefits Agreement between Guitar Center, Inc., Musician’s Friend, Inc. or Guitar Center Stores,Inc. and our executive officers not party to employment agreements (Filedherewith).

 

10.5                           Amendmentto 1997 Equity Participation Plan (Filed herewith).

 

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

 

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

 

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

 

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

 

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

 

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

 

(b)                                 Reports on Form 8-K:

 

We filed a Current Report on Form 8-K on April 27, 2004 disclosingunder caption of Items 5 and 12, financial information for the quarter endedMarch 31, 2004.

 

We filed a Current Report on Form 8-K on July 1, 2004 disclosingunder caption of Item 5, information regarding the convertibility of our 4.0%Senior Convertible Notes due 2013 and the related treatment, of such notes forfinancial reporting purposes.

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized as of the 3rd day of August 2004.

 

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

 

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