**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  March 31, 2006**                                                                                                                                                                                                                                                                                                                                                                                               |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                                                                    |
|       |       | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|       |       | **For the transition period from                                 to                                 ** |

 

**CommissionFile No. 000 – 22207**

 

**GUITAR CENTER, INC.**

(Exact Name ofRegistrant as Specified in its Charter)

 

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

 

Indicate by 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 the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

 

Yes   ý     No   o

 

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

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

 

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

 

Yes   o     No   ý

 

As of May 5, 2006, therewere 26,266,944 shares of our Common Stock, $.01 par value, outstanding.

 

 

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**GUITARCENTER, INC. AND SUBSIDIARIES**

 

**INDEXTO FINANCIAL STATEMENTS**

 
| Part I.      | Financial Information                                                                     |                                                                                             |
|--------------|-------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------|
|         |                                                                                      |                                                                                             |
|         | **Item 1. Consolidated Financial Statements  (Unaudited)**                                |                                                                                             |
|         |                                                                                      |                                                                                             |
|         | Consolidated  Balance Sheets – March 31, 2006 and December 31, 2005                  | 3                                                                                                |
|         |                                                                                      |                                                                                             |
|         | Consolidated  Statements of Income – Three months ended  March 31, 2006 and 2005     | 4                                                                                                |
|         |                                                                                      |                                                                                             |
|         | Consolidated  Statements of Cash Flows – Three months ended  March 31, 2006 and 2005 | 5                                                                                                |
|         |                                                                                      |                                                                                             |
|         | Notes  to Consolidated Financial Statements                                               | 6                                                                                                |
|         |                                                                                      |                                                                                             |
| ** **   | **Item 2.**                                                                               | **Management’s Discussion and  Analysis of Financial Condition and  Results of Operations** | 13 |
|         |                                                                                      |                                                                                             |
|         | **Item 3.**                                                                               | **Quantitative and Qualitative  Disclosures About Market Risk**                                  | 23 |
|         |                                                                                      |                                                                                             |
|         | **Item  4.**                                                                              | **Controls  and Procedures.**                                                                    | 23 |
|         |                                                                                      |                                                                                             |
| **Part II.** | **Other Information**                                                                     | ** **                                                                                       |
| ** **   | ** **                                                                                | ** **                                                                                       |
|         | **Item 1.**                                                                               | **Legal Proceedings**                                                                            | 23 |
|         |                                                                                      |                                                                                             |
|         | **Item 1A.**                                                                              | **Risk Factors**                                                                                 | 23 |
|         |                                                                                      |                                                                                             |
|         | **Item  6.**                                                                              | **Exhibits**                                                                                     | 24 |
|              |                                                                                           |                                                                                                  |  |  |

 

2

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**GUITARCENTER, INC. AND SUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                                                                                 | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                 |       |                     |       |                        |       |
| Current assets:                                                                                                                            |       |                     |       |                        |       |
| Cash and cash  equivalents                                                                                                                 |       | $                        | 9,932      |                        | $          | 14,529 |   |
| Accounts  receivable, less allowance for doubtful accounts of $2,369 and $2,844,  respectively                                             |       | 31,751                   |       | 40,844                      |       |
| Merchandise  inventories                                                                                                                   |       | 445,894                  |       | 445,771                     |       |
| Prepaid expenses  and other current assets                                                                                                 |       | 14,688                   |       | 15,533                      |       |
| Deferred income  taxes                                                                                                                     |       | 11,803                   |       | 13,492                      |       |
| Total current  assets                                                                                                                      |       | 514,068                  |       | 530,169                     |       |
| Property and  equipment, net of accumulated depreciation and amortization of $132,906 and  $125,440, respectively                          |       | 157,817                  |       | 149,209                     |       |
| Goodwill                                                                                                                                   |       | 87,213                   |       | 85,929                      |       |
| Intangible and  other assets, net                                                                                                          |       | 14,006                   |       | 14,883                      |       |
|                                                                                                                                       |       | $                        | 773,104    |                        | $          | 780,190 |   |
| **Liabilities  and stockholders’ equity**                                                                                             |       |                     |       |                        |       |
| Current  liabilities:                                                                                                                      |       |                     |       |                        |       |
| Accounts payable                                                                                                                           |       | $                        | 89,329     |                        | $          | 79,497 |   |
| Accrued expenses  and other current liabilities                                                                                            |       | 72,193                   |       | 106,181                     |       |
| Merchandise  advances                                                                                                                      |       | 21,931                   |       | 25,127                      |       |
| Borrowing under  revolving line of credit                                                                                                  |       | 30,049                   |       | 32,266                      |       |
| Total current  liabilities                                                                                                                 |       | 213,502                  |       | 243,071                     |       |
| Other long-term  liabilities                                                                                                               |       | 12,727                   |       | 11,995                      |       |
| Deferred income  taxes                                                                                                                     |       | 15,331                   |       | 20,307                      |       |
| Long-term debt                                                                                                                             |       | 100,000                  |       | 100,000                     |       |
| Total  liabilities                                                                                                                         |       | 341,560                  |       | 375,373                     |       |
| Stockholders’  equity:                                                                                                                |       |                     |       |                        |       |
| Preferred stock,  5,000 authorized, none issued and outstanding                                                                            |       | —                   |       | —                      |       |
| Common stock,  $0.01 par value, authorized 55,000 shares, issued and outstanding 26,236 at  March 31, 2006 and 26,092 at December 31, 2005 |       | 262                      |       | 261                         |       |
| Additional  paid-in capital                                                                                                                |       | 337,774                  |       | 326,755                     |       |
| Retained  earnings                                                                                                                         |       | 93,508                   |       | 77,801                      |       |
| Stockholders’  equity                                                                                                                 |       | 431,544                  |       | 404,817                     |       |
|                                                                                                                                       |       | $                        | 773,104    |                        | $          | 780,190 |   |

 

*See accompanying notes to consolidated financialstatements.*

 

3

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**GUITARCENTER, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF INCOME**

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

**(Unaudited)**

** **
| ** **                                                              | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                              | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Net sales                                                               |       | $                                                    | 470,747    |   | $ | 396,386 |   |
| Cost of goods  sold, buying and occupancy                               |       | 334,241                                              |       | 285,214 |   |
| Gross profit                                                            |       | 136,506                                              |       | 111,172 |   |
| Selling, general  and administrative expenses                           |       | 109,114                                              |       | 84,471 |   |
| Operating income                                                        |       | 27,392                                               |       | 26,701 |   |
| Interest  expense, net of interest income of $75 and $503, respectively |       | 1,852                                                |       | 875 |   |
| Income before  income taxes                                             |       | 25,540                                               |       | 25,826 |   |
| Income taxes                                                            |       | 9,833                                                |       | 9,942 |   |
| Net income                                                              |       | $                                                    | 15,707     |   | $ | 15,884 |   |
|                                                                    |       |                                                 |       |   |   |
| Net income per  share:                                                  |       |                                                 |       |   |   |
| Basic                                                                   |       | $                                                    | 0.60       |   | $ | 0.62 |   |
| Diluted                                                                 |       | $                                                    | 0.55       |   | $ | 0.56 |   |
|                                                                    |       |                                                 |       |   |   |
| Weighted average  shares outstanding:                                   |       |                                                 |       |   |   |
| Basic                                                                   |       | 26,176                                               |       | 25,593 |   |
| Diluted                                                                 |       | 29,863                                               |       | 29,724 |   |

 

*See accompanying notes to consolidated financialstatements.*

 

4

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**GUITARCENTER, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Inthousands)**

**(Unaudited)**

 
| ** **                                                                                      | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| **Operating  activities:**                                                                      |       |                                                 |       |   |   |
| Net income                                                                                      |       | $                                                    | 15,707     |   | $ | 15,884 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:              |       |                                                 |       |   |   |
| Depreciation and  amortization                                                                  |       | 8,376                                                |       | 5,859 |   |
| Amortization of  deferred financing fees                                                        |       | 261                                                  |       | 261 |   |
| Stock-based  compensation                                                                       |       | 7,083                                                |       | — |   |
| Tax benefit from  exercise of stock options                                                     |       | —                                               |       | 7,059 |   |
| Deferred income  taxes                                                                          |       | (2,400                                               | )          | — |   |
| Changes in  operating assets and liabilities, net of effect of acquisitions:                    |       |                                                 |       |   |   |
| Accounts  receivable                                                                            |       | 9,429                                                |       | 6,659 |   |
| Merchandise  inventories                                                                        |       | 1,761                                                |       | (13,399 | ) |
| Prepaid expenses  and other current assets                                                      |       | 845                                                  |       | (1,849 | ) |
| Deposits and  other assets                                                                      |       | (264                                                 | )          | 1,011 |   |
| Accounts payable                                                                                |       | 9,832                                                |       | 25,177 |   |
| Accrued expenses  and other current liabilities                                                 |       | (35,312                                              | )          | (25,622 | ) |
| Merchandise  advances                                                                           |       | (3,196                                               | )          | (2,998 | ) |
| Other long-term  liabilities                                                                    |       | 732                                                  |       | 833 |   |
| Net cash  provided by operating activities                                                      |       | 12,854                                               |       | 18,875 |   |
| **Investing  activities:**                                                                      |       |                                                 |       |   |   |
| Purchase of  property and equipment                                                             |       | (16,099                                              | )          | (22,879 | ) |
| Purchase of  available-for-sale securities                                                      |       | —                                               |       | (27,305 | ) |
| Proceeds from  sale of available-for-sale securities                                            |       | —                                               |       | 1,309 |   |
| Acquisition of businesses                                                                       |       | (3,072                                               | )          | — |   |
| Net cash used in  investing activities                                                          |       | (19,171                                              | )          | (48,875 | ) |
| **Financing  activities:**                                                                      |       |                                                 |       |   |   |
| Net change in borrowing  under revolving line of credit                                         |       | (2,217                                               | )          | — |   |
| Proceeds from  exercise of stock options                                                        |       | 2,407                                                |       | 7,752 |   |
| Tax benefit from  exercise of stock options                                                     |       | 1,530                                                |       | — |   |
| Net cash  provided by financing activities                                                      |       | 1,720                                                |       | 7,752 |   |
| Net decrease in  cash and cash equivalents                                                      |       | (4,597                                               | )          | (22,248 | ) |
| Cash and cash  equivalents at beginning of period                                               |       | 14,529                                               |       | 60,453 |   |
| Cash and cash  equivalents at end of period                                                     |       | $                                                    | 9,932      |   | $ | 38,205 |   |
| **Non-cash  investing activities:**                                                             |       |                                                 |       |   |   |
| Acquisition of  businesses, in which the fair value of assets and liabilities were as  follows: |       |                                                 |       |   |   |
| Accounts  receivable                                                                            |       | $                                                    | 336        |   | $ | — |   |
| Merchandise  inventories                                                                        |       | 1,884                                                |       | — |   |
| Deferred income  taxes                                                                          |       | 887                                                  |       | — |   |
| Intangible  assets                                                                              |       | 5                                                    |       | — |   |
| Goodwill                                                                                        |       | 1,284                                                |       | — |   |
| Total assets  acquired                                                                          |       | 4,396                                                |       | — |   |
| Total  liabilities assumed – current liabilities                                           |       | (1,324                                               | )          | — |   |
| Net assets  acquired                                                                            |       | $                                                    | 3,072      |   | $ | — |   |

 

*See accompanying notes to consolidated financialstatements.*

 

5

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**GUITARCENTER, INC. AND SUBSIDIARIES**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**(Unaudited)**

 

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

** **

*Nature ofBusiness*

 

Guitar Center, Inc.(the “Company”) is the leading United States retailer of guitars, amplifiers,percussion instruments, keyboards and pro-audio and recording equipment. As ofMarch 31, 2006, our retail subsidiary operated 171 Guitar Center storesacross the United States, with 129 stores in 51 primary markets, 40 stores insecondary markets and two stores in tertiary markets. In addition, as ofMarch 31, 2006, our Music & Arts Center division operated 87stores specializing in band instruments for sale and rental, serving teachers,band directors, college professors and students. We are also the largest directresponse retailer of musical instruments in the United States through ourwholly owned subsidiary, Musician’s Friend, Inc., and its catalog and website,www.musiciansfriend.com.

 

*Basis ofPresentation*

 

In theopinion of management, the accompanying unaudited consolidated financialstatements contain all adjustments necessary to present fairly the financialposition of Guitar Center, Inc. and subsidiaries as of March 31, 2006 andDecember 31, 2005, and the results of operations and cash flows for the threemonths ended March 31, 2006 and 2005. 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, 2005.

 

Theresults of operations for the three months ended March 31, 2006 are notnecessarily indicative of the results to be expected for the full year.

 

*Useof Estimates in the Preparation of Financial Statements*

* *

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

 

**2.**Acquisitionof Businesses**

** **

During the three monthsended March 31, 2006, our Music & Arts Center division acquired a total ofsix stores and the related assets. The results of operations of the acquiredstores were not material to the consolidated financial statements and, as such,pro forma financial information is not presented for these acquisitions. Theresults of operations of the acquired stores are included in the consolidatedfinancial statements from the respective dates of acquisition.

 

The aggregate purchaseprice for the acquisitions in the first quarter of 2006 totaled $3.0 million,which was principally allocated to inventories of $1.9 million, accountsreceivable of $0.3 million and goodwill of $0.8 million.

 

On April 15, 2005,we completed the acquisition of Music & Arts Center, Inc., aMaryland-based musical instruments retailer with an emphasis on the beginningmusician. At the time of the acquisition, Music & ArtsCenter, Inc. operated 61 retail locations, primarily located in theNortheast, Mid-Atlantic and Southern regions of the U.S. We acquired Music& Arts Center, Inc. to expand our existing presence in the band andorchestra instrument business. The acquired business and our existing AmericanMusic Group business were combined into a new division under theMusic & Arts Center name. In the quarter ended March 31, 2006, werecorded purchase price adjustments resulting in a net increase in goodwill of$0.5 million.

 

All changes to goodwillduring the three months ended March 31, 2006 related to the Music & ArtsCenter segment.

 

6

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**3.**IntangibleAsset**

** **

Intangible assets withdefinite useful lives are amortized over their respective estimated usefullives. The following is a summary of intangible assets as of March 31, 2006 andDecember 31, 2005 (dollars in thousands, life in years):

 
| ** **                | ** ** | ** **                               | ** ** | **March 31, 2006** | ** ** |
|---------------------------|------------|------------------------------------------|------------|------------------------------|------------|
| ** **                | ** ** | **Weighted-  Average Useful  Life** | ** ** | **Gross  Carrying  Amount**  | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
| Unamortized  Trademark    |       | —                                   |       | $                            | 5,000      |   | $ | — |   | $ | 5,000 |   |
| Amortized                 |       |                                     |       |                         |       |   |   |   |   |
| Customer  contracts       |       | 1.4                                      |       | 3,430                        |       | (2,348 | ) | 1,082 |   |
| Covenants not to  compete |       | 3.7                                      |       | 2,205                        |       | (766 | ) | 1,439 |   |
| Other                     |       | 2.6                                      |       | 834                          |       | (414 | ) | 420 |   |
| Total Intangible Assets   |       |                                     |       | $                            | 11,469     |   | $ | (3,528 | ) | $ | 7,941 |   |

 
| ** **                | ** ** | ** **                               | ** ** | **December 31, 2005** | ** ** |
|---------------------------|------------|------------------------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **Weighted-  Average Useful  Life** | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
| Unamortized  Trademark    |       | —                                   |       | $                               | 5,000      |   | $ | — |   | $ | 5,000 |   |
| Amortized                 |       |                                     |       |                            |       |   |   |   |   |
| Customer  contracts       |       | 1.4                                      |       | 3,430                           |       | (1,734 | ) | 1,696 |   |
| Covenants not to  compete |       | 3.7                                      |       | 2,200                           |       | (596 | ) | 1,604 |   |
| Other                     |       | 2.6                                      |       | 834                             |       | (317 | ) | 517 |   |
| Total Intangible Assets   |       |                                     |       | $                               | 11,464     |   | $ | (2,647 | ) | $ | 8,817 |   |

 

Amortization ofintangible assets is included in selling, general and administrative expenses.

 

Estimated amortizationexpense related to intangible assets at March 31, 2006, for the remainder of2006 and for each of the years through December 31, 2009 is:  remainder of 2006 - $1.8 million; 2007 - $0.6million; 2008 - $0.3 million; 2009 - $0.2 million.

 

**4. Earnings Per Share**

** **

The following tablesummarizes the calculation of basic to diluted weighted average shares anddiluted income per share for the periods presented below:

 
| ** **                                                                | ** ** | **Three months ended March  31,**               | ** ** |
|---------------------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2006**                                                       | ** ** | **2005** | ** ** |
| ** **                                                                | ** ** | **(in thousands, except per  share data)** | ** ** |
| Net income, as  reported                                                  |       | $                                                              | 15,707     |   | $ | 15,884 |   |
| Add back  interest, net of tax, on 4% Senior Convertible Notes (a)   |       | 782                                                            |       | 727 |   |
| Net income  excluding interest expense on 4% Senior Convertible Notes     |       | $                                                              | 16,489     |   | $ | 16,611 |   |
|                                                                      |       |                                                           |       |   |   |
| Basic weighted  average shares outstanding                                |       | 26,176                                                         |       | 25,593 |   |
| Dilutive effect  of stock options outstanding                             |       | 795                                                            |       | 1,239 |   |
| Shares issuable  on assumed conversion of 4% Senior Convertible Notes (b) |       | 2,892                                                          |       | 2,892 |   |
| Diluted weighted  average shares outstanding                              |       | 29,863                                                         |       | 29,724 |   |
|                                                                      |       |                                                           |       |   |   |
| Diluted income  per share                                                 |       | $                                                              | 0.55       |   | $ | 0.56 |   |
|                                                                           |            |                                                                |            |  |  |  |  |  |  |

 

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(a)           Representsthe interest expense, including contingent interest and amortization ofdeferred financing costs, on the 4% Senior Convertible Notes (the “SeniorConvertible Notes”), net of tax, using an effective tax rate of 38.5%.

 

(b)           Representsthe number of common shares issuable upon the conversion of the SeniorConvertible Notes.

 

7

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For the three monthsended March 31, 2006 and 2005, the only potential additional shares of commonstock that could become outstanding were shares issuable upon exercise of stockoptions and the conversion of the Senior Convertible Notes.

 

For the three monthsended March 31, 2006, options to acquire 533,400 weighted-average sharesat prices ranging from $53.08 to $64.66 were outstanding but were excluded fromthe computation of diluted earnings per share because the exercise price ofthese options was greater than the average market price of our common stock.For the three months ended March 31, 2005, all options outstanding had adilutive effect.

 

For the three monthsended March 31, 2006 and 2005, the 2.9 million shares of common stock issuableupon conversion of the Senior Convertible Notes issued in June 2003(reflecting an effective conversion price of $34.58) are deemed to be potentialcommon stock and are deemed to be outstanding for the purposes of calculatingdiluted earnings per share under the “if-converted” method of accounting underwhich the after-tax interest expense, including contingent interest and amortizationof deferred financing costs, for the period is added back to net income.

 

**5. Segment Information**

** **

Our reportable businesssegments are Guitar Center stores, Music & Arts Center and Musician’sFriend direct response. Management evaluates segment performance basedprimarily on net sales and income (loss) before income taxes. Accountingpolicies of the segments are the same as the accounting policies for theconsolidated company. There are no differences between the measurements ofprofits or losses or assets of the reportable segments and those of the Companyon a consolidated basis.

 

The following tablesummarizes financial information for our operating segments as of March 31,2006 and December 31, 2005 and for the three months ended March 31, 2006and 2005 (in thousands):

 
| ** **                                    | ** ** | **Guitar Center** | ** ** | **Music & Arts (1)** | ** ** | **Direct Response** | ** ** | **Total**  | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|--------------------------|------------|------------|------------|
| Three months  ended March 31, 2006:           | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **               | ** ** | ** ** | ** ** |
| Net sales                                     |       | $                      | 339,291    |                                    | $          | 33,185                   |       | $          | 98,271     |   | $ | 470,747 |   |
| Gross profit                                  |       | 92,383                 |       | 15,423                                  |       | 28,700                   |       | 136,506    |       |
| Depreciation and  amortization                |       | 6,351                  |       | 1,306                                   |       | 719                      |       | 8,376      |       |
| Selling, general  and administrative expenses |       | 71,634                 |       | 14,973                                  |       | 22,507                   |       | 109,114    |       |
| Income (loss)  before income tax (benefit)    |       | 21,139                 |       | (2,302                                  | )          | 6,703                    |       | 25,540     |       |
| Capital  expenditures                         |       | 13,690                 |       | 924                                     |       | 1,485                    |       | 16,099     |       |
|                                          |       |                   |       |                                    |       |                     |       |       |       |
| Three months  ended March 31, 2005:           | ** ** | ** **             | ** ** | ** **                              | ** ** | ** **               | ** ** | ** ** | ** ** |
| Net sales                                     |       | $                      | 294,643    |                                    | $          | 10,238                   |       | $          | 91,505     |   | $ | 396,386 |   |
| Gross profit                                  |       | 79,690                 |       | 3,832                                   |       | 27,650                   |       | 111,172    |       |
| Depreciation and  amortization                |       | 4,828                  |       | 510                                     |       | 521                      |       | 5,859      |       |
| Selling, general  and administrative expenses |       | 61,438                 |       | 5,164                                   |       | 17,869                   |       | 84,471     |       |
| Income (loss)  before income tax (benefit)    |       | 17,834                 |       | (2,103                                  | )          | 10,095                   |       | 25,826     |       |
| Capital  expenditures                         |       | 21,456                 |       | 243                                     |       | 1,180                    |       | 22,879     |       |
|                                          |       |                   |       |                                    |       |                     |       |       |       |
| Total assets at  March 31, 2006               |       | $                      | 504,651    |                                    | $          | 196,617                  |       | $          | 71,836     |   | $ | 773,104 |   |
| Total assets at  December 31, 2005            |       | $                      | 512,802    |                                    | $          | 197,045                  |       | $          | 70,343     |   | $ | 780,190 |   |

 

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(1)           For thethree months ended March 31, 2005, the information included for theMusic & Arts Center division included only the operations of AmericanMusic.

 

**6. Stock-BasedCompensation**

** **

Effective January 1,2006, we adopted the provisions of, and account for stock-basedcompensation in accordance with, Statement of Financial Accounting Standards (“SFAS”)No. 123—revised 2004 (“SFAS No. 123(R)”), “*Share-Based Payment*,”which replaced SFAS No. 123, “*Accounting forStock-Based Compensation*,” and supersedes AccountingPrinciples Board ("APB") Opinion No. 25, “*Accountingfor Stock Issued to Employees*.” Under the fair value recognitionprovisions of this statement, stock-based compensation cost for optionawards is measured at the grant date based on the fair value of the award andis recognized as expense on a

 

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straight-line basis over the requisite serviceperiod, which is the vesting period. For performance share awards, stock-basedcompensation expense is measured at the market price of the Company's stock onthe date the underlying plan receives compensation committee approval, or otherform of a mutual understanding of the key terms and conditions of performance.We elected the modified prospective method, under which prior periods are notrestated for comparative purposes. The valuation provisions of SFAS No. 123(R)apply to new grants and to grants that were outstanding as of the effectivedate and are subsequently modified. Estimated compensation for unvested grantsthat were outstanding as of the effective date will be recognized over theremaining service period using the compensation cost estimated for the SFAS No. 123pro forma disclosures.

 

Total stock-basedcompensation expense included in our consolidated statement of income for thethree months ended March 31, 2006 was $7.1 million ($4.4 million, net of tax),or $0.15 per diluted share. As a result of adopting SFAS No. 123(R) onJanuary 1, 2006, our income before income taxes and net income for the threemonths ended March 31, 2006 were $4.3 million and $2.6 million lower,respectively, than if we had continued to account for stock-based compensationunder APB No. 25. If we had not adopted SFAS No. 123(R), our basicand diluted income per share for the three months ended March 31, 2006 wouldhave been increased by $0.10 and $0.09, respectively.

 

Prior to the adoption ofSFAS No. 123(R), we presented all tax benefits for deductions resultingfrom the exercise of stock options as operating cash flows on our consolidatedstatement of cash flows. SFAS No. 123(R) requires the benefits of taxdeductions in excess of recognized compensation expense to be reported as afinancing cash flow, rather than as an operating cash flow. This requirementwill reduce net operating cash flows and increase net financing cash flows inperiods after adoption. Total cash flow will remain unchanged from what wouldhave been reported under prior accounting rules. For the three months endedMarch 31, 2006, $1.5 million of tax benefit from exercise of stock optionsreported in financing cash flows would have been reported as in operating cashflows had SFAS No. 123(R) not been adopted.

 

The following tabledetails the effect on net income and income per share as if we had applied thefair value recognition provisions of SFAS No. 123 to stock-basedcompensation during the three months ended March 31, 2005 (in thousands, exceptper share data):

 
| ** **                                                                                                                                     | ** ** | **Three months ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **March 31, 2005**     | ** ** |
| Net income, as  reported                                                                                                                       |       | $                                | 15,884     |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  methods for all awards, net of related tax effects |       | 1,425                            |       |
| Pro forma net  income                                                                                                                          |       | $                                | 14,459     |   |
|                                                                                                                                           |       |                             |       |
| Income per  share:                                                                                                                             |       |                             |       |
| Basic—as  reported                                                                                                                        |       | $                                | 0.62       |   |
| Basic—pro forma                                                                                                                           |       | $                                | 0.56       |   |
| Diluted—as  reported                                                                                                                      |       | $                                | 0.56       |   |
| Diluted—pro  forma                                                                                                                        |       | $                                | 0.51       |   |
|                                                                                                                                                |            |                                  |            |  |  |

 

*Incentive Compensation Plans*

 

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

 

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

 

Under the 2004 Plan andthe Prior Plans, an aggregate of 1.1 million shares of common stock wereavailable for issuance as of March 31, 2006. On April 28, 2006, our stockholdersapproved an additional 0.7 million shares to be available for grant under the2004 Plan. The Company generally issues new shares for stock option exercises,performance share awards and restricted stock awards.

 

*Stock Options*

 

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

 

9

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

 

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

 

The assumptions used tovalue option grants for the quarters ended March 31, 2006 and 2005 are asfollows:

 
| ** **                            | ** ** | **Three months ended March 31,** | ** ** |
|---------------------------------------|------------|------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Valuation Model                       |       | Binomial  Lattice                                    |       | Black-  Scholes |   |
| Expected  volatility range            |       | 35 – 50                                         | %          | NA |   |
| Weighted-average  expected volatility |       | 42.4                                                 | %          | 59.7 | % |
| Expected term  (in years)             |       | 4.75 – 5.74                                     |       | 6.36 |   |
| Risk-free  interest rate              |       | 4.4 – 4.8                                       | %          | 4.3 | % |
| Expected  dividends                   |       | —                                               |       | — |   |

 

Stock option activityfor all plans during the three months ended March 31, 2006 is as follows:

 
| ** **                             | ** ** | **No. of Shares** | ** ** | **Weighted -  Average  Exercise Price** | ** ** | **Weighted-  Average  Remaining  Contractual Term  (in years)** | ** ** | **Aggregate  Intrinsic Value  (in thousands)** | ** ** |
|----------------------------------------|------------|-----------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| Outstanding at  December 31, 2005 |       | 2,802,394                   |       | $                                                 | 31.94      |                                                                      |       |                                                     |       |   |
| Granted                                |       | 15,000                      |       | 54.72                                             |       |                                                                      |       |                                                     |       |
| Exercised                              |       | (142,976                    | )          | 16.83                                             |       |                                                                      |       |                                                     |       |
| Forfeited                              |       | (19,048                     | )          | 49.37                                             |       |                                                                      |       |                                                     |       |
| Outstanding at  March 31, 2006    |       | 2,655,370                   |       | $                                                 | 32.76      |                                                                      | 6.84       |                                                     | $          | 46,106 |   |
|                                   |       |                        |       |                                              |       |                                                                      |       |                                                     |       |
| Exercisable at  March 31, 2006         |       | 1,623,865                   |       | $                                                 | 22.96      |                                                                      | 4.55       |                                                     | $          | 39,882 |   |

 

The weighted-averagegrant-date fair value of options granted during the three months ended March31, 2006 was $19.80. There were no stock option grants in the three monthsended March 31, 2005. The aggregate intrinsic value of options (the amount bywhich the stock price on the date of exercise exceeded the stock price of theoption on the date of grant) exercised during the three months ended March 31,2006 and 2005 was $5.1 million and $21.7 million, respectively.

 

In February 2006, theCompany entered into an agreement (the “Transition Agreement”) with its formerChief Financial Officer upon his retirement from the Company. The TransitionAgreement provided for the immediate acceleration of all of his outstandingoptions totaling 32,002 shares. The resulting stock-based compensation expenserecognized in the three months ended March 31, 2006 related to thisacceleration was $0.8 million ($0.5 million net of tax).

 

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*EmployeeStock Purchase Plan*

* *

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

 

For the quarter endedMarch 31, 2006, the ESPP option grants were valued using a lattice-basedbinomial model. The assumptions were as follows:  expected volatility range 32 – 40% withaverage expected volatility of 36%, expected term 6 months, and risk-freeinterest rate 4.0%. The weighted-average grant-date fair value of the ESPPoptions granted during the three months ended March 31, 2006 was $12.88.

 

*LongTerm Incentive Plan*

* *

In July 2005, we adoptedthe 2005 Long Term Incentive Plan (the “LTIP”), which provides equityincentives to senior management that include not only stock options or similargrants, but also a performance share program that measures performance on amulti-year basis. The performance period under the LTIP began on July 1,2005 and ends on December 31, 2007. Awards under the LTIP are made underthe 2004 Plan or any successor plan. It is expected that each participant willreceive an annual grant of stock options under the 2004 Plan, pursuant to itsterms. Performance shares in the form of common stock are earned by theparticipants based upon specified objective performance goals during the tenquarter performance period of the LTIP. The target number of performance sharespotentially issuable under the LTIP is expected to be 244,800, with the actualnumber of shares ultimately issuable to be between zero and twice such amount,depending on actual performance and number of participants. The number ofshares issuable could also increase if we add additional executives to the plan.The compensation committee also has the discretion to make cash payments inlieu of performance shares.

 

Stock-based compensationexpense related to the LTIP is estimated based on our ten quarter forecastedperformance compared to plan targets. At the end of each reporting period, wereevaluate our assessment of performance under the plan and make adjustments tothe expense as necessary based on the latest estimates available. The grant-datefair value was based on the quoted market value on the date the LTIP receivedfinal approval from the compensation committee in September 2005.

 

For the quarter endedMarch 31, 2006, we recorded stock-based compensation expense related to theLTIP of $3.3 million ($2.0 million net of tax), or $0.07 per diluted share. Includedin the $3.3 million expense is $1.8 million ($1.1 million after tax), or $0.04per diluted share, of stock-based compensation expense related to the LTIP thatshould have been recorded in the fourth quarter of 2005 under the variable planaccounting method established by APB No. 25. We do not believe that thismisstatement is material to our current or previously issued consolidatedfinancial statements. Stock-based compensation for the LTIP related to thequarter ended March 31, 2006 was $1.5 million ($0.9 million net of tax), or$0.03 per diluted share.

 

*Restricted Stock Awards*

 

Restricted stock awardshave generally been made to the directors of the Company and are measured onthe date of grant. These time-based awards vest over three to five years andare forfeitable under certain conditions.

 

11

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A summary of the Company’sperformance share and restricted stock awards as of and for the three monthsended March 31, 2006 is presented below:

 
| ** **                                      | ** ** | **No. of Shares  (1)** | ** ** | **Weighted-Average  Grant-Date Fair  Value** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|---------------------------------------------------|------------|
| Nonvested balance  at December 31, 2005    |       | 502,698                          |       | $                                                 | 56.06      |   |
| Granted                                         |       | 319                              |       | 54.72                                             |       |
| Vested                                          |       | (969                             | )          | 46.22                                             |       |
| Forfeited                                       |       | —                           |       | —                                            |       |
| Nonvested balance  stock at March 31, 2006 |       | 502,048                          |       | $                                                 | 56.08      |   |

 

----

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

 

*The total fair value ofrestricted stock vested during the three months ended March 31, 2006 wasimmaterial. Based on our latest estimates, there was $7.7 million ($4.7 millionnet of tax) of total unrecognized compensation cost for nonvested shares, as ofMarch 31, 2006, that is expected to be recognized over a period of 1.8 years.*

* *

**7. Legal Proceedings**

** **

On November 29,2005, a case was filed against us and other defendants, including our ChiefExecutive Officer, in the United States District Court for the Southern Districtof Florida. The complaint asserts, among other things, violations of theFederal Racketeering Influenced and Corrupt Organization Act (RICO) and acorresponding Florida statute, Sections 1 and 2 of the Sherman Antitrust Act,Section 2 of the Clayton Act (as amended by the Robinson-Patman Act), theAntidumping Act of 1916, the Florida Antitrust Act of 1980, and the FloridaDeceptive and Unfair Trade Practices Act, as well as tortious interference withbusiness relationship under Florida law and civil conspiracy under Florida lawby some or all of the identified defendants in connection with the claimedinability of Ace Pro Sound and Recording, L.L.C. to obtain vendor lines for itsstore. The complaint purports to be made as a class action on behalf of allcurrent and former retail sellers of musical instruments and/or sound equipmentand/or recording equipment with stores located in geographical regions in theUnited States wherein some or all of the defendants have carried on business,and seeks compensatory damages, treble damages, punitive damages, injunctiverelief and attorneys’ fees.

 

On March 6, 2006,defendants, jointly and separately, filed responsive pleadings comprised offour motions to dismiss and a motion to strike. On or about March 21, 2006,plaintiff sought leave of the court to file an amended complaint, which wasgranted by the court. The amended complaint was filed by plaintiff on April 10,2006. The amended complaint abandoned an alleged violation of the AntidumpingAct of 1916, and now asserts, among other things, additional common lawviolations. We and the other defendants have 30 days to file responsivepleadings.

 

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

 

On October 13,2004, a putative class action lawsuit entitled Carlos Rodriguez v. The GuitarCenter, Inc. [sic], Case No. GC322958, was filed in the SuperiorCourt of the State of California for the County of Los Angeles. The lawsuit wasfiled by an individual purporting to represent all hourly retail storeemployees employed by us within the State of California. On December 15,2004, a putative class action lawsuit entitled James McClain et. al. v. GuitarCenter Stores, Inc., Case No. BC326002, was filed in the SuperiorCourt of the State of California for the County of Los Angeles. The lawsuit wasfiled by three individuals purporting to represent all hourly retail storeemployees employed by us within the State of California. Among other things,the lawsuits alleged that we improperly failed to document and enforcebreak-time and lunch-time periods for such employees and sought an unspecifiedamount of damages, penalties and attorneys’ fees. In March 2006, the courtgranted its preliminary approval of the proposed class settlement that we hadreached with the other parties on December 15, 2005. Under the terms of theproposed settlement, we will make cash payments of up to $3.5 million to fullyresolve claims by eligible class members, including payments to class membersand payments for plaintiff attorneys’ fees and the costs of a third-partyadministrator.

 

In addition to thelawsuits described above, we are involved in various claims and legal actionsarising in the ordinary course of our business and, while the results of thoseproceedings cannot be

 

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predicted withcertainty, we believe that the final outcome of those matters will not have amaterial adverse effect on our business, financial condition and results ofoperations.

 

**8. Subsequent Events**

** **

**On April 26, 2006, we enteredinto an amendment of our credit facility. The amendment increases the maximumborrowings available under the credit facility from $125 million to $200million, with the option to increase the line an additional $50 million undercertain circumstances, as defined, in each case subject to borrowing base andminimum availability limitations. The amendment also extends the maturity dateof the facility to December 2011, reduces the interest rate charged over theapplicable index rates and increases the borrowing base as a percentage ofworking capital. Details of the amendment were included in the Current Report onForm 8-K we filed on April 26, 2006.**

** **

**On April 28, 2006, ourstockholders approved an increase in the number of authorized shares of commonstock from 55 million to 100 million and an increase to the shares availablefor grant under the 2004 Plan from 2.1 million to 2.8 million.**

** **

**Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

** **

**General**

 

Guitar Center, Inc.is the leading United States retailer of guitars, amplifiers, percussioninstruments, keyboards and pro-audio and recording equipment. As ofMarch 31, 2006, our retail subsidiary operated 171 Guitar Center storesacross the United States, with 129 stores in 51 primary markets, 40 stores insecondary markets and two stores in tertiary markets. In addition, as ofMarch 31, 2006, our Music & Arts Center division operated 87stores specializing in band instruments for sale and rental, serving teachers,band directors, college professors and students. We are also the largest directresponse retailer of musical instruments in the United States through ourwholly owned subsidiary, Musician’s Friend, Inc., and its catalog andwebsite, www.musiciansfriend.com.

 

During the firstquarter, we opened a total of 10 Guitar Center stores, including three primarymarket stores in Allen Park, Michigan, El Paso, Texas and Clearwater, Florida, sixsecondary market stores in Madison, Wisconsin, Appleton, Wisconsin, Rockford,Illinois, Portland, Maine, Evansville, Indiana, and Gilroy, California and onetertiary market store in Terre Haute, Indiana. These stores added 118,450square feet of Guitar Center retail space and brought us to a total of 2.5 millionsquare feet of Guitar Center retail space at the end of the quarter.

 

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

 

From2001 to 2005, our net sales grew at an annual compound growth rate of 17%,principally due to the comparable store sales growth of our retail storesaveraging 7% per year, the opening of new stores, and a 21% per year increasein the direct response channel. We believe such volume increases are the resultof the continued success of the implementation of our business strategy,continued growth in the music products industry and increasing consumerawareness of the Guitar Center, Musician’s Friend and Music & ArtsCenter brand names. We achieved comparable store sales growth of 6.3% for thefirst quarter of 2006 compared to 5.3% for the first quarter of 2005 for our GuitarCenter retail division. We believe this growth reflects the strength of ourmerchandise selection, effective advertising and promotion, and well-trainedand committed personnel.

 

**FinancialReporting Change**

** **

InDecember 2004, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), *Share-Based Payment*(“SFAS No. 123(R)”),effective for a company’s first fiscal year beginning after June 15, 2005. SFASNo. 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees*.SFAS No. 123(R) requires all

 

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share-basedcompensation to employees, including grants of employee stock options, to berecognized in the consolidated statements of income based on fair values ratherthan pro forma footnote disclosure.

 

EffectiveJanuary 1, 2006, we adopted SFAS No. 123(R), and elected the modifiedprospective transition method. This method permits us to apply the newrequirements on a prospective basis. For additional information on our adoptionofSFAS No. 123(R), see Note 6, Stock-BasedCompensation, of the Notes to Consolidated Financial Statements in thisQuarterly Report on Form 10-Q.

 

**ExecutiveSummary**

** **

Consolidated net sales forthe quarter ended March 31, 2006 increased 18.8%, or $74.4 million, to $470.7million compared to $396.4 million in the first quarter of 2005. Consolidatednet income for the quarter was $15.7 million, which is a decrease of 1.1%compared to the first quarter of 2005. Income per diluted share decreased to$0.55 from $0.56 in the first quarter of 2005.

 

For the quarter, ourGuitar Center stores generated 6.3% comparable store sales growth and anincrease of 15.2% in total net sales compared to the first quarter of 2005. Salesfrom new stores totaled $26.3 million and represented 58.9% of the overall increasein sales. We opened 10 new Guitar Center stores in the quarter.

 

Musician’s Friend, ourdirect response unit, generated an increase in net sales of 7.4% for thequarter to $98.3 million compared to $91.5 million in the first quarter of 2005.Within the overall sales increase for direct response, our web-based sales grewat a rate of 12.7% in the first quarter of 2006, reflecting an increasedconsumer preference in using the web to place orders. Gross profit marginsdecreased by 1.0% of net sales reflecting a lower selling margin due to reducedshipping and handling revenue resulting from the competitive environment andhigher freight expense.

 

On April 15, 2005, wecompleted our acquisition of Music & Arts Center, Inc., aMaryland-based musical instrument retailer with an emphasis on the beginningmusician. The acquired business was combined with our former American Musicbusiness into a new division of our retail store subsidiary that operates underthe Music & Arts Center name. Financial results for the first quarterof 2005 reflect only our former American Music stores and do not includeresults from the acquired business. However, comparable sales for the quarterare computed using the combined comparable sales of Music & ArtsCenter, Inc. and American Music stores.

 

Primarily as a result ofthis acquisition, the net sales for the Music & Arts Center businessincreased to $33.2 million for the three months ended March 31, 2006 from $10.2million for the same period in 2005. Comparable sales for the quarter decreased1.4%. Comparable sales decreased principally due to the reduction in low margininstitutional sales which is not part of our ongoing Music & ArtsCenter strategy. We saw gross margin expand to 46.5% for the three months endedMarch 31, 2006 compared to 37.4% for the same period in 2005. This marginexpansion is principally due to improved product mix and better pricing underthe Music & Arts Center business and the elimination of theinstitutional sales.

 

**Discussion of CriticalAccounting Policies**

** **

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

 

*Valuationof Inventory*

* *

We value our merchandiseinventory at the lower of cost using the weighted-average method or market.Rental inventories are valued at the lower of cost or market using the specificidentification method and are depreciated on a straight-line basis while outunder a rental agreement for rent-to-own sales. We record adjustments to thevalue of inventory based upon obsolescence and changes in market value.Applicable costs associated with bringing inventory through our Guitar Centerretail distribution center are capitalized to inventory. The amounts areexpensed to cost of goods sold as the associated inventory is sold. Managementhas evaluated the current level of inventories considering future customerdemand for our products, taking into account general economic conditions,growth prospects within the marketplace,

 

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competition, marketacceptance of current and upcoming products, and management initiatives. Basedon this evaluation, we have recorded impairment adjustments to inventory and tocost of goods sold for estimated decreases in net realizable value. Thesejudgments are made in the context of our customers’ shifting needs, product andtechnological trends, and changes in the demographic mix of our customers. Amisinterpretation or misunderstanding of these conditions and uncertainties inthe future outlook of our industry or the economy, or other failure to estimatecorrectly, could result in inventory valuation changes as of any given balancesheet date.

 

*Valuationof Long-Lived Assets*

* *

Long-lived assets suchas property and equipment and identifiable intangibles with finite lives arereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable. Goodwill and otherintangibles with indefinite lives that are not amortized are required to bereviewed for impairment on an annual basis, or more frequently when triggeringevents occur. Factors we consider important, 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 assetsother than goodwill and intangibles that are not amortized, the determinationof whether impairment has occurred is based on an estimate of undiscountedfuture cash flows attributable to the assets, as compared to the carrying valueof the assets. Assumptions used in these cash flows are consistent withinternal forecasts and consider current and future expected sales volumes andrelated operating costs and any anticipated increases or declines based onexpected market conditions and local business environment factors. If apotential impairment is identified, the amount of the impairment lossrecognized would be determined by estimating the fair value of the assets and recordinga loss if the fair value was less than the book value. Fair value will bedetermined based on appraisal values assessed by third parties, if deemednecessary, or a discounted future cash flows analysis. For goodwill and otherintangibles that are not amortized, impairment to be recognized is measured asthe amount by which the carrying amount of the assets exceeds the fair value ofthe related assets of the underlying reporting unit to which the goodwillrelates.

 

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

 

*SalesReturns*

* *

As part of our “satisfactionguaranteed” policy, we allow Guitar Center customers to return productgenerally within 30 days after the date of purchase, and we allow Musician’sFriend customers to return product within 45 days. Music & Arts Centercustomers have 14 business days from the date of purchase to return product. Weregularly review and revise, when deemed necessary, our estimates of salesreturns based upon historical trends. While our estimates during the past fewyears have approximated actual results, actual returns may differ significantlyfrom estimate, either favorably or unfavorably, if factors such as economicconditions or the competitive environment differ from our expectations.

 

*Creditsand Other Vendor Allowances*

* *

We receive cooperativeadvertising allowances (i.e., an allowance from the manufacturer to subsidizequalifying advertising and similar promotional expenditures we make relating tothe vendor’s products), price protection credits (i.e., credits from vendorswith respect to in-stock inventory if the vendor subsequently lowers theirwholesale price for such products) and vendor rebates (i.e., credits or rebatesprovided by vendors based on the purchase of specified products and paid at alater date). Cooperative advertising allowances are recognized as a reductionto selling, general, and administrative expense when we incur the advertisingexpense eligible for the credit. We recognized cooperative advertisingallowances of $2.8 million and $1.6 million for the three months ended March 31,2006 and 2005, respectively, recorded as an offset to selling, general andadministrative expense. Price protection credits and vendor rebates areaccounted for as a reduction of the cost of merchandise inventory and arerecorded at the time the credit or rebate is earned. The effect of priceprotection credits and vendor rebates is recognized in the income

 

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statement at the timethe related inventory is sold as a reduction in cost of goods sold. The reservesagainst cooperative advertising and rebate receivables are determined byspecifically identifying uncollectible accounts through an aging review and ananalysis of vendor relationships. We received payments for vendor rebates of $9.4million and $7.8 million for the three months ended March 31, 2006 and 2005,respectively. We earned and recognized vendor rebates of $9.2 million and $7.2million for the three months ended March 31, 2006 and 2005, respectively.None of these credits are recorded as revenue.

 

*Stock-basedCompensation*

* *

Effective January 1,2006, we adopted SFAS No. 123(R) to account for our stock-basedcompensation plans. We elected the modified prospective method of adoption,which permitted application of the new requirements on a prospective basis. Accordingly,prior period amounts have not been restated. Under this application,stock-based compensation is recorded for all awards granted on or after thedate of adoption and for the portion of previously granted awards that remainunvested at the date of adoption. Currently, our stock-based compensationexpense relates to stock options, our employee stock purchase program,performance share awards, and restricted stock awards.

 

Under SFAS No. 123(R), wedetermine the fair value of stock options, including options granted under ourEmployee Stock Purchase Plan (the “ESPP”), using a lattice-based binomialmodel. Assumptions used in the model were developed in consultation with anoutside valuation specialist. The model requires the input of severalassumptions including expected volatility, dividend yield, and risk-free rateof return, as well as certain assumptions regarding exercise behavior.Assumptions were developed separately for our senior management from the otherparticipants of our stock plans, since senior management’s exercise behavior isexpected to differ materially from the other participants. These assumptionsreflect management’s best estimates, but they involve inherent uncertaintiesbased on market conditions, generally outside of our control. As a result, ifother assumptions were used, total stock-based compensation cost, as determinedin accordance with SFAS No. 123(R) could have been materiallyimpacted. Furthermore, if different assumptions are used for future grants,stock-based compensation could be materially impacted in future periods.

 

Also, under SFAS No. 123(R),stock-based compensation expense is recorded net of estimated forfeitures. Theforfeiture rate assumption used in determining stock-based compensation expenseis estimated based on historical data. The actual forfeiture rate could differfrom these estimates.

 

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

 

**Results of Operations**

** **

The following tablepresents our consolidated statements of income, as a percentage of sales, forthe periods indicated:

 
| ** **                                    | ** ** | **Three months ended March  31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| ** **                                    | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Net sales                                     |       | 100.0                                            | %          | 100.0 | % |
| Gross profit                                  |       | 29.0                                             |       | 28.0 |   |
| Selling, general  and administrative expenses |       | 23.2                                             |       | 21.3 |   |
| Operating income                              |       | 5.8                                              |       | 6.7 |   |
| Interest  expense, net                        |       | 0.4                                              |       | 0.2 |   |
| Income before  income tax expense             |       | 5.4                                              |       | 6.5 |   |
| Income taxes                                  |       | 2.1                                              |       | 2.5 |   |
| Net income                                    |       | 3.3                                              | %          | 4.0 | % |

 

**ThreeMonths Ended March 31, 2006 Compared to the Three Months Ended March 31, 2005**

 

Net sales for the three months ended March 31, 2006increased 18.8% to $470.7 million, compared to $396.4 million for the sameperiod in 2005.

 

Net sales from Guitar Center stores for the threemonths ended March 31, 2006 totaled $339.3 million, a 15.2% increase from $294.6million for the same period in 2005. Sales from new stores were

 

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$26.3million and represented 58.9% of the total increase in Guitar Center retailstore sales. Comparable Guitar Center store sales for the quarter increased 6.3%.Comparable store sales are defined as sales for the comparable periods,excluding net sales attributable to stores not open for 14 months as of the endof the reporting period. We believe that comparable store sales are a moreuseful indicator of store performance than the change in total net sales, sincecomparable store sales exclude the effects of changes in the number of storesopen.

 

The financialinformation for the Music & Arts Center division for the three months endedMarch 31, 2006 include the results of the combined businesses ofMusic & Arts Center, Inc. and American Music, while the resultsfor the first quarter of 2005 include only American Music. However, comparablesales for the quarter are computed using the combined comparable sales ofMusic & Arts Center, Inc. and American Music. Net sales fromMusic & Arts Center for the three months ended March 31, 2006 totaled$33.2 million compared to $10.2 million for the same period in 2005. Theincrease in net sales is primarily due to the acquisition of Music & ArtsCenter, Inc. on April 15, 2005. Comparable sales for only American Musiclocations decreased 22.2% while comparable sales for only Music & ArtsCenter locations increased 8.3%, resulting in a combined comparable salesdecrease of 1.4% for the first quarter of 2006. Comparable sales decreased atAmerican Music principally due to the reduction in low margin institutionalsales which is not part of our ongoing Music & Arts Center strategy.

 

Net sales from the direct response channel totaled $98.3million for the three months ended March 31, 2006, a $6.8 million, or 7.4%,increase from 2005. Sales from the contact center, which represent sales placedvia phone, live chat, mail and e-mail, increased to $38.6 million for the threemonths ended March 31, 2006 compared to $38.5 million for the same period in2005. We continue to face increased competition. We expect that this trend ofincreased competition in the direct response channel and its negative impact onthat segment’s net sales and gross margin to continue for the foreseeablefuture. Internet sales from orders placed via the Musician’s Friend,Giardinelli, Amazon and Musician.com web sites increased 12.7% to $59.7 millionin the first quarter of 2006 from $53.0 million for the same period in 2005. Thegrowth of web-based sales reflects the continued trend of our catalog customers’preference in using the web to place their orders, the success of web-basedpromotions, and that the web site includes a more complete inventorypresentation than our catalogs.

 

Consolidated gross profit for the three months ended March31, 2006 compared to 2005 increased 22.8% to $136.5 million from $111.2 million.Gross profit as a percentage of net sales for the three months ended March 31,2006 compared to 2005 increased to 29.0% from 28.0%.

 

Gross profit as a percentage of net sales for GuitarCenter was 27.2% in the first quarter of 2006 compared with 27.0% in the firstquarter of 2005. The increase is due to higher selling margin 0.7% offset byhigher occupancy costs 0.3% and higher freight costs 0.2%. We define sellingmargin as net sales less the cost of the associated merchandise charged by thevendor plus the associated inventory costs from fulfilling inventory throughour distribution center. The cost of merchandise inventory is net of allassociated vendor discounts and rebates. Freight is not included in sellingmargin.

 

The gross profit margin for the Music & ArtsCenter division was 46.5% for the three months ended March 31, 2006 compared to37.4% for the same period in 2005. The increase in gross profit margin is dueto higher selling margin 10.3% offset by increased shrink 1.0% and higheroccupancy costs 0.2%. The improved selling margin was driven by a change inproduct mix and better pricing under the Music & Arts business as comparedto the American Music business in 2005. We discontinued our low margininstitutional business sales which are not part of our ongoing Music & ArtsCenter strategy.

 

Gross profit margin for the direct response divisionwas 29.2% for the three months ended March 31, 2006 compared to 30.2% in thefirst quarter of 2005. The decrease was primarily due to lower selling margindue to reduced shipping and handling income resulting from the competitiveenvironment 0.7%, increased freight costs 0.2% and increased purchasing costs0.1%.

 

Consolidated selling, general and administrativeexpenses for the three months ended March 31, 2006 increased 29.2% to $109.1 millionfrom $84.5 million for the same period in 2005. As a percentage of netsales, selling, general and administrative expenses were 23.2% for the firstquarter in 2006 compared to 21.3% in the first quarter of 2005. The increase inthe SG&A rate as a percentage of sales was primarily due to stock-basedcompensation expenses and the one-time severance expense for the retirement ofour former Chief Financial Officer. For the three months ended March 31, 2006,total stock-based compensation expenses were $7.1 million, or 1.5% ofconsolidated net sales, comprised of the following components:

 

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| ** **                                                                                                              | ** ** | **Amount in  millions** | ** ** | **% of  consolidated  net sales** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|---------------------------------------------|------------|
| **Stock-based  Compensation Expense for the three months ended March 31, 2006:**                                        | ** ** | ** **                   | ** ** | ** **                                  | ** ** |
| Stock options  and ESPP for the quarter ended March 31, 2006                                                            |       | $                            | 3.0        |                                        | 0.6        | % |
| Acceleration of  stock option vesting related to the retirement of our former Chief Financial  Officer in February 2006 |       | 0.8                          |       | 0.2                                         |       |
| Total expense  from options and ESPP                                                                                    |       | 3.8                          |       | 0.8                                         |       |
| LTIP performance  related to the fourth quarter of 2005                                                                 |       | 1.8                          |       | 0.4                                         |       |
| LTIP performance  related to the quarter ended March 31, 2006                                                           |       | 1.5                          |       | 0.3                                         |       |
| Total expense  from LTIP                                                                                                |       | 3.3                          |       | 0.7                                         |       |
| Total  stock-based compensation expense                                                                                 |       | $                            | 7.1        |                                        | 1.5        | % |

 

The stock-based compensation related to stock optionsand ESPP was recorded as a result of the adoption ofSFAS No. 123(R) effective January 1, 2006. Upon the retirement of our formerChief Financial Officer in February 2006, all of his remaining unvested optionstotaling 32,002 shares immediately vested. Pursuant to SFAS No. 123(R), astock-based compensation expense in the amount of $0.8 million was recorded dueto the vesting acceleration. A total of $3.3 million of stock-basedcompensation expense related to the LTIP was recorded in the three months endedMarch 31, 2006. Included in this figure was $1.8 million of expense that shouldhave been recorded in the consolidated financial statements in the fourthquarter of 2005. The error was discovered subsequent to the issuance of the2005 consolidated financial statements. We do not believe that thismisstatement is material to our current or previously issued consolidatedfinancial statements. The remaining LTIP expense of $1.5 million relates to theinitial adoption of SFAS No. 123(R) and recognition of performance underthe LTIP provisions for the first quarter of 2006.

 

Selling, general and administrative expenses for theGuitar Center stores in the first quarter of 2006 were 21.1% as a percentage ofnet sales compared to 20.9% in first quarter of 2005. The increase is primarilydue to stock-based compensation expense allocated to this segment 1.2% and severanceexpense related to the retirement of our former Chief Financial Officer 0.2% offsetby improved leveraging of advertising costs 0.5% and improved leveraging ofcorporate overhead, including lower profit sharing expense 0.3% and lower equipmentrent costs 0.4%.

 

Selling, general and administrative expenses for Music& Arts Center were 45.1% of sales in the first quarter of 2006 compared to 50.4%in the first quarter of 2005. The reduction in expenses was primarily due toimproved leveraging on the higher revenue base of the combined businesses ofMusic & Arts Center, Inc. and American Music. The reductions as apercentage of net sales were in payroll 6.0%, depreciation 3.1%, automobile andtravel 1.5%, and computer maintenance 0.9%. Higher expenses were experienced inthe first quarter of 2006 in amortization expense associated with intangibleassets from acquired businesses 2.4%, stock-based compensation expenseallocated to this segment 2.0%, bad debt expense 1.3% and credit card expense0.5%.

 

Selling, general and administrative expenses for thedirect response division were 22.9% of sales in the first quarter of 2006 comparedto 19.5% in the first quarter of 2005. The increase was primarily due tostock-based compensation expense allocated to this segment 2.4%, higher salarycosts 0.8%, insurance 0.4%, computer maintenance 0.2%, depreciation andamortization 0.2%, moving expense 0.1%, and supplies expense 0.1% offset by loweradvertising 0.9%. The lower advertising was primarily the result of reducedcatalog circulation, offset somewhat by higher web-based marketing.

 

Operating income increased 2.6% to $27.4 million forthe three months ended March 31, 2006 from $26.7 million in the comparable 2005period. As a percentage of net sales, consolidated operating income declined to5.8% from 6.7% in the first quarter of 2005. This decline reflects the impactof the stock-based compensation expenses and the one-time severance expensesfor the retirement of our former Chief Financial Officer partially offset by improvedconsolidated gross profit margins in the first quarter of 2006.

 

Interestexpense, net for the three months ended March 31, 2006 increased to $1.9 millionfrom $0.9 million in the first quarter of 2005. The increase is due to borrowingsunder the revolving credit facility that were primarily used to fund theacquisition of Music & Arts Center, Inc. on April 15, 2005.

 

Forthe three months ended March 31, 2006, a $9.8 million provision for incometaxes was recorded compared to $9.9 million for the same period in 2005, basedon an effective tax rate of approximately 38.5% for both periods. The effectivetax rate is subject to ongoing review and evaluation and may fluctuate infuture quarters.

 

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Netincome for the three months ended March 31, 2006 decreased 1.1% to $15.7million, compared to $15.9 million in the same period in 2005 as a result ofthe combinations of factors described above.

 

### **Liquidity and Capital Resources**

 

Our need for liquiditywill arise primarily from the funding of capital expenditures, 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. Pleasesee “Risk Factors” in our Annual Report on Form 10-K filed for the year endedDecember 31, 2005 for a discussion of factors which could reasonably likelyresult in a decrease in the amount of internally generated funds available tofinance capital expenditures and working capital requirements. As of March 31,2006, we had $30.0 million in borrowings outstanding under our credit facilityand had available borrowings of $77.9 million (net of $7.1 million ofoutstanding letters of credit).

 

Our credit facility witha syndicate of banks led by Wells Fargo Retail Finance, as amended throughApril 26, 2006, permits borrowings up to $200 million (which may be increasedto $250 million at our option), subject to borrowing base limitations. Theactual amount available is tied to our inventory and receivable base, and ourobligations under the credit facility are secured by liens on our principalassets. Borrowing options are prime rate plus applicable prime margin, orLondon Interbank Offered Rate (“LIBOR”), plus applicable LIBOR margin. Theapplicable prime and LIBOR margins are based upon levels of excess availabilityand adjusted quarterly. If excess availability is greater than $30 million, theapplicable prime margin is -0.25% and applicable LIBOR margin is 0.75%. Ifexcess availability is less than or equal to $30 million and greater than $15million, the applicable prime margin is 0.00% and the applicable LIBOR marginis 1.00%. If excess availability is less than or equal to $15 million, theapplicable prime margin is 0.00% and the applicable LIBOR margin is 1.25%. Anunused fee of 0.25% is assessed on the unused portion of the credit facility.The agreement underlying the credit facility includes significant restrictivenegative covenants. Among other things, these covenants restrict or prohibitour ability to incur debt and issue specified equity instruments, incur lienson our assets, make any significant changes in our corporate structure or thenature of our business, dispose of assets, make guaranties, prepay debt, engagein a change in control transaction, pay dividends, make investments oracquisitions, engage in transactions with affiliates and incur capitalexpenditures, and also require that we satisfy a minimum availability test. Theminimum availability test requires that we maintain $12.5 million of reservedavailability under the agreement based on its borrowing base limitations. Theamount we disclose in our public reports from time to time as available toborrow under the agreement is already reduced by this required reserve andoutstanding letters of credit, and thus represents a net amount available underthe agreement. The agreement also includes representations and warranties whichmust be true each time we borrow funds under the credit facility andaffirmative covenants. The full text of the contractual requirements imposed bythis financing is set forth in the Amended and Restated Loan and SecurityAgreement and related amendments which have been filed with the Securities andExchange Commission. Subject to limited cure periods, the lenders under ourcredit facility may demand repayment of these borrowings prior to statedmaturity upon the occurrence of specified events, including if we breach theterms of the agreement, suffer a material adverse change, engage in a change incontrol transaction, suffer a significant adverse legal judgment, default onother significant obligations, or in the event of specified events ofinsolvency. The credit agreement matures in December 2011.

 

On June 16, 2003,we completed the issuance of $100 million principal amount of 4.00% SeniorConvertible Notes (the “Notes”) due 2013. The convertible notes bear interestat the rate of 4.00% per annum, subject to the payment of contingent interestunder certain circumstances commencing January 15, 2006 (0.43% per annumfor the current payment period due July 15, 2006), 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 convertible notes, subject to certain exceptions, they are notconvertible into common stock unless and until the trading price of the commonstock reaches at least $41.50 for a specified period in advance of eachquarterly conversion period or designated corporate events occur. As of March 31,2006, the convertible notes were convertible for the current quarterlyconversion period. The convertible notes will also become convertible upon theoccurrence of specified corporate transactions and other events described inthe indenture. The final maturity of the convertible notes is July 2013,although holders may require us to repurchase the Notes at their election 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. The indenture governing the convertible notes does not limitour ability to incur indebtedness or otherwise substantively restrict theoperation of our business to any significant degree. Subject to limited cureperiods, the holders of the convertible 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, if we failto satisfy our conversion obligation, if another obligation of ours

 

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having an outstandingprincipal amount in excess of $15 million is accelerated prior to statedmaturity and upon the occurrence of specified events of insolvency.

 

We may call the Notesfor redemption beginning July 15, 2006.

 

During 2002 we enteredinto master operating lease agreements with General Electric CapitalCorporation and US Bank to lease equipment and other property primarily tosupport the operations of the distribution center for our Guitar Center retailstores. Under these agreements, we leased a total of $10.5 million in equipmentand other property. The agreements call for monthly payments of $138,000through September 30, 2009.

 

The terms of oursignificant financing agreements, including those related to our creditfacility, the Notes and the equipment lease facilities described above, are notdependent on any change in our credit rating. We believe that the keycompany-specific factors affecting our ability to maintain our existing debtand lease financing relationships and to access such capital in the future areour present and expected levels of profitability and cash flow from operations,our working capital and fixed asset collateral bases, our expected level ofcapital expenditures, and the level of our equity capital relative to the levelof debt obligations. In addition, as noted above, our existing agreementsinclude significant restrictions on future financings, including among others,limits on the amount of indebtedness that we may incur and whether or not suchindebtedness may be secured by any of our assets.

 

As is the case with mostmulti-unit retailers, substantially all of the real property used in ourbusiness is leased under operating lease agreements. Please see Item 2.Properties, “—Disclosures About Contractual Obligations and CommercialCommitments” and Note 8 to the Consolidated Financial Statements in our AnnualReport on Form 10-K for the year ended December 31, 2005. We anticipate makingadditional capital investments of $8.0 million to $10.0 million in fiscal 2006 inconnection with the expansion of our Guitar Center stores distribution centerand we expect to incur increased rent expense for the expanded distributioncenter starting during the third quarter of 2006. On March 30, 2006, ourMusician’s Friend division executed a lease agreement for a new distributioncenter for our direct response business that will have a capacity significantlyexceeding the capacity of the current distribution center that it will replace.This lease is treated as an operating-type lease for accounting purposes.Details of the lease agreement were included in the Current Report on Form 8-Kwe filed on March 30, 2006.

 

Net cash provided byoperating activities was $12.9 million for the three months endedMarch 31, 2006 compared to $18.9 million for the same period in 2005. The positiveoperating cash flow was primarily due to the net income generated in the firstquarter of $15.7 million. The fluctuation in operating accounts did not have asignificant net impact upon our operating cash flows. The largest use of cash inthe quarter was a reduction of accrued expenses and other current liabilitiesof $35.3 million primarily due to payments of income taxes and sales taxes.

 

Cash used in investingactivities decreased to $19.2 million for the three months ended March 31,2006 compared to $48.9 million for the same period in 2005. In the firstquarter of 2006, our capital expenditures consisted primarily of expendituresfor new stores and remodels of $9.6 million compared to $9.4 million in thesame period in 2005, computer equipment purchases of $3.7 million compared to$1.9 million in the same period in 2005, and expenditures related to theexpansion of our distribution center facilities of $2.1 million. Also, in thefirst quarter of 2006, our acquisition of businesses for the Music & Arts Centerdivision totaled $3.1 million. In the first quarter of 2005, we purchased acorporate airplane for $10.6 million and we purchased available-for-salesecurities of $27.3 million.

 

Cash provided by financingactivities totaled $1.7 million for the three months ended March 31, 2006compared to $7.8 million in the same period in 2005. In the first quarter of2006, exercises of stock options provided $3.9 million, including $1.5 millionin tax related benefits that are reflected in cash flows from financingactivities. In the same period for 2005, exercises of stock options provided$14.8 million, including $7.1 million in tax related benefits that arereflected in cash flows from operating activities. In addition, in the firstquarter of 2006, we made net repayments of $2.2 million on our revolving creditfacility.

 

We believe that ourcurrent operating cash flows, working capital, cash on hand, borrowingsavailable under our credit facility and other sources of liquidity will besufficient to meet our obligations in the ordinary course of business over thenext 12 months, including capital expenditures and new store openings. Weanticipate our capital expenditures will be between $76 million and $82 millionfor the remainder of fiscal 2006.

 

Our known capitalresource and liquidity requirements for 2006 are expected to be primarilyprovided by net cash flow from operations and borrowings available under ourcredit facility. Traditionally, we have experienced the largest use of cashfrom operating activities in the latter part of the third quarter and in thefourth quarter due to the build up of inventory to support the holiday season,resulting in additional borrowings under our line of credit. We believe that ourborrowing ability under the recently amended credit

 

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facility will besufficient to provide the seasonal liquidity we believe will be required duringthe 2006 fiscal year.

 

Depending upon marketconditions, we may also elect or be required to raise additional capital in theform of common or preferred equity, debt or convertible securities for thepurpose of providing additional capital to fund working capital needs orcontinued growth of our existing business, or to refinance existing obligationsincluding the senior convertible debentures which the indenture permits us tocall for redemption at our election commencing in July 2006. Any suchfinancing activity will be dependent upon many factors, including our liquidityneeds, market conditions and prevailing market terms, and we cannot assure youthat future external financing for us will be available on attractive terms orat all. If we require but are unable to obtain additional liquidity onfavorable terms, we may be required to curtail our growth plans and ourfinancial condition and results of operations would likely be materiallyadversely impacted.

 

We intend to pursue anaggressive growth strategy by opening additional stores in new and existingmarkets. During the three months ended March 31, 2006, we opened a total of tennew Guitar Center stores, consisting of three stores in primary markets, sixstores in secondary markets and one store in a tertiary market. We expect ourcost of capital improvements for a primary market Guitar Center store toaverage approximately $1.2 million consisting of leasehold improvements,fixtures and equipment. A new primary market store is also expected to require$2.0 to $2.5 million in gross inventory. We have developed secondary marketGuitar Center stores to build in sites that we do not believe will support ourprimary market format units. For our secondary market stores, we expect torequire an average of approximately $900,000 in capital improvements and $1.7to $2.0 million in gross inventory. Our first tertiary market store to servesmaller population centers was opened in late 2005 and our second was opened inthe first quarter of 2006. For our tertiary market stores, we  expect to require an average of approximately$575,000 in capital improvements and approximately $1.0 million in grossinventory. These capital expenditures reflect the increasing construction coststhat we have recently begun to experience. We expect these increases tocontinue for the foreseeable future, and these costs may increase above ourexpectations.

 

We are also anticipatingadditional capital and strategic investments related to improving ourfulfillment facilities and upgrading our technology and systems, including an enterprisedata warehouse, retail point of sale system replacement, retail inventorymanagement systems improvements, and enterprise systems replacement for ourdirect response division. We also continue to make significant investments ininformation technology across our businesses and to incur costs and make investmentsdesigned to expand the reach of our businesses on the Internet. The costs ofthese initiatives and other investments related to our businesses will continueto be significant.

 

Throughout our history,we have primarily grown organically. However, we also believe there may beattractive opportunities to expand by selectively acquiring existing musicproducts retailers or other complimentary businesses, if attractiveopportunities can be identified. We believe that our growth at Music &Arts Center will in large part be driven through many small acquisitions. Whilewe cannot provide assurance that we will complete any further acquisitiontransactions, in the ordinary course of our business we investigate and engagein negotiations regarding such opportunities. Acquisitions will be financedwith cash on hand, drawings under our existing credit facilities, expansion ofour credit facilities, issuance of debt or equity securities, or a combination,depending upon transaction size and market conditions, among other things.

 

**RecentlyIssued Accounting Pronouncements**

** **

There are no recentlyissued accounting standards that are reasonably likely to materially affect ourconsolidated financial statements.

 

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**Seasonality**

** **

Our business follows aseasonal pattern, peaking during the holiday selling season inNovember 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. In addition, band rental season for ourMusic & Arts Center business starts in August and carries throughmid-October, but that seasonality does not have a significant impact on ourconsolidated results.

 

**Inflation**

** **

We believe that therelatively moderate rates of inflation experienced in recent years have not hada significant impact on our net sales or profitability. However, in 2006 weanticipate that rising steel, lumber, concrete, labor, fuel and freight costsmay increase expenses related to opening, remodeling, operating and relocatingour stores, expanding our distribution center and operating our business.

 

**Forward-LookingStatements; Business Risks**

** **

This report containsforward-looking statements relating to, among other things, future results ofoperations, growth and investment plans, sales, trends in gross margin, growthin the Internet portion of our direct response business and other factorsaffecting growth in sales and earnings. Specific forward-looking statements areprovided regarding our management’s current views regarding new store openings,capital expenditure levels and the dates new facilities and systems will becomeoperational. Statements regarding new store openings are based largely on ourcurrent expectations and are necessarily subject to associated business risksrelated to, among other things, the identification of suitable sites oracquisition opportunities, the timely construction, staffing and merchandisingof those stores and other matters, some of which are outside of our control.Statements regarding the dates new facilities and systems will becomeoperational are dependent upon third parties and events beyond our control,such as the availability of third party consulting resources, constructiondelays, technology development delays and other events. Sales and earningstrends are also affected by many other factors including, among others, worldand national political events, including general economic conditions, theeffectiveness of our promotion and merchandising strategies, our ability tointegrate and profitably operate acquired businesses, the efficient operationof our supply chain,

 

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including the continuedsupport of our key vendors, our effective management of business risks,including litigation, and competitive factors applicable to our retail anddirect response markets.

 

In light of these risks,there can be no assurance that the forward-looking statements contained in thisreport will in fact be realized. The statements made by us in this reportrepresent our views as of the date of this report, and it should not be assumedthat the statements made herein remain accurate as of any future date. We donot presently intend to update these statements and undertake no duty to anyperson to affect any such update under any circumstances.

 

**Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

** **

We do not have anyassets or liabilities which, in our view, impose upon us significant marketrisk except for our outstanding indebtedness represented by $100 millionprincipal amount of our convertible notes with a fixed interest rate of 4%(subject to contingent interest commencing January 15, 2006) and ourcredit facility which has a variable rate of interest generally consisting ofstated premiums above LIBOR. As of March 31, 2006, the fair value of our4% Senior Convertible Notes was $140 million, based on quoted marketprices. At March 31, 2006, we had $30.0 million in outstanding borrowingsunder our credit facility. To the extent prevailing short-term interest ratesfluctuates, the interest expense we incur on our credit facility will changewith a resulting effect (positive or negative) on our financial position,results of operations and cash flows. At this borrowing level for our creditfacility, a one percentage point increase in interest rates would have anunfavorable impact on pre-tax earnings and cash flows of $0.3 million on anannual basis. The primary interest rate exposure on the credit facility isbased on LIBOR. We do not use derivative financial instruments in ourinvestment portfolio. Historically, we have not carried significant cashbalances and any cash in excess of our daily operating needs has been used toreduce our borrowings. Excess cash is generally invested in short-term, highquality interest bearing investments.

 

**Item 4. CONTROLS AND PROCEDURES**

** **

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

 

As required bySecurities and Exchange Commission Rule 13a-15(b), we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this report. Based on theforegoing, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures were effective to providereasonable assurance that information relating to us and our subsidiaries thatwe are required to disclose in the reports that we file or submit to the SEC isrecorded, processed, summarized and reported within the time periods specifiedin the SEC’s rules and forms.

 

**Part II.  OTHER INFORMATION**

 

**Item 1. Legal Proceedings**

** **

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

 

**Item1A. Risk Factors**

** **

In addition to the otherinformation set forth in this report, you should carefully consider the factorsdiscussed in Part I, “Item 1A. Risk Factors” in our Annual Report onForm 10-K for the year ended December 31, 2005, which could materiallyaffect our business, financial condition or future results. The risks describedin our Annual Report on Form 10-K are not the only risks facing us.Additional risks and uncertainities not currently known to us or that we currentlydeem to be immaterial also may materially adversely affect our business,financial condition and/or operating results.

 

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**Item 6.  Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                         | ** ** |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 10.1                |       | Lease Agreement between Musician’s Friend, Inc. and  Panattoni Development Company, LLC, dated effective as of March 30, 2006  (Incorporated by reference to Exhibit 10.1 of the Company’s Current Report on  Form 8-K dated March 30, 2006). |       |
| 10.2                |       | Fourth Amendment to Second Amended and Restated Loan  and Security Agreement, effective April 26, 2006 (Incorporated by reference  to Exhibit 10.1 of the Company’s Current Report on Form 8-K dated April 26,  2006).                             |       |
| 31.1                |       | Certification of the Company’s Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                            |       |
| 31.2                |       | Certification of the Company’s Chief Financial  Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                            |       |
| 32.1                |       | Certification of the Company’s Chief Executive  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                            |       |
| 32.2                |       | Certification of the Company’s Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                            |       |

 

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Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorizedas of the 10th day of May 2006.

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

 

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