**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

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

 

**GUITARCENTER, INC.**

(Exact Name ofRegistrant as Specified in its Charter)

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

 

**(818)735-8800**

Registrant’stelephone 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 an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

 

Yes     ý                No       o

 

As of November 5, 2004, 25,319,036shares of our Common Stock, $.01 par value, were outstanding.

 

 

----

 

**GuitarCenter, Inc. and subsidiaries**

 

#### INDEX

 
| Part I.      | Financial Information                                                                       |                                                                                            |
|--------------|---------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------|
|         |                                                                                        |                                                                                            |
|         | **Item 1. Consolidated Financial  Statements (Unaudited)**                                  |                                                                                            |
|         |                                                                                        |                                                                                            |
|         | Consolidated Balance Sheets  – September 30, 2004 and December 31, 2003                |                                                                                            |
|         |                                                                                        |                                                                                            |
|         | Consolidated  Statements of Income – Three months ended September 30, 2004 and 2003    |                                                                                            |
|         |                                                                                        |                                                                                            |
|         | Consolidated  Statements of Income – Nine months ended September 30, 2004 and 2003     |                                                                                            |
|         |                                                                                        |                                                                                            |
|         | Consolidated  Statements of Cash Flows – Nine months ended September 30, 2004 and 2003 |                                                                                            |
|         |                                                                                        |                                                                                            |
|         | Notes to  Consolidated Financial Statements                                                 |                                                                                            |
|         |                                                                                        |                                                                                            |
| ** **   | **Item 2.**                                                                                 | **Management’s Discussion and Analysis of  Financial Condition and Results of Operations** |   |
|         |                                                                                        |                                                                                            |
|         | **Item 3. **                                                                           | **Quantitative and  Qualitative Disclosures About Market Risk**                                 |   |
|         |                                                                                        |                                                                                            |
|         | **Item 4. **                                                                           | **Controls and  Procedures**                                                                    |   |
|         |                                                                                        |                                                                                            |
| **Part II.** | **Other Information**                                                                       | ** **                                                                                      |
| ** **   | ** **                                                                                  | ** **                                                                                      |
|         | **Item 6. **                                                                           | **Exhibits**                                                                                    |   |

 

2

----

 

**GuitarCenter, Inc. and subsidiaries**

# **ConsolidatedBalance Sheets**

(In thousands,except per share data)

(Unaudited)

 
| ** **                                                                                                                                                | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
|                                                                                                                                                      |       |                    |       |                   |       |
| **Assets**                                                                                                                                                |       |                    |       |                   |       |
| Current assets:                                                                                                                                           |       |                    |       |                   |       |
| Cash and cash equivalents                                                                                                                                 |       | $                       | 11,804     |                   | $          | 5,350 |   |
| Accounts receivable, net                                                                                                                                  |       | 23,592                  |       | 23,814                 |       |
| Merchandise inventories                                                                                                                                   |       | 321,943                 |       | 288,873                |       |
| Prepaid expenses and deposits                                                                                                                             |       | 20,561                  |       | 11,543                 |       |
| Deferred income taxes                                                                                                                                     |       | 5,631                   |       | 5,631                  |       |
| Total current assets                                                                                                                                      |       | 383,531                 |       | 335,211                |       |
|                                                                                                                                                      |       |                    |       |                   |       |
| Property and equipment, net                                                                                                                               |       | 95,143                  |       | 93,347                 |       |
| Goodwill                                                                                                                                                  |       | 26,399                  |       | 25,995                 |       |
| Deposits and other assets, net                                                                                                                            |       | 8,259                   |       | 6,318                  |       |
|                                                                                                                                                      |       | $                       | 513,332    |                   | $          | 460,871 |   |
|                                                                                                                                                      |       |                    |       |                   |       |
| **Liabilities and stockholders’ equity**                                                                                                             |       |                    |       |                   |       |
| Current liabilities:                                                                                                                                      |       |                    |       |                   |       |
| Accounts payable                                                                                                                                          |       | $                       | 50,082     |                   | $          | 47,778 |   |
| Accrued expenses and other current liabilities                                                                                                            |       | 57,418                  |       | 71,616                 |       |
| Merchandise advances                                                                                                                                      |       | 16,773                  |       | 17,104                 |       |
| Total current liabilities                                                                                                                                 |       | 124,273                 |       | 136,498                |       |
|                                                                                                                                                      |       |                    |       |                   |       |
| Other long-term liabilities                                                                                                                               |       | 6,605                   |       | 5,982                  |       |
| Deferred income taxes                                                                                                                                     |       | 4,220                   |       | 4,220                  |       |
| Long-term debt                                                                                                                                            |       | 100,000                 |       | 100,000                |       |
| Total liabilities                                                                                                                                         |       | 235,098                 |       | 246,700                |       |
|                                                                                                                                                      |       |                    |       |                   |       |
| Stockholders’ equity:                                                                                                                                |       |                    |       |                   |       |
| Preferred stock; 5,000 authorized, none issued  and outstanding                                                                                      |       | —                  |       | —                 |       |
| Common stock, $0.01 par value, authorized  55,000 shares, issued and outstanding  25,312 at September 30, 2004 and 23,998 at  December 31, 2003 |       | 253                     |       | 240                    |       |
| Additional paid in capital                                                                                                                                |       | 303,948                 |       | 276,233                |       |
| Accumulated deficit                                                                                                                                       |       | (25,967                 | )          | (62,302                | )          |
| Stockholders’ equity                                                                                                                                 |       | 278,234                 |       | 214,171                |       |
|                                                                                                                                                      |       | $                       | 513,332    |                   | $          | 460,871 |   |

 

See accompanyingnotes to consolidated financial statements.

 

3

----

 

**GuitarCenter, Inc. and subsidiaries**

# **ConsolidatedStatements of Income**

(In thousands,except per share data)

(Unaudited)

 
| ** **                                   | ** ** | **Three months ended September  30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                   | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| ** **                                   | ** ** | ** **                            | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                                     | 354,909    |   | $ | 300,112 |   |
| Cost of goods sold, buying and occupancy     |       | 256,968                               |       | 220,261 |   |
| Gross profit                                 |       | 97,941                                |       | 79,851 |   |
|                                         |       |                                  |       |   |   |
| Selling, general and administrative expenses |       | 76,628                                |       | 66,182 |   |
| Operating income                             |       | 21,313                                |       | 13,669 |   |
|                                         |       |                                  |       |   |   |
| Interest expense, net                        |       | 1,294                                 |       | 4,335 |   |
|                                         |       |                                  |       |   |   |
| Income before income taxes                   |       | 20,019                                |       | 9,334 |   |
|                                         |       |                                  |       |   |   |
| Income taxes                                 |       | 7,608                                 |       | 3,553 |   |
|                                         |       |                                  |       |   |   |
| Net income                                   |       | $                                     | 12,411     |   | $ | 5,781 |   |
|                                         |       |                                  |       |   |   |
| Net income per share                         |       |                                  |       |   |   |
| Basic                                        |       | $                                     | 0.49       |   | $ | 0.25 |   |
| Diluted                                      |       | $                                     | 0.45       |   | $ | 0.23 |   |
|                                         |       |                                  |       |   |   |
| Weighted average shares outstanding          |       |                                  |       |   |   |
| Basic                                        |       | 25,211                                |       | 23,430 |   |
| Diluted                                      |       | 29,235                                |       | 24,944 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

----

 

**GuitarCenter, Inc. and subsidiaries**

# **ConsolidatedStatements of Income**

(In thousands,except per share data)

(Unaudited)

 
| ** **                                   | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------|------------|-------------------------------------|------------|
| ** **                                   | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                   | ** ** | ** **                          | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                                   | 1,044,234  |   | $ | 879,254 |   |
| Cost of goods sold, buying and occupancy     |       | 757,397                             |       | 649,197 |   |
| Gross profit                                 |       | 286,837                             |       | 230,057 |   |
|                                         |       |                                |       |   |   |
| Selling, general and administrative expenses |       | 224,146                             |       | 191,846 |   |
| Operating income                             |       | 62,691                              |       | 38,211 |   |
|                                         |       |                                |       |   |   |
| Interest expense, net                        |       | 4,082                               |       | 10,430 |   |
|                                         |       |                                |       |   |   |
| Income before income taxes                   |       | 58,609                              |       | 27,781 |   |
|                                         |       |                                |       |   |   |
| Income taxes                                 |       | 22,274                              |       | 10,573 |   |
|                                         |       |                                |       |   |   |
| Net income                                   |       | $                                   | 36,335     |   | $ | 17,208 |   |
|                                         |       |                                |       |   |   |
| Net income per share                         |       |                                |       |   |   |
| Basic                                        |       | $                                   | 1.47       |   | $ | 0.75 |   |
| Diluted                                      |       | $                                   | 1.38       |   | $ | 0.71 |   |
|                                         |       |                                |       |   |   |
| Weighted average shares outstanding          |       |                                |       |   |   |
| Basic                                        |       | 24,698                              |       | 23,075 |   |
| Diluted                                      |       | 26,905                              |       | 24,329 |   |
|                                              |            |                                     |            |  |  |  |  |  |

 

See accompanyingnotes to consolidated financial statements.

 

5

----

 

**GuitarCenter, Inc. and subsidiaries**

**ConsolidatedStatements of Cash Flows**

(In thousands)

(Unaudited)

 
| ** **                                                                         | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                         | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| **Operating activities**                                                           |       |                                |       |   |   |
| Net income                                                                         |       | $                                   | 36,335     |   | $ | 17,208 |   |
| Adjustments to reconcile net income to net cash provided by  operating activities: |       |                                |       |   |   |
| Depreciation and amortization                                                      |       | 16,640                              |       | 15,056 |   |
| Amortization of deferred financing fees                                            |       | 784                                 |       | 650 |   |
| Write down of deferred financing fees                                              |       | —                              |       | 722 |   |
| Tax benefit from exercise of stock options                                         |       | 9,686                               |       | — |   |
| Changes in operating assets and liabilities:                                       |       |                                |       |   |   |
| Accounts receivable, net                                                           |       | 695                                 |       | 659 |   |
| Merchandise inventories                                                            |       | (31,263                             | )          | 1,485 |   |
| Prepaid expenses and deposits                                                      |       | (9,018                              | )          | (728 | ) |
| Deposits and other assets, net                                                     |       | (2,781                              | )          | (509 | ) |
| Accounts payable                                                                   |       | 2,304                               |       | (17,882 | ) |
| Accrued expenses and other current liabilities                                     |       | (14,198                             | )          | (3,132 | ) |
| Merchandise advances                                                               |       | (331                                | )          | (686 | ) |
| Other long term liabilities                                                        |       | 623                                 |       | 232 |   |
| Net cash provided by operating activities                                          |       | 9,476                               |       | 13,075 |   |
|                                                                               |       |                                |       |   |   |
| **Investing activities**                                                           |       |                                |       |   |   |
| Purchase of property and equipment                                                 |       | (18,289                             | )          | (16,855 | ) |
| Acquisition of business                                                            |       | (2,775                              | )          | — |   |
| Net cash used in investing activities                                              |       | (21,064                             | )          | (16,855 | ) |
|                                                                               |       |                                |       |   |   |
| **Financing activities**                                                           |       |                                |       |   |   |
| Net change in revolving line of credit                                             |       | —                              |       | (40,345 | ) |
| Proceeds from exercise of stock options                                            |       | 17,336                              |       | 12,416 |   |
| Proceeds from stock issued under employee purchase plan                            |       | 706                                 |       | 422 |   |
| Proceeds from senior convertible note                                              |       | —                              |       | 96,875 |   |
| Payments on senior note                                                            |       | —                              |       | (66,667 | ) |
| Payments under capital lease                                                       |       | —                              |       | (151 | ) |
| Net cash provided by financing activities                                          |       | 18,042                              |       | 2,550 |   |
|                                                                               |       |                                |       |   |   |
| Net increase (decrease) in cash                                                    |       | 6,454                               |       | (1,230 | ) |
| Cash and cash equivalents at beginning of year                                     |       | 5,350                               |       | 5,931 |   |
|                                                                               |       |                                |       |   |   |
| Cash and cash equivalents at end of period                                         |       | $                                   | 11,804     |   | $ | 4,701 |   |
|                                                                               |       |                                |       |   |   |
| **Non-cash  activities**                                                           |       |                                |       |   |   |
| Acquisition of business:                                                           |       |                                |       |   |   |
| Fair value of assets acquired                                                      |       | $                                   | 1,988      |   |   |   |
| Receivables held in escrow                                                         |       | 540                                 |       |   |   |
| Goodwill                                                                           |       | 404                                 |       |   |   |
| Liabilities assumed                                                                |       | (157                                | )          |   |   |
| Cash paid for acquisition                                                          |       | $                                   | 2,775      |   |   |   |

 

See accompanyingnotes to consolidated financial statements.

 

6

----

 

**GuitarCenter, Inc. and subsidiaries**

**Notes toConsolidated Financial Statements**

 

1.             Natureof Business and Basis of Presentation

 

Nature of Business

 

GuitarCenter, Inc., and subsidiaries (“Guitar Center,” the “Company,” “we,” “us” or “our”)is the nation’s leading retailer of guitars, amplifiers, percussioninstruments, keyboards and pro-audio and recording equipment based on annualrevenue. As of September 30, 2004, our retail subsidiary operated 135 GuitarCenter retail stores, with 112 stores in 46 major markets and 23 stores insecondary markets across the United States. In addition, as of September 30, 2004, our American Music divisionoperated 20 family music stores specializing in band and orchestral instrumentsfor sale and rental, serving teachers, band directors, college professors andstudents. We are also the largest direct response retailer of musicalinstruments in the United States through our wholly-owned subsidiary, Musician’sFriend, Inc., and its catalog and web site, www.musiciansfriend.com.

 

Basis of Presentation

 

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 September 30, 2004 andthe results of operations and cash flows for the three and nine months endedSeptember 30, 2004 and 2003. The accompanying consolidated financial statementsshould be read in conjunction with the audited consolidated financialstatements and notes thereto contained in our Annual Report on Form 10-K forthe year ended December 31, 2003.

 

Theresults of operations for the three and nine months ended September 30, 2004,are not necessarily indicative of the results to be expected for the full year.

 

2.             Acquisition

 

OnJuly 23, 2004, our American Music division acquired one store and relatedassets in the Chicago area. The results of operations of the acquired storewere not material to Guitar Center’s previously presented consolidatedfinancial statements and, as such, pro-forma financial information is notpresented. The results of operations are included in the Guitar Center’sconsolidated financial statements from the date of the acquisition.

 

3.             EarningsPer Share

 

Thefollowing table summarizes the reconciliation of basic to diluted weightedaverage shares for the three and nine months ended September 30, 2004 and 2003:

 
| ** **                                                                               | ** ** | **Three months ended  September 30,**      | ** ** | **Nine months ended  September 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                               | ** ** | **2004**                                   | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                               | ** ** | **(in thousands, except per  share data)** | ** ** |
| Net income                                                                               |       | $                                          | 12,411     |                                 | $          | 5,781 |   | $ | 36,335 |   | $ | 17,208 |   |
| Add: Interest,  net of tax on 4% Senior Convertible Notes                                |       | 733                                        |       | —                               |       | 733 |   | — |   |
| Net income  excluding interest expense on 4% Senior Convertible Notes                    |       | 13,144                                     |       | 5,781                                |       | 37,068 |   | 17,208 |   |
|                                                                                     |       |                                       |       |                                 |       |   |   |   |   |
| Basic shares                                                                             |       | 25,211                                     |       | 23,430                               |       | 24,698 |   | 23,075 |   |
| Common stock  equivalents - dilutive effect of options outstanding                       |       | 1,132                                      |       | 1,514                                |       | 1,243 |   | 1,254 |   |
| Common stock  equivalents - dilutive effect of conversion of 4% Senior Convertible Notes |       | 2,892                                      |       | —                               |       | 964 |   | — |   |
| Diluted shares                                                                           |       | 29,235                                     |       | 24,944                               |       | 26,905 |   | 24,329 |   |
| Diluted net  income per share                                                            |       | $                                          | 0.45       |                                 | $          | 0.23 |   | $ | 1.38 |   | $ | 0.71 |   |

 

7

----

 

Forthe nine months ended September 30, 2004, 381,000 options with an exerciseprice of $39.98 per share were outstanding but were not included in thecomputation of diluted earnings per share because the exercise price of theseoptions was greater than the average market price of our common stock.  For the nine months ended September 30, 2003,145,000 options with exercise prices ranging from $28.30 to $30.70 wereoutstanding but were not included in the computation of diluted earnings per sharebecause the exercise prices of these options were greater than the averagemarket price of our common stock.

 

The 4.0% Senior Convertible Notesdue 2013 (Note 6) became convertible into common stock during the conversionperiod commencing July 16, 2004 and continuing through and including October14, 2004. Since the notes were convertible during the third quarter of 2004, dilutednet income per share is determined using the “if-converted” method asprescribed under Statement of Financial Accounting Standards No. 128. Theimpact on our diluted income per share from the incremental shares on the 4%Senior Convertible Notes was $0.02 for the three and nine months endedSeptember 30, 2004.

 

**4.**             Segment Information

** **

**Our reportable business segments are Guitar Center stores,American Music stores and direct response (Musician’s Friend’s catalog and Internet).  Management evaluates segment performancebased primarily on net sales and income (loss) before income taxes.  Accounting policies of the segments are thesame as the accounting policies for the consolidated Company.  There are no differences between themeasurements of profits or losses or assets of the reportable segments andthose of the Company on a consolidated basis. Our operating and reportablesegments under SFAS No. 131 are consistent with our reporting units under SFASNo. 142.**

** **

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

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

** **

**8**

----

** **
| ** **                                   | ** ** | **Three Months Ended September 30, 2003** | ** ** | **Nine Months Ended September 30, 2003** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                   | ** ** | **Guitar  Center**                        | ** ** | **American  Music**                      | ** ** | **Direct  Response** | ** ** | **Total** | ** ** | **Guitar  Center** | ** ** | **American  Music** | ** ** | **Direct  Response** | ** ** | **Total** | ** ** |
| Net sales                                    |       | $                                         | 231,178    |                                     | $          | 9,936 |   | $ | 58,998 |   | $ | 300,112 |   | $ | 672,659 |   | $ | 27,209 |   | $ | 179,386 |   | $ | 879,254 |   |
| Gross profit                                 |       | 57,556                                    |       | 3,231                                    |       | 19,064 |   | 79,851 |   | 162,964 |   | 9,877 |   | 57,216 |   | 230,057 |   |
| Depreciation and amortization                |       | 4,135                                     |       | 303                                      |       | 656 |   | 5,094 |   | 12,200 |   | 843 |   | 2,013 |   | 15,056 |   |
| Selling, general and administrative expenses |       | 48,412                                    |       | 5,055                                    |       | 12,715 |   | 66,182 |   | 138,923 |   | 13,562 |   | 39,361 |   | 191,846 |   |
| Income (loss) before income taxes            |       | 5,680                                     |       | (2,648                                   | )          | 6,302 |   | 9,334 |   | 16,276 |   | (6,022 | ) | 17,527 |   | 27,781 |   |
| Capital expenditures                         |       | 4,586                                     |       | 501                                      |       | 485 |   | 5,572 |   | 13,804 |   | 1,716 |   | 1,335 |   | 16,855 |   |
| Total assets                                 |       |                                      |       |                                     |       |   |   |   |   | 348,145 |   | 66,865 |   | 38,807 |   | 453,817 |   |
|                                              |            |                                           |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

** **

5.             Stock-BasedCompensation

 

We adopted SFAS No. 123, “*Accountingfor Stock-Based Compensation,”*which permits entities to recognizeas expense over the vesting period the fair value of all stock-based awards onthe date of grant.  Alternatively, SFASNo. 123 also allows entities to continue to apply the provisions of AccountingPrinciples Board (“*APB”*) OpinionNo. 25, “*Accounting for Stock Issued toEmployees**,”*and relatedinterpretations and provide pro forma net income and pro forma earnings pershare disclosures for employee stock options as if the fair-value-based methoddefined in SFAS No. 123 had been applied. We have elected to continue to apply the provisions of APB Opinion No.25 and provide the pro forma disclosures of SFAS No. 123.  As such, compensation expense for stockoptions issued to employees is recorded on the date of grant only if thethen-current market price of the underlying stock exceeded the exerciseprice.  Had we determined compensationcost based upon the fair value at the grant date for our stock options underSFAS No. 123 using the Black Scholes option pricing model, pro forma net incomeand pro forma net income per share, including the following weighted averageassumptions used in these calculations, would have been as follows ($ inthousands, except per share amounts):

 
| ** **                                                                                                                                     | ** ** | **For the three months  ended September 30,** | ** ** | **For the nine months  ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **2004**                                      | ** ** | **2003**                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income, as  reported                                                                                                                       |       | $                                             | 12,411     |                                         | $          | 5,781 |   | $ | 36,335 |   | $ | 17,208 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  methods for all awards, net of related tax effects |       | 870                                           |       | 2,173                                        |       | 2,873 |   | 4,739 |   |
| Pro forma net  income                                                                                                                          |       | $                                             | 11,541     |                                         | $          | 3,608 |   | $ | 33,462 |   | $ | 12,469 |   |
|                                                                                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Earnings per  share:                                                                                                                           |       |                                          |       |                                         |       |   |   |   |   |
| Basic - as reported                                                                                                                            |       | 0.49                                          |       | 0.25                                         |       | 1.47 |   | 0.75 |   |
| Basic - pro forma                                                                                                                              |       | 0.46                                          |       | 0.15                                         |       | 1.35 |   | 0.54 |   |
| Diluted - as reported                                                                                                                          |       | 0.45                                          |       | 0.23                                         |       | 1.38 |   | 0.71 |   |
| Diluted - pro forma                                                                                                                            |       | 0.42                                          |       | 0.14                                         |       | 1.27 |   | 0.51 |   |
| Assumptions:                                                                                                                                   |       |                                          |       |                                         |       |   |   |   |   |
| Risk free interest rate                                                                                                                        |       | 3.8                                           | %          | 3.7                                          | %          | 3.8 | % | 3.7 | % |
| Expected life of options                                                                                                                       |       | 6.67                                          |       | 6.67                                         |       | 6.67 |   | 6.67 |   |
| Expected volatility                                                                                                                            |       | 60.8                                          | %          | 63.1                                         | %          | 60.8 | % | 63.1 | % |
| Expected dividends                                                                                                                             |       | —                                        |       | —                                       |       | — |   | — |   |
|                                                                                                                                                |            |                                               |            |                                              |            |  |  |  |  |  |  |  |  |  |

 

9

----

 

6.                                       ConvertibleNotes Offering

 

OnJune 16, 2003, we completed the issuance of $100 million principal amount of4.00% Senior Convertible Notes due 2013.  The notes are convertible at an effectiveconversion price of $34.58 per share and the full number of shares issuableupon conversion of the notes are 2,892,000 shares. Of the net proceeds from theoffering, approximately $68.2 million was used in July 2003 to retire all $66.7million principal amount of Senior Notes outstanding and pay the relatedredemption premium, and the balance was used to reduce the amount outstandingunder our credit agreement and pay offering expenses. Interest expense relatedto the redemption premium and the write-off of deferred financing costsassociated with the Senior Notes redeemed was $1.9 million.

 

InJuly 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on IssueNo. 04-8, *“Accounting Issues Related to Certain Features ofContingently Convertible Debt and the Effect on Diluted Earnings per share”*(“EITF No. 04-8”). TheTask Force reached a consensus that contingently convertible debt instruments,such as our 4.00% Senior Convertible Notes, should be included in thecomputation of diluted earnings per share under the if-converted method regardlessof whether the market price trigger (or other contingent feature) has been met.The EITF 04-8 consensus must be applied by retroactive restatement based on theterm in effect on the last day of the fiscal period in which the consensusbecomes effective. This consensus requires an amendment to FASB Statement No.128, *“Earnings per Share”*, and may beeffective before the end of 2004.

 

**Item 2.**                                                           Management’sDiscussion and Analysis of Financial Condition and Results of Operations

** **

### **General**

### ** **

Guitar Center is thenation’s leading retailer of guitars, amplifiers, percussion instruments,keyboards and pro-audio and recording equipment based on annual revenue. Ourretail subsidiary operated 135 Guitar Center retail locations as of September 30,2004, with 112 stores in 46 major markets and 23 stores in secondary marketsacross the United States. In addition, at September 30, 2004 our American Musicdivision operated 20 family music stores specializing in band and orchestralinstruments for sale and rental, serving teachers, band directors, collegeprofessors and students. We are also the largest direct response retailer ofmusical instruments in the United States through our wholly-owned subsidiary,Musician’s Friend, Inc., and its catalog and web site, www.musiciansfriend.com.

 

Duringthe third quarter, we opened a large format Guitar Center store in Glen Burnie,Maryland, and four small format stores in South Bend, Indiana, Kalamazoo,Michigan, Baton Rouge, Louisiana and Peoria, Illinois. These stores added 56,400square feet of Guitar Center retail space and brought us to a total of 2.053million square feet of Guitar Center retail space at the end of the quarter.Also, during the quarter, our American Music division acquired one store in theChicago market. As we enter new markets, we expect that we will initially incurhigher administrative and promotional costs per store than is currentlyexperienced in established markets.

 

From 1999 to 2003, our net sales grew at an annualcompound growth rate of 19%, principally due to the comparable store salesgrowth of our retail stores averaging 7% per year, the opening of new stores,and a 31% per year increase in the direct response channel. We believe suchvolume increases are the result of the continued success of the implementationof our business strategy, continued growth in the music products industry andincreasing consumer awareness of the Guitar Center, Musician’s Friend andAmerican Music brand names. We achieved comparable store sales growth of 11%, 8%and 9% for the first three quarters of 2004 compared to 4%, 5% and 7% for thesame periods in 2003. We believe this growth reflects the strength of ourmerchandise selection, effective advertising and promotion, and well-trainedand committed personnel. Comparable store sales

 

10

----

 

compares net sales for the comparable periods, excluding net salesattributable to stores not open for 14 months as of the end of the latterreporting period.  All references in thisreport to comparable stores sales are based on this calculation methodology.

 

**Executive Summary**

 

Consolidated net salesfor the quarter ended September 30, 2004 increased 18.3%, or $54.8 million, to$354.9 million compared to $300.1 million in the third quarter of 2003. Netincome for the third quarter was $12.4 million, which is a 114.7% increase overthe $5.8 million we reported in the third quarter of 2003. Earnings per dilutedshare increased to $0.45 compared to $0.23 in the third quarter of 2003.

 

Our Guitar Center retaildivision turned in a strong performance for the quarter, including 9%comparable stores sales. Our stores experienced strong traffic during thequarter which we believe reflects the heightened interest in music participationand the development of Internet vehicles to create, produce and market music asthese factors also contribute to our sales. Net sales from our Guitar Centerstores increased 17.8% to $272.3 million from $231.2 million in last year’s thirdquarter. Sales from new stores contributed $20.3 million and accounted for 49.5%of the increase.

 

Musician’s Friend, ourdirect response division, generated a net sales increase of 21.7% for thequarter to $71.8 million compared to $59.0 million in the third quarter of2003. Operating income was above our expectations. For the third quarter, weachieved an initial order fill rate of 94%, up from 93% in the third quarter of2003. Initial order fill rate reflects the percentage of items ordered by ourcustomers that we are able to supply in the initial shipment to that customer.Inventory turn improved to 5.3 times on a trailing twelve-month basis comparedto 5.1 times in the third quarter of 2003. The improvements that were made tothe Musician’s Friend web site over the last year, as well as theinfrastructure and systems at the direct response call center and fulfillmentcenter, permitted us to capitalize on high demand.

 

InJuly 2004, we acquired the band and orchestra business of Karnes Music tocontinue the build out of our American Music presence in the Chicago market. ComparableAmerican Music stores sales for the quarter were approximately flat with theprior year. American Music incurred an operating loss of $1.3 million for the thirdquarter on a pre-tax basis. During the quarter, we continued to focus onremerchandising, systems execution and infrastructure build out. Failure toexecute on these initiatives could potentially require us to recognize animpairment related to the significant amount of goodwill recorded in theacquisitions of American Music, M&M Music and Karnes Music, which totaled$21.0 million at September 30, 2004. No such impairment has been recognizedthrough September 30, 2004.

 

We are focused onleveraging the infrastructure investments we have made to streamline inventorymanagement and improve operating efficiencies across the Company. Continuedexecution of these initiatives will be necessary to our business objectives forthe remainder of 2004.

 

**Discussion of Critical Accounting Policies**

 

In the ordinary course ofbusiness, we have made a number of estimates and assumptions relating to thereporting of results of operations and financial condition in the preparationof our financial statements in conformity with accounting principles generallyaccepted in the United States of America. Actual results could differ significantly from those estimates underdifferent assumptions and conditions.  Webelieve that the following discussion addresses our most critical accountingpolicies, which are those that are most important to the portrayal of ourfinancial condition and results and require management’s most difficult,subjective and complex judgments, often as a result of the need to makeestimates about the effect of matters 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 inventoriesat the lower of cost using the first-in, first-out (FIFO) method or market.  Rental inventories are valued at the lower ofcost or market using the specific identification method and are depreciated ona straight-line basis over the term of the associated rental agreement forrent-to-own sales, or over the estimated useful life of the rented instrumentfor rental only items.  We recordadjustments to the value of inventory based upon obsolescence and changes inmarket value.  Applicable costsassociated with bringing inventory through our Guitar Center retaildistribution center are capitalized to inventory.  The amounts are expensed to cost of goodssold as the associated inventory is sold. Management has evaluated the current level of

 

11

----

 

inventories considering future customer demand for ourproducts, taking into account general economic conditions, growth prospectswithin the marketplace, competition, market acceptance of current and upcomingproducts, and management initiatives. Based on this evaluation, we record impairment adjustments to cost ofgoods sold for estimated decreases in net realizable value.  These judgments are made in the context ofour customers’ shifting needs, product and technological trends, and changes inthe demographic mix of our customers. A misinterpretation or misunderstandingof these conditions and uncertainties in the future outlook of our industry orthe economy, or other failure to estimate accurately, could result in inventoryvaluation changes in the future.

 

*Valuationof Long-Lived Assets*

 

Long-livedassets such as property and equipment and identifiable intangibles are reviewedfor impairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable. Goodwill is 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:

 

•                  Significant underperformance relativeto historical or projected operating results;

 

•                  Significant changes in the manner ofour use of the acquired assets or the strategy of our overall business;

 

•                  Significant negative industry oreconomic trends; and

 

•                  Significant decline in stock valuefor a sustained period.

 

Forlong-lived assets other than goodwill and intangibles that are not amortized,the determination of whether impairment has occurred is based on an estimate ofundiscounted future cash flows attributable to the assets, as compared to thecarrying value of the assets.  Assumptionsused in these cash flows are consistent with internal forecasts and considercurrent and future expected sales volumes and related operating costs and anyanticipated increases or declines based on expected market conditions and localbusiness environment factors. If a potential impairment is identified, theamount of the impairment loss recognized would be determined by estimating thefair value of the assets and recording a loss if the fair value was less thanthe book value. Fair value will be determined based on appraisal valuesassessed by third parties, if deemed necessary, or a discounted future cashflows analysis. For goodwill and other intangibles that are not amortized,impairment to be recognized is measured as the amount by which the carrying amountof the assets exceeds the fair value of the related assets of the underlyingsegment to which the goodwill relates.

 

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

 

*Sales Returns*

 

As part of our “satisfactionguaranteed” policy, we allow Guitar Center customers to return productgenerally within thirty days after the date of purchase, and we allow Musician’sFriend customers to return product within forty-five days. American Musiccustomers have ten business days from the date of purchase to return product.We regularly 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 differsignificantly, either favorably or unfavorably, from estimates if factors suchas economic conditions or the competitive environment differ from ourexpectations.

 

*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

 

12

----

 

the purchase of specified products and paid at a later date).Cooperative advertising allowances are recognized as a reduction to selling,general, and administrative expense when we incur the advertising expenseeligible for the credit. We recognized cooperative advertising allowances of $4.5million and $3.6 million in the nine months ended September 30, 2004 and 2003,respectively.  Price protection creditsand vendor rebates are accounted for as a reduction of the cost of merchandiseinventory and are recorded at the time the credit or rebate is earned.  The effect of price protection credits andvendor rebates is recognized in the income statement at the time the relatedinventory is sold, as a reduction in cost of goods sold. None of these creditsare recorded as revenue.

 

**Results of Operations**

 

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

 
| ** **                                   | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                   | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                                    |       | 100.0                                 | %          | 100.0                                | %          | 100.0 | % | 100.0 | % |
| Gross profit                                 |       | 27.6                                  |       | 26.6                                 |       | 27.5 |   | 26.2 |   |
| Selling, general, and administrative expense |       | 21.6                                  |       | 22.1                                 |       | 21.5 |   | 21.8 |   |
| Operating income                             |       | 6.0                                   |       | 4.5                                  |       | 6.0 |   | 4.4 |   |
| Interest expense, net                        |       | 0.4                                   |       | 1.4                                  |       | 0.4 |   | 1.2 |   |
| Income before income tax expense             |       | 5.6                                   |       | 3.1                                  |       | 5.6 |   | 3.2 |   |
| Income tax expense                           |       | 2.1                                   |       | 1.2                                  |       | 2.1 |   | 1.2 |   |
| Net income                                   |       | 3.5                                   |       | 1.9                                  |       | 3.5 |   | 2.0 |   |

 

### **ThreeMonths Ended September 30, 2004 Compared to the Three Months Ended September30, 2003**

### ** **

Netsales for the three months ended September 30, 2004 increased 18.3% to $354.9million, compared to $300.1 million same period last year.  Comparable store sales increased 9%. Webelieve that comparable store sales are a more useful indicator of storeperformance than the change in total net sales, since comparable store salesexclude the effects of changes in the number of stores open.

 

Netsales from Guitar Center stores for the three months ended September 30, 2004totaled $272.3 million, a 17.8% increase from $231.2 million for the sameperiod in 2004.  Sales from new storescontributed $20.3 million and represent 49.5% of the total increase in retailstore sales.  Comparable Guitar Centerstore sales for the quarter increased 9%. The increase in comparable store sales was due to good response to ouradvertising and marketing strategy for our Guitar Center stores. Our managementis presently anticipating comparable store sales growth for the Guitar Centerstores of 3% to 5% for the fourth quarter in 2004.  Please see “Forward-Looking Statements;Business Risks,” below. Net sales from American Music stores for the threemonths ended September 30, 2004 totaled $10.7 compared to $9.9 million in 2003.$666,000 of the increase relates to the Karnes Music acquisition. ComparableAmerican Music stores sales for the quarter were approximately flat with theprior year. Net sales from the direct response channel totaled $71.8 millionfor the three months ended September 30, 2004, a $12.8 million, or 21.7%,increase from 2003. This increase primarily reflects the improved performanceof catalog circulation strategies.  Salesfrom the contact center, which represent sales placed via phone, live chat,mail and e-mail, increased 20.9% to $33.0 million from $27.3 million for thethree months ended September 30, 2004 compared to 2003. Internet sales fromorders placed via the Musician’s Friend and Giardinelli web sites increased 22.4%to $38.8 million from $31.7 million for the same period last year.

 

Grossprofit for the three months ended September 30, 2004 compared to 2003 increased22.7% to $97.9 million from $79.9 million. Gross profit as a percentage of net sales for the quarter ended September30, 2004 compared to 2003 increased to 27.6% from 26.6%.  Gross profit as a percentage of net sales forGuitar Center was 26.4% compared with 24.9% in the third quarter of 2003. Theincrease is due to higher selling margin 1.2%, reduced freight 0.1%, andleveraged occupancy costs 0.3% due to the strong comparable store salesincrease, offset by higher inventory shrink 0.1%. We define selling margin asnet sales less the cost of the associated merchandise charged by the vendorplus the associated inventory costs from fulfilling inventory through ourdistribution center.  The cost of

 

13

----

 

merchandise inventory is net of all associated vendor discounts andrebates. Freight is not included in selling margin. The gross profit margin forthe American Music stores was 33.6% compared to 32.5% for the same period lastyear.  The increase reflects the benefitof the acquisition of Karnes Music 0.4% and reduced inventory shrink 3.8%,offset by declining selling margin due to a change in product mix 3.1%. Grossprofit margin for the direct response division was 31.3% for the quartercompared to 32.3% in the third quarter of 2003. The decrease resulted primarilyfrom reduced selling margin 0.7% and higher freight costs 0.3%.

 

Selling,general and administrative expenses for the three months ended September 30,2004 increased 15.8% to $76.6 million from $66.2 million for the sameperiod in 2003. Selling, general and administrative expenses were 21.6% as apercentage of sales in the three months ended September 30, 2004 compared to22.1% in the same period last year. Selling, general and administrativeexpenses for the Guitar Center stores in the third quarter were 20.8% as apercentage of net sales compared to 20.9% in last year’s third quarter. The improvementis primarily due to leveraging on sales and increased operational efficienciesas indicated by reduced general insurance 0.2%, lower travel and entertainment0.2%, offset by increased professional fees 0.2% and credit card expense 0.1%. Selling,general and administrative expenses for the American Music stores were 45.6% ofsales in the third quarter compared to 50.9% in the same period last year. Thedecrease is primarily due to decreased advertising expense 3.2%, bad debt 1.6%,supplies 0.7%, and auto expense 0.4%, partially offset by increased salarycosts 0.6%. Selling, general and administrative expenses for the directresponse division were 21.1% of sales compared to 21.6% for the three monthended September 30, 2004 and 2003, respectively. The improvement is primarilydue to decrease in salary costs 1.0%, and a reduction in depreciation expense0.4% due to the maturation of the direct response operating system, partially offsetby an increase in advertising expense 0.7% and credit card expense 0.2%.

 

Operatingincome increased 55.9% to $21.3 million from $13.7 million for the three monthsended September 30, 2004. This increase reflects performance of the GuitarCenter and Musician’s Friend businesses at or above expected levels, offsetsomewhat by an operating loss of approximately $1.3 million for the AmericanMusic segment for the quarter ended September 30, 2004.

 

Interest expense, net forthe three months ended September 30, 2004, decreased to $1.3 million from$4.3 million in the second quarter of 2003. The reduction in interestexpense is due primarily to the retirement of $67 million in 11% senior notesthrough a $100 million 4% convertible bond offering completed in June 2003.

 

In the three months endedSeptember 30, 2004, a $7.6 million provision for income taxes was recordedcompared to $3.6 million for the same period last year, both based on an effectivetax rate of approximately 38%.

 

Net income for the threemonths ended September 30, 2004 increased 114.7% to $12.4 million, compared to$5.8 million in the same period last year as a result of the factors describedabove.

 

**Nine Months Ended September 30,2004 Compared to the Nine Months Ended September 30, 2003**

 

Netsales for the nine months ended September 30, 2004 increased 18.8% to $1.0 billion,compared to $879.3 million in the same period last year.  Comparable store sales increased 9%.  We believe that comparable store sales are amore useful indicator of store performance than the change in total net sales,since comparable store sales exclude the effects of changes in the number ofstores open.

 

Netsales from Guitar Center stores for the nine months ended September 30, 2004totaled $798.7 million, an 18.7% increase from $672.7 million for the sameperiod in 2003.  Sales from new storescontributed $62.7 million and represent 49.8% of the total increase in retailstore sales.  Comparable Guitar Centerstore sales increased 9%. Net sales from American Music stores for the ninemonths ended September 30, 2004 totaled $28.7 compared to $27.2 million in2003.  American Music comparable storessales was 2%. Net sales from the direct response channel totaled $216.8 millionfor the nine months ended September 30, 2004, a $37.4 million, or 20.9%,increase from 2003. This increase primarily reflects the improved performanceof catalog circulation strategies.  Salesfrom the contact center, which represent sales placed via phone, live chat,mail and e-mail, increased 15.4% to $97.6 million from $84.6 million for the ninemonths ended September 30, 2004 compared to 2003. Internet sales from ordersplaced via the Musician’s Friend and Giardinelli web sites increased 25.7% to $119.2million from $94.8 million for the same period last year.  The growth of web-based sales reflects thecontinued trend of our catalog customers’ preference in using the web to placetheir orders, the success of web-based promotions, and that the web siteincludes a more complete inventory presentation than our catalogs.

 

14

----

 

Gross profitfor the nine months ended September 30, 2004 compared to 2003 increased 24.7%to $286.8 million from $230.1 million. Gross profit as a percentage of net sales for the nine months endedSeptember 30, 2004 compared to 2003 increased to 27.5% from 26.2%.  Gross profit as a percentage of net sales forGuitar Center was 25.9% compared with 24.2% for the nine months ended September30, 2003. The increase is due to higher selling margin 1.4%, lower inventory shrinkexpense 0.1%, lower freight costs and leveraged occupancy costs 0.3%. The grossprofit margin for the American Music stores was 34.3% compared to 36.3% for thesame period last year.  The decrease isprimarily due to lower selling margin due to a change in product mix 1.5% andincreased occupancy costs 0.5%. Gross profit margin for the direct responsedivision was 32.3% for the nine months ended September 30, 2004 compared to31.9% in the same period last year.  Theincrease is due to higher selling margin resulting from better buying performanceand favorable product mix 0.6%, decrease in inventory shrink 0.1%, partiallyoffset by increased freight costs 0.2%.

 

Selling, general and administrative expensesfor the nine months ended September 30, 2004 increased 16.8% to$224.1 million from $191.8 million for the same period in 2003.Selling, general and administrative expenses as a percentage of sales, for thenine months ended September 30, 2004 compared to 2003, decreased to 21.5% from21.8%. Selling, general and administrative expenses for the Guitar Centerstores were 20.6% as a percentage of sales for the nine months ended September30, 2004 compared to 20.7% for the same period last year. The improvement isprimarily due to leveraging on sales and increased operational efficiencies asindicated by reduced general insurance 0.1%, and lower computer repairs andmaintenance 0.1%, offset by increased professional fees 0.1%. Selling, generaland administrative expenses for the American Music stores were 47.3% of salesfor the nine months compared to 49.8% in the same period last year. Thedecrease is primarily due to decreased advertising expense 2.0%, bad debtexpense 0.6%, medical insurance 0.5% and supplies 0.5%, partially offset byincreases in depreciation and amortizations costs 0.5%, salary costs 0.4% andprofessional fees 0.2%. Selling, general and administrative expenses for thedirect response division were 21.4% of sales compared to 21.9% for the ninemonths ended September 30, 2004 and 2003, respectively. The improvement isprimarily due to leveraging on better than expected sales and increasedoperational efficiencies as indicated by a reduction in payroll costs 1.0%, adecrease in depreciation and amortization 0.4%, partially offset by an increasein advertising expense primarily related to programs to increase web traffic0.5% and an increase in general insurance 0.2%.

 

Operating income increased 64.1% to $62.7million from $38.2 million for the nine months ended September 30, 2004. Thisincrease reflects performance of the Guitar Center and Musician’s Friendbusinesses at or above expected levels, offset somewhat by an operating loss ofapproximately $3.7 million for the American Music segment for the nine monthsended September 30, 2004.

 

Interest expense, net for the nine months ended September 30, 2004,decreased to $4.1 million from $10.4 million in the same period lastyear. The reduction in interest expense is due primarily to the retirement of$67 million in 11% senior notes through a $100 million 4% convertible bondoffering completed in June 2003 and the use of cash flow from operations to payoff our line of credit borrowings.

 

In the nine months endedSeptember 30, 2004, a $22.3 million provision for income taxes was recordedcompared to $10.6 million for the same period last year, both based on aneffective tax rate of approximately 38%.

 

Net income for the nine months ended September 30, 2004 increased111.2% to $36.3 million, compared to $17.2 million in the same period last yearas a result of the factors described above.

 

### **Liquidityand Capital Resources**

### ** **

Our need for liquiditywill arise primarily from the funding of capital expenditures related toinfrastructure improvements and retail store expansion, working capitalrequirements and payments on our indebtedness, as well as possibleacquisitions. We have historically financed our operations primarily throughinternally generated funds and borrowings under our credit facilities. As ofSeptember 30, 2004, we had no borrowings under our credit facility and hadavailable borrowings of $110.4 million (net of $4.6 million of outstandingletters of credit).

 

In the fourth quarter of2003, we amended our credit facility with a syndicate of banks led by WellsFargo Retail Finance. The credit facility permits borrowings up to $125 million,subject to borrowing base limitations ($115 million at September 30,2004).  The actual amount available istied to our inventory and receivable base, and repayment obligations under thecredit facility are secured by liens on our principal assets. Borrowing optionsare prime rate (4.75% at September 30, 2004) plus applicable prime margin, orLondon Interbank Offered Rate, or

 

15

----

 

LIBOR (nine month rate at September 30, 2004 was2.35%), plus applicable LIBOR margin. The applicable prime and LIBOR marginsare fixed for the first six months of the amended agreement and were 0.00% and1.50%, respectively. After the initial six months, the applicable prime andLIBOR margins are based upon levels of excess availability and adjustedquarterly. If excess availability is greater than $20 million, the applicableprime margin is 0.00% and applicable LIBOR margin is 1.50%. If excessavailability is less than or equal to $20 million and greater than $10 million,the applicable prime margin is 0.00% and the applicable LIBOR margin is 1.75%.If excess availability is less than or equal to $10 million, the applicableprime margin is 0.25% and the applicable LIBOR margin is 2.00%. An unused linefee is assessed on the unused portion of the credit facility based upon levelsof excess availability. If excess availability is greater than $10 million, theunused line fee is 0.25%. If excess availability is less than or equal to $10million, the unused line fee is 0.375%. The agreement underlying the creditfacility includes significant restrictive negative covenants. Among otherthings, these covenants restrict our ability to incur debt and issue specifiedequity instruments, incur liens on our assets, make any significant change inour corporate structure or the nature of our business, dispose of assets, makeguaranties, prepay debt, engage in a change in control transaction, paydividends, make investments or acquisitions, engage in transactions withaffiliates and incur capital expenditures, and also require that we satisfy aminimum availability test. The minimum availability test requires that wemaintain $10 million of reserved availability under the agreement based on itsborrowing base limitations.  The amountwe disclose in our public reports from time to time as available to borrowunder the agreement ($110.4 million at September 30, 2004) is already reducedby this required reserve and outstanding letters of credit, and thus representsa net amount available under the agreement. The agreement also includesrepresentations and warranties which must be true each time we borrow fundsunder the credit facility and affirmative covenants.  The full text of the contractual requirementsimposed by this financing is set forth in the Amended and Restated Loan andSecurity Agreement and related amendments which have been filed with theSecurities and Exchange Commission.  Wewere in compliance with such requirements as of September 30, 2004.  Subject to limited cure periods, the lendersunder our credit facility may demand repayment of any borrowings prior tostated maturity upon the occurrence of specified events, including if we breachthe terms of the agreement, suffer a material adverse change, engage in achange in control transaction, suffer a significant adverse legal judgment,default on other significant obligations, or in the event of specified eventsof insolvency.  The credit agreementmatures in December 2007.

 

On June 16, 2003, we completed the issuance of $100 million principalamount of 4.00% Senior Convertible Notes due 2013.  Of the net proceeds from the offering,approximately $68.2 million was used in July 2003 to retire all outstandingSenior Notes and pay the related redemption premium, and the balance was usedto reduce the amount outstanding under our credit agreement and pay offeringexpenses.  The Notes bear interest at therate of 4.00% per annum, subject to the payment of contingent interest undercertain circumstances, and are convertible into shares of common stock at aconversion price of $34.58 per share, subject to adjustment under specifiedcircumstances. Under the contingent conversion feature of the Notes, subject tocertain exceptions, they are not convertible into common stock unless and untilthe trading price of the common stock reaches at least $41.50 for a specifiedperiod or designated corporate events occur. As of September 30, 2004, GuitarCenter’s common stock closed at or above $41.50 per share for twenty tradingdays within the thirty trading day period prior to the next conversionperiod.  As a result, holders of Guitar Center 4.0% Senior ConvertibleNotes due 2013 may, if they elect, convert the notes into common stock duringthe conversion period commencing July 16, 2004 and continuing through andincluding October 14, 2004. During the thirty trading days ending October 15,2004, our common stock traded above $41.50, and as a result the notes willremain convertible for the next quarterly conversion period. The notes willalso become convertible upon the occurrence of specified corporate transactionsand other events described in the indenture. The final maturity of the Notes isJuly 2013, although holders may require us to repurchase the Notes at theirelection in July 2008, July 2010 or upon the occurrence of a change in control,in each case for a purchase price equal to the original principal amount plusaccrued interest.  We may call the Notesfor redemption commencing in July 2006 subject to the payment of a redemptionpremium of 1.6% if redeemed prior to July 2007 and 0.8% if redeemed prior toJuly 2008 (thereafter there is no redemption premium). The indenture governingthe Notes does not limit our ability to incur indebtedness or otherwisesubstantively restrict the operation of our business to any significantdegree.  Subject to limited cure periods,the holders of the Notes may demand repayment of these borrowings prior to thestated maturity upon the occurrence of specified events, including if we failto pay interest or principal when due, fail to satisfy our conversionobligation, if another obligation of ours having an outstanding principalamount in excess of $15 million is accelerated prior to stated maturity andupon the occurrence of specified events of insolvency.

 

During 2002 we entered into master operating lease agreements withGeneral Electric Capital Corporation and US Bank to lease equipment and otherproperty primarily to support the operations of the new central distributioncenter for our Guitar Center retail stores. Under these agreements, we leased atotal of $10.5 million in equipment and other property. The agreements call formonthly payments of $138,000 for a term of 36

 

16

----

 

months through September 1,2005 with an option to extend through September 30, 2009 and monthly paymentsof $48,000 for a term of 24 months through December 28, 2005.

 

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

 

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

 

Net cash provided by operating activities was $9.5 million for the ninemonths ended September 30, 2004 compared to $13.1 million for the same periodlast year. We used cash generated from our improved operations during the ninemonths ended September 30, 2004 to increase inventories by $31 million andreduce accrued expenses by $14 million. The increase in merchandise inventoryis required to support the continuing growth of the Company.

 

Cash used in investing activities increased to $21.1 million for thenine months ended September 30, 2004 compared to $16.9 million for the sameperiod last year. The current period capital expenditures consisted primarilyof capital expenditures for store expansions and remodels of $11.8 millioncompared to $9.9 million in the prior period and computer equipment purchasesof $5.3 million in the current period compared to $4.8 million in the sameperiod last year.

 

 Cash provided by financingactivities totaled $18.0 million for the nine months ended September 30, 2004compared to $2.6 million for the same period last year. The cash provided byfinancing activities for the current period primarily consist of the proceedsreceived from the exercise of stock options of $17.3 million compared to theprior period which principally consisted of proceeds from the SeniorConvertible Notes offset by the redemption of the senior notes and the paydownof the credit facility.

 

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

 

We intend to pursue an aggressive growth strategy by opening additionalstores in new and existing markets. During the nine months ended September 30, 2004, we opened 13 new GuitarCenter stores (four large format and nine small format stores). Each new largeformat Guitar Center store typically has required approximately $1.6 to $1.8million for gross inventory. Historically, our cost of capital improvements for a large format GuitarCenter store has been approximately $850,000, consisting of leaseholdimprovements, fixtures and equipment. We incur higher costs in some geographicareas, particularly the Northeast, and when we build a larger flagshipstore.  We have developed smaller GuitarCenter stores to build in secondary markets or sites that we do not believewill support our large format units. The first of these units was opened inlate 2000 and 23 more had been opened as of September 30, 2004. Our smallformat stores have typically incurred approximately $560,000 in capitalexpenditures and require approximately $1.1 million to $1.2 million ininventory.

 

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

 

Our distribution center in the Indianapolis, Indiana area supports ourGuitar Center retail store operations. We have a 10-year agreement to lease thefacility and we also have numerous additional commitments necessary to supportthe operations of the facility. Starting in 2003, nearly all products flowthrough the distribution facility, with the exception of special orders whichwill continue, for the most part, to be drop shipped to our stores. Migrationfrom our former “drop-ship” model to a centralized distribution model is animportant

 

17

----

 

development in our operatingstrategy and has required the allocation of significant financial andmanagerial resources. In accordance with generally accepted accountingprinciples, a portion of the costs of operating this facility are absorbed intoour Guitar Center merchandise inventories and recognized as an element of costof goods sold when the related inventory is sold. This can result in a slightdecrease in reported gross margin depending on our success in defraying theseadditional costs, although we also expect to realize efficiencies involvingother costs such as selling, general and administrative expense and interestexpense.

 

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

 

Our expansion strategy is to continue to increase our market share inexisting markets and to penetrate strategically selected new markets.  We opened a total of 14 Guitar Center storesin 2003 and 12 stores in 2002, and currently anticipate opening 14 GuitarCenter stores in 2004. Approximately two-thirds of the stores opened in 2004 aresmaller format units designed for secondary markets. We opened a total of eightAmerican Music stores in 2002, five of the eight by acquisition of M&MMusic, a band instrument and retail merchandise retailer. In 2003, we openedone and closed two American Music stores. As of September 30, 2004, we have 20American Music stores, one of which was the acquisition of the former KarnesMusic store completed in July 2004. For the remainder of 2004, we do notpresently plan to open any American Music stores. We have slowed our plannedgrowth of the American Music division because our infrastructure andremerchandising projects at this business have to date required more time andresources than originally anticipated. We do, however, believe there exists anumber of acquisition opportunities in the relatively fragmented bandinstruments market that could be a good fit with our American Music platformand we continue to pursue acquisition opportunities.

 

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

 

Our known capital resource and liquidity requirements for 2004 arepresently expected to be primarily provided by cash on hand, net cash flow fromoperations and, possibly, borrowings under our credit facility. Depending uponmarket conditions, we may also elect or be required to raise additional capitalin the form of common or preferred equity, debt or convertible securities forthe purpose of providing additional capital to fund working capital needs orcontinued growth of our existing business, or to refinance existingobligations. Any such financing activity will be dependent upon many factors,including our liquidity needs, market conditions and prevailing market terms,and we cannot assure you that future external financing for us will beavailable on attractive terms or at all.

 

### **NewAccounting Pronouncements**

### ** **

In January2003, the Financial Accounting Standards Board issued FASB Interpretation No.46, *“Consolidation of Variable Interest Entities” (FIN46).*  This interpretationclarifies the application of Accounting Research Bulletin No. 51, *“Consolidated Financial Statements” (ARB 51),* and requirescompanies to evaluate variable interest entities for specific characteristicsto determine whether additional consolidation and disclosure requirementsapply.  This interpretation wasimmediately applicable for variable interest entities created after January 31,2003, and applies to the first fiscal year or interim period beginning afterJune 15, 2003 for variable interest entities acquired prior to February 1,2003. The adoption of this interpretation did not have any impact on ourfinancial position or results of operations. In December 2003, the FASB revisedFIN 46 to exempt certain entities from its requirements and to clarify certainissues arising during the implementation of FIN 46. The adoption of thisrevised interpretation in the first quarter of 2004 did not have any impact onour consolidated financial statements.

 

18

----

 

In May 2003, theFinancial Accounting Standards Board issued Statement No. 150, *“Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity”(SFAS No. 150). *The statement establishes standardsfor how an issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. It requires that an issuerclassify a financial instrument that is within its scope as a liability (or anasset in some circumstances). It is effective for financial instruments enteredinto or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003.   We adopted this standard effective July 1,2003, and it did not have a material effect on our consolidated financialstatements.

### ** **

In July 2004, the Emerging Issues Task Force (“EITF”) reached aconsensus on Issue No. 04-8, *“Accounting Issues Relatedto Certain Features of Contingently Convertible Debt and the Effect on DilutedEarnings per share”* (“EITF No. 04-8”). The Task Force reached aconsensus that contingently convertible debt instruments, such as our 4.00%Senior Convertible Notes, should be included in the computation of dilutedearnings per share under the if-converted method regardless of whether themarket price trigger (or other contingent feature) has been met. The EITF 04-8consensus must be applied by retroactive restatement based on the term ineffect on the last day of the fiscal period in which the consensus becomeseffective. This consensus requires an amendment to FASB Statement No. 128, *“Earnings per Share”*, and may be effective before the end of2004.

 

### **Seasonality**

### ** **

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

 

### **Inflation**

### ** **

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

 

### **Forward-LookingStatements**

### ** **

This report contains forward-looking statements relating to, amongother things, future results of operations, growth and investment plans, sales,trends in gross margin, growth in the Internet portion of our direct responsebusiness and other factors affecting growth in sales and earnings.  Specific forward-looking statements areprovided regarding our management’s current views regarding comparable storesales, new store openings, and capital expenditure levels.  Statements regarding new store openings arebased largely on our current expectations and are necessarily subject toassociated business risks related to, among other things, the identification ofsuitable sites or acquisition opportunities, the timely construction, staffingand merchandising of those stores and other matters, some of which are outsideof our control. Comparable store sales growth is highly dependent upon thestate of the economy, the effectiveness of our sales and promotion strategies,and the effect of competition, including other national operators of musicproducts stores attempting to implement national growth strategies. TheAmerican Music business has in the past and may in the future give rise tosignificant fluctuations from period to period as we reformat their store modeland build-out the information technology and management structure. The AmericanMusic stores incurred significant operating losses in 2003 and for the firstnine months of 2004, and are expected to incur operating losses for at leastthe next several quarters.

 

Sales and earnings trends are also affected by many other factorsincluding, among others, world and national political events, general economicconditions, the effectiveness of our promotion and merchandising strategies,changes in the music products industry, retail sales trends and the emergenceof new or growing specialty retailers of music products.  In light of these risks, there can be noassurance that the forward-looking statements contained in this report will infact be realized.  The statements made byus in this report represent our views as of the date of this report, and itshould not be assumed that the statements made herein remain accurate as of anyfuture date.  We do not presently intendto update these statements and undertake no duty to any person to affect anysuch update under any circumstances.

 

19

----

 

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

 

**Risks Related to the Business**

 

An investment in our securities involves a high degree of risk.  Described below are some of the risks anduncertainties facing our company.  Theremay be additional risks that we do not presently know of or that we currently considerimmaterial.  Any of these risks couldadversely affect our business, results of operations, liquidity and financialposition.  A shortfall in comparativesales growth in any period will likely cause a shortfall in earnings, andresult in financial performance below that for which we have planned or theinvestment community expects.

 

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

* *

Our retail store growth strategy includes opening new stores in new andexisting markets and increasing sales at existing locations.  As of September 30, 2004, we operated 135Guitar Center stores and 20 American Music stores.  We opened a total of 14 Guitar Center storesin 2003, and currently expect to open 14 additional Guitar Center stores in2004.  Approximately two-thirds of theGuitar Center stores opened in 2004 are smaller format units designed forsecondary markets. Our planned store opening schedule may be affected by anyacquisitions we may transact during a given period. If we complete any suchtransactions, our planned organic store openings may be reduced.

 

We opened a total of eight American Music stores in 2002, five of whichwere acquired in connection with American Music’s acquisition of M&M Music,a band instrument retailer. In 2003, we opened one American Music store andclosed two. In 2004, we acquired one additional American Music store in theChicago area. We believe there exist a number of acquisition opportunities inthe relatively fragmented band instruments market that could be a good fit withour American Music platform. However, we have slowed our planned growth of theAmerican Music division because our infrastructure and remerchandising projectsat this business have to date required more time and resources than originallyanticipated.  As a result of thesefactors, the American Music stores incurred significant operating losses in2003 and for the first nine months of 2004, and are expected to incur operatinglosses for at least the next several quarters.

 

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

 

•                  identificationof suitable retail sites and appropriate acquisition candidates;

 

•                  negotiation ofacceptable lease terms;

 

•                  hiring, trainingand retention of skilled personnel;

 

•                  availability ofadequate capital;

 

•                  sufficientmanagement and financial resources to support the new locations;

 

•                  vendor support;and

 

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

 

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

 

20

----

 

*We face unique competitive and merchandising challenges inconnection with our plans to open additional Guitar Center and American Musicretail stores in new markets.*

 

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

 

•                  significantstart-up costs, including promotion and advertising;

 

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

 

•                  management ofstores in distant locations or foreign countries;

 

•                  availability ofdesirable product lines; and

 

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

 

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

 

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

 

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

 
| ** ** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| Quarter 1  |       | 11       | %          | 4        | %          | 5        | %          |
| Quarter 2  |       | 8        | %          | 5        | %          | 8        | %          |
| Quarter 3  |       | 9        | %          | 7        | %          | 5        | %          |
| Quarter 4  |       | —   | %          | 10       | %          | 7        | %          |
|       |       |     |       |     |       |     |       |
| Full Year  |       | —   | %          | 7        | %          | 6        | %          |

 

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

 

•                  competition;

 

•                  economicconditions, including in particular, discretionary consumer spending;

 

•                  consumer andmusic trends;

 

•                  changes in ourmerchandise mix;

 

•                  productdistribution; and

 

•                  timing andeffectiveness of our promotional events.

 

Our management ispresently anticipating comparable store sales growth of 3% to 5% for the GuitarCenter stores’ fourth quarter of 2004. A shortfall in comparative sales growthin any period will likely cause a shortfall in earnings, and result infinancial performance below that for which we have planned or the investmentcommunity expects.

 

21

----

 

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

* *

We believe that ourexpansion may be accelerated by the acquisition of existing music productretailers. For example, in April 2001 we acquired the business of AmericanMusic Group, a New York-based retailer of band instruments, a business in whichwe were not previously engaged, and in July 2004 we acquired the assets of theband and orchestra instrument business of Karnes Music located in the Chicagoarea. We regularly investigate acquisition opportunities complimentary to ourGuitar Center, Musician’s Friend and American Music businesses. Accordingly, inthe ordinary course of our business, we regularly consider, evaluate and enterinto negotiations related to potential acquisition opportunities. We may payfor these acquisitions in cash or securities, including equity securities, or acombination of both. We cannot assure you that attractive acquisition targetswill be available at reasonable prices or that we will be successful in anysuch transaction.  Acquisitions involve anumber of special risks, including:

 

•                  diversion of ourmanagement’s attention;

 

•                  integration ofthe acquired business with our business; and

 

•                  unanticipatedlegal liabilities and other circumstances or events.

 

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

* *

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

 

*We face products liability risk.*

 

Products thatwe develop or sell may expose us to liability from claims by users of suchproducts for damages including, but not limited to, bodily injury or propertydamage. This risk is expected to increase as we use the capabilities of ourGuitar Center and Musician’s Friend distribution centers to increase theprivate label and other proprietary product that we offer. Much of this productis manufactured by small companies located overseas. We currently maintainproduct liability insurance coverage in amounts that we believe are adequate.However, there can be no assurance that we will be able to maintain suchcoverage or obtain additional coverage on acceptable terms in the future, orthat such insurance will provide adequate coverage against all potentialclaims.

* *

*22*

----

 

*We face significant competition, and our efforts toincrease our market share may be inhibited by existing or new competitors alsotrying to execute national expansion strategies.*

 

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

 

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

 

*We must grow our American Musicbusiness in order to reach profitability and earn an acceptable return on thatinvestment.*

 

In April 2001, we completed our acquisition of American Music Group, aNew York-based retailer of band instruments. We had not previously participatedin the band instruments segment of the music products business and had no priorexperience in this distribution channel. We intend to use the acquired AmericanMusic business as a platform to develop and grow a family music store conceptthat will emphasize band instruments and also sell selected “combo” productssold by our Guitar Center stores, such as guitars, drums and the like. Thus, weface the normal challenges of any acquisition, such as integration of personneland systems as well as the need to learn, understand and further develop thisbusiness. We are installing a new management information system at AmericanMusic, which has proven to be a challenging project requiring more time andresources than originally anticipated. This implementation is an importantproject to provide a systems backbone to permit growth of this division. Inaddition, we have begun marketing through the American Music stores some GuitarCenter products not previously carried by American Music and offering lessons.This change in merchandising strategy from the historic focus of American Musicon band instruments is in process and is an important element of our familymusic store concept for this brand.  Thisremerchandising strategy is not yet proven. Further, we have slowed our plannedgrowth of the American Music division because the challenges posed by ourinfrastructure and remerchandising projects. As a result of these factors, the American Music stores incurredsignificant operating losses in 2003 and the first nine months of 2004, and areexpected to incur operating losses for at least the next several quarters.Failure to execute on the requirements and initiatives described above couldresult in a poor or no return on our investment, constitute a distraction ofthe efforts of our management team from the core Guitar Center and Musician’sFriend brands and potentially require us to recognize an impairment in thesignificant amount of goodwill recorded in the acquisitions of American Music,M&M Music and Karnes Music, which totaled $21.0 million at September 30,2004.

 

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

* *

  Historically, wehave promoted employees from within our organization to fill senior operations,sales and store management positions.  Inorder to achieve our growth plans, we will depend upon our ability to retainand promote existing personnel to senior management, and we must attract andretain new personnel with the skills and expertise to manage our business. Ifwe cannot hire, retain and promote qualified personnel, our business, resultsof operations, financial condition and prospects could be adversely affected.

 

*The implementation of ourdistribution center for the Guitar Center retail stores presents operationalrisks and represents a significant investment.*

 

Our distribution center in the Indianapolis, Indiana area supports ourGuitar Center retail store operations. The conveyor systems, the warehousemanagement system, and all other technology systems and infrastructurecommenced operations in July 2002. Migration from our former “drop-ship” modelto a centralized distribution model is an important development in ouroperating strategy. The efficient operation of the distribution center is alsodependent upon the performance of third parties that we do not control, such asvendors who must comply with new operating procedures and common carriers whomust deliver product on time. This

 

23

----

 

program involves financial andoperating risks that could include the need to expend greater funds thanpresently budgeted or disruptions in retail store operations and the loss ofsales if inventory is not timely provided in the required quantities. Further,one of the key underlying economic assumptions of our distribution centerproject is that this program will permit us to reduce overall inventory levelsas a percentage of sales thereby resulting in significantly reduced workingcapital requirements. Any failure to reach our inventory reduction targets willadversely affect our future financial performance and capital needs,potentially in a material manner. Failure to execute on these requirementscould result in a poor or no return on our investment, disruption of our retailstore business and a distraction of the efforts of our management team.

 

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

* *

As of September 30, 2004, our corporate headquarters as well as 23 ofour 135 Guitar Center stores were located in California, and stores located inthat state generated 18.1% and 26.1% of our retail sales for the third quarterof 2004 and 2003, respectively.  Althoughwe have opened and acquired stores in other areas of the United States, asignificant percentage of our net sales and results of operations will likelyremain concentrated in California for the foreseeable future.  As a result, our results of operations andfinancial condition are heavily dependent upon general consumer trends andother general economic conditions in California and are subject to otherregional risks, including earthquakes. We do maintain earthquake insurance, but such policies carry significantdeductibles and other restrictions.

 

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

 

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

 

*While we believe that our internal controlover financial reporting operates at a reasonable level of effectiveness, weare still exposed to potential risks from recent legislation requiringcompanies to evaluate such controls under Section 404 of the Sarbanes-Oxley Actof 2002.*

 

We areevaluating our internal control over financial reporting in order to allowmanagement to report on, and our independent auditors to attest to, suchcontrols, as required by Section 404 of the Sarbanes-Oxley Act.  During this process, we have identified whatmay be deemed to be potential control deficiencies and have established aprocess to investigate and, as appropriate, remediate such matters.  To date, we do not believe that any of theseissues constitute a material weakness. Nonetheless, since this is the first year of implementation of Section404 the compliance standards are not fully known and we and all other publiccompanies are incurring additional expenses related to outside experts and adiversion of management’s time.  Althoughwe have made this project a top priority for the Company, there can be noassurances that all potential deficiencies identified will be remediated beforethe end of our fiscal year.

 

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

 

The adoption or modification of laws or regulations, orrevised interpretations of existing laws, relating to the direct responseindustry could adversely affect the manner in which we currently conduct ourcatalog and e-commerce business and the results of operations of that unit. Forexample, laws and enforcement practices related to the taxation of catalog,telephone and online commercial activity, including the collection of sales taxon direct response sales, remain in flux. In addition, the growth anddevelopment of the market for online commerce may lead to more stringentconsumer protection laws, both in the United States and abroad, that may imposeadditional burdens on us. Laws and regulations directly applicable tocommunications or commerce over the Internet are becoming more prevalent. Thelaw of the Internet, however, remains largely unsettled, even in areas wherethere has been some legislative action. It may take years to determine whetherand how existing laws such as those governing intellectual property, consumerprivacy, sales-based and other taxation of e-commerce transactions and the likeare interpreted and enforced. Any adverse change in any of these laws or in theenforcement, interpretation or scope of existing laws could have a materialadverse effect on our results of operations, financial condition or prospects.

 

24

----

 

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

 

We are involved in a number of litigation matters in the ordinarycourse of our business.  Among thesecases is a putative class action brought against us for alleged violations ofwhat is known as California’s “wage and hour” law.  The plaintiff has alleged, among otherthings, that we improperly failed to document and enforce break-time andlunch-time periods for employees.  Thislitigation has just recently been filed and no discovery has yet commenced.  We intend to defend this mattervigorously.  Current and futurelitigation that our Company is involved in may result in substantial costs andexpenses and significantly divert the attention of our management regardless ofthe outcome.  In addition, current andfuture litigation, governmental proceedings, labor disputes or environmentalmatters could lead to increased costs or interruptions of our normal businessoperations.

 

*We must manage efficiently the expansion of our DirectResponse business, including the musiciansfriend.com website, our systems thatprocess orders in our Direct Response business, and our fulfillment resourcesin order to service our customers properly.*

* *

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

 

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

 

Our relationships with our e-commerce customers may be adverselyaffected if the security measures that we use to protect their personalinformation, such as credit card numbers, are ineffective.  If, as a result, we lose customers, our netsales could decrease. We rely on security and authentication technology that welicense from third parties. With this technology, we perform real-time creditcard authorization and verification with our bank. We cannot predict whetherevents or developments will result in a compromise or breach of the technologywe use to protect a customer’s personal information.  Furthermore, our servers may be vulnerable tocomputer viruses, physical or electronic break-ins and similar disruptions. Wemay need to expend significant additional capital and other resources to protectagainst a security breach or to alleviate problems caused by any breaches. Wecannot assure that we can prevent all security breaches.

 

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

 

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

 

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

 

We rely on our computerhardware and software systems for the efficient operation of our retail storesand direct response business. Our information systems provide our managementwith real-time inventory, sales and cost information that is essential to theoperation of our business. Due to our number of stores, geographic diversityand other factors, we would be unable to generate this information in a timelyand accurate manner in

 

25

----

 

the event our hardware or software systems wereunavailable. These systems are vulnerable to damage or interruption from anumber of factors, including:

 

•      earthquake, fire, flood and other naturaldisasters; and

 

•      power loss, computer systems failure, Internetand telecommunications or data network failure.

 

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

 

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

 

*Our stock price could bevolatile.*

 

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

 

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

** **

From time to time, werelease projections and similar guidance regarding our future performance thatrepresent our management’s estimates as of the date of release. Theseprojections, which are forward looking-statements, are prepared by ourmanagement and are qualified by, and subject to, the assumptions and the otherinformation contained or referred to in the release. Our projections are notprepared with a view toward compliance with published guidelines of theAmerican Institute of Certified Public Accountants, and neither our independentpublic accountants nor any other independent expert or outside party compilesor examines the projections and, accordingly, no such person expresses anyopinion or any other form of assurance with respect thereto.

 

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

 

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

 

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

 

26

----

 

**Item 3****.                Quantitative and QualitativeDisclosures About Market Risk**

 

We do not have any assets or liabilities which, in our view, imposeupon us significant market risk except for our outstanding indebtednessrepresented by $100 million principal amount of Senior Convertible Notes due2013 with a fixed interest rate of 4% (subject to contingent interest) and ourcredit facility which has a variable rate of interest generally consisting ofstated premiums above LIBOR.  AtSeptember 30, 2004, we had no outstanding borrowings under our creditfacility.  To the extent prevailingshort-term interest rates fluctuate, the interest expense we incur on ourcredit facility will change with a resulting effect (positive or negative) onour financial position, results of operations and cash flows. We do not usederivative financial instruments in our investment portfolio.  Historically, we have not carried significantcash balances and any cash in excess of our daily operating needs has been usedto reduce our borrowings.  Excess cash isinvested in short-term, high quality interest bearing investments.

 

**Item 4****.                Controls and Procedures**

 

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in our Securities Exchange Act reports is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms and that such information is accumulatedand communicated to our management, including our Co-Chief Executive Officersand Chief Financial Officer, as appropriate, to allow for timely decisionsregarding required disclosure. In designing and evaluating the disclosure controlsand procedures, management recognizes that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and management is required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

 

As required by SECRule 13a-15(b), we carried out an evaluation, under the supervision and withthe participation of our management, including our Co-Chief Executive Officersand Chief Financial Officer, of the effectiveness of the design and operationof our disclosure controls and procedures as of the end of the period coveredby this report.  Based on the foregoing, our Co-Chief Executive Officersand Chief Financial Officer concluded that our disclosure controls andprocedures were effective at the reasonable assurance level.

 

There has been nochange in our internal control over financial reporting during our most recentfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

We areevaluating our internal control over financial reporting in order to allowmanagement to report on, and our independent auditors to attest to, suchcontrols, as required by Section 404 of the Sarbanes-Oxley Act.  During this process, we have identified whatmay be deemed to be potential control deficiencies and have established aprocess to investigate and, as appropriate, remediate such matters.  To date, we do not believe that any of theseissues constitute a material weakness. Nonetheless, since this is the first year of implementation of Section404 the compliance standards are not fully known and we and all other publiccompanies are incurring additional expenses related to outside experts and adiversion of management’s time.  Althoughwe have made this project a top priority for the Company, there can be noassurances that all potential deficiencies identified will be remediated beforethe end of our fiscal year.

 

 

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

 

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

 

Exhibits:

 

10.1         Form of Stock OptionAgreement under the 2004 Guitar Center, Inc. Incentive Stock Award Plan (filedherewith).

 

10.2         Form of RestrictedStock Agreement under the 2004 Guitar Center, Inc. Incentive Stock Award Plan(filed herewith).

 

10.3         Form of DeferredStock Agreement under the 2004 Guitar Center, Inc. Incentive Stock Award Plan(filed herewith).

 

31.1         Certification of theCompany’s Co-Chief ExecutiveOfficer pursuant to Section 302 of the Sarbanes-OxleyAct of 2002.

 

27

----

 

31.2         Certification of theCompany’s Co-Chief Executive Officer pursuant to Section 302 of theSarbanes-Oxley Act of 2002.

 

31.3         Certification of theCompany’s Chief Financial Officer pursuant to Section 302 of the Sarbanes-OxleyAct of 2002.

 

32.1         Certification of theCompany’s Co-Chief Executive Officer pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

32.2         Certification of theCompany’s Co-Chief Executive Officer pursuant to Section 906 of theSarbanes-Oxley Act of 2002.

 

32.3         Certification of theCompany’s Chief Financial Officer pursuant to Section 906 of the Sarbanes-OxleyAct of 2002.

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized as of the 8th day of November 2004.

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

 

28

----