**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-Q**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe quarterly period ended June 30, 2007**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934

**Forthe transition periodfrom                                 to                                 **

**CommissionFile No. 000-22207**

**GUITAR CENTER, INC.**

(Exact Name of Registrantas Specified in its Charter)

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

 

**(818) 735-8800**

Registrant’s telephonenumber, including area code

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.

Yes  x   No  o

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

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

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes  o   No  x

Asof August 2, 2007, there were 29,622,000 shares of our common stock, $.01par value, outstanding.

 

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**GUITAR CENTER, INC.AND SUBSIDIARIESINDEX**
| Part I.  |       | Financial Information                                                                    |       |                                                                                            |
|---------------|------------|------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|
|          | ** ** | **Item 1. Consolidated Financial Statements  (Unaudited)**                               |       |                                                                                            |
|          |       | Consolidated  Balance Sheets—June 30, 2007 and December 31, 2006          |       | 1                                                                                               |
|          |       | Consolidated  Statements of Income—Three months ended June 30, 2007 and 2006   |       | 2                                                                                               |
|          |       | Consolidated Statements  of Income—Six months ended June 30, 2007 and 2006     |       | 3                                                                                               |
|          |       | Consolidated  Statements of Cash Flows—Six months ended June 30, 2007 and 2006 |       | 4                                                                                               |
|          |       | Notes  to Consolidated Financial Statements                                              |       | 6                                                                                               |
| ** **    | ** ** | **Item 2.**                                                                              | ** ** | **Management’s Discussion and  Analysis of Financial Condition and Results of Operations** |   | 14 |
|          | ** ** | **Item 3.**                                                                              | ** ** | **Quantitative and Qualitative  Disclosures About Market Risk**                                 |   | 27 |
|          | ** ** | **Item 4.**                                                                              | ** ** | **Controls  and Procedures**                                                                    |   | 27 |
| Part II. |       | Other Information                                                                        |       | 29                                                                                              |
|          | ** ** | **Item 1.**                                                                              | ** ** | **Legal  Proceedings**                                                                          |   | 29 |
|          | ** ** | **Item 1A.**                                                                             | ** ** | **Risk  Factors**                                                                               |   | 29 |
|          | ** ** | **Item 4.**                                                                              | ** ** | **Submission of Matters to a  Vote of Security Holders**                                        |   | 31 |
|          | ** ** | **Item  6.**                                                                             | ** ** | **Exhibits**                                                                                    |   | 32 |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES** CONSOLIDATED BALANCE SHEETS (In thousands) (Unaudited)

| ** **                                                                                                                                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| **Assets**                                                                                                                                                |       |              |       |                  |       |   |   |
| Current assets:                                                                                                                                           |       |              |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                 |       | $                 | 13,624     |                  |       | $ | 15,153 |   |   |
| Accounts receivable, less allowance for doubtful  accounts of $3,213 and $2,618, respectively                                                        |       | 44,920            |       |                  | 53,916     |   |   |
| Merchandise inventories                                                                                                                                   |       | 627,084           |       |                  | 578,082    |   |   |
| Prepaid expenses and other current assets                                                                                                                 |       | 20,909            |       |                  | 16,178     |   |   |
| Deferred income taxes                                                                                                                                     |       | 26,974            |       |                  | 22,739     |   |   |
| Total current  assets                                                                                                                                     |       | 733,511           |       |                  | 686,068    |   |   |
| Property and  equipment, net of accumulated depreciation and amortization of $172,949  and $153,033, respectively                                    |       | 219,998           |       |                  | 201,986    |   |   |
| Goodwill                                                                                                                                                  |       | 20,330            |       |                  | 18,507     |   |   |
| Intangible  assets, net                                                                                                                                   |       | 8,179             |       |                  | 7,612      |   |   |
| Other assets, net                                                                                                                                         |       | 13,525            |       |                  | 13,305     |   |   |
| Total assets                                                                                                                                              |       | $                 | 995,543    |                  |       | $ | 927,478 |   |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                            |       |              |       |                  |       |   |   |
| Current liabilities:                                                                                                                                      |       |              |       |                  |       |   |   |
| Cash overdraft                                                                                                                                            |       | $                 | 22,267     |                  |       | $ | 20,243 |   |   |
| Accounts payable                                                                                                                                          |       | 100,850           |       |                  | 93,717     |   |   |
| Accrued expenses and other current liabilities                                                                                                            |       | 71,432            |       |                  | 117,595    |   |   |
| Merchandise advances                                                                                                                                      |       | 23,329            |       |                  | 26,830     |   |   |
| Borrowings under revolving line of credit                                                                                                                 |       | 169,611           |       |                  | 101,144    |   |   |
| Total current  liabilities                                                                                                                                |       | 387,489           |       |                  | 359,529    |   |   |
| Other long-term  liabilities                                                                                                                              |       | 19,753            |       |                  | 17,292     |   |   |
| Deferred income  taxes                                                                                                                                    |       | 5,195             |       |                  | 5,165      |   |   |
| Long-term debt                                                                                                                                            |       | 887               |       |                  | 1,416      |   |   |
| Total liabilities                                                                                                                                         |       | 413,324           |       |                  | 383,402    |   |   |
| Minority interest                                                                                                                                         |       | 1,077             |       |                  | 1,339      |   |   |
| Commitments and  contingencies                                                                                                                            |       |              |       |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                |       |              |       |                  |       |   |   |
| Preferred stock, 5,000 authorized, none issued and  outstanding                                                                                           |       | —            |       |                  | —     |   |   |
| Common stock, $0.01 par value, authorized  100,000 shares, issued and outstanding 29,614 at June 30, 2007 and 29,469  at December 31, 2006 |       | 296               |       |                  | 295        |   |   |
| Additional paid-in capital                                                                                                                                |       | 475,841           |       |                  | 464,217    |   |   |
| Retained earnings                                                                                                                                         |       | 105,005           |       |                  | 78,225     |   |   |
| Total stockholders’  equity                                                                                                                          |       | 581,142           |       |                  | 542,737    |   |   |
| Total liabilities and  stockholders’ equity                                                                                                          |       | $                 | 995,543    |                  |       | $ | 927,478 |   |   |

 

See accompanying notes to consolidated financial statements.

1

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**GUITAR CENTER, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(In thousands, except per share data)(Unaudited)**

| ** **                                                              | ** ** | **Three months ended June 30,**                              | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                              | ** ** | **      2007      ** | ** ** | **      2006      ** | ** ** |
| Net sales                                                               |       |                                                                             | $          | 518,902 |   |   |   | $ | 457,978 |   |   |
| Cost of goods  sold, buying and occupancy                               |       |                                                                             | 372,254    |   |   |   | 326,621 |   |   |
| Gross profit                                                            |       |                                                                             | 146,648    |   |   |   | 131,357 |   |   |
| Selling, general  and administrative expenses                           |       |                                                                             | 128,345    |   |   |   | 107,984 |   |   |
| Operating income                                                        |       |                                                                             | 18,303     |   |   |   | 23,373 |   |   |
| Interest expense,  net of interest income of $242 and $73, respectively |       |                                                                             | 2,375      |   |   |   | 2,374 |   |   |
| Income before  income taxes and minority interest                       |       |                                                                             | 15,928     |   |   |   | 20,999 |   |   |
| Income taxes                                                            |       |                                                                             | 6,505      |   |   |   | 7,570 |   |   |
| Minority interest  in loss                                              |       |                                                                             | (132       | ) |   |   | — |   |   |
| Net income                                                              |       |                                                                             | $          | 9,555 |   |   |   | $ | 13,429 |   |   |
| Net income per  share:                                                  |       |                                                                             |       |   |   |   |   |   |   |
| Basic                                                                   |       |                                                                             | $          | 0.32 |   |   |   | $ | 0.51 |   |   |
| Diluted                                                                 |       |                                                                             | $          | 0.32 |   |   |   | $ | 0.47 |   |   |
| Weighted average  shares outstanding:                                   |       |                                                                             |       |   |   |   |   |   |   |
| Basic                                                                   |       |                                                                             | 29,557     |   |   |   | 26,278 |   |   |
| Diluted                                                                 |       |                                                                             | 30,276     |   |   |   | 30,012 |   |   |

 

See accompanying notes to consolidated financial statements.

2

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**GUITAR CENTER, INC.AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(In thousands, except per share data)(Unaudited)**

| ** **                                                               | ** ** | **Six months ended June 30,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                               | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
| Net sales                                                                |       | $                                                 | 1,053,385  |   | $ | 928,725 |   |
| Cost of goods  sold, buying and occupancy                                |       | 752,361                                           |       | 660,862 |   |
| Gross profit                                                             |       | 301,024                                           |       | 267,863 |   |
| Selling, general  and administrative expenses                            |       | 252,382                                           |       | 217,098 |   |
| Operating income                                                         |       | 48,642                                            |       | 50,765 |   |
| Interest expense,  net of interest income of $467 and $148, respectively |       | 4,168                                             |       | 4,226 |   |
| Income before  income taxes and minority interest                        |       | 44,474                                            |       | 46,539 |   |
| Income taxes                                                             |       | 17,924                                            |       | 17,403 |   |
| Minority interest  in loss                                               |       | (230                                              | )          | — |   |
| Net income                                                               |       | $                                                 | 26,780     |   | $ | 29,136 |   |
| Net income per  share:                                                   |       |                                              |       |   |   |
| Basic                                                                    |       | $                                                 | 0.91       |   | $ | 1.11 |   |
| Diluted                                                                  |       | $                                                 | 0.89       |   | $ | 1.03 |   |
| Weighted average  shares outstanding:                                    |       |                                              |       |   |   |
| Basic                                                                    |       | 29,532                                            |       | 26,227 |   |
| Diluted                                                                  |       | 30,223                                            |       | 29,849 |   |

 

See accompanying notes to consolidated financial statements.

3

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**GUITAR CENTER, INC. AND SUBSIDIARIES**CONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)(Unaudited)

 

| ** **                                                                     | ** ** | **Six months ended June 30,**                                | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **      2007      ** | ** ** | **      2006      ** | ** ** |
| **Operating activities:**                                                      | ** ** |                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net income                                                                     |       |                                                                             | $          | 26,780 |   |   |   | $ | 29,136 |   |   |
| Adjustments to reconcile  net income to net cash used in operating activities: |       |                                                                             |       |   |   |   |   |   |   |
| Depreciation and amortization                                                  |       |                                                                             | 22,799     |   |   |   | 17,192 |   |   |
| Amortization of deferred financing fees                                        |       |                                                                             | 47         |   |   |   | 485 |   |   |
| Stock-based compensation                                                       |       |                                                                             | 6,938      |   |   |   | 11,908 |   |   |
| Deferred income taxes                                                          |       |                                                                             | (4,205     | ) |   |   | (7,150 | ) |   |
| Minority interest in loss                                                      |       |                                                                             | (230       | ) |   |   | — |   |   |
| Changes in operating  assets and liabilities, net of effect of acquisitions:   |       |                                                                             |       |   |   |   |   |   |   |
| Accounts receivable                                                            |       |                                                                             | 11,696     |   |   |   | 6,393 |   |   |
| Merchandise inventories                                                        |       |                                                                             | (22,495    | ) |   |   | (40,769 | ) |   |
| Prepaid expenses and other current assets                                      |       |                                                                             | (3,638     | ) |   |   | (2,254 | ) |   |
| Other assets, net                                                              |       |                                                                             | (267       | ) |   |   | (279 | ) |   |
| Cash overdraft                                                                 |       |                                                                             | 2,024      |   |   |   | 860 |   |   |
| Accounts payable                                                               |       |                                                                             | 7,133      |   |   |   | 19,025 |   |   |
| Accrued expenses and other current liabilities                                 |       |                                                                             | (47,385    | ) |   |   | (43,106 | ) |   |
| Merchandise advances                                                           |       |                                                                             | (4,201     | ) |   |   | (4,977 | ) |   |
| Other long-term liabilities                                                    |       |                                                                             | 2,461      |   |   |   | 2,438 |   |   |
| Net cash used in  operating activities                                         |       |                                                                             | (2,543     | ) |   |   | (11,098 | ) |   |
| **Investing activities:**                                                      | ** ** |                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Purchase of property and equipment                                             |       |                                                                             | (39,047    | ) |   |   | (38,046 | ) |   |
| Acquisition of intangible assets                                               |       |                                                                             | (33        | ) |   |   | — |   |   |
| Acquisition of businesses                                                      |       |                                                                             | (32,056    | ) |   |   | (17,396 | ) |   |
| Net cash used in  investing activities                                         |       |                                                                             | (71,136    | ) |   |   | (55,442 | ) |   |
| **Financing activities:**                                                      | ** ** |                                                                             | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net change in borrowings under revolving line of  credit                       |       |                                                                             | 68,467     |   |   |   | 55,283 |   |   |
| Proceeds from exercise of stock options                                        |       |                                                                             | 2,546      |   |   |   | 4,741 |   |   |
| Proceeds from stock issued under employee purchase  plan                       |       |                                                                             | 1,331      |   |   |   | 1,220 |   |   |
| Excess tax benefit from exercise of stock options                              |       |                                                                             | 367        |   |   |   | 1,693 |   |   |
| Repayment of long-term debt                                                    |       |                                                                             | (529       | ) |   |   | — |   |   |
| Other                                                                          |       |                                                                             | (32        | ) |   |   | — |   |   |
| Net cash provided  by financing activities                                     |       |                                                                             | 72,150     |   |   |   | 62,937 |   |   |
| Net decrease in  cash and cash equivalents                                     |       |                                                                             | (1,529     | ) |   |   | (3,603 | ) |   |
| Cash and cash  equivalents at beginning of period                              |       |                                                                             | 15,153     |   |   |   | 14,529 |   |   |
| Cash and cash  equivalents at end of period                                    |       |                                                                             | $          | 13,624 |   |   |   | $ | 10,926 |   |   |

 

See accompanying notes to consolidated financial statements.

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**GUITAR CENTER, INC. AND SUBSIDIARIES**CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)(In thousands)(Unaudited)

 

| ** **                                                                                          | ** ** | **Six months ended June 30,**                    | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **     2007     ** | ** ** | **     2006     ** | ** ** |
| **Non-cash investing and  financing activities:**                                                   | ** ** |                                                                 | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Acquisition of  businesses, in which the fair value of assets and liabilities were as follows: |       |                                                                 |       |   |   |   |   |   |   |
| Accounts receivable                                                                                 |       |                                                                 | $          | 2,700 |   |   |   | $ | 488 |   |   |
| Merchandise inventories                                                                             |       |                                                                 | 26,507     |   |   |   | 6,633 |   |   |
| Prepaid expenses and other current assets                                                           |       |                                                                 | 1,093      |   |   |   | — |   |   |
| Deferred income taxes                                                                               |       |                                                                 | —     |   |   |   | 887 |   |   |
| Property and equipment                                                                              |       |                                                                 | 841        |   |   |   | 191 |   |   |
| Goodwill                                                                                            |       |                                                                 | 1,823      |   |   |   | 9,772 |   |   |
| Intangible assets                                                                                   |       |                                                                 | 1,457      |   |   |   | 845 |   |   |
| Total assets acquired                                                                               |       |                                                                 | 34,421     |   |   |   | 18,816 |   |   |
| Accrued expenses and other current liabilities                                                      |       |                                                                 | (1,665     | ) |   |   | (1,371 | ) |   |
| Merchandise advances                                                                                |       |                                                                 | (700       | ) |   |   | (49 | ) |   |
| Total liabilities assumed                                                                           |       |                                                                 | (2,365     | ) |   |   | (1,420 | ) |   |
| Net assets acquired                                                                                 |       |                                                                 | $          | 32,056 |   |   |   | $ | 17,396 |   |   |
| Conversion of  debt to common stock                                                                 |       |                                                                 | $          | — |   |   |   | $ | 185 |   |   |

 

See accompanying notes to consolidated financial statements.

5

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

**1.**                 Natureof Business and Significant Accounting Policies

*Nature of Business*

Guitar Center, Inc.(the “Company”) is the leading United States retailer of guitars, amplifiers,percussion instruments, keyboards and pro-audio and recording equipment. As of June 30,2007, our wholly owned retail subsidiary operated 212 Guitar Center storesacross the United States consisting of 139 primary format stores, 70secondary format stores and 3 tertiary format stores. In addition, as of June 30,2007, our Music & Arts division operated 97 stores specializing inband instruments for sale and rental, serving thousands of teachers, banddirectors, college professors and students. We are also the largest directresponse retailer of musical instruments in the United States through ourwholly owned subsidiary, Musician’s Friend, Inc., and its catalogs andwebsites, including www.musiciansfriend.com, www.guitarcenter.com,www.wwbw.com, www.music123.com and related websites.

*Basis ofPresentation*

In the opinion of management, the accompanyingunaudited consolidated financial statements contain all adjustments necessaryto present fairly the financial position of the Company as of June 30, 2007,the results of operations for the three and six months ended June 30, 2007and 2006, respectively, and its cash flows for the six months ended June 30,2007 and 2006. The accompanying consolidated financial statements should beread in conjunction with the audited consolidated financial statements andnotes thereto contained in our Annual Report on Form 10-K for theyear ended December 31, 2006.

The Company’s results ofoperations and cash flows for the interim periods may not be indicative of theresults of operations and cash flows for the full year.

*Use of Estimates inthe Preparation of Financial Statements*

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires the Company to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from our estimates.

*Reclassifications*

A reclassification hasbeen made to the June 30, 2006 consolidated cash flows statement toseparately report cash overdraft, which was previously included with accountspayable. This reclassification has no impact on the previously reported netcash provided by operating activities.

*Recently IssuedAccounting Pronouncements*

In June 2006, the Financial Accounting StandardsBoard (“FASB”) ratified Emerging Issues Task Force (“EITF”) Issue 06-3, *How Sales Taxes Collected From Customers and Remitted to GovernmentalAuthorities Should Be Presented in the Income Statement,* (“EITF 06-3”). EITF 06-3 requiresa company to disclose its accounting policy (i.e., gross or net presentation)regarding the presentation of taxes within the scope of EITF 06-3. Iftaxes are significant, a company should disclose the amount of such taxes foreach period for which an income statement is presented. As required, theCompany adopted EITF 06-3 as of 

6

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January 1, 2007 andthe effect of the initial adoption of EITF 06-3 did not have any impacton its consolidated financial statements as we have historically presentedsales excluding these taxes.

In September 2006, the FASB issued Statement ofFinancial Accounting Standards (“SFAS”) No. 157, *Fair ValueMeasurements*. SFAS No. 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements. Accordingly, thisStatement does not require any new fair value measurements. SFAS No. 157is effective for fiscal years beginning after November 15, 2007. TheCompany is currently evaluating the impact, if any, the adoption of SFAS No. 157will have on its consolidated financial statements.

In February 2007, theFASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilitie*s. SFAS No. 159permits companies to choose to measure certain financial instruments andcertain other items at fair value. The standard requires that unrealized gainsand losses on items for which the fair value option has been elected bereported in earnings. SFAS No. 159 is effective as of the beginning of anentity’s first fiscal year that begins after November 15, 2007, and theCompany is required to adopt SFAS No. 159 in the first quarter of 2008.The Company is currently evaluating the impact that SFAS No. 159 will haveon its consolidated financial statements.

**2.**                 Acquisitionof Businesses

On February 9, 2007, our Musician’s Friend, Inc.subsidiary acquired substantially all of the assets of Dennis Bamber, Inc.and its Chapter 11 bankruptcy estate, d/b/a The Woodwind & TheBrasswind, for an aggregate purchase price of approximately $26.0 million,which includes $22.5 million in merchandise inventories and $2.7 million inaccounts receivable. The purchase price is preliminary subject to finalvaluation of the related net assets and approval by the bankruptcy court. Anyrevisions to the purchase price may affect the amount of goodwill recorded, whichis zero as of June 30, 2007, and the valuation of the related noncurrentassets. The acquisition included a variety of direct response catalogs andwebsites, including those under the brand names Woodwind & Brasswindand Music123. The Woodwind & Brasswind brand is targeted primarily toonline and catalog purchases of band and orchestra instruments, while theMusic123 brand name is targeted primarily to online purchases of guitars,amplifiers, percussion instruments, keyboards and pro audio and recording equipment.The acquired business operates as a division of our Musician’s Friendsubsidiary, through an office, retail outlet and warehouse facility and adistribution center facility, both located in South Bend, Indiana.

In the first quarter of 2007, our retail subsidiaryacquired the Victor’s House of Music retail location in Paramus, New Jersey andits related net assets for an aggregate purchase price of approximately $6.2million. Net assets for the retail band and orchestra and rental business wereallocated to the Music & Arts division, with the remaining net assetsand goodwill of $1.8 million allocated to the Guitar Center Stores division.

The aggregate purchase price for the acquisitions inthe six months ended June 30, 2007 (including purchase price adjustmentsof $0.1 million) totaled approximately $32.1 million, which was principallyallocated to merchandise inventories of $26.5 million, accounts receivable of$2.7 million and goodwill of $1.8 million.

The acquisitions wereaccounted for under the purchase method of accounting in accordance with SFAS No. 141,*Business Combinations*. The results ofoperations of the acquisitions were not material to the current periodconsolidated financial statements and, as such, pro forma financial informationis not presented for these acquisitions. The results of operations of theacquired businesses are included in the consolidated financial statements fromthe respective dates of acquisition.

7

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**3.**                 Goodwilland Intangible Assets

Goodwillrepresents the excess of the purchase price over the fair value of identifiablenet assets acquired resulting from business acquisitions accounted for underthe purchase method. The changes in the carrying amount of goodwill byreportable segment for the six months ended June 30, 2007 were as follows(in thousands):

| ** **                            | ** ** | **Guitar** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|---------------------|------------|------------|------------|
| ** **                            | ** ** | **Center** | ** ** | **Friend**          | ** ** | **Total**  | ** ** |
| Balance at  December 31, 2006    |       | $          | 15,066     |                |       | $          | 3,441      |   |   | $ | 18,507 |   |
| Goodwill resulting from  acquisitions |       | 1,823      |       |                | —     |       |       | 1,823 |   |
| Balance at June 30, 2007         |       | $          | 16,889     |                |       | $          | 3,441      |   |   | $ | 20,330 |   |

 

Intangibleassets with finite useful lives are amortized over their respective estimateduseful lives. The following is a summary of intangible assets as of June 30,2007 and December 31, 2006 (dollars in thousands, life in years):

| ** **               | ** ** | ** **                           | ** ** | **June 30, 2007** | ** ** |
|--------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **               | ** ** | **Weighted-  Average  Useful  Life** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
| Unamortized trademark    |       |                                 | —     |                        |       | $ | 5,328 |   |   | $ | — |   |   | $ | 5,328 |   |
| Amortized                |       |                                 |       |                        |       |   |   |   |   |   |   |   |   |
| Customer contracts       |       |                                 | 1.4        |                        |       | 1,188 |   |   | (731 | ) |   | 457 |   |
| Covenants not to compete |       |                                 | 4.1        |                        |       | 3,263 |   |   | (1,727 | ) |   | 1,536 |   |
| Other                    |       |                                 | 2.0        |                        |       | 1,726 |   |   | (868 | ) |   | 858 |   |
| Intangible assets, net   |       |                                 |       |                        |       | $ | 11,505 |   |   | $ | (3,326 | ) |   | $ | 8,179 |   |

 

| ** **               | ** ** | ** **                           | ** ** | **December 31, 2006** | ** ** |
|--------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **Weighted-  Average  Useful  Life** | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
| Unamortized trademark    |       |                                 | —     |                            |       | $ | 5,367 |   |   | $ | — |   |   | $ | 5,367 |   |
| Amortized                |       |                                 |       |                            |       |   |   |   |   |   |   |   |   |
| Customer contracts       |       |                                 | 1.4        |                            |       | 847 |   |   | (379 | ) |   | 468 |   |
| Covenants not to compete |       |                                 | 3.5        |                            |       | 2,950 |   |   | (1,350 | ) |   | 1,600 |   |
| Other                    |       |                                 | 2.6        |                            |       | 851 |   |   | (674 | ) |   | 177 |   |
| Intangible assets, net   |       |                                 |       |                            |       | $ | 10,015 |   |   | $ | (2,403 | ) |   | $ | 7,612 |   |

 

Amortizationof intangible assets is included in selling, general and administrativeexpenses. Amortization expense for the six months ended June 30, 2007 and2006 was $0.9 million and $1.9 million, respectively. The estimatedamortization expense related to intangible assets for each of the five years asof June 30, 2007 is as follows (in thousands):

| **Year ending December 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------|------------|------------|------------|------------|------------|
| Remainder of 2007                           |       | $          | 969        |       |
| 2008                                        |       | 1,149      |       |
| 2009                                        |       | 378        |       |
| 2010                                        |       | 210        |       |
| 2011                                        |       | 133        |       |
| 2012                                        |       | 12         |       |
| Total                                       |       | $          | 2,851      |       |

 

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**4.**                 NetIncome Per Share

Thefollowing table summarizes the calculation of diluted weighted average sharesand diluted net income per share for the periods presented below (in thousands,except per share data):

| ** **                                                                     | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                     | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net income, as  reported                                                       |       | $                                               | 9,555      |                                          | $          | 13,429 |   | $ | 26,780 |   | $ | 29,136 |   |
| Add back  interest, net of tax, on 4% Senior  Convertible Notes(a)             |       | —                                          |       | 825                                           |       | — |   | 1,604 |   |
| Net income, excluding  interest expense on 4% Senior Convertible Notes    |       | $                                               | 9,555      |                                          | $          | 14,254 |   | $ | 26,780 |   | $ | 30,740 |   |
| Basic weighted average shares outstanding                                      |       | 29,557                                          |       | 26,278                                        |       | 29,532 |   | 26,227 |   |
| Dilutive effect  of stock options outstanding and non-vested stock awards |       | 719                                             |       | 842                                           |       | 691 |   | 730 |   |
| Shares issuable  on assumed conversion of 4% Senior Convertible Notes(b)  |       | —                                          |       | 2,892                                         |       | — |   | 2,892 |   |
| Diluted weighted  average shares outstanding                                   |       | 30,276                                          |       | 30,012                                        |       | 30,223 |   | 29,849 |   |
| Basic net income per share                                                     |       | $                                               | 0.32       |                                          | $          | 0.51 |   | $ | 0.91 |   | $ | 1.11 |   |
| Diluted net income per  share                                                  |       | $                                               | 0.32       |                                          | $          | 0.47 |   | $ | 0.89 |   | $ | 1.03 |   |

----

(a)           Represents the interestexpense for the period the 4% Senior Convertible Notes (the “Notes”) wereoutstanding, including contingent interest and amortization of deferredfinancing costs, net of tax, using an effective tax rate of 36.1% and 37.4% forthe three and six months ended June 30, 2006. The Notes were called forredemption by the Company on June 15, 2006 and substantially all of theoutstanding Notes were converted into common stock prior to the July 15,2006 redemption date.

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

For the three and six months ended June 30, 2007,the only potential additional shares of common stock that could becomeoutstanding were shares issuable upon exercise of stock options and non-vestedstock awards. For the three and six months ended June 30, 2006, the onlypotential additional shares of common stock that could become outstanding wereshares issuable upon exercise of stock options, non-vested stock awards, andconversion of the Notes up to the date of actual conversion.

For the three and sixmonths ended June 30, 2007, options to acquire weighted-average shares of1,032,138 and 1,091,799, respectively, were outstanding but were excluded fromthe computation of diluted net income per share because their effect wasanti-dilutive. For the three and six months ended June 30, 2006, optionsto acquire weighted-average shares of 612,194 and 573,684, respectively, wereoutstanding but were excluded from the computation of diluted net income pershare because their effect was anti-dilutive. Performance shares granted underthe long-term incentive plan (“LTIP”) are excluded from the computations ofbasic and diluted net income per share until the necessary conditions of theplan have been satisfied.

**5.**                 SegmentInformation

Our reportable business segments are Guitar Centerstores, Music & Arts and Musician’s Friend direct response. Managementevaluates segment performance based primarily on net sales, operating income(loss) and income (loss) before income taxes and minority interest. Accountingpolicies of the segments are the same as the accounting policies for the consolidatedcompany. There are no differences 

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between the measurementsof profits or losses or assets of the reportable segments and those of theCompany on a consolidated basis.

Thefollowing table summarizes financial information for our operating segments as ofJune 30, 2007 and December 31, 2006 and for the three and six monthsended June 30, 2007 and 2006 (in thousands):

| ** **                                                         | ** ** | **Three Months Ended June 30, 2007** | ** ** | **Six Months Ended June 30, 2007** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Guitar**                                                    | ** ** | **Music &**                                        | ** ** | **Musician’s** | ** ** | ** ** | ** ** | **Guitar** | ** ** | **Music &** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
| ** **                                                         | ** ** | **Center**                                                    | ** ** | **Arts**                                                    | ** ** | **Friend** | ** ** | **Total** | ** ** | **Center** | ** ** | **Arts** | ** ** | **Friend** | ** ** | **Total** | ** ** |
| Net Sales                                                          |       | $                                                             | 371,080    |                                                        |       | $ | 37,187 |   |   |   | $ | 110,635 |   |   | $ | 518,902 |   | $ | 749,615 |   | $ | 76,776 |   |   | $ | 226,994 |   |   | $ | 1,053,385 |   |
| Gross Profit                                                       |       | 100,066                                                       |       |                                                        | 14,034     |   |   |   | 32,548 |   |   | 146,648 |   | 202,649 |   | 31,013 |   |   | 67,362 |   |   | 301,024 |   |
| Depreciation and amortization                                      |       | 8,926                                                         |       |                                                        | 1,294      |   |   |   | 1,160 |   |   | 11,380 |   | 17,582 |   | 2,738 |   |   | 2,479 |   |   | 22,799 |   |
| Selling, general and administrative  expenses                      |       | 81,756                                                        |       |                                                        | 16,567     |   |   |   | 30,022 |   |   | 128,345 |   | 161,366 |   | 33,709 |   |   | 57,307 |   |   | 252,382 |   |
| Operating income (loss)                                            |       | 18,310                                                        |       |                                                        | (2,533     | ) |   |   | 2,526 |   |   | 18,303 |   | 41,283 |   | (2,696 | ) |   | 10,055 |   |   | 48,642 |   |
| Income (loss) before income taxes (benefit) and  minority interest |       | 19,715                                                        |       |                                                        | (6,565     | ) |   |   | 2,778 |   |   | 15,928 |   | 44,392 |   | (10,741 | ) |   | 10,823 |   |   | 44,474 |   |
| Capital expenditures                                               |       | 13,786                                                        |       |                                                        | 1,361      |   |   |   | 2,813 |   |   | 17,960 |   | 30,892 |   | 2,794 |   |   | 5,361 |   |   | 39,047 |   |
|                                                                    |            |                                                               |            |                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                   | ** ** | **Three Months Ended June 30, 2006** | ** ** | **Six Months Ended June 30, 2006** | ** ** |
|----------------------------------------------|------------|---------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                   | ** ** | **Guitar**                                                    | ** ** | **Music &**                                        | ** ** | **Musician’s** | ** ** | ** ** | ** ** | **Guitar** | ** ** | **Music &** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Center**                                                    | ** ** | **Arts**                                                    | ** ** | **Friend** | ** ** | **Total** | ** ** | **Center** | ** ** | **Arts** | ** ** | **Friend** | ** ** | **Total** | ** ** |
| Net Sales                                    |       | $                                                             | 339,840    |                                                        |       | $ | 31,805 |   |   |   | $ | 86,333 |   |   | $ | 457,978 |   | $ | 679,131 |   | $ | 64,990 |   |   | $ | 184,604 |   |   | $ | 928,725 |   |
| Gross Profit                                 |       | 90,821                                                        |       |                                                        | 13,913     |   |   |   | 26,623 |   |   | 131,357 |   | 183,204 |   | 29,336 |   |   | 55,323 |   |   | 267,863 |   |
| Depreciation and amortization                |       | 6,588                                                         |       |                                                        | 1,474      |   |   |   | 754 |   |   | 8,816 |   | 12,939 |   | 2,780 |   |   | 1,473 |   |   | 17,192 |   |
| Selling, general and administrative expenses |       | 72,481                                                        |       |                                                        | 14,500     |   |   |   | 21,003 |   |   | 107,984 |   | 144,115 |   | 29,473 |   |   | 43,510 |   |   | 217,098 |   |
| Operating income (loss)                      |       | 18,340                                                        |       |                                                        | (587       | ) |   |   | 5,620 |   |   | 23,373 |   | 39,089 |   | (137 | ) |   | 11,813 |   |   | 50,765 |   |
| Income (loss) before income taxes (benefit)  |       | 18,372                                                        |       |                                                        | (3,444     | ) |   |   | 6,071 |   |   | 20,999 |   | 39,511 |   | (5,746 | ) |   | 12,774 |   |   | 46,539 |   |
| Capital expenditures                         |       | 18,644                                                        |       |                                                        | 1,006      |   |   |   | 2,297 |   |   | 21,947 |   | 32,334 |   | 1,930 |   |   | 3,782 |   |   | 38,046 |   |
| Total assets at June 30, 2007           |       |                                                          |       |                                                        |       |   |   |   |   |   |   |   |   | $ | 705,743 |   | $ | 159,236 |   |   | $ | 130,564 |   |   | $ | 995,543 |   |
| Total assets at  December 31, 2006      |       |                                                          |       |                                                        |       |   |   |   |   |   |   |   |   | $ | 682,344 |   | $ | 158,503 |   |   | $ | 86,631 |   |   | $ | 927,478 |   |
|                                              |            |                                                               |            |                                                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**6.**                 Stock-BasedCompensation

Stock-basedcompensation expense for all stock award plans included in our consolidatedstatements of income was as follows:

| ** **                              | ** ** | **Three months ended June 30,**                                                      | ** ** | **Six months ended June 30,**                                                        | ** ** |
|-----------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
| ** **                              | ** ** | **        2007        ** | ** ** | **        2006        ** | ** ** | **      2007      ** | ** ** | **      2006      ** | ** ** |
| Stock options                           |       |                                                                                                     | $          | 2,422                                                                                                    |       |   |   | $ | 2,766 |   |   |   | $ | 4,966 |   |   |   | $ | 6,303 |   |   |
| Long-term  incentive plan (LTIP)        |       |                                                                                                     | 456        |                                                                                                     |       |   | 1,801 |   |   |   | 912 |   |   |   | 5,110 |   |   |
| Employee stock  purchase plan (ESPP)    |       |                                                                                                     | 167        |                                                                                                     |       |   | 196 |   |   |   | 381 |   |   |   | 389 |   |   |
| Restricted and  deferred stock          |       |                                                                                                     | 515        |                                                                                                     |       |   | 62 |   |   |   | 679 |   |   |   | 106 |   |   |
| Total stock-based  compensation expense |       |                                                                                                     | $          | 3,560                                                                                                    |       |   |   | $ | 4,825 |   |   |   | $ | 6,938 |   |   |   | $ | 11,908 |   |   |

 

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No stock options were granted for the three monthsended June 30, 2007. In the six months ended June 30, 2007, optionsto purchase 19,700 shares of common stock were granted with an exercise priceof $47.13 per share and grant-date fair value of $16.64 per share. For thethree months ended June 30, 2006, options to purchase 117,250 shares ofcommon stock were granted with an exercise price of $53.78 per share and weighted-averagegrant-date fair value of $21.65 per share. For the six months endedJune 30, 2006, options to purchase 132,350 shares of common stock weregranted with weighted-average exercise price of $53.89 per share and weighted-averagegrant-date fair value of $21.44 per share. The options were issued with anexercise price equal to fair market value on the date of grant and vest overfour years.

Theassumptions used to value option grants under the lattice-based binomial modelfor the three and six months ended June 30, 2007 and 2006 are as follows:

| ** **                                              | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                              | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Expected  volatility range                              |       | 30-48                                           | %          | 37-49                                         | %          | 30-48 | % | 35-49 | % |
| Weighted-average  expected volatility                   |       | 39.2                                            | %          | 43.1                                          | %          | 39.2 | % | 43.1 | % |
| Expected term (in  years)                               |       | 4.46                                            |       | 4.75-5.75                                     |       | 4.46 |   | 4.75-5.75 |   |
| Risk-free  interest rate                                |       | 4.7                                             | %          | 4.4-4.9                                       | %          | 4.7 | % | 4.4-4.9 | % |
| Expected  dividends                                     |       | —                                          |       | —                                        |       | — |   | — |   |
| Suboptimal exercise term  (multiple of exercise  price) |       | 1.5                                             |       | 2.0                                           |       | 1.5 |   | 2.0 |   |

 

Theassumptions used to value the ESPP options under the lattice-based binomialmodel for the three and six months ended June 30, 2007 and 2006 are asfollows:

| ** **                              | ** ** | **Three and six months ended  June 30,** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                              | ** ** | **2007**                                                          | ** ** | **2006** | ** ** |
| Expected  volatility range              |       | 29-32                                                             | %          | 32-40 | % |
| Weighted-average  expected volatility   |       | 30.3                                                              | %          | 36.0 | % |
| Expected term                           |       | 6 months                                                          |       | 6 months |   |
| Risk-free  interest rate                |       | 4.9                                                               | %          | 4.0 | % |
| Weighted-average  grant-date fair value |       | $                                                            | 10.79      |   | $  | 12.88 |   |
|                                         |            |                                                                   |            |  |  |  |  |

 

As of June 30, 2007, the target number ofperformance shares potentially issuable under the LTIP is 240,221, with theactual number of shares ultimately issuable to be between zero and twice suchamount, depending on actual performance and number of participants. Stock-basedcompensation expense related to the LTIP is estimated based on forecastedperformance during the performance period compared to plan targets. At the endof each reporting period, we reevaluate our assessment of performance under theplan and make adjustments to the expense as necessary based on the latestestimates available. The fair value of performance share awards is based on themarket price of the Company’s stock on the date the underlying plan receivescompensation committee approval, or other form of a mutual understanding of thekey terms and conditions of performance.

In the three and sixmonths ended June 30, 2007, 21,128 shares of deferred stock were grantedwith a grant-date fair value of $47.32 per share. In the three and six monthsended June 30, 2006, 19,968 shares of deferred stock were granted with agrant-date fair value of $53.76 per share. The awards were issued with agrant-date fair value equal to fair market value on the date of grant and vestover three years.

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**7.**                 IncomeTaxes

In June 2006, the FASB issued FASBInterpretation No. 48 (“FIN 48”), *Accounting for Uncertaintyin Income Taxes.*FIN 48 clarifies the accounting for uncertainty inincome taxes recognized in an enterprise’s financial statements in accordancewith SFAS No. 109, *Accounting for IncomeTaxes*. This Interpretation defines the minimum recognition thresholda tax position is required to meet before being recognized in the financialstatements. The Company adopted FIN 48 on January 1, 2007. In May 2007,the FASB issued FASB Staff Position FIN 48-1, *Definitionof Settlement in FASB Interpretation No. 48,* (“FSP FIN 48-1”).FSP FIN 48-1 provides guidance on how a company should determine whethera tax position is effectively settled for the purpose of recognizing previouslyunrecognized tax benefits. FSP FIN 48-1 is effective upon initialadoption of FIN 48. As a result of the implementation, the Company recognizedno material adjustment in the liability of unrecognized income tax benefits. Atthe adoption date of January 1, 2007, we had $1.7 million of unrecognizedtax benefits, all of which would affect our effective tax rate if recognized. AtJune 30, 2007, we had $1.8 million of unrecognized tax benefits. It isreasonably possible that our recognized tax benefit could change; however, wedo not expect any such change to be material.

Guitar Center, Inc. and its subsidiaries aresubject to U.S. federal income tax as well as income tax of multiple statejurisdictions. The Company has concluded all U.S. federal income tax mattersfor years through 2002. Substantially all material state and local income taxmatters have been concluded through 2001 or 2002, depending on the statute oflimitations for a given jurisdiction. Federal income tax returns for 2003through 2005 are currently under examination.

We recognize interest and penalties related touncertain tax positions in income tax expense. At the adoption date of January 1,2007 and June 30, 2007, we had approximately $0.3 million and $0.4 millionof accrued interest and penalties, respectively, related to uncertain taxpositions.

A noncurrent receivable isincluded in other assets, net in the amount of $9.4 million for income taxrefunds and associated interest income related to claims for refund for taxyears 2003, 2004, and 2005 for deductions for disqualified dispositions ofincentive stock options not previously claimed on federal and state taxreturns.

**8.**                 LegalProceedings

On November 29, 2005, a case was filed against usand other defendants, including our Chief Executive Officer, in the UnitedStates District Court for the Southern District of Florida. The complaintasserts, among other things, violations of the Federal Racketeering Influencedand Corrupt Organization Act (“RICO”) and a corresponding Florida statute,Sections 1 and 2 of the Sherman Antitrust Act, Section 2 of the ClaytonAct (as amended by the Robinson-Patman Act), the Antidumping Act of 1916, theFlorida Antitrust Act of 1980, and the Florida Deceptive and Unfair TradePractices Act, as well as tortious interference with business relationshipunder Florida law and civil conspiracy under Florida law by some or all of theidentified defendants in connection with the claimed inability of Ace Pro Soundand Recording, LLC to obtain vendor lines for its store. The complaint purportsto be made as a class action on behalf of all current and former retail sellersof musical instruments and/or sound equipment and/or recording equipment withstores located in geographical regions in the United States wherein some or allof the defendants have carried on business, and seeks compensatory damages,treble damages, punitive damages, injunctive relief and attorneys fees.

On April 1, 2007, the court entered its order ondefendants’ motions to dismiss. The court dismissed plaintiff’s RICO claimsagainst Mr. Albertson and further granted a motion to strike a claim forconsequential damages brought under the Florida Deceptive and Unfair TradePractices Act. The court denied all other motions to dismiss. In June andJuly, 2007, plaintiff filed second amended complaints, dropping the classallegations and the RICO claims. The court established pretrial deadlines andset a trial date of April 14, 2008. Discovery has commenced in thismatter.

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On December 6, 2006, a lawsuit named J. KevinSnyder v. Guitar Center Stores, Inc. that is a putative class action wasfiled in Los Angeles Superior Court alleging violations of the Song-BeverlyCredit Card Act. Discovery has commenced in this matter.

On January 11, 2007, a lawsuit named Michael Kuhlv. Guitar Center Stores, Inc. was filed by a Guitar Center sales associateas a putative class action in the United States District Court for the NorthernDistrict of Illinois. The lawsuit alleges violations of the Illinois WagePayment and Collection Act and the Fair Labor Standards Act, based upon GuitarCenter’s allegedly unlawful payroll deduction policies. The lawsuit has beenbrought on behalf of plaintiff and all former and current hourly employees inIllinois and nationwide. A motion to dismiss was filed on the Company’s behalfon March 26, 2007. Plaintiff filed an amended complaint on June 8,2007. Plaintiffs now allege jurisdiction under the Class Action FairnessAct, in an attempt to establish a nationwide class action. On July 11,2007, we filed a motion to dismiss on the grounds of lack of jurisdiction ofthe federal court over state law claims and failure of Illinois employees torepresent a nationwide class. Plaintiffs have until early August 2007 to opposethe motion.

The following putative class action complaints havebeen filed in connection with our proposed merger with an affiliate of BainCapital Partners, LLC.: Mary Benton, v. Guitar Center, Inc., et al., Inthe Court of Chancery of the State of Delaware, New Castle County, Delaware;Nina Weitman vs. Guitar Center, Inc., et al., Los Angeles Superior Court,California; Lou Ann Murphy vs. Guitar Center, Inc., et al., Los AngelesSuperior Court, California; Terri Connors and Dennis Connors vs. Guitar Center, Inc.et al., Los Angeles Superior Court, California; K Family LLC vs. Guitar Center, Inc.et al., Los Angeles Superior Court, California. The lawsuits allege that ourboard of directors breached their fiduciary duties to the Company’sstockholders in connection with the merger. These lawsuits seek equitablerelief, including a preliminary injunction blocking the proposed merger, andcompensatory damages from the directors and the Company.

We expect to defend these actions vigorously. However,these actions, regardless of the outcome, may result in substantial expensesand damages to us and may significantly divert the attention of our management.There can be no assurance that we will be able to achieve a favorablesettlement of these lawsuits or obtain a favorable resolution if they are notsettled. An unfavorable resolution of these lawsuits could have a materialadverse effect on our business, financial condition and results of operations. Regardlessof the outcome, the costs and expenses incurred by us to defend them couldadversely impact our financial condition.

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

**9.**                 Acquisitionby Bain Capital

On June 27, 2007, the Company agreed to beacquired by affiliates of Bain Capital Partners, LLC, a leading global privateinvestment firm, following a comprehensive auction process. The totaltransaction value, including assumed debt, is approximately $2.1 billion. Underthe terms of the merger agreement, the Company’s stockholders will receive$63.00 in cash in exchange for each share of the Company’s common stock theyown. The transaction is subject to customary closing conditions, including theapproval of the Company’s stockholders. On July 23, 2007, the FederalTrade Commission cleared the purchase of the Company by Bain Capital.

The Company engaged financial and legal advisors toassist in the review of the strategic alternatives prior to the announcement ofits sale to Bain Capital. As of June 30, 2007, costs associated with theassessment of strategic alternatives and other merger related costs included inselling, general and administrative expenses were approximately $2.8 million.

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

**General**

Guitar Center, Inc. (the “Company”) is theleading United States retailer of guitars, amplifiers, percussion instruments,keyboards and pro-audio and recording equipment. As of June 30, 2007, ourwholly owned retail subsidiary operated 212 Guitar Center stores across theUnited States consisting of 139 primary format stores, 70 secondary formatstores and 3 tertiary format stores. In addition, as of June 30, 2007, ourMusic & Arts division operated 97 stores specializing in bandinstruments for sale and rental, serving thousands of teachers, band directors,college professors and students. We are also the largest direct responseretailer of musical instruments in the United States through our wholly ownedsubsidiary, Musician’s Friend, Inc., and its catalogs and websites,including www.musiciansfriend.com, www.guitarcenter.com, www.wwbw.com,www.music123.com and related websites.

We acquired the www.wwbw.com and www.music123.comwebsites on February 9, 2007 when Musician’s Friend, Inc.acquired substantially all of the assets of Dennis Bamber, Inc. and itsChapter 11 bankruptcy estate, d/b/a The Woodwind and The Brasswind. Werefer to this business as “Woodwind & Brasswind.”

During the second quarter, we opened two secondaryformat Guitar Center stores in Killeen, Texas and Fayetteville, Arkansas. Thenew stores increased the retail space for Guitar Center stores to a total of3.1 million square feet at the end of the second quarter of 2007.

As we enter new markets,we expect that we will initially incur higher administrative and promotionalcosts per store than is currently experienced in established markets. As weopen multiple stores in markets, we expect that sales at new stores in a marketmay reduce sales at mature stores in that same market, to some extent. Ourbusiness strategy will also emphasize opportunities to continue to grow each ofour brands, including further acquisitions if attractive candidates can belocated for reasonable prices.

**Recent Event**

On June 27, 2007, theCompany agreed to be acquired by affiliates of Bain Capital Partners, LLC, aleading global private investment firm, following a comprehensive auctionprocess. The total transaction value, including assumed debt, is approximately$2.1 billion. Under the terms of the merger agreement, the Company’sstockholders will receive $63.00 in cash in exchange for each share of theCompany’s common stock they own. The transaction is expected to close in thefourth quarter of 2007 and is subject to customary closing conditions,including the approval of the Company’s stockholders. On July 23, 2007,the Federal Trade Commission cleared the purchase of the Company by Bain Capital.

**Executive Summary**

Consolidated net sales for the quarter ended June 30,2007 increased 13.3%, or $60.9 million, to $518.9 million compared to $458.0million in the second quarter of 2006. Consolidated net income for the quarterdecreased to $9.6 million compared to $13.4 million in the second quarter of2006. Net income per diluted share decreased to $0.32 from $0.47 in the secondquarter of 2006. Results for the second quarter of 2007 were impacted bytransaction costs of $2.8 million, or $0.06 per diluted share, related to thepending sale of the Company.

For the second quarter of 2007, sales from new GuitarCenter stores totaled $31.4 million. Comparable store sales declined 0.1%, or$0.2 million, compared to the second quarter of 2006. We opened 2 newGuitar Center stores in the quarter. We continue to face a challenging retailenvironment, which may impact sales and operating margin trends for theforeseeable future. Selling, general and administrative expenses (“SG&A”)increased to 22.0% of the segment net sales compared to 21.3% in the 

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second quarter of 2006,primarily reflecting the transaction costs related to the pending sale of theCompany.

Musician’s Friend, our direct response unit, generatedan increase in net sales for the second quarter of 28.1% to $110.6 millioncompared to $86.3 million in the second quarter of 2006. The acquired Woodwind &Brasswind business contributed $22.2 million in net sales for the quarter,representing 92% of the overall growth in the segment net sales. Gross profitdeclined by 1.4% of segment net sales compared to the second quarter of 2006,reflecting lower margins from the Woodwind & Brasswind business.SG&A expenses increased to 27.1% from 24.3% of segment net sales primarilyreflecting the effects of the transition to the new distribution center,expected to be completed in the third quarter. The process of converting to ournew direct response distribution center, which opened in the third quarter, hasresulted in lower than expected fill rates and higher than expected freight andpayroll costs. We expect that the lower fill rates during the third quarterconversion process will result in back orders, cancellations, and, ultimately,lower net sales. We also expect that the higher freight and payroll costsduring the third quarter conversion process will result in both lower grossprofit and higher SG&A expenses.

For the three months endedJune 30, 2007, net sales for our Music & Arts division increased16.9% to $37.2 million from $31.8 million for the same period in 2006. Theincrease was generated primarily from new locations. Comparable sales for thesecond quarter decreased 1.0%. Gross profit declined by 6.0% of segment netsales compared to the second quarter of 2006. The decrease was primarily theresult of higher shrink expense and increased occupancy costs.

**Discussion ofCritical Accounting Policies**

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

*Valuation ofInventory*

We value our merchandiseinventory at the lower of cost, using the weighted-average method, or market.Rental inventories are valued at the lower of cost or market using the specificidentification method and are depreciated on a straight-line basis while outunder a rental agreement. We record adjustments to the value of inventory basedupon obsolescence and changes in market value. Applicable costs associated withbringing inventory through our Guitar Center retail distribution center arecapitalized to inventory. The amounts are expensed to cost of goods sold as theassociated inventory is sold. Management has evaluated the current level of inventoriesconsidering future customer demand for our products, taking into accountgeneral economic conditions, growth prospects within the marketplace,competition, market acceptance of current and upcoming products, and managementinitiatives. Based on this evaluation, we have recorded impairment adjustmentsto inventory and to cost of goods sold for estimated decreases in netrealizable value. These judgments are made in the context of our customers’shifting needs, product and technological trends, and changes in thedemographic mix of our customers. A misinterpretation or misunderstanding ofthese conditions and uncertainties in the future outlook of our industry or theeconomy, or other failure to estimate correctly, could result in inventoryvaluation changes as of any given balance sheet date.

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*Valuation ofLong-Lived Assets*

Long-lived assetssuch as property and equipment and identifiable intangibles with finite livesare reviewed for impairment whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be recoverable. Goodwilland other intangibles with indefinite lives that are not amortized are requiredto be reviewed for impairment on an annual basis, or more frequently whentriggering events occur. Factors we consider important, which could triggerimpairment, include, among other things:

·       Significantunderperformance relative to historical or projected operating results;

·       Significantchanges in the manner of our use of the acquired assets or the strategy of ouroverall business as well as the individual segments of the business;

·       Significantnegative industry or economic trends; and

·       Significantdecline in stock value for a sustained period.

For long-lived assets other than goodwill andintangibles that are not amortized, the determination of whether impairment hasoccurred is based on an estimate of undiscounted future cash flows attributableto the assets, as compared to the carrying 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 carryingamount of the assets exceeds the fair value of the related assets of theunderlying reporting unit to which the goodwill relates.

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

*Sales Returns*

As part of our “satisfactionguaranteed” policy, Guitar Center customers are allowed to return productgenerally within 30 days after the date of purchase, and Musician’s Friendcustomers are allowed to return product within 45 days. Music & Artscustomers have 30 business days from the date of purchase to return product. Weregularly review and revise, when deemed necessary, our estimates of salesreturns based upon historical trends. While our estimates during the past fewyears have approximated actual results, actual returns may differ significantlyfrom our estimates, either favorably or unfavorably, if factors such aseconomic conditions or the competitive environment differ from ourexpectations.

*Credits and OtherVendor Allowances*

We receive cooperativeadvertising allowances (i.e., an allowance from the manufacturer to subsidize qualifyingadvertising and similar promotional expenditures relating to the vendor’sproducts), price protection credits (i.e., credits from vendors with respect toin-stock inventory if the vendor subsequently lowers their wholesale price forsuch products) and vendor rebates (i.e., credits or rebates provided by vendorsbased on 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 the 

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advertisingexpense eligible for the credit is incurred. We recognized cooperativeadvertising allowances of $2.5 million and $2.8 million for the three monthsended June 30, 2007 and 2006, respectively. For the six months ended June 30,2007 and 2006, we recognized $4.6 million and $5.6 million of cooperativeadvertising allowances. Price protection credits and vendor rebates areaccounted for as a reduction of the cost of merchandise inventory and arerecorded at the time the credit or rebate is earned. The effect of priceprotection credits and vendor rebates is recognized in the income statement atthe time the related inventory is sold as a reduction in cost of goods sold.The reserve against rebates receivable is determined by specifically identifyinguncollectible accounts through an aging review and an analysis of vendorrelationships. We received payments for vendor rebates of $10.5 million and$8.1 million for the three months ended June 30, 2007 and 2006 and $21.9million and $17.6 million for the six months ended June 30, 2007 and 2006,respectively. We earned and recognized vendor rebates of $9.2 million and $6.8 millionfor the three months ended June 30, 2007 and 2006 and $19.9 million and$16.0 million for the six months ended June 30, 2007 and 2006,respectively. None of these credits are recorded as revenue.

*Stock-basedCompensation*

Effective January 1, 2006, we adopted Statementof Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment*(“SFAS No. 123(R)”) to accountfor our stock-based compensation plans. Currently, our stock-based compensationexpense relates to stock options, our employee stock purchase program (“ESPP”),performance share awards, restricted stock awards and deferred stock awards.

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

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

Stock-based compensationexpense related to performance share awards issued under the Company’slong-term incentive plan (“LTIP”) is estimated based on our forecastedperformance compared to plan targets. At the end of each reporting period, wereevaluate our assessment of performance under the plan and make adjustments tothe expense as necessary based on the latest estimates available. UnderSFAS No. 123(R), the fair value of performance share awards is basedon the market price of the Company’s stock on the date the underlying planreceives compensation committee approval, or other form of a mutualunderstanding of the key terms and conditions of performance.

*Gift Cards*

We sell gift cards to ourcustomers in our Guitar Center retail stores and on-line. Revenue from giftcard sales is recognized at redemption of the gift card. Our gift cards do nothave expiration dates. Based on historical redemption rates, a certainpercentage of gift cards will never be redeemed, which is referred to as “breakage.”Estimated breakage income is recognized as the remaining gift card values areredeemed and is recorded as a reduction of cost of goods sold.

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**Results of Operations**

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

| ** **                                        | ** ** | **Three months ended June 30,**                                          | ** ** | **Six months ended June 30,**                                            | ** ** |
|---------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **       2007       ** | ** ** | **       2006       ** | ** ** | **      2007      ** | ** ** | **      2006      ** | ** ** |
| Net sales                                         |       |                                                                                         | 100.0      | %                                                                                            |       |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |
| Gross profit                                      |       |                                                                                         | 28.3       |                                                                                         |       |   | 28.7 |   |   |   | 28.6 |   |   |   | 28.8 |   |   |
| Selling, general  and administrative expenses     |       |                                                                                         | 24.7       |                                                                                         |       |   | 23.6 |   |   |   | 24.0 |   |   |   | 23.3 |   |   |
| Operating income                                  |       |                                                                                         | 3.6        |                                                                                         |       |   | 5.1 |   |   |   | 4.6 |   |   |   | 5.5 |   |   |
| Interest expense,  net                            |       |                                                                                         | 0.5        |                                                                                         |       |   | 0.5 |   |   |   | 0.4 |   |   |   | 0.5 |   |   |
| Income before  income taxes and minority interest |       |                                                                                         | 3.1        |                                                                                         |       |   | 4.6 |   |   |   | 4.2 |   |   |   | 5.0 |   |   |
| Income taxes                                      |       |                                                                                         | 1.3        |                                                                                         |       |   | 1.7 |   |   |   | 1.7 |   |   |   | 1.9 |   |   |
| Minority interest  in loss                        |       |                                                                                         | 0.0        |                                                                                         |       |   | 0.0 |   |   |   | 0.0 |   |   |   | 0.0 |   |   |
| Net income                                        |       |                                                                                         | 1.8        | %                                                                                            |       |   | 2.9 | % |   |   | 2.5 | % |   |   | 3.1 | % |   |

 

**Three Months Ended June 30,2007 Compared to the Three Months Ended June 30, 2006**

Consolidated net sales for the three months ended June 30,2007 increased 13.3% to $518.9 million compared to $458.0 million for the sameperiod in 2006.

Net sales from Guitar Center stores for the threemonths ended June 30, 2007 totaled $371.1 million, an increase of 9.2%from $339.8 million for the same period in 2006. Sales from new stores were$31.4 million and represented all of the total increase in Guitar Centerretail store sales. Comparable Guitar Center store sales for the second quarterdeclined 0.1%, or $0.2 million. Comparable store sales is defined as sales forthe comparable periods, excluding net sales attributable to stores not open for14 months as of the end of the reporting period. We believe thatcomparable store sales is a more useful indicator of store performance than thechange in total net sales, since comparable store sales exclude the effects ofchanges in the number of stores open. We continue to face a challenging retailenvironment, which may impact sales and operating margin trends for theforeseeable future.

Net sales from the Music & Arts segment forthe three months ended June 30, 2007 increased 16.9% to $37.2 million from$31.8 million for the same period in 2006. Sales from new locations, primarilyacquired businesses and new affiliates, represented all of the total increasein Music & Arts sales for the quarter. Comparable sales declined 1.0%in the second quarter of 2007.

Net sales from the Musician’s Friend segment totaled$110.6 million for the three months ended June 30, 2007, an increase of$24.3 million, or 28.1%, from the same period in 2006. The acquired Woodwind &Brasswind business contributed $22.2 million in net sales for the quarter,representing 92% of the overall growth in segment net sales. Second quartersales results also reflected sales generated from our e-commerce site atwww.guitarcenter.com of $7.4 million, which was launched in June 2006. Wecontinue to face increased competition in the direct response channel, which weexpect to impact that segment’s net sales and gross profit for the foreseeablefuture. The process of converting to our new direct response distributioncenter, which opened in the third quarter, has resulted in lower than expectedfill rates and higher than expected freight and payroll costs. We expect thatthe lower fill rates during the third quarter conversion process will result inback orders, cancellations, and, ultimately, lower net sales. We also expectthat the higher freight and payroll costs during the third quarter conversionprocess will result in both lower gross profit and higher SG&A expenses.

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Consolidated gross profit for the three months ended June 30,2007 compared to 2006 increased 11.6% to $146.6 million from $131.4 million.Gross profit as a percentage of net sales for the three months ended June 30,2007 declined to 28.3% from 28.7% in the same period in 2006. In the followingdiscussion, we define selling margin as net sales less the cost of theassociated merchandise charged by the vendor plus the associated inventorycosts from fulfilling inventory through our distribution center. The cost ofmerchandise inventory is net of all associated vendor discounts and rebates.Freight is not included in selling margin.

Gross profit as a percentage of net sales for GuitarCenter stores was 27.0% in the second quarter of 2007 compared with 26.7% inthe second quarter of 2006. The increase in gross margin was primarily due tohigher selling margin of 0.9% partially offset by higher occupancy costs of0.5%. Selling margin benefited from an increase in our proprietary accessoriesfor our technology product line and a favorable sales mix consisting of higheraccessories sales. The higher occupancy costs were primarily due to higherdepreciation and amortization expense and higher store rent.

Gross profit for the Music & Arts segment was37.7% for the three months ended June 30, 2007 compared to 43.7% for thesame period in 2006. The decline in gross margin was primarily due to highershrink expense of 4.9% and higher occupancy costs of 1.5% partially offset byhigher selling margin of 0.4%. Higher shrink expense was driven by a decreasedestimate of instrument recoveries than realized in the prior year period.Higher occupancy costs were primarily due to higher store rent and higherdepreciation and amortization expense resulting from the closure of certainunderperforming locations.

Gross profit for the Musician’s Friend segment was 29.4%for the three months ended June 30, 2007 compared to 30.8% in the secondquarter of 2006. The decreased gross margin was primarily due to lower sellingmargin of 1.1% and higher freight costs of 0.4%. The lower selling margin wasprimarily impacted by the Woodwind & Brasswind business, whichhistorically has had a lower selling margin. Freight costs were driven by moresplit shipments impacted by the ongoing conversion to the new distribution centerand higher freight associated with the Woodwind & Brasswind business.

Consolidated SG&A expenses for the three monthsended June 30, 2007 increased 18.9% to $128.3 million from$108.0 million for the same period in 2006. As a percentage of net sales,SG&A expenses were 24.7% compared to 23.6% in the second quarter of 2006.The increase was primarily due to transaction costs of $2.8 million related tothe pending sale of the Company and increased overhead expenses impacted by newand expanded facilities.

Stock-basedcompensation expense for all stock award plans included in our consolidatedstatements of income was as follows (in thousands, except per share):

| ** **                              | ** ** | **Three months ended June 30,** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                              | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| ** **                              | ** ** | **Pre-tax**                                         | ** ** | **After tax** | ** ** | **Per diluted  share** | ** ** | **Pre-tax** | ** ** | **After tax** | ** ** | **Per diluted  share** | ** ** |
| Stock options                           |       | $                                                   | 2,422      |   |   | $ | 1,434 |   |   |   | $ | 0.05 |   |   | $ | 2,766 |   |   | $ | 1,767 |   |   |   | $ | 0.06 |   |   |
| Long-term  incentive plan (LTIP)        |       | 456                                                 |       |   | 270 |   |   |   | 0.01 |   |   | 1,801 |   |   | 1,151 |   |   |   | 0.04 |   |   |
| Employee stock  purchase plan (ESPP)    |       | 167                                                 |       |   | 99 |   |   |   | — |   |   | 196 |   |   | 125 |   |   |   | — |   |   |
| Restricted and  deferred stock          |       | 515                                                 |       |   | 305 |   |   |   | 0.01 |   |   | 62 |   |   | 40 |   |   |   | — |   |   |
| Total stock-based  compensation expense |       | $                                                   | 3,560      |   |   | $ | 2,108 |   |   |   | $ | 0.07 |   |   | $ | 4,825 |   |   | $ | 3,083 |   |   |   | $ | 0.10 |   |   |

 

SG&A expenses for the Guitar Center segment in thesecond quarter of 2007 were 22.0% as a percentage of segment net sales comparedto 21.3% in the second quarter of 2006. The increase in expenses was primarilydue to the transaction costs related to the pending sale of the Company of 0.8%,which have been entirely charged to this segment. In addition, higher salariesexpense of 0.2% was 

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primarily offset by lowergrand opening costs of 0.3% due to the reduction in new store openings ascompared to the prior year period.

SG&A expenses for the Music & Artssegment were 44.6% of segment net sales in the second quarter of 2007 compared to45.6% in the second quarter of 2006. The decrease primarily consisted of lowerintangibles amortization expense of 2.0% and lower stock-based compensationexpense under the LTIP of 0.6% partially offset by higher bad debt expense of2.0%. The reduced intangible amortization expense was primarily due to thecompletion of amortization in the prior year for certain intangibles acquiredfrom Music & Arts Center, Inc. The lower LTIP cost was due to thereduction in plan achievement levels as compared to the prior year period.Higher bad debt expense reflects increased uncollectible accounts resultingfrom recent business expansion and the effect of certain bad debt recoveriesrealized in the prior year period.

SG&A expenses for the Musician’s Friend segment were27.1% of segment net sales in the second quarter of 2007 compared to 24.3% inthe second quarter of 2006. The increase in SG&A was primarily related tothe conversion to our new distribution center, which was opened in the thirdquarter. The effect of these additional costs was seen primarily in higherexpenses in payroll of 1.7%, building rent of 0.8%, contract labor of 0.7%, anddepreciation and amortization of 0.4%. Partially offsetting the increases was areduction in stock-based compensation expense for options and LTIP of 0.9%.

Consolidated operating income decreased to $18.3million for the three months ended June 30, 2007 from $23.4 million in thecomparable 2006 period. As a percentage of net sales, consolidated operatingincome declined in the second quarter of 2007 to 3.6% from 5.1% in the secondquarter of 2006.

Interest expense, net for the three months ended June 30,2007 was flat at $2.4 million as compared to the second quarter of 2006. Thereduction in interest resulting from the conversion of the 4% senior notes tocommon stock in July 2006 was offset by higher borrowings under therevolving credit facility used primarily to fund working capital requirementsand business acquisitions.

For the three months ended June 30, 2007, incometax expense was $6.5 million compared to $7.6 million for the same periodin 2006. The effective tax rate in the second quarter was 40.8% compared to36.1% in the prior year quarter. The rate was lower in the prior year quarterdue to the reduction of a valuation allowance related to a capital gain in2001. The effective tax rate is subject to ongoing review and evaluation andmay fluctuate in future quarters.

Consolidated net incomefor the three months ended June 30, 2007 decreased to $9.6 million,compared to $13.4 million in the same period in 2006 as a result of thecombinations of factors described above.

**Six Months Ended June 30,2007 Compared to the Six Months Ended June 30, 2006**

Consolidated net sales for the six months ended June 30,2007 increased 13.4% to $1,053.4 million compared to $928.7 million for thesame period in 2006.

Net sales from Guitar Center stores for the six monthsended June 30, 2007 totaled $749.6 million, an increase of 10.4% from$679.1 million for the same period in 2006. Sales from new stores were $68.5 millionand represented 97% of the total increase in Guitar Center retail store sales.Comparable Guitar Center store sales increased 0.3% for the six month period.Comparable store sales achieved this level despite experiencing a challengingretail environment throughout the quarter. We continue to face a challengingretail environment, which may impact sales and operating margin trends for theforeseeable future.

Net sales from the Music & Arts segment forthe six months ended June 30, 2007 increased 18.1% to $76.8 million from$65.0 million for the same period in 2006. Sales from new locations, primarilyacquired 

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businesses and newaffiliates, represented 96% of the total increase in Music & Artssales for the six month period. Comparable sales increased 0.8% in the sixmonth period.

Net sales from the Musician’s Friend segment totaled$227.0 million for the six months ended June 30, 2007, an increase of$42.4 million, or 23.0%, from the same period in 2006. The acquired Woodwind &Brasswind business contributed $31.4 million in net sales for the six monthperiod, representing 74% of the overall growth in segment net sales. Salesresults for the six month period in 2007 also reflected sales generated fromour e-commerce site at www.guitarcenter.com of $15.6 million, which waslaunched in June 2006. We continue to face increased competition in thedirect response channel, which we expect to impact that segment’s net sales andgross profit for the foreseeable future. The process of converting to our newdirect response distribution center, which opened in the third quarter, hasresulted in lower than expected fill rates and higher than expected freight andpayroll costs. We expect that the lower fill rates during the third quarterconversion process will result in back orders, cancellations, and, ultimately,lower net sales. We also expect that the higher freight and payroll costsduring the third quarter conversion process will result in both lower grossprofit and higher SG&A expenses.

Consolidated gross profit for the six months ended June 30,2007 compared to 2006 increased 12.4% to $301.0 million from $267.9 million.Gross profit as a percentage of net sales for the six months ended June 30,2007 declined to 28.6% from 28.8% in the same period in 2006.

Gross profit as a percentage of net sales for GuitarCenter stores was 27.0% for both six month periods ended June 30, 2007 and2006. Higher selling margin of 0.8% was substantially offset by higheroccupancy costs of 0.6% and higher shrink of 0.1%. Selling margin benefitedfrom an increase in our proprietary accessories for our technology product lineand a favorable sales mix consisting of higher accessories sales. The higheroccupancy costs were primarily due to higher depreciation and amortizationexpense and higher store rent.

Gross profit for the Music & Arts segment was40.4% for the six months ended June 30, 2007 compared to 45.1% for thesame period in 2006. The decline in gross margin was primarily due to highershrink expense of 2.3%, higher occupancy costs of 1.6%, and lower sellingmargin of 0.9%. Higher shrink expense was driven by a decreased estimate ofinstrument recoveries than realized in the prior year period. Higher occupancycosts were primarily due to higher depreciation and amortization expense andhigher store rent resulting from the closure of certain underperforminglocations. The reduced selling margin was primarily due to a change in productmix consisting of a higher proportion of instrument sales and a lowerproportion of rental revenues.

Gross profit for the Musician’s Friend segment was29.7% for the six months ended June 30, 2007 compared to 30.0% for thesame period in 2006. The decreased gross margin was primarily due to higher freightcosts of 0.3%, reduced shipping & handling revenue of 0.1%, and highersalaries of 0.1% partially offset by higher selling margin of 0.2%. Freightcosts were driven by more split shipments impacted by the ongoing conversion tothe new distribution center and higher freight associated with the Woodwind &Brasswind business. The higher selling margin reflects higher margins for theexisting Musician’s Friend business partially offset by the effects of theWoodwind & Brasswind business, which historically has had a lowerselling margin.

Consolidated SG&A expenses for the six monthsended June 30, 2007 increased 16.3% to $252.4 million from$217.1 million for the same period in 2006. As a percentage of net sales,SG&A expenses were 24.0% compared to 23.3% in the same period in 2006. Theincrease was primarily due to transaction costs related to the pending sale ofthe Company, higher advertising costs, and increased overhead expenses impactedby new and expanded facilities partially offset by reduced stock-basedcompensation expenses for options and LTIP.

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Stock-based compensation expense for all stock awardplans included in our consolidated statements of income was as follows (inthousands, except per share): 

| ** **                              | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------|------------|---------------------------------------------------|------------|
| ** **                              | ** ** | **2007**                                          | ** ** | **2006** | ** ** |
| ** **                              | ** ** | **Pre-tax**                                       | ** ** | **After tax** | ** ** | **Per diluted  share** | ** ** | **Pre-tax** | ** ** | **After tax** | ** ** | **Per diluted  share** | ** ** |
| Stock options                           |       | $                                                 | 4,966      |   |   | $ | 2,965 |   |   |   | $ | 0.10 |   |   | $ | 6,303 |   |   | $ | 3,946 |   |   |   | $ | 0.13 |   |   |
| Long-term  incentive plan (LTIP)        |       | 912                                               |       |   | 544 |   |   |   | 0.02 |   |   | 5,110 |   |   | 3,199 |   |   |   | 0.11 |   |   |
| Employee stock  purchase plan (ESPP)    |       | 381                                               |       |   | 227 |   |   |   | 0.01 |   |   | 389 |   |   | 244 |   |   |   | 0.01 |   |   |
| Restricted and  deferred stock          |       | 679                                               |       |   | 405 |   |   |   | 0.01 |   |   | 106 |   |   | 66 |   |   |   | — |   |   |
| Total stock-based  compensation expense |       | $                                                 | 6,938      |   |   | $ | 4,141 |   |   |   | $ | 0.14 |   |   | $ | 11,908 |   |   | $ | 7,455 |   |   |   | $ | 0.25 |   |   |

 

SG&A expenses for the Guitar Center segment forthe six months ended June 30, 2007 were 21.5% as a percentage of segmentnet sales compared to 21.2% for the same period in 2006. The increase inexpenses was primarily due to the transaction costs related to the pending saleof the Company of 0.4% and higher advertising costs of 0.4% partially offset byreduced stock-based compensation expense for options and LTIP of 0.5%. Thehigher advertising costs resulted primarily from increased promotional andmarketing efforts. The lower LTIP cost was due to the reduction in planachievement levels as compared to the prior year period.

SG&A expenses for the Music & Artssegment were 43.9% of segment net sales in the six months ended June 30,2007 compared to 45.4% for the same period in 2006. The decrease primarilyconsisted of lower intangibles amortization expense of 1.7% and lowerstock-based compensation expense under the LTIP of 0.9% partially offset byhigher bad debt expense of 1.1%. The reduced intangible amortization expensewas primarily due to the completion of amortization in the prior year forcertain intangibles acquired from Music & Arts Center, Inc. Thelower LTIP cost was due to the reduction in plan achievement levels as comparedto the prior year period. Higher bad debt expense reflects increaseduncollectible accounts resulting from recent business expansion and the effectof certain bad debt recoveries realized in the prior year period.

SG&A expenses for the Musician’s Friend segmentwere 25.2% of segment net sales in the six months ended June 30, 2007compared to 23.6% for the same period in 2006. The increase in SG&A wasprimarily related to the conversion to our new distribution center, which wasopened in the third quarter. The effect of these additional costs was seenprimarily in higher expenses in payroll of 1.1%, building rent of 0.6%,contract labor of 0.4%, and depreciation and amortization of 0.4%.Additionally, consulting costs were higher by 0.4%, stock-based compensationexpense for options and LTIP was lower by 1.2%, and legal costs were lower by0.3%.

Consolidated operating income decreased 4.2% to $48.6million for the six months ended June 30, 2007 from $50.8 million in thecomparable 2006 period. As a percentage of net sales, consolidated operatingincome declined in the six months ended June 30, 2007 to 4.6% from 5.5%for the same period in 2006.

Interest expense, net for the six months ended June 30,2007 was flat at $4.2 million as compared to the same period in 2006. Thereduction in interest resulting from the conversion of the 4% senior notes tocommon stock in July 2006 was offset by higher borrowings under therevolving credit facility used primarily to fund working capital requirementsand business acquisitions.

For the six months ended June 30, 2007, incometax expense was $17.9 million compared to $17.4 million for the sameperiod in 2006. The effective tax rate for the six month period was 40.3%compared to 37.4% in the prior year period. The rate was lower in the prioryear period due to the reduction of a valuation allowance related to a capitalgain in 2001.

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Consolidated net incomefor the six months ended June 30, 2007 decreased 8.1% to $26.8 million,compared to $29.1 million in the same period in 2006 as a result of thecombinations of factors described above.

**Liquidity andCapital Resources**

Our need for liquidity will arise primarily from thefunding of capital expenditures, working capital requirements and payments onour indebtedness, as well as possible acquisitions. We have historicallyfinanced our operations primarily through internally generated funds andborrowings under our credit facilities. Please see “Risk Factors” in our AnnualReport on Form 10-K filed for the year ended December 31, 2006for a discussion of factors which could possibly result in a decrease in theamount of internally generated funds available to finance capital expendituresand working capital requirements. As of June 30, 2007, we had $169.6million in borrowings outstanding under our credit facility and had availableborrowings of $34.7 million (net of $5.7 million of outstanding letters ofcredit).

We have maximum borrowings available under our creditfacility of $210 million, subject to borrowing base limitations. The creditagreement allows for the increase of the maximum borrowings to $250 million atthe option of the Company. The maturity date of the facility isDecember 2011. The actual amount available is tied to our inventory andreceivable base, and our obligations under the credit facility are secured byliens on our principal assets. Borrowing options are prime rate plus applicableprime margin, or London Interbank Offered Rate or LIBOR, plus applicable LIBORmargin. The applicable prime and LIBOR margins are based upon levels of excessavailability and adjusted quarterly. If excess availability is greater than $30million, the applicable prime margin is -0.25%and applicable LIBOR margin is 0.75%. If excess availability is less than orequal to $30 million and greater than $15 million, the applicable prime marginis 0.00% and the applicable LIBOR margin is 1.00%. If excess availability isless than or equal to $15 million, the applicable prime margin is 0.00% and theapplicable LIBOR margin is 1.25%. An unused fee of 0.25% is assessed on theunused portion of the credit facility. The agreement underlying the creditfacility includes significant restrictive negative covenants. Among otherthings, these covenants restrict or prohibit our ability to incur debt andissue specified equity instruments, incur liens on our assets, make anysignificant changes in our corporate structure or the nature of our business,dispose of assets, make guaranties, prepay debt, engage in a change in controltransaction, pay dividends, make investments or acquisitions, engage intransactions with affiliates and incur capital expenditures. The agreement alsoincludes representations and warranties which must be true each time we borrowfunds under the credit facility and affirmative covenants. The full text of thecontractual requirements imposed by this financing is set forth in the Amendedand Restated Loan and Security Agreement and related amendments which have beenfiled as exhibits to our periodic reports with the Securities and ExchangeCommission (“SEC”). Subject to limited cure periods, the lenders under ourcredit facility may demand repayment of these borrowings prior to statedmaturity upon the occurrence of specified events, including if we breach theterms of the agreement, suffer a material adverse change, engage in a change incontrol transaction, suffer a significant adverse legal judgment, default onother significant obligations, or in the event of specified events ofinsolvency. In the event the Company elects to terminate the agreement prior tothe maturity, a prepayment fee of 0.25% is assessed on the maximum borrowings,subject to certain conditions.

During 2002 we entered into master operating leaseagreements with US Bank to lease equipment and other property primarily tosupport the operations of the distribution center for our Guitar Center retailstores. Under these agreements, we leased a total of $10.5 million in equipmentand other property. In August 2006, we entered into a master operatinglease agreement to lease equipment totaling approximately $13 million tosupport the operations of the new distribution center for our Musician’s Friendsubsidiary.

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

As is the case with most multi-unit retailers,substantially all of the real property used in our business is leased underoperating lease agreements. Please see Item 2. Properties, and Note 7 to theConsolidated Financial Statements in our Annual Report on Form 10-Kfor the year ended December 31, 2006. For the remainder of fiscal 2007, weanticipate our capital expenditures will be between $34 million and $40 million.

Net cash used in operating activities was $2.5 millionfor the six months ended June 30, 2007 compared to net cash used inoperating activities of $11.1 million for the same period in 2006. The primaryuse of cash during the six months ended June 30, 2007 was a decrease inaccrued expenses and other current liabilities of $47.4 million and an increasein inventories of $22.5 million. The reduction of accrued expenses and othercurrent liabilities was primarily due to payments of income taxes and salestaxes. The primary sources of cash were generated from the current periodearnings and a decrease in accounts receivable of $11.7 million reflectingseasonal collection trends.

Cash used in investing activities was $71.1 millionfor the six months ended June 30, 2007 compared to $55.4 million for thesame period in 2006. The cash used in investing activities for the six monthsended June 30, 2007 included $32.1 million related to acquisition ofbusinesses and $39.0 million of capital expenditures, comprised primarily of$16.4 million on new stores and remodels, $11.2 million on computer softwareand equipment purchases and $4.2 million on the expansion of our distributionfacilities.

Cash provided by financing activities totaled $72.2million for the six months ended June 30, 2007 compared to $62.9 millionin the same period in 2006. The cash provided by financing activities in thesix months ended June 30, 2007 was due to increased borrowings under therevolving line of credit to support business acquisitions, capital expendituresand working capital requirements. In addition, proceeds from the exercise ofstock options provided $2.9 million (including $0.4 million in excess taxbenefits that are reflected in cash flows from financing activities) andemployee purchases of our common stock provided $1.3 million.

We believe that our current operating cash flow,working capital, cash on hand, borrowings available under our credit facilityand other sources of liquidity we believe are available to us will besufficient to meet our obligations in the ordinary course of business over thenext 12 months, including capital expenditures and new store openings.

Our known capital resource and liquidity requirementsfor 2007 are expected to be primarily provided by net cash flow from operationsand borrowings available under our credit facility. In addition, the moderationof our growth plans in 2007 by reduced Guitar Center retail store openings andfewer Music & Arts acquisitions will provide us the opportunity togenerate incremental cash flows.

Depending upon market conditions, we may also elect toraise additional capital in the form of common or preferred equity, debt orconvertible securities for the purpose of providing additional capital to fundworking capital needs or continued growth of our existing business, or torefinance existing obligations or changes in our capital structure. Any suchfinancing activity will be dependent upon many 

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factors, including ourliquidity needs, market conditions and prevailing market terms, and we cannotassure you that future external financing for us will be available onattractive terms or at all.

We intend to open additional stores in new andexisting markets. Each new primary format Guitar Center store typically hasrequired approximately $1.1 million to $1.2 million in gross inventory.Historically, our cost of capital improvements for a primary format GuitarCenter store has been approximately $1.2 million consisting of leasehold improvements,fixtures and equipment. We incur higher costs in some geographic areas,particularly the Northeast, and when we build a larger flagship store. We havedeveloped secondary format Guitar Center stores to build in sites that we donot believe will support our primary format units. Our secondary format storeshave typically required approximately $0.9 million to $1.0 million in grossinventory and approximately $0.9 million in capital improvements. Our tertiaryformat stores have required approximately $0.5 million in gross inventory andapproximately $0.6 million in capital improvements. These capital expendituresreflect the increasing construction costs that we have been experiencing. Weexpect these increases to continue for the foreseeable future and these costsmay increase above our expectations.

We are also anticipating additional capital andstrategic investments related to improving our fulfillment facilities andupgrading our technology and systems, including an enterprise data warehouse,retail point of sale replacement, retail inventory management systemsimprovements and enterprise systems replacement for our direct responsedivision. We also continue to make significant investments in informationtechnology across our businesses and to incur costs and make investmentsdesigned to expand the reach of our businesses on the Internet. The costs ofthese initiatives and other investments related to our businesses will continueto be significant.

Throughout our history, wehave primarily grown organically. However, we also believe there may beattractive opportunities to expand by selectively acquiring existing musicproducts retailers or other complimentary businesses, if attractiveopportunities can be identified. While we cannot provide assurance that we willcomplete any further acquisition transactions, in the ordinary course of ourbusiness we investigate and engage in negotiations regarding suchopportunities. Acquisitions will be financed with cash on hand, drawings underour existing credit facilities, expansion of our credit facilities, issuance ofdebt or equity securities, or a combination, depending upon transaction sizeand market conditions, among other things.

**Recently IssuedAccounting Pronouncements**

In June 2006, the Financial AccountingStandards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), *Accounting for Uncertainty in Income Taxes.*FIN 48 clarifiesthe accounting for uncertainty in income taxes recognized in an enterprise’sfinancial statements in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 109, *Accounting for IncomeTaxes*. This Interpretation defines the minimum recognition thresholda tax position is required to meet before being recognized in the financialstatements. In May 2007, the FASB issued FASB Staff Position FIN 48-1,*Definition of Settlement in FASB Interpretation No. 48,*(“FSP FIN 48-1”). FSP FIN 48-1 provides guidance on how a companyshould determine whether a tax position is effectively settled for the purposeof recognizing previously unrecognized tax benefits. FSP FIN 48-1 iseffective upon initial adoption of FIN 48, which the Company adopted on January 1,2007. As a result of the implementation, the Company recognized no materialadjustment in the liability of unrecognized income tax benefits. See Note 7 tothe Consolidated Financial Statements in this report.

In June 2006, the FASB ratified Emerging IssuesTask Force Issue 06-3, *How Sales Taxes CollectedFrom Customers and Remitted to Governmental Authorities Should Be Presented inthe Income Statement,* (“EITF06-3”). EITF 06-3 requires a company to disclose its accountingpolicy (i.e., gross or net presentation) regarding the presentation of taxeswithin the scope of EITF 06-3. If taxes are significant, a 

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company should disclosethe amount of such taxes for each period for which an income statement ispresented. As required, the Company adopted EITF 06-3 as of January 1,2007 and the effect of the initial adoption of EITF 06-3 did not have anyimpact on its consolidated financial statements as we have historicallypresented sales excluding these taxes.

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*. SFAS No. 157defines fair value, establishes a framework for measuring fair value ingenerally accepted accounting principles and expands disclosures about fairvalue measurements. Accordingly, this Statement does not require any new fairvalue measurements. SFAS No. 157 is effective for fiscal years beginningafter November 15, 2007. The Company is currently evaluating the impact,if any, the adoption of SFAS No. 157 will have on its consolidatedfinancial statements.

In February 2007, theFASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilitie*s. SFAS No. 159 permitscompanies to choose to measure certain financial instruments and certain otheritems at fair value. The standard requires that unrealized gains and losses onitems for which the fair value option has been elected be reported in earnings.SFAS No. 159 is effective as of the beginning of an entity’s first fiscalyear that begins after November 15, 2007, and the Company is required toadopt SFAS No. 159 in the first quarter of 2008. The Company is currentlyevaluating the impact that SFAS No. 159 will have on its consolidatedfinancial statements.

**Seasonality**

Our business follows aseasonal pattern, peaking during the holiday selling season in November andDecember. Sales in the fourth quarter are typically significantly higher on aper store basis and through the direct response unit than in any other quarter.In addition, band rental season for our Music & Arts division startsin August and carries through mid-October, but that seasonality does nothave a significant impact on our consolidated results.

**Inflation**

We believe that therelatively moderate rates of inflation experienced in recent years have not hada significant impact on our net sales or profitability. However, we have beenexperiencing rising steel, lumber, concrete, labor, fuel and freight costsrelated to opening, remodeling, operating and relocating our stores, expandingour distribution centers and operating our business.

**Forward-LookingStatements; Business Risks**

This report contains forward-looking statementsrelating to, among other things, future results of operations, growth andinvestment plans, sales, trends in gross margin, growth in the Internet portionof our direct response business, the integration of acquisitions and otherfactors affecting growth in sales and earnings. Specific forward-lookingstatements are provided regarding our management’s current views regarding thedates new facilities and systems will become operational and the expensesrelated to those facilities. Statements regarding the dates new facilities andsystems will become operational are dependent upon third parties and eventsbeyond our control, such as the availability of third party consultingresources, construction delays, technology development delays and other events.Sales and earnings trends are also affected by many other factors including,among others, world and national political events, general economic conditions,the effectiveness of our promotion and merchandising strategies, our ability tointegrate and profitably operate acquired businesses, including Woodwind &Brasswind, the efficient operation of our supply chain, including the continuedsupport of our key vendors, our effective management of business risks,including litigation, and competitive factors applicable to our retail anddirect response markets. In addition, during the recent past, we haveexperienced greater fluctuations in 

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weekly and monthlyoperating results than has been our historic experience and this volatilityhas, and is likely to continue to, reduce the reliability of our futureprojections.

In addition, theproposed merger with affiliates of Bain Capital, as reported on our currentreport on Form 8-K filed with the SEC on June 27, 2007, maycause the price of our common stock to fluctuate significantly. Factors thatmay cause fluctuations in our operating results and/or the price of our commonstock include, but are not limited to, the following:

·       theoccurrence of any event, change or other circumstance that could give rise tothe termination of the merger agreement;

·       theinability to complete the proposed merger due to the failure to obtainstockholder approval or the failure to satisfy other closing conditions;

·       risksthat the proposed merger disrupts current plans and operations, as well asrelationships with key suppliers, and the potential difficulties in employeeretention as a result of the proposed merger;

·       theimpact of the substantial indebtedness incurred to finance the proposed mergerof our Company;

·       theamount of costs, fees, expenses and charges related to the proposed merger andthe actual terms of certain financings that will be obtained for the proposedmerger;

·       theoutcome of pending or future litigation and administrative claims, includingstockholder securities class actions filed in connection with the proposedmerger.

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

**Item 3.**                        QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We do not have any assetsor liabilities which, in our view, impose upon us significant market riskexcept for our credit facility which has a variable rate of interest generallyconsisting of stated premiums above prime and LIBOR. At June 30, 2007, wehad $169.6 million in outstanding borrowings under our credit facility. Asshort-term interest rates fluctuate, the interest expense we incur on ourcredit facility will change resulting in either a positive or negative effecton our financial position, results of operations and cash flows. At thisborrowing level for our credit facility, a one percentage point increase ininterest rates would have an unfavorable impact on pre-tax earnings of $1.7million on an annual basis. The primary interest rate exposure on the creditfacility is based on LIBOR. We do not use derivative financial instruments inour investment portfolio. Historically, we have not carried significant cashbalances and any cash in excess of our daily operating needs has been used toreduce our borrowings. Excess cash is generally invested in short-term, highquality interest bearing investments.

**Item 4.**                        CONTROLSAND PROCEDURES

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in our reportsfiled pursuant to the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and formsand that such information is accumulated and communicated to our management,including our Chief Executive Officer and Chief Financial Officer, asappropriate, to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, management recognizesthat any controls and 

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procedures, no matter howwell designed and operated, can provide only reasonable assurance of achievingthe desired control objectives, and management is required to apply itsjudgment in evaluating the cost-benefit relationship of possible controlsand procedures.

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

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**Part II.   OTHER INFORMATION**

**Item1.**                        LegalProceedings

For information on legalproceedings, see Note 8 of Notes to Consolidated Financial Statements “LegalProceedings”, which is incorporated by reference in response to this Item 1.

**Item1A.**                Risk Factors

Except for the riskfactors set forth below, there have been no material changes to the riskfactors disclosed in Item 1A of Part 1 in our Form 10-K for theyear ended December 31, 2006. Certain of the risk factors set forth belowwere disclosed in our Form 10-K, but have been updated to provideadditional information.

*We may be adversely impacted if our security measuresfail; we will need to comply with credit card security regulations.*

Our relationships with ourcustomers may be adversely affected if the security measures that we use toprotect their personal information, such as credit card numbers, areineffective. We primarily rely on security and authentication technology thatwe license from other parties. With this technology, we perform real-time creditcard authorization and verification with our banks and we are subject to thecustomer privacy standards of credit card companies. We cannot predict whetherevents or developments will result in a compromise or breach of the technologywe use to protect our customers’ personal information. If there is a compromiseor breach of this nature, there is the potential that parties could seekdamages from us, and a compromise or breach could lead to loss of confidence ofcustomers or significant fines from credit card companies or regulatoryagencies. Furthermore, our servers may be vulnerable to computer viruses,physical or electronic break-ins and similar disruptions. We may need to expendsignificant additional capital and other resources to protect against asecurity breach or to alleviate problems caused by any breaches. There is noassurance that we can prevent security breaches or systems failures.

We will need to becomecompliant with the Payment Card Industry requirements for security andprotection of customer credit card information. As a merchant who processescredit card payments from customers, we are required to comply with the PaymentCard Industry requirements imposed on us for the protection and security of ourcustomers’ credit card information. If we are unable to successfully complywith these requirements on a timely basis, currently expected to be on or aboutthe end of 2007, our business could be harmed because we could incursignificant fines from credit card companies or we could be prevented in thefuture from accepting customer payments by means of a credit card. In addition,we may need to expend significant management and financial resources inbecoming compliant with these requirements, which could divert these resourcesfrom other initiatives and adversely impact our financial results.

*We cannot provideany assurance that the proposed merger with an affiliate of Bain CapitalPartners, LLC, will be consummated.*

Consummation of ourproposed merger with an affiliate of Bain Capital Partners, LLC, is subject tothe satisfaction of various conditions, including approval of the acquisitionby a vote of a majority of the outstanding shares of our common stock and othercustomary closing conditions described in the merger agreement. We cannot guaranteethat these closing conditions will be satisfied, that we will receive therequired approvals or that the proposed acquisition will be successfullycompleted. In the event that the proposed acquisition is not completed:

·       management’sand our employees’ attention from our day-to-day business may be divertedbecause matters related to the proposed merger require substantial commitmentsof time and resources;

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·       wemay lose key employees as the result of the announcement or completion of theproposed merger;

·       ourrelationships with customers and vendors may be substantially disrupted as aresult of uncertainties with regard to our business and prospects;

·       wemust pay costs and expenses related to the proposed merger, such as legal andaccounting fees, whether or not the proposed merger is completed;

·       undercertain circumstances, we may be required to pay a termination (break-up) feeof up to $58 million if the proposed merger is not completed; and

·       themarket price of our common stock may decline to the extent that the currentmarket price reflects a market assumption that the proposed merger will becompleted.

Any of these events couldhave a material negative impact on our results of operations and financialcondition and could adversely affect the price of our common stock.

*The proposed mergermay impair our ability to attract or retain officers or key employees and mayadversely affect our relationships with key customers and suppliers.*

The announcement andcompletion of the proposed merger may have a negative impact on our ability toattract and retain officers and other key employees and may adversely affectour relationships with key customers and suppliers. These events could have amaterial negative impact on our results of operations and financial condition.

*As a result of theproposed acquisition, we will have substantially more debt.*

We will have substantialindebtedness if the proposed merger is consummated. There can be no assurancethat our businesses will be able to generate sufficient cash flows fromoperations to meet our anticipated debt service obligations. Our level ofindebtedness will have important consequences, including limiting our abilityto invest operating cash flow to expand our businesses or execute ourstrategies, to capitalize on business opportunities and to react to competitivepressures, because we will need to dedicate a substantial portion of these cashflows to service our debt. In addition, we could be unable to refinance orobtain additional financing because of market conditions, high levels of debtand the debt restrictions expected to be included in the debt instrumentsexecuted in connection with the consummation of the proposed merger.

*Our credit ratingsmay be downgraded as the result of the announcement of the proposed merger,which could negatively affect our ability to access capital.*

In connection with the announcement of the proposedacquisition, Standard & Poor’s Rating Services (S&P) has announcedthat it will review our corporate credit rating. Downgrades in our corporatecredit ratings generally cause borrowing costs to increase and the potentialpool of investors and funding sources to decrease and may have other negativeconsequences on our business.

Most of our largecustomers, suppliers and counterparties require an expected level ofcreditworthiness in order for them to enter into transactions with us. In theevent our corporate credit ratings decline, counterparties may decline to dobusiness with us or may require more stringent credit terms.

*In the future, we could have liquidity needs thatcould be difficult to satisfy under some circumstances.*

The inability toraise capital on favorable terms, particularly during times of uncertainty inthe financial markets, could impact our ability to sustain and grow ourbusinesses, which would increase our 

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capitalcosts. Our access to the financial markets could be adversely impacted by theannouncement of the proposed merger and various other factors, such as:

·       changesin credit markets that reduce available credit or the ability to renew existingliquidity facilities on acceptable terms;

·       changesin interest rates;

·       adeterioration of our credit or a reduction in our credit ratings; and

·       theoccurrence of material adverse changes in our businesses that restrict ourability to access the credit markets.

A lack of necessarycapital and cash reserves could adversely impact the evaluation of ourcreditworthiness by counterparties and rating agencies, and would likelyincrease our capital costs. An increase in our capital costs could have amaterial negative impact on our results of operations and financial condition.

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

(a)           Our annual meeting ofstockholders was held on May 10, 2007. At that time there were present, inperson or by proxy, 26,690,760 shares of our common stock.

(b)          At the annual meeting,three items were submitted to a vote of stockholders: (1) the election ofdirectors; (2) the approval of an amendment to the 2004 Guitar Center, Inc.Incentive Stock Award Plan to increase the number of shares authorized forissuance; and (3) the ratification of the selection of KPMG LLP as GuitarCenter’s independent registered public accounting firm for the year ending December 31,2007.

(c)           (1)   The results of voting for the election ofnine directors at the annual meeting were as follows:

| **Nominee**      | ** ** | ** ** | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|------------------|------------|------------|------------|------------|------------|--------------|------------|
| Marty Albertson  |       | 25,200,046 |       | 1,490,714  |       |
| Larry Livingston |       | 25,107,347 |       | 1,583,413  |       |
| Pat MacMillan    |       | 26,047,735 |       | 648,025    |       |
| Bob L. Martin    |       | 13,260,041 |       | 13,430,719 |       |
| George Mrkonic   |       | 26,043,433 |       | 647,327    |       |
| Kenneth Reiss    |       | 26,042,728 |       | 648,032    |       |
| Walter Rossi     |       | 26,054,941 |       | 635,819    |       |
| Peter Starrett   |       | 25,078,484 |       | 1,612,276  |       |
| Paul Tarvin      |       | 26,054,658 |       | 636,102    |       |

 

(2)         Theresults of voting for the amendment to the 2004 Guitar Center, Inc.Incentive Stock Award Plan to increase the number of shares authorized forissuance were as follows:

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** | **Broker Non-Votes** | ** ** |
|------------|------------|-------------|------------|-------------|------------|---------------------------|------------|
| 17,471,769 |       | 6,206,472   |       | 54,470      |       |                      | 2,958,049  |   |   |
|            |            |             |            |             |            |                           |            |  |  |

 

(3)         Theresults of voting to ratify the selection of KPMG LLP as Guitar Center’sindependent registered public accounting firm for the year ending December 31,2007 were as follows:

| **For**    | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|------------|------------|-------------|------------|-------------|------------|
| 25,223,676 |       | 1,460,618   |       | 6,466       |       |

 

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**Item6.**                        Exhibits
| Exhibit  Number | ** ** | ** **                                                                                                                    | ** ** | **Description** |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 10.1            |       | Letter to waive the  grant of 2007 stock options to Marty Albertson dated August 6, 2007.                                |
| 31.1            |       | Certification of the  Company’s Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
| 31.2            |       | Certification of the  Company’s Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
| 32.1            |       | Certification of the  Company’s Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |
| 32.2            |       | Certification of the Company’s Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.  |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized as of the 9th day of August 2007.
|        | GUITAR CENTER, INC.                                |
|--------|---------------------------------------------------------|
|   | /s/ ERICK MASON                                         |
|   | Erick Mason                                             |
|   | *Executive Vice President and Chief Financial  Officer* |

 

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