**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-K**

**x**                               ANNUAL REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the fiscal year ended December 31, 2006**

**OR**

**o**                                  TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**For the transition period from                           to                           **

**Commission file number 000-22207**

**GUITAR CENTER, INC.**

(Exactname of registrant as specified in charter)

| **Delaware**                                                     |   | **95-4600862**                           |
|------------------------------------------------------------------|--------|------------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification Number) |
| **5795 Lindero Canyon Road**                                     |   | ** **                               |
| **Westlake  Village, California**                                |   | **91362**                                |
| (Address of  principal executive offices)                        |   | (Zip Code)                               |

 

Registrant’stelephone number, including area code: **(818) 735-8800**

Securities registeredpursuant to 12(b) of the Act:

**None**

Securities registeredpursuant to 12(g) of the Act:

**CommonStock, $.01 par value**

**(Title ofClass)**

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.

Yesx                      No o

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Exchange Act.

Yeso                      No x

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

Yesx                      No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. x

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct.

| 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

As of June 30, 2006, the aggregate market valueof the registrant’s common stock held by non-affiliates of the registrant wasapproximately $1,169,000,000 based on the closing price as reported on theNASDAQ Global Select Market. Shares of Common Stock held by each executiveofficer, director and each person or entity known to the Registrant to beaffiliates of the foregoing have been excluded in that such persons may bedeemed to be affiliates. This assumption regarding affiliate status is notnecessarily a conclusive determination for other purposes.

Asof February 23, 2007, there were 29,502,000 shares of Common Stock, parvalue $0.01 per share, outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the Definitive Proxy Statement for the 2007annual stockholders’ meeting are incorporated by reference into Part III.

 

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**PART I**

**Item 1. BUSINESS**

**Introduction**

Guitar Center, Inc. is the leading United Statesretailer of guitars, amplifiers, percussion instruments, keyboards andpro-audio and recording equipment. As of December 31, 2006, our wholly owned retail subsidiary operated 198 Guitar Centerstores across the United States, with 134 primary format stores,61 secondary format stores and 3 tertiary format stores. In addition, as of December 31, 2006,our Music & Arts Center division operated 97 stores specializing inband instruments for sale and rental, serving teachers, band directors, collegeprofessors and students. We are also the largest direct response retailer ofmusical instruments in the United States through our wholly owned subsidiary,Musician’s Friend, Inc., and its catalogs and websites,www.musiciansfriend.com. www.guitarcenter.com, www.wwbw.com, www.music123.comand related websites.

We are a Delaware corporation with principal executiveoffices located at 5795 Lindero Canyon Road, Westlake Village, California91362, and our telephone number is (818) 735-8800. We maintain severalcorporate websites, including www.guitarcenter.com. However, none of theinformation contained on our websites is incorporated into this annual report.Whenever we refer to the “Company” or “us,” or use the terms “we” or “our” inthis annual report, we are referring to Guitar Center, Inc. and itssubsidiaries.

**History**

Guitar Center, Inc. was founded in 1964 inHollywood, California. Our flagship Hollywood store currently is one of thelargest and best-known retail stores of its kind in the United States,with approximately 30,600 square feet of retail space. Our Hollywood storefeatures one of the largest used and vintage guitar collections in the UnitedStates, attracting buyers and collectors from around the world. In front of ourHollywood store is the Rock Walk, which memorializes over 200 famous musiciansand music pioneers. The Rock Walk has helped to create internationalrecognition of the Guitar Center name.

In May 1999, we acquired Musician’s Friend, Inc.,an Oregon-based direct response retailer of musical instruments. Musician’sFriend is the largest direct response retailer of musical instruments in theUnited States, through its catalog and e-commerce website. In February 2007,we acquired substantially all of the assets of Dennis Bamber, Inc., d/b/aThe Woodwind & The Brasswind and Music123, an Indiana-based directresponse retailer of musical instruments. We refer to this business as“Woodwind & Brasswind.”

In April 2001, weacquired American Music Group, Ltd. and its related companies, a musicalinstrument retailer specializing in the sale and rental of band instruments andaccessories serving the student and family market. In April 2005, weacquired Music & Arts Center, Inc., a Maryland-based musicalinstruments retailer which primarily serves the beginning musician andemphasizes rentals, music lessons and band and orchestra instrument sales.Subsequent to the Music & Arts Center acquisition, our American Musicand Music & Arts Center businesses were combined into a new divisionof our retail store subsidiary that operates under the Music & ArtsCenter name.

**Recent Events**

On February 9, 2007, we acquired out of abankruptcy proceeding substantially all of the assets of Dennis Bamber, Inc.,also known as The Woodwind & The Brasswind. The acquisition consistedof a variety of direct response catalogs and websites, including those underthe brand names Woodwind & Brasswind and Music123, related inventoryand other assets. The acquired business operates as a division of ourMusician’s Friend subsidiary, through an office, retail outlet and warehousefacility and a distribution center facility, both located in South Bend,Indiana.

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The Woodwind & Brasswind brand is targetedprimarily to online and catalog purchases of band and orchestra instruments,while the Music123 brand name is targeted primarily to online purchases ofguitars, amplifiers, percussion instruments, keyboards and pro audio andrecording equipment. In connection with the purchase of this business, weentered into leases for the two Woodwind & Brasswind facilities, for aterm of 24 months for the approximately 122,000 square foot office, retailoutlet and warehouse facility and 18 months for the approximately 220,000square foot distribution center facility. During the term of the leases, weexpect to evaluate and implement a plan to integrate the various functions ofthe Woodwind & Brasswind business with or into our existing directresponse business.

**Industry Overview**

The United States retail market for music products in2005 was estimated in a study by the National Association of Music Merchants,or NAMM, to be approximately $7.8 billion in net sales. The broadlydefined music products market, according to NAMM, includes retail sales ofstring and fretted instruments, sound reinforcement and recording equipment,drums, keyboards, print music, pianos, organs, and school band and orchestralinstruments. Products currently offered by us include categories of productswhich account for approximately $7.1 billion of the retail market formusic products.

Over the past decade,technological advances in the industry have resulted in dramatic changes to thenature of music-related products. Manufacturers have combined computersand microprocessor technologies with musical equipment to create a newgeneration of products capable of high grade sound processing and reproduction.Products featuring those technologies are available in a variety of forms andhave broad application across most of our music product categories. Rapidtechnological advances have resulted in the continued introduction of higherquality products offered at lower prices, and we believe this trend willcontinue. Today, an individual consumer can affordably create a home recordingstudio which interacts with personal computers and is capable of producing high-qualitydigital recordings. Until recently, this type of powerful sound processingcapability was expensive and was typically purchased primarily by professionalsound recording studios.

**Business Overview**

During 2006, we operatedthree reportable segments under the classifications of Guitar Center stores,direct response and Music & Arts Center.

***Guitar Center Stores***

Our Guitar Center stores offer a unique retail conceptin the music products industry, combining an interactive, hands-on shoppingexperience with superior customer service and a broad selection of brand name,high-quality products at guaranteed low prices. We create an entertainingand exciting atmosphere in our stores with bold and dramatic merchandisepresentations, highlighted by bright, multi-colored lighting, highceilings, music and videos. We believe that more than half of our Guitar Centerstore sales are to professional and aspiring musicians who generally view thepurchase of music products as a career necessity. These sophisticated customersrely on our highly trained salespeople to answer technical questions and toassist in product demonstrations.

Our primary format Guitar Center stores are designedto serve major metropolitan population centers. Our primary format GuitarCenter store generally ranges in size from 12,000 to 30,000 square feet. Inlate 2000, we opened our first secondary format store to serve metropolitanareas that previously were not served by our primary format stores. Ourstandard secondary format Guitar Center store generally ranges in size from8,000 to 10,000 square feet. In late 2005, we opened our first tertiary marketstore to serve smaller population centers. Our tertiary format stores generallyare expected to be approximately 5,000 square feet.

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In 2006, we opened a total of 33 Guitar Center stores,including 12 primary format stores, 19 secondary format stores and 2tertiary format stores. We also added four stores via acquisition consisting oftwo primary format stores and two secondary format stores. We presently expectto open approximately 16 to 19 new Guitar Center stores in 2007, consisting of5 to 6 primary format stores, 9 to 11 secondary format stores and up to 2tertiary format stores.

Thefollowing summarizes key operating statistics of our Guitar Center stores andis based on the stores operated by us for the full year ended December 31:

| ** **                                   | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
| Number of stores  operated for the full year |       | 161      |       | 136      |       |
| Average net sales  per square foot           |       | $        | 580        |     | $          | 599 |   |
| Average net sales  per store                 |       | $        | 8,740,000  |     | $          | 9,214,000 |   |
| Average store-level  operating income        |       | $        | 1,151,000  |     | $          | 1,502,000 |   |
| Average store-level  operating income margin |       | 13.2     | %          | 16.3     | %          |

 

These key operatingstatistics are based on results of Guitar Center stores in operation for atleast 12 months as of December 31, 2006 and 2005, respectively. Averagenet sales per square foot is a measure of sales efficiency based on squarefootage. Average net sales per store represents the average result of storesopen at least 12 months, and is typically adversely affected by the opening ofsecondary and tertiary format stores which generate lower levels of sales thanprimary format stores. Although these smaller format stores generate lowerlevels of sales, these stores cost less to build, stock and operate than ourlarge format stores. Store-level operating income and margin includesindividual store revenue and expenses plus allocated rebates, cash discountsand purchasing department salaries (based upon individual store sales).

***Direct Response***

Our Musician’s Friend subsidiary, which we operate asa separate business unit, is a direct response e-commerce and catalogbusiness. Musician’s Friend offers musicians a shopping experience thatincludes technical product information, confirmations by a live person, quickand efficient sales and service and a musician-based staff for after-salesupport. Musician’s Friend’s catalogs and websites offer an assortment ofproducts and promotions throughout the year, mixing brand name products withunique and practical offerings. In June 2006, GuitarCenter.com waslaunched as an eCommerce website as part of our direct response division. InFebruary 2007, we acquired the Woodwind & Brasswind business andits websites and catalogs.

Our direct response businessis based in Medford, Oregon and is supported by a customer contact centerlocated in Salt Lake City, Utah and a distribution facility located in KansasCity, Missouri. The Kansas City distribution center also houses an outlet storefor selling returns and blemished product.

***Music & Arts Center***

The Music & Arts Center division of ourretail store subsidiary operates stores specializing in band and orchestrainstruments for sale and rental, serving teachers, band directors, collegeprofessors and students. Most of the Music & Arts Center stores alsosell a limited assortment of guitars, amplifiers, percussion instruments,keyboards, pro audio and recording equipment, as well as provide music lessons.Music & Arts Center instrument rentals are conducted on-site throughour outbound education representatives, over the counter at our retaillocations, on-line, and through “affiliate” stores operated by third partymusical instrument dealers.

As of December 31,2006, Music & Arts Center operated 97 retail stores. Existing Music &Arts Center stores range from 830 to 11,500 square feet, with a target storesize of approximately 3,800 square feet. Our Music & Arts Centerbusiness is based in Frederick, Maryland and is supported there by a 

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distributionfacility and call center, along with additional call centers in Liverpool, NewYork and Horsham, Pennsylvania.

**Strategy**

***Guitar Center Stores***

Our Guitar Center storesgrowth strategy is to continue to increase our presence in existing markets andto open new stores in strategically selected markets, which could includeinternational markets. We expect to continue pursuing our strategy ofclustering stores in primary markets to take advantage of operating andadvertising efficiencies, as well as opening stores in new and smaller marketsto build awareness of our name. Our Guitar Center stores business strategyincludes offering an extensive selection of brand name and hard to find new andvintage music products, developing creative and interactive presentations anddisplays, creating innovative promotional and marketing programs, providingspecialized and qualified customer service and providing guaranteed low prices.

***Direct Response***

Our direct response growthstrategy is to increase our market share in the direct response segment of theindustry, particularly relating to the Internet portion of the direct responsebusiness. While our catalogs remain an important marketing tool, we are focusedmore on Internet marketing, technology and infrastructure than we have been inthe past. Our core strategies include personalization and one-to-one marketingthat delivers products and services customized to the specific needs ofmusicians. Additionally, we are focused on technology and infrastructure thatenhances our website user experience, improves our business agility, increasesour ‘speed to market’ and further differentiates us from the competition. Inour back office, we are making investments to improve our analytic tools andenhance our data warehouse.

***Music & Arts Center***

Our Music & ArtsCenter growth strategy is to increase market share by expanding our existingbusiness. We are currently focusing on improving operational efficiencies andreducing working capital requirements. We may moderate our growth plans forthis business unit until these improvements are complete.

**Merchandising**

***Guitar Center Stores***

Our primary format Guitar Center stores carry anaverage of 7,200 core stock keeping units, or SKUs, our secondary format GuitarCenter stores carry an average of 5,700 core SKUs and our tertiary formatGuitar Center stores carry an average of 4,200 core SKUs. Our core SKUsrepresent our consistent and established product lines which are consideredstaple products for our customers.

Our stores areorganized into five departments (guitars and amplifiers, drums, keyboards, proaudio and recording, and accessories), with each department focused on oneproduct category. These departments address our customer’s specific productneeds and are staffed by specialized salespeople, many of whom are practicingmusicians. Our trade-in policy provides musicians with an alternative form ofpayment and the convenience of selling a used instrument and purchasing a new oneat a single location. Used products are bought and priced to sell by storemanagers who are trained and knowledgeable in the used musical instrumentmarket.

·       *Guitars and Amplifiers*. Ourguitar and amplifiers department carries a wide variety of new, used andvintage electric, acoustic, classical and bass guitars. Major manufacturersincluding Fender, Gibson, Martin, PRS, Yamaha, Ovation, Peavey, Line 6 andIbanez are well represented in popular 

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models and colors. Anumber of our stores also carry other stringed instruments such as banjos andmandolins. We also offer an extensive selection of guitar sound processingunits and products that allow guitars to interface with a personal computer.These products serve crossover demand from the traditional guitarist into newcomputer-related sound products.

Weoffer an extensive selection of electric, acoustic and bass guitar amplifiers,including a variety of boutique and vintage amplifiers with prices ranging from$50 to $5,000. We carry amplifiers from most major manufacturers, includingMarshall, Fender, Crate, Ampeg, Vox, Peavey, Line 6 and Mesa Boogie.

·       *Drums*. Our drum departmentcarries a range of percussion instruments, from drum kits to congas, bongos andother rhythmic and electronic percussion products. We also carry a selection ofvintage and used percussion instruments. We carry name brands such as Drum Workshop,Sabian, Pearl, Gretsch, Yamaha, Tama and Zildjian.

·       *Keyboards*. We carry a wideselection of keyboard products and computer peripheral and software packages.Our keyboard product line covers a wide range of manufacturers, includingRoland, Casio, Korg and Yamaha.

·       *Pro Audio and Recording*. Ourpro audio and recording department carries live-sound, DJ and recordingequipment for musicians at every level, from the casual hobbyist to theprofessional recording engineer. We maintain a broad selection ofcomputer-related recording products, including sound cards, sound libraries andcomposition and recording software. Our products range from recordingaccessories to state-of-the-art digital recording systems. Wealso carry a large assortment of professional stage audio, DJ and lightingequipment for small traveling bands, mobile DJs, private clubs and largetouring professional bands. Our pro audio brand name manufacturers includeDigidesign, JBL, Sony, Mackie, Shure, Tascam, Yamaha, Roland, M Audio, KRK,PreSonus and Apple.

·       *Accessories*. Ouraccessories department offers a wide range of items considered consumables byour musician customers. These items range from guitar strings, picks, cables,straps, performance microphones and stands to sophisticated signal processorsthat modify and enhance the sound of voices and instruments during performanceor recording.

***Direct Response***

Our direct response business offers primarily newmerchandise through its catalogs and on-line through its websites. In addition,our direct response business offers returned and blemished merchandise throughits outlet store in Kansas City, Missouri, and on-line through its websites.

Our direct responsebusiness offers a product mix that includes the same categories as thoseoffered by our Guitar Center stores, including guitars and amplifiers, drums,keyboard, pro audio and accessories. In addition, our direct response businessoffers a range of private label products and band and orchestra instruments andaccessories that primarily are targeted at intermediate and professionalmusicians. Our direct response catalogs generally offer an average ofapproximately 5,000 SKUs and approximately 39,500 SKUs are offered on ourwebsites. We believe that the breadth of SKUs offered by our direct responsebusiness differentiates it from many of its competitors.

***Music & Arts Center***

Our Music & ArtsCenter business focuses on the student and family music market, particularlyband and orchestra instruments. These stores offer band and orchestralinstruments and related accessories for sale and rental, musical instrumentlessons and a limited assortment of guitars, amplifiers, percussioninstruments, keyboards, live-sound/DJ and recording equipment. Our Music &Arts Center stores offer a 

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fullrange of brass and woodwind band instruments including trumpets, flutes,clarinets, trombones, saxophones, piccolos, French horns, flugelhorns, cornets,baritones and related music accessories. These stores also offer a full rangeof stringed instruments, such as violins, violas, cellos, string basses andrelated accessories. These stores carry a wide range of sheet music. Name brandmanufacturers carried at Music & Arts Center stores include Leblanc,Jupiter, Gemeinhardt, Selmer, Buffet, Ludwig, Conn, Yamaha, Bach and Eastman.

**Operations**

***Guitar Center Stores***

We have centralized many key aspects of our GuitarCenter store operations, including the development of policies and procedures,accounting systems, training programs, store site selection, store layouts,purchasing and replenishment, advertising and pricing. This centralizationutilizes the experience and resources of our headquarters staff to establishconsistency throughout our stores.

Our Executive Vice President of Stores, 4 regionalsales managers, 4 regional operations managers, 23 district sales managers and21 district operation managers manage the Guitar Center stores. Storemanagement for our primary and secondary format stores generally is comprisedof a store manager, a sales manager, an operations manager, 2 assistant storemanagers and 5 department managers. Each store also has a warehousemanager and a commissioned sales staff that ranges from 20 to 40 employees. Weexpect that our tertiary format stores generally will be managed by a storemanager, 2 assistant managers and a sales staff that ranges from 7 to 15employees.

We provide ongoing training to our store managers andinstill in the managers the values of operating as a business owner. We seek toencourage responsiveness and entrepreneurship at each store by providing storemanagers with a high degree of autonomy relating to operations, personnel andmerchandising. Managers also play an integral role in the presentation ofmerchandise and the promotion and protection of our reputation.

We encourage employeedevelopment by providing our sales force with extensive training and theopportunity to increase both compensation and responsibility through increasedproduct knowledge and performance. We provide employees with the ability tomove into operations, sales and store management positions. As we open newstores, the qualified and experienced employees from existing stores often fillkey in-store management positions. By adopting a “promotion from within”strategy, we maintain a well-trained, loyal and enthusiastic sales forcethat is motivated by opportunities for advancement. Marty Albertson, our ChiefExecutive Officer, Mark Galster, our Executive Vice President of Stores, begantheir careers as a salesperson at Guitar Center stores.

***Direct Response***

Musician’s Friendoperations are managed by the division’s President and Chief Operating Officer.

***Music & Arts Center***

Music & ArtsCenters’ operations are managed by a Senior Vice President of Merchandising, aSenior Vice President of Operations, a Senior Vice President of Sales, andregional, district and store level managers. Store management generally iscomprised of a store manager, assistant store manager, one or more educationalrepresentatives and related sales and support staff.

**Marketing andPromotion**

Our proprietary databasesare a central element of our marketing and promotion programs. We maintainthree unique and proprietary databases that we have developed for GuitarCenter, Musician’s 

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Friendand Music & Arts Center. Included in these databases is information onapproximately 12 million of our Guitar Center store customers, approximately8.7 million of our direct response customers and approximately 315,000 of ourMusic & Arts Center customers. We believe that these databases assistus in identifying customer prospects, in generating repeat business bytargeting customers based on their purchasing history and by permitting us toestablish and maintain personal relationships with our customers.

***Guitar Center Retail***

Our advertising and promotion strategy for our GuitarCenter stores is designed to enhance the Guitar Center name and increasecustomer awareness and loyalty. Our advertising and promotional campaignsgenerally are developed around “events” designed to attract significant storetraffic and exposure. We regularly plan large promotional events including theGreen Tag Sale in March, the Anniversary Sale in August and the Guitar-a-thonin November/December. These events often are coordinated with productdemonstrations, interactive displays, clinics and in-store artistappearances.

As we enter new markets we initiate an advertisingprogram, including mail and radio promotions, television and Internet campaignsand other special grand opening activities. Each element of this advertisingprogram is designed to accelerate sales volume for each new store. Radioadvertising plays a significant part in our store opening campaign to generateinterest and create customer awareness.

We also maintain a varietyof promotional financing alternatives for our customers. Generally, all creditmade available to retail customers and all extended payment arrangements areprovided by third party consumer credit companies which are non-recourse to us,meaning that the risk of non-payment is borne by the third party provider solong as we comply with its administrative and approval policies. Thesearrangements also give us the flexibility to offer attractive payment optionsto our customers on a promotional basis, such as no interest periods, reducedinterest rates or deferred payment options. These programs are alsonon-recourse to us, but we pay the credit provider a fee reflecting thebelow-market, promotional benefit of the particular program.

***Direct Response***

Our direct response business maintains regularcommunication in electronic and print media. We perform an extensive analysisof customer behavior and transactions, and the industry expertise of ourmerchandising staff provides our marketing staff with offers that are targetedfor optimal customer response.

The same transactional databases that make markettargeting information available for catalog and e-mail circulation areenhanced by the information archived from our website traffic. Ourmerchandising and marketing departments use these tools to design personalizedproduct and promotional offerings for prospective customers. We are also makingsignificant investments in enhanced web-based analytical search engine toolsand web-based direct marketing initiatives.

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Our direct response strategy includes the developmentof catalogs targeted towards particular segments of the musician market. Forexample, Musician’s Friend produces two small catalogs, the LMI Catalog, whichis oriented toward young, school-aged children, and the Giardinelli catalogwhich is targeted to band and orchestra customers. Our direct response businessalso targets specific customers with keyboard, percussion and DJ specialtycatalogs.

We believe that there may be Internet-basedopportunities to expand the reach of our brands. We have expanded our Internetpresence to include the www.harmony-central.com and www.musician.com web sites.These opportunities are being created in part by the rapid development ofauction, content and community sites oriented towards music and musicians. Aspart of these opportunities, we are expanding our customer-focused marketingstrategy to include personalization and one-to-one marketing designed todeliver products and services customized to specific needs of our musician andaspiring musician customers. We also are completing the installation of asophisticated internal search and comparison shopping engine that we believewill improve user functionality and enhance search capabilities. We believethat these engines, along with several other planned advancements andimprovements to our websites, will continue to enhance the user experience,improve our business agility, increase our ‘speed to market’ and differentiateus from the competition.

***Music & Arts Center***

Our advertising effortsfor the Music & Arts Center stores are focused primarily on the schoolband and orchestra market and community. For instrument rentals, advertisingand promotional campaigns are developed around “rental nights” designed todisplay our orchestral and band instruments at elementary and middle schools.These events attract band directors, music educators, parents and students. Ourkey promotional events are held primarily from August through October. Inaddition to rental nights, we have education representatives that travel aroundthe country to promote and educate band directors on our instruments and oursales and rental programs. We maintain long-term relationships with educatorsin order to provide visibility to our products and obtain access to studentmusicians.

**Customer Service**

***Guitar Center Stores***

Exceptional customerservice is fundamental to our operating strategy. With the rapid changes intechnology and continuous new product introductions, we believe that customersdepend on our salespeople to offer expert advice and to assist with productdemonstrations. Our employees typically are musicians trained to understand theneeds of our customers. Guitar Center store salespeople specialize in one ofour five product categories and typically begin training on their first day ofemployment. Guitar Center store sales and management training programs areimplemented on an ongoing basis to maintain and improve the level of customerservice and sales support in the stores.

***Direct Response***

Our Musician’s Friend customer contact staff receivesproduct and customer service training in our Salt Lake City, Utah contactcenter facility. Extensive product information, including technicalinformation, product features and benefits and real-time stocking informationis available to the staff on their desktop systems via intranet and back-endinformation systems. Most of the staff is comprised of musicians who are givenextensive and ongoing product training, and the facility houses an extensiveproduct demonstration area and training facility. As of December 31, 2006,we had 268 full-time and 102 part-time customer service employees,staffing the contact center 24 hours a day, seven days a week. Our customerservice telephone staff for returns is located in the Kansas City, Missouridistribution center where they are closer to the returns process whileassisting customers.

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For customers that haveregistered e-mail addresses with us, we offer automated order and shipmentverification. This service provides customers with UPS or FedEx order trackinginformation as soon as their shipment has been processed. To provide customerswith a high degree of satisfaction, customers may return items for a fullrefund within 45 days of purchase. Additionally, if customers find a loweradvertised price within 45 days of purchase, we will match the competitor’sadvertised price.

***Music & Arts Center***

Sales at our Music &Arts Center stores are conducted primarily through sales made by oureducational sales representatives and sales made over the counter at ourretail stores. The majority of our educational representative sales force iscomprised of music teachers who are experienced band and orchestra instructors.The customer service functions relating to sales made by our educationalrepresentatives generally are conducted by our centralized call center. Thecustomer service functions relating to sales made over the counter at ourretail stores generally are conducted by our retail staff, who provide afull service retail experience for our customers.

**Purchasing**

We believe that we have excellent relationships withour vendors and, in many instances, we are our vendors’ largest customer. Givenour high volume, we are generally able to receive prompt order fulfillment andaccess to our vendors’ premium products. Guitar Center, Musician’s Friend andMusic & Arts Center each maintain centralized buying groups. Ourcentralized buyers include merchandise managers, buyers, planners, forecasters,replenishers and allocators. Merchandise managers and buyers are responsiblefor the selection and development of product assortments and the negotiation ofprices and terms. The planners, forecasters, replenishers and allocators areresponsible for maintaining inventory levels and allocating the merchandise tothe retail distribution center, stores and direct response fulfillment center.Guitar Center and Musician’s Friend use merchandise replenishment systems whichautomatically analyze and forecast sales trends for each SKU using various statisticalmodels, supporting the buyers by predicting merchandise requirements.

Our business and expansionplans are dependent to a significant degree upon our vendors. As we believe iscustomary in the industry, we do not have any long-term supply contractswith our vendors. Please see Item 1A. Risk Factors—*We depend ona relatively small number of manufacturers, suppliers and common carriers, andtheir inability to supply our requirements could adversely impact our business.*

**Distribution andInventory Control**

***Guitar Center Stores***

Our distribution center in the Indianapolis, Indianaarea supports our Guitar Center retail store operations. Nearly all productflows through the distribution facility, with the exception of special orders,which generally are drop shipments to our stores. A portion of the costs ofoperating this facility are absorbed into our Guitar Center merchandiseinventories and recognized as an element of cost of goods sold when the relatedinventory is sold. We have numerous commitments necessary to support theoperations of the facility, including a lease on the facility. We expanded thisfacility from approximately 505,000 square feet to approximately 773,000 squarefeet in 2006.

We have investedsignificant time and resources in our inventory control system at the GuitarCenter stores. We perform inventory cycle counts daily, both to measureshrinkage and to update the perpetual inventory on a store-by-storebasis. As appropriate, we also stock balance inventory among stores to assureproper distribution of product and to control overall inventory levels. Ourinventory shrinkage level has historically been low, which we attribute to oursophisticated system controls and strong corporate culture.

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***Direct Response***

Musician’s Friend orders are fulfilled out of ourKansas City, Missouri distribution center. As we have exceeded the capacity ofthe existing distribution center, we have leased a new distribution facility ofapproximately 702,000 square feet located in Kansas City, Missouri, which isexpected to be placed in service in the second half of 2007. The existingdistribution center is planned to be closed upon expiration of the lease in August 2007.

Orders, whether taken electronically or by anassociate in our customer contact center, are processed by our automatedtransaction system. We have implemented sophisticated inventory planningsystems to increase the level of in-stock products with the goal of maintaininga high initial line item fill rate. The initial line item fill rate reflectsthe percentage of items ordered by our customers that we are able to supply inthe initial shipment to that consumer. Split shipments of a single order imposeadditional shipping, handling and materials costs on us when compared to beingable to fulfill an entire order in a single shipment. The technology on ourwebsite also permits our customers to monitor their orders online by accessingthe UPS and FedEx tracking services.

All Musician’s Friendreturns are routed to the Kansas City distribution center where repairs andquality evaluations are made. On site repair and customer servicerepresentatives assist our customers, with the goal of reducing the costsassociated with returns. Returned and blemished products are sold through theoutlet store in the Kansas City facility, and by offering those products atreduced prices on the Musician’s Friend website.

***Music & Arts Centers***

Products for our Music &Arts Center stores generally are processed through a central distributionfacility located in Frederick, Maryland of approximately 60,000 square feet. Wehave a number of local hubs and/or support centers to guarantee productavailability during our peak back to school season. Music & ArtsCenter also maintains additional call centers in Liverpool, New York andHorsham, Pennsylvania.

**Retail Store SiteSelection**

We have developed a set ofselection criteria to identify prospective store sites for our Guitar Centerand Music & Arts Center stores. In evaluating the suitability of aparticular location, we concentrate on the demographics of our target customeras well as traffic patterns and specific site characteristics such asvisibility, accessibility, traffic volume, shopping patterns and availabilityof adequate parking. Our Guitar Center stores generally are located in free-standinglocations and high visibility “power center” shopping centers to maximize theiroutside exposure and signage, while our Music & Arts Center storesgenerally are located in specialized shopping centers to maximize traffic fromtargeted customers such as students and their parents.

**InformationTechnology**

***Guitar Center Stores***

We have invested significant resources in informationtechnology systems that provide real-time information for our GuitarCenter stores. These systems have been designed to integrate all major aspectsof our business, including sales, gross margins, inventory levels, purchaseorder management, automated replenishment and merchandise planning. Our systemcapabilities include inter-store transactions, vendor analysis, serialnumber tracking, inventory analysis and commission sales reporting.

In 2006, we developed andimplemented a data warehouse that enables us to improve our marketingtechniques and inventory planning. Also, in 2006, we began operation in our newdata center, which 

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augmentedthe previous operations center by providing increased capacity, improvedservice levels and improved recovery flexibility. The new data centerinfrastructure also improves our ability to support anticipated business growthand new technology initiatives. We are in the process of developing andimplementing a new point-of-sale system to replace the current sales processingsolution which is built on an aging infrastructure and is difficult to enhancefor future business requirements. The point-of-sale system is presentlyscheduled to begin a pilot program in 2008 and will provide us with enhancedcustomer sales information and more intuitive training modules.

***Direct Response***

Our direct response business maintains an extensivemulti-channel retail transaction processing system, as well as systemssupporting e-commerce operations, catalog operations, marketing analysis and internalsupport information. These systems provide our direct response business withmarketing, merchandising and operational information and provide call centerand customer service staff with current inventory and customer accountinformation.

We are in the process of developing and implementing anew multi-channel retail transaction processing solution that when implementedwill function as the core retail platform, supporting merchandising, inventorymanagement, order management, order entry, distribution center operations andvarious other major multi-channel direct response business functions. Thissystem is presently scheduled to begin operation in late 2007 or early 2008 andwill provide a more flexible and efficient retail platform supporting continuedgrowth objectives, possible international expansion and various other directresponse enhancements.

The operations of ourdirect response business are highly dependent on its information technologysystems. Our direct response business does not have redundant Internet oroperating systems and currently would be vulnerable to catastrophic events. Inthe event of a disaster, our direct response business would most likelyexperience delays in processing and shipping orders until we executed ourfailure recovery plans. Please see Item 1A. Risk Factors—*Our failureto develop and implement critical new systems for our business could adverselyimpact our business.*

***Music & Arts Center Stores***

We continue to investsignificant resources in the development and implementation of informationsystems at our Music & Arts Center stores. These systems are beingdesigned to operate and control significant business processes, includingsales, rentals, store operations, inventory levels, purchase order management,special orders and other financial transactions. These systems are in an earlystage of development and will require significant additional resources. Thisbusiness is not susceptible to using “off-the-shelf” retail solutionsbecause of our large rental business and the presence of off-site sales throughaffiliates and sales at schools.

**Competition**

The retail musical instrument industry is highlycompetitive and fragmented. Our stores compete against other large and smallmusical instrument retailers, online music retailers, on-line auctions, direct-to-consumeralternatives and a growing number of large mass merchants. A number of largemass merchants, including Wal-Mart, Best Buy, Target and Costco sell musicalinstruments in categories that we compete in, including entry-level guitars,electronic keyboards and band instruments. Best Buy also operates astore-within-a-store concept for musical instruments which includes asignificantly expanded selection of products. These retailers could represent asignificant source of future competition for our retail and direct responsebusinesses, particularly if these retailers continue to expand their productlines beyond entry-level merchandise.

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We primarily are in direct competition with othermusical instrument retailers, such as Sam Ash Music based in New York, NewYork, a major multi-unit retail chain in the music products industry. Sam Ashhas continued to open new or acquired stores in markets in which we arelocated. In addition, our retail stores and direct response business competewith various direct response companies such as American Musical Supply, Sam AshMusic, Sweetwater Sound and Full Compass. Competition within the musicalinstrument industry remains dynamic and we cannot predict the scope and extentof national and local competition our retail store and direct responsebusinesses will face in the future. In particular, competition within theInternet portion of our direct response business has been increasing and isintense, and we expect that this competition will continue in the future.

We believe that theability to compete successfully in our markets is determined by severalfactors, including breadth and quality of product selection, pricing, effectivemerchandise presentation, customer service, store location and proprietarydatabase marketing programs.

**Employees**

As of December 31,2006, we employed 9,540 people, of whom 7,955 were hourly employees and 1,585were salaried. As of December 31, 2006, we employed 1,730 part timeemployees and 7,810 full time employees. None of our employees are covered by acollective bargaining agreement. We believe that we enjoy good employeerelations.

**Brand Names andService Marks**

We believe we own valuableintellectual property including trademarks, service marks and tradenames, someof which are of material importance to our business. These marks and namesinclude “Guitar Center,” “Musician’s Friend” and “Music & Arts Center.”Some of our intellectual property is the subject of numerous United States andforeign trademark and service mark registrations. We believe our intellectualproperty has significant value and is an important factor in our marketing, ourstores and our websites.

**AvailableInformation**

We are subject to the reporting requirements of theSecurities Exchange Act of 1934, as amended, and its rules andregulations, which we collectively refer to as the Exchange Act. The ExchangeAct requires us to file reports, proxy statements and other information withthe Securities and Exchange Commission. Copies of these reports, proxystatements and other information can be read and copied at:

SEC Public Reference Room450 Fifth Street, N.W.Washington, DC 20549

The Securities and Exchange Commission maintains awebsite that contains reports, proxy statements and other information regardingissuers that file electronically with the Securities and Exchange Commission.These materials may be obtained electronically by accessing the home page ofthe Securities and Exchange Commission at http://www.sec.gov.

We make available free of charge on our website ourAnnual Report on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K and amendments to these reports filed orfurnished pursuant to Section 13(a) or 15(d) of the ExchangeAct, as soon as reasonably practicable after we electronically file thesedocuments with or furnish them to the Securities and Exchange Commission. Wealso make available free of charge on our website the charters of the AuditCommittee, Compensation Committee and Nominating and Corporate GovernanceCommittee, as well as the Corporate Governance 

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Guidelines and Code ofBusiness Conduct and Ethics (including any amendment to or waiver from aprovision of the Code of Business Conduct and Ethics) adopted by our Board ofDirectors.

References to our website addresses do not constituteincorporation by reference of the information contained on the websites, andsuch information is not part of this document.

Copies of any of the above-referenced information willalso be made available, free of charge, by calling (818) 735-8800 or uponwritten request to:

Guitar Center, Inc.Investor Relations5795 Lindero Canyon RoadWestlake Village, CA 91362

**Item 1A. RISKFACTORS**

An investment in oursecurities involves a high degree of risk. Described below are some of therisks and uncertainties facing our company. There may be additional risks thatwe do not presently know of or that we currently consider immaterial. All ofthese risks could adversely affect our business, results of operations,liquidity and financial position. A shortfall in comparative sales growth inany period will likely cause a shortfall in earnings, and result in financialperformance below that for which we have planned or the investment community expects.

*We may be unable tomeet our retail store growth strategy, which could adversely affect our resultsof operations.*

Our retail store growth strategy includes openingand/or acquiring new stores in new and existing markets and increasing sales atexisting locations. As of December 31, 2006, our wholly owned retailsubsidiary operated 198 Guitar Center stores across the United States, with 134primary format stores, 61 secondary format stores and 3 tertiary formatstores. We presently expect to open approximately 16 to 19 new Guitar Centerstores in 2007, consisting of 5 to 6 primary format stores, 9 to 11 secondaryformat stores and up to 2 tertiary format stores. As of December 31,2006, we also operated 97 Music & Arts Center stores. Our retailgrowth strategy also involves increasing the number of Music & ArtsCenter stores through opening approximately 8 to 10 new stores in 2007.

Our planned store opening schedule may be affected byany acquisitions we may transact during a given period. If we complete any suchtransactions, our planned organic store openings may be reduced.

The success of ourretail store expansion plans depends on many factors, including:

·       identificationof suitable retail sites and appropriate acquisition candidates;

·       negotiationof acceptable lease terms;

·       hiring,training and retention of skilled personnel;

·       availabilityof adequate capital;

·       sufficientmanagement and financial resources to support the new locations;

·       vendorsupport; and

·       successfulintegration of newly-acquired businesses, including the Woodwind &Brasswind business.

A number of these factorsare to a significant extent beyond our control. As a result, we do not knowwhether we will be able to continue to open and/or acquire additional GuitarCenter and Music & Arts Center stores at the rates currentlyanticipated. If we are unable to achieve our retail store expansion goals, orthe new stores do not perform to our level of expectations, our results ofoperations could be adversely 

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affected.During 2006, our new stores did not perform up to our expectations, and wecannot be assured that our new stores will meet our expectations in the future.

*If we do not respond to rapid technological changes,our direct response and other e-commerce services could become obsolete and wecould lose customers and our business could suffer.*

If we face material delaysin introducing new services, products and enhancements, our e-commercecustomers may forego the use of our services and use those of our competitors.To remain competitive, we must continue to enhance and improve thefunctionality and features of our online stores and the efficiency andeffectiveness of our advertising strategies, including evaluating andimplementing effective search engine technologies, on-line advertising andaffiliate programs. The Internet and the online commerce industry are rapidlychanging. If competitors introduce new products and services embodying newtechnologies, or if new industry standards and practices emerge, our existingwebsite and proprietary technology and systems may become obsolete. To developour website and other proprietary technology entails significant technical andbusiness risks. We may use new technologies ineffectively or we may fail toadapt our website, our transaction processing systems and our computer networkto meet customer requirements or emerging industry standards. In addition, oure-commerce operations may require greater efficiency, lower prices, expandedadvertising requirements through search engines and other parties, and othercompetitive factors such as free shipping or extended warranties or returnperiods in order to compete successfully. Each of these factors could have anadverse effect on selling prices and margins in our business and generallyconstrain our profitability.

*Our business could be adversely affected if we areunable to address unique competitive and merchandising challenges in connectionwith our plans to open additional Guitar Center and Music & ArtsCenter retail stores in new markets.*

As part of ourretail growth strategy, we plan to open and/or acquire additional Guitar Centerand Music & Arts Center stores in new markets, which could includeinternational markets. This expansion into new markets will present uniquecompetitive and merchandising challenges, including:

·       significantstart-up costs, including promotion and advertising;

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

·       managementof stores in distant locations or foreign countries;

·       availabilityof desirable product lines; and

·       potentialacquisitions of business lines in which we have limited or no experience.

Any of these factors maylead to a shortfall in revenues or an increase in costs with respect to theoperation of these stores. If we are not able to operate these storesprofitably, or to our expected level of performance, our results of operationscould be adversely affected. During 2006, our new stores did not perform up toour expectations, and we cannot be assured that our new stores will meet ourexpectations in the future.

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

Historically,we have achieved significant sales growth in existing Guitar Center stores. Ourquarterly comparable stores sales results have fluctuated significantly in thepast. Sales growth for comparable 

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periods, excluding net sales attributable to storesnot open for 14 months, was as follows for our Guitar Center retail stores:

| ** ** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| Quarter 1  |       |     | 6.3        | %        |       |     | 5.3        | % |   | 11.0 | % |
| Quarter 2  |       |     | 5.1        |     |       |     | 7.0        |   |   | 8.3 |   |
| Quarter 3  |       |     | 2.9        |     |       |     | 6.9        |   |   | 9.0 |   |
| Quarter 4  |       |     | 1.3        |     |       |     | 4.6        |   |   | 10.3 |   |
| Full Year  |       |     | 3.7        | %        |       |     | 5.8        | % |   | 9.7 | % |

 

We do not knowwhether our new stores will achieve sales or profitability levels similar toour existing stores. Our expansion strategy includes clustering stores inexisting markets. Clustering has in the past and may in the future result inthe transfer of sales to the new store and a reduction in the profitability ofan existing store. In addition, a variety of factors affect our comparablestore sales results, including:

·       competition;

·       economicconditions, including in particular discretionary consumer spending;

·       consumerand music trends;

·       changesin our merchandise mix;

·       productdistribution; and

·       timingand effectiveness of our promotional events.

A shortfall in comparativesales growth in any period will likely cause a shortfall in earnings, andresult in financial performance below that for which we have planned or theinvestment community expects.

*Our failure tomaintain and expand our direct response distribution center could adverselyimpact our business.*

The lease for our directresponse distribution center expires in August 2007. We are currentlydeveloping a larger facility to replace and expand our direct responsedistribution capabilities to coincide with the expiration of the lease on ourcurrent facility. This expansion also is expected to require a significantcapital commitment Our failure to complete this transition on time and onbudget may result in the need for us to expend additional capital and mayimpair the efficient operation of our distribution system. In addition, movingour distribution operations to a new facility will result in overlappingoperations and duplicative costs during the transition period. In the event thetransition does not proceed as planned, these duplicative costs couldsubstantially exceed our budgeted expectations. These events could materiallyadversely impact our business, results of operations, financial condition andprospects.

*Our inability toaddress the special risks associated with acquisitions could adversely impactour business.*

We believe that ourexpansion may be accelerated by the acquisition of existing music productretailers, such as our acquisition in February 2007 of Woodwind &Brasswind. We regularly investigate acquisition opportunities complementary toour Guitar Center, Musician’s Friend and Music & Arts Centerbusinesses. Accordingly, in the ordinary course of our business, we consider,evaluate and enter into negotiations related to potential acquisitionopportunities. We may pay for these acquisitions in cash or securities or a combinationof both. There is no assurance that attractive acquisition targets will beavailable at reasonable prices or that we will be successful in any suchtransaction. Acquisitions involve a number of special risks, including:

·       diversionof our management’s attention;

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·       integrationof acquired businesses with our business; and

·       unanticipatedlegal liabilities and other circumstances or events.

The failure to identify complementary acquisitions,the failure to obtain favorable pricing on those acquisitions or the occurrenceof any special risks involved in acquisitions could have a material adverseeffect on our ability to achieve our growth strategy, and our results ofoperations could be materially affected as a result.

Our acquisition of theWoodwind & Brasswind business is subject to additional risks. We acquiredthe assets of this business pursuant to a bankruptcy proceeding, and at thetime of the acquisition the business was experiencing declining revenue, wasnot profitable and had substantially lower initial order fill rates and longerorder fill times than we experience with our existing direct response business.In addition to the normal challenges associated with an acquisition describedabove, we face the challenge of restoring customer loyalty and customer servicelevels that may have been lost as a result of the financial and operationalcondition of the business prior to the acquisition. During the transitionperiod during which this business is integrated into our existing directresponse business, we will be subject to a variety of duplicative costs andsystems, including lease payments, technology platforms and payment systems. Wealso expect to make a substantial additional investment in this business torestore its inventory levels to those necessary to properly support thebusiness. As a result of these factors and the general condition of thebusiness, we expect that this acquisition will be dilutive to the earnings ofour direct response business for the near term. We cannot assure you as to whenor what extent this business will become accretive to our financial results. Ourfailure to have properly identified the strategy that is necessary for thisbusiness to achieve profitability, and our failure to execute on that strategyand successfully face the challenges associated with this acquisition, couldhave a material adverse effect on our results of operations and prospects andcould result in a poor or no return on our investments in this business.

*Our failure todevelop and implement critical new systems for our business could adverselyimpact our business.*

We are in the process ofdeveloping and implementing a data warehouse, new point-of-sale system and datacenter infrastructure for our Guitar Center stores as well as a newmulti-channel retail system and warehouse managment system for our directresponse business. The development and implementation of these initiativesrequires significant management attention and capital resources. Our failure toeffectively develop and implement these initiatives on a timely basis couldlead to the distraction of our management and the need to expend additionalcapital resources. Such a failure could reduce the quantity or quality ofoperating data available to our management necessary to run our business efficientlyand as a result could adversely impact our business, results of operations,financial condition and prospects.

*We must efficiently manage the expansion of our directresponse business in order to service our customers properly, otherwise ourbusiness could be adversely affected.*

Our direct responsebusiness, particularly our e-commerce business, requires significantinvestments to respond to anticipated growth and competitive pressures. If wefail to rapidly upgrade our website in order to accommodate increased traffic,we may lose customers, which would reduce our net sales. Furthermore, if wefail to expand the computer systems that we use to process and ship customerorders and process payments and the fulfillment facilities we use to manage andship our inventory, we may not be able to successfully distribute customerorders. We may experience difficulty in improving and maintaining such systemsif our employees or contractors that develop or maintain our key systems becomeunavailable to us. We have experienced periodic service disruptions andinterruptions, which we believe will continue to occur, while enhancing andexpanding these systems.

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*We depend on a relatively small number ofmanufacturers, suppliers and common carriers, and their inability to supply ourrequirements could adversely impact our business.*

Brand recognition is of significant importance in theretail music products business. There are a relatively small number of highquality, recognized brand names in the music products business. We depend onthis relatively small number of manufacturers and suppliers for both ourexisting retail stores and our direct response business. We do not have anylong-term contracts with our suppliers and any failure to maintain ourrelationships with our key brand name vendors would have a material adverseeffect on our business.

A number of the manufacturers of the products we sellare limited in size and manufacturing capacity and have significant capital orother constraints. These manufacturers may not be able or willing to meet ourincreasing requirements for inventory, and we cannot be assured that there willbe sufficient quantities or the appropriate mix of products available in thefuture to supply our existing stores and expansion plans. These capacityconstraints could lead to extended lead times and shortages of desirableproducts. The risk is especially prevalent in new markets where our vendorshave existing agreements with other dealers and may be unwilling or unable forcontractual or other reasons to meet our requirements.

The efficient operation of our distribution center forthe Guitar Center stores is also highly dependent upon compliance by ourvendors with precise requirements as to the timing, format and composition ofshipments, which in many instances require changes and upgrades to theoperational procedures and logistics and supply chain management capabilitiesof our vendors, all of which are outside of our control. Additionally, many ofour vendors receive product from overseas and depend on an extensive supplychain including common carriers and port access to transport merchandise intothe country. Foreign manufacturing is subject to a number of risks, includingpolitical and economic disruptions, the imposition of tariffs, quotas and otherimport or export controls and changes in governmental policies.

We rely on common carriersto transport product from our vendors to our central distribution center inIndianapolis, Indiana and from the distribution facility to our Guitar Centerstores. Similarly, Musician’s Friend relies on common carriers to transportproduct to its fulfillment center in Kansas City, Missouri and from thefulfillment center to customers. A disruption in the services of commoncarriers due to weather, employee strikes or other unforeseen events couldimpact our ability to maintain sufficient quantities of inventory in our retaillocations or to fulfill orders by direct response customers.

*Significantexisting and new competition in our industry could continue to adversely affectour retail business.*

The retail music products industry is fragmented andhighly competitive. We compete with many different types of music productretailers, including conventional retailers, as well as other catalog and e-commerceretailers, who sell many or most of the items we sell. We believe that largeformat music product retailers such as our company will seek to expand in partthrough the acquisition of small, independently owned stores or franchises, andwe anticipate increased competition in our existing markets and planned newmarkets from these consolidating retailers. These retailers may identify targetcompanies or execute their acquisition strategies more effectively than ourcompany. In addition, these retailers may have greater financial resources thanus or other competitive advantages. Our expansion to new markets will beinhibited by these and other established competitors. In addition, one or moreof our competitors may adopt a new, innovative store format or retail sellingmethod. If we are not able to compete effectively, we may fail to achievemarket position gains or may lose market share.

A number of large massmerchants, including Wal-Mart, Best Buy, Target and Costco, sell musicalinstruments in categories that we compete in, including entry-level guitars,electronic keyboards and band instruments. Best Buy also operates astore-within-a-store concept for musical instruments which includes asignificantly expanded selection of products. These retailers could represent asignificant source of future 

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competitionfor our retail and direct response businesses, particularly if these retailersexpand their product lines beyond entry-level merchandise.

*We must successfully implement our business strategyfor our Music & Arts Center business in order to reach profitability andearn an acceptable return on that business.*

Historically, our Music & Arts Center business hasnot been profitable, and we had focused our efforts on significant incrementalrevenue growth, primarily through acquisitions, to attain profitability forthis business. We have recently determined we should focus our immediateefforts on the removal of costs from the business, improving operatingefficiencies and reducing working capital needs, rather than significantincremental growth. As a consequence, we plan for the immediate future toreduce our continued investment in this business and to moderate its growth. Mostof our anticipated revenue growth for 2007 is planned to come from theinclusion of acquired companies for a full year and the opening of several newstores, principally in Texas. We do not expect to complete any additionalacquisitions for this division in 2007. We believe that the success of thesenew initiatives is critical in allowing this business to attain and sustainprofitability. Our failure to have properly identified the strategy that isnecessary for this business to achieve profitability, and our failure toexecute on the requirements of the initiatives we have identified could have amaterial adverse effect on our results of operations and prospects and couldresult in a poor or no return on our investments in this business. In 2006, we recordedan impairment charge related to the write down of goodwill associated with theMusic & Arts Center business. If we are unable to favorably change theperformance of this business, there may be write downs of the goodwillassociated with future acquisitions by this business, or possibly associatedwith other long-lived assets of this business.

*Our Music & Arts Center business is dependenton state and local funding of primary and secondary schools, and decreases infunding could adversely affect our Music & Arts Center business.*

Our Music & ArtsCenter business derives the majority of its revenue from sales or services tomusic students enrolled in primary and secondary schools. Any decrease in thestate and local funding of such music programs could have a material adverseeffect on our Music & Arts Center business and its results ofoperations.

*If we fail to maintain an effective system of internalcontrols, we may not be able to accurately report our financial results, and asa result, current and potential stockholders could lose confidence in ourfinancial reporting, which could have a negative market reaction.*

Section 404 of theSarbanes-Oxley Act of 2002, or Section 404, requires our management toreport on, and our independent registered public accounting firm to attest to,the effectiveness of our internal control over financial reporting. We haveimplemented an ongoing program to perform the system and process evaluation andtesting necessary to continue to comply with these requirements. Accordingly,we must continue to incur significant expenses and devote management resourcesto Section 404 compliance as necessary. Further, effective internalcontrols and procedures are necessary for us to provide reliable financialreports. If our internal controls and procedures become ineffective, we may notbe able to provide reliable financial reports, and our business and operatingresults could be harmed.

*Our retailoperations are concentrated in California, which ties our financial performanceto events in that state.*

As of December 31,2006, our corporate headquarters as well as 27 of our 198 Guitar Center storeswere located in California. Although we have opened and acquired stores inother areas of the United States, a significant percentage of our net sales andresults of operations will likely remain concentrated in California for theforeseeable future. As a result, our results of operations and financialcondition are heavily dependent upon general consumer trends and other generaleconomic conditions in California and 

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aresubject to other regional risks, including earthquakes. We do maintainearthquake insurance, but such policies carry significant deductibles and otherrestrictions.

*We may be adverselyimpacted if our security measures fail.*

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 third parties. With this technology, we perform real-timecredit card authorization and verification with our bank and we are subject tothe customer privacy standards of credit card companies. We cannot predictwhether events or developments will result in a compromise or breach of thetechnology we use to protect our customers’ personal information, and suchbreaches could lead to loss of confidence of customers or significant finesfrom credit card companies or regulatory agencies. Furthermore, our servers maybe vulnerable to computer viruses, physical or electronic break-ins and similardisruptions. We may need to expend significant additional capital and otherresources to protect against a security breach or to alleviate problems causedby any breaches. There is no assurance that we can prevent security breaches orsystems failures.

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

Our success depends to asignificant extent on the services of members of our senior management. Theloss of one or more of these individuals or other key personnel could have amaterial adverse effect on our business, results of operations, liquidity andfinancial position. Historically, we have promoted employees from within ourorganization to fill senior operations, sales and store management positions.In order to achieve our growth plans, we depend upon our ability to retain andpromote existing personnel to senior management, and we must attract and retainnew personnel with the skills and expertise to manage our business. If wecannot hire, retain and promote qualified personnel, our business, results ofoperations, financial condition and prospects could be adversely affected.

*Economic conditionsor changing consumer preferences could adversely impact us.*

Our business is sensitiveto consumer spending patterns, which can be affected by prevailing economicconditions. We believe that the musical instruments industry currently is experiencinga cyclical slowdown, and we cannot predict with accuracy the duration or extentof the slowdown. In addition, a general downturn in economic conditions in oneor more of our markets, such as occurred after September 11, 2001, couldhave a material adverse effect on our results of operations, financialcondition, business and prospects. Although we attempt to stay informed ofconsumer preferences for musical products and accessories typically offered forsale in our stores, any sustained failure on our part to identify and respondto trends would have a material adverse effect on our results of operations,financial condition, business and prospects.

*If our productscontain defects, our business could be harmed significantly.*

Products that we developor sell may expose us to liability from claims by users of those products fordamages, including bodily injury or property damage. This risk is expected toincrease as we use the capabilities of our Guitar Center and Musician’s Frienddistribution centers to increase the private label and other proprietaryproducts that we offer. Many of these products are manufactured by smallcompanies located overseas. We currently maintain products liability insurancecoverage in amounts that we believe are adequate. However, there can be noassurance that we will be able to maintain adequate coverage or obtainadditional coverage on acceptable terms in the future, or that insurance willprovide adequate coverage against all potential claims. Liability from claimsof users of our products could result in 

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damageto our reputation and sales, and our failure to maintain adequate productsliability insurance could adversely impact our financial condition.

*We may need to change the manner in which we conductour business if government regulation or taxation imposes additional costs andadversely affects our financial results.*

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

*We face riskscreated by litigation, governmental proceedings, labor disputes or environmentalmatters.*

Historically, we have beeninvolved in a variety of lawsuits. Current and future litigation that we mayface may result in substantial costs and expenses and significantly divert theattention of our management regardless of the outcome, and an unfavorableresolution could have a material adverse effect on our business, financialcondition and results of operations. In addition, current and futurelitigation, governmental proceedings, labor disputes or environmental matterscould lead to increased costs or interruptions of our normal businessoperations.

*Our hardware and software systems are vital to theefficient operation of our retail stores and direct response business, anddamage to these systems could harm our business.*

We rely on our computer hardware and software systemsfor the efficient operation of our retail stores and direct response business.Our information systems provide our management with real-time inventory, salesand cost information that is essential to the operation of our business. Due toour number of stores, geographic diversity and other factors, we would beunable to generate this information in a timely and accurate manner in theevent our hardware or software systems were unavailable. These systems are vulnerableto damage or interruption from a number of factors, including earthquake, fire,flood and other natural disasters and power loss, computer systems failure, orsecurity breaches, Internet and telecommunications or data network failure.

A significant informationsystems failure could reduce the quality or quantity of operating dataavailable to our management. If this information were unavailable for anyextended period of time, our management would be unable to efficiently run ourbusiness, which would result in a reduction in our net sales.

*Any failure by us to maintain compliance with creditfacility covenants could have a material adverse impact on our business.*

A significant decrease inour operating results could adversely affect our ability to maintain compliancewith required covenants under our credit facility. If these covenants are notcomplied with, our 

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lenderswill have the option to require immediate repayment of all amounts outstandingunder the credit facility, if any, or may limit future borrowings under thecredit facility. The most likely result would require us to renegotiate certainterms of the credit agreement, obtain a waiver from the lenders, or obtain anew credit agreement with another group of lenders, which may contain differentterms or may not be available at all. A failure to maintain, renegotiate orreplace our credit facility could materially impact our liquidity.

*The volatility ofour stock price could affect the value of an investment in our common stock.*

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

*Our actualoperating results may differ significantly from our projections.*

From time to time, we release projections and similarguidance regarding our future performance that represent our management’sestimates as of the date of release. These projections, which areforward-looking statements, are prepared by our management and are qualifiedby, and subject to, the assumptions and the other information contained orreferred to in the release. Our projections are not prepared with a view towardcompliance with published guidelines of the American Institute of CertifiedPublic Accountants, and neither our registered public accountants nor any otherindependent expert or outside party compiles or examines the projections and,accordingly, no such person expresses any opinion or any other form ofassurance with respect thereto.

Projections are based upon a number of assumptions andestimates that, while presented with numerical specificity, are inherentlysubject to significant business, economic and competitive uncertainties andcontingencies, many of which are beyond our control and are based upon specificassumptions with respect to future business decisions, some of which willchange. We generally state possible outcomes as high and low ranges which areintended to provide a sensitivity analysis as variables are changed but are notintended to represent that actual results could not fall outside of thesuggested ranges. The principal reason that we release this data is to providea basis for our management to discuss our business outlook with analysts andinvestors. We do not accept any responsibility for any projections or reportspublished by any such persons.

Projections are necessarily speculative in nature, andit can be expected that some or all of the assumptions of the projectionsfurnished by us will not materialize or will vary significantly from actualresults. Accordingly, our projections are only an estimate of what managementbelieves is realizable as of the date of release. Actual results will vary fromthe projections and the variations may be material. Investors should alsorecognize that the reliability of any forecasted financial data diminishes thefarther in the future that the data is projected. In light of the foregoing,investors are urged to put the projections in context and not to place unduereliance on them.

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

**Item 1B. UNRESOLVEDSTAFF COMMENTS**

None.

22

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**Item 2. PROPERTIES**

Our corporate office, which also serves as theheadquarters for our Guitar Center Retail business, is located in WestlakeVillage, California and consists of 173,000 aggregate square feet of bothleased and owned property. Approximately 69,000 square feet are under a leaseagreement expiring in April 2009. The remaining square footage, comprisedof office and warehouse space, provides growth space for our corporate staff.The distribution center for our Guitar Center stores is located in a leasedfacility in the Indianapolis, Indiana area, which was expanded from 505,000 to773,000 square feet in 2006. The lease term expires in December 2018.

Our direct response business is headquartered in afacility of 45,000 square feet that we own located in Medford, Oregon. We leaseapproximately 25,500 square feet of office space in Salt Lake City, Utah, forour direct response customer contact center facility. This lease expires in December 2008.We lease facilities with approximately 473,000 of aggregate square footageunder agreements expiring through August 2007 for use as a distributioncenter for our direct response division in Kansas City, Missouri. In March 2006,we entered into an agreement to lease a new distribution facility ofapproximately 702,000 square feet located in Kansas City, Missouri, which isexpected to be placed in service in the second half of 2007. Rental paymentsfor the new distribution center commence in February 2007. The currentdistribution center facilities will be closed upon the opening of the newfacility. In February 2007, we entered into leases for an office, retail outletand warehouse facility and a distribution center facility relating to ourWoodwind & Brasswind business, with terms of 24 months and 18 months,respectively. Both of these facilities are in South Bend, Indiana. The office,retail outlet and warehouse facility is approximately 122,000 square feet andthe distribution center facility is approximately 220,000 square feet.

Our Music & ArtsCenter business is headquartered in a leased facility located in Frederick,Maryland. The lease for this property expires in December 2012. We alsolease a distribution facility of approximately 60,000 square feet in Frederick,Maryland with a lease expiration of February 2009 and call centerfacilities of approximately 5,000 aggregate square feet in Liverpool, New Yorkand Horsham, Pennsylvania. The leases for these facilities expire in September 2010and June 2009, respectively. Additionally, we lease approximately 176,000square feet of warehouse hub space throughout the United States. The initiallease terms for our warehouses typically range from one to five years.

**Store Locations**

In connection with our retail business, as of December 31,2006, we operated 198 Guitar Center stores consisting of approximately2,899,000 square feet, consisting of 2,845,000 square feet under leaseagreements and approximately 54,000 square feet of owned property. The initiallease terms for our Guitar Center retail stores typically range from 10-15years and allow us to renew for two additional five-year terms. As of December 31,2006, we operated 97 Music & Arts Center stores consisting ofapproximately 368,000 square feet, all under lease agreements. The initiallease terms for our Music & Arts Center retail stores typically rangefrom 5-10 years and allow us to renew for one additional five-year term.Most of the leases require us to pay property tax, utilities, normal repairs,common area maintenance and insurance expenses.

23

----

The table below sets forth the location and openingdate for our Guitar Center and Music & Arts Center retail stores as ofDecember 31, 2006:

| **Store**                | ** ** | ** ** | ** ** | **Year   Opened** | ** ** | ** ** |
|--------------------------|------------|------------|------------|-------------------|------------|------------|
| **Guitar Center Stores** |       |       | ** ** |              |       |       |
| *Alabama*                |       |       |       |              |       |       |
| Mobile                   |       |       | 2004       |              |       |       |
| Birmingham               |       |       | 2005       |              |       |       |
| Montgomery               |       |       | 2006       |              |       |       |
| *Arizona*                |       |       |       |              |       |       |
| Phoenix                  |       |       | 1997       |              |       |       |
| Tempe                    |       |       | 1997       |              |       |       |
| Tucson                   |       |       | 2001       |              |       |       |
| Scottsdale               |       |       | 2003       |              |       |       |
| *Arkansas*               |       |       |       |              |       |       |
| Little Rock              |       |       | 2002       |              |       |       |
| *Southern California*    |       |       |       |              |       |       |
| Hollywood                |       |       | 1964       |              |       |       |
| San Diego                |       |       | 1973       |              |       |       |
| Fountain Valley          |       |       | 1980       |              |       |       |
| Sherman Oaks             |       |       | 1982       |              |       |       |
| Covina                   |       |       | 1985       |              |       |       |
| Southbay                 |       |       | 1985       |              |       |       |
| San Bernardino           |       |       | 1993       |              |       |       |
| Brea                     |       |       | 1995       |              |       |       |
| San Marcos               |       |       | 1996       |              |       |       |
| Rancho Cucamonga         |       |       | 1999       |              |       |       |
| El Toro                  |       |       | 1999       |              |       |       |
| Oxnard                   |       |       | 2000       |              |       |       |
| Bakersfield              |       |       | 2000       |              |       |       |
| Palmdale                 |       |       | 2001       |              |       |       |
| Pasadena                 |       |       | 2002       |              |       |       |
| Cerritos                 |       |       | 2003       |              |       |       |
| Northridge               |       |       | 2005       |              |       |       |
| Murrieta                 |       |       | 2006       |              |       |       |
| *Northern California*    |       |       |       |              |       |       |
| San Francisco            |       |       | 1972       |              |       |       |
| San Jose                 |       |       | 1978       |              |       |       |
| El Cerrito               |       |       | 1983       |              |       |       |
| Concord                  |       |       | 1996       |              |       |       |
| Fresno                   |       |       | 2000       |              |       |       |
| Sacramento               |       |       | 2000       |              |       |       |
| Modesto                  |       |       | 2001       |              |       |       |
| Gilroy                   |       |       | 2006       |              |       |       |
| Roseville                |       |       | 2006       |              |       |       |
| *Colorado*               |       |       | ** ** |              |       |       |
| Denver                   |       |       | 1998       |              |       |       |
| Englewood                |       |       | 1998       |              |       |       |
| Arvada                   |       |       | 1999       |              |       |       |
| Colorado Springs         |       |       | 2002       |              |       |       |
| Pueblo                   |       |       | 2005       |              |       |       |
| *Connecticut*            |       |       |       |              |       |       |
| Manchester               |       |       | 1999       |              |       |       |
| Orange                   |       |       | 2002       |              |       |       |
| New London               |       |       | 2006       |              |       |       |
| *Florida*                |       |       |       |              |       |       |
| North Miami area         |       |       | 1996       |              |       |       |
| South Miami area         |       |       | 1996       |              |       |       |
| West Palm Beach          |       |       | 2001       |              |       |       |
| Orlando                  |       |       | 2002       |              |       |       |
| Lakeland                 |       |       | 2003       |              |       |       |
| Tampa                    |       |       | 2003       |              |       |       |
| Ft. Myers                |       |       | 2004       |              |       |       |
| Orlando                  |       |       | 2005       |              |       |       |
| Jacksonville             |       |       | 2005       |              |       |       |
| Tallahassee              |       |       | 2005       |              |       |       |
| Pensacola                |       |       | 2005       |              |       |       |
| Clearwater               |       |       | 2006       |              |       |       |
| *Georgia*                |       |       |       |              |       |       |
| Atlanta                  |       |       | 1997       |              |       |       |
| Marietta                 |       |       | 1997       |              |       |       |
| Lawrenceville            |       |       | 2004       |              |       |       |
| Fayetteville             |       |       | 2006       |              |       |       |
| *Idaho*                  |       |       |       |              |       |       |
| Boise                    |       |       | 2001       |              |       |       |
| *Illinois*               |       |       |       |              |       |       |
| South Chicago            |       |       | 1979       |              |       |       |
| North Chicago            |       |       | 1981       |              |       |       |
| Central Chicago          |       |       | 1988       |              |       |       |
| Villa Park               |       |       | 1996       |              |       |       |
| Highland Park            |       |       | 2001       |              |       |       |
| Peoria                   |       |       | 2004       |              |       |       |
| Naperville               |       |       | 2004       |              |       |       |
| Rockford                 |       |       | 2006       |              |       |       |
| Country Club  Hills      |       |       | 2006       |              |       |       |
| Algonquin                |       |       | 2006       |              |       |       |
| Joliet                   |       |       | 2006       |              |       |       |
| Fairview Heights         |       |       | 2006       |              |       |       |
| *Indiana*                |       |       |       |              |       |       |
| Indianapolis             |       |       | 2001       |              |       |       |
| Hobart                   |       |       | 2003       |              |       |       |
| South Bend               |       |       | 2004       |              |       |       |
| Ft. Wayne                |       |       | 2005       |              |       |       |
| Terre Haute              |       |       | 2006       |              |       |       |
| Evansville               |       |       | 2006       |              |       |       |
| Greenwood                |       |       | 2006       |              |       |       |

24

----

 

| *Iowa*           |   |   |       |   |   |   |
|------------------|--------|--------|------------|--------|--------|--------|
| Des Moines       |   |   | 2005       |   |   |   |
| Davenport        |   |   | 2006       |   |   |   |
| *Kansas*         |   |   |       |   |   |   |
| Wichita          |   |   | 2005       |   |   |   |
| Overland Park    |   |   | 2005       |   |   |   |
| *Kentucky*       |   |   |       |   |   |   |
| Lexington        |   |   | 2006       |   |   |   |
| *Louisiana*      |   |   |       |   |   |   |
| New Orleans      |   |   | 1999       |   |   |   |
| Baton Rouge      |   |   | 2004       |   |   |   |
| *Maine*          |   |   |       |   |   |   |
| Portland         |   |   | 2006       |   |   |   |
| *Maryland*       |   |   |       |   |   |   |
| Towson           |   |   | 1998       |   |   |   |
| Rockville        |   |   | 2000       |   |   |   |
| Glen Burnie      |   |   | 2004       |   |   |   |
| *Massachusetts*  |   |   |       |   |   |   |
| Boston           |   |   | 1994       |   |   |   |
| Danvers          |   |   | 1996       |   |   |   |
| Natick           |   |   | 1997       |   |   |   |
| N. Attleboro     |   |   | 1998       |   |   |   |
| Millbury         |   |   | 2006       |   |   |   |
| *Michigan*       |   |   |       |   |   |   |
| Detroit          |   |   | 1994       |   |   |   |
| Southfield       |   |   | 1996       |   |   |   |
| Canton           |   |   | 1998       |   |   |   |
| Grand Rapids     |   |   | 2002       |   |   |   |
| Saginaw          |   |   | 2003       |   |   |   |
| Kalamazoo        |   |   | 2004       |   |   |   |
| Flint            |   |   | 2005       |   |   |   |
| Allen Park       |   |   | 2006       |   |   |   |
| *Minnesota*      |   |   |       |   |   |   |
| Twin Cities      |   |   | 1988       |   |   |   |
| Edina            |   |   | 1997       |   |   |   |
| *Mississippi*    |   |   |       |   |   |   |
| Jackson          |   |   | 2005       |   |   |   |
| *Missouri*       |   |   |       |   |   |   |
| N. St. Louis     |   |   | 1999       |   |   |   |
| Bridgeton        |   |   | 1999       |   |   |   |
| Independence     |   |   | 2005       |   |   |   |
| *Nebraska*       |   |   |       |   |   |   |
| Lincoln          |   |   | 2006       |   |   |   |
| *Nevada*         |   |   |       |   |   |   |
| Las Vegas        |   |   | 1998       |   |   |   |
| Summerlin        |   |   | 2005       |   |   |   |
| Reno             |   |   | 2006       |   |   |   |
| *New Hampshire*  |   |   |       |   |   |   |
| Nashua           |   |   | 2004       |   |   |   |
| *New Jersey*     |   |   | ** ** |   |   |   |
| Springfield      |   |   | 1998       |   |   |   |
| E. Brunswick     |   |   | 1998       |   |   |   |
| Totowa           |   |   | 1999       |   |   |   |
| Paramus          |   |   | 1999       |   |   |   |
| Cherry Hill      |   |   | 2001       |   |   |   |
| Atlantic City    |   |   | 2002       |   |   |   |
| *New Mexico*     |   |   |       |   |   |   |
| Albuquerque      |   |   | 2004       |   |   |   |
| *New York*       |   |   |       |   |   |   |
| Carle Place      |   |   | 1998       |   |   |   |
| Queens           |   |   | 1999       |   |   |   |
| Larchmont        |   |   | 1999       |   |   |   |
| Commack          |   |   | 2000       |   |   |   |
| Buffalo          |   |   | 2000       |   |   |   |
| Rochester        |   |   | 2001       |   |   |   |
| Albany           |   |   | 2003       |   |   |   |
| Manhattan        |   |   | 2003       |   |   |   |
| Syracuse         |   |   | 2005       |   |   |   |
| Brooklyn         |   |   | 2005       |   |   |   |
| *North Carolina* |   |   |       |   |   |   |
| Charlotte        |   |   | 2002       |   |   |   |
| Raleigh          |   |   | 2002       |   |   |   |
| Durham           |   |   | 2006       |   |   |   |
| Greensboro       |   |   | 2006       |   |   |   |
| *Ohio*           |   |   |       |   |   |   |
| Cleveland        |   |   | 1997       |   |   |   |
| Mayfield Heights |   |   | 1998       |   |   |   |
| Cincinnati       |   |   | 1998       |   |   |   |
| Columbus         |   |   | 2002       |   |   |   |
| Toledo           |   |   | 2004       |   |   |   |
| Akron            |   |   | 2005       |   |   |   |
| Youngstown       |   |   | 2005       |   |   |   |
| Dayton           |   |   | 2006       |   |   |   |
| *Oklahoma*       |   |   |       |   |   |   |
| Oklahoma City    |   |   | 2000       |   |   |   |
| Tulsa            |   |   | 2005       |   |   |   |
| *Oregon*         |   |   |       |   |   |   |
| Medford          |   |   | 1987       |   |   |   |
| Eugene           |   |   | 1996       |   |   |   |
| Clackamas        |   |   | 2000       |   |   |   |
| Beaverton        |   |   | 2000       |   |   |   |
| *Pennsylvania*   |   |   |       |   |   |   |
| Philadelphia     |   |   | 2000       |   |   |   |
| Plymouth Meeting |   |   | 2001       |   |   |   |
| Monroeville      |   |   | 2001       |   |   |   |

25

----

 

| Harrisburg                       |   |   | 2003       |   |   |   |
|----------------------------------|--------|--------|------------|--------|--------|--------|
| Pittsburgh                       |   |   | 2005       |   |   |   |
| Allentown                        |   |   | 2006       |   |   |   |
| *Rhode Island*                   |   |   |       |   |   |   |
| Warwick                          |   |   | 2003       |   |   |   |
| *South Carolina*                 |   |   |       |   |   |   |
| Greenville                       |   |   | 2005       |   |   |   |
| Charleston                       |   |   | 2005       |   |   |   |
| *South Dakota*                   |   |   | ** ** |   |   |   |
| Sioux Falls                      |   |   | 2006       |   |   |   |
| *Tennessee*                      |   |   | ** ** |   |   |   |
| Knoxville                        |   |   | 1998       |   |   |   |
| Memphis                          |   |   | 2003       |   |   |   |
| Nashville                        |   |   | 2003       |   |   |   |
| Chattanooga                      |   |   | 2005       |   |   |   |
| *Texas*                          |   |   |       |   |   |   |
| Dallas                           |   |   | 1989       |   |   |   |
| Arlington                        |   |   | 1991       |   |   |   |
| South Houston                    |   |   | 1993       |   |   |   |
| North Houston                    |   |   | 1994       |   |   |   |
| Central Dallas                   |   |   | 1998       |   |   |   |
| Clearlake                        |   |   | 1998       |   |   |   |
| Austin                           |   |   | 2000       |   |   |   |
| Plano                            |   |   | 2000       |   |   |   |
| Corpus Christi                   |   |   | 2002       |   |   |   |
| Ft. Worth                        |   |   | 2004       |   |   |   |
| South Austin                     |   |   | 2005       |   |   |   |
| El Paso                          |   |   | 2006       |   |   |   |
| Lubbock                          |   |   | 2006       |   |   |   |
| South Antonio                    |   |   | 2006       |   |   |   |
| McAllen                          |   |   | 2006       |   |   |   |
| Laredo                           |   |   | 2006       |   |   |   |
| Brownsville                      |   |   | 2006       |   |   |   |
| Lewisville                       |   |   | 2006       |   |   |   |
| Beaumont                         |   |   | 2006       |   |   |   |
| *Utah*                           |   |   |       |   |   |   |
| Salt Lake City                   |   |   | 1998       |   |   |   |
| Ogden                            |   |   | 2002       |   |   |   |
| *Virginia*                       |   |   |       |   |   |   |
| Fairfax                          |   |   | 1999       |   |   |   |
| Seven Corners                    |   |   | 1999       |   |   |   |
| Virginia Beach                   |   |   | 2000       |   |   |   |
| Fredericksburg                   |   |   | 2003       |   |   |   |
| Richmond                         |   |   | 2003       |   |   |   |
| *Washington*                     |   |   |       |   |   |   |
| Tukwila                          |   |   | 1997       |   |   |   |
| Kirkland                         |   |   | 1997       |   |   |   |
| Seattle                          |   |   | 1997       |   |   |   |
| Lynnwood                         |   |   | 1998       |   |   |   |
| Tacoma                           |   |   | 2001       |   |   |   |
| Spokane                          |   |   | 2001       |   |   |   |
| *Wisconsin*                      |   |   |       |   |   |   |
| Brookfield                       |   |   | 2004       |   |   |   |
| Madison                          |   |   | 2006       |   |   |   |
| Appleton                         |   |   | 2006       |   |   |   |
| **Music & Arts Center** |   |   |       |   |   |   |
| *Arizona*                        |   |   |       |   |   |   |
| Phoenix                          |   |   | 1987       |   |   |   |
| Mesa                             |   |   | 1995       |   |   |   |
| Tucson                           |   |   | 2004       |   |   |   |
| North Tucson                     |   |   | 2005       |   |   |   |
| North Mesa                       |   |   | 2006       |   |   |   |
| East Gilbert                     |   |   | 2006       |   |   |   |
| East Mesa                        |   |   | 2006       |   |   |   |
| *Colorado*                       |   |   |       |   |   |   |
| Englewood                        |   |   | 2000       |   |   |   |
| Loveland                         |   |   | 2001       |   |   |   |
| Littleton                        |   |   | 2002       |   |   |   |
| Westminster                      |   |   | 2002       |   |   |   |
| *Connecticut*                    |   |   |       |   |   |   |
| East Hartford                    |   |   | 1993       |   |   |   |
| Avon                             |   |   | 2002       |   |   |   |
| Vernon                           |   |   | 2003       |   |   |   |
| West Hartford                    |   |   | 2003       |   |   |   |
| Waterford                        |   |   | 2005       |   |   |   |
| Fairfield                        |   |   | 2006       |   |   |   |
| *Delaware*                       |   |   |       |   |   |   |
| Wilmington                       |   |   | 2000       |   |   |   |
| *Florida*                        |   |   |       |   |   |   |
| Longwood                         |   |   | 1986       |   |   |   |
| Jupiter                          |   |   | 1995       |   |   |   |
| Jacksonville                     |   |   | 2002       |   |   |   |
| *Georgia*                        |   |   |       |   |   |   |
| North Fulton                     |   |   | 1996       |   |   |   |
| Lawrenceville                    |   |   | 1997       |   |   |   |
| Snellville                       |   |   | 1997       |   |   |   |
| Peachtree                        |   |   | 2001       |   |   |   |
| Valdosta                         |   |   | 2002       |   |   |   |
| Albany                           |   |   | 2002       |   |   |   |
| East Cobb                        |   |   | 2004       |   |   |   |
| Conyers                          |   |   | 2006       |   |   |   |
| *Illinois*                       |   |   |       |   |   |   |
| Naperville                       |   |   | 2003       |   |   |   |
| Itasca                           |   |   | 2004       |   |   |   |
| *Massachusetts*                  |   |   |       |   |   |   |
| Greenfield                       |   |   | 1982       |   |   |   |

26

----

 

| Peabody          |   |   | 2006       |   |   |   |
|------------------|--------|--------|------------|--------|--------|--------|
| Newton Centre    |   |   | 2006       |   |   |   |
| Milford          |   |   | 2006       |   |   |   |
| *Maryland*       |   |   | ** ** |   |   |   |
| Bel Air          |   |   | 1993       |   |   |   |
| Ellicott City    |   |   | 1994       |   |   |   |
| Rockville        |   |   | 1994       |   |   |   |
| Frederick        |   |   | 1996       |   |   |   |
| Germantown       |   |   | 1997       |   |   |   |
| Timonium         |   |   | 1997       |   |   |   |
| Severna Park     |   |   | 1998       |   |   |   |
| South Howard     |   |   | 1999       |   |   |   |
| Hagerstown       |   |   | 2001       |   |   |   |
| Bowie            |   |   | 2004       |   |   |   |
| *North Carolina* |   |   |       |   |   |   |
| Burlington       |   |   | 2001       |   |   |   |
| Cary             |   |   | 2003       |   |   |   |
| Huntersville     |   |   | 2003       |   |   |   |
| North Charlotte  |   |   | 2003       |   |   |   |
| Charlotte        |   |   | 2005       |   |   |   |
| *New Hampshire*  |   |   |       |   |   |   |
| Manchester       |   |   | 2004       |   |   |   |
| *New Jersey*     |   |   |       |   |   |   |
| Marlton          |   |   | 2003       |   |   |   |
| Princeton        |   |   | 2003       |   |   |   |
| *Nevada*         |   |   |       |   |   |   |
| Henderson        |   |   | 2002       |   |   |   |
| Summerlin        |   |   | 2005       |   |   |   |
| *New York*       |   |   |       |   |   |   |
| Syracuse         |   |   | 1970       |   |   |   |
| Pittsford        |   |   | 1975       |   |   |   |
| New York Mills   |   |   | 1999       |   |   |   |
| East Rochester   |   |   | 2006       |   |   |   |
| North Syracuse   |   |   | 2006       |   |   |   |
| Mamaroneck       |   |   | 2006       |   |   |   |
| Lindenhurst      |   |   | 2006       |   |   |   |
| Lake Grove       |   |   | 2006       |   |   |   |
| *Ohio*           |   |   |       |   |   |   |
| Hillard          |   |   | 2006       |   |   |   |
| Marion           |   |   | 2006       |   |   |   |
| Columbus         |   |   | 2006       |   |   |   |
| Westerville      |   |   | 2006       |   |   |   |
| Worthington      |   |   | 2006       |   |   |   |
| *Pennsylvania*   |   |   |       |   |   |   |
| Lancaster        |   |   | 1993       |   |   |   |
| Plymouth Meeting |   |   | 1994       |   |   |   |
| Horsham          |   |   | 1998       |   |   |   |
| Exton            |   |   | 2000       |   |   |   |
| Doylestown       |   |   | 2004       |   |   |   |
| Newton Square    |   |   | 2004       |   |   |   |
| *South Carolina* |   |   |       |   |   |   |
| Columbia         |   |   | 1999       |   |   |   |
| Spartanburg      |   |   | 2002       |   |   |   |
| Charleston       |   |   | 2004       |   |   |   |
| *Tennessee*      |   |   |       |   |   |   |
| Murfreesbro      |   |   | 1993       |   |   |   |
| Cool Springs     |   |   | 2001       |   |   |   |
| Hendersonville   |   |   | 2002       |   |   |   |
| *Texas*          |   |   |       |   |   |   |
| Houston          |   |   | 2003       |   |   |   |
| Shenandoah       |   |   | 2006       |   |   |   |
| *Virginia*       |   |   |       |   |   |   |
| Springfield      |   |   | 1989       |   |   |   |
| Richmond         |   |   | 1990       |   |   |   |
| Oakton           |   |   | 1991       |   |   |   |
| Midlothian       |   |   | 1994       |   |   |   |
| Virginia Beach   |   |   | 1995       |   |   |   |
| Manassas         |   |   | 1997       |   |   |   |
| McLean           |   |   | 1997       |   |   |   |
| Kempsville       |   |   | 1998       |   |   |   |
| Sterling         |   |   | 1998       |   |   |   |
| Yorktown         |   |   | 1998       |   |   |   |
| Woodbridge       |   |   | 1999       |   |   |   |
| Chesapeake       |   |   | 2000       |   |   |   |
| Baileys          |   |   | 2001       |   |   |   |
| Burke            |   |   | 2002       |   |   |   |
| Charlottesville  |   |   | 2002       |   |   |   |

 

**Item 3. 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 

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all of the identifieddefendants in connection with the claimed inability of Ace Pro Sound andRecording, LLC to obtain vendor lines for its store. The complaint purports tobe made as a class action on behalf of all current and former retail sellers ofmusical 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. Servicerelating to the complaint was made on January 12, 2006. In May of2006, defendants filed their motions to dismiss all claims contained in theamended complaint and currently the motion is pending before the court. Whilewe believe this lawsuit is without merit and intend to defend it vigorously, itmay, regardless of the outcome, result in substantial expenses and damages tous and may significantly divert the attention of our management. There can beno assurance that we will be able to achieve a favorable settlement of thislawsuit or obtain a favorable resolution of this lawsuit if it is not settled.An unfavorable resolution of this lawsuit could have a material adverse effecton our business, financial condition and results of operations. Regardless ofthe outcome, the costs and expenses incurred by us to defend this lawsuit couldadversely impact our financial condition.

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, based upon Guitar Center’s allegedly unlawful point-of-salecredit card practices.

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.

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.Regardless of the outcome, the costs and expenses incurred by us to defend themcould adversely 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.

**Item 4. SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

No matters were submitted to a vote of securityholders during the fiscal quarter ended December 31, 2006.

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**PART II**

**Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATEDSTOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.**

**Market Information**

Ourcommon stock is quoted on the NASDAQ Global Select Market under the symbol “GTRC.”The following table sets forth the high and low closing sale prices for thecommon stock for the calendar quarters indicated:

| ** **     | ** ** | **2006** | ** ** | **2005** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First quarter  |       | $        | 57.05      |     | $          | 46.79 |   | $ | 60.58 |   | $ | 50.84 |   |
| Second quarter |       | 54.34    |       | 44.47    |       | 62.06 |   | 47.17 |   |
| Third quarter  |       | 46.24    |       | 36.37    |       | 65.00 |   | 53.88 |   |
| Fourth quarter |       | 47.35    |       | 41.59    |       | 62.20 |   | 48.20 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

As of December 31,2006, there were 491 stockholders of record, excluding the number of beneficialowners whose shares were held in street name. We believe that the number ofbeneficial holders is significantly in excess of such amount based on thesecurity position listings we obtain from time to time for the purpose offacilitating mailings to our stockholders.

**Dividend Policy**

We have historically retainedall earnings to provide funds for the operation and expansion of our businessand for the servicing and repayment of indebtedness. Our Board of Directorsintends to review this practice from time to time based on the capital,investment and debt service needs of our business. The terms of our creditfacility with Wells Fargo Retail Finance, LLC and a syndicate of other lendersincludes restrictive covenants which, among other things, prohibit the paymentof cash dividends on our capital stock. See Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of Operations—Liquidity and CapitalResources. Any determination to pay cash dividends on the common stock in thefuture will be at the sole discretion of our Board of Directors.

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**Stock PerformanceGraph**

The following graph compares our cumulative totalstockholder return on the common stock (no dividends have been paid thereon) withthe cumulative total return of (1) the S&P 500 Index and (2) theS&P Retail (Specialty) Index, from December 31, 2001 through December 31,2006. The comparison assumes an investment of $100 on December 31, 2001 inour common stock and in each of the foregoing indices.

The historical stockmarket performance of the common stock shown below is not necessarilyindicative of future stock performance.

**COMPARISON OF 5 YEARCUMULATIVE TOTAL RETURNAmong Guitar Center, Inc., The S & P 500 IndexAnd The S & P Specialty Stores Index**

****

*Thisperformance graph shall not be deemed ‘‘filed’’ with the SEC or subject to Section 18of the Exchange Act, nor shall it be deemed incorporated by reference in any ofour filings under the Securities Act of 1933, as amended.*

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**Item 6. SELECTEDFINANCIAL DATA**

Theselected data presented below under the captions “Income Statement Data” and “BalanceSheet and Other Data” for, and as of the end of, each of the years in thefive-year periods ended December 31, 2006, are derived from theconsolidated financial statements of Guitar Center, Inc. and subsidiaries,which financial statements have been audited by KPMG LLP, independentregistered public accounting firm. The consolidated financial statements as of December 31,2006 and 2005, and for each of the years in the three-year period ended December 31,2006, and the report thereon, are included elsewhere in this annual report. Theselected historical financial data should be read in conjunction withManagement’s Discussion and Analysis of Financial Condition and Results ofOperations, our consolidated financial statements and the notes theretoincluded elsewhere in this annual report.

| ** **                                                           | ** ** | **Year ended December 31,**                                                 | ** ** |
|----------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **2006**                                                                                   | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                           | ** ** | **(in thousands, except per share and operating data)** | ** ** |
| **Income statement data:**                                           |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Net sales                                                            |       | $                                                                                          | 2,029,966  |   | $ | 1,782,499 |   | $ | 1,513,172 |   | $ | 1,275,059 |   | $ | 1,100,889 |   |
| Cost of goods sold                                                   |       | 1,435,963                                                                                  |       | 1,262,097 |   | 1,087,899 |   | 931,014 |   | 810,474 |   |
| Gross profit                                                         |       | 594,003                                                                                    |       | 520,402 |   | 425,273 |   | 344,045 |   | 290,415 |   |
| Selling, general and administrative expenses                         |       | 466,555                                                                                    |       | 388,380 |   | 317,585 |   | 271,996 |   | 236,537 |   |
| Goodwill impairment                                                  |       | 80,160                                                                                     |       | — |   | — |   | — |   | — |   |
| Operating income                                                     |       | 47,288                                                                                     |       | 132,022 |   | 107,688 |   | 72,049 |   | 53,878 |   |
| Interest expense,  net                                               |       | 8,448                                                                                      |       | 7,339 |   | 5,390 |   | 12,540 |   | 13,077 |   |
| Gain on sale of  property                                            |       | 2,115                                                                                      |       | — |   | — |   | — |   | — |   |
| Income before income taxes                                           |       | 40,955                                                                                     |       | 124,683 |   | 102,298 |   | 59,509 |   | 40,801 |   |
| Income taxes                                                         |       | 40,531                                                                                     |       | 48,005 |   | 38,873 |   | 22,649 |   | 15,545 |   |
| Net income                                                           |       | $                                                                                          | 424        |   | $ | 76,678 |   | $ | 63,425 |   | $ | 36,860 |   | $ | 25,256 |   |
| Diluted net income per share                                         |       | $                                                                                          | 0.01       |   | $ | 2.67 |   | $ | 2.29 |   | $ | 1.47 |   | $ | 1.09 |   |
| Diluted weighted average shares outstanding (1)                      |       | 28,402                                                                                     |       | 29,846 |   | 28,976 |   | 26,119 |   | 23,130 |   |
| **Operating data:**                                                  |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Guitar Center net sales per gross square foot (2)               |       | $                                                                                          | 580        |   | $ | 599 |   | $ | 585 |   | $ | 560 |   | $ | 546 |   |
| Net sales growth                                                     |       | 13.9                                                                                       | %          | 17.8 | % | 18.7 | % | 15.8 | % | 16.0 | % |
| Increase in Guitar Center comparable store sales (3)            |       | 3.7                                                                                        | %          | 5.8 | % | 9.7 | % | 6.9 | % | 6.5 | % |
| Guitar Center stores open at end of period                           |       | 198                                                                                        |       | 161 |   | 136 |   | 122 |   | 108 |   |
| Ratio of earnings to fixed charges (4)                               |       | 2.6x                                                                                       |       | 6.5x |   | 6.6x |   | 3.5x |   | 2.8x |   |
| Net cash provided by operating activities (thousands)           |       | $                                                                                          | 21,583     |   | $ | 65,710 |   | $ | 85,506 |   | $ | 58,005 |   | $ | 12,248 |   |
| EBITDA (thousands) (5)                                               |       | $                                                                                          | 86,180     |   | $ | 161,022 |   | $ | 129,992 |   | $ | 92,669 |   | $ | 70,738 |   |
| **Balance sheet and other data:**                                    |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Net working capital                                                  |       | $                                                                                          | 326,539    |   | $ | 287,098 |   | $ | 269,859 |   | $ | 198,713 |   | $ | 110,825 |   |
| Property and equipment, net                                          |       | 201,986                                                                                    |       | 149,209 |   | 97,349 |   | 93,347 |   | 89,702 |   |
| Total assets                                                         |       | 927,478                                                                                    |       | 780,190 |   | 574,593 |   | 460,871 |   | 452,399 |   |
| Total long-term and revolving debt  (including current portion) |       | 103,134                                                                                    |       | 132,266 |   | 100,000 |   | 100,000 |   | 149,590 |   |
| Stockholders’ equity                                            |       | 542,737                                                                                    |       | 404,817 |   | 306,682 |   | 214,171 |   | 154,928 |   |
| Capital  expenditures                                                |       | 84,417                                                                                     |       | 75,493 |   | 26,151 |   | 24,245 |   | 26,309 |   |

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(1)           Weighted average shares represents shares calculated ona diluted basis. For the year ended December 31, 2006, 1.5 million sharesof common stock issuable upon conversion of the 4% Senior Convertible Notes (the“Notes”) were deemed to be potential common stock but were excluded in thecomputation of net income per share as its 

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effect would beantidilutive. For the years ended December 31, 2005 and 2004, the commonstock issuable upon conversion of the Notes amounted to 2.9 million shares. Forthe year ended December 31, 2003, the common stock issuable uponconversion of the Notes amounted to 1.6 million shares. The Notes were calledfor redemption by the Company on June 15, 2006 and substantially all ofthe outstanding Notes were converted into common stock prior to the July 15,2006 redemption date. The diluted earnings per share for 2003 has been restatedto conform to EITF 04-08, *Accounting Issues Relatedto Certain Features of Contingently Convertible Debt and the Effect on DilutedEarnings per Share.*

(2)           Net sales per gross square foot is a measure of salesefficiency based on square footage. This calculation is presented for GuitarCenter retail stores only, excluding Music & Arts Center retailstores, and does not include new stores opened during the reporting period.

(3)           Compares net sales for the comparable periods,excluding net sales attributable to stores not open for 14 months as of the endof the latter reporting period. All references in this annual report tocomparable store sales results are based on this calculation methodology. Thiscalculation is presented for Guitar Center retail stores only, excluding Music &Arts Center retail stores.

(4)           For the purpose of calculating the ratio of earnings tofixed charges, “earnings” represents income before provision for income taxesand fixed charges. “Fixed charges” consist of interest expense, amortization ofdebt financing costs, and one third of lease expense, which management believesis representative of the interest component of lease expense.

(5)           Represents net income before interestexpense, income taxes, and depreciation and amortization expense. Thereconciliation from reported net income to EBITDA is as follows:

| **EBITDA**                    | ** ** | ** ** | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net income as reported        |       | $          | 424        |     | $          | 76,678   |       | $        | 63,425     |     | $          | 36,860   |       | $ | 25,256 |   |
| Income taxes                  |       | 40,531     |       | 48,005   |       | 38,873   |       | 22,649   |       | 15,545   |       |
| Interest expense              |       | 8,448      |       | 7,339    |       | 5,390    |       | 12,540   |       | 13,077   |       |
| Depreciation and amortization |       | 36,777     |       | 29,000   |       | 22,304   |       | 20,620   |       | 16,860   |       |
| EBITDA                        |       | $          | 86,180     |     | $          | 161,022  |       | $        | 129,992    |     | $          | 92,669   |       | $ | 70,738 |   |

 

EBITDA is not a measure of financial performance undergenerally accepted accounting principles. We present EBITDA because manyinvestors view this information as a useful measure of a company’s ability togenerate cash flow and service debt or capital obligations, and some of ourdebt instruments have in the past and may in the future include covenants thatuse similar concepts. EBITDA should not, however, be considered as a substitutefor measures determined under generally accepted accounting principles, such asnet income and cash flow from operations. Further, the calculation of EBITDAvaries from company to company and thus the amount that we calculated using themethodology described above may not be comparable to the amount of EBITDAreported by other companies.

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**Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS**

**General**

Guitar Center, Inc. is the leading United Statesretailer of guitars, amplifiers, percussion instruments, keyboards andpro-audio and recording equipment. As of December 31, 2006, our whollyowned retail subsidiary operated 198 Guitar Center stores across the UnitedStates, with 134 primary format stores, 61 secondary format stores and 3tertiary format stores. In addition, as of December 31, 2006, our Music &Arts Center division operated 97 stores specializing in band instruments forsale and rental, serving thousands of teachers, band directors, collegeprofessors and students. We are also the largest direct response retailer ofmusical instruments in the United States through our wholly owned subsidiary,Musician’s Friend, Inc., and its catalogs and websites,www.musiciansfriend.com. www.guitarcenter.com, www.wwbw.com, www.music123.comand related websites. We acquired the www.wwbw.com and www.music123.comwebsites on February 9, 2007 when Musician’s Friend, Inc. acquiredsubstantially all of the assets of the Dennis Bamber, Inc. and its chapter 11bankruptcy estate, d/b/a The Woodwind and The Brasswind.

In 2006, we opened a total of 33 Guitar Center stores,including 12 primary format stores, 19 secondary format stores and 2tertiary format stores. Additionally, we acquired 4 stores from Hermes TradingCompany, Inc., a musical instruments retailer. We presently expect to openapproximately 16 to 19 new Guitar Center stores in 2007, consisting of 5 to 6primary format stores, 9 to 11 secondary format stores and up to 2 tertiaryformat stores.

As we enter new markets, we expect that we willinitially incur higher administrative and promotional costs per store than iscurrently experienced in established markets. As we open multiple stores inmarkets, we expect that sales at new stores in a market may reduce sales atmature stores in that same market, to some extent. We expect competition tocontinue to increase as other music product retailers attempt to executenational growth strategies. Our business strategy will also emphasizeopportunities to continue to grow each of our brands, including furtheracquisitions if attractive candidates can be located for reasonable prices.

From 2002 to 2006, our netsales grew at an annual compound growth rate of 16%, principally due to thecomparable store sales growth of our Guitar Center retail stores averaging 6%per year, the opening of new stores, and a 20% per year increase in the directresponse channel. We believe such volume increases are the result of thecontinued success of the implementation of our business strategy, continuedgrowth in the music products industry and increasing consumer awareness of theGuitar Center, Musician’s Friend and Music & Arts Center brand names.Our Guitar Center and Music & Arts Center retail stores achieved comparablestore sales growth of 3.4%, 5.4%, and 9.4% for the fiscal years ended December 31,2006, 2005 and 2004, respectively. We believe this growth reflects the strengthof our merchandise selection, effective advertising and promotion, andwell-trained and committed personnel.

**Financial ReportingChange**

In December 2004, theFinancial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards (“SFAS”) No. 123 (revised 2004), *Share-Based Payment*(“SFAS No. 123(R)”),effective for a company’s first fiscal year beginning after June 15, 2005.SFAS No. 123(R) supersedes Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for StockIssued to Employees*. SFAS No. 123(R) requires all share-basedcompensation to employees, including grants of employee stock options, to berecognized in the consolidated statements of income based on fair values ratherthan pro forma footnote disclosure.

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Effective January 1,2006, we adopted SFAS No. 123(R), and elected the modified prospectivetransition method. This method permits us to apply the new requirements on aprospective basis. Accordingly, our results for 2006 are not entirelycomparable with prior years, because in 2006 we recognized $15.0 million($9.3 million net of tax), or $0.33 per diluted share, of stock–basedcompensation expensed compared to zero in prior years. For additionalinformation on our adoption of SFAS No. 123(R), see Note 9, Stock-Based Compensation, of the Notes to Consolidated FinancialStatements in this annual Report on Form 10-K.

**Executive Summary**

Consolidated net sales in2006 increased 13.9% to $2.0 billion from $1.8 billion in 2005. Consolidatednet income in 2006 decreased 4.0% to $73.6 million, or $2.52 per diluted share,from $76.7 million, or $2.67 per diluted share, in 2005. Financial results wereimpacted by the recognition of stock-based compensation expenses, as requireddue to the adoption of SFAS No. 123(R), totaling $15.0 million, or $0.33per diluted share, for the year ended December 31, 2006.

During 2006, our GuitarCenter stores generated 3.7% comparable store sales growth and an increase of13.6% in total net sales compared to 2005. Sales from new stores totaled $130.9million and represented 73.1% of the overall increase in sales. In 2006, we opened33 new Guitar Center stores and added 4 new stores via acquisition. We continueto face a challenging retail environment, which may adversely impact sales andoperating margins trends for the foreseeable future.

Musician’s Friend, ourdirect response unit, generated an increase in net sales of 7.3% in 2006compared to 2005. The increase in sales primarily reflects the improvedleveraging of an expanding buyer file and advertising strategies. Gross profitmargins increased by 8.7% in 2006 compared to 2005, reflecting a higher sellingmargin offset somewhat by reduced shipping and handling revenue resulting fromthe competitive environment. We continue to face increased competition in thedirect response channel, which we expect to impact that segment’s net sales andgross margin for the foreseeable future. Early in 2007, we acquired out of a bankruptcyproceeding substantially all of the assets of Woodwind & Brasswind, adirect response retailer located in South Bend, Indiana. We expect thisacquisition to be dilutive to earnings in 2007.

Net sales for our Music &Arts Center segment totaled $145.0 million for 2006 compared to $103.1 millionfor 2005. The increase in sales was primarily the result of our acquisition on April 15,2005 of Music & Arts Center, Inc., a Maryland-based musicalinstrument retailer with an emphasis on the beginning musician. The acquiredbusiness was combined with our former American Music business into a newdivision of our retail store subsidiary that operates under the Music &Arts Center name. Financial results prior to April 15, 2005 for our Music &Arts Center business reflect only our former American Music stores and do notinclude results from the acquired business. However, comparable sales for theyear are computed using the combined comparable sales of Music & ArtsCenter, Inc. and American Music stores. Comparable sales for the full yearincreased 0.7%. We saw gross margin increase to 43.3% in 2006 compared to 41.8%in 2005, primarily due to reduced shrink expense and higher selling marginpartially offset by higher occupancy costs.

In the fourth quarter of2006, the Music & Arts Center segment recorded an impairment charge of$80.2 million, or $73.2 million after-tax, or $2.49 per diluted share, relatedto the write down of goodwill. The determination to write down the goodwill atMusic & Arts Center was a result of the segment’s current operatingperformance and our fourth quarter change in strategy to reduce futureinvestments in the segment and slow down growth in future years. $57.0 millionof the total write down of goodwill at Music & Arts Center is notdeductible for federal income tax purposes and is also not deductible in certainstates. This raised our effective income tax rate for the year to approximately99.0%.

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**Discussion of Critical Accounting Policies**

In the ordinary course ofbusiness, we have made a number of estimates and assumptions relating to thereporting of results of operations and financial condition in the preparationof our financial statements in conformity with accounting principles generallyaccepted in the United States. 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 of Inventory*

We value our merchandiseinventory at the lower of cost using the weighted average method or market.Rental inventories are valued at the lower of cost or market using the specificidentification method and are depreciated on a straight-line basis while outunder a rental agreement for rent-to-own sales. We record adjustments to thevalue of inventory based upon obsolescence and changes in market value. Applicablecosts associated with bringing inventory through our Guitar Center retaildistribution center are capitalized to inventory. The amounts are expensed tocost of goods sold as the associated inventory is sold. Management hasevaluated the current level of inventories considering future customer demandfor our products, taking into account general economic conditions, growthprospects within the marketplace, competition, market acceptance of current andupcoming products, and management initiatives. Based on this evaluation, wehave recorded impairment adjustments to inventory and to cost of goods sold forestimated decreases in net realizable value. These judgments are made in thecontext of our customers’ shifting needs, product and technological trends, andchanges in the demographic mix of our customers. A misinterpretation ormisunderstanding of these conditions and uncertainties in the future outlook ofour industry or the economy, or other failure to estimate correctly, couldresult in inventory valuation changes as of any given balance sheet date.

*Valuation of Long-Lived Assets*

Long-livedassets such as property and equipment and identifiable intangibles with finitelives are 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 assetsother than goodwill and intangibles that are not amortized, the determinationof whether impairment has occurred is based on an estimate of undiscountedfuture cash flows attributable to the assets, as compared to the carrying valueof the assets. Assumptions used in these cash flows are consistent withinternal forecasts and consider current and future expected sales volumes andrelated operating costs and any anticipated increases or declines based onexpected market conditions and local 

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businessenvironment factors. If a potential impairment is identified, the amount of theimpairment loss recognized would be determined by estimating the fair value ofthe assets and recording a loss if the fair value was less than the book value.Fair value will be determined based on appraisal values assessed by thirdparties, if deemed necessary, or a discounted future cash flows analysis. Forgoodwill and other intangibles that are not amortized, impairment to berecognized is measured as the amount by which the carrying amount of the assetsexceeds the fair value of the related assets.

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

See Note 3, Goodwill andIntangible Assets, of the Notes to Consolidated Financial Statements in thisannual report on Form 10-K.

*Sales Returns*

As part of our “satisfactionguaranteed” policy, we allow Guitar Center customers to return productgenerally within 30 days after the date of purchase, and we allow Musician’s Friendcustomers to return product within 45 days. Music & Arts Centercustomers have 30 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 Other Vendor Allowances*

We receive cooperativeadvertising allowances (i.e., an allowance from the manufacturer to subsidizequalifying advertising and similar promotional expenditures we make relating tothe vendor’s products), price protection credits (i.e., credits from vendorswith respect to in-stock inventory if the vendor subsequently lowers theirwholesale price for such products) and vendor rebates (i.e., credits or rebatesprovided by vendors based on the purchase of specified products and paid at alater date). Cooperative advertising allowances are recognized as a reductionto selling, general, and administrative expense when we incur the advertisingexpense eligible for the credit. We recognized cooperative advertisingallowances of $11.5 million, $10.1 million and $6.4 million for the years endedDecember 31, 2006, 2005 and 2004, respectively, recorded as an offset toselling, general and administrative expense. Price protection credits andvendor rebates are accounted for as a reduction of the cost of merchandiseinventory and are recorded at the time the credit or rebate is earned. Theeffect of price protection credits and vendor rebates is recognized in theincome statement at the time the related inventory is sold as a reduction incost of goods sold. The reserve against rebates receivable is determined byspecifically identifying uncollectible accounts through an aging review and ananalysis of vendor relationships. We received payments for vendor rebates of$33.2 million, $30.6 million and $20.9 million for the years ended December 31,2006, 2005 and 2004, respectively. We earned and recognized vendor rebates of$33.0 million, $28.3 million and $23.2 million for the years ended December 31,2006, 2005 and 2004, respectively. None of these credits are recorded asrevenue.

*Stock-based Compensation*

Effective January 1,2006, we adopted SFAS No. 123(R) to account for our stock-basedcompensation plans. We elected the modified prospective method of adoption, whichpermitted application of the new requirements on a prospective basis.Accordingly, prior period amounts have not been restated. Under thisapplication, stock-based compensation is recorded for all awards granted on orafter the date of adoption and for the portion of previously granted awardsthat remain unvested at the date of adoption. Currently, 

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ourstock-based compensation expense relates to stock options, our employee stockpurchase program, performance share awards, restricted stock awards, and deferredstock awards.

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

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

Stock-based compensationexpense related to performance share awards issued under our Long TermIncentive Plan (the “LTIP”) is estimated based on our forecasted performancecompared to plan targets. At the end of each reporting period, we reevaluateour assessment of performance under the plan and make adjustments to the expenseas necessary based on the latest estimates available. Under SFAS No. 123(R),the fair value of performance share awards is based on the market price of theCompany’s stock on the date the underlying plan receives compensation committeeapproval, or other form of a mutual understanding of the key terms andconditions 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.

**Results of Operations**

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

| ** **                                    | ** ** | **Fiscal year ended December 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                     |       | 100.0                                                  | %          | 100.0 | % | 100.0 | % |
| Gross profit                                  |       | 29.3                                                   |       | 29.2 |   | 28.1 |   |
| Selling, general  and administrative expenses |       | 23.0                                                   |       | 21.8 |   | 21.0 |   |
| Goodwill  impairment                          |       | 3.9                                                    |       | 0.0 |   | 0.0 |   |
| Operating income                              |       | 2.3                                                    |       | 7.4 |   | 7.1 |   |
| Interest expense,  net                        |       | 0.4                                                    |       | 0.4 |   | 0.3 |   |
| Gain on sale of  property                     |       | 0.1                                                    |       | 0.0 |   | 0.0 |   |
| Income before  income tax expense             |       | 2.0                                                    |       | 7.0 |   | 6.8 |   |
| Income taxes                                  |       | 2.0                                                    |       | 2.7 |   | 2.6 |   |
| Net income                                    |       | 0.0                                                    | %          | 4.3 | % | 4.2 | % |

 

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**Fiscal 2006 Compared to Fiscal 2005**

Consolidated net sales forthe year ended December 31, 2006 increased 13.9% to $2.030 billion,compared with $1.782 billion in 2005.

Net sales from GuitarCenter stores for 2006 totaled $1.493 billion, a 13.6% increase from $1.314billion in 2005. Net sales from new stores contributed $130.9 million andrepresented 73.1% of the total increase in retail store sales. ComparableGuitar Center store sales for the full year increased 3.7%. Comparable storesales are defined as sales for the comparable periods, excluding net salesattributable to stores not open for 14 months as of the end of the reportingperiod. We believe that comparable store sales are a more useful indicator ofstore performance than the change in total net sales, since comparable storesales exclude the effects of changes in the number of stores open. We continueto face a challenging retail environment. We believe the musical instrumentsindustry is experiencing a cyclical slowdown, and we cannot predict withaccuracy the duration or extent of the slowdown.

On April 15, 2005, wecompleted our acquisition of Music & Arts Center, Inc., aMaryland-based musical instrument retailer with an emphasis on the beginningmusician. The acquired business was combined with our former American Musicbusiness into a new division of our retail store subsidiary that operates underthe Music & Arts Center name. Financial results for the period of January 1,2005 through April 15, 2005 reflect only our former American Music storesand do not include results from the acquired business. However, comparablesales for the periods are computed using the combined comparable sales of Music &Arts Center, Inc. and American Music stores. Net sales from the Music &Arts Center segment for 2006 totaled $145.0 million compared to $103.1 millionfor 2005. The increase in net sales is primarily due to the acquisition ofMusic & Arts Center, Inc. on April 15, 2005 and acquisitionsof other businesses in 2006. Combined comparable sales for the full yearincreased 0.7%.

Net sales from theMusician’s Friend segment for 2006 totaled $391.7 million, a 7.3% increase from$365.1 million in 2005. The increase primarily reflects the improved leveragingof an expanding buyer file and advertising strategies. We continue to faceincreased competition in the direct response channel, which we expect to impactthat segment’s net sales and gross margin for the foreseeable future.

Consolidated gross profitfor the year ended December 31, 2006 compared to 2005 increased 14.1% to$594.0 million from $520.4 million. Gross profit as a percentage of net salesfor the year ended December 31, 2006 compared to 2005 increased to 29.3%from 29.2%. As discussed below, we define selling margin as net sales less thecost of the associated merchandise charged by the vendor plus the associatedinventory costs from fulfilling inventory through our distribution center. Thecost of merchandise inventory is net of all associated vendor discounts andrebates. Freight is not included in selling margin.

Gross profit as a percentageof net sales for the Guitar Center stores was 27.6% in 2006 compared with 28.0%in 2005. The decline in gross profit was primarily due to higher occupancycosts of 0.6% and higher freight expense of 0.1% partially offset by higherselling margin of 0.3%. The higher occupancy costs were primarily due to higherstore rent and higher depreciation and amortization expense. Selling margin wasbenefited by a slight change in product mix, which consisted of moreaccessories sales and less used instrument sales in 2006 compared to 2005.

The gross profit marginfor the Music & Arts Center segment was 43.3% for 2006 compared to41.8% for 2005. The increase in gross margin was due to reduced shrink expenseof 1.2% resulting from a change in estimate in rental instrument recoveries andhigher selling margin of 0.6% partially offset by higher occupancy costs of0.8%. The improved selling margin was driven by a change in product mix andbetter pricing under the Music & Arts Center business as compared tothe former American Music business. During 2005, we discontinued our low margininstitutional sales which are not part of our ongoing Music & ArtsCenter strategy. In addition, the 2005 results included a charge of $588,000 tocost of sales, or 0.6% of 

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sales,reflecting a reduction of the value of certain inventories previously in ourAmerican Music assortment that we discontinued upon the acquisition of Music &Arts Center, Inc.

Gross profit margin forthe Musician’s Friend segment was 30.2% for the year ended December 31,2006 compared to 29.8% in 2005. The increased gross margin was primarily due tohigher selling margin of 1.3% partially offset by reduced shipping and handlingrevenue of 0.8% and higher purchasing costs of 0.1%. Reduced shipping andhandling revenue resulted from expanded free freight offers due to increasedonline competition.

Consolidatedselling, general and administrative (“SG&A”) expenses for 2006 increased20.1% to $466.6 million from $388.4 million in fiscal 2005. As apercentage of net sales, selling, general and administrative expenses for 2006increased to 23.0% from 21.8% in 2005. SG&A expenses were primarilyimpacted by the recognition of $15.0 million of stock-based compensationexpenses in the current year consisting of expenses for stock options and otherawards totaling $12.3 million, or 0.6% of sales, and expense under the LTIPtotaling $2.7 million, or 0.1% of sales. The components of stock-basedcompensation for the year ended December 31, 2006 consisted of thefollowing:

| ** **                                                                                                                  | ** ** | ** **         | ** ** | **As a % of** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------------|------------|
| ** **                                                                                                                  | ** ** | **Amount in** | ** ** | **consolidated**             | ** ** |
| ** **                                                                                                                  | ** ** | **millions**       | ** ** | **net sales**           | ** ** |
| **Stock-based compensation  expense for the year ended December 31, 2006:**                                            | ** ** |               | ** ** | ** **                   |       |   | ** ** | ** ** |   |
| Stock options and other awards for the year ended  December 31, 2006                                                   |       |               | $          | 11.5                         | ** ** |   |   | 0.6 | % |   |
| Acceleration of stock option vesting related to the  retirement of our former Chief Financial Officer in February 2006 |       |               | 0.8        | ** **                   |       |   | 0.0 | % |   |
| Total expense from options and other awards                                                                                 |       |               | 12.3       | ** **                   |       |   | 0.6 | % |   |
| Expense from LTIP                                                                                                           |       |               | 2.7        | ** **                   |       |   | 0.1 | % |   |
| Total stock-based  compensation expense                                                                                     |       |               | $          | 15.0                         | ** ** |   |   | 0.7 | % |   |

 

The stock-basedcompensation expense related to stock options, including the ESPP, and otherawards was recorded as a result of the adoption of SFAS No. 123(R) effectiveJanuary 1, 2006. Upon the retirement of our former Chief Financial Officerannounced in February 2006, all of his remaining unvested options totaling32,002 shares immediately vested. Pursuant to SFAS No. 123(R), stock-basedcompensation expense in the amount of $0.8 million was recorded due to thevesting acceleration. A total of $2.7 million of stock-based compensationexpense related to the LTIP was recorded in the year ended December 31,2006.

SG&A expenses for theGuitar Center stores segment for 2006 were 20.8% as a percentage of net salescompared to 19.9% in 2005. The increase was primarily due to higher expensesfor stock-based compensation of 0.6%, advertising spend of 0.2%, credit cardprograms of 0.2%, and salaries of 0.1%, partially offset by lower legal andsettlement costs of 0.2% primarily associated with expense in 2005 related to thesettlement of a California wage and hour class action lawsuit.

SG&A expenses for theMusic & Arts Center segment were 44.1% of net sales for 2006 comparedto 47.9% for 2005. The reduction in expenses was primarily due to expensestotaling $2.8 million, or 2.7% of sales, recorded in 2005 related to theacquisition of Music & Arts Center, Inc. consisting of theelimination of a redundant point of sales system, severance costs, and movingcosts to relocate certain American Music employees to the Music & Artscorporate office in Maryland. Excluding the prior year acquisition-relatedexpenses, the SG&A expenses decreased by 1.0% of sales compared to theprior year, which was primarily due to improved leveraging on the higherrevenue base of the combined businesses of Music & Arts Center, Inc.and American Music partially offset by higher expenses in stock-basedcompensation of 0.8%, higher professional fees of 0.5%, and increasedadvertising and promotional costs of 0.4%. Higher professional fees wereprimarily due to Sarbanes-Oxley Section 404 compliance efforts.

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In the fourth quarter of2006, the Music & Arts Center segment recorded an impairment charge of$80.2 million, or $73.2 million after-tax, or $2.49 per diluted share, relatedto the write down of goodwill. The determination to write down the goodwill atMusic & Arts Center was a result of the segment’s current operatingperformance and our fourth quarter change in strategy to reduce futureinvestments in the segment and slow down growth in future years.

SG&A expenses for theMusician’s Friend segment were 23.4% of sales for 2006 compared to 21.2% for2005. The increase was primarily due to higher expenses for stock-basedcompensation of 1.3%, payroll costs of 0.6%, insurance of 0.2%, anddepreciation and amortization of 0.2% partially offset by lower advertisingspend of 1.2%. Higher payroll costs were driven by higher office and warehousesalaries. The lower advertising expense was primarily the result of reducedcatalog circulation, offset somewhat by higher web-based marketing. Othersmaller increases were experienced with tax-related audit expense, contractlabor costs, computer maintenance expense, and credit card program expense.

Consolidated operatingincome decreased to $47.3 million in 2006 from $132.0 million in 2005. As apercentage of net sales, consolidated operating income declined to 2.3% from7.4% in 2005. This decline reflects the goodwill impairment charge related tothe Music & Arts Center of $80.2 million and the higher SG&A expensesresulting primarily from the recognition of stock-based compensation expensesin 2006.

Interest expense, net for2006 increased to $8.4 million from $7.3 million in 2005. Theincrease is primarily due to higher borrowings under the revolving credit facilityused primarily to fund the acquisition of Music & Arts Center, Inc.on April 15, 2005 and increased working capital requirements offsetsomewhat by reduced interest resulting from the conversion of the 4% seniornotes in July 2006.

The gain on sale ofproperty of $2.1 million recorded in 2006 resulted from the disposition of realestate made available by the relocation of a Guitar Center store.

For the year ended December 31,2006, a $40.5 million provision for income taxes was recorded compared to $48.0million in 2005, based on effective tax rates of approximately 99.0% and 38.5%,respectively. The significant increase in the 2006 effective tax rate was dueto the $57 million non-deductible portion of the goodwill impairment charge.The remaining charges result from the treatment of incentive stock optionsunder SFAS No. 123(R) offset somewhat by the reduction of a valuationallowance in 2006 of $0.8 million, or $0.03 per diluted share, related to acapital loss recorded in 2001.

Consolidated net incomefor 2006 decreased to $0.4 million from $76.7 million in 2005 as aresult of the combinations of factors described above.

**Fiscal 2005 Compared to Fiscal 2004**

Consolidated net sales forthe year ended December 31, 2005 increased 17.8% to $1.782 billion,compared with $1.513 billion in 2004.

Net sales from GuitarCenter stores for 2005 totaled $1.3 billion, a 13.2% increase from $1.2 billionin 2004. Net sales from new stores contributed $85.3 million and represented55.9% of the total increase in retail store sales. Comparable Guitar Centerstore sales for the full year increased 5.8%. Comparable store sales aredefined as sales for the comparable periods, excluding net sales attributableto stores not open for 14 months as of the end of the reporting period. Webelieve that comparable store sales are a more useful indicator of storeperformance than the change in total net sales, since comparable store salesexclude the effects of changes in the number of stores open.

The financial informationof the Music & Arts Center segment for the year ended December 31,2005 includes the results of American Music for the entire year and Music &Arts Center from the time of its acquisition on April 15, 2005 through December 31,2005, while the 2004 results include only American Music. However, comparablestore sales for the year ended December 31, 2005 is computed using thecomparable store sales of American Music stores for the year ended December 31,2005 combined with comparable store sales for the Music & Arts Center, Inc.stores for the period from April 15, 2005 through 

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December 31,2005. Net sales from Music & Arts Center for 2005 totaled $103.1million compared to $40.4 million in 2004. The increase in net sales isprimarily due to the acquisition of Music & Arts Center, Inc.Comparable sales for only American Music locations decreased 16.1%, whilecomparable sales for only Music & Arts Center locations, increased9.6%, resulting in the combined comparable sales decrease of 0.3%. Comparablesales decreased at American Music principally due to the reduction in lowmargin institutional sales which is not part of our ongoing Music &Arts Center strategy.

Net sales from theMusician’s Friend segment totaled $365.1 million in 2005, a $53.8 million, or17.3%, increase from 2004. The increase primarily reflects the benefits fromincreased advertising, free freight incentives and improved leveraging of anexpanding buyer file offset somewhat by competitors’ expanded free shippingprograms and increased competition. We continued to face increased competition.Sales from the contact center, which represents sales placed via phone, livechat, mail and e-mail, increased 4.8% to $145.2 million in 2005 from $138.5million in 2004. Internet sales from orders placed via the Musician’s Friend,Giardinelli and affiliate web sites increased 27.3% to $219.9 million in 2005from $172.8 million in 2004. The growth of web-based sales reflects thecontinued trend of our catalog customers’ preference in using the web to placetheir orders, the success of web-based promotions and that the web siteincludes a more complete inventory presentation than our catalogs.

Consolidated gross profitfor the year ended December 31, 2005 compared to 2004 increased 22.4% to$520.4 million from $425.3 million. Gross profit as a percentage of net salesfor the year ended December 31, 2005 compared to 2004 increased to 29.2%from 28.1%.

Gross profit as apercentage of net sales for the Guitar Center stores was 28.0% compared with26.7% for each of the years ended December 31, 2005 and 2004. The increasewas due to higher selling margin of 1.2% and reduced freight of 0.1%. We defineselling margin as net sales less the cost of the associated merchandise chargedby the vendor plus the associated inventory costs from fulfilling inventorythrough our distribution center. The cost of merchandise inventory is net ofall associated vendor discounts and rebates. Freight is not included in sellingmargin.

The gross profit marginfor the Music & Arts Center segment was 41.8% for the year ended December 31,2005 compared to 34.8% for the same period in 2004. The increase in grossprofit margin was due to higher selling margin of 9.6% and reduced freight of 0.4%,offset by increased shrink of 1.4% and higher occupancy costs of 1.0%. Duringthe second quarter of 2005, we recorded a charge of $0.6 million to costof sales, or 0.6% of sales, for the Music & Arts Center division,reflecting a reduction of the value of certain inventories previously in ourAmerican Music assortment that we discontinued upon the acquisition of Music &Arts Center, Inc. Otherwise the improved selling margin was driven by achange in product mix and better pricing under the Music & Arts Centerbusiness as compared to the American Music business in 2004. We discontinuedour low margin institutional sales which are not part of our ongoing Music &Arts Center strategy.

Gross profit margin forthe Musician’s Friend segment was 29.8% for the year ended December 31,2005 compared to 32.3% for the same period in 2004. The 2005 selling margin wassignificantly impacted by expanded free freight offers made during the year inresponse to the increased competition and due to lower selling margin driven byincreased online competition.

Consolidated SG&Aexpenses for 2005 increased 22.3% to $388.4 million from$317.6 million in 2004. As a percentage of net sales, selling, general andadministrative expenses for 2005 increased to 21.8% from 21.0% in 2004.

SG&A expenses as apercentage of sales for the Guitar Center segment for 2005 decreased to 19.9%from 20.2% in 2004. The decrease was primarily due to leveraging of ouradvertising spend of 0.3% and payroll costs of 0.2%, reduced bad debt of 0.1%,offset by higher legal and settlement costs associated with the settlement of aCalifornia wage and hour class action lawsuit of 0.2% and higher rent costsassociated with the termination of two equipment leases of 0.1%.

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SG&A expenses forMusic & Arts Center segment were 47.9% of sales for 2005 compared to46.2% for the same period in 2004. Excluding acquisition related charges of$2.8 million, selling, general and administrative expenses were 45.1% of salesfor 2005 compared to 46.2% for the same period in 2004. The charge of $2.8million represents the elimination of a redundant point of sales system,severance costs and moving costs to relocate certain American Music employeesto the Music & Arts Center corporate office in Maryland. The decreasewas due to improved leveraging on the higher revenue base of the combinedbusinesses of Music & Arts Center and American Music. The reductionsas a percentage of sales were in payroll of 2.2%, travel costs of 1.2%,supplies of 0.4%, computer maintenance of 0.3% and insurance of 0.4%, offset byhigher advertising of 1.8%, amortization of intangibles of 0.7%, depreciationof 0.4%, credit card expense of 0.3%, and consulting fees of 0.2%.

SG&A expenses for theMusician’s Friend segment were 21.2% of sales for 2005 compared to 20.7% forthe same period in 2004. The increase was driven by advertising expense relatedto programs to increase web traffic of 1.2%, offset by reduced credit cardexpense of 0.1%, reduced bad debt expense of 0.1%, leveraging of payroll of 0.3%and insurance costs of 0.1%, and lower consulting fees of 0.1%.

Consolidated operatingincome increased 22.6% to $132.0 million in 2005 from $107.7 million in 2004.This increase reflects the strong performance of the Guitar Center stores in2005, with increased sales of 13.2%, increased gross profit as a percentage ofsales of 1.3%, and leveraging of selling, general and administrative expensesas a percentage of sales by 0.3%, when compared to 2004. This was offset by adecline in the direct response operating income of $4.7 million, or down 13.0%,from 2005 compared to 2004. We experienced increased competition in our directresponse unit, resulting in lower selling margins and higher marketing andadvertising costs. The direct response unit gross profit as a percentage ofsales decreased 2.5% while selling general and administrative expenses as apercentage of sales increased 0.5% for 2005 compared to 2004. Music &Arts Center operating loss as a percentage of sales improved from negative11.4% of sales in 2004 to negative 6.1% of sales in 2005. Excluding acquisitionrelated charges, Music & Arts Center operating loss as a percentage ofsales was negative 2.7% of sales in 2005.

Interest expense, net for2005 increased to $7.3 million from $5.4 million in 2004. Theincrease was primarily due to interest on borrowings related to the acquisitionof Music & Arts Center, Inc., increased inventory levels at ourGuitar Center retail stores and purchases of a corporate office building andother property and equipment.

For the year ended December 31,2005, a $48.0 million provision for income taxes was recorded compared to $38.9million for the same period in 2004, based on effective tax rates ofapproximately 38.5% and 38.0%, respectively. There was a change in theeffective tax rate as a result of higher blended state income tax rates as wellas $0.5 million in non-deductible costs associated with our California wage andhour class action settlement.

Consolidated net incomefor 2005 increased to $76.7 million from $63.4 million in 2004 as aresult of the combinations of factors described above.

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**Liquidity andCapital Resources**

**Disclosures aboutContractual Obligations and Commercial Commitments**

Thefollowing table aggregates the material contractual obligations and commercialcommitments that affect our financial condition and liquidity as of December 31,2006 (in thousands):

| ** **                       | ** ** | **Payments due by period** | ** ** |               |
|----------------------------------|------------|-------------------------------------------|------------|--------------------|
| ** **                       | ** ** | ** **                                | ** ** | **Less than** | ** ** | **1-3** | ** ** | **4-5** | ** ** | **More than** | ** ** |   |
| **Contractual obligations** | ** ** | ** **                                | ** ** | **Total**          | ** ** | **1 year** | ** ** | **years** | ** ** | **years** | ** ** | **5 years** | ** ** |   |
| Line of credit                   |       | $                                         | 101,144    |               | $ | 101,144 |   | $ |   |   | $ |   |   | $ |   |   |
| Capital lease  obligation        |       | 1,749                                     |       | 583                |   | 1,166 |   | — |   | — |   |
| Operating lease  obligations (1) |       | 362,148                                   |       | 58,805             |   | 100,762 |   | 73,742 |   | 128,839 |   |
| Total                            |       | $                                         | 465,041    |               | $ | 160,532 |   | $ | 101,928 |   | $ | 73,742 |   | $ | 128,839 |   |
|                                  |            |                                           |            |                    |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Operating lease commitmentsconsist principally of real property leases for our corporate offices, retailstore facilities and distribution centers. These leases frequently includeoptions which permit us to extend the terms beyond the initial fixed leaseterm. We also have rented personal property through operating leases. Paymentsfor these lease commitments are provided for by cash flows generated fromoperations. Please see Note 7 to the consolidated financial statements.

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 Item 1A. Risk Factors for adiscussion of factors which could reasonably likely result in a decrease in theamount of internally generated funds available to finance capital expendituresand working capital requirements. As of December 31, 2006, we had $101.1million in borrowings under our credit facility and had available borrowings of$102.6 million (net of $6.2 million of outstanding letters of credit).

On April 26, 2006, we entered into an amendmentof our credit facility. The amendment increased the maximum borrowingsavailable under the credit facility from $125 million to $200 million, subjectto borrowing base limitations. The amendment allows for the increase of themaximum borrowings to $250 million at the option of the Company. As of December 31,2006, we had elected to increase the maximum borrowings to $210 million. Theamendment also extended the maturity date of the facility to December 2011,reduced the interest rate charged over the applicable index rates and increasedthe borrowing base as a percentage of working capital. Details of the amendmentwere included in the Current Report on Form 8-K we filed on April 26,2006. The actual amount available is tied to our inventory and receivable base,and our obligations under the credit facility are secured by liens on ourprincipal assets. Borrowing options are prime rate (8.00% at December 31,2006) plus applicable prime margin, or London Interbank Offered Rate or LIBOR(12 month rate at December 31, 2006 was 5.33%), 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 LIBORmargin is 0.75%. If excess availability is less than or equal to $30 millionand greater than $15 million, the applicable prime margin is 0.00% and theapplicable LIBOR margin is 1.00%. If excess availability is less than or equalto $15 million, the applicable prime margin is 0.00% and the applicable LIBORmargin is 1.25%. An unused fee of 0.25% is assessed on the unused portion ofthe credit facility. The agreement underlying the credit facility includessignificant restrictive negative covenants. Among other things, these covenantsrestrict or prohibit our ability to incur debt and issue specified equityinstruments, incur liens on our assets, make any significant changes in ourcorporate structure or the nature of our business, dispose of assets, make guaranties,prepay debt, engage in a change in control transaction, pay dividends, makeinvestments or acquisitions, engage in transactions with affiliates and incurcapital expenditures. The agreement also includes representations andwarranties 

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which must be true eachtime we borrow funds under the credit facility and affirmative covenants. Thefull text of the contractual requirements imposed by this financing is setforth in the Amended and Restated Loan and Security Agreement and relatedamendments which have been filed with the Securities and Exchange Commission (“SEC”).Subject to limited cure periods, the lenders under our credit facility maydemand repayment of these borrowings prior to stated maturity upon theoccurrence of specified events, including if we breach the terms of theagreement, suffer a material adverse change, engage in a change in controltransaction, suffer a significant adverse legal judgment, default on othersignificant obligations, or in the event of specified events of insolvency.

On June 16, 2003, we completed the issuance of$100 million principal amount of 4.00% Senior Convertible Notes (the “Notes”)due 2013. The Notes bore interest at the rate of 4.00% per annum, subject tothe payment of contingent interest under certain circumstances commencing January 15,2006, and were convertible into shares of common stock at a conversion price of$34.58 per share, subject to adjustment under specified circumstances.

On June 15, 2006, we called for redemption of allof our Notes. Holders were able to convert the Notes into shares of commonstock at an effective conversion price of approximately $34.58 per share, inlieu of accepting redemption. Holders of substantially all of the outstandingNotes elected to convert their Notes into shares of the Company’s common stock.As a result of these conversions, approximately 2.9 million shares of commonstock were issued to the holders that elected to convert their Notes. Inconnection with the redemption of the unconverted Notes, we paid approximately$3,000 in cash, which includes the redemption and premium payments and cashpaid in lieu of fractional shares.

For the years ended December 31, 2006, 2005 and2004, $562,000, $1.0 million and $1.0 million of amortization of deferredfinancing fees was included in interest expense. Unamortized deferred financingfees at December 31, 2006, 2005 and 2004 were $0.5 million, $2.5 millionand $3.6 million and related accumulated amortization was $0.8 million, $2.1million and $1.0 million, respectively.

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.

The terms of our significant financing agreements,including those related to our credit facility, the Notes and the equipmentlease facilities described above, are not dependent on any change in our creditrating. We believe that the key company-specific factors affecting our abilityto maintain our existing debt and lease financing relationships and to accesssuch capital in the future are our present and expected levels of profitabilityand cash flow from operations, our working capital and fixed asset collateralbases, our expected level of capital expenditures, and the level of our equitycapital relative to the level of debt obligations. In addition, as noted above,our existing 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. We anticipate incurring increased rentexpense starting in the first quarter of 2007 related to our new Musician’sFriend distribution center in Kansas City and our Woodwind & Brasswindoperations in South Bend.

Net cash provided by operating activities was $23.3million for the year ended December 31, 2006 compared to $65.7 million forthe same period last year. The largest use of cash was an increase ininventories of $120.6 million. The increase in inventories was primarily due tothe opening of 33 new Guitar Center retail stores, an increase in businessvolumes across all segments and fourth quarter 2006 sales below projectedlevels. The primary sources of cash were generated from the current period 

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operations and an increasein accounts payable of $32.0 million due mostly to higher business volumes andtiming of payments.

Cash used in investing activities decreased to $106.3million for the year ended December 31, 2006 compared to $157.8 millionfor the same period last year. The cash used in investing activities for thecurrent year included $84.4 million of capital expenditures, comprisedprimarily of $45.0 million on new stores and remodels, $20.0 million oncomputer equipment purchases and $9.2 million related to the expansion of ourdistribution center facilities. Also, the Music & Arts Center divisionacquired businesses totaling $13.5 million for the current year. Also, ourGuitar Center segment acquired four retail locations from Hermes TradingCompany, Inc. for approximately $11.1 million.

Cash provided by financing activities totaled $83.6million for the year ended December 31, 2006 compared to $46.1 million inthe same period last year. The cash provided by financing activities was due toincreased borrowings under the revolving line of credit to support businessacquisitions, capital expenditures and working capital requirements. Inaddition, proceeds from the exercise of stock options provided $11.9 million(including $2.5 million in excess tax benefits that are reflected in cash flowsfrom financing activities) and employee purchases of our common stock under theESPP provided $2.4 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 andfew Music & Arts Center acquisitions will provide us opportunity togenerate incremental cash flows. We will continue to evaluate the best use ofthose cash flows, including possible changes in our capital structure.

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. Traditionally, we haveexperienced the largest use of cash from operating activities in the latterpart of the third quarter and in the fourth quarter due to the build up ofinventory to support the holiday season, resulting in additional borrowingsunder our line of credit.

Depending upon market conditions, we may also elect orbe required to raise additional capital in the form of common or preferredequity, debt or convertible securities for the purpose of providing additionalcapital to fund working capital needs or continued growth of our existingbusiness, or to refinance existing obligations or changes in our capitalstructure. Any such financing activity will be dependent upon many factors,including our liquidity needs, market conditions and prevailing market terms,and we cannot assure you that future external financing for us will beavailable on attractive terms or at all.

We intend to open additional stores in new andexisting markets. Each new primary format Guitar Center store typically hasrequired approximately $2.0 to $2.5 million in gross inventory. Historically,our cost of capital improvements for a primary format Guitar Center store hasbeen approximately $1.2 million consisting of leasehold improvements, fixturesand equipment. We incur higher costs in some geographic areas, particularly theNortheast, and when we build a larger flagship store. We have developedsecondary format Guitar Center stores to build in sites that we do not believewill support our primary format units. We have opened 61 secondary marketstores between late 2000 and December 31, 2006. Our secondary formatstores have typically required approximately $1.7 million to $2.0 million ingross inventory and approximately $0.9 million in capital improvements. We haveopened three tertiary format stores between late 2005 and December 31,2006 to serve smaller population centers. Our tertiary format stores haverequired approximately $1.0 million in gross inventory and approximately $0.6million in capital 

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improvements. Thesecapital expenditures reflect the increasing construction costs that we havebeen experiencing. We expect these increases to continue for the foreseeablefuture and these costs may 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.

**New AccountingPronouncements**

In June 2006, the FASB issued FASBInterpretation No. 48 (“FIN 48”), “*Accounting for Uncertaintyin Income Taxes*.” FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with SFAS No. 109, “Accounting for Income Taxes.” ThisInterpretation defines the minimum recognition threshold a tax position isrequired to meet before being recognized in the financial statements. FIN48 is effective for fiscal years beginning after December 15, 2006. We donot expect the adoption of FIN 48 to have a material effect on ourconsolidated financial statements.

In June 2006, the FASB ratified Emerging IssuesTask Force issued Issue 06-3, “*How Sales Taxes CollectedFrom Customers and Remitted to Governmental Authorities Should Be Presented inthe 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. The guidance iseffective for periods beginning after December 15, 2006. EITF 06-3will not impact the method for recording these taxes in the consolidatedfinancial statements as we have historically presented sales excluding thesetaxes.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, “*Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*” (“SAB 108”), to address diversity in practicein quantifying financial statement misstatements. SAB 108 requires that wequantify misstatements based on their impact on each of our financialstatements and related disclosures. SAB 108 was effective as of the end of our2006 fiscal year, allowing a one-time transitional cumulative effect adjustmentto retained earnings as of January 1, 2006 for errors that were notpreviously deemed material, but are material under the guidance in SAB 108. Theadoption of the provisions of SAB 108 had no impact on our consolidatedfinancial statements.

In September 2006,the FASB issued SFAS No. 157, “*Fair Value Measurements*.”SFAS No. 157 defines fair value, establishes a framework for measuringfair value in generally accepted accounting principles and expands disclosuresabout fair value measurements. This Statement applies under other accountingpronouncements that require or permit fair value measurements, the FASB havingpreviously 

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concludedin those accounting pronouncements that fair value is the relevant measurementattribute. Accordingly, this Statement does not require any new fair valuemeasurements. SFAS No. 157 is effective for fiscal years beginning after November 15,2007. The Company is currently evaluating the impact, if any, the adoption ofSFAS No. 157 will have on our operating income or net income.

**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 Center businessstarts in August and carries through mid-October, but that seasonalitydoes not have 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, in 2007 weanticipate that rising steel, lumber, concrete, labor, fuel and freight costsmay increase expenses related to opening, remodeling, operating and relocatingour stores, expanding our Musician’s Friend distribution center and operatingour business.

**Forward-Looking Statements; Business Risks**

This annual reportcontains forward-looking statements relating to, among other things, futureresults of operations, growth and investment plans, sales, trends in grossmargin, growth in the Internet portion of our direct response business andother factors affecting growth in sales and earnings. Specific forward-lookingstatements are provided regarding our management’s current views regardingcomparable store sales, new store openings, capital expenditure levels and thedates new facilities and systems will become operational. Statements regardingnew store openings are based largely on our current expectations and arenecessarily subject to associated business risks related to, among otherthings, the identification of suitable sites or acquisition opportunities, thetimely construction, staffing and merchandising of those stores and othermatters, some of which are outside of our control. Comparable store salesgrowth is highly dependent upon the state of the economy, the effectiveness ofour sales and promotion strategies, and the effect of competition, includingother national operators of music products stores attempting to implementnational growth strategies. 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, changes in themusic products industry, retail sales trends and the emergence of new orgrowing specialty retailers of music products.

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 any personto affect any such update under any circumstances.

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For further discussion ofrisks associated with our business, please see the discussion under the captionItem 1A. Risks Factors.

**Item7A. QUANTITATIVE AND 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 LIBOR. At December 31, 2006, we had$101.1 million in outstanding borrowings under our credit facility. Asshort-term interest rates and the total level of borrowings under the facility fluctuate,the interest expense we incur on our credit facility will change resulting ineither a positive or negative effect on our financial position, results of operationsand cash flows. At this borrowing level for our credit facility, a onepercentage point increase in interest rates would have an unfavorable impact onpre-tax earnings of $1.0 million on an annual basis. The primary interest rateexposure on the credit facility is based on LIBOR. We do not use derivativefinancial instruments in our investment portfolio. Historically, we have notcarried significant cash balances and any cash in excess of our daily operatingneeds has been used to reduce our borrowings. Excess cash is generally investedin short-term, high quality interest bearing investments.

**Item 8. FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA**

See the index included at Item15. Exhibits and Financial Statement Schedules.

**Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTSON ACCOUNTING AND**FINANCIALDISCLOSURE

None

**Item 9A. CONTROLSAND PROCEDURES**

**Disclosure Controls and 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 Securities and ExchangeCommission’s rules and forms and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow for timely decisions regardingrequired disclosure. In designing and evaluating the disclosure controls andprocedures, management recognizes that any controls and procedures, no matterhow well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and management is required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

As required by Securitiesand Exchange Commission Rule 13a-15(b), we carried out anevaluation, under the supervision and with the participation of our management,including our Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures as of the end of the period covered by this report. Based on theforegoing, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures were effective.

**Management’s Report on InternalControl Over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rules 13a-15(e) and 15d-15(e).Under the supervision and with the participation of our management, includingour principal executive officer and principal financial officer, we conductedan assessment of the effectiveness of our internal control over financialreporting based on the framework in *InternalControl—Integrated Framework* issued by the 

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Committee of SponsoringOrganizations of the Treadway Commission. Based on our evaluation under theframework in *Internal Control—Integrated Framework*,our management concluded that our internal control over financial reporting waseffective as of December 31, 2006.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Our management’s assessment of the effectiveness ofour internal control over financial reporting as of December 31, 2006 hasbeen audited by KPMG LLP, an independent registered public accounting firm, asstated in their report which is included herein.

**Changesin Internal Control Over Financial Reporting**

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

**Report of IndependentRegistered Public Accounting Firm**

The Board of Directors and StockholdersGuitar Center, Inc.:

We have audited management’s assessment, included in theaccompanying Management’s Report on Internal Controls Over Financial Reporting,that Guitar Center, Inc. maintained effective internal control overfinancial reporting as of December 31, 2006, based on criteria establishedin *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). Guitar Center, Inc.’s management is responsible for maintainingeffective internal control over financial reporting and for its assessment ofthe effectiveness of internal control over financial reporting. Ourresponsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the Company’s internal control over financialreporting based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinion.

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk 

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thatcontrols may become inadequate because of changes in conditions, or that thedegree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Guitar Center, Inc.maintained effective internal control over financial reporting as of December 31,2006, is fairly stated, in all material respects, based on criteria establishedin *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO). Also, in our opinion, Guitar Center, Inc. maintained, in allmaterial respects, effective internal control over financial reporting as of December 31,2006, based on criteria established in *Internal Control—IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO).

We also have audited, in accordance with the standards ofthe Public Company Accounting Oversight Board (United States), the consolidatedbalance sheets of Guitar Center, Inc. and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of income, stockholders’equity, and cash flows for each of the years in the three-year period ended December 31,2006, and the related financial statement schedule, and our report dated March 1,2007 expressed an unqualified opinion on those consolidated financialstatements and financial statement schedule.

/s/ KPMG LLP

Los Angeles, CaliforniaMarch 1, 2007

**Item9B. OTHER INFORMATION**

Not Applicable

**PART III**

**Item10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE**

We have adopted a code of business conduct and ethics,or code of conduct, containing general guidelines for conducting our businessconsistent with the highest standards of business ethics. The code of conductis designed to qualify as a “code of ethics” within the meaning of Section 406of the Sarbanes-Oxley Act of 2002 and the rules promulgated thereunder aswell as under applicable rules of the Nasdaq Global Select Market. Thecode is available on the investor relations section of our website(www.guitarcenter.com), under subsection captioned “Corporate Governance.” Tothe extent required by law or the rules of the NASDAQ Global Select Market,any amendments to, or waivers from, any provision of the code will be promptlydisclosed publicly. To the extent permitted by such requirements, we intend tomake such public disclosure by posting the relevant material on the corporategovernance page of the investor relations section of our website inaccordance with SEC rules.

All additional informationrequired by this item is incorporated by reference to our definitive ProxyStatement to be filed pursuant to Regulation 14A under the Exchange Act inconnection with our annual meeting of stockholders.

**Item11. EXECUTIVE COMPENSATION**

The information requiredby this item is incorporated by reference to our definitive Proxy Statement tobe filed pursuant to Regulation 14A under the Exchange Act in connection withour annual meeting of stockholders.

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**Item12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATEDSTOCKHOLDER MATTERS**

The information requiredby this item is incorporated by reference into our definitive Proxy Statementto be filed pursuant to Regulation 14A under the Exchange Act in connectionwith our annual meeting of stockholders.

**Item13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE**

The information requiredby this item is incorporated by reference to our definitive Proxy Statement tobe filed pursuant to Regulation 14A under the Exchange Act in connection withour annual meeting of stockholders.

**Item 14. PRINCIPALACCOUNTING FEES AND SERVICES**

The information required by this item is incorporatedby reference to our definitive Proxy Statement to be filed pursuant toRegulation 14A under the Exchange Act in connection with our annual meeting ofstockholders.

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**PART IV**

**Item 15. EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

(a)           Documents filed as partof this Report:

1.     The following financial statements for theCompany are included as part of this Report:
| Index to Financial  Statements |   | Page 59 |
|--------------------------------|--------|--------------|

 

2.                Thefollowing financial statement schedule for the Company is included as part ofthis Report:
| Schedule II—Valuation and  Qualifying Accounts |   | Page II-1 |
|-----------------------------------------------------|--------|----------------|

 

All other scheduleshave been omitted since the required information is not present in amountssufficient to require submission of the schedules, or because the informationrequired is included in the financial statements.

(b)          The Index and Exhibits,required to be filed by Item 601 of Regulation S-K are included with theReport. Management contracts and other compensation plans or arrangementsrequired to be filed are identified on the attached Index with an asterisk (*).

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| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                 | **Description** |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------|
| 2.1              |       | Agreement and Plan of Merger, dated as of February  8, 2005, by and among Guitar Center Stores, Inc., a Delaware corporation,  GCSI Acquisition Corp., a Maryland corporation, Music & Arts Center,  Inc., a Maryland corporation, and the common stockholders of Music & Arts  Center, Inc. (Incorporated by reference to Exhibit 10.2 of the Company’s  Current Report on Form 8-K dated February 8, 2005). |
| 3.1              |       | Restated Certificate of  Incorporation (Incorporated by reference to Exhibit 3.5 of the Company’s  Registration Statement on Form S-1; Registration No. 333-20931).                                                                                                                                                                                                                                    |
| 3.2              |       | Amended and Restated  Bylaws (Incorporated by reference to Exhibit 3.2 to the Company’s Annual  Report on Form 10-K for the period ended December 31, 2005).                                                                                                                                                                                                                                                     |
| 4.2              |       | Form of Indenture  (Incorporated by reference to Exhibit 4.3 of the Company’s Registration  Statement on Form S-3; Registration No. 333-65220).                                                                                                                                                                                                                                                   |
| 4.3              |       | Form of Stock  Certificate (Incorporated by reference to Exhibit 4.4 of the Company’s  Registration Statement on Form S-1; Registration No. 333-20931).                                                                                                                                                                                                                                           |
| 10.1*            |       | Amended 1997 Equity  Participation Plan (Incorporated by reference to Exhibit 10.22 of the  Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 1998).                                                                                                                                                                                                                        |
| 10.2*            |       | Amendment to the 1997  Equity Participation Plan approved by stockholders at the 2000 Annual Meeting  of Stockholders (Incorporated by reference to Exhibit 10.36 of the  Company’s Annual Report on Form 10-K; for the fiscal year ended  December 31, 1999).                                                                                                                                         |
| 10.3*            |       | Amendment to the 1997  Equity Participation Plan approved by stockholders at the 2001 Annual Meeting  of Stockholders (Incorporated by reference to Exhibit 10.37 to the  Company’s Quarterly Report on Form 10-Q for the period ended  March 31, 2001).                                                                                                                                               |
| 10.4*            |       | Amendment to the 1997  Equity Participation Plan approved July 26, 2001 (Incorporated by  reference to Exhibit 10.42 to the Company’s Quarterly Report on  Form 10-Q for the period ended September 30, 2001).                                                                                                                                                                                    |
| 10.5*            |       | Amendment to the 1997 Equity Participation Plan  approved by stockholders at the 2003 Annual Meeting of Stockholders  (Incorporated by reference to Exhibit 10.40 to the Company’s Quarterly  Report on Form 10-Q for the period ended March 31, 2003).                                                                                                                                                |
| 10.6*            |       | Amendment to the 1997  Equity Participation Plan approved April 29, 2004 (Incorporated by  reference to Exhibit 10.5 to the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2004).                                                                                                                                                                                         |
| 10.7*            |       | Form of Employee  Stock Purchase Plan as approved by stockholders at the 2001 Annual Meeting of  Stockholders (Incorporated by reference to Exhibit 10.38 to the  Company’s Quarterly Report Form 10-Q for the period ended  March 31, 2001).                                                                                                                                                     |
| 10.8*            |       | 2004 Guitar  Center, Inc. Incentive Stock Award Plan (Incorporated by reference to  the Definitive 2004 Proxy Statement as filed on Schedule 14A).                                                                                                                                                                                                                                                                    |
| 10.9*            |       | Form of Amendment  to the 2004 Guitar Center, Inc. Incentive Stock Award Plan (Incorporated  by reference to Exhibit 99.1 of the Company’s Current Report on  Form 8-K dated March 11, 2005).                                                                                                                                                                                           |
| 10.10*           |       | Form of Stock  Option Agreement under the 2004 Guitar Center, Inc. Incentive Stock  Award Plan (Incorporated by reference to Exhibit 10.1 to the Company’s  Quarterly Report on Form 10-Q for the period ended  September 30, 2004).                                                                                                                                                         |
| 10.11*           |       | Form of Restricted  Stock Agreement under the 2004 Guitar Center, Inc. Incentive Stock Award  Plan (Incorporated by reference to Exhibit 10.2 to the Company’s  Quarterly Report on Form 10-Q for the period ended  September 30, 2004).                                                                                                                                                     |

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| 10.12* |   | Form of  Non-Employee Director Restricted Stock Agreement under the 2004 Guitar  Center, Inc. Incentive Stock Award Plan (Incorporated by reference to  Exhibit 10.5 of the Company’s Current Report on Form 8-K  dated July 28, 2005).                                         |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.13* |   | Form of Deferred  Stock Agreement under the 2004 Guitar Center, Inc. Incentive Stock Award  Plan (Incorporated by reference to Exhibit 10.3 to the Company’s  Quarterly Report on Form 10-Q for the period ended  September 30, 2004).                                          |
| 10.14* |   | Guitar Center, Inc.  Senior Executive Performance Bonus Plan (Incorporated by reference to  Exhibit 10.35 to the Company’s Quarterly Report on Form 10-Q  for the period ended March 31, 2003).                                                                                 |
| 10.15* |   | Guitar Center, Inc.  2005 Long Term Incentive Plan (Incorporated by reference to Exhibit 10.2  of the Company’s Current Report on Form 8-K dated July 28,  2005).                                                                                                                    |
| 10.16* |   | Form of  Indemnification Agreement between the Company and each of its directors and  executive officers (Incorporated by reference to Exhibit 10.20 to the Company’s  Annual Report on Form 10-K for the period ended December 31, 2005).                                                     |
| 10.17* |   | Compensation Committee  Non-Employee Director Equity Compensation Policy (Incorporated by reference  to Exhibit 10.4 of the Company’s Current Report on Form 8-K  dated July 28, 2005).                                                                                              |
| 10.18* |   | Second Amended and  Restated Employment Agreement, dated as of October 8, 2004, between  Guitar Center, Inc. and Marty Albertson (Incorporated by reference to  Exhibit 99.1 of the Company’s Current Report on Form 8-K  dated October 8, 2004).                               |
| 10.19* |   | Amendment No. 1 to  Second Amended and Restated Employment Agreement made effective as of July 28,  2005 between Guitar Center, Inc., and Marty Albertson (Incorporated by  reference to Exhibit 10.3 of the Company’s Current Report on Form 8-K  dated July 28, 2005).   |
| 10.20* |   | Transition Agreement between Guitar  Center, Inc. and Bruce L. Ross, dated effective as of  February 10, 2006 (Incorporated by reference to Exhibit 10.2 of the  Company’s Current Report on Form 8-K dated February 10, 2006).                                            |
| 10.21* |   | Third Amended and  Restated Employment Agreement between Musician’s Friend, Inc. and Robert V.  Eastman, dated effective as of January 1, 2006 (Incorporated by  reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K  dated January 30, 2006). |
| 10.22* |   | Employment Agreement,  dated as of April 15, 2005, by and between Music & Arts  Center, Inc., a Maryland corporation, and Kenneth O’Brien (Incorporated  by reference to Exhibit 99.3 of the Company’s Current Report on  Form 8-K dated April 15, 2005).         |
| 10.23* |   | Agreement Not to  Compete, dated as of April 15, 2005, by and between Guitar Center  Stores, Inc., a Delaware corporation, and Kenneth O’Brien (Incorporated by  reference to Exhibit 99.4 of the Company’s Current Report on Form 8-K  dated April 15, 2005).                  |
| 10.24  |   | Lease Agreement, dated  as of August 15, 2001, by and between Guitar Center Stores, Inc., and  Eaglepoint Partners Two, LLC (Incorporated by reference to Exhibit 10.27  to the Company’s Annual Report on Form 10-K for the year ended  December 31, 2001).               |
| 10.25  |   | Master Lease Agreement,  dated as of March 4, 2002, between Guitar Center, Inc. and General  Electric Capital Corporation (Incorporated by reference to Exhibit 10.31  to the Company’s Quarterly Report on Form 10-Q for the quarterly period  ended March 31, 2002).          |

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| 10.26  |   | Standard  Industrial/Commercial Single-Tenant Lease by and between The J. David  Gladstone Institutes, a Charitable Trust, as lessor and Guitar Center, Inc.  as lessee relating to 5795 Lindero Canyon Road, Westlake Village,  California (Incorporated by reference to Exhibit 10.36 to the Company’s  Quarterly Report on Form 10-Q for the period ended March 31,  2003).                                |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.27  |   | Addendum to  Industrial/Commercial Single-Tenant Lease by and between The J. David  Gladstone Institutes, a Charitable Trust, as lessor and Guitar  Center, Inc. as lessee relating to 5795 Lindero Canyon Road,  Westlake Village, California (Incorporated by reference to Exhibit 10.37  to the Company’s Quarterly Report on Form 10-Q for the period  ended March 31, 2003).                             |
| 10.28  |   | Standard Commercial  Lease by and between Mid-West Terminal Warehouse Company as lessor and  Musician’s Friend, Inc. as lessee relating to 1491 North Universal Avenue,  Kansas City, Missouri (Incorporated by reference to Exhibit 10.38 to the  Company’s Quarterly Report on Form 10-Q for the period ended March 31,  2003).                                                                                                      |
| 10.29  |   | Addendum to Commercial  Lease Agreement by and between Mid-West Terminal Warehouse Company, Inc. as  lessor and Musician’s Friend, Inc. as lessee relating to 1491 North Universal  Avenue, Kansas City, Missouri (Incorporated by reference to Exhibit 10.39 to  the Company’s Quarterly Report on Form 10-Q for the period ended March  31, 2003).                                                                                   |
| 10.30  |   | First Amendment to Lease  dated November 2, 2005, by and between Brownsburg Music LLC and Guitar  Center Stores, Inc. (Incorporated by reference to Exhibit 10.1 of  the Company’s Current Report on Form 8-K dated November 2,  2005).                                                                                                                                                                       |
| 10.31* |   | Aircraft Time Sharing  Agreement between Guitar Center, Inc. and Marty Albertson, dated  February 15, 2006 (Incorporated by reference to Exhibit 10.1 of the  Company’s Current Report on Form 8-K dated February 10, 2006).                                                                                                                                                                                       |
| 10.32  |   | Second Amended and Restated  Loan and Security Agreement entered into as of December 21, 2001,  between and among the Company, Guitar Center Stores, Inc., Musician’s  Friend, Inc. and the lenders identified therein (Incorporated by  reference to Exhibit 10.30 to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2001).                                                  |
| 10.33  |   | Consent and Amendment,  dated as of June 9, 2003, by and among, Wells Fargo Retail  Finance, LLC, as the arranger and administrative agent, the lenders  named therein, and Guitar Center, Inc., Guitar Center Stores, Inc. and  Musician’s Friend, Inc., as borrowers (Incorporated by reference to  Exhibit 10.42 to the Company’s Quarterly Report on Form 10-Q for  the period ended June 30, 2003). |
| 10.34  |   | Second Amendment to Second  Amended and Restated Loan and Security Agreement between Guitar  Center, Inc. and Wells Fargo Retail Finance, LLC (Incorporated by  reference to Exhibit 10.36 of the Company’s Annual Report on  Form 10-K for the fiscal year ended December 31, 2003).                                                                                                                              |
| 10.35  |   | Third Amendment to  Second Amended and Restated Loan and Security Agreement, effective  February 8, 2005 (Incorporated by reference to Exhibit 10.1 of the  Company’s Current Report on Form 8-K dated February 8, 2005).                                                                                                                                                                                               |
| 10.36  |   | Lease Agreement between Musician’s  Friend, Inc., and Panattoni Development Company, LLC, dated  effective as of March 30, 2006 (Incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K dated  March 30, 2006).                                                                                                                                                          |

55

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| 10.37  |   | Fourth Amendment to  Second Amended and Restated Loan and Security Agreement, effective April 26,  2006 (Incorporated by reference to Exhibit 10.1 to the Company’s Current  Report on Form 8-K dated April 26, 2006).                                                                                                          |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.38* |   | Guitar Center, Inc.  2006 Long Term Incentive Plan (Incorporated by reference to Exhibit 10.1  to the Company’s Current Report on Form 8-K dated June 21,  2006).                                                                                                                                                               |
| 10.39* |   | Amendment to the Guitar  Center, Inc. Amended 1997 Equity Participation Plan (Incorporated by  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K  dated November 2, 2006).                                                                                                                                  |
| 10.40* |   | Amendment to the 2004 Guitar  Center, Inc. Incentive Stock Award Plan (Incorporated by reference to  Exhibit 10.2 to the Company’s Current Report on Form 8-K  dated November 2, 2006).                                                                                                                                         |
| 10.41* |   | Amendment to the 2004 Guitar  Center, Inc. Incentive Stock Award Plan (Incorporated by reference to  Exhibit 10.3 to the Company’s Current Report on Form 8-K  dated November 2, 2006).                                                                                                                                    |
| 10.42  |   | Asset Purchase Agreement, dated as of  January 30, 2007, by and between Musician’s Friend, Inc. and Dennis  Bamber, Inc. D/B/A The Woodwind & the Brasswind and its  Chapter 11 Estate (Incorporated by reference to Exhibit 10.1 to the  Company’s Current Report on Form 8-K dated February 5, 2007). |
| 10.43* |   | Form of amended and  restated Executive Severance Benefits Agreement relating to certain  executives of Guitar Center, Inc., Guitar Center Stores, Inc. and  Musician Friend, Inc. (Incorporated by reference to Exhibit 10.2 to the  Company’s Quarterly Report on Form 10-Q for the period ended  June 30, 2006).        |
| 10.44* |   | Amendment to the Guitar  Center, Inc. 2005 Long Term Incentive Plan (Incorporated by reference to  Exhibit 10.1 to the Company’s Current Report on Form 8-K  dated February 26, 2007).                                                                                                                                          |
| 10.45* |   | Amendment to the Guitar  Center, Inc., 2006 Long Term Incentive Plan (Incorporated by reference  to Exhibit 10.2 to the Company’s Current Report on Form 8-K dated  February 26, 2007).                                                                                                                                         |
| 12.1   |   | Ratio of Earnings to  Fixed Charges (Filed herewith).                                                                                                                                                                                                                                                                                                    |
| 21.1   |   | Material subsidiaries of  the Registrant as of December 31, 2006 (Filed herewith).                                                                                                                                                                                                                                                                  |
| 23.1   |   | Consent of Independent  Registered Public Accounting Firm (KPMG LLP) (Filed herewith).                                                                                                                                                                                                                                                                   |
| 24.1   |   | Power of Attorney  (Included on page 54).                                                                                                                                                                                                                                                                                                           |
| 31.1   |   | Certification of the  Company’s Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 (Filed herewith).                                                                                                                                                                                                           |
| 31.2   |   | Certification of the  Company’s Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 (Filed herewith).                                                                                                                                                                                                           |
| 32.1   |   | Certification of the  Company’s Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (Filed herewith).                                                                                                                                                                                                           |
| 32.2   |   | Certification of the  Company’s Chief Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (Filed herewith).                                                                                                                                                                                                           |

----

*                    Managementcontract or other compensation plan or arrangement.

56

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, as amended, the Registrant has duly caused this Report to besigned on its behalf by the undersigned, thereunto duly authorized as of this1st day of March 2007.
|        | Guitar Center, Inc.                     |
|--------|-----------------------------------------|
|   | /s/  MARTY ALBERTSON                    |
|   | Marty Albertson                         |
|   | *Chairman  and Chief Executive Officer* |

 

KNOW ALL PERSONS BY THESE PRESENTS, that each personwhose signature appears below constitutes and appoints Marty Albertson, ErickMason and Leland Smith as his attorneys-in-fact, each with the power ofsubstitution, for him in any and all capacities, to sign any amendment to thisReport on Form 10-K, and to file the same, with exhibits thereto andother documents in connection therewith with the Securities and ExchangeCommission, hereby ratifying and confirming all that each of said attorneys-in-fact,or his substitute or substitutes may do or cause to be done by virtue hereof.

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, this Reporthas been signed below by the following persons on behalf of the Registrant andin the capacities and on the dates indicated.
|                            | **Name** | ** **                                       | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|----------------------------|----------|--------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/ MARTY  ALBERTSON  |     | Chief Executive  Officer and Director            |       | March 1,  2007 |
| Marty  Albertson           |     | (Principal Executive  Officer)                   |       |                |
| /s/ ERICK  MASON      |     | Executive Vice  President and Chief              |       | March 1,  2007 |
| Erick  Mason               |     | Financial Officer  (Principal Financial Officer) |       |                |
| /s/ DAVID  ROBSON     |     | Senior Vice  President of Finance                |       | March 1,  2007 |
| David  Robson              |     | (Principal Accounting  Officer)                  |       |                |
| /s/ LARRY  LIVINGSTON |     | Director                                         |       | March 1,  2007 |
| Larry  Livingston          |     |                                             |       |                |
| /s/ BOB  MARTIN       |     | Director                                         |       | March 1,  2007 |
| Bob  Martin                |     |                                             |       |                |
| /s/ PAT  MACMILLAN         |     | Director                                         |       | March 1,  2007 |
| Pat  MacMillan             |     |                                             |       |                |

57

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| /s/ GEORGE  MRKONIC      |   | Director |   | March 1,  2007 |
|--------------------------|--------|----------|--------|---------------------|
| George  Mrkonic          |   |     |   |                |
| /s/ KENNETH  REISS  |   | Director |   | March 1,  2007 |
| Kenneth  Reiss           |   |     |   |                |
| /s/ WALTER  ROSSI   |   | Director |   | March 1,  2007 |
| Walter  Rossi            |   |     |   |                |
| /s/ PETER  STARRETT |   | Director |   | March 1,  2007 |
| Peter  Starrett          |   |     |   |                |
| /s/ PAUL  TARVIN    |   | Director |   | March 1,  2007 |
| Paul  Tarvin             |   |     |   |                |

 

58

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**INDEXTO FINANCIAL STATEMENTS**

| Report of Independent  Registered Public Accounting Firm                                                              |   |   | 60 |   |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|--------|----|--------|--------|
| Consolidated  Balance Sheets as of December 31, 2006 and 2005                                                    |   |   | 61 |   |   |
| Consolidated  Statements of Income for the years ended December 31, 2006, 2005 and  2004                         |   |   | 62 |   |   |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2006, 2005 and 2004 |   |   | 63 |   |   |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2006, 2005 and  2004                     |   |   | 64 |   |   |
| Notes to Consolidated  Financial Statements                                                                           |   |   | 66 |   |   |

 

|                                    | ** ** | **Schedule** | ** ** |
|------------------------------------|------------|--------------|------------|
| Financial Statement  Schedule:     |       |         |       |   |   |
| Valuation and Qualifying  Accounts |       |         | II-1       |   |   |

 

59

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersGuitar Center, Inc.:

We have audited the accompanying consolidated balancesheets of Guitar Center, Inc. and subsidiaries as of December 31,2006 and 2005, and the related consolidated statements of income, stockholders’equity, and cash flows for each of the years in the three-year period ended December 31,2006. In connection with our audits of the consolidated financial statements,we also have audited the related financial statement schedule. These consolidated financial statements andfinancial statement schedule are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidated financial statements andfinancial statement schedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Guitar Center, Inc.and subsidiaries as of December 31, 2006 and 2005, and the results oftheir operations and their cash flows for each of the years in the three-yearperiod ended December 31, 2006, in conformity with U.S. generally acceptedaccounting principles. Also in our opinion, the related financial statementschedule, when considered in relation to the basic consolidated financialstatements taken as a whole, presents fairly, in all material respects, theinformation set forth therein.

As discussed in Notes 1 and 9 to the consolidatedfinancial statements, effective January 1, 2006, the Company adopted theprovisions of Statement of Financial Accounting Standards No. 123 (revised2004),*Share-Based Payment*.

We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of Guitar Center, Inc.’s internalcontrol over financial reporting as of December 31, 2006, based on criteria established in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commission(COSO), and our report dated March 1, 2007 expressed an unqualified opinion on management’sassessment of, and the effective operation of, internal control over financialreporting.

/s/ KPMG LLP

LosAngeles, California

March 1, 2007

60

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**GUITAR CENTER, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands)**

| ** **                                                                                                                                                                                                                                | ** ** | **December 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                                                                                                                |       |                        |       |                        |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                           |       |                        |       |                        |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                                                                                                                 |       |                        | $          | 15,153                      |       |   |   | $ | 14,529 |   |   |
| Accounts receivable, less allowance for doubtful  accounts of $2,618 and $2,844, respectively                                                                                                                                             |       |                        | 53,916     |                        |       |   | 40,844 |   |   |
| Merchandise inventories                                                                                                                                                                                                                   |       |                        | 578,082    |                        |       |   | 445,771 |   |   |
| Prepaid expenses and other current assets                                                                                                                                                                                                 |       |                        | 16,178     |                        |       |   | 15,533 |   |   |
| Deferred income taxes                                                                                                                                                                                                                     |       |                        | 22,739     |                        |       |   | 13,492 |   |   |
| Total current  assets                                                                                                                                                                                                                     |       |                        | 686,068    |                        |       |   | 530,169 |   |   |
| Property and  equipment, net                                                                                                                                                                                                              |       |                        | 201,986    |                        |       |   | 149,209 |   |   |
| Goodwill                                                                                                                                                                                                                                  |       |                        | 18,507     |                        |       |   | 85,929 |   |   |
| Intangible  assets, net                                                                                                                                                                                                                   |       |                        | 7,612      |                        |       |   | 9,142 |   |   |
| Other assets, net                                                                                                                                                                                                                         |       |                        | 13,305     |                        |       |   | 5,741 |   |   |
| Total assets                                                                                                                                                                                                                              |       |                        | $          | 927,478                     |       |   |   | $ | 780,190 |   |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                                                                            |       |                        |       |                        |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                                      |       |                        |       |                        |       |   |   |   |   |
| Cash overdraft                                                                                                                                                                                                                            |       |                        | $          | 20,243                      |       |   |   | $ | 18,482 |   |   |
| Accounts payable                                                                                                                                                                                                                          |       |                        | 93,717     |                        |       |   | 61,015 |   |   |
| Accrued expenses and other current liabilities                                                                                                                                                                                            |       |                        | 117,595    |                        |       |   | 106,181 |   |   |
| Merchandise advances                                                                                                                                                                                                                      |       |                        | 26,830     |                        |       |   | 25,127 |   |   |
| Borrowings under revolving line of credit                                                                                                                                                                                                 |       |                        | 101,144    |                        |       |   | 32,266 |   |   |
| Total current  liabilities                                                                                                                                                                                                                |       |                        | 359,529    |                        |       |   | 243,071 |   |   |
| Other long-term  liabilities                                                                                                                                                                                                              |       |                        | 17,292     |                        |       |   | 11,995 |   |   |
| Deferred income  taxes                                                                                                                                                                                                                    |       |                        | 5,165      |                        |       |   | 20,307 |   |   |
| Long-term debt                                                                                                                                                                                                                            |       |                        | 1,416      |                        |       |   | 100,000 |   |   |
| Total liabilities                                                                                                                                                                                                                         |       |                        | 383,402    |                        |       |   | 375,373 |   |   |
| Minority interest                                                                                                                                                                                                                         |       |                        | 1,339      |                        |       |   | — |   |   |
| Commitments and contingencies (Notes 7 and 11)                                                                                                                                                                                            |       |                        |       |                        |       |   |   |   |   |
| Stockholders’  equity:                                                                                                                                                                                                               |       |                        |       |                        |       |   |   |   |   |
| Preferred stock, 5,000 authorized, none issued and  outstanding                                                                                                                                                                           |       |                        | —     |                        |       |   | — |   |   |
| Common stock, $0.01 par value, authorized 100,000  shares at December 31, 2006 and 55,000 shares at December 31, 2005,  issued and outstanding 29,469 at December 31, 2006 and 26,092 at December 31,  2005 |       |                        | 295        |                        |       |   | 261 |   |   |
| Additional paid-in capital                                                                                                                                                                                                                |       |                        | 464,217    |                        |       |   | 326,755 |   |   |
| Retained earnings                                                                                                                                                                                                                         |       |                        | 78,225     |                        |       |   | 77,801 |   |   |
| Total  stockholders’ equity                                                                                                                                                                                                          |       |                        | 542,737    |                        |       |   | 404,817 |   |   |
| Total liabilities and  stockholders’ equity                                                                                                                                                                                          |       |                        | $          | 927,478                     |       |   |   | $ | 780,190 |   |   |

 

***See accompanying notes to consolidated financial statements.***

61

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

| ** **                                                                     | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                     | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                                                                      |       | $                                          | 2,029,966  |   | $ | 1,782,499 |   | $ | 1,513,172 |   |
| Cost of goods  sold, buying and occupancy                                      |       | 1,435,963                                  |       | 1,262,097 |   | 1,087,899 |   |
| Gross profit                                                                   |       | 594,003                                    |       | 520,402 |   | 425,273 |   |
| Selling, general  and administrative expenses                                  |       | 466,555                                    |       | 388,380 |   | 317,585 |   |
| Goodwill  impairment                                                           |       | 80,160                                     |       | — |   | — |   |
| Operating income                                                               |       | 47,288                                     |       | 132,022 |   | 107,688 |   |
| Interest expense,  net of interest income of $908, $714 and $189, respectively |       | 8,448                                      |       | 7,339 |   | 5,390 |   |
| Gain on sale of  property                                                      |       | 2,115                                      |       | — |   | — |   |
| Income before  income taxes                                                    |       | 40,955                                     |       | 124,683 |   | 102,298 |   |
| Income taxes                                                                   |       | 40,531                                     |       | 48,005 |   | 38,873 |   |
| Net income                                                                     |       | $                                          | 424        |   | $ | 76,678 |   | $ | 63,425 |   |
| Net income per  share:                                                         |       |                                       |       |   |   |   |   |
| Basic                                                                          |       | $                                          | 0.02       |   | $ | 2.96 |   | $ | 2.55 |   |
| Diluted                                                                        |       | $                                          | 0.01       |   | $ | 2.67 |   | $ | 2.29 |   |
| Weighted average  shares outstanding:                                          |       |                                       |       |   |   |   |   |
| Basic                                                                          |       | 27,686                                     |       | 25,873 |   | 24,856 |   |
| Diluted                                                                        |       | 28,402                                     |       | 29,846 |   | 28,976 |   |

 

*See accompanying notes toconsolidated financial statements.*

62

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**GUITAR CENTER, INC. AND SUBSIDIARIES** CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (In thousands)

| ** **                                                            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **     | ** ** | **Retained**     | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------|------------|------------|------------|----------------|------------|------------------|------------|------------|------------|
| ** **                                                            | ** ** | ** **         | ** ** | ** ** | ** ** | **Additional** | ** ** | **Earnings**     | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Number of** | ** ** | **Common** | ** ** | **Paid-in**    | ** ** | **(Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                            | ** ** | **Shares**         | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Deficit)**     | ** ** | **Total**  | ** ** |
| Balance at December 31,  2003                                    |       |               | 23,998     |       |       |           | $          | 240              |       |       | $          | 276,233 |   |   | $ | (62,302 | ) |   | $ | 214,171 |   |
| Exercise of employee stock options, including tax  benefit of $9,756  |       |               | 1,313      |       |       |           | 14         |             |       | 27,537     |       |   | — |   |   | 27,551 |   |
| Stock issued under employee stock purchase plan                  |       |               | 48         |       |       |           | —     |             |       | 1,535      |       |   | — |   |   | 1,535 |   |
| Net income                                                            |       |               | —     |       |       |           | —     |             |       | —     |       |   | 63,425 |   |   | 63,425 |   |
| Balance at  December 31, 2004                                    |       |               | 25,359     |       |       |           | 254        |             |       | 305,305    |       |   | 1,123 |   |   | 306,682 |   |
| Exercise of employee stock options, including tax  benefit of $7,591  |       |               | 687        |       |       |           | 7          |             |       | 19,418     |       |   | — |   |   | 19,425 |   |
| Stock issued under employee stock purchase plan                  |       |               | 46         |       |       |           | —     |             |       | 2,032      |       |   | — |   |   | 2,032 |   |
| Net income                                                            |       |               | —     |       |       |           | —     |             |       | —     |       |   | 76,678 |   |   | 76,678 |   |
| Balance at  December 31, 2005                                    |       |               | 26,092     |       |       |           | 261        |             |       | 326,755    |       |   | 77,801 |   |   | 404,817 |   |
| Exercise of employee stock options, including tax  benefit of $12,129 |       |               | 422        |       |       |           | 4          |             |       | 21,526     |       |   | — |   |   | 21,530 |   |
| Stock issued under employee stock purchase plan                  |       |               | 64         |       |       |           | 1          |             |       | 2,425      |       |   | — |   |   | 2,426 |   |
| Stock-based compensation expense                                      |       |               | —     |       |       |           | —     |             |       | 15,028     |       |   | — |   |   | 15,028 |   |
| Conversion of debt to common stock                                    |       |               | 2,891      |       |       |           | 29         |             |       | 98,483     |       |   | — |   |   | 98,512 |   |
| Net income                                                            |       |               | —     |       |       |           | —     |             |       | —     |       |   | 424 |   |   | 424 |   |
| Balance at  December 31, 2006                                    |       |               | 29,469     |       |       |           | $          | 295              |       |       | $          | 464,217 |   |   | $ | 78,225 |   |   | $ | 542,737 |   |

 

*See accompanying notes toconsolidated financial statements.*

63

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

| ** **                                                                              | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Operating  activities:**                                                              |       |                                       |       |   |   |   |   |
| Net income                                                                              |       | $                                          | 424        |   | $ | 76,678 |   | $ | 63,425 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Goodwill impairment                                                                     |       | 80,160                                     |       | — |   | — |   |
| Depreciation and amortization                                                           |       | 36,777                                     |       | 29,000 |   | 22,304 |   |
| (Gain) loss on disposal of property and equipment                                       |       | (2,115                                     | )          | 1,849 |   | — |   |
| Amortization of deferred financing fees                                                 |       | 562                                        |       | 1,045 |   | 1,045 |   |
| Stock-based compensation                                                                |       | 15,028                                     |       | — |   | — |   |
| Tax benefit from exercise of stock options                                              |       | 8,581                                      |       | 7,591 |   | 9,756 |   |
| Deferred income taxes                                                                   |       | (23,502                                    | )          | (5,476 | ) | 916 |   |
| Changes in operating  assets and liabilities, net of of acquisitions:                   |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                     |       | (12,716                                    | )          | (7,415 | ) | (3,341 | ) |
| Merchandise inventories                                                                 |       | (120,645                                   | )          | (74,188 | ) | (24,281 | ) |
| Prepaid expenses and other current assets                                               |       | (645                                       | )          | (862 | ) | (1,824 | ) |
| Other assets, net                                                                       |       | (9,597                                     | )          | (733 | ) | (2,869 | ) |
| Cash overdraft                                                                          |       | 1,761                                      |       | 11,655 |   | (21,067 | ) |
| Accounts payable                                                                        |       | 31,995                                     |       | 4,560 |   | 23,061 |   |
| Accrued expenses and other current liabilities                                          |       | 10,325                                     |       | 19,397 |   | 11,990 |   |
| Merchandise advances                                                                    |       | 1,654                                      |       | (1,705 | ) | 5,430 |   |
| Other long-term liabilities                                                             |       | 5,297                                      |       | 4,314 |   | 961 |   |
| Net cash provided  by operating activities                                              |       | 23,344                                     |       | 65,710 |   | 85,506 |   |
| **Investing activities:**                                                               |       |                                       |       |   |   |   |   |
| Purchase of property and equipment                                                      |       | (84,417                                    | )          | (75,493 | ) | (26,151 | ) |
| Proceeds from sale of property and equipment                                            |       | 2,565                                      |       | — |   | — |   |
| Purchase of available-for-sale securities                                               |       | —                                     |       | (27,305 | ) | (20,807 | ) |
| Proceeds from sale of available-for-sale securities                                     |       | —                                     |       | 47,460 |   | — |   |
| Acquisition of businesses, net of cash acquired                                         |       | (24,442                                    | )          | (102,428 | ) | (2,775 | ) |
| Net cash used in  investing activities                                                  |       | (106,294                                   | )          | (157,766 | ) | (49,733 | ) |
| **Financing activities:**                                                               |       |                                       |       |   |   |   |   |
| Net change in borrowings under revolving line of  credit                                |       | 68,878                                     |       | 32,266 |   | — |   |
| Proceeds from exercise of stock options                                                 |       | 9,401                                      |       | 11,834 |   | 17,795 |   |
| Proceeds from stock issued under employee purchase  plan                                |       | 2,426                                      |       | 2,032 |   | 1,535 |   |
| Excess tax benefit from exercise of stock options                                       |       | 2,483                                      |       | — |   | — |   |
| Other, net                                                                              |       | 386                                        |       | — |   | — |   |
| Net cash provided  by financing activities                                              |       | 83,574                                     |       | 46,132 |   | 19,330 |   |
| Net increase (decrease)  in cash and cash equivalents                                   |       | 624                                        |       | (45,924 | ) | 55,103 |   |
| Cash and cash  equivalents at beginning of year                                         |       | 14,529                                     |       | 60,453 |   | 5,350 |   |
| Cash and cash  equivalents at end of year                                               |       | $                                          | 15,153     |   | $ | 14,529 |   | $ | 60,453 |   |

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

 

| **Supplemental disclosures of  cash flow information:**                                         |   |   |       |    |       |    |       |
|-------------------------------------------------------------------------------------------------|--------|--------|------------|---------|------------|---------|------------|
| Cash paid during  the year for:                                                                 |   |   |       |    |       |    |       |
| Interest                                                                                        |   | $      | 7,775      |    | $          | 6,005   |       | $ | 4,665 |   |
| Income taxes                                                                                    |   | $      | 58,011     |    | $          | 34,747  |       | $ | 27,611 |   |
| **Non-cash investing and  financing activities:**                                               |   |   |       |    |       |    |       |
| Conversion of  long-term debt to common stock                                                   |   | $      | 98,512     |    | $          | —  |       | $ | — |   |
| Assets acquired  under capital lease                                                            |   | 1,731  |       | —  |       | —  |       |
| Acquisition of  businesses, in which the fair value of assets and liabilities were as  follows: |   |   |       |    |       |    |       |
| Accounts receivable                                                                             |   | 356    | ** ** | 5,802   | ** ** | —  | ** ** |
| Merchandise inventories                                                                         |   | 11,666 |       | 57,655  |       | 1,802   |       |
| Prepaid expenses and other current assets                                                       |   | — |       | 584     |       | —  |       |
| Property and equipment                                                                          |   | 701    |       | 3,428   |       | 120     |       |
| Goodwill                                                                                        |   | 12,738 |       | 59,455  |       | 478     |       |
| Intangible assets                                                                               |   | 1,625  |       | 10,014  |       | 375     |       |
| Other assets                                                                                    |   | 14     |       | —  |       | —  |       |
| Total assets acquired                                                                           |   | 27,100 |       | 136,938 |       | 2,775   |       |
| Current liabilities                                                                             |   | (2,206 | )          | (21,724 | )          | —  |       |
| Other long-term liabilities                                                                     |   | — |       | (738    | )          | —  |       |
| Deferred income taxes                                                                           |   | 887    |       | (12,048 | )          | —  |       |
| Minority interest                                                                               |   | (1,339 | )          | —  |       | —  |       |
| Total liabilities assumed                                                                       |   | (2,658 | )          | (34,510 | )          |    |       |
| Net assets  acquired                                                                            |   | $      | 24,442     |    | $          | 102,428 |       | $ | 2,775 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

65

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2006**

**1. Nature of Business andSignificant Accounting Policies**

*Nature of Business*

Guitar Center, Inc. is the leading United Statesretailer of guitars, amplifiers, percussion instruments, keyboards andpro-audio and recording equipment. As of December 31, 2006, our whollyowned retail subsidiary operated 198 Guitar Center stores across the UnitedStates, with 134 primary format stores, 61 secondary format stores and 3tertiary format stores. In addition, as of December 31, 2006, our Music &Arts Center division operated 97 stores specializing in band instruments forsale and rental, serving thousands of teachers, band directors, collegeprofessors and students. We are also the largest direct response retailer ofmusical instruments in the United States through our wholly owned subsidiary,Musician’s Friend, Inc., and its catalogs and websites,www.musiciansfriend.com, www.guitarcenter.com, www.wwbw.com, www.music123.comand related websites.

We acquired thewww.wwbw.com and www.music123.com websites on February 9, 2007 whenMusician’s Friend, Inc. acquired substantially all of the assets of the DennisBamber, Inc. and its chapter 11 bankruptcy estate, d/b/a The Woodwind andThe Brasswind.

*Principles ofConsolidation*

The consolidated financialstatements include the financial statements of Guitar Center, Inc. and itswholly owned subsidiaries. All significant intercompany balances andtransactions have been eliminated in consolidation.

*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 December 31, 2005 consolidated balance sheet toseparately report intangible assets, net, which was previously included withother assets, net. This reclassification has no impact on the previouslyreported net income or stockholders’ equity.

*Cash and CashEquivalents*

Cash and cash equivalentsconsist of cash on hand and marketable debt securities with original maturitiesof three months or less.

*Accounts Receivable*

In the normal course ofbusiness, the Company grants credit directly to certain customers, after acredit analysis based on financial and other criteria and generally requires nocollateral. Accounts receivable are recorded net of an allowance for doubtfulaccounts. The Company maintains allowances for 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**1. Nature of Business and SignificantAccounting Policies (Continued)**

doubtful accounts for estimated losses that result fromthe failure of its customers to make their required payments. The Company basesits allowances on analysis of the aging of accounts receivable at the date ofthe financial statements, assessments of historical collections trends and anevaluation of the impact of current economic conditions.

*Merchandise Inventories*

Inventories, includingused merchandise and vintage guitars, are valued at the lower of cost using theweighted average method or market. Applicable costs associated with bringinginventory through the Guitar Center retail distribution center are capitalizedto inventory. The amounts are expensed to cost of goods sold as the associatedinventory is sold. Rental inventories are valued at the lower of cost or marketusing the specific identification method and are depreciated on a straight-linebasis while out under the rental agreement for rent-to-own sales. We receiveprice protection credits and vendor rebates from vendors, which are accountedfor as a component of merchandise inventory and are recorded at the time thecredit or rebate is earned. The effect of price protection credits and vendorrebates is recognized in the income statement as an effective reduction in costof goods sold at the time the related item of inventory is sold. None of thesecredits are recorded as revenue.

*Property andEquipment*

Property and equipment arerecorded at cost. Depreciation is computed using the straight-line methodover the estimated useful lives of the assets; generally 5 years for furnitureand fixtures, computer equipment and vehicles, and 15 years for buildings.Leasehold improvements are amortized over the shorter of their estimated usefullives or the terms of the related leases. Corporate aircraft is depreciatedover 10 years with a 50% salvage value. Maintenance and repair costs areexpensed as they are incurred, while renewals and betterments are capitalized.

*Goodwill and OtherIntangibles*

Goodwill represents theexcess of the purchase price over the fair value of the net assets acquiredresulting from business acquisitions. In 2002, we adopted Statement ofFinancial Accounting Standards (“SFAS”) No. 142, *Goodwill andOther Intangible Assets*, which eliminated the systematicamortization of goodwill. As of December 31, 2006 and 2005 we hadunamortized goodwill in the amount of $18.5 million and $85.9 million,respectively. We also had unamortized identifiable intangible assets withindefinite lives in the amount of $5.4 million and $5.3 million as of December 31,2006 and 2005, respectively. Our policy is to test for impairment on an annualbasis, or more frequently when triggering events occur. We have tested goodwilland intangible assets for impairment under the provisions of SFAS No. 142and these tests indicated a goodwill impairment of $80.2 million relating tothe Music & Arts segment during the fourth quarter ended December 31, 2006.See Note 3 for further discussion of the goodwill impairment.

*Impairment andDisposal of Long-Lived Assets*

We account for theimpairment or disposal of long-lived assets in accordance with SFAS No. 144,*Accounting for the Impairment or Disposal of Long-LivedAssets*, which requires long-lived assets, such as property andequipment, to be evaluated for impairment whenever events or changes incircumstances 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**1. Natureof Business and Significant Accounting Policies (Continued)**

indicatethe carrying value of an asset may not be recoverable. Recoverability of assetsto be held and used is measured by a comparison of the carrying amount of theassets to future undiscounted net cash flows expected to be generated by saidassets. If such assets are considered to be impaired, the impairment to berecognized is the amount by which the carrying amount of the assets exceeds thefair value of the assets. Assets to be disposed of are reported at the lower ofthe carrying amount or fair value less selling costs. No impairment wasidentified for the years ended December 31, 2006, 2005 and 2004.

*MerchandiseAdvances/Gift Cards*

Merchandise advances represent layaway deposits whichare recorded as a liability pending consummation of the sale when the fullpurchase price is received from the customer, outstanding gift certificates orgift cards which are recorded as a liability until redemption by the customer,credit on account for customer returns and special orders.

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 cardvalues are redeemed and is recorded as a reduction of cost of goods sold.

*Self-InsuranceReserves*

We maintain aself-insurance program for workers’ compensation of up to $250,000 per claimand medical insurance of up to $150,000 per claim, with any amounts in excessof these covered by stop-loss insurance coverage. Estimated costs under theseprograms, including incurred but not reported claims, are recorded as expensesbased upon actuarially determined historical experience and trends of paid andincurred claims. Self-insurance reserves for workers’ compensation and medicalinsurance amounted to $3.3 million and $1.1 million at December 31, 2006and $3.3 million and $1.0 million at December 31, 2005, respectively. Thebalances are included in accrued expenses and other current liabilities in theaccompanying consolidated balance sheets.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**1. Natureof Business and Significant Accounting Policies (Continued)**

*Revenue Recognition*

Retailsales are recognized at the time of sale, net of a provision for estimatedreturns. Band instrument rentals are recognized on a straight-line basis overthe term of the rental agreement, unless a trial period is offered, in whichcircumstances the rental income for the trial period is amortized over thetrial period. The terms of the majority of our rental agreements do not exceed36 months. Trial periods are usually from one to four months. Direct responsesales are recognized when the products are estimated to be received by thecustomers, net of a provision for estimated returns. Direct response items soldto customers are estimated to be received, on average, three days aftershipment. Return allowances are estimated using historical experience.

*Advertising Costs*

We expense Guitar Center’s and Music & ArtsCenter’s advertising costs as incurred. Advertising costs included in theconsolidated statements of income for the years ended December 31, 2006,2005 and 2004 were $46.2 million, $36.6 million and $34.0 million,respectively. Musician’s Friend’s non-catalog advertising costs for the yearsended December 31, 2006, 2005 and 2004 were $15.0 million, $12.6 millionand $5.5 million, respectively. Mail order catalog costs are capitalized on acatalog by catalog basis and are amortized over the expected period of futurebenefits, not to exceed five months, under the provisions of AICPA Statement ofPosition 93-7, *Reporting ofAdvertising Costs.*Capitalized mail order catalog costs included inprepaid expenses and other current assets at December 31, 2006, 2005 and2004 were $1.3 million, $1.8 million and $4.5 million, respectively.The realizability of the capitalized mail order catalog costs, are evaluated ateach balance sheet date by comparing the carrying amount of such assets on acost-pool-by-cost-pool basis to the probable remaining future net revenuesexpected to result directly from such advertising. If the carrying amounts ofsuch deferred mail order catalog costs exceed the remaining future net revenuesthat probably will be realized from such catalog, the excess capitalized amountis written down and expensed in the current period. There was no write-down ofcapitalized mail order catalog costs for the years ended December 31,2006, 2005 and 2004.

We receive cooperativeadvertising allowances from manufacturers in order to subsidize advertising andsimilar promotional expenditures we make relating to the vendor’s products.These advertising allowances are recognized as a reduction to selling, generaland administrative expense when we incur the advertising costs. Guitar Center,Musician’s Friend and Music & Arts Center recognized cooperativeadvertising allowances of $11.5 million, $10.1 million and $6.4 million for theyears ended December 31, 2006, 2005 and 2004, respectively.

*Rent Expense*

We lease the majority ofour store locations under operating leases that provide for monthly paymentsthat increase over the life of the leases. The aggregate of the minimum annualpayments are expensed on a straight-line basis over the term of therelated lease. The amount by which straight-line rent expense exceedsactual lease payment requirements in the early years of the leases is accruedas deferred minimum rent and reduced in later years when the actual cashpayment requirements exceed the straight-line expense. When a leaseincludes lease incentives (such as a rent holiday or reimbursement of certainlessee construction costs) or requires fixed escalations of the minimum leasepayments, rental expense is 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**1. Natureof Business and Significant Accounting Policies (Continued)**

recognizedon a straight-line basis over the initial term of the lease and the differencebetween the average rental amount charged to expense and amounts payable underthe lease is included in deferred rent and lease incentives in the accompanyingconsolidated balance sheets.

*ComprehensiveIncome*

For the years presented,comprehensive income was the same as net income.

*Income Taxes*

We account for income taxes under SFAS No. 109, *Accounting for Income Taxes*. Under the asset and liabilitymethod of SFAS No. 109, deferred income tax assets and liabilities arerecognized for the future tax consequences attributable to differences betweenfinancial statement carrying amounts of existing assets and liabilities andtheir respective tax bases and operating loss and tax credit carryforwards.Deferred tax assets and liabilities are measured using tax rates expected toapply to taxable income in the years in which those temporary differences areexpected to be recovered or settled. Under SFAS No. 109, the effect ondeferred tax assets and liabilities of a change in tax rates is recognized inincome in the period that includes the enactment date.

In assessing therealizability of deferred tax assets, we consider whether it is more likelythan not that some portion or all of the deferred tax assets will not berealized. The ultimate realization of deferred tax assets is dependent upon thegeneration of future taxable income during the periods in which those temporarydifferences become deductible. We consider the scheduled reversals of deferredtax liabilities, projected future taxable income and tax planning strategies inmaking this assessment.

*Stock-basedCompensation*

Effective January 1, 2006, the Company adopted SFASNo. 123 (revised 2004),*Share-Based Payment*(“SFAS No. 123R”) to account for our stock-basedcompensation plans. The Company elected the modified prospective method ofadoption, which permitted application of the new requirements on a prospectivebasis. Accordingly, prior period amounts have not been restated. Under thisapplication, stock-based compensation is recorded for all awards granted on orafter the date of adoption and for the portion of previously granted awardsthat remain unvested at the date of adoption. Estimated compensation forunvested grants that were outstanding as of the effective date will berecognized over the remaining service period using the compensation costestimated for the SFAS No. 123 pro forma disclosures. Currently, ourstock-based compensation expense relates to stock options, our employee stockpurchase program (the “ESPP”), performance share awards, restricted stockawards, and deferred stock awards.

Under SFAS No. 123(R), the Company determines thefair value of stock options, including options granted under ESPP, using alattice-based binomial model. Under the fair value recognition provisions ofthis statement, stock-based compensation cost for option awards is measured at thegrant date based on the fair value of the award and is recognized as expense ona straight-line basis over the requisite service period of the award.Assumptions used in the model were developed in consultation with an outsidevaluation specialist. The model requires the input of several assumptionsincluding expected volatility, dividend yield, and risk-free rate of return, aswell as certain assumptions regarding exercise behavior. 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**1. Natureof Business and Significant Accounting Policies (Continued)**

Assumptions were developedseparately for our senior management from the other participants of our stockplans, since senior management’s exercise behavior is expected to differmaterially from the other participants.

Also, under SFAS No. 123(R), stock-based compensationexpense is recorded net of estimated forfeitures. The forfeiture rateassumption used in determining stock-based compensation expense is estimatedbased on historical data. The actual forfeiture rate could differ from theseestimates.

Stock-based compensation expense related toperformance share awards issued under our Long Term Incentive Plan (the “LTIP”)is estimated based on our forecasted performance compared to plan targets. 

At the end of eachreporting period, we reevaluate our assessment of performance under the planand make adjustments to the expense as necessary based on the latest estimatesavailable. Under SFAS No. 123(R), the fair value of performance shareawards is based on the market price of the Company’s stock on the date the underlyingplan receives compensation committee approval, or other form of a mutualunderstanding of the key terms and conditions of performance.

*Earnings Per Share*

Thefollowing table summarizes the reconciliation of basic to diluted weightedaverage shares for the years ended December 31, 2006, 2005 and 2004 (inthousands, except per share data):

| ** **                                                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income, as  reported                                                |       | $        | 424        |     | $          | 76,678   |       | $ | 63,425 |   |
| Add back  interest, net of tax, on 4% Senior Convertible Notes(a)       |       | —   |       | 2,907    |       | 2,931    |       |
| Net income,  excluding interest expense on 4% Senior Convertible Notes  |       | $        | 424        |     | $          | 79,585   |       | $ | 66,356 |   |
| Basic weighted  average shares outstanding                              |       | 27,686   |       | 25,873   |       | 24,856   |       |
| Dilutive effect  of stock options outstanding                           |       | 716      |       | 1,081    |       | 1,228    |       |
| Shares issuable  on assumed conversion of4% Senior Convertible Notes(b) |       | —   |       | 2,892    |       | 2,892    |       |
| Diluted weighted  average shares outstanding                            |       | 28,402   |       | 29,846   |       | 28,976   |       |
| Basic net income  per share                                             |       | $        | 0.02       |     | $          | 2.96     |       | $ | 2.55 |   |
| Diluted net income per  share                                           |       | $        | 0.01       |     | $          | 2.67     |       | $ | 2.29 |   |

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(a)           Representsthe interest expense for the period the 4% Senior Convertible Notes (the “Notes”)were outstanding, including contingent interest and amortization of deferredfinancing costs, net of tax, using an effective tax rate of 38.5% for 2005 and38.0% for 2004. The interest expense on the Notes for 2006 was not included inthe computation of diluted net income per share as its effect would beantidilutive.

(b)          Representsthe weighted-average number of common shares issuable upon the conversion ofthe Notes, up to the date of actual conversion. The shares issuable on assumedconversion of the Notes for 2006 were not included in the computation ofdiluted net income per share as its effect would be antidilutive.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**1. Nature of Business andSignificant Accounting Policies (Continued)**

For the years endedDecember 31, 2006, 2005 and 2004, the only potential additional shares ofcommon stock that could become outstanding were shares issuable upon exerciseof stock options and conversion of the Notes up to the date of actualconversion. For the years ended December 31, 2006 and 2005, options toacquire weighted-average shares of 1,034,428 and 261,479, respectively, wereoutstanding but were excluded from the computation of diluted net income pershare because their effect was antidilutive. For the year endedDecember 31, 2004, all options outstanding had a dilutive effect.

For the year ended December 31, 2006, 1.5 millionshares of common stock issuable upon conversion of the Notes issued inJune 2003 (reflecting an effective conversion price of $34.58) wereexcluded for the purposes of calculating diluted net income per share as itseffect would be antidilutive. For the year ended December 31, 2005 and2004, the common stock issuable upon conversion of the Notes amounted to 2.9million shares. Under the “if-converted” method of accounting, the after-taxinterest expense, including contingent interest and amortization of deferredfinancing costs, for the period is added back to net income, unlessantidilutive. The Notes were called for redemption by the Company onJune 15, 2006 and substantially all of the outstanding Notes wereconverted into common stock prior to the July 15, 2006 redemption date.See Note 5 for further discussion of the Notes.

In July 2004, theEmerging Issues Task Force (“EITF”) reached a consensus on Issue No. 04-8,*Accounting Issues Related to Certain Features ofContingently Convertible Debt and the Effect on Diluted Earnings per Share*that contingently convertible debt instruments, such as our 4% SeniorConvertible Notes, should be included in the computation of diluted earningsper share under the if-converted method regardless of whether the market pricetrigger (or other contingent feature) has been met. The consensus must beapplied by retroactive restatement based on the term in effect on the last dayof the fiscal period in which the consensus becomes effective. This consensusbecame effective for all financial statements issued after December 15,2004. Accordingly, we retroactively restated all earnings per share measuresfor all periods to reflect the consensus.

*Concentration ofCredit Risk*

Our cash deposits are withvarious high quality financial institutions. Customer purchases generally aretransacted using cash or credit cards. In limited instances, we grant creditfor larger purchases, generally to professional musicians, under normal tradeterms. Trade accounts receivable were approximately $12.2 million and $10.5million at December 31, 2006 and 2005, respectively. Credit losses havehistorically been within our expectations.

*Fair Value ofFinancial Instruments*

The principal amount ofour revolving line of credit reflects the fair value based upon current ratesavailable to us for similar debt. The book value of all other financialinstruments is representative of their fair values.

*New AccountingPronouncements*

In June 2006, the FASB issued FASBInterpretation No. 48 (FIN 48), “*Accounting for Uncertaintyin Income Taxes.*” FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**1. Natureof Business and Significant Accounting Policies (Continued)**

enterprise’s financialstatements in accordance with SFAS No. 109, “Accounting for Income Taxes.” ThisInterpretation defines the minimum recognition threshold a tax position isrequired to meet before being recognized in the financial statements. FIN48 is effective for fiscal years beginning after December 15,2006. The Company does not expect the adoption of FIN 48 to have amaterial effect on our consolidated financial statements.

In June 2006, the FASB ratified EITF issued Issue06-3, “*How Sales Taxes Collected From Customers andRemitted to Governmental Authorities Should Be Presented in the IncomeStatement*” (EITF 06-3). EITF 06-3 requires acompany 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. The guidance iseffective for periods beginning after December 15, 2006. EITF 06-3 willnot impact the method for recording these taxes in the consolidated financialstatements as we have historically presented sales excluding these taxes.

In September 2006, the SEC issued StaffAccounting Bulletin No. 108, “*Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements*” (SAB 108), to address diversity in practice inquantifying financial statement misstatements. SAB 108 requires that wequantify misstatements based on their impact on each of our financialstatements and related disclosures. SAB 108 was effective as of the end of our2006 fiscal year, allowing a one-time transitional cumulative effect adjustmentto retained earnings as of January 1, 2006 for errors that were notpreviously deemed material, but are material under the guidance in SAB 108. Theadoption of the provisions of SAB 108 had no impact on our consolidatedfinancial statements.

In September 2006,the FASB issued SFAS No. 157, “*Fair Value Measurements*.”SFAS No. 157 defines fair value, establishes a framework for measuringfair value in generally accepted accounting principles and expands disclosuresabout fair value measurements. This Statement applies under other accountingpronouncements that require or permit fair value measurements, the FASB havingpreviously concluded in those accounting pronouncements that fair value is therelevant measurement attribute. Accordingly, this Statement does not requireany new fair value measurements. SFAS No. 157 is effective for fiscalyears beginning after November 15, 2007. The Company is currentlyevaluating the impact, if any, the adoption of SFAS No. 157 will have onour operating income or net income.

**2.**Acquisitionof Businesses**

During the second quarter of 2006, our Guitar Centerdivision acquired four retail locations in Texas and related net assets fromHermes Trading Company, Inc., a musical instruments retailer, forapproximately $11.1 million.

During the year ended December 31, 2006, ourMusic & Arts Center division acquired a total of 18 stores and relatednet assets for an aggregate purchase price of approximately $13.5 million.

The aggregate purchase price for the acquisitions forthe year ended December 31, 2006 (including purchase price adjustments of$0.4 million) totaled approximately $24.4 million, which was principallyallocated to merchandise inventories of $11.7 million and goodwill of $12.7million.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**2.Acquisition of Businesses (Continued)**

The acquisitions were accounted for under the purchasemethod of accounting in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 141, Business Combinations. The results ofoperations of the acquisitions were not material to the consolidated financialstatements and, as such, pro forma financial information is not presented forthese acquisitions. The results of operations of the acquired businesses areincluded in the consolidated financial statements from the respective dates ofacquisition.

On April 15, 2005,the Company completed the acquisition of Music & Arts Center, Inc.,a Maryland-based musical instruments retailer with an emphasis on the beginningmusician. At the time of the acquisition, Music & Arts Center, Inc.operated 61 retail locations, primarily located in the Northeast, Mid-Atlanticand Southern regions of the United States. The Company acquired Music &Arts Center, Inc. to expand our existing presence in the band andorchestra instrument business. The acquired business and our existing AmericanMusic Group business were combined into a new division under the Music &Arts Center name.

**3. Goodwill and IntangibleAssets**

Goodwill represents the excess of the purchase priceover the fair value of identifiable net assets acquired resulting from businessacquisitions accounted for under the purchase method.

In the fourth quarter of 2006, the Music & ArtsCenter segment recorded an impairment charge of $80.2 million, related to thewrite down of goodwill. The determination to write down the goodwill at Music& Arts Center was a result of the segment’s current operating performanceand our fourth quarter change in strategy to reduce future investments in thesegment and slow down growth in future years.

Thechanges in the carrying amount of goodwill by reportable segment during theyears ended December 31, 2006 and 2005 were as follows (in thousands):

| ** **                            | ** ** | **Guitar** | ** ** | **Music &** | ** ** | **Musician’s** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|------------|------------|----------------------|------------|---------------------|------------|------------|------------|
| ** **                            | ** ** | **Center** | ** ** | **Arts**             | ** ** | **Friend**          | ** ** | **Total**  | ** ** |
| Balance at  December 31, 2004    |       | $          | 5,382      |                 | $          | 21,092              |       |       | $          | — |   |   | $ | 26,474 |   |
| Goodwill  resulting from acquisitions |       | —     |       | 56,014               |       |                | 3,441      |       |       | 59,455 |   |
| Balance at  December 31, 2005    |       | 5,382      |       | 77,106               |       |                | 3,441      |       |       | 85,929 |   |
| Goodwill  resulting from acquisitions |       | 9,684      |       | 2,624                |       |                | —     |       |       | 12,308 |   |
| Goodwill impairment                   |       | —     |       | (80,160              | )          |                | —     |       |       | (80,160 | ) |
| Goodwill  adjustments                 |       | —     |       | 430                  |       |                | —     |       |       | 430 |   |
| Balance at  December 31, 2006    |       | $          | 15,066     |                 | $          | —              |       |       | $          | 3,441 |   |   | $ | 18,507 |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**3.Goodwill and Intangible Assets (Continued)**

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

| ** **               | ** ** | ** **              | ** ** | **December 31, 2006** | ** ** |
|--------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **Weighted-**           | ** ** | **Gross**                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Average Useful** | ** ** | **Carrying**                    | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Life**                | ** ** | **Amount**                      | ** ** | **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 |   |

 

| ** **               | ** ** | ** **              | ** ** | **December 31, 2005** | ** ** |
|--------------------------|------------|-------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **Weighted-**           | ** ** | **Gross**                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Average Useful** | ** ** | **Carrying**                    | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Life**                | ** ** | **Amount**                      | ** ** | **Amortization** | ** ** | **Total** | ** ** |
| Unamortized  trademark   |       |                    | —     |                            |       | $ | 5,325 |   |   | $ | — |   |   | $ | 5,325 |   |
| Amortized                |       |                    |       |                            |       |   |   |   |   |   |   |   |   |
| Customer contracts       |       |                    | 1.4        |                            |       | 3,430 |   |   | (1,734 | ) |   | 1,696 |   |
| Covenants not to compete |       |                    | 3.7        |                            |       | 2,200 |   |   | (596 | ) |   | 1,604 |   |
| Other                    |       |                    | 2.6        |                            |       | 834 |   |   | (317 | ) |   | 517 |   |
| Intangible assets, net   |       |                    |       |                            |       | $ | 11,789 |   |   | $ | (2,647 | ) |   | $ | 9,142 |   |

 

Amortizationof intangible assets is included in selling, general and administrativeexpenses. The estimated amortization expense related to intangible assets foreach of the five years and thereafter as of December 31, 2006 is as follows (inthousands):

| **Year** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------|------------|------------|------------|------------|------------|
| 2007     |       | $          | 1,212      |       |
| 2008     |       | 506        |       |
| 2009     |       | 304        |       |
| 2010     |       | 149        |       |
| 2011     |       | 74         |       |
| Total    |       | $          | 2,245      |       |

 

75

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**4. Balance SheetComponents**

Selectedbalance sheet components consisted of the following (in thousands): 

| ** **                | ** ** | **December 31,** | ** ** |
|---------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Merchandise  inventories: |       |                  |       |   |   |
| Major goods               |       | $                     | 317,802    |   | $ | 246,260 |   |
| Band instruments          |       | 104,747               |       | 79,378 |   |
| Accessories               |       | 129,004               |       | 97,950 |   |
| Vintage guitars           |       | 15,924                |       | 11,795 |   |
| Used major goods          |       | 21,341                |       | 20,056 |   |
|                      |       | 588,818               |       | 455,439 |   |
| Less inventory reserves   |       | 10,736                |       | 9,668 |   |
|                      |       | $                     | 578,082    |   | $ | 445,771 |   |

 

Majorgoods include stringed merchandise, percussion, keyboards, live-sound/DJ andrecording equipment. Band instruments include horns, flutes, brass and woodwindinstruments. Accessories are comprised of accessories to major goods, and bandinstruments, apparel, cables and books.

| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Property and equipment:                        |       |                  |       |   |   |
| Land                                           |       | $                     | 7,376      |   | $ | 7,666 |   |
| Buildings                                      |       | 21,537                |       | 20,091 |   |
| Furniture and fixtures                         |       | 36,791                |       | 30,656 |   |
| Transportation equipment                       |       | 13,286                |       | 12,402 |   |
| Computer equipment                             |       | 93,308                |       | 73,877 |   |
| Leasehold improvements                         |       | 163,464               |       | 123,992 |   |
| Construction in progress                       |       | 19,257                |       | 5,965 |   |
|                                           |       | 355,019               |       | 274,649 |   |
| Less accumulated depreciation and amortization |       | 153,033               |       | 125,440 |   |
|                                           |       | $                     | 201,986    |   | $ | 149,209 |   |

 

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**4.Balance Sheet Components(Continued)**

As of December 31, 2006, $1.7 million of computerequipment was under a capital lease.

| ** **                                       | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|-----------------------|------------|
| ** **                                       | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Accrued expenses and  other current liabilities: |       |                  |       |   |   |
| Wages, salaries and benefits                     |       | $                     | 31,834     |   | $ | 30,564 |   |
| Accrued income taxes                             |       | 21,944                |       | 18,846 |   |
| Sales tax payable                                |       | 16,536                |       | 12,813 |   |
| Accrued advertising                              |       | 8,268                 |       | 8,193 |   |
| Unearned revenue                                 |       | 7,132                 |       | 5,802 |   |
| Provision for sales returns                      |       | 5,765                 |       | 5,007 |   |
| Accrued insurance                                |       | 4,356                 |       | 4,310 |   |
| Accrued real estate tax                          |       | 2,421                 |       | 1,847 |   |
| Accrued professional fees                        |       | 1,893                 |       | 4,281 |   |
| Accrued freight                                  |       | 1,482                 |       | 1,432 |   |
| Accrued utilities                                |       | 1,470                 |       | 922 |   |
| Current portion of capital lease obligation      |       | 574                   |       | — |   |
| Other                                            |       | 13,920                |       | 12,164 |   |
|                                             |       | $117,595              |       | $ | 106,181 |   |
|                                                  |            |                       |            |  |  |  |  |

 

**5. Long-Term Debt andRevolving Line of Credit**

Long-termdebt consisted of the following (in thousands):

| ** **                                                                     | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                     | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Obligations under  capital lease, payable in monthly installments through 2009 |       | $                     | 1,731      |   | $ | — |   |
| Notes, 4%, face  amount of $100 million                                        |       | —                |       | 100,000 |   |
| Other                                                                          |       | 259                   |       | — |   |
|                                                                           |       | 1,990                 |       | 100,000 |   |
| Less current  portion                                                          |       | 574                   |       | — |   |
| Total long-term debt                                                           |       | $                     | 1,416      |   | $ | 100,000 |   |

 

On June 16, 2003, the Company completed theissuance of $100 million of Notes due 2013. The Notes bore interest at the rateof 4.00% per annum, subject to the payment of contingent interest under certaincircumstances commencing January 15, 2006, and became convertible intoshares of common stock at a conversion price of $34.58 per share, subject toadjustment under specified circumstances.

On June 15, 2006, the Company called forredemption all of the outstanding Notes due 2013. Holders were able to convertthe Notes into shares of common stock at an effective conversion price ofapproximately $34.58 per share, in lieu of accepting redemption. Prior to theredemption date of July 15, 2006, holders of substantially all of theremaining outstanding Notes elected to convert their Notes into shares of theCompany’s common stock. As a result of these conversions, approximately 2.9million shares of common stock were issued to the holders that elected toconvert their Notes. In connection with the 

77

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**5.Long-Term Debt and Revolving Line of Credit (Continued)**

redemption of theunconverted Notes, the Company paid approximately $3,000 in cash, whichincludes the redemption and premium payments and cash paid in lieu of fractionalshares. In conjunction with the redemption, the Company reclassifiedapproximately $1.5 million of unamortized debt issuance costs from other assetsto additional paid-in capital in the third quarter of 2006.

On April 26, 2006, the Company entered into anamendment of our credit facility. The amendment increased the maximumborrowings available under the credit facility from $125 million to $200million, subject to borrowing base limitations. The amendment allows for theincrease of the maximum borrowings to $250 million at the option of theCompany. As of December 31, 2006, we had elected to increase the maximumborrowings to $210 million. The amendment also extended the maturity date ofthe facility to December 2011, reduced the interest rate charged over theapplicable index rates and increased the borrowing base as a percentage ofworking capital. 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 (8.00% at December 31,2006) plus applicable prime margin, or London Interbank Offered Rate or LIBOR(12 month rate at December 31, 2006 was 5.33%), 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 with the 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.

For the years ended December 31,2006, 2005 and 2004, $0.6 million, $1.0 million and $1.0 million ofamortization of deferred financing fees was included in interest expense.Unamortized deferred financing fees at December 31, 2006, 2005 and 2004were $0.5 million, $2.5 million and $3.6 million and related accumulatedamortization was $0.8 million, $2.1 million and $1.0 million,respectively.

78

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**6. Segment Information**

Our reportable business segments are Guitar Centerstores, Music & Arts Center stores and Musician’s Friend directresponse. Prior to the acquisition of Music & Arts Center, Inc.,that segment was referred to as American Music stores. Both brands have similaroperations and there has been no change to the internal structure of theoverall organization. Therefore, there has been no change in the nature of thecompany segment reporting. Management evaluates segment performance basedprimarily on net sales, operating income (loss) and income (loss) before incometaxes. Accounting policies of the segments are the same as the accountingpolicies for the consolidated company. There are no differences between themeasurements of profits or losses or assets of the reportable segments andthose of the company on a consolidated basis. Our business segments under SFAS No. 131,*Disclosures about Segments of an Enterpriseand Related Information,* are consistent with our reporting unitsunder SFAS No. 142*, Goodwill and OtherIntangible Assets.*SFAS No. 131 establishes standards for thereporting of operating segment information in annual financial statements andin interim financial reports issued to shareholders. SFAS No. 142requires that goodwill no longer be amortized, reclassifications betweengoodwill and other intangible assets be made based upon certain criteria, and,once allocated to reporting units (the business segment level, or one levelbelow), that tests for impairment of goodwill be performed at least annually.We will continue to evaluate goodwill annually or whenever events andcircumstances indicate that there may be an impairment of the asset value.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**6. Segment Information(Continued)**

Thefollowing table summarizes financial information for our operating segments forthe years ended December 31, 2006, 2005 and 2004 (in thousands):

| ** **                                     | ** ** | **2006**               | ** ** |
|------------------------------------------------|------------|------------------------|------------|
| ** **                                     | ** ** | **Guitar Center** | ** ** | **Music & Arts** | ** ** | **Musician’s Friend** | ** ** | **Total** | ** ** |
| Net sales                                      |       |                   | $          | 1,493,339 |   |   |   | $ | 144,972 |   |   |   | $ | 391,655 |   |   | $ | 2,029,966 |   |
| Gross profit                                   |       |                   | 412,870    |   |   |   | 62,803 |   |   |   | 118,330 |   |   | 594,003 |   |
| Depreciation and  amortization                 |       |                   | 28,028     |   |   |   | 5,141 |   |   |   | 3,608 |   |   | 36,777 |   |
| Selling, general  and adiministrative expenses |       |                   | 310,943    |   |   |   | 63,950 |   |   |   | 91,662 |   |   | 466,555 |   |
| Operating income  (loss)                       |       |                   | 101,927    |   |   |   | (81,307 | ) |   |   | 26,668 |   |   | 47,288 |   |
| Income (loss)  before income tax (benefit)     |       |                   | 105,394    |   |   |   | (92,998 | ) |   |   | 28,559 |   |   | 40,955 |   |
| Capital  expenditures                          |       |                   | 73,458     |   |   |   | 3,805 |   |   |   | 7,154 |   |   | 84,417 |   |
| Total assets                                   |       |                   | 682,344    |   |   |   | 158,503 |   |   |   | 86,631 |   |   | 927,478 |   |
|                                                |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                     | ** ** | **2005**               | ** ** |
|------------------------------------------------|------------|------------------------|------------|
| ** **                                     | ** ** | **Guitar Center** | ** ** | **Music & Arts(1)** | ** ** | **Musician’s Friend** | ** ** | **Total** | ** ** |
| Net sales                                      |       |                   | $          | 1,314,277 |   |   |   | $ | 103,116 |   |   |   | $ | 365,106 |   |   | $ | 1,782,499 |   |
| Gross profit                                   |       |                   | 368,498    |   |   |   | 43,064 |   |   |   | 108,840 |   |   | 520,402 |   |
| Depreciation and  amortization                 |       |                   | 22,157     |   |   |   | 4,312 |   |   |   | 2,531 |   |   | 29,000 |   |
| Selling, general  and adiministrative expenses |       |                   | 261,621    |   |   |   | 49,357 |   |   |   | 77,402 |   |   | 388,380 |   |
| Operating income  (loss)                       |       |                   | 106,877    |   |   |   | (6,293 | ) |   |   | 31,438 |   |   | 132,022 |   |
| Income (loss)  before income tax (benefit)     |       |                   | 105,809    |   |   |   | (14,095 | ) |   |   | 32,969 |   |   | 124,683 |   |
| Capital  expenditures                          |       |                   | 67,964     |   |   |   | 1,130 |   |   |   | 6,399 |   |   | 75,493 |   |
| Total assets                                   |       |                   | 512,802    |   |   |   | 197,045 |   |   |   | 70,343 |   |   | 780,190 |   |
|                                                |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

| ** **                                      | ** ** | **2004**               | ** ** |
|-------------------------------------------------|------------|------------------------|------------|
| ** **                                      | ** ** | **Guitar Center** | ** ** | **Music & Arts (1)** | ** ** | **Musician’s Friend** | ** ** | **Total** | ** ** |
| Net sales                                       |       |                   | $          | 1,161,511 |   |   |   | $ | 40,400 |   |   |   | $ | 311,261 |   |   | $ | 1,513,172 |   |
| Gross profit                                    |       |                   | 310,674    |   |   |   | 14,067 |   |   |   | 100,532 |   |   | 425,273 |   |
| Depreciation and  amortization                  |       |                   | 18,671     |   |   |   | 1,469 |   |   |   | 2,164 |   |   | 22,304 |   |
| Selling, general  and adiministrative expenses  |       |                   | 234,549    |   |   |   | 18,656 |   |   |   | 64,380 |   |   | 317,585 |   |
| Operating income  (loss)                        |       |                   | 76,125     |   |   |   | (4,589 | ) |   |   | 36,152 |   |   | 107,688 |   |
| Income (loss)  before income tax (benefit) |       |                   | 72,789     |   |   |   | (7,228 | ) |   |   | 36,737 |   |   | 102,298 |   |
| Capital  expenditures                           |       |                   | 21,240     |   |   |   | 1,272 |   |   |   | 3,639 |   |   | 26,151 |   |
| Total assets                                    |       |                   | 451,677    |   |   |   | 63,365 |   |   |   | 59,551 |   |   | 574,593 |   |
|                                                 |            |                        |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

----

(1)          Theinformation included for the Music & Arts Center division includedonly the operation of American Music prior to April 15, 2005.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**7. Lease Commitments**

The Company leases offices, retail store facilities,distribution centers and various personal property used in our business underoperating leases which expire at varying dates through December 2018.Generally, the agreements contain provisions which require paying for normalrepairs and maintenance, property taxes and insurance.

Thefuture annual minimum lease payments at December 31, 2006, under capitaland operating leases, are as follows (in thousands): 

| ** **                          | ** ** | **Capital** | ** ** | **Operating** | ** ** |
|-------------------------------------|------------|-------------|------------|---------------|------------|
| **Year**                            | ** ** | ** **  | ** ** | **Lease**     | ** ** | **Leases** | ** ** |
| 2007                                |       | $           | 583        |          | $          | 58,805 |   |
| 2008                                |       | 583         |       | 54,821        |       |
| 2009                                |       | 583         |       | 45,941        |       |
| 2010                                |       | —      |       | 39,265        |       |
| 2011                                |       | —      |       | 34,477        |       |
| Thereafter                          |       | —      |       | 128,839       |       |
| Total minimum  lease payments       |       | 1,749       |       | $             | 362,148    |   |
| Less imputed  interest              |       | 18          |       |          |       |
| Present value of lease  obligations |       | $           | 1,731      |          |       |   |
|                                     |            |             |            |               |            |  |  |  |  |

 

Total rent expenseincluded in the consolidated statements of income for the years ended December 31,2006, 2005 and 2004 is $53.8 million, $45.4 million and $38.2 million,respectively.

**8. Employee Benefit Plan**

We have a definedcontribution 401(k) plan with a 401(a) profit-sharing component (the “Plan”)maintained for the exclusive benefit of eligible employees and theirbeneficiaries. Eligible employees can contribute from one to seventy-fivepercent of their compensation. At our discretion, we can make matchingcontributions to the Plan, which will be a uniform percentage of the eligibleemployees’ contributions. We may also, at our discretion, make profit-sharingcontributions to the Plan. The profit-sharing contributions are allocated basedon the relative compensation of all eligible employees. Contribution expensewas $1.5 million, $3.6 million and $2.1 million for the years ended December 31,2006, 2005 and 2004.

**9. Stock-BasedCompensation**

Stock-based compensation expense for all stock awardplans included in our consolidated statement of income for the year ended December 31,2006 was $15.0 million ($9.3 million net of tax), or $0.33 per diluted share.There was no stock-based compensation expense for the years ended December 31,2005 and 2004. As a result of adopting SFAS No. 123(R) on January 1,2006, income before income taxes and net income for the year ended December 31,2006 was $12.4 million and $7.7 million lower, respectively, than if we hadcontinued to account for stock-based compensation under APB No. 25. If wehad not adopted SFAS No. 123(R), our basic and diluted net income pershare for the year ended December 31, 2006 would have been increased by$0.29 and $0.26, respectively. Under the APB No. 25 intrinsic value 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**9.Stock-Based Compensation (Continued)**

method, the Company wouldnot have recorded stock-based compensation expense in 2006 related to stockoption awards, but would have recorded stock-based compensation expense relatedto awards of performance shares, restricted stock and deferred stock.

Prior to the adoption of SFAS No. 123(R), wepresented all tax benefits for deductions resulting from the exercise of stockoptions as operating cash flows on our consolidated statement of cash flows.SFAS No. 123(R) requires the benefits of tax deductions inexcess of recognized compensation expense to be reported as a financing cashflow, rather than as an operating cash flow. This requirement will reduce netoperating cash flows and increase net financing cash flows in periods afteradoption. Total cash flow will remain unchanged from what would have beenreported under prior accounting rules. For the year ended December 31,2006, $2.5 million of excess tax benefits from the exercise of stock optionsreported in financing cash flows would have been reported as operating cashflows had SFAS No. 123(R) not been adopted.

Thefollowing table details the effect on net income and net income per share as ifwe had applied the fair value recognition provisions of SFAS No. 123 tostock-based compensation during the year ended December 31, 2005 and 2004(in thousands, except per share data):

| ** **                                                                                                                                     | ** ** | **Year ended December 31,**                           | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **     2005     ** | ** ** | **     2004     ** | ** ** |
| Net income, as  reported                                                                                                                       |       |                                                                 | $          | 76,678 |   |   |   | $ | 63,425 |   |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  methods for all awards, net of related tax effects |       |                                                                 | 6,608      |   |   |   | 6,271 |   |   |
| Pro forma net  income                                                                                                                          |       |                                                                 | $          | 70,070 |   |   |   | $ | 57,154 |   |   |
| Net income per share:                                                                                                                          |       |                                                                 |       |   |   |   |   |   |   |
| Basic—as reported                                                                                                                         |       |                                                                 | $          | 2.96 |   |   |   | $ | 2.55 |   |   |
| Basic—pro forma                                                                                                                           |       |                                                                 | $          | 2.71 |   |   |   | $ | 2.30 |   |   |
| Diluted—as reported                                                                                                                       |       |                                                                 | $          | 2.67 |   |   |   | $ | 2.29 |   |   |
| Diluted—pro forma                                                                                                                         |       |                                                                 | $          | 2.44 |   |   |   | $ | 2.07 |   |   |

 

*IncentiveCompensation Plans*

Our 2004 Incentive Stock Award Plan (as amended, the “2004Plan”) provides for the issuance of stock options, stock appreciation rights,restricted stock, deferred stock, dividend equivalents, performance awards andstock payments, or any combination thereof. Substantially all stock awards arecurrently issued under the 2004 Plan.

Prior to fiscal 2004, the Company had adopted variousstock option plans (the “Prior Plans”). A small number of grants are expectedto be made under the Prior Plans, and outstanding awards under the Prior Planswill continue to be in effect.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**9. Stock-BasedCompensation (Continued)**

Under the 2004 Plan andthe Prior Plans, an aggregate of 1.3 million shares of common stock wereavailable for issuance as of December 31, 2006. The Company generallyissues new shares for stock option exercises, performance share awards andrestricted stock awards.

*Stock Options*

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

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

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

The assumptions used to value option grants for theyear ended December 31, 2006, 2005 and 2004 are as follows:

| ** **                                             | ** ** | **Year ended December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Valuation Model                                        |       | Binomial  Lattice                          |       | Binomial  Lattice |   | Black-  Scholes |   |
| Expected  volatility range                             |       | 35.2-49.6                                  | %          | 32-52 | % | — |   |
| Weighted-average  expected volatility                  |       | 42.6                                       | %          | 42.0 | % | 59.6 | % |
| Expected term (in  years)                              |       | 3.98-5.75                                  |       | 5.40-7.38 |   | 6.70 |   |
| Risk-free  interest rate                               |       | 4.4-4.9                                    | %          | 3.5-4.0 | % | 3.9 | % |
| Expected  dividends                                    |       | —                                     |       | — |   | — |   |
| Suboptimal exercise term  (multiple of exercise price) |       | 2.0                                        |       | 2.0 |   | — |   |

 

83

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**9.Stock-Based Compensation (Continued)**

Stock option activity for all plans during the yearended December 31, 2006 is as follows:

| ** **                             | ** ** | ** **      | ** ** | ** **    | ** ** | **Weighted-**             | ** ** | ** **              | ** ** |
|----------------------------------------|------------|-----------------|------------|---------------|------------|---------------------------|------------|-------------------------|------------|
| ** **                             | ** ** | ** **      | ** ** | **Weighted-** | ** ** | **Average**               | ** ** | **Aggregate**           | ** ** |
| ** **                             | ** ** | ** **      | ** ** | **Average**   | ** ** | **Remaining**             | ** ** | **Instrinsic**          | ** ** |
| ** **                             | ** ** | **No. of** | ** ** | **Exercise**  | ** ** | **Contractual Term** | ** ** | **Value**               | ** ** |
| ** **                             | ** ** | **Shares**      | ** ** | **Price**     | ** ** | **(in years)**       | ** ** | **(in thousands)** | ** ** |
| Outstanding at  December 31, 2005 |       | 2,802,394       |       |          | $          | 31.94                     |       |                    |       |   |   |   |   |   |   |   |
| Granted                                |       | 558,500         |       |          | 43.58      |                      |       |                    |       |   |   |   |   |   |   |
| Exercised                              |       | (420,375        | )          |          | 22.36      |                      |       |                    |       |   |   |   |   |   |   |
| Forfeited                              |       | (136,848        | )          |          | 50.62      |                      |       |                    |       |   |   |   |   |   |   |
| Expired                                |       | —          |       |          | —     |                      |       |                    |       |   |   |   |   |   |   |
| Outstanding at  December 31, 2006 |       | 2,803,671       |       |          | $          | 34.78                     |       |                    |       | 6.77 |   |   |   | $ | 37,578 |   |   |
| Exercisable at  December 31, 2006 |       | 1,593,445       |       |          | $          | 25.86                     |       |                    |       | 5.38 |   |   |   | $ | 32,964 |   |   |

 

The weighted-averagegrant-date fair value of options granted during the years 2006, 2005 and 2004was $18.87, $27.46 and $24.63. The aggregate intrinsic value of options (theamount by which the stock price on the date of exercise exceeded the stockprice of the option on the date of grant) exercised during the years 2006, 2005and 2004 was $10.8 million, $28.0 million and $34.2 million, respectively.

In February 2006, the Company entered into atransition agreement with its former Chief Financial Officer upon hisretirement from the Company, which provided for the immediate acceleration ofall of his outstanding options totaling 32,002 shares. Included in thestock-based compensation expense for the year ended December 31, 2006 isexpense related to this acceleration of $0.8 million ($0.5 million net of tax).

*Employee StockPurchase Plan*

Our ESPP is a tax-qualified employee stock purchaseplan under which options are permitted to purchase our common stock at a pricewhich is eighty-five percent of the stock’s fair market value on either thefirst or last day of the offering period, whichever price is lower. The optionsare then automatically exercised on the last business day of the offeringperiods, which end in June and December. The participants purchase theshares through payroll deductions.

84

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**9.Stock-Based Compensation (Continued)**

The assumptions used to value the ESPP options underthe lattice-based binomial model for the year ended December 31, 2006 areas follows:

| ** **                              | ** ** | **Year ended**             | ** **        |
|-----------------------------------------|------------|---------------------------------|-------------------|
| ** **                              | ** ** | **December 31, 2006** | ** **        |
| Valuation Model                         |       |                            | Binomial  Lattice |   |   |
| Expected  volatility range              |       |                            | 32-40             | % |   |
| Weighted-average  expected volatility   |       |                            | 36.3              | % |   |
| Expected term                           |       |                            | 6 months          |   |   |
| Risk-free  interest rate                |       |                            | 4.4-5.0           | % |   |
| Weighted-average  grant-date fair value |       |                            | $11.84            |   |   |

 

Total stock-based compensation expense recognized forESPP options was $0.8 million for the year ended December 31, 2006.

*Long Term IncentivePlan*

In July 2005, theCompany adopted the LTIP, which provides equity incentives to senior managementthat include not only stock options or similar grants, but also a performanceshare program that measures performance on a multi-year basis. The performanceperiod under the LTIP began on July 1, 2005 and ends on December 31,2007. Awards under the LTIP are made under the 2004 Plan or any successor plan.It is expected that each participant will receive an annual grant of stockoptions under the 2004 Plan, pursuant to its terms. Performance shares in theform of common stock are earned by the participants based upon specifiedobjective performance goals during the performance period of the LTIP. The numberof shares issuable could change if we add or subtract executives to or from theplan. The compensation committee also has the discretion to make cash paymentsin lieu of performance shares. Any subsequent long-term incentive plansestablished during the performance period for inclusion of new participants arecombined for reporting purposes with the LTIP.

The target number ofperformance shares potentially issuable under the LTIP is expected to be250,912, with the actual number of shares ultimately issuable to be betweenzero and twice such amount, depending on actual performance and number ofparticipants. Included in the target performance shares are 21,382 shares fortwo new executives added to the plan effective April 1, 2006. Theperformance period for these new participants began on April 1, 2006 andends on December 31, 2007. The number of target shares was reduced in 2006by 25,964 shares due to the departure of two participants. The previouslyrecorded stock compensation expense related to these participants were reversedin 2006.

Stock-based compensation expense related to the LTIPis estimated based on forecasted performance during the performance periodcompared to plan targets. At the end of each reporting period, we reevaluateour assessment of performance under the plan and make adjustments to theexpense as necessary based on the latest estimates available. The fair value ofperformance share awards is based on the market price of the Company’s stock onthe date the underlying plan receives compensation committee approval, or otherform of a mutual understanding of the key terms and conditions of performance.

85

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**9.Stock-Based Compensation (Continued)**

For the year ended December 31,2006, the Company recorded stock-based compensation expense related to the LTIPof $2.7 million ($1.8 million net of tax), or $0.06 per diluted share.

*Restricted StockAwards/Deferred Stock Awards*

Awards of restricted stockand deferred stock are generally made to the non-employee directors of theCompany and are measured on the date of grant. These time-based awards vestover three to five years, or sooner in the event of a qualified retirement, andare forfeitable under certain conditions.

A summary of the Company’s awards of performanceshares, restricted stock, and deferred stock as of and for the year ended December 31,2006 is presented below:

| ** **                                   | ** ** | ** **                     | ** ** | **Weighted-Average**     | ** ** |
|----------------------------------------------|------------|--------------------------------|------------|--------------------------|------------|
| ** **                                   | ** ** | ** **                     | ** ** | **Grant-Date Fair** | ** ** |
| ** **                                   | ** ** | **No. of Shares(1)** | ** ** | **Value**                | ** ** |
| Nonvested balance  at December 31, 2005 |       |                           | 506,848    |                     |       |   | $ | 55.94 |   |   |
| Granted                                      |       |                           | 63,051     |                     |       |   | 48.88 |   |   |
| Vested                                       |       |                           | (2,186     | )                        |       |   | 49.98 |   |   |
| Forfeited                                    |       |                           | (30,546    | )                        |       |   | 56.32 |   |   |
| Nonvested balance at  December 31, 2006 |       |                           | 537,167    |                     |       |   | $ | 55.12 |   |   |

----

(1)          Represents the maximumnumber of shares that can be issued based on the achievement of certainperformance criteria.

The total fair value of restricted stock and deferredstock vested during the year ended December 31, 2006 was immaterial. Basedon our latest estimates, there was $2.9 million ($1.6 million net of tax) oftotal unrecognized compensation cost for nonvested shares, as of December 31,2006, that is expected to be recognized over a weighted average period of 1.5years.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**10.** Income Taxes

Totalincome taxes for the years ended December 31, 2006, 2005 and 2004 are asfollow (in thousands):

| ** **                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                      |       |     |       |     |       |     |       |
| Federal                       |       | $        | 55,113     |     | $          | 48,391   |       | $ | 34,332 |   |
| State                         |       | 8,920    |       | 5,090    |       | 3,625    |       |
| Total current tax  provision  |       | 64,033   |       | 53,481   |       | 37,957   |       |
| Deferred:                     |       |     |       |     |       |     |       |
| Federal                       |       | (21,941  | )          | (5,223   | )          | 793      |       |
| State                         |       | (1,561   | )          | (253     | )          | 123      |       |
| Total deferred  tax provision |       | (23,502  | )          | (5,476   | )          | 916      |       |
| Total income taxes            |       | $        | 40,531     |     | $          | 48,005   |       | $ | 38,873 |   |

 

Thecharge in lieu of taxes attributable to tax benefit from employee stock optionsfor 2006, 2005 and 2004 are $3.5 million, $7.6 million and $9.8 million,respectively.

Actualincome taxes for 2006, 2005 and 2004 differ from the statutory tax rate of 35%as applied to income before income taxes as follows (in thousands):

| ** **                                               | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Expected income  tax expense                             |       | $        | 14,334     |     | $          | 43,641   |       | $ | 35,804 |   |
| State income  taxes, net of federal tax benefit          |       | 4,396    |       | 3,317    |       | 2,436    |       |
| Goodwill  impairment                                     |       | 19,879   |       | —   |       | —   |       |
| Stock options                                            |       | 2,006    |       | —   |       | —   |       |
| Change in  valuation allowance                           |       | (1,145   | )          | (52      | )          | —   |       |
| Meals &  entertainment and non deductible items |       | 549      |       | 1,508    |       | 402      |       |
| Other                                                    |       | 512      |       | (409     | )          | 231      |       |
| Actual income tax expense                                |       | $        | 40,531     |     | $          | 48,005   |       | $ | 38,873 |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**10.Income Taxes (Continued)**

The tax effects oftemporary differences that give rise to significant portions of deferred taxassets and liabilities are presented below (in thousands):

| ** **                                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                                            |       |     |       |     |       |
| State net operating loss carryforward                           |       | $        | 38         |     | $          | 41 |   |
| Accrued liabilities                                             |       | 9,850    |       | 7,893    |       |
| Merchandise inventories                                         |       | 4,572    |       | 5,568    |       |
| Intangibles                                                     |       | 5,757    |       | —   |       |
| Stock options                                                   |       | 2,435    |       | —   |       |
| Capital loss carryover                                          |       | 132      |       | 1,181    |       |
| Total gross  deferred tax assets                                |       | 22,784   |       | 14,683   |       |
| Deferred tax  liabilities:                                      |       |     |       |     |       |
| Depreciation                                                    |       | (4,667   | )          | (13,551  | )          |
| Intangibles                                                     |       | —   |       | (4,820   | )          |
| Other                                                           |       | (498     | )          | (1,936   | )          |
| Total gross  deferred tax liabilities                           |       | (5,165   | )          | (20,307  | )          |
| Net deferred tax  assets (liabilities) and net operating losses |       | 17,619   |       | (5,624   | )          |
| Less valuation  allowance                                       |       | (45      | )          | (1,191   | )          |
| Net deferred tax  assets (liabilities)                          |       | $        | 17,574     |     | $          | (6,815 | ) |

 

In assessing the realizability of deferred tax assets,management considers whether it is more likely than not that some portion orall of the deferred tax assets will not be realized. The ultimate realizationof deferred tax assets is dependent upon the generation of future taxableincome during the periods in which those temporary differences becomedeductible. We consider scheduled reversal of deferred tax liabilities,projected future taxable income and tax planning strategies in making thisassessment. Based upon the level of historical taxable income and projectionsof future taxable income over the periods which the deferred tax assets aredeductible, management believes it is more likely than not that we will realizethe benefits of these deductible differences. The amount of the deferred taxassets considered realizable, however, could be reduced in the near term ifestimates of future taxable income during the carryforward periods are reduced.The valuation allowance for 2006 and 2005 consists of capital losscarryforwards and state net operating losses.

The Company accounts forthe tax benefit resulting from the employee exercises of non-qualifying stockoptions or the disqualified disposition of incentive stock options as areduction in income tax payable and an increase to additional paid-in capitalin the accompanying consolidated financial statements. The Company recorded$12.1 million, $7.6 million and $9.8 million of a benefit in 2006, 2005 and2004, respectively. Of the $12.1 million recorded in 2006, $8.6 million isrelated to claims for refund for tax years 2003, 2004 and 2005 for deductionsfor disqualified dispositions of incentive stock options not previously claimedon federal and state tax returns.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**11. Legal**

On November 29, 2005,a case was filed against us and other defendants, including our Chief ExecutiveOfficer, in the United States District Court for the Southern District ofFlorida. The complaint asserts, among other things, violations of the FederalRacketeering Influenced and Corrupt Organization Act (RICO) and a correspondingFlorida statute, Sections 1 and 2 of the Sherman Antitrust Act, Section 2of the Clayton Act (as amended by the Robinson-Patman Act), the Antidumping Actof 1916, the Florida Antitrust Act of 1980, and the Florida Deceptive andUnfair Trade Practices Act, as well as tortious interference with businessrelationship under Florida law and civil conspiracy under Florida law by someor all of the identified defendants in connection with the claimed inability ofAce Pro Sound and Recording, LLC to obtain vendor lines for its store. Thecomplaint purports to be made as a class action on behalf of all current andformer retail sellers of musical instruments and/or sound equipment and/orrecording equipment with stores located in geographical regions in the UnitedStates wherein some or all of the defendants have carried on business, and seekscompensatory damages, treble damages, punitive damages, injunctive relief andattorneys fees. Service relating to the complaint was made on January 12,2006. In May of 2006, defendants filed their motions to dismiss all claimscontained in the amended complaint and currently the motion is pending beforethe court. While we believe this lawsuit is without merit and intend to defendit vigorously, it may, regardless of the outcome, result in substantialexpenses and damages to us and may significantly divert the attention of ourmanagement. There can be no assurance that we will be able to achieve afavorable settlement of this lawsuit or obtain a favorable resolution of thislawsuit if it is not settled. An unfavorable resolution of this lawsuit could havea material adverse effect on our business, financial condition and results ofoperations. Regardless of the outcome, the costs and expenses incurred by us todefend this lawsuit could adversely impact our financial condition. Due to theuncertainty of the outcome and the inability to estimate the possible loss orrange of losses, we have not accrued for any potential losses.

On December 6, 2006,a lawsuit named J. Kevin Snyder v. Guitar Center Stores, Inc. that is aputative class action was filed in Los Angeles Superior Court allegingviolations of the Song-Beverly Credit Card Act, based upon Guitar Center’sallegedly unlawful point-of-sale credit card practices.

On January 11, 2007,a lawsuit named Michael Kuhl v. Guitar Center Stores, Inc. was filed by aGuitar Center sales associate as a putative class action in the United StatesDistrict Court for the Northern District of Illinois. The lawsuit allegesviolations of the Illinois Wage Payment and Collection Act and the Fair LaborStandards Act, based upon Guitar Center’s allegedly unlawful payroll deductionpolicies. The lawsuit has been brought on behalf of plaintiff and all formerand current hourly employees in Illinois and nationwide.

We expect to defend theseactions vigorously. However, these actions, regardless of the outcome, mayresult in substantial expenses and damages to us and may significantly divertthe attention of our management. There can be no assurance that we will be ableto achieve a favorable settlement of these lawsuits or obtain a favorableresolution if they are not settled. An unfavorable resolution of these lawsuitscould have a material adverse effect on our business, financial condition andresults of operations. Regardless of the outcome, the costs and expensesincurred by us to defend them could adversely impact our financial condition.Due to the uncertainty of the outcome and the inability to estimate thepossible loss or range of losses, we have not accrued for any potential losses.

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 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2006**

**11. Legal(Continued)**

certainty,we believe that the final outcome of those matters will not have a materialadverse effect on our business, financial condition and results of operations.

**12. Subsequent Event**

On February 9, 2007,the Company acquired substantially all of the assets of the Dennis Bamber, Inc.and its chapter 11 bankruptcy estate, d/b/a The Woodwind & TheBrasswind, for approximately $29.9 million. Under the terms of theagreement, our Musician’s Friend subsidiary acquired substantially all of theassets of The Woodwind & The Brasswind, including its inventory ofband and orchestra and combo instruments, non-governmental accounts receivable,fixed assets, personal property, trade names and other intangible assets.Musician’s Friend will also assume approximately $2.0 million of specificallyidentified accrued liabilities. The transaction was funded through the Company’savailable cash and credit facility.

**13.Quarterly Financial Data (unaudited)**

| ** **                           | ** ** | **2006**                                                           | ** ** |
|--------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                           | ** ** | **First**                                                          | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **                           | ** ** | **(in thousands, except per share data)** | ** ** |
| Net sales                            |       | $                                                                  | 470,747    |   | $ | 457,978 |   | $ | 472,732 |   | $ | 628,509 |   | $ | 2,029,966 |   |
| Gross profit                         |       | $                                                                  | 136,506    |   | $ | 131,357 |   | $ | 133,267 |   | $ | 192,873 |   | $ | 594,003 |   |
| Net income (loss)                    |       | $                                                                  | 15,707     |   | $ | 13,429 |   | $ | 11,321 |   | $ | (40,033 | ) | $ | 424 |   |
| Net income (loss) per diluted  share |       | $                                                                  | 0.55       |   | $ | 0.47 |   | $ | 0.38 |   | $ | (1.36 | ) | $ | 0.01 |   |

 

| ** **                    | ** ** | **2005**                                                           | ** ** |
|-------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                    | ** ** | **First**                                                          | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **                    | ** ** | **(in thousands, except per share data)** | ** ** |
| Net sales                     |       | $                                                                  | 396,386    |   | $ | 402,296 |   | $ | 421,061 |   | $ | 562,756 |   | $ | 1,782,499 |   |
| Gross profit                  |       | $                                                                  | 111,172    |   | $ | 115,340 |   | $ | 123,818 |   | $ | 170,072 |   | $ | 520,402 |   |
| Net income                    |       | $                                                                  | 15,884     |   | $ | 12,911 |   | $ | 14,409 |   | $ | 33,474 |   | $ | 76,678 |   |
| Net income diluted  per share |       | $                                                                  | 0.56       |   | $ | 0.46 |   | $ | 0.51 |   | $ | 1.14 |   | $ | 2.67 |   |

 

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**Schedule II**

**GUITARCENTER, INC. AND SUBSIDIARIESVALUATION AND QUALIFYING ACCOUNTSYears ended December 31, 2006, 2005 and 2004(amounts in thousands)**

| ** **                       | ** ** | **Balance at** | ** ** | **Additions**       | ** ** | **Deductions** | ** ** | **Balance**      | ** ** |
|----------------------------------|------------|---------------------|------------|---------------------|------------|----------------|------------|------------------|------------|
| ** **                       | ** ** | **beginning**       | ** ** | **charged to** | ** ** | **from**       | ** ** | **at end**  | ** ** |
| ** **                       | ** ** | **of year**    | ** ** | **operations**      | ** ** | **allowance**  | ** ** | **of year** | ** ** |
| Allowance for doubtful  accounts |       |                |       |                |       |           |       |             |       |   |   |   |   |   |   |
| December 31, 2006           |       |                | $          | 2,844               |       |           |       | 3,131            |       |   |   | 3,357 |   |   | $ | 2,618 |   |
| December 31, 2005           |       |                | $          | 3,489               |       |           |       | 3,501            |       |   |   | 4,146 |   |   | $ | 2,844 |   |
| December 31,  2004          |       |                | $          | 1,708               |       |           |       | 4,126            |       |   |   | 2,345 |   |   | $ | 3,489 |   |

 

II-1

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