**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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FORM 10-K

**FORANNUAL AND TRANSITION REPORTS PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**
| **(Mark One)**                                       |
|------------------------------------------------------|
| **x**                                                | **ANNUAL REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
| **For the fiscal year ended December 31, 2004** |
| **or**                                               |
| **o**                                                | **TRANSITION REPORT  PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |

 

**For the transition periodfrom _______________ to _______________**

**Commission file number 000-22207**

**GUITAR CENTER, INC.**

(Exact name of registrantas 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’s telephone number, including areacode:  **(818)735-8800**

Securities registered pursuant to 12(b) of theAct:**None**

Securities registered pursuant to 12(g) of theAct:**Common Stock, $.01 par value**

(Title of Class)

Indicateby check mark whether the Registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x  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. o

Indicateby check mark whether the Registrant is an accelerated filer (as defined inExchange Act Rule 12b-2). Yes x  No o

Asof March 1, 2005, the aggregate market value of voting stock held bynonaffiliates of the Company was approximately $1,538,489,000 (based upon thelast business day of the Registrant’s most recently completed second fiscalquarter sales price of the Common Stock as reported by the Nasdaq NationalMarket). Shares of Common Stock held by each executive officer, director andeach person or entity known to the Registrant to be affiliates of the foregoinghave been excluded in that such persons may be deemed to be affiliates. Thisassumption regarding affiliate status is not necessarily a conclusive determinationfor other purposes.

Asof March 1, 2005, there were 25,807,410 shares of Common Stock, par value$.01 per share, outstanding.

Portionsof the Proxy Statement for the annual stockholders’ meeting scheduled to beheld on May 5, 2005 are incorporated by reference into Part III.

The Exhibit Index appears on page 48.

 

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**PART I**

**Item 1. BUSINESS**

**Company History**

Guitar Center, Inc. was founded in 1964 inHollywood, California. Our flagship Hollywood store currently is one of thenation’s largest and best-known retail stores of its kind withapproximately 30,600 square feet of retail space. The Hollywood store featuresone of the largest used and vintage guitar collections in the United States,attracting buyers and collectors from around the world. In front of theHollywood store is the Rock Walk which memorializes over 200 famous musiciansand music pioneers. The Rock Walk attracts several tour buses daily and hashelped to create international recognition of the Guitar Center name. In 1972,we opened our second store in San Francisco to capitalize on the emerging SanFrancisco rock ‘n roll scene. By this time, our inventory had been expanded toinclude drums, keyboards, accessories, live-sound/DJ and recording equipment.

Throughout the 1980s, we expanded by opening ninestores in five major markets, including Chicago, Dallas and Minneapolis. Since1990, we have continued our new store expansion and have focused on buildingthe infrastructure necessary to manage our strategically planned growth. As of December 31,2004, we operated 136 Guitar Center stores. Among the 14 new stores we openedin 2004 were 5 large format stores and 9 small format stores. Current executiveofficers and key managers have been with our company for an average of11 years, and our Chief Executive Officer, Mr. Marty Albertson andour Chairman Emeritus, Mr. Larry Thomas, effectively assumed fulloperating control in 1992. Since then, we have focused on developing andrealizing our long-term goal of expanding our position as the leadingmusic products retailer throughout the United States.

In May of 1999, we merged with Musician’s Friend, Inc.Musician’s Friend, a separate business unit of our company, operates thelargest direct response channel (catalog and e-commerce) in the musicalinstruments industry in the United States. Robert Eastman, Chief ExecutiveOfficer of Musician’s Friend, has been with the company for 21 years.

In April of 2001, we acquired the assets ofAmerican Music Group, Ltd. and related companies, a leading musical instrumentretailer specializing in the sale and rental of band instruments andaccessories. American Music operates as a retail business and serves thestudent and family market through its 19 band instrument retail stores.

On February 8, 2005, we entered into a definitiveagreement to acquire privately held Music & Arts Center, aMaryland-based musical instruments retailer, which primarily addresses thebeginning musician, with an emphasis on rentals, music lessons, and band andorchestra instrument sales. Music & Arts Center’s operations includeapproximately 60 retail locations and seven educational support centers. In thefiscal year ended January 31, 2005, Music & Arts’ sales wereapproximately $80 million. The Music & Arts stores are primarilylocated in the Northeast, Mid-Atlantic and Southern regions of the U.S. Underthe terms of the agreement, we will acquire Music & Arts Center forapproximately $90 million plus the assumption of an estimated $8 million indebt and other deferred obligations. The transaction will be funded through ouravailable cash and recently amended credit facility. The acquisition is subjectto customary terms and conditions, including the receipt of third partyconsents, and the closing is expected to occur in the second quarter of fiscal2005. We intend to combine our American Music business and Music &Arts, with the combined business operating under the Music & Artsname.

We are a Delawarecorporation with our principal executive offices located at 5795 Lindero CanyonRoad, Westlake Village, California 91362, and our telephone number is (818)735-8800. We maintain several corporate websites, includingwww.guitarcenter.com, however none of the information contained on our websitesis incorporated into this annual report. Our periodic and current reports areavailable, free of charge, on the website noted above at a reasonable timefollowing the filing with the SEC. Whenever we 

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refer tothe “Company” or to “us,” or use the terms “we” or “our” in this annual report,we are referring to Guitar Center, Inc. and its subsidiaries.

**Industry Overview**

The United States retail market for music products in2003 was estimated in a study by the National Association of Music Merchants,or NAMM, to be approximately $7.0 billion in net sales, representing afive-year compound annual growth rate of 2.1%. The broadly defined musicproducts market, according to NAMM, includes retail sales of string and frettedinstruments, sound reinforcement and recording equipment, drums, keyboards,print music, pianos, organs, and school band and orchestral instruments. Productscurrently offered by us include categories of products which account forapproximately $5.8 billion of the estimated $7.0 billion of this market’ssales, representing a five-year compound annual growth rate of 6.2%. Themusic products market, as currently defined by NAMM, however, does not includethe significant used and vintage product markets or apparel markets in which weactively participate.

Included in the $7.0 billion of estimated industrysales is the school music market estimated at $530 million in the UnitedStates. According to NAMM, despite the ongoing concerns of a national fundingcrisis in school music, all indications are that the industry’s sales woes hadlittle if anything to do with the number of children participating ininstrumental music programs. Rather, the cause seems to be a combination offalling unit prices and new competition. According to published reports,demographics in the school business remain favorable and the public’sappreciation of the value of music training continues to rise.

According to *The Music Trades*magazine,the industry is highly fragmented with the nation’s five leading  music products retailers, as measured by theamount of sales generated by such retailers (i.e., Guitar Center, Inc.,  Sam Ash Music Corp., Brook Mays Music, Victor’sHouse of Music  and Hermes), accountingfor approximately 29.1% of the industry’s estimated total sales in 2003.According to Music USA 2004, there are approximately 8,400 retailers in theindustry, and a typical music products store averages approximately 5,100square feet and generates an average of approximately $1.1 million inannual net sales. In contrast, our standard large format Guitar Center storesgenerally range in size from 12,000 to 30,000 square feet, and in 2004 thesestores generated an average of approximately $9.9 million in annual netsales for stores open the full year.

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. Mostimportantly, rapid technological advances have resulted in the continuedintroduction of higher quality products offered at lower prices, and this trendis continuing. Today, an individual consumer can affordably create a homerecording studio which interacts with personal computers and is capable ofproducing high-quality digital recordings. Until recently, this type ofpowerful sound processing capability was expensive and was typically purchasedprimarily by professional sound recording studios. This trend accelerated in2004 with the introduction of products such as Apple’s Garage Band.

**Business**

Of the 136 Guitar Center stores we operated at December 31,2004, 113 were located in 46 major U.S. markets, including, among others, areasin or near Los Angeles, San Francisco, Chicago, Miami, Houston, Dallas,Detroit, Boston, Minneapolis, Seattle, Phoenix, Atlanta, New York, Denver andCleveland, and 23 stores were located in secondary markets. We alsooperated 19 American Music stores. From 2000 to 

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2004, our net sales grewat an annual compound growth rate of 17%, principally due to comparable storesales growth averaging 7% per year, the opening of new stores, and a 22%increase in the direct response channel. We achieved comparable Guitar Centerstore sales growth of 10%, 7%, and 6% for the fiscal years ended December 31,2004, 2003 and 2002, respectively. Comparable store sales are defined as salesfor the comparable periods, excluding net sales attributable to stores not openfor 14 months as of the end of the reporting period.

For the fiscal years endedDecember 31, 2004, 2003 and 2002, we had net income of $63.4 million,$36.9 million and $25.3 million, respectively.

***Guitar Center Retail***

At our Guitar Center stores, we offer a unique retailconcept in the music products industry, combining an interactive, hands-onshopping experience with superior customer service and a broad selection ofbrand name, high-quality products at guaranteed low prices. We create anentertaining and exciting atmosphere in our stores with bold and dramaticmerchandise presentations, highlighted by bright, multi-colored lighting,high ceilings, music and videos. Based on market research conducted by us, webelieve that more than half of our Guitar Center store sales are toprofessional and aspiring musicians who generally view the purchase of musicproducts as a career necessity. These sophisticated customers rely on ourknowledgeable and highly trained salespeople to answer technical questions andto assist in product demonstrations.

Our standard large format Guitar Center storegenerally ranges in size from 12,000 to 30,000 square feet (as compared to atypical music products retail store which averages approximately 5,100 squarefeet) and is designed to encourage customers to hold and play instruments. Inlate 2000, we opened our first smaller format store, and have since opened 23additional small format stores. We plan to continue to open additional storesusing this format of approximately 8,000 to 10,000 square feet to servesecondary markets. Each large format store carries an average of 12,000 corestock keeping units, or SKUs, and each small format store carries an average of7,000 core SKUs, which in each case our management believes is significantlygreater than a typical music products retail store. Our core SKUs represent ourconsistent and established product lines which are considered staple productsfor our customers. Our stores are organized into five departments (guitars,drums, keyboards, live-sound/DJ and recording, and accessories), each focusedon one product category. These departments cater to a musician’s specific productneeds and are staffed by specialized salespeople, many of whom are practicingmusicians. We believe this retail concept differentiates us from ourcompetitors and encourages repeat business.

We opened a total of 14 Guitar Center stores in 2004,and presently expect to open approximately 22 to 26 additional Guitar Centerstores in 2005. This includes 8 to 10 large format stores and 14 to 16 smallformat stores. The small format stores are designed for secondary marketsunable to support a large format unit..

Thefollowing summarizes key operating statistics of our Guitar Center stores andis based upon the stores operated by us for the full year ended December 31:
| ** **                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
| Number of stores  operated for the full year |       | 122      |       | 108      |       |
| Average net sales  per square foot           |       | $        | 585        |     | $          | 560 |   |
| Average net sales  per store                 |       | $        | 9,184,000  |     | $          | 8,720,000 |   |
| Average store-level  operating income        |       | $        | 1,347,000  |     | $          | 1,113,000 |   |
| Average store-level  operating income margin |       | 14.7     | %          | 12.8     | %          |

 

The above key operating statistics are based uponresults of Guitar Center retail stores in operation for at least 12 months asof December 31, 2004 and 2003, respectively. Average net sales per squarefoot, 

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which increased $25 in thecurrent year, is a measure of sales efficiency based on square footage. Averagenet sales per store represents the average result of stores open more than 12months, and is typically affected by the opening of small format stores whichgenerate lower levels of sales. Although small format stores generate lower levelsof sales, these stores cost less to build, stock and operate than our largeformat stores. Store-level operating income and margin includes individualstore revenue and expenses plus allocated rebates, cash discounts andpurchasing department salaries (based upon individual store sales).

Our Guitar Center retail growth strategy is tocontinue to increase our presence in our existing markets and to open newstores in strategically selected markets. We will continue to pursue ourstrategy of clustering stores in major markets to take advantage of operatingand advertising efficiencies and to build awareness of our name in new markets.

Our distribution center inthe Indianapolis, Indiana area supports our Guitar Center retail storeoperations. We have a 10-year agreement to lease the facility and we alsohave numerous additional commitments necessary to support the operations of thefacility. Starting in 2003, nearly all products flow through the distributionfacility, with the exception of special orders which will continue, for themost part, to be drop shipped to our stores. Migration from our former “drop-ship”model to a centralized distribution model is an important development in ouroperating strategy and has required the allocation of significant financial andmanagerial resources. A portion of the costs of operating this facility areabsorbed into our Guitar Center merchandise inventories and recognized as anelement of cost of goods sold when the related inventory is sold.

***American Music Retail***

Our American Musicdivision operates family music stores, retailing band and orchestralinstruments, introductory guitars, percussion instruments and keyboards, aswell as the related accessories. This division also rents its instruments onsite and through “satellite stores” operated by third party musical instrumentdealers. The principal market for American Music is the school band market. Some of our American Music divisionstores offer band and orchestral instruments for sale and rental as well asrelated accessories and a limited assortment of guitars, amplifiers, percussioninstruments, keyboards, live-sound/DJ and recording equipment. As of December 31,2004, American Music operated 19 stores located in New York, Maine, Florida,Massachusetts, Illinois, Arizona, Nevada and Georgia. During 2002, we openedthree American Music stores, and acquired five M&M Music stores which wererebranded as American Music stores. In 2003, we opened one and closed twoAmerican Music stores. In 2004, we acquired one additional American Musicstore, Karnes Music, in the Chicago area and, following the acquisition,consolidated the operation of our Carol Stream location into the Karnes Musicsite in Itasca, resulting in the closure of the Carol Stream location. On February 8,2005, we entered into a definitive agreement to acquire privately held Music &Arts Center, a Maryland-based musical instruments retailer, which primarilyaddresses the beginning musician, with an emphasis on rentals, music lessons,and band and orchestra instrument sales. We intend to combine our AmericanMusic business and Music & Arts, with the combined business operatingunder the Music & Arts name. We continue to believe there exists anumber of additional acquisition opportunities in the relatively fragmentedband instruments market that, like Karnes Music, could be a good fit into ourAmerican Music platform and continue to pursue acquisition opportunities. Theexisting American Music retail stores range from 1,400 to 25,800 square feet,with an average store size of approximately 6,400 square feet. Music &Arts Center’s operations include approximately 60 retail locations and 7educational support centers.

***Direct Response***

Our Musician’s Friend subsidiary, which operates as aseparate business unit, is an integrated e-commerce and catalog business.Musician’s Friend offers musicians a shopping experience that satisfies theneed for technical product information, confirmation of needs by a live person,quick and efficient 

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service, and amusician-based staff for after-sale support. Our catalogs present a freshassortment of products and promotions throughout the year, mixing big nameproducts with unique and practical offerings. The Musician’s Friend website,www.musiciansfriend.com, offers all that is shown in our catalogs and more,supported by the same service and staff.

The Musician’s Friend business is based in Medford,Oregon and is supported by a customer contact center located in Salt Lake City,Utah and a distribution facility located in Kansas City, Missouri which alsohouses an outlet store for selling returns and blemished product.

Our customer contact staff receives product andcustomer service training in the Salt Lake City contact center facility. Extensiveproduct information, including technical information, product features andbenefits, and real-time stocking information is available to the staff on theirdesktop systems via intranet and back-end information systems. As of December 31,2004, we had 131 full-time associates and 93 part-time associates trained andready to respond to questions to help ensure that customers can purchaseconfidently. Website visitors are treated to a constantly updated and evolving,information rich shopping experience that includes product availability and purchaserecommendations generated through collaborative filtering processes. Questionsregarding products can be submitted electronically, or the musician can callthe support center directly. Our customer service telephone staff for returnsis located in the Kansas City distribution center where they can be closer tothe returns process while assisting customers.

Orders, whether taken electronically or by anassociate in our customer contact center, are processed by our automatedtransaction system and generally ship within 24 hours. In 2002 our Kansas Citydistribution center was expanded by 100,000 square feet to its present 241,000square feet. In 2003, initiatives were completed to improve inventorymanagement and reduce outbound shipping costs. We have implementedsophisticated inventory planning systems to help ensure that products arein-stock with the goal of maintaining a high initial line item fill rate. Theinitial line item fill rate reflects the percentage of items ordered by ourcustomers that we are able to supply in the initial shipment to that consumer.Split shipments of a single order impose additional shipping, handling andmaterials costs on us when compared to being able to fulfill an entire order ina single shipment. The technology on our website also permits our customers tomonitor their orders online by accessing the UPS and FedEx tracking services.

The focus of the Musician’s Friend business strategyis to increase market share in the non-bricks and mortar retail segment of ourindustry. Our mailing and e-mail lists give us a significant base from which togrow. Our catalog circulation, which is broader than any other direct-mailcirculation in our industry, provides a unique advertising and marketingplatform for e-commerce.

Our business plan is tocontinue to leverage our leading industry position and existing infrastructure,and to build on that base to support the continued growth in e-commerce. Webelieve that our leadership position and established direct marketing modelleverages both Internet and direct mail mechanics to provide a significantcompetitive advantage. We also believe that there may be opportunities toacquire complementary direct response businesses and regularly investigate suchopportunities.

**Business Strategy**

***Guitar Center Retail***

The goal in theretail stores business is to continue to expand our position as the leadingmusic products retailer throughout the United States. The principal elements ofour business strategy are as follows:

·       ***Store Expansion Strategy.***Ourexpansion strategy is to continue to increase our market share in existingmarkets and to penetrate strategically selected new markets. We opened a totalof 14 Guitar Center stores in each of 2004 and 2003 and 12 stores in 2002. Wecurrently anticipate 

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opening approximately 22to 26 additional Guitar Center stores in 2005. This includes 8 to 10 largeformat stores and 14 to 16 small format stores. In preparation for thisexpansion, we have dedicated a substantial amount of our resources over thepast several years to building the infrastructure necessary to support a largenational chain. In addition, we have developed and continue to refine amethodology for targeting prospective store sites which includes analyzingdemographic and psychographic characteristics of a potential store location.

·       ***Extensive Selection of Merchandise.***Weoffer an extensive selection of brand name music products complemented bylesser known, hard to find items and unique vintage equipment. The average12,000 core SKUs offered through each of our large format Guitar Center stores,and the average 7,000 core SKUs for our small format Guitar Center stores,provide a breadth and depth of in-stock items which we believe are notavailable from traditional music products retailers.

·       ***Brand Development Strategy*.**Our plan is to continue to grow our Guitar Center business while alsobuilding a retail and rental business in the student and family market usingthe  Music & Arts brand name.While the two brands have distinctly different customer bases that we intend toserve through separate retail concepts, we also believe that each retail brandwill benefit from the other.

·       ***Highly Interactive, Musician-Friendly StoreConcept.***The purchase of musical instruments is a highlypersonal decision for musicians. We therefore believe that a large part of oursuccess is attributable to our creative instrument presentations and colorful,interactive displays which encourage the customer to hold and play instrumentsas well as to participate in product demonstrations. Most stores also provideprivate sound-controlled rooms to enhance a customer’s listeningexperience while testing various instruments.

·       ***Exceptional Customer Service.***Exceptionalcustomer service is fundamental to our operating strategy. Accordingly, weconduct extensive training programs for our Guitar Center salespeople, whospecialize in one of our five product categories. Many of our salespeople arealso musicians. With the advances in technology and continuous new productintroductions in the music products industry, customers increasingly rely onqualified salespeople to offer expert advice and assist in productdemonstrations. We believe that our emphasis on training and customer servicedistinguishes us within the industry and is a critical part of our success.

·       ***Innovative Promotional and Marketing Programs.***Wesponsor innovative promotional and marketing events, which include in-storedemonstrations, famous artist appearances and weekend themed sales events,designed to create significant store traffic and exposure. In addition, ourspecial grand opening activities in new markets are designed to generateconsumer awareness for each new store. We believe these events help us to builda loyal customer base and to encourage repeat business. Since our inception, wehave compiled a unique, proprietary database containing information on morethan 10 million customers. This database enables us to advertise to selecttarget customers based on historical buying patterns. We added to our customerdatabase in early 2003 by buying the customer database of Mars Music at anauction conducted in connection with that company’s bankruptcy proceedings. Webelieve the typical music products retailer does not have the resources tosupport large-scale promotional events or an extensive advertisingprogram.

·       ***Guaranteed Low Prices.***We endeavorto be the low price leader in each of our markets, as underscored by our GuitarCenter 30-day low price guarantee. Our size permits us to take advantageof volume discounts for large orders and other vendor supported programs. Althoughprices are usually determined on a regional basis, store managers are trainedand authorized to adjust prices in response to local market conditions.

·       ***Experienced and Motivated Management Team.***Ourexecutive officers and key managers have an average of 11 years employment withGuitar Center.

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***American Music Retail***

·       ***Store Expansion Strategy.***We openeda total of eight American Music stores in 2002, five of which we obtainedthrough the acquisition of M&M Music, a family music retailer. In 2003, weopened one and closed two American Music stores. In 2004, we acquired oneadditional American Music store, Karnes Music, in the Chicago area and,following the acquisition, consolidated the operation of our Carol Streamlocation to the Karnes Music site in Itasca, resulting in the closure of theCarol Stream location. On February 8, 2005, we entered into a definitiveagreement to acquire privately held Music & Arts Center, aMaryland-based musical instruments retailer, which primarily addresses thebeginning musician, with an emphasis on rentals, music lessons, and band andorchestra instrument sales. We intend to combine our American Music businessand Music & Arts, with the combined business operating under the Music &Arts name. We continue to believe there exists additional attractiveopportunities to expand by selectively acquiring existing music productsretailers and regularly investigate acquisition opportunities. Most of theseopportunities, however, are similar to Karnes Music and involve single storesor small chains in light of the relatively fragmented nature of our industry.

·       ***Experienced and Motivated Management Team.***Ourexecutive officers and key managers have an average of 10 years employment withAmerican Music. Effective March 31, 2005, Mr. David Fleming isretiring as President of American Music Group. Upon completion of the Music &Arts transaction, it is expected that the CEO of that business will bePresident of the combined division.

***Direct Response***

The goal of the e-commerce and catalog business unitis to capitalize and expand on our leadership position. Our extensive customerdatabase is used to design effective marketing campaigns. The presentation ofan extensive selection of products and continual and informative contact withprospects and customers provides attention grabbing content designed togenerate results. In 2004 we circulated over 18 million catalogs under theMusician’s Friend, Giardinelli and LMI names and sent over 103 million e-mailsto prospects and customers. The call center fielded over 2.1 million callsduring 2004, and hosted over 64,000 live chat sessions.

Our key businessstrategies include the following:

·       ***Targeted Marketing.*** We haveexperience at targeting appropriate prospect and customer segments with theright offers. Extensive segmentation of customer lists and continual analysisby our circulation department are designed to ensure that the right mix ofcatalog and e-commerce offers are presented to each segment of customers. Ourutilization of techniques in demographic data overlay and statistical modelinghelp ensure that Musician’s Friend retains a leadership position in music geardirect marketing.

·       ***Extensive Product Selection.***Musician’sFriend stocks a broad assortment of products representing most of the premierlines; in some cases we are the exclusive direct sales dealer for themanufacturer. With some manufacturers, the Musician’s Friend business unitalone is their second largest dealer behind Guitar Center’s retail operations.A typical Musician’s Friend catalog presents 4,500 or more SKUs, selected fromthe 35,000 or more SKUs that we carry. The website presents a more completeselection of products than the catalog due to its significantly lowerpublishing cost. During 2002 we added to our selection by assuming theoperation of two small catalogs, Giardinelli and LMI, targeted to the band andeducational market previously operated by American Music.

·       ***Continual Customer Contact.***Prospectsand customers receive periodic mailings from Musician’s Friend, depending ontheir particular attributes. Musicians can “opt-in” for weekly electronicnewsletters featuring news, information and promotions. Our preferred creditcard customers (our 

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“Platinum” and “ClefMember” cards, all issued by a third party provider) receive additionalmarketing contacts via monthly statement mailings. Our musician-staffed contactcenter is available 24-hours-a-day, seven-days-a-week for questions,technical information and customer service. While browsing the website,customers are presented with customized product recommendations.

·       ***Experienced and Motivated Management Team.***Ourexecutive officers and key managers have an average of 10 years employment withMusician’s Friend.

**RetailMerchandising**

***Guitar Center Retail***

Our merchandisingconcept differentiates us from most of our competitors. Guitar Center offersmerchandise at guaranteed low prices and utilizes aggressive marketing andadvertising to attract new customers and maintain existing customer loyalty.The principal elements of our merchandising philosophy are as follows:

·       ***Extensive Selection of Merchandise at Guitar Center.***We seek to maintain a broad customer appeal by offering high-qualitymerchandise at multiple price points to serve musicians ranging from the casualhobbyist to the serious professional performer. Our Guitar Center units offerproducts in five primary categories: guitars and amplifiers, percussioninstruments, keyboards and live sound/DJ and recording equipment, used andvintage, and accessories.

·        *Guitars and Amplifiers.*We believe that our electric,acoustic, classic and bass guitar selections are among the deepest and broadestin the industry. Major manufacturers, including Fender, Gibson, Taylor, Martin,PRS, Yamaha, Ovation and Ibanez, are well represented in popular models andcolors. We believe we have one of the largest selections of custom, one-of-a-kindand used/vintage guitars of any retailer. Prices range from $99 for entry-levelguitars to over $100,000 for special vintage guitars. In addition, our line ofstringed instruments includes banjos and mandolins, among others, although notall of these products are for sale at each of our retail locations. We alsooffer an extensive selection of guitar sound processing units and products thatallow the guitar to interface with a personal computer. These products servecrossover demand from the traditional guitarist into new computer-relatedsound products.

Weoffer an extensive selection of electric, acoustic and bass guitar amplifiersand, in addition, carry a broad selection of boutique and vintage amplifierswith prices ranging from $50 to $5,000. We represent most manufacturers,including Marshall, Fender, Crate, Ampeg, Vox, S.W.R. and Mesa Boogie.

·        *Percussion Instruments.*We believe that we are the largestseller of percussion products in the United States. Our offerings range frombasic drum kits to congas and bongos and other rhythmic and electronicpercussion products with prices ranging from $10 to $10,000. We also have alarge selection of vintage and used percussion instruments. Name brands includeDrum Workshop, Remo, Sabian, Pearl, Yamaha, Tama and Zildjian. We carry anextensive selection of electronic drum kits. These digital units produce avariety of high quality life-like drum sounds and have broad appeal tomusicians.

·        *Keyboards, Live-sound/DJ and Recording Equipment.*We carry awide selection of keyboard products and computer peripheral and softwarepackages with prices ranging from $100 to $5,000. We offer an extensiveselection of software for the professional, hobbyist, studio engineer and thepost-production markets. The product line covers a broad range of manufacturersincluding Roland, Casio, Korg and Yamaha. We also maintain a broad selection ofcomputer-related recording products, including sound cards, sound libraries,and composition and recording software.

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Ourlive-sound/DJ and recording equipment category offers products ranging in pricefrom $100 to $25,000 for musicians at every level, from the casual hobbyist tothe professional recording engineer. Our products range from recordingaccessories to state-of-the-art digital recording systems. Webelieve we also carry one of the largest assortments of professional stageaudio, disc jockey and lighting equipment for small traveling bands, mobiledisc jockeys, private clubs and large touring professional bands. Our majorbrand name manufacturers include Digidesign, JBL, Sony, Mackie, Shure, Tascam,Yamaha, Roland and Apple.

·        *Used and Vintage.*We offer an extensive selection of usedmerchandise, the majority of which derives from instruments and technologyproducts traded in or sold to us by customers. Our trade-in policy providesmusicians with an alternative form of payment and the convenience of selling anold instrument and purchasing a new one at a single location. Used products arebought and priced to sell by store managers who are trained and knowledgeablein the used musical instrument market.

·        *Accessories.*Our accessory department offers a broad range of items consideredconsumables by our musician customers. These items range from guitar strings,picks, cables and straps, to performance microphones, cables and stands, tosophisticated signal processors that modify and enhance the sound of aninstrument during performance or recording.

***American Music Retail***

American Musicfocuses on the family music market, particularly band instruments.

·       ***Band and Orchestral Instrumentsand Accessories*.**Our American Music division offersband and orchestral instruments for sale and rental as well as relatedaccessories and a limited assortment of guitars, amplifiers, percussioninstruments, keyboards, live-sound/DJ and recording equipment. We offer a fullrange of brass and woodwind band instruments including trumpets, flutes,clarinets, trombones, saxophones, piccolos, French horns, flugelhorns, cornets,baritones, and related music accessories. We also offer a full range ofstringed instruments, such as violins, violas, cellos, and string basses, andrelated accessories. Name brand manufacturers include Leblanc, Jupiter,Gemeinhardt, Selmer, Buffet, Schiller, Blessing, DEG, Yamaha and Rico.

**Retail StoreOperations**

***Guitar Center Retail***

To facilitate our strategy of accelerated butcontrolled growth, we have centralized many key aspects of Guitar Center storeoperations, including the development of policies and procedures, accountingsystems, training programs, store layouts, purchasing and replenishment,advertising and pricing. Such centralization utilizes the experience andresources of our headquarters staff to establish a high level of consistencythroughout all of our stores.

Our Executive Vice President of Stores, four regionalmanagers and 17 district sales managers manage the Guitar Center retail stores.Store management is normally comprised of a store manager, a sales manager, anoperations manager, two assistant store managers and five department managers. Eachstore also has a warehouse manager and a sales staff that ranges from 20 to 40employees.

We ensure that store managers are well trained andexperienced individuals who will maintain our store concept and philosophy. Eachmanager completes an extensive training program that instills the values ofoperating as a business owner, and only experienced store employees arepromoted to the position of store manager. We seek to encourage responsivenessand entrepreneurship at each store by providing store managers with arelatively high degree of autonomy relating to operations, personnel and 

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merchandising. Managersplay an integral role in the presentation of merchandise, as well as thepromotion of our reputation.

We view our employees aslong-term members of our team. We encourage employee development byproviding the sales force with extensive training and the opportunity toincrease both compensation and responsibility level through increased productknowledge and performance. Our aggressive growth strategy provides employeeswith the ability to move into operations, sales and store management positions,an opportunity which our management believes is not available at most othermusic retailers. As we open new stores, the qualified and experienced employeesfrom existing stores primarily fill key in-store management positions. Byadopting a “promotion from within” strategy, we maintain a well-trained, loyaland enthusiastic sales force that is motivated by our strong opportunities foradvancement. Marty Albertson, our Chief Executive Officer, Mark Galster, ourExecutive Vice President of Stores and our four regional managers began theircareers as a salespersons at Guitar Center.

***American Music Retail***

Retail store operationsfor American Music are led by the Vice President of Retail and the educationalsales are led by the Vice President of Education. Store management is comprisedof a store manager, assistant store manager, educational representative andrelated sales and support staff.

**Marketing andPromotion**

We maintain three uniqueand proprietary databases (Guitar Center, Musician’s Friend and American Music)containing information on over 10 million customers. We believe that thesedatabases assist in identifying customer prospects and in generating repeatbusiness by targeting consumers based on their purchasing history and bypermitting us to establish and maintain personal relationships with ourcustomers.

***Guitar Center Retail***

For the Guitar Center retail stores, our advertisingand promotion strategy is designed to enhance the Guitar Center name andincrease consumer awareness and loyalty. The advertising and promotionalcampaigns 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. We believe that our special events have a broad reach asmany of them have occurred annually during the past 22 years. These events areoften coordinated with product demonstrations, interactive displays, clinicsand in-store artist appearances. Cooperative advertising and in-storetraining from our major vendors ensures that our customers are kept currentwith trends presented by the latest music gear.

As we enter new markets, we initiate an advertisingprogram, including mail and radio promotions, television and Internetcampaigns, and other special grand opening activities, designed to acceleratesales volume for each new store. Radio advertising plays a significant part inour store-opening campaign to generate excitement and create customerawareness.

Generally, all credit madeavailable 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.

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***American Music Retail***

For the American Musicretail stores, our advertising efforts are focused primarily on the school bandmarket and community. For instrument rental the advertising and promotionalcampaigns are developed around “rental nights” designed to display our orchestraland band instruments at elementary and high schools. These events attract banddirectors, music educators, parents and students. Our key promotional eventsare held primarily from August through October. In addition to “rentalnights,” we also have education representatives that travel around the countryto promote and educate band directors on our instruments and our sales andrental programs. We maintain long-term relationships with educators in order toprovide visibility to our products and obtain access to student musicians. OurAmerican Music stores also rent instruments over the counter.

***Direct Response***

Our direct response division maintains a stream ofcommunication in electronic and print media, presenting consumers with anoptimized and refreshed mix of offers. Extensive analysis of customer behaviorand transactions along with the industry expertise of our merchandising staffprovides our marketing staff with offers carefully targeted for optimalresponse. Key industry suppliers provide on-going training and advertising toensure our customers are kept current with trends and the latest music gear.

The same transactional databases that make accuratemarket targeting available for catalog and e-mail circulation areenhanced by the information archived from our website traffic. With the use ofan analytical engine developed by Net Perceptions, and continued development ofadditional tools, our merchandising and marketing departments are able topresent relevant and personalized product and promotional offerings toprospects.

Musician’s Friend also offers its customers privatelabel credit card programs on non-recourse terms comparable to those offered byGuitar Center. These programs include the Platinum Card offered by Musician’sFriend and the Clef Card offered for customers of the Giardinelli bandinstruments catalog. These credit cards permit us to offer carefully tailoredcompetitive promotional opportunities to our customers.

Our plans for Musician’s Friend include thedevelopment of catalogs targeted towards particular segments of the musicianmarket. In 2002, Musician’s Friend took over production of two small catalogsfrom the American Music division. The LMI Catalog is oriented toward young,school-aged children and the Giardinelli Catalog is targeted to band andorchestra buyers. We target specific customers with keyboard, percussion and DJspecialty catalogs.

We believe that there maybe opportunities to acquire complementary direct response businesses and arealso examining opportunities to use the Internet to expand further the reach ofour brands. For example, in early 2003 we purchased the principal assets ofMarsmusic.com, including the URL address and hardware. New opportunities arebeing created by the rapid development of auction, content and community sitesoriented towards music and musicians.

**Customer Service**

***Guitar Center Retail***

Exceptional customer service is fundamental to ouroperating strategy. With the rapid changes in technology and continuous newproduct introductions, customers depend on salespeople to offer expert adviceand to assist with product demonstrations. We believe that our well-trained andknowledgeable sales force differentiates us from our competitors and iscritical to maintaining customer confidence and loyalty. Our employees aretypically musicians trained to understand the needs of our customers. GuitarCenter store salespeople specialize in one of our six product categories andbegin training on their first day 

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of employment. GuitarCenter store sales and management training programs are implemented on anongoing basis to maintain and continually improve the level of customer serviceand sales support in the stores. We believe that our employee testing programimpresses upon our salespeople a sense of professionalism and reduces employeeturnover by providing salespeople with the opportunity to increase theirsalaries by advancing through the certification program. We believe that due toour emphasis on training, we are able to attract and retain well-qualified,highly motivated salespeople committed to providing superior customer service.

Our Guitar Center storecustomer base consists of the professional or aspiring musician who makes orhopes to make a living through music and the amateur musician or hobbyist whoviews music as recreation. Our management estimates that professional andaspiring musicians, who generally view the purchase of musical products as acareer necessity, represent approximately half of our customer base, andaccount for more than half of our sales. These customers make frequent visitsto a store and develop relationships with the sales force. We generate repeatbusiness and are successful in utilizing our unique and proprietary database tomarket selectively to these customers based on past buying patterns. Inaddition, we service touring professionals, providing customized products formusical artists.

***American Music Retail***

The majority of oureducational representative sales force at American Music is composed of musicteachers who are experienced band instructors. We also have added a limitedretail sales force. The customer base of American Music has historicallyconsisted of band directors, music educators, college professors who areinvolved in music education and students of music education programs.

***Direct Response***

As of December 31, 2004, Musician’s Friend had a staffof 131 full-time and 93 part-time contact center customer service associates,staffing the contact center 24-hours-a-day, seven-days-a-week. Customerscan contact agents via phone, e-mail, live chat or fax for questions regardingproducts, technical information or the status of their orders. Most of thestaff is comprised of musicians who are given extensive and ongoing producttraining. The Salt Lake City contact center houses an extensive productdemonstration area and training facility. In-house technical staff as well asmanufacturers’ representatives conduct regular product training.

We maintain a database of product information for useby the agents in our contact center that is always available on our corporateintranet. The intranet also makes operational and instructional informationavailable to agents, minimizing their downtime and maximizing their ability toservice customer needs effectively. All of this information, along withcustomer account information, is available in real time, giving agents theability to keep customers constantly up to date.

The website is updated every 15 minutes with newproduct information so customers can work with the latest available data. Asthis is an area that is constantly evolving, customers are continuallypresented with new and more extensive information. In addition, thecollaborative filtering process results in customized product recommendation tocustomers browsing the website. The website is continuously improved forcustomer ease and, in 2004, the Musician’s Friend web site received thePlatinum Award from BizRate for customer service.

To provide the customer with a high degree ofsatisfaction, customers may return items for a full refund within 45 days ofpurchase. Additionally, if customers find a lower advertised price within 45days of purchase, we will match the competitor’s advertised price.

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For customers that haveregistered e-mail addresses with us, we offer automated order and shipmentverification. This provides customers with UPS or FedEx order trackinginformation as soon as their shipment has been processed.

**Direct ResponseOrder Fulfillment**

Musician’s Friend orders are fulfilled out of thecompany-operated distribution center located in Kansas City, Missouri, whichbecame fully operational in 2001. In 2002, we expanded the facility to 241,000square feet.

Credit card authorization and fraud management systemsare automated, minimizing delays in processing. The distribution centerprocesses orders taken before 5 p.m., Eastern Time, for same-day shippingof in-stock items, minimizing delays in delivery to customers. Orders shipprimarily by UPS and FedEx.

All returns are routed tothe Kansas City distribution center where repairs and quality evaluations aremade. On site repair and customer service representatives assist our customersand reduce the costs associated with returns. Returned and blemished productsare sold through an outlet store located in the Kansas City facility and byoffering such products at reduced prices on the musiciansfriend.com website.

**Purchasing,Distribution and Inventory Control**

***Purchasing.  ***Webelieve that we have excellent relationships with our vendors and, in manyinstances, are the vendor’s largest customer. Given our high volume, we aregenerally able to receive prompt order fulfillment and access to our vendors’premium products. Both Guitar Center and Musician’s Friend maintain centralizedbuying groups. Our centralized buyers include merchandise managers, buyers,planners, forecasters, replenishers and allocators. Merchandise managers andbuyers are responsible for the selection and development of product assortmentsand the negotiation of prices and terms. The planners, forecasters,replenishers and allocators are responsible for maintaining inventory levelsand allocating the merchandise to the retail distribution center, stores and directresponse fulfillment center. We use merchandise replenishment systems whichautomatically analyze and forecast sales trends for each stock keeping unit, orSKU, using various statistical models, supporting the buyers by predictingmerchandise requirements. This has resulted in limited “out of stock” positionswhile maintaining satisfactory inventory levels.

Our business and expansion plans are dependent to asignificant degree upon our vendors. As we believe is customary in theindustry, we do not have any long-term supply contracts with our vendors.Please see “—Risks Related to the Business—We depend on a relatively smallnumber of manufacturers, suppliers and common carriers who may not be able toor desire to supply our requirements.”

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***Distribution.  ***Ourdistribution center in the Indianapolis, Indiana area supports our GuitarCenter retail store operations. The facility commenced operations in July 2002.We have a 10-year agreement to lease the facility. Commencing in 2003, nearlyall products flowed through the distribution facility, with the exception ofspecial orders which will continue, for the most part, to be drop-shipped toour stores. Migration from our former “drop-ship” model to a centralizeddistribution model is an important development in our operating strategy andhas required the allocation of significant financial and managerial resources. Inaccordance with generally accepted accounting principles, a portion of thecosts of operating this facility are absorbed into our Guitar Centermerchandise inventories and recognized as an element of cost of goods sold whenthe related inventory is sold.

We also continue to makesignificant investments in information technology across our businesses and toincur costs and make investments designed to expand the reach of our businesseson the Internet. The costs of these initiatives and other investments relatedto our businesses will continue to be significant.

***Inventory Control.  ***Wehave invested significant time and resources in our inventory control system atthe Guitar Center retail stores and believe we have one of the mostsophisticated systems in the music products retail industry. We believe thevast majority of music product retailers do not use a computerized inventorymanagement system. 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 at Guitar Center andMusician’s Friend, which we attribute to our sophisticated system controls andstrong corporate culture.

**Retail Store Site Selection**

We believe we havedeveloped unique and, what historically have been, highly effective selectioncriteria to identify prospective store sites for our Guitar Center units. Inevaluating the suitability of a particular location, we concentrate on thedemographics of our target customer as well as traffic patterns and specificsite characteristics such as visibility, accessibility, traffic volume,shopping patterns and availability of adequate parking. Stores are typicallylocated in free-standing locations to maximize their outside exposure andsignage.

**Management Information Systems**

***Guitar CenterRetail***

We have investedsignificant resources in management information systems that provide real-timeinformation for the Guitar Center division. The systems have been designed tointegrate all major aspects of our business, including sales, gross margins,inventory levels, purchase order management, automated replenishment andmerchandise planning. Our sophisticated management information systems provideus with the ability to monitor all critical aspects of activity on a real-timebasis. Our system capabilities include inter-store transactions, vendoranalysis, serial number tracking, inventory analysis and commission sales reporting.We believe that the system we have developed will enable us to continue toimprove customer service and operational efficiency and support our needs forthe immediately foreseeable future.

***American MusicRetail***

We continue to investsignificant resources in the development and implementation of the basicinformation systems for American Music. The systems have been designed tooperate and control fundamental business processes, including sales, rentals,store operations, inventory levels, purchase order management, and finance.

***Direct Response***

Musician’s Friendmaintains an extensive transaction processing system as well as systemssupporting e-commerce, operations and marketing analysis, and internal supportinformation. All transaction and 

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inventoryinformation is available real-time. The e-commerce website is updated duringthe day through a firewall, providing a high degree of security for ourinternal systems. Our direct response business does not have redundant Internetor operating systems and would be vulnerable to catastrophic events. In theevent of a disaster, our direct response business would most likely experiencedelays in processing and shipping orders until we executed our failure recoveryplans. Dedicated systems are used for inventory planning and for websiteanalysis. In 2003, initiatives were completed to improve inventory managementand reduce outbound shipping costs. Many of the systems which run ourdistribution center operations function via wireless technology.

The systems providemanagement with extensive marketing, merchandising and operational information,and provide call center and customer service staff with current inventory andcustomer account information. The choice of platforms and databases provides uswith a strong foundation for ongoing development of systems.

**Competition**

We are in directcompetition with Sam Ash Music based in New York, New York, a major multi-unitretail chain in the music products industry. In addition, we compete withvarious direct response companies such as American Music Supply (unrelated toour American Music division), Sam Ash Music, and Sweetwater Sound. As of December 31,2004, we were in direct competition with Sam Ash in 38 of our markets. Inrecent years, Sam Ash has continued to open new or acquired stores. One of ourprimary competitors, Mars Music, Inc., filed for federal bankruptcy courtprotection on September 27, 2002, and completed a liquidation resulting inthe closure of all of its stores. Of the Mars Music stores closed, Sam Ashacquired four of the locations from the bankruptcy court. The competitivelandscape remains dynamic and we cannot predict what level of national andlocal competition our retail store and direct response businesses will face inthe future. Nonetheless, we continue to believe that there is room for furtherconsolidation within the music products retailing industry as the top tworetailers, per *The Music Trades* magazine (GuitarCenter and Sam Ash), only accounted for an estimated 24.0% of the market in2003.

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. Customer satisfaction is paramount to ouroperating strategy and we believe that providing knowledgeable and friendlycustomer service gives us a competitive advantage. The store environment isdesigned to be an entertaining and exciting environment in which to shop. In aneffort to exceed customer expectations, our stores provide a number of servicesnot generally offered by most competitors, including the ability to hold anduse merchandise, product demonstrations and extensive product selection. Salespeopleare highly trained and specialize in one of our five product areas. Salespeopleare certified by an internal training team, based on extensive training andproduct knowledge testing. We believe that this certification process hasincreased the professionalism of our employees while reducing turnover.Customers are encouraged to help themselves to the displayed instruments and toseek the assistance of the professional salespeople.

Various factors, however,could materially and adversely affect our ability to compete successfully inour markets, including, among others, the expansion by us into new markets inwhich our competitors are already established, competitors’ expansion intomarkets in which we are currently operating, the adoption by competitors ofinnovative store formats and retail sales methods or the entry into our marketsby competitors with substantial financial or other resources. See “—RisksRelated to the Business—We may be unable to meet our Guitar Center and AmericanMusic retail growth strategy, which could adversely affect our results ofoperations” and “—We face significant competition, and our efforts to increaseour market share may be inhibited by existing or new competitors also trying toexecute national expansion strategies.”

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**Employees**

As of December 31,2004, we employed 6,434 people, of whom 5,442 were hourly employees and 992were salaried. None of our employees are covered by a collective bargainingagreement. We believe that we enjoy good employee relations.

**Brand Names and Service Marks**

We operate our retailstores under the “Guitar Center” and “American Music” brands and our directresponse business under the “Musician’s Friend” brand.

We have registered theGUITAR CENTER, ROCK WALK, MUSICIAN’S FRIEND, ROGUE, AXMAN, PULSE PERCUSSION,RAM, MITCHELL GUITARS, THE MUSICIAN’S CHOICE, AMERICAN MUSIC, DIGITAL REFERENCEand MUSICIAN’S FRIEND.COM, FRETREST, GUITAR CENTER’S DRUMOFF, GUITAR CENTER’SSPINOFF, LIVEWIRE AND PROLINE service marks with the United States Patent andTrademark Office. We believe that these service marks have become importantcomponents of our merchandising and marketing strategy. The loss of the GUITARCENTER, MUSICIAN’S FRIEND or AMERICAN MUSIC service mark would likely have amaterial adverse effect on our business.

**Risks Related to the Business**

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 communityexpects.

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

Our retail store growthstrategy includes opening new stores in new and existing markets and increasingsales at existing locations. As of December 31, 2004, we operated 136Guitar Center stores and 19 American Music stores. We opened a total of 14Guitar Center stores in 2004, and currently expect to open approximately 22 to26 additional Guitar Center stores in 2005. This includes 8 to 10 large formatstores and 14 to 16 small format stores. Our planned store opening schedule maybe affected by any acquisitions we may transact during a given period. If wecomplete any such transactions, our planned organic store openings may bereduced.

We opened a total of eightAmerican Music stores in 2002, five of which were acquired in connection withAmerican Music’s acquisition of M&M Music, a band instrument retailer. In2003, we opened one American Music store and closed two. In 2004, we acquiredone additional American Music store in the Chicago area and, following theacquisition, moved the operation of our Carol Stream location to the KarnesMusic site in Itasca, resulting in the closure of the Carol Stream location. Webelieve there exists a number of acquisition opportunities, like Karnes Music,in the relatively fragmented band instruments market that could be a good fitinto our American Music platform. On February 8, 2005, we entered into adefinitive agreement to acquire privately held Music & Arts Center, aMaryland-based musical instruments retailer, which primarily addresses thebeginning musician, with an emphasis on rentals, music lessons, and band andorchestra instrument sales. We intend to combine our American Music businessand Music & Arts, with the combined business operating under the Music &Arts name. The American Music division incurred significant operating losses in2003 and 2004, and absent the scale to be provided by the Music & Artstransaction, would likely incur operating losses in 2005.

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Thesuccess of our retail store expansion plans depend 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

·       successfulcompletion of our management information system and infrastructure build-out atAmerican Music and integration of the Music & Arts 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 American Music stores at the rates currently anticipated. If we areunable to achieve our retail store expansion goals, or the new stores underperform our expectations, our results of operations could be adverselyaffected.

*Weface unique competitive and merchandising challenges in connection with ourplans to open additional Guitar Center and American Music retail stores in newmarkets.*

Aspart of our retail growth strategy, we plan to open and/or acquire additionalGuitar Center and American Music 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

·       ourexpansion may involve acquisitions, including acquisitions in business segmentsin 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 stores profitably,our results of operations would be adversely affected.

*OurGuitar Center retail store expansion strategy, including our strategy ofclustering retail stores, may adversely impact our comparable 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 periods, excluding net sales attributable tostores not open for 14 months, was as follows for our Guitar Center retailstores:
| ** ** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| Quarter 1  |       |     | 11         | %        |       |     | 4          | % |   |   | 5 | % |   |
| Quarter 2  |       |     | 8          | %        |       |     | 5          | % |   |   | 8 | % |   |
| Quarter 3  |       |     | 9          | %        |       |     | 7          | % |   |   | 6 | % |   |
| Quarter 4  |       |     | 10         | %        |       |     | 10         | % |   |   | 7 | % |   |
| Full Year  |       |     | 10         | %        |       |     | 7          | % |   |   | 6 | % |   |

 

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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.

Our management ispresently anticipating comparable store sales growth of 4% to 6% for the firstquarter of 2005. A shortfall in comparative sales growth in any period willlikely cause a shortfall in earnings, and result in financial performance belowthat for which we have planned or the investment community expects.

*Our growth plansdepend on our completion of acquisitions, and these transactions involvespecial risks.*

We believe that ourexpansion may be accelerated by the acquisition of existing music productretailers. For example, in April 2001 we acquired the business of AmericanMusic Group, a New York-based retailer of band instruments, a business in whichwe were not previously engaged, and in July 2004 we acquired the assets ofthe band and orchestra instrument business of Karnes Music located in theChicago area. On February 8, 2005, we entered into a definitive agreementto acquire privately held Music & Arts Center, a Maryland-basedmusical instruments retailer, which primarily addresses the beginning musician,with an emphasis on rentals, music lessons, and band and orchestra instrumentsales. We intend to combine our American Music business and Music &Arts, with the combined business operating under the Music & Artsname. We regularly investigate acquisition opportunities complementary to ourGuitar Center, Musician’s Friend and American Music businesses. Accordingly, inthe ordinary course of our business, we regularly consider, evaluate and enterinto negotiations related to potential acquisition opportunities. We may payfor these acquisitions in cash or securities, including equity securities, or acombination of both. We cannot assure you that attractive acquisition targetswill be available at reasonable prices or that we will be successful in anysuch transaction. Acquisitions involve a number of special risks, including:

·       diversionof our management’s attention;

·       integrationof the acquired business with our business; and

·       unanticipatedlegal liabilities and other circumstances or events.

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*We depend on a relatively small number ofmanufacturers, suppliers and common carriers who may not be able or desire tosupply our requirements.*

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

*We face products liability risk.*

Products that we developor sell may expose us to liability from claims by users of such products fordamages including, but not limited to, bodily injury or property damage. Thisrisk is expected to increase as we use the capabilities of our Guitar Centerand Musician’s Friend distribution centers to increase the private label andother proprietary product that we offer. Much of this product is manufacturedby small companies located overseas. We currently maintain products liabilityinsurance coverage in amounts that we believe are adequate. However, there canbe no assurance that we will be able to maintain such coverage or obtainadditional coverage on acceptable terms in the future, or that such insurancewill provide adequate coverage against all potential claims.

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

The retail music products industry is fragmented andhighly competitive. We compete with many different types of music productretailers, including conventional retailers, as well as other catalog ande-commerce retailers, who sell many or most of the items we sell. We believethat large format music product retailers such as our company will seek toexpand in part through the acquisition of small, independently owned stores orfranchises, and we anticipate increased competition in our existing markets andplanned new markets from these consolidating retailers. These retailers mayidentify target companies or execute their acquisition strategies moreeffectively than our company. In addition, these retailers may have greaterfinancial resources or other competitive advantages as compared to our company.Our expansion to new 

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markets will be inhibitedby these and other established competitors. In addition, one or more of ourcompetitors may adopt a new, innovative store format or retail selling method.If we are not able to compete effectively, we may fail to achieve marketposition gains or may lose market share.

Recently, several largemass merchants, including Wal-Mart and Costco, have begun to sell musicalinstruments in categories that we compete in, including entry-level guitars,electronic keyboards and band instruments, and thus could represent asignificant source of future competition for our retail and direct responsebusinesses, particularly if these retailers expand their product lines beyondentry-level merchandise.

*We must grow our American Music business in order toreach profitability and earn an acceptable return on that investment.*

In April 2001, wecompleted our acquisition of American Music Group, a New York-based retailer ofband instruments. We had not previously participated in the band instrumentssegment of the music products business and had no prior experience in thisdistribution channel. We intend to use the acquired American Music business asa platform to develop and grow a family music store concept that will emphasizeband instruments and also sell selected “combo” products sold by our GuitarCenter stores, such as guitars, drums and the like. Thus, we face the normalchallenges of any acquisition, such as integration of personnel and systems aswell as the need to learn, understand and further develop this business. During2005 we will face further significant challenges as we attempt to close ourpending acquisition of Music & Arts and combine that business with ourexisting American Music business. The American Music division incurredsignificant operating losses in 2003 and 2004. Failure to execute on therequirements and initiatives described above could result in a poor or noreturn on our investment, constitute a distraction of the efforts of ourmanagement team from the core Guitar Center and Musician’s Friend brands andpotentially require us to recognize an impairment in the significant amount ofgoodwill recorded in the acquisitions of American Music, M&M Music andKarnes Music, which totaled $21.0 million at December 31, 2004. Inaddition, we will recognize a material increase in this goodwill amount uponthe acquisition of Music & Arts.

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

Historically,we have promoted employees from within our organization to fill senior operations,sales and store management positions. In order to achieve our growth plans, wewill depend upon our ability to retain and promote existing personnel to seniormanagement, and we must attract and retain new personnel with the skills andexpertise to manage our business. If we cannot hire, retain and promotequalified personnel, our business, results of operations, financial conditionand prospects could be adversely affected.

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

Our distribution center inthe Indianapolis, Indiana area supports our Guitar Center retail storeoperations. The conveyor systems, the warehouse management system, and allother technology systems and infrastructure commenced operations in July 2002.Migration from our former “drop-ship” model to a centralized distribution modelis an important development in our operating strategy. The efficient operationof the distribution center is also dependent upon the performance of thirdparties that we do not control, such as vendors who must comply with newoperating procedures and common carriers who must deliver product on time. Thisprogram involves financial and operating risks that could include the need toexpend greater funds than presently budgeted or disruptions in retail storeoperations and the loss of sales if inventory is not timely provided in therequired quantities. Further, one of the key underlying economic 

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assumptionsof our distribution center project is that this program will permit us toreduce overall inventory levels as a percentage of sales thereby resulting insignificantly reduced working capital requirements. Any failure to reach ourinventory reduction targets will adversely affect our future financialperformance and capital needs, potentially in a material manner. Failure toexecute on these requirements could result in a poor or no return on ourinvestment, disruption of our retail store business and a distraction of theefforts of our management team.

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

As of December 31,2004, our corporate headquarters as well as 23 of our 136 Guitar Center storeswere located in California, and stores located in that state generated 24.3%and 25.8% of our retail sales for 2004 and 2003, respectively. Although we haveopened and acquired stores in other areas of the United States, a significantpercentage of our net sales and results of operations will likely remainconcentrated in California for the foreseeable future. As a result, our resultsof operations and financial condition are heavily dependent upon generalconsumer trends and other general economic conditions in California and aresubject to other regional risks, including earthquakes. We do maintainearthquake insurance, but such policies carry significant deductibles and otherrestrictions.

*Economic conditions or changing consumer preferencescould also adversely impact us.*

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

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

Theadoption or modification of laws or regulations, or revised interpretations ofexisting laws, relating to the direct response industry could adversely affectthe manner in which we currently conduct our catalog and e-commerce businessand the results of operations of that unit. For example, laws and enforcementpractices related to the taxation of catalog, telephone and online commercialactivity, including 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 risks created by litigation, governmentalproceedings, labor disputes or environmental matters.*

We are involved in anumber of litigation matters in the ordinary course of our business. Amongthese cases are two putative class actions brought against us for allegedviolations of what is known as California’s “wage and hour” law. The plaintiffshave alleged, among other things, that we improperly failed to document andenforce break-time and lunch-time periods for employees. We intend to defend 

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thesematters vigorously. Current and future litigation that our Company is involvedin may result in substantial costs and expenses and significantly divert theattention of our management regardless of the outcome. In addition, current andfuture litigation, governmental proceedings, labor disputes or environmentalmatters could lead to increased costs or interruptions of our normal businessoperations.

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

Our direct responsebusiness, particularly our e-commerce business, will require 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 experienced some delays of this sort in 2001 in connection with theconsolidation of our fulfillment centers. As a result, we could incur excessiveshipping costs due to the need to split delayed shipments, increased marketingcosts in the form of special offers to affected customers or the loss ofcustomers altogether. We may experience difficulty in improving and maintainingsuch systems if our employees or contractors that develop or maintain our keysystems become unavailable to us. We have experienced periodic servicedisruptions and interruptions, which we believe will continue to occur, whileenhancing and expanding these systems.

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

Our relationships with oure-commerce customers may be adversely affected if the security measures that weuse to protect their personal information, such as credit card numbers, areineffective. If, as a result, we lose customers, our net sales could decrease.We rely on security and authentication technology that we license from thirdparties. With this technology, we perform real-time credit card authorizationand verification with our bank. We cannot predict whether events ordevelopments will result in a compromise or breach of the technology we use toprotect a customer’s personal information. Furthermore, our servers may bevulnerable 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. We cannot assure that we can prevent all security breaches.

*If we do not respond to rapid technological changes,our services could become obsolete and we could lose customers.*

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 store. The Internet and the onlinecommerce industry are rapidly changing. If competitors introduce new productsand services embodying new technologies, or if new industry standards andpractices emerge, our existing website and proprietary technology and systemsmay become obsolete. To develop our website and other proprietary technologyentails significant technical and business risks. We may use new technologiesineffectively or we may fail to adapt our website, our transaction processingsystems and our computer network to meet customer requirements or emergingindustry standards. In addition, the success of e-commerce may result ingreater efficiency and lower prices, which could have an adverse effect onselling prices and margins in our retail store business and in our catalogbusiness and generally constrain profitability in the specialty retail business.

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*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 ourcomputer hardware and software systems for the efficient operation of ourretail stores and direct response business. Our information systems provide ourmanagement with real-time inventory, sales and cost information that isessential to the operation of our business. Due to our number of stores,geographic diversity and other factors, we would be unable to generate thisinformation in a timely and accurate manner in the event our hardware orsoftware systems were unavailable. These systems are vulnerable to damage orinterruption from a number of factors, including:

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

·       powerloss, computer systems failure, Internet and telecommunications or data networkfailure.

A significant information systems failure could reducethe quality or quantity of operating data available to our management. If thisinformation were unavailable for any extended period of time, our managementwould be unable to efficiently run our business, which would result in areduction in our net sales.

To attempt to mitigatethese risks we have contracted services from third parties to provide backupsystems for our Guitar Center retail stores in the event of a disaster. Theseservices are designed to permit our “mission critical” systems to be onlinewithin 48 hours following most disasters. Our direct response business does nothave redundant Internet or operating systems and would be vulnerable tocatastrophic events. In the event of a disaster, our direct response businesswould most likely experience delays in processing and shipping orders.

*Our stock price could be volatile.*

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

*Our actual operating results may differ significantlyfrom 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 are forwardlooking-statements, are prepared by our management and are qualified by, andsubject to, the assumptions and the other information contained or referred toin the release. Our projections are not prepared with a view toward compliancewith published guidelines of the American Institute of Certified PublicAccountants, and neither our independent 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 

24

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reason that we releasethis data is to provide a basis for our management to discuss our businessoutlook with analysts and investors. We do not accept any responsibility forany projections or reports published 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 2. PROPERTIES**

We lease our corporate offices of approximately 69,600square feet, which are located at 5795 Lindero Canyon Road, Westlake Village,California 91362. We also lease an adjoining office space of approximately7,500 square feet at 5785 Lindero Canyon Road, Westlake Village, California91362. These leases expire in April 2009. Our direct response business isheadquartered in a facility we own located at 931 Chevy Way, Medford, Oregon97504 and the American Music division is headquartered in a facility we leaselocated at 7845 Maltage Drive, Liverpool, New York 13090. The lease expires on June 30,2005.

We lease approximately 25,500 square feet of officespace in Salt Lake City, Utah, for our direct response customer contact centerfacility. This lease expires in December 2008. We lease approximately241,000 square feet for use as a central distribution center for our direct responsedivision, in Kansas City, Missouri. This lease expires in June 2007. Welease approximately 505,000 square feet of warehouse space near Indianapolis,Indiana for use as our Guitar Center retail distribution center. This leaseexpires in June 2012.

In connection with ourretail business, as of December 31, 2004, we leased approximately2,087,000 square feet for our 136 Guitar Center stores and approximately154,100 square feet for our 19 American Music stores. Our retail stores’initial lease terms range from 10-15 years and typically allow us to renew fortwo additional five-year terms. Most of the leases require us to pay propertytax, utilities, normal repairs, common area maintenance and insurance expenses.

**Store Locations**

The table below sets forth information concerning ourGuitar Center and American Music retail stores as of December 31, 2004:

| **Store**                | ** ** | ** ** | ** ** | **Year   Opened** | ** ** | **Gross   Square   Feet** | ** ** | **Status** | ** ** |
|--------------------------|------------|------------|------------|-------------------|------------|---------------------------|------------|------------|------------|
| **Guitar Center Stores** |       |       |       |              |       |                      |       |       |       |
| *Alabama*                |       |       |       |              |       |                      |       |       |       |
| Mobile                   |       |       | 2004       |              |       | 11,100                    |       | Lease      |       |
| Birmingham (1)           |       |       | 2005       |              |       | 15,900                    |       | Lease      |       |
| *Arizona*                |       |       |       |              |       |                      |       |       |       |
| Phoenix                  |       |       | 1997       |              |       | 13,600                    |       | Lease      |       |
| Tempe                    |       |       | 1997       |              |       | 12,100                    |       | Lease      |       |
| Tucson                   |       |       | 2001       |              |       | 15,000                    |       | Lease      |       |
| Scottsdale               |       |       | 2003       |              |       | 17,500                    |       | Lease      |       |
| *Arkansas*               |       |       |       |              |       |                      |       |       |       |
| Little Rock              |       |       | 2002       |              |       | 8,700                     |       | Lease      |       |
| *Southern California*    |       |       |       |              |       |                      |       |       |       |
| Hollywood                |       |       | 1964       |              |       | 30,600                    |       | Own        |       |
| San Diego                |       |       | 1973       |              |       | 15,100                    |       | Lease      |       |
| Fountain Valley          |       |       | 1980       |              |       | 16,800                    |       | Lease      |       |
| Sherman Oaks             |       |       | 1982       |              |       | 18,700                    |       | Lease      |       |

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| Covina                 |   |   | 1985   |   |   | 15,400 |   | Lease  |   |
|------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Southbay               |   |   | 1985   |   |   | 14,500 |   | Lease  |   |
| San Bernardino         |   |   | 1993   |   |   | 15,000 |   | Lease  |   |
| Brea                   |   |   | 1995   |   |   | 14,900 |   | Lease  |   |
| San Marcos             |   |   | 1996   |   |   | 14,700 |   | Lease  |   |
| Rancho Cucamonga  |   |   | 1999   |   |   | 15,000 |   | Lease  |   |
| El Toro                |   |   | 1999   |   |   | 16,300 |   | Lease  |   |
| Oxnard                 |   |   | 2000   |   |   | 14,000 |   | Lease  |   |
| Bakersfield            |   |   | 2000   |   |   | 8,000  |   | Lease  |   |
| Palmdale               |   |   | 2001   |   |   | 12,000 |   | Lease  |   |
| Pasadena               |   |   | 2002   |   |   | 19,400 |   | Lease  |   |
| Cerritos               |   |   | 2003   |   |   | 15,300 |   | Lease  |   |
| Northridge (1)         |   |   | 2005   |   |   | 15,100 |   | Lease  |   |
| *Northern California*  |   |   |   |   |   |   |   |   |   |
| San Francisco (2)      |   |   | 1972   |   |   | 30,400 |   | Lease  |   |
| San Jose               |   |   | 1978   |   |   | 14,200 |   | Own    |   |
| El Cerrito (3)         |   |   | 1983   |   |   | 11,300 |   | Lease  |   |
| Concord                |   |   | 1996   |   |   | 15,800 |   | Lease  |   |
| Fresno                 |   |   | 2000   |   |   | 15,500 |   | Lease  |   |
| Sacramento             |   |   | 2000   |   |   | 15,800 |   | Lease  |   |
| Modesto                |   |   | 2001   |   |   | 9,000  |   | Lease  |   |
| *Colorado*             |   |   |   |   |   |   |   |   |   |
| Denver                 |   |   | 1998   |   |   | 16,800 |   | Lease  |   |
| Englewood              |   |   | 1998   |   |   | 16,800 |   | Lease  |   |
| Arvada                 |   |   | 1999   |   |   | 15,700 |   | Lease  |   |
| Colorado Springs       |   |   | 2002   |   |   | 8,600  |   | Lease  |   |
| *Connecticut*          |   |   |   |   |   |   |   |   |   |
| Manchester             |   |   | 1999   |   |   | 16,000 |   | Lease  |   |
| Orange                 |   |   | 2002   |   |   | 15,400 |   | Lease  |   |
| *Florida*              |   |   |   |   |   |   |   |   |   |
| North Miami area       |   |   | 1996   |   |   | 20,900 |   | Lease  |   |
| South Miami area       |   |   | 1996   |   |   | 14,700 |   | Lease  |   |
| West Palm Beach        |   |   | 2001   |   |   | 15,200 |   | Lease  |   |
| Orlando                |   |   | 2002   |   |   | 15,300 |   | Lease  |   |
| *Florida*              |   |   |   |   |   |   |   |   |   |
| Lakeland               |   |   | 2003   |   |   | 13,000 |   | Lease  |   |
| Tampa                  |   |   | 2003   |   |   | 15,000 |   | Lease  |   |
| Ft. Myers              |   |   | 2004   |   |   | 13,300 |   | Lease  |   |
| Orlando (1)            |   |   | 2005   |   |   | 15,000 |   | Lease  |   |
| Jacksonville (1)       |   |   | 2005   |   |   | 15,000 |   | Lease  |   |
| Tallahassee (1)        |   |   | 2005   |   |   | 8,300  |   | Lease  |   |
| Pensacola (1)          |   |   | 2005   |   |   | 9,600  |   | Lease  |   |
| *Georgia*              |   |   |   |   |   |   |   |   |   |
| Atlanta                |   |   | 1997   |   |   | 23,600 |   | Own    |   |
| Marietta               |   |   | 1997   |   |   | 22,800 |   | Lease  |   |
| Lawrenceville          |   |   | 2004   |   |   | 16,200 |   | Lease  |   |
| *Idaho*                |   |   |   |   |   |   |   |   |   |
| Boise                  |   |   | 2001   |   |   | 10,800 |   | Lease  |   |
| *Illinois*             |   |   |   |   |   |   |   |   |   |
| South Chicago          |   |   | 1979   |   |   | 13,800 |   | Lease  |   |
| North Chicago          |   |   | 1981   |   |   | 11,000 |   | Lease  |   |
| Central Chicago        |   |   | 1988   |   |   | 20,500 |   | Lease  |   |
| Villa Park             |   |   | 1996   |   |   | 15,000 |   | Lease  |   |
| Highland Park          |   |   | 2001   |   |   | 15,200 |   | Lease  |   |
| Peoria                 |   |   | 2004   |   |   | 10,200 |   | Lease  |   |
| Naperville             |   |   | 2004   |   |   | 15,000 |   | Lease  |   |
| *Indiana*              |   |   |   |   |   |   |   |   |   |
| Indianapolis           |   |   | 2001   |   |   | 15,600 |   | Lease  |   |
| Hobart                 |   |   | 2003   |   |   | 12,000 |   | Lease  |   |
| South Bend             |   |   | 2004   |   |   | 8,000  |   | Lease  |   |
| *Iowa*                 |   |   |   |   |   |   |   |   |   |
| Des Moines (1)         |   |   | 2005   |   |   | 10,100 |   | Lease  |   |
| *Louisiana*            |   |   |   |   |   |   |   |   |   |
| New Orleans            |   |   | 1999   |   |   | 19,700 |   | Lease  |   |
| Baton Rouge            |   |   | 2004   |   |   | 10,200 |   | Lease  |   |
| *Maryland*             |   |   |   |   |   |   |   |   |   |
| Towson                 |   |   | 1998   |   |   | 14,600 |   | Lease  |   |
| Rockville (4)          |   |   | 2000   |   |   | 24,000 |   | Lease  |   |
| Glen Burnie            |   |   | 2004   |   |   | 15,300 |   | Lease  |   |
| *Massachusetts*        |   |   |   |   |   |   |   |   |   |
| Boston                 |   |   | 1994   |   |   | 12,600 |   | Lease  |   |
| Danvers                |   |   | 1996   |   |   | 14,600 |   | Lease  |   |
| Natick                 |   |   | 1997   |   |   | 15,100 |   | Lease  |   |
| N. Attleboro           |   |   | 1998   |   |   | 16,800 |   | Lease  |   |
| *Michigan*             |   |   |   |   |   |   |   |   |   |
| Detroit                |   |   | 1994   |   |   | 16,500 |   | Lease  |   |
| Southfield             |   |   | 1996   |   |   | 18,800 |   | Lease  |   |
| Canton                 |   |   | 1998   |   |   | 16,800 |   | Lease  |   |
| Grand Rapids           |   |   | 2002   |   |   | 11,400 |   | Lease  |   |
| Saginaw                |   |   | 2003   |   |   | 13,800 |   | Lease  |   |
| Kalamazoo              |   |   | 2004   |   |   | 12,700 |   | Lease  |   |
| Flint (1)              |   |   | 2005   |   |   | 10,000 |   | Lease  |   |
| *Minnesota*            |   |   |   |   |   |   |   |   |   |
| Twin Cities            |   |   | 1988   |   |   | 15,000 |   | Lease  |   |
| Edina                  |   |   | 1997   |   |   | 15,700 |   | Lease  |   |
| *Missouri*             |   |   |   |   |   |   |   |   |   |
| N. St. Louis           |   |   | 1999   |   |   | 15,700 |   | Lease  |   |
| Bridgeton              |   |   | 1999   |   |   | 15,000 |   | Lease  |   |
| *Nevada*               |   |   |   |   |   |   |   |   |   |
| Las Vegas              |   |   | 1998   |   |   | 20,000 |   | Lease  |   |
| *New Hampshire*        |   |   |   |   |   |   |   |   |   |
| Nashua                 |   |   | 2004   |   |   | 9,000  |   | Lease  |   |

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| *New Jersey*     |   |   |   |   |   |   |   |   |   |
|------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
| Springfield      |   |   | 1998   |   |   | 20,000 |   | Lease  |   |
| E. Brunswick     |   |   | 1998   |   |   | 20,000 |   | Lease  |   |
| Totowa           |   |   | 1999   |   |   | 15,600 |   | Lease  |   |
| Paramus          |   |   | 1999   |   |   | 14,100 |   | Lease  |   |
| Cherry Hill      |   |   | 2001   |   |   | 15,800 |   | Lease  |   |
| Atlantic City    |   |   | 2002   |   |   | 10,300 |   | Lease  |   |
| *New Mexico*     |   |   |   |   |   |   |   |   |   |
| Albuquerque      |   |   | 2004   |   |   | 11,600 |   | Lease  |   |
| *New York*       |   |   |   |   |   |   |   |   |   |
| Carle Place      |   |   | 1998   |   |   | 22,800 |   | Lease  |   |
| Queens           |   |   | 1999   |   |   | 19,000 |   | Lease  |   |
| Larchmont        |   |   | 1999   |   |   | 15,300 |   | Lease  |   |
| Commack          |   |   | 2000   |   |   | 16,000 |   | Lease  |   |
| Buffalo          |   |   | 2000   |   |   | 15,000 |   | Lease  |   |
| Rochester        |   |   | 2001   |   |   | 15,300 |   | Lease  |   |
| Albany           |   |   | 2003   |   |   | 14,000 |   | Lease  |   |
| Manhattan        |   |   | 2003   |   |   | 30,000 |   | Lease  |   |
| *North Carolina* |   |   |   |   |   |   |   |   |   |
| Charlotte        |   |   | 2002   |   |   | 15,200 |   | Lease  |   |
| Raleigh          |   |   | 2002   |   |   | 15,900 |   | Lease  |   |
| *Ohio*           |   |   |   |   |   |   |   |   |   |
| Cleveland        |   |   | 1997   |   |   | 15,600 |   | Lease  |   |
| Mayfield Heights |   |   | 1998   |   |   | 15,400 |   | Lease  |   |
| Cincinnati       |   |   | 1998   |   |   | 18,500 |   | Lease  |   |
| Columbus         |   |   | 2002   |   |   | 17,600 |   | Lease  |   |
| Toledo           |   |   | 2004   |   |   | 11,600 |   | Lease  |   |
| Akron (1)        |   |   | 2005   |   |   | 10,500 |   | Lease  |   |
| *Oklahoma*       |   |   |   |   |   |   |   |   |   |
| Oklahoma City    |   |   | 2000   |   |   | 15,200 |   | Lease  |   |
| Tulsa (1)        |   |   | 2005   |   |   | 14,200 |   | Lease  |   |
| *Oregon*         |   |   |   |   |   |   |   |   |   |
| Eugene           |   |   | 1996   |   |   | 10,000 |   | Lease  |   |
| Medford          |   |   | 1987   |   |   | 11,900 |   | Lease  |   |
| Clackamas        |   |   | 2000   |   |   | 15,600 |   | Lease  |   |
| Beaverton        |   |   | 2000   |   |   | 15,300 |   | Lease  |   |
| *Pennsylvania*   |   |   |   |   |   |   |   |   |   |
| Philadelphia     |   |   | 2000   |   |   | 15,200 |   | Lease  |   |
| Plymouth Meeting |   |   | 2001   |   |   | 14,900 |   | Lease  |   |
| Monroeville      |   |   | 2001   |   |   | 14,000 |   | Lease  |   |

 
| **Store**      | ** ** | ** ** | ** ** | **Year   Opened** | ** ** | **Gross   Square   Feet** | ** ** | **Status** | ** ** |
|----------------|------------|------------|------------|-------------------|------------|---------------------------|------------|------------|------------|
| Harrisburg     |       |       | 2003       |              |       | 10,000                    |       | Lease      |       |
| Pittsburgh (1) |       |       | 2005       |              |       | 15,500                    |       | Lease      |       |
| *Rhode Island* |       |       |       |              |       |                      |       |       |       |
| Warwick        |       |       | 2003       |              |       | 14,000                    |       | Lease      |       |
| *Tennessee*    |       |       |       |              |       |                      |       |       |       |
| Knoxville      |       |       | 1998       |              |       | 15,000                    |       | Lease      |       |
| Memphis        |       |       | 2003       |              |       | 15,500                    |       | Lease      |       |
| Nashville      |       |       | 2003       |              |       | 20,000                    |       | Lease      |       |
| *Texas*        |       |       |       |              |       |                      |       |       |       |
| Dallas         |       |       | 1989       |              |       | 18,375                    |       | Lease      |       |
| Arlington      |       |       | 1991       |              |       | 19,200                    |       | Lease      |       |
| South Houston  |       |       | 1993       |              |       | 14,700                    |       | Lease      |       |
| North Houston  |       |       | 1994       |              |       | 14,700                    |       | Lease      |       |
| Central Dallas |       |       | 1998       |              |       | 17,800                    |       | Lease      |       |
| Clearlake      |       |       | 1998       |              |       | 15,000                    |       | Lease      |       |
| Austin         |       |       | 2000       |              |       | 15,200                    |       | Lease      |       |
| Plano          |       |       | 2000       |              |       | 15,500                    |       | Lease      |       |
| Corpus Christi |       |       | 2002       |              |       | 10,500                    |       | Lease      |       |
| Ft. Worth      |       |       | 2004       |              |       | 12,500                    |       | Lease      |       |
| Austin (1)     |       |       | 2005       |              |       | 13,500                    |       | Lease      |       |
| *Utah*         |       |       |       |              |       |                      |       |       |       |
| Salt Lake City |       |       | 1998       |              |       | 15,000                    |       | Lease      |       |
| Ogden          |       |       | 2002       |              |       | 7,500                     |       | Lease      |       |
| *Virginia*     |       |       |       |              |       |                      |       |       |       |
| Fairfax        |       |       | 1999       |              |       | 15,600                    |       | Lease      |       |
| Seven Corners  |       |       | 1999       |              |       | 15,400                    |       | Lease      |       |
| Virginia Beach |       |       | 2000       |              |       | 16,000                    |       | Lease      |       |
| Fredericksburg |       |       | 2003       |              |       | 9,000                     |       | Lease      |       |
| Richmond       |       |       | 2003       |              |       | 14,000                    |       | Lease      |       |
| *Washington*   |       |       |       |              |       |                      |       |       |       |
| Tukwila        |       |       | 1997       |              |       | 18,000                    |       | Lease      |       |
| Kirkland       |       |       | 1997       |              |       | 20,200                    |       | Lease      |       |
| Seattle        |       |       | 1997       |              |       | 18,300                    |       | Lease      |       |
| Lynnwood       |       |       | 1998       |              |       | 14,000                    |       | Lease      |       |
| Tacoma         |       |       | 2001       |              |       | 15,600                    |       | Lease      |       |
| Spokane        |       |       | 2001       |              |       | 12,800                    |       | Lease      |       |
| *Wisconsin*    |       |       |       |              |       |                      |       |       |       |
| Brookfield     |       |       | 2004       |              |       | 15,000                    |       | Lease      |       |

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| **Store**                 | ** ** | ** ** | ** ** | **Year   Opened** | ** ** | **Gross   Square   Feet** | ** ** | **Status** | ** ** |
|---------------------------|------------|------------|------------|-------------------|------------|---------------------------|------------|------------|------------|
| **American Music Stores** |       |       |       |              |       |                      |       |       |       |
| *Arizona*                 |       |       |       |              |       |                      |       |       |       |
| Phoenix                   |       |       | 1987       |              |       | 6,000                     |       | Lease      |       |
| Mesa                      |       |       | 1995       |              |       | 4,100                     |       | Lease      |       |
| Tucson                    |       |       | 2002       |              |       | 1,900                     |       | Lease      |       |
| *Florida*                 |       |       |       |              |       |                      |       |       |       |
| Longwood                  |       |       | 1986       |              |       | 4,600                     |       | Lease      |       |
| Ft. Myers                 |       |       | 1994       |              |       | 1,400                     |       | Lease      |       |
| Jupiter                   |       |       | 1995       |              |       | 2,300                     |       | Lease      |       |
| Jacksonville              |       |       | 2002       |              |       | 1,600                     |       | Lease      |       |
| *Georgia*                 |       |       |       |              |       |                      |       |       |       |
| Valdosta                  |       |       | 2002       |              |       | 10,000                    |       | Lease      |       |
| Atlanta (2)               |       |       | 2002       |              |       | 15,000                    |       | Lease      |       |
| Albany                    |       |       | 2002       |              |       | 7,200                     |       | Lease      |       |
| *Illinois*                |       |       |       |              |       |                      |       |       |       |
| Chicago                   |       |       | 2004       |              |       | 25,800                    |       | Lease      |       |
| Naperville                |       |       | 2003       |              |       | 6,000                     |       | Lease      |       |
| *Maine*                   |       |       |       |              |       |                      |       |       |       |
| W. Falmouth               |       |       | 1973       |              |       | 4,700                     |       | Lease      |       |
| *Massachusetts*           |       |       |       |              |       |                      |       |       |       |
| Greenfield                |       |       | 1982       |              |       | 7,200                     |       | Lease      |       |
| *Nevada*                  |       |       |       |              |       |                      |       |       |       |
| Las Vegas                 |       |       | 1998       |              |       | 2,000                     |       | Lease      |       |
| Henderson                 |       |       | 2002       |              |       | 4,800                     |       | Lease      |       |
| *New York*                |       |       |       |              |       |                      |       |       |       |
| Syracuse                  |       |       | 1970       |              |       | 6,100                     |       | Lease      |       |
| Pittsford                 |       |       | 1975       |              |       | 7,200                     |       | Lease      |       |
| New York Mills            |       |       | 1999       |              |       | 4,600                     |       | Lease      |       |

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(1)          We have signed leasesfor these locations and presently expect each to open in 2005.

(2)          Represents storesrelocated in 2004.

(3)          Excludes 10,000 squarefeet consisting of a basement warehouse space.

(4)          Excludes24,000 square feet consisting of a basement warehouse space.

**Item 3. LEGAL PROCEEDINGS**

We are involved in various claims and legal actionsarising in the ordinary course of our business and, while the results of theproceedings cannot be predicted with certainty, we believe that the finaloutcome of such matters will not have a material adverse effect on ourconsolidated financial position or results of operations.

On October 13, 2004, a putative class actionlawsuit entitled Carlos Rodriguez v. The Guitar Center, Inc. [sic], Case No. GC322958,was filed in the Superior Court of the State of California for the County ofLos Angeles. The lawsuit was filed by an individual purporting to represent allhourly retail store employees employed by us within the State of California. OnDecember 15, 2004, a putative class action lawsuit entitled James McClainet. al. v. Guitar Center Stores, Inc., Case No. BC326002, was filedin the Superior Court of the State of California for the County of Los Angeles.The lawsuit was filed by three individuals purporting to represent all hourlyretail store employees employed by us within the State of California.  Among other things, the lawsuits allege thatwe improperly failed to document and enforce break-time and lunch-time periodsfor such employees and seek an unspecified amount of damages, penalties andattorneys’ fees. In the Rodriguez case, we have filed an answer to theplaintiff’s complaint and are in the process of responding to the plaintiff’srequests for discovery. The McClain complaint has not been served on us, and wehave not responded to the complaint.

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While we believe theselawsuits are without merit and intend to defend them vigorously, they may,regardless of the outcome, result in substantial expenses and damages to us andmay significantly divert the attention of our management. There can be no assurancethat we will be able to achieve a favorable settlement of these lawsuits orobtain a favorable resolution of such lawsuits if they are not settled. Anunfavorable resolution of these lawsuits 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 these lawsuitscould also have a material adverse effect on our business, financial conditionand results of operations.

**Item4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

No matters were submittedto a vote of security holders during the fiscal quarter ended December 31,2004.

**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 National 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:
| ** **     | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $        | 37.14      |     | $          | 30.49 |   | $ | 21.55 |   | $ | 16.12 |   |
| Second Quarter |       | 46.46    |       | 36.04    |       | 29.39 |   | 19.62 |   |
| Third Quarter  |       | 45.91    |       | 40.02    |       | 35.56 |   | 27.71 |   |
| Fourth Quarter |       | 53.37    |       | 43.04    |       | 36.53 |   | 27.37 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

As of December 31,2004, there were 511 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 currently intend toretain any earnings to provide funds for the operation and expansion of ourbusiness and for the servicing and repayment of indebtedness, and do not intendto pay cash dividends on our common stock in the foreseeable future. The termsof our credit facility with Wells Fargo Retail Finance, LLC and a syndicate ofother lenders includes restrictive covenants which, among other things,prohibit the payment of cash dividends on our capital stock. See “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Liquidity and Capital Resources.” Any determination to pay cashdividends on the common stock in the future will be at the sole discretion ofour Board of Directors.

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**Item6. SELECTED FINANCIAL DATA**

The selected datapresented below under the captions “Income Statement Data” and “Balance Sheetand Other Data” for, and as of the end of, each of the years in the five-yearperiods ended December 31, 2004, are derived from the consolidatedfinancial statements of Guitar Center, Inc. and subsidiaries, whichfinancial statements have been audited by KPMG LLP, independent registeredpublic accounting firm. The consolidated financial statements as of December 31,2004 and 2003, and for each of the years in the three-year period ended December 31,2004, 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,**                                                 | ** ** |
|-----------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **2004**                                                                                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                      | ** ** | **(in thousands, except per share and operating data)** | ** ** |
| **Income  Statement Data:**                                     |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Net sales                                                       |       | $                                                                                          | 1,513,172  |   | $ | 1,275,059 |   | $ | 1,100,889 |   | $ | 949,284 |   | $ | 794,786 |   |
| Cost of goods sold                                              |       | 1,087,899                                                                                  |       | 931,014 |   | 810,474 |   | 702,310 |   | 589,864 |   |
| Gross profit                                                    |       | 425,273                                                                                    |       | 344,045 |   | 290,415 |   | 246,974 |   | 204,922 |   |
| Selling, general and administrative expenses                    |       | 317,585                                                                                    |       | 271,996 |   | 236,537 |   | 200,748 |   | 156,698 |   |
| Operating income                                                |       | 107,688                                                                                    |       | 72,049 |   | 53,878 |   | 46,226 |   | 48,224 |   |
| Other expense:                                                  |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Other expense                                                   |       | —                                                                                     |       | — |   | — |   | 3,539 |   | — |   |
| Interest expense, net                                           |       | 5,390                                                                                      |       | 12,540 |   | 13,077 |   | 13,411 |   | 12,466 |   |
| Total other expense                                             |       | 5,390                                                                                      |       | 12,540 |   | 13,077 |   | 16,950 |   | 12,466 |   |
| Income before income taxes                                      |       | 102,298                                                                                    |       | 59,509 |   | 40,801 |   | 29,276 |   | 35,758 |   |
| Income taxes                                                    |       | 38,873                                                                                     |       | 22,649 |   | 15,545 |   | 12,243 |   | 13,304 |   |
| Net income                                                      |       | $                                                                                          | 63,425     |   | $ | 36,860 |   | $ | 25,256 |   | $ | 17,033 |   | $ | 22,454 |   |
| Net income per share (diluted)                                  |       | $                                                                                          | 2.29       |   | $ | 1.47 |   | $ | 1.09 |   | $ | 0.75 |   | $ | 1.01 |   |
| Weighted average shares outstanding (1)                         |       | 28,976                                                                                     |       | 26,119 |   | 23,130 |   | 22,700 |   | 22,247 |   |
| **Operating Data:**                                             |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Guitar Center net sales per gross square foot (2)     |       | $                                                                                          | 585        |   | $ | 560 |   | $ | 546 |   | $ | 537 |   | $ | 535 |   |
| Net sales growth                                                |       | 19%                                                                                        |       | 16% |   | 16% |   | 19% |   | 27% |   |
| Increase in comparable store sales (3)                     |       | 9%                                                                                         |       | 7% |   | 6% |   | 6% |   | 7% |   |
| Guitar Center stores open at end of period                      |       | 136                                                                                        |       | 122 |   | 108 |   | 96 |   | 83 |   |
| Ratio of earnings to fixed charges (4)                          |       | 6.6x                                                                                       |       | 3.5x |   | 2.8x |   | 2.4x |   | 3.0x |   |
| Net cash provided by operating activities (thousands)           |       | $                                                                                          | 85,506     |   | $ | 58,005 |   | $ | 12,248 |   | $ | 16,511 |   | $ | 34,367 |   |
| EBITDA (thousands) (5)                                          |       | $                                                                                          | 129,992    |   | $ | 92,669 |   | $ | 70,738 |   | $ | 57,693 |   | $ | 59,267 |   |
| **Balance Sheet and Other Data:**                               |       |                                                                                       |       |   |   |   |   |   |   |   |   |
| Net working capital                                             |       | $                                                                                          | 269,859    |   | $ | 198,713 |   | $ | 110,825 |   | $ | 90,113 |   | $ | 94,034 |   |
| Property and equipment, net                                     |       | 97,349                                                                                     |       | 93,347 |   | 89,702 |   | 81,056 |   | 68,658 |   |
| Total assets                                                    |       | 574,593                                                                                    |       | 460,871 |   | 452,399 |   | 404,684 |   | 325,569 |   |
| Total long-term and revolving debt (including current  portion) |       | 100,000                                                                                    |       | 100,000 |   | 149,590 |   | 144,466 |   | 103,783 |   |
| Stockholders’ equity                                       |       | 306,682                                                                                    |       | 214,171 |   | 154,928 |   | 123,868 |   | 103,463 |   |
| Capital  expenditures                                           |       | 26,151                                                                                     |       | 24,245 |   | 26,309 |   | 24,697 |   | 17,862 |   |

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(1)*   *Weighted average shares represents shares calculated ona diluted basis. For the year ended December 31, 2004, the 2.9 millionshares of common stock issuable upon conversion of the 4% Senior ConvertibleNotes issued in June 2003 (reflecting an effective conversion price of$34.58) are deemed to be potential common stock and are 

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deemed to be outstanding for the purposes ofcalculating diluted earnings per share under the “if-converted” method ofaccounting under which the after-tax interest expense, including amortizationof deferred financing costs, for the year is added back to net income. For theyear ended December 31, 2003, the 1.6 million weighted average shares ofcommon stock issuable upon conversion of the 4% Senior Convertible Notes weredeemed to be potential common stock and are included in the calculation ofearnings per share from the period of June 16, 2003, the issuance date ofthe Notes, to December 31, 2003, under the “if-converted” method. Thediluted earnings per share for 2003 has been restated to conform to EITF 04-08,*“Accounting Issues Related to Certain Features ofContingently Convertible Debt and the Effect on Diluted Earnings per Share.”*

(2)    Netsales per gross square foot is a measure of sales efficiency based on squarefootage. This calculation is presented for Guitar Center retail stores only,excluding American Music retail stores, and does not include new stores openedduring the reporting period.

(3)    Comparesnet sales for the comparable periods, excluding net sales attributable tostores not open for 14 months as of the end of the latter reporting period. Allreferences in this annual report to comparable store sales results are based onthis calculation methodology.

(4)    For thepurpose of calculating the ratio of earnings to fixed charges, “earnings”represents income before provision for income taxes and fixed charges. “Fixedcharges” consist of interest expense, amortization of debt financing costs, andone third of lease expense, which management believes is representative of theinterest components of lease expense.

(5)    Represents net income before interest expense, incometaxes, and depreciation and amortization expense. The reconciliation fromreported net income to EBITDA is as follows:
| **EBITDA**                     | ** ** | ** ** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
|--------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net income as  reported        |       | $          | 63,425     |     | $          | 36,860   |       | $        | 25,256     |     | $          | 17,033   |       | $ | 22,454 |   |
| Income taxes                   |       | 38,873     |       | 22,649   |       | 15,545   |       | 12,243   |       | 13,304   |       |
| Interest expense               |       | 5,390      |       | 12,540   |       | 13,077   |       | 13,411   |       | 12,466   |       |
| Depreciation and  amortization |       | 22,304     |       | 20,620   |       | 16,860   |       | 15,006   |       | 11,043   |       |
| EBITDA                         |       | $          | 129,992    |     | $          | 92,669   |       | $        | 70,738     |     | $          | 57,693   |       | $ | 59,267 |   |

 

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 is the nation’s leading retailer ofguitars, amplifiers, percussion instruments, keyboards and live-sound/DJ andrecording equipment based on annual revenue. As of December 31, 2004, weoperated 136 Guitar Center stores, with 113 stores in 46 major markets and 23stores in secondary markets. In addition, our American Music division operates19 stores specializing in band and orchestral instruments for sale and rental,serving teachers, band directors, college professors and students. We are alsothe largest direct response retailer of musical instruments in the UnitedStates through our wholly owned subsidiary, Musician’s Friend, Inc., andits catalog and web site, www.musiciansfriend.com.

During 2004, we opened 14 new stores and relocated onestore which resulted in the addition of approximately 190,700 square feet ofstore space. The new store opening program for 2004 included nine small formatGuitar Center stores and five large format stores. In the five year period fromthe beginning of 2000 to the end of 2004, we have grown from 69 Guitar Centerstores to 136 Guitar Center stores, consisting of large flagship stores inHollywood, Manhattan, Nashville and San Francisco, 108 other large formatstores and 24 small format stores. Total square footage grew from 1,148,000square feet at the beginning of 2000 to 2,087,000 square feet at the end of2004.

As we enter new markets, we expect that we willinitially incur higher administrative and promotional costs per store than iscurrently experienced in established markets. We expect competition to continueto increase as other music product retailers attempt to execute national growthstrategies. Our business strategy will also emphasize opportunities to continueto grow each of our brands, including further acquisitions if attractivecandidates can be located for reasonable prices.

From 2000 to 2004, our netsales grew at an annual compound growth rate of 17%, principally due to thecomparable store sales growth of our retail stores averaging 7% per year, theopening of new stores, and a 22% per year increase in the direct responsechannel. We believe such volume increases are the result of the continuedsuccess of the implementation of our business strategy, continued growth in themusic products industry and increasing consumer awareness of the Guitar Center,Musician’s Friend and American Music brand names. We achieved comparable storesales growth of 9%, 7%, and 6% for the fiscal years ended December 31,2004, 2003 and 2002, respectively. We believe this growth reflects the strengthof our merchandise selection, effective advertising and promotion, andwell-trained and committed personnel.

**Executive Summary**

Consolidated net sales in 2004 increased 18.7% to$1.513 billion from $1.275 billion in 2003. Consolidated net income in 2004increased 72.1% to $63.4 million or $2.29 per diluted share, from $36.9million, or $1.47 per diluted share, in 2003.

During 2004, our Guitar Center stores generated 10%comparative store sales growth and an 18.6% increase in total net sales. Salesfrom new stores contributed $87.8 million and accounted for 48.1% of the salesincrease in our Guitar Center stores. Late in the year we increased ouradvertising expenditure, predominately focused on generating a greater numberof impressions through our mailing list, which resulted in higher traffic inour stores.

Our direct response division generated a 20.7%increase in net sales. For the year, we achieved an initial order fill rate of92.3% compared to 91.7% in 2003. Our return rate as a percentage of sales was7.9% in 2004 compared to 9.0% in 2003. The improvements that were made to theMusician’s Friend web site over the last year, as well as to the infrastructureand systems at the direct response call center and fulfillment center,permitted us to capitalize on high demand.

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We continue to encounter operational challenges in ourAmerican Music stores. The results of American Music also continue to reflectinvestments in the systems and infrastructure for the stores. Despite thechallenges we are experiencing in this business, we generated an increase of5.7% in net sales and achieved 1.0% comparable store sales for the year. We arerepositioning our American Music stores and establishing scalableinfrastructure and systems for this area of our business. The American Musicstores incurred operating losses in 2004. Failure to execute on therequirements and initiatives described above could potentially require us torecognize an impairment in the significant amount of goodwill recorded in theacquisitions of American Music, M&M Music and Karnes Music, which totaled$21.1 million at December 31, 2004. No such impairment has been recordedthrough December 31, 2004.

On February 8, 2005, two of our subsidiariesentered into an Agreement and Plan of Merger pursuant to which it iscontemplated that Music & Arts Center, Inc. (“MAC”) will become awholly owned subsidiary of our subsidiary Guitar Center Stores, Inc. MACis a privately-held musical instruments retailer based in Maryland whichprimarily addresses the beginning musician, with an emphasis on rentals, musiclessons and band and orchestra instrument sales. MAC’s operations includeapproximately 60 retail locations and seven educational support centers.

The purchase price for the stock of MAC is $90 million,subject to adjustment for the actual level at closing of working capital and aterm note of MAC due to its bank, and seller transaction expenses. In addition,we are assuming designated debt and other deferred obligations, presentlyestimated at approximately $8 million. The purchase consideration for the stockof MAC is all cash, with $7 million to be held in an escrow account for 18months as partial security for the stockholders’ indemnification obligations inthe event of a breach of a representation, warranty, covenant or agreementcontained in the Merger Agreement or any related instrument. We intend to fundthe acquisition from available cash and drawings under our credit facility.

**Discussion ofCritical Accounting Policies**

In the ordinary course ofbusiness, we have made a number of estimates and assumptions relating to thereporting of results of operations and financial condition in the preparationof our financial statements in conformity with accounting principles generallyaccepted in the United States of America. Actual results could differsignificantly from those estimates under different assumptions and conditions.We believe that the following discussion addresses our most critical accountingpolicies, which are those that are most important to the portrayal of ourfinancial condition and results and require management’s most difficult,subjective and complex judgments, often as a result of the need to makeestimates about the effect of matters that are inherently uncertain. Additionally,the policy described below regarding credits and other vendor allowances isunique to our industry and deserves the attention of a reader of our financialstatements.

*Valuation ofInventory*

We value our inventoriesat the lower of cost using the first-in, first-out (FIFO) method or market.Rental inventories are valued at the lower 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, we haverecorded impairment adjustments to cost of goods sold for estimated decreasesin net realizable value. These judgments are made in the context of ourcustomers’ shifting needs, product 

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andtechnological trends, and changes in the demographic mix of our customers. Amisinterpretation or misunderstanding of these conditions and uncertainties inthe future outlook of our industry or the economy, or other failure to estimatecorrectly, could result in inventory valuation changes as of any given balancesheet date.

*Valuation ofLong-Lived Assets*

Long-livedassets such as property and equipment and identifiable intangibles withdefinite lives are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. Goodwill and intangibles that are not amortized is required to bereviewed for impairment on an annual basis, or more frequently when triggeringevents occur. Factors we consider important, which could trigger impairment,include, among other things:

·        Significantunderperformance relative to historical or projected operating results;

·        Significantchanges in the manner of our use of the acquired assets or the strategy of ouroverall business;

·        Significantnegative industry or economic trends; and

·        Significantdecline in stock value for a sustained period.

For long-lived assets other than goodwill andintangibles that are not amortized, the determination of whether impairment hasoccurred is based on an estimate of undiscounted future cash flows attributableto the assets, as compared to the carrying value of the assets. Assumptionsused in these cash flows are consistent with internal forecasts and considercurrent and future expected sales volumes and related operating costs and any anticipatedincreases or declines based on expected market conditions and local 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 of the underlying reporting unitto which the goodwill relates.

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

*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. American Music customers have tenbusiness days from the date of purchase to return product. We regularly reviewand revise, when deemed necessary, our estimates of sales returns based uponhistorical trends. While our estimates during the past few years haveapproximated actual results, actual returns may differ significantly, eitherfavorably or unfavorably, from estimates if factors such as economic conditionsor the competitive environment differ from our expectations.

*Credits and OtherVendor 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), 

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priceprotection credits (i.e., credits from vendors with respect to in-stockinventory if the vendor subsequently lowers their wholesale price for suchproducts) and vendor rebates (i.e., credits or rebates provided by vendorsbased on the purchase of specified products and paid at a later date).Cooperative advertising allowances are recognized as a reduction to selling,general, and administrative expense when we incur the advertising expenseeligible for the credit. We recognized cooperative advertising allowances of$6.4 million, $5.1 million and $4.9 million for the years ended December 31,2004, 2003 and 2002, respectively, recorded as an offset to selling, generaland administrative expense. Price protection credits and vendor rebates areaccounted for as a reduction of the cost of merchandise inventory and arerecorded at the time the credit or rebate is earned. The effect of priceprotection credits and vendor rebates is recognized in the income statement atthe time the related inventory is sold, as a reduction in cost of goods sold.We regularly review and revise, when deemed necessary, our estimates of rebatesreserve based upon historical trends. We received payments of $15.4 million and$6.3 million for the years ended December 31, 2004 and 2003, respectively.We earned vendor rebates of $23.2 million and $17.6 million for the years endedDecember 31, 2004 and 2003, respectively. None of these credits arerecorded as revenue.

**Results ofOperations**

Thefollowing table presents our consolidated statements of income, as a percentageof sales, for the periods indicated:
| ** **                                    | ** ** | **Fiscal Year Ended** | ** ** |
|-----------------------------------------------|------------|---------------------------------|------------|
| ** **                                    | ** ** | **December 31,**           | ** ** |
| ** **                                    | ** ** | **2004**                        | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net sales                                     |       | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Gross profit                                  |       | 28.1                            |       | 27.0 |   | 26.4 |   |
| Selling, general  and administrative expenses |       | 21.0                            |       | 21.3 |   | 21.5 |   |
| Operating income                              |       | 7.1                             |       | 5.7 |   | 4.9 |   |
| Interest expense, net                         |       | 0.3                             |       | 1.0 |   | 1.2 |   |
| Income before  income taxes                   |       | 6.8                             |       | 4.7 |   | 3.7 |   |
| Income taxes                                  |       | 2.6                             |       | 1.8 |   | 1.4 |   |
| Net income                                    |       | 4.2                             | %          | 2.9 | % | 2.3 | % |

 

**Fiscal 2004Compared to Fiscal 2003**

Net sales for the year ended December 31, 2004increased 18.7% to $1.5 billion, compared with $1.3 billion last year.

Net sales from Guitar Center stores for fiscal 2004totaled $1.162 billion, an 18.6% increase from $979.0 million in fiscal 2003. Salesfrom new stores contributed $87.8 million and represented 48.1% of the totalincrease in retail store sales. Comparable Guitar Center store sales for thefull year increased 10%. Comparable store sales are defined as sales for thecomparable periods, excluding net sales attributable to stores not open for 14months as of the end of the reporting period. We believe that comparable storesales are a more useful indicator of store performance than the change in totalnet sales, since comparable store sales exclude the effects of changes in thenumber of stores open. The increase in comparable store sales was due topositive response to our advertising and marketing strategy for our GuitarCenter stores. Total advertising and marketing expense increased from $28.5million to $33.5 million in 2004. Our management is presently anticipatingcomparable Guitar Center store sales growth of 4% to 6% for the first quarterin 2005. Please see “Forward-Looking Statements; Business Risks”, below. Netsales from American Music stores for 2004 totaled $40.4 million, a 5.7%increase from $38.2 million in 2003. Comparable American Music stores sales forthe full year increased 1.0%.

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Net sales from the direct response channel totaled$311.3 million in 2004, a $53.4 million, or 20.7%, increase from 2003. Thisincrease primarily reflects the improved performance of catalog circulationstrategies. Sales from the contact center, which represents sales placed viaphone, live chat, mail and e-mail, increased 17.0% to $138.5million from $118.4 million in 2003. Internet sales from orders placed via theMusician’s Friend and Giardinelli web sites increased 23.9% to $172.8 millionfrom $139.5 million for the same period last year. The growth of web-basedsales reflects the continued trend of our catalog customers’ preference inusing the web to place their orders, the success of web-based promotions, andthat the web site includes a more complete inventory presentation than ourcatalogs.

Gross profit for the year ended December 31, 2004compared to 2003 increased 23.6% to $425.3 million from $344.0 million. Grossprofit as a percentage of net sales for the year ended December 31, 2004compared to 2003 increased to 28.1% from 27.0%. Gross profit as a percentage ofnet sales for the Guitar Center stores was 26.7% compared with 25.3% for theyear ended December 31, 2004 and 2003. The increase is due to higherselling margin 1.2%, leveraged occupancy costs 0.2% due to the strongcomparable store sales increase, and lower inventory shrink 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 margin for the American Music stores was 34.8%compared to 35.7% for the same period last year. The decrease is due to lowerselling margin 0.9% and an increase in occupancy costs 0.4%, partially offsetby a decrease in inventory shrink 0.2% and freight costs 0.2%. The gross profitmargin for the direct response division was 32.3% for 2004 compared to 32.1% in2003. The increase is due to higher selling margin 0.1% and reduction ininventory shrink 0.1%.

Selling, general and administrative expenses for 2004increased 16.8% to $317.6 million from $272.0 million in fiscal 2003.As a percentage of net sales, selling, general and administrative expenses for2004 decreased to 21.0% from 21.3% in 2003. The overall increase is due to theoperation of 136 Guitar Center stores in 2004 compared to 122 Guitar Centerstores in 2003. Selling, general and administrative expenses as a percentage ofsales for the Guitar Center stores were 20.2% for both December 31, 2004and 2003. The unchanged percentage reflects reduced general insurance 0.1% andlower computer repairs and maintenance 0.1%, offset by an increase in bonuscosts 0.2%. Selling, general and administrative expenses for the American Musicstores were 46.2% of sales compared to 48.0% last year. The decrease isprimarily due to decreased advertising expense 1.8%, bad debt expense 0.7%, andmedical insurance 0.6%, partially offset by increases in depreciation andamortization 0.5% and salary costs 0.6%.

Selling, general and administrative expenses for thedirect response division were 20.7% of sales in 2004 compared to 21.6% lastyear. The improvement is primarily due to leveraging on better than expectedsales and increased operational efficiencies as indicated by a reduction inpayroll costs 0.8% and a decrease in depreciation and amortization 0.3%,partially offset by an increase in advertising expense primarily related toprograms to increase web traffic 0.2%.

Operating income increased 49.5% to $107.7 millionfrom $72.0 million in 2004. This increase reflects the performance of theGuitar Center and Musician’s Friend businesses at or above expected levels,offset somewhat by continued spending on systems and infrastructure build outand merchandising and operational challenges at the American Music storesresulting in an operating loss of approximately $4.6 million for this segmentfor the year ended December 31, 2004.

Interest expense, net for 2004 decreased to$5.4 million from $12.5 million in 2003. The reduction in interestexpense is due primarily to the retirement of $67 million in 11% senior notesthrough a $100 million 4% convertible bond offering completed in June 2003and the use of cash flow from operations to pay off our line of credit borrowings.Accordingly, included in interest expense for 2003 are the redemption 

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premium of $1.2 millionand the write-off of deferred financing costs of $0.7 million associated withthe Senior Notes redeemed in July 2003 for a total of $1.9 million.

Income tax expense for 2004 was $38.9 million comparedto $22.6 million for the same period last year, both based on an effective taxrate of approximately 38%.

Net income for 2004increased to $63.4 million from $36.9 million in 2003 as a result ofthe combinations of factors described above.

**Fiscal 2003Compared to Fiscal 2002**

Net sales for the year ended December 31, 2003increased 15.8% to $1.3 billion, compared with $1.1 billion last year. Comparablestore sales for the full year increased 7%.

Net sales from Guitar Center stores for 2003 totaled$979.0 million, a 13.9% increase from $859.6 million in 2002. Sales from newstores contributed $60.0 million and represent 50.7% of the total increase inretail store sales. Comparable Guitar Center store sales for the full yearincreased 7%. The increase in comparable store sales was due to good responseto our advertising and marketing strategy for our Guitar Center stores. Totaladvertising and marketing expense increased from $23.9 million to $28.5 millionin 2003. Net sales from American Music stores for 2003 totaled $38.2 million, a17.5% increase from $32.5 million in 2002. Comparable American Music storessales for the full year increased 10%. The increase is due to improved retailtraffic and sales in combo products not historically carried in these stores.

Net sales from the direct response channel totaled$257.9 million in 2003, a $49.1 million, or 23.5%, increase from 2002. Thisincrease primarily reflects the improved performance of catalog circulationstrategies. Sales from the contact center, which represents sales placed viaphone, live chat, mail and e-mail, increased 8.4% to $118.4 million from$109.2 million in 2003. Internet sales from orders placed via Musician’s Friendand Giardinelli web sites increased 40.2% to $139.5 million from $99.5 millionfor the same period last year. The growth of web-based sales reflects thecontinued trend of our catalog customers’ preference in using the web to placetheir orders, the success of web-based promotions, and that the web siteincludes a more complete inventory presentation than our catalogs. During thefourth quarter, the direct response division changed its revenue recognitionmethodology, whereby we do not recognize revenue until the estimated date anorder is received by the customer, instead of the date shipped. This changeresulted in a reduction of approximately $3.9 million in net sales, and ofapproximately $546,000 in net income, or $0.02 per diluted share, for thefourth quarter. The impact of this change was immaterial to the prior quartersof 2003. On a going forward basis, we do not expect this change to have amaterial effect on operating results because the amount of revenue deferred atthe end of a given quarter should be largely offset by revenue carried overfrom the prior period.

Gross profit for the year ended December 31, 2003compared to 2002 increased 18.5% to $344.0 million from $290.4 million. Grossprofit as a percentage of net sales for the year ended December 31, 2003compared to 2002 increased to 27.0% from 26.4%. Gross profit as a percentage ofnet sales for Guitar Center was 25.3% for both the year ended December 31,2003 and 2002. The unchanged percentage reflects improved selling margins0.21%, leveraging of occupancy costs on higher sales 0.11% and a reduction inshrink 0.07%, offset by increased freight. The gross profit margin for theAmerican Music stores was 35.7% compared to 34.1% for the same period last year.The gross margin percentage increased due to a reduction in shrink 3.7% offsetby a decline in selling margins due to a change in product mix 1.6% with theremainder primarily due to higher store depreciation. The gross profit marginfor the direct response division was 32.1% for 2003 compared to 29.7% in 2002. Theincrease is due to higher selling margin resulting from better buyingperformance and favorable product mix 1.6% and better than expected margins onthe sell through of slow moving products 0.6%.

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Selling, general and administrative expenses for 2003increased 15.0% to $272.0 million from $236.5 million in 2002. As apercentage of net sales, selling, general and administrative expenses for 2003decreased to 21.3% from 21.5% in 2002. Selling, general and administrativeexpenses for the Guitar Center stores in 2003 was 20.2% as a percentage of netsales compared to 20.5% in 2002. The decrease reflects leveraging due to higherthan expected sales, as indicated by lower payroll costs 0.2%, decrease in telephoneexpense 0.02% as a result of better negotiated rates, decrease in suppliesexpense 0.04% and a decrease in entertainment costs 0.03%. Selling, general andadministrative expenses for the American Music stores were 48.0% of salescompared to 41.1% last year. The increase is primarily due to increased salarycosts 3.0%, increase in bad debt expense 2.1%, advertising 0.8%, travel andentertainment 0.6% and profit sharing plan 0.4%.

Selling, general and administrative expenses for thedirect response division were 21.6% of sales compared to 22.6% last year. Theimprovement is primarily due to a reduction in advertising costs 0.3% as aresult of leveraging of catalog and postage costs, decrease in bad debt 0.2%,decrease in credit card expense 0.2% reflecting reduced fees and a decrease incomputer maintenance costs 0.1%.

Operating income increased 33.7% to $72.0 million from$53.9 million in 2002. This increase reflects performance of the Guitar Centerand Musician’s Friend businesses at or above expected levels, offset somewhatby continued spending on systems and infrastructure build out and merchandisingand operational challenges at the American Music stores resulting in anoperating loss of approximately $4.7 million for this segment for the year endedDecember 31, 2003.

Interest expense, net for 2003 decreased to$12.5 million from $13.1 million in 2002. The decrease is due tolower rates and reduced borrowings, offset by a charge to redeem our $66million in senior notes. We issued $100 million of 4% Convertible Senior Notesin June of 2003 and redeemed our 11% senior notes in July of 2003.Accordingly, included in interest expense for 2003 are the redemption premiumof $1.2 million and the write-off of deferred financing costs of $0.7 millionassociated with the senior notes redeemed in July 2003 for a total of $1.9million.

Income tax expense for 2003 was $22.6 million comparedto $15.5 million for the same period last year, both based on an effective taxrate of approximately 38%.

Net income for 2003increased to $36.9 million from $25.3 million in 2002 as a result ofthe combinations of factors described above.

**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 31,2004:
| ** **                                 | ** ** | **Payments Due by Period** | ** ** |
|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                 | ** ** | **(In thousands)**                   | ** ** |
| **Contractual Cash Obligations** | ** ** | ** **                                | ** ** | **Total** | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **After 5  Years** | ** ** |
| Long-term  obligations (1)                 |       | $                                         | 100,000    |   | $ | — |   | $ | — |   | $ | 100,000 |   | $ | — |   |
| Operating lease obligations (2)            |       | 216,359                                   |       | 37,271 |   | 63,288 |   | 51,058 |   | 64,742 |   |
| Other long-term liabilities (3)            |       | 3,905                                     |       | 3,905 |   | — |   | — |   | — |   |
| Total                                      |       | $                                         | 320,264    |   | $ | 41,176 |   | $ | 63,288 |   | $ | 151,058 |   | $ | 64,742 |   |
|                                            |            |                                           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Long-term debt consistsof the $100 million principal amount of 4% Senior Convertible Notes due in2013. Of the net proceeds from the offering, approximately $68.2 million wasused in July 2003 to retire all outstanding Senior Notes and pay therelated redemption premium, and the balance was 

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used to reduce the amountoutstanding under our credit agreement and pay offering expenses. On July 15,2008 and July 2010, holders may at their election require us to purchaseall of the notes at 100% of the principal amount, plus any accrued interest,including contingent interest. Final maturity of the Notes is July 15,2013. As amended in February 2005, our revolving line of credit permitsborrowings up to $125 million (which may be increased to $150 million at ouroption), subject to borrowing base limitations, and expires in December 2010.We had no borrowings under our credit facility at December 31, 2004.

(2)          Operating leasecommitments consist principally of real property leases for our corporateoffices, retail store facilities and distribution centers. These leasesfrequently include options which permit us to extend the terms beyond theinitial fixed lease term. We also have rented personal property throughoperating leases. Payments for these lease commitments are provided for by cashflows generated from operations. Please see Note 9 to the consolidatedfinancial statements.

(3)          Other long-termliabilities consist of our outstanding standby letters of credit at December 31,2004.

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 1. Business—“RisksRelated to the Business” for a discussion of factors which could reasonablylikely result in a decrease in the amount of internally generated fundsavailable to finance capital expenditures and working capital requirements. Asof December 31, 2004, we had no borrowings under our credit facility andhad available borrowings of $111 million (net of $4.0 million of outstandingletters of credit).

In February of 2005, we amended our creditfacility with a syndicate of banks led by Wells Fargo Retail Finance. Thecredit facility permits borrowings up to $125 million (which may be increasedto $150 million at our option), subject to borrowing base limitations. Theactual amount available is tied to our inventory and receivable base, andrepayment obligations under the credit facility are secured by liens on ourprincipal assets. Borrowing options are prime rate (5.25% at December 31,2004) plus applicable prime margin, or London Interbank Offered Rate, or LIBOR(six month rate at December 31, 2004 was 2.78%) plus applicable LIBORmargin. The applicable prime and LIBOR margins are based upon levels of excessavailability and adjusted quarterly. If excess availability is greater than $20million, the applicable prime margin is 0.00% and applicable LIBOR margin is1.0%. If excess availability is less than or equal to $20 million and greaterthan $10 million, the applicable prime margin is 0.00% and the applicable LIBORmargin is 1.25%. If excess availability is less than or equal to $10 million,the applicable prime margin is 0.00% and the applicable LIBOR margin is 1.5%.An unused fee of 0.25% is assessed on the unused portion of the credit facility.The agreement underlying the credit facility includes significant restrictivenegative covenants. Among other things, these covenants restrict our ability toincur debt and issue specified equity instruments, incur liens on our assets,make any significant change in our corporate structure or the nature of ourbusiness, dispose of assets, make guaranties, prepay debt, engage in a changein control transaction, pay dividends, make investments or acquisitions, engagein transactions with affiliates and incur capital expenditures, and alsorequire that we satisfy a minimum availability test. The minimum availabilitytest requires that we maintain $10 million of reserved availability under theagreement based on its borrowing base limitations. The amount we disclose inour public reports from time to time as available to borrow under the agreement($111 million at December 31, 2004) is already reduced by this requiredreserve and outstanding letters of credit, and thus represents a net amountavailable under the agreement. The agreement also includes representations andwarranties which must be true each time we borrow funds under the creditfacility and affirmative covenants. The full text of the contractualrequirements imposed by this financing is set forth in the Amended and RestatedLoan and Security Agreement and related amendments which have been filed withthe Securities and Exchange Commission. We were in compliance with suchrequirements as of December 31, 2004. Subject to limited cure periods, 

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the lenders under ourcredit facility may demand repayment of these borrowings prior to statedmaturity upon the occurrence of specified events, including if we breach theterms of the agreement, suffer a material adverse change, engage in a change incontrol transaction, suffer a significant adverse legal judgment, default onother significant obligations, or in the event of specified events ofinsolvency. The credit agreement matures in December 2010.

On June 16, 2003, we completed the issuance of$100 million principal amount of 4.00% Senior Convertible Notes due 2013 (theNotes). Of the net proceeds from the offering, approximately $68.2 million wasused in July 2003 to retire all outstanding Senior Notes and pay therelated redemption premium, and the balance was used to reduce the amountoutstanding under our credit agreement and pay offering expenses. The Notesbear interest at the rate of 4.00% per annum, subject to the payment ofcontingent interest under certain circumstances, and are convertible into sharesof common stock at a conversion price of $34.58 per share, subject toadjustment under specified circumstances. Under the contingent conversionfeature of the Notes, subject to certain exceptions, they are not convertibleinto common stock unless and until the trading price of the common stockreaches at least $41.50 for a specified period in advance of each quarterlyconversion period or designated corporate events occur. As of December 31,2004, the notes were convertible for the current quarterly conversion period.The Notes will also become convertible upon the occurrence of specifiedcorporate transactions and other events described in the indenture. The finalmaturity of the Notes is July 2013, although holders may require us torepurchase the Notes at their election in July 2008, July 2010 orupon the occurrence of a change in control, in each case for a purchase priceequal to the original principal amount plus accrued interest. We may call theNotes for redemption commencing in July 2006 subject to the payment of aredemption premium of 1.6% if redeemed prior to July 2007 and 0.8% ifredeemed prior to July 2008 (thereafter there is no redemption premium).The indenture governing the Notes does not limit our ability to incurindebtedness or otherwise substantively restrict the operation of our businessto any significant degree. Subject to limited cure periods, the holders of theNotes may demand repayment of these borrowings prior to the stated maturityupon the occurrence of specified events, including if we fail to pay interestor principal when due, fail to satisfy our conversion obligation, if anotherobligation of ours having an outstanding principal amount in excess of $15million is accelerated prior to stated maturity and upon the occurrence ofspecified events of insolvency.

During 2002 we entered into master operating leaseagreements with General Electric Capital Corporation and US Bank to leaseequipment and other property primarily to support the operations of the newcentral distribution center for our Guitar Center retail stores. Under theseagreements, we leased a total of $10.5 million in equipment and other property.The agreements call for monthly payments of $138,000 for a term of 36 monthsthrough September 1, 2005 with an option to extend through September 30,2009 and monthly payments of $48,000 for a term of 24 months through December 28,2005.

The terms of our significant financing agreements,including those related to our credit facility, the Senior Convertible Notesand the equipment lease facilities described above, are not dependent on anychange in our credit rating. We believe that the key company-specific factorsaffecting our ability to maintain our existing debt and lease financingrelationships and to access such capital in the future are our present andexpected levels of profitability and cash flow from operations, our workingcapital and fixed asset collateral bases, our expected level of capitalexpenditures, and the level of equity capital of the Company relative to thelevel of debt obligations. In addition, as noted above, our existing agreementsinclude significant restrictions on future financings, including among others,limits on the amount of indebtedness that we may incur and whether or not suchindebtedness may be secured by any of our assets.

As is the case with most multi-unit retailers,substantially all of the real property used in our business is leased underoperating lease agreements. Please see, Item 2. Properties, “—Disclosures AboutContractual Obligations and Commercial Commitments” and Note 9 to our financialstatements.

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Net cash provided by operating activities was $85.5million for the year ended December 31, 2004 compared to $58.0 million forthe same period last year. The increase in net cash provided by operatingactivities is primarily due to an increase in net income of $63.4 million. Thelargest use of cash was an increase in inventories of $24.3 million. Theincrease in merchandise inventory is required to support the continuing growth ofthe Company.

Cash used in investing activities increased to $49.7million for the year ended December 31, 2004 compared to $24.2 million forthe same period last year. The current period capital expenditures consistedprimarily of capital expenditures for store expansions and remodels of $16.8million compared to $15.3 million in the prior period and computer equipmentpurchases of $7.4 million in the current period compared to $6.7 million in thesame period last year. Additionally, we purchased available-for-sale securitiesof $20.8 million and acquired a business for $2.8 million in 2004.

Cash provided by financing activities totaled $19.3million for the year ended December 31, 2004 compared to $34.3 millionused in the same period last year. The cash provided by financing activitiesfor the current period primarily consists of the proceeds received from theexercise of stock options of $17.8 million compared to the prior period whichprincipally consisted of paydown of credit facility and redemption of thesenior notes of $149.4 million, partially offset by the proceeds from theSenior Convertible Notes of $96.9 million, and proceeds from stock options of$17.4 million.

Our principal working capital need is to provide forthe inventory levels necessary to support our sales activities, particularlythe Guitar Center retail stores. Inventory increased from $288.9 million to$315.0 million, or 9.0%. Inventory per square foot at Guitar Center retailstores (Guitar Center store and distribution center inventories under GAAPdivided by total store retail square footage on a given date) was $116 at December 31,2004 compared to $121 in 2003. Our ongoing objective is to improve inventoryperformance by refining our replenishment processes and systems, utilizing adistribution center for our Guitar Center stores, and through improvedplanning, presentation and display of inventories in our retail stores.

We believe that our current operating cash flow,working capital, and cash and cash equivalents on hand will be sufficient tomeet our obligations in the ordinary course of business, including capitalexpenditures and new store openings. In the second quarter of 2005, we expectto fund the closing of the Music & Arts acquisition from availablecash and drawings under our credit facility.

We intend to pursue an aggressive growth strategy byopening additional stores in new and existing markets. During the year ended December 31,2004, we opened 14 new Guitar Center stores (five large format and nine smallformat stores). Each new large format Guitar Center store typically hasrequired approximately $1.3 to $1.5 million for gross inventory. Historically,our cost of capital improvements for a large format Guitar Center store hasbeen approximately $900,000, consisting of leasehold improvements, fixtures andequipment. We incur higher costs in some geographic areas, particularly theNortheast, and when we build a larger flagship store. We have developed smallerGuitar Center stores to build in secondary markets or sites that we do notbelieve will support our large format units. The first of these units wasopened in late 2000 and 23 more had been opened as of December 31, 2004.Our small format stores have typically incurred approximately $700,000 incapital expenditures and require approximately $1.0 million to $1.2 million ininventory.

We are also anticipating additional capital andstrategic requirements related to improving our fulfillment facilities,upgrading our technology and systems, and pursuing new opportunities in the e-commerceactivities of our retail and direct response divisions as well as relatedbusinesses.

Our distribution center in the Indianapolis, Indianaarea supports our Guitar Center retail store operations. We have a 10-yearagreement to lease the facility and we also have numerous additionalcommitments necessary to support the operations of the facility. Starting in2003, nearly all products flow 

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through the distributionfacility, with the exception of special orders which will continue, for themost part, to be drop shipped to our stores. Migration from our former “drop-ship”model to a centralized distribution model is an important development in ouroperating strategy and has required the allocation of significant financial andmanagerial resources. A portion of the costs of operating this facility areabsorbed into our Guitar Center merchandise inventories and recognized as anelement of cost of goods sold when the related inventory is sold.

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.

Our expansion strategy is to continue to increase ourmarket share in existing markets and to penetrate strategically selected newmarkets. We opened a total of 14 Guitar Center stores in each of 2004 and 2003,and currently anticipate opening 22 to 26 Guitar Center stores in 2005.Approximately two-thirds of the stores opened in 2004 are smaller format unitsdesigned for secondary markets. During 2005 we expect to close the Music &Arts acquisition and combine that business with our existing American Musicbusiness. We also continue to believe that there exists a number of additionalacquisition opportunities in the relatively fragmented band instruments marketthat could be a good fit with our company and continue to pursue acquisitionopportunities.

Throughout our history, we have primarily grownorganically, and we do not expect this to change. However, we also believethere may be attractive opportunities to expand by selectively acquiringexisting music products retailers or other complimentary businesses, ifattractive opportunities can be identified. While we cannot provide assurancethat we will complete any further acquisition transactions, in the ordinarycourse of our business 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.

Our known capital resourceand liquidity requirements for 2005 are presently expected to be primarilyprovided by cash on hand, net cash flow from operations and, possibly,borrowings under our credit facility. Depending upon market conditions, we mayalso elect or be required to raise additional capital in the form of common orpreferred equity, debt or convertible securities for the purpose of providingadditional capital to fund working capital needs or continued growth of ourexisting business, or to refinance existing obligations. Any such financingactivity will be dependent upon many factors, including our liquidity needs,market conditions and prevailing market terms, and we cannot assure you thatfuture external financing for us will be available on attractive terms or atall.

**New AccountingPronouncements**

In January 2003, the Financial AccountingStandards Board issued FASB Interpretation No. 46, *“Consolidationof Variable Interest Entities” (FIN 46).*This interpretationclarifies the application of Accounting Research Bulletin No. 51, *“Consolidated Financial Statements” (ARB 51),* and requirescompanies to evaluate variable interest entities for specific characteristicsto determine whether additional consolidation and disclosure requirements apply.This interpretation was immediately applicable for variable interest entitiescreated after January 31, 2003, and applies to the first fiscal year orinterim period beginning after June 15, 2003 for variable interestentities acquired prior to February 1, 2003. The adoption of thisinterpretation did not have any impact on our financial position or results ofoperations. In December 2003, the FASB revised FIN 46 to exempt certainentities from its requirements and to clarify certain issues arising during theimplementation of FIN 46. The adoption of this revised interpretation in thefirst quarter of 2004 did not have any impact on our consolidated financialstatements.

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In May 2003, the FinancialAccounting Standards Board issued Statement No. 150*, “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity”*(SFAS No. 150). The statement establishes standards forhow an issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. It requires that an issuerclassify a financial instrument that is within its scope as a liability (or anasset in some circumstances). It is generally effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003. We adopted this standard effective July 1, 2003, and it did not havea material effect on our consolidated financial statements.

In July 2004, the Emerging Issues Task Force (“EITF”)reached a consensus on Issue No. 04-8, *“AccountingIssues Related to Certain Features of Contingently Convertible Debt and theEffect on Diluted Earnings per Share” (EITF No. 04-8)*.The Task Force reached a consensus that contingently convertible debtinstruments, such as our 4% Senior Convertible Notes, should be included in thecomputation of diluted earnings per share under the if-converted method regardlessof whether the market price trigger (or other contingent feature) has been met.The EITF 04-8 consensus must be applied by retroactive restatement basedon the term in effect on the last day of the fiscal period in which theconsensus becomes effective. This consensus became effective for all financialstatements issued after December 15, 2004. Accordingly, we retroactivelyrestated all earnings per share measures for all periods to reflect theconsensus.

In December 2004,the FASB issued SFAS No. 123 (revised 2004) *“Share-BasedPayment (SFAS No. 123R).”* SFAS No. 123R requires that thecost from all share-based payment transactions, including stock options, berecognized in the financial statements at fair value. SFAS No. 123R iseffective for public companies in the first interim period after June 15,2005. We will adopt the provisions of this statement in the third quarter of2005. We anticipate adopting SFAS No. 123R using the modified prospectivemethod, which will not require us to restate any prior periods.

**Seasonality**

Our operating results arenot highly seasonal, except for the effect of 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.

**Inflation**

We believe that therelatively moderate rates of inflation experienced in recent years have not hada significant impact on our net sales or profitability.

**Forward-LookingStatements; Business Risks**

This annual report contains forward-looking statementsrelating to, among other things, future results of operations, growth andinvestment plans, sales, trends in gross margin, growth in the Internet portionof our direct response business, the pending Music & Arts transaction,and other factors affecting growth in sales and earnings. Specificforward-looking statements are provided regarding our management’s currentviews regarding comparable store sales, new store openings, and capitalexpenditure levels. Statements regarding new store openings are based largelyon our current expectations and are necessarily subject to associated businessrisks related to, among other things, the identification of suitable sites oracquisition opportunities, the timely construction, staffing and merchandisingof those stores and other matters, some of which are outside of our control.Comparable store sales growth is highly dependent upon the state of theeconomy, the effectiveness of our sales and promotion strategies, and theeffect of competition, including other national operators of music productsstores attempting to implement national growth strategies. The American Musicbusiness has in the past and may in the future give rise to significant 

43

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fluctuations from period toperiod as we reformat their store model and build-out the informationtechnology and management structure. The American Music stores have incurredsignificant operating losses in 2004.

Sales and earnings trends are also affected by manyother factors including, among others, world and national political events,general economic conditions, the effectiveness of our promotion andmerchandising strategies, changes in the music products industry, retail salestrends and the emergence of new or growing specialty retailers of musicproducts. In light of these risks, there can be no assurance that theforward-looking statements contained in this report will in fact be realized. Thestatements made by us in this report represent our views as of the date of thisreport, and it should not be assumed that the statements made herein remainaccurate as of any future date. We do not presently intend to update thesestatements and undertake no duty to any person to affect any such update underany circumstances.

For further discussion ofrisks associated with our business, please see the discussion under the captionItem 1. Business—“Risks Related to the Business.”

**Item 7A.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 outstanding indebtedness represented by $100 million principalamount of Senior Convertible Notes due 2013 with a fixed interest rate of 4%(subject to contingent interest) and our credit facility which has a variablerate of interest generally consisting of stated premiums above LIBOR. As of December 31,2004 the fair value of our 4% Senior Convertible Notes was $151 million,based on quoted market prices. At December 31, 2004, we had no outstandingborrowings under our credit facility. To the extent prevailing short-terminterest rates fluctuate, the interest expense we incur on our credit facilitywill change with a resulting effect (positive or negative) on our financialposition, results of operations and cash flows. We do not use derivativefinancial instruments in our investment portfolio. Historically, we have notcarried significant cash balances and any cash in excess of our daily operatingneeds has been used to reduce our borrowings. Excess cash is invested in highquality interest bearing investments, generally with short-term maturities.

**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 FINANCIAL DISCLOSURE**

Not Applicable

**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 ourExchange Act reports is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms and that such information is accumulated and communicated to ourmanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

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As required by SEC Rule 13a-15(e),we carried out an evaluation, under the supervision and with the participationof our management, including our Chief Executive Officer and Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures as of the end of the period covered by this report. Basedon the foregoing, our Chief Executive Officer and Chief Financial Officerconcluded that our disclosure controls and procedures were effective at thereasonable assurance level.

**MANAGEMENT’S REPORT ON INTERNAL CONTROL 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(f) and 15d-15(f). Under thesupervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anassessment of the effectiveness of our internal control over financialreporting based on the framework in Internal Control - Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.Based on our evaluation under the framework in Internal Control—Integrated Framework,our management concluded that our internal control over financial reporting waseffective as of December 31, 2004.

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.

There has been no change in our internal control overfinancial reporting during our most recent fiscal year end that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

Our management’sassessment of the effectiveness of our internal control over financialreporting as of December 31, 2004 has been audited by KPMG LLP, anindependent registered public accounting firm, as stated in their report whichis included herein.

**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

**TheBoard of Directors and Stockholders**

**Guitar Center, Inc.:**

We have audited management’s assessment, included inthe accompanying Management’s Report on Internal Control Over FinancialReporting, that Guitar Center, Inc. maintained effective internal controlover financial reporting as of December 31, 2004, based on criteriaestablished in Internal Control—Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission (COSO). Guitar Center, Inc.’smanagement is responsible for maintaining effective internal control overfinancial reporting and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon management’s assessment and an opinion on the effectiveness of the Company’sinternal control over financial reporting based on our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinion.

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A company’s internal control over financial reportingis a process designed to provide reasonable assurance regarding the reliabilityof financial reporting and the preparation of financial statements for externalpurposes in accordance with generally accepted accounting principles. Acompany’s internal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions and dispositionsof the assets of the company; (2) provide reasonable assurance thattransactions are recorded as necessary to permit preparation of financialstatements in accordance with generally accepted accounting principles, andthat receipts and expenditures of the company are being made only in accordancewith authorizations of management and directors of the company; and(3) provide reasonable assurance regarding prevention or timely detectionof unauthorized acquisition, use, or disposition of the company’s assets thatcould have a material effect on the financial statements.

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.

In our opinion, management’s assessment that GuitarCenter, Inc. maintained effective internal control over financialreporting as of December 31, 2004, is fairly stated, in all materialrespects, based on criteria established in Internal Control—IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO). Also, in our opinion, Guitar Center, Inc. maintained,in all material respects, effective internal control over financial reportingas of December 31, 2004, based on criteria established in InternalControl—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the consolidated balance sheets ofGuitar Center Inc. and subsidiaries as of December 31, 2004 and 2003, andthe related consolidated statements of income, stockholders’ equity, and cashflows for each of the years in the three-year period ended December 31,2004, and our report dated March 9, 2005, expressed an unqualified opinionon those consolidated financial statements.
| /s/ KPMG LLP            |
|-------------------------|
| Los Angeles, California |
| March 9, 2005      |

 

**Item 9B. OTHERINFORMATION**

Not Applicable

**PART III**

**Item 10. DIRECTORSAND EXECUTIVE OFFICERS OF THE REGISTRANT**

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 National Market. The code isavailable on the investor relations section of our website (www.guitarcenter.com),under subsection captioned “Corporate Governance.”  To the extent required by law or the rules ofthe Nasdaq National Market, any amendments to, or waivers from, any provisionof the code will be promptly disclosed publicly. To the extent permitted bysuch requirements, we intend to make such public disclosure by posting therelevant material on the corporate governance page of the investorrelations section of our website in accordance with SEC rules.

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All additional informationrequired by this item is incorporated by reference to our definitive ProxyStatement to be filed pursuant to Regulation 14A under the Securities ExchangeAct of 1934, as amended, or Exchange Act, in connection with our annual meetingof stockholders.

**Item 11. EXECUTIVECOMPENSATION**

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 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIALOWNERS AND MANAGEMENT AND RELATED STOCKHOLDER 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.

**Item 13. CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

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. PRINCIPALACCOUNTANT 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.

**PART IV**

**Item 15. EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

(a)           Documents filed as partof this Report:

1.                Thefollowing financial statements for the Company are included as part of thisReport:
| Index to Financial Statements | Page 55 |
|-------------------------------|--------------|

 

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

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**INDEX TO EXHIBITS**
| 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 Acqusition 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              |       | The Company’s 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 3.1 to the Company’s  Quarterly Report on Form 10-Q for the period ended June 30, 2004).                                                                                                                                                                                                                                                                                         |
| 4.1              |       | Indenture dated as of  June 10, 2003 by and between the Company and BNY Western Trust Company  as trustee (Incorporated by reference to Exhibit 4.1 of the Company’s  Annual Report on Form 10-K for the fiscal year ended December 31,  2003).                                                                                                                                                                                                |
| 4.2              |       | 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).                                                                                                                                                                                                                                                                                        |
| 4.3              |       | Form of Indenture  (Incorporated by reference to Exhibit 4.2 of the Company’s Registration  Statement on Form S-3; Registration No. 333-65220).                                                                                                                                                                                                                                                                                                |
| 4.4              |       | Form of Officer’s  Certificate pursuant to Section 2.02 of the Indenture governing the  Senior Convertible Notes due 2013 (Incorporated by reference to  Exhibit 4.1 to the Company’s Current Report on Form 8-K dated  June 13, 2003).                                                                                                                                                                                              |
| 4.5              |       | Form of Global Note  relating to the Senior Convertible Notes due 2013 (Incorporated by reference  to Exhibit 4.2 to the Company’s Current Report on Form 8-K dated  June 13, 2003).                                                                                                                                                                                                                                                           |
| 10.1*            |       | The Company’s Amended  and Restated 1996 Performance Stock Option Plan (Incorporated by reference to  Exhibit 10.5 of the Company’s Registration Statement on Form S-1;  Registration No. 333-20931).                                                                                                                                                                                                                                          |
| 10.2*            |       | Modification to Amended  and Restated 1996 Performance Stock Option Plan (Incorporated by reference to  Exhibit 10.28 of the Company’s Registration Statement on Form S-1;  Registration No. 333-20931).                                                                                                                                                                                                                                            |
| 10.3*            |       | Amendment No. 2 to  the Amended and Restated 1996 Performance Stock Option Plan (Incorporated by  reference to Exhibit 10.30 of the Company’s Registration Statement on  Form S-1; Registration No. 333-20931).                                                                                                                                                                                                                                |
| 10.4*            |       | Amendment No. 3 to  Amended and Restated 1996 Performance Stock Option Plan (Incorporated by  reference to Exhibit 10.29 of the Company’s Annual Report on  Form 10-K for the fiscal year ended December 31, 1998).                                                                                                                                                                                                                            |
| 10.5*            |       | 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).                                                                                                                                                                                                                                                                     |
| 10.6*            |       | Amendment to the 1997  Equity Participation Plan of Guitar Center, Inc. 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).                                                                                                                                                          |
| 10.7*            |       | Amendment to the  Company’s 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).                                                                                                                                                                             |

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| 10.8*  |   | Amendment to the  Company’s 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).                                                                                                                                |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.9*  |   | Amendment to the 1997  Equity Participation Plan of Guitar Center, Inc. approved by  stockholders at the March 24, 2003 Annual Meeting of Stockholders increasing  the authorized shares under the plan to 4,000,000 (Incorporated by reference  to Exhibit 10.40 to the Company’s Quarterly Report on Form 10-Q for  the period ended March 31, 2003). |
| 10.10* |   | Amendment to the 1997  Equity Participation Plan of Guitar Center, Inc. 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).                                                                                                             |
| 10.11* |   | 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).                                                                                                                |
| 10.12* |   | Form of  Indemnification Agreement between the Company and each of its directors and  executive officers (Incorporated by reference to Exhibit 10.11 of the  Company’s Registration Statement on Form S-1; Registration  No. 333-20931).                                                                                                                     |
| 10.13* |   | Management Stock Option  agreement dated June 5, 1996 by and between the Company and Larry Thomas  (Incorporated by reference to Exhibit 10.16 of the Company’s  Registration Statement on Form S-1; Registration No. 333-10491).                                                                                                                            |
| 10.14* |   | Amendment No. 1 to  Management Stock Option Agreement dated as of October 15, 1996 between  the Company and Larry Thomas (Incorporated by reference to Exhibit 10.21  contained in Registration Statement on Form S-1; File No. 333-10491).                                                                                                                  |
| 10.15* |   | Management Stock Option  agreement dated June 5, 1996 by and between the Company and Marty  Albertson (Incorporated by reference to Exhibit 10.17 of the Company’s  Registration Statement on Form S-1; Registration No. 333-10491).                                                                                                                         |
| 10.16* |   | Amendment No. 1 to  Management Stock Option Agreement dated as of October 15, 1996 between  the Company and Marty Albertson (Incorporated by reference to  Exhibit 10.22 contained in Registration Statement on Form S-1; File  No. 333-10491).                                                                                                              |
| 10.17* |   | 2004 Guitar  Center, Inc. Incentive Stock Award Plan (Incorporated by reference to  the Definitive 2004 Proxy Statement as filed on Schedule 14A).                                                                                                                                                                                                                               |
| 10.18* |   | 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).                                                                                                                    |
| 10.19* |   | Form of Restricted  Stock Agreement under the 2004 Guitar Center, Inc. Incentive Stock Award  Plan 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).                                                                                                           |
| 10.20* |   | Form of Deferred  Stock Agreement under the 2004 Guitar Center, Inc. Incentive Stock Award  Plan 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).                                                                                                             |
| 10.21* |   | Amended and Restated  Employment Agreement between the Company and Larry Thomas, effective as of  June 6, 2001, with exhibits (Incorporated by reference to  Exhibit 10.23 to the Company’s Annual Report on Form 10-K for the  year ended December 31, 2001).                                                                                               |

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| 10.22* |   | Amendment to  Amended and Restated Employment Agreement by and between Larry Thomas and  Guitar Center, Inc. dated March 24, 2003 (Incorporated by reference  to Exhibit 10.33 to the Company’s Quarterly Report on Form 10-Q for  the period ended March 31, 2003).          |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.23* |   | Amendment No. 2  dated July 1, 2003 to Amended and Restated Employment Agreement between  Guitar Center, Inc. and Larry Thomas (Incorporated by reference to  Exhibit 10.43 to the Company’s Quarterly Report on Form 10-Q for  the period ended September 30, 2003).    |
| 10.24* |   | Amendment No. 3  dated January 1, 2004 to Amended and Restated Employment Agreement  between Guitar Center, Inc. and Larry Thomas (Incorporated by reference  to Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for  the period ended June 30, 2004).       |
| 10.25* |   | Employment Agreement  Termination Agreement, dated as of October 8, 2004, between Guitar  Center, Inc. and Larry Thomas (Incorporated by reference to Exhibit 99.2  of the Company’s Current Report on Form 8-K dated October 8, 2004).                                       |
| 10.26* |   | Employment Agreement,  effective as of January 1, 2005, between Guitar Center, Inc. and  Larry Thomas (Incorporated by reference to Exhibit 99.3 of the Company’s  Current Report on Form 8-K dated October 8, 2004).                                                         |
| 10.27* |   | Amended and Restated  Employment Agreement between the Company and Marty Albertson, effective as of  June 6, 2001, with exhibits (Incorporated by reference to  Exhibit 10.22 to the Company’s Annual Report on Form 10-K for the  year ended December 31, 2001).                  |
| 10.28* |   | Amendment to Amended and  Restated Employment Agreement by and between Marty Albertson and Guitar  Center, Inc. dated March 24, 2003 (Incorporated by reference to  Exhibit 10.34 to the Company’s Quarterly Report on Form 10-Q for  the period ended March 31, 2003).       |
| 10.29* |   | Amendment No. 2  dated July 1, 2003 to Amended and Restated Employment Agreement between  Guitar Center, Inc. and Marty Albertson (Incorporated by reference to  Exhibit 10.44 to the Company’s Quarterly Report on Form 10-Q for  the period ended September 30, 2003). |
| 10.30* |   | Amendment No. 3  dated January 1, 2004 to Amended and Restated Employment Agreement  between Guitar Center, Inc. and Marty Albertson (Incorporated by  reference to Exhibit 10.1 to the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2004).    |
| 10.31* |   | 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).                             |
| 10.32* |   | Third Amended and  Restated Employment Agreement dated July 1, 2003 between Guitar  Center, Inc. and Bruce Ross (Incorporated by reference to  Exhibit 10.45 to the Company’s Quarterly Report on Form 10-Q for  the period ended September 30, 2003).                        |
| 10.33* |   | Amendment No. 1  dated January 1, 2004 to Third Amended and Restated Employment Agreement  between Guitar Center, Inc. and Bruce Ross (Incorporated by reference to  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the  period ended June 30, 2004).   |
| 10.34* |   | Amended and Restated  Employment Agreement dated May 13, 1999 between Musician’s  Friend, Inc. and Robert Eastman (Incorporated by reference to  Exhibit 10.31 of the Company’s Quarterly Report on Form 10-Q for  the period ending June 30, 1999).                     |

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| 10.35* |   | Second Amended  and Restated Employment Agreement dated June 1, 2003 between Musician’s  Friend, Inc. and Robert Eastman (Incorporated by reference to  Exhibit 10.25 of the Company’s Annual Report on Form 10-K for the  fiscal year ended December 31, 2003).                                                                                                                                                                                                                                                                                                                                                                    |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.36* |   | Form of Executive  Severance Benefits Agreement between Guitar Center, Inc., Musician’s  Friend, Inc. or Guitar Center Stores, Inc. and our executive  officers not party to employment agreements (Incorporated by reference to  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q for the  period ended June 30, 2004).                                                                                                                                                                                                                                                                                       |
| 10.37* |   | 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).                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.38* |   | Amended and Restated  Registration Rights Agreement dated May 13, 1999 by and among the  Company, Chase Venture Capital Associates, L.P., Weston Presidio Capital II,  L.P., Wells Fargo Small Business Investment Company, Inc., Larry Thomas,  Marty Albertson, Amazing Grace Foundation, The Emmanuel Foundation, Midas  Touch Investments Trust, Sterling Investments Trust, Syringa Investments  Trust, Eiger Mountain Real Estate Trust, Promise Land Real Estate Development  Trust and Musician’s Friend Trust (Incorporated by reference to  Exhibit 2.2 of the Company’s Current Report on Form 8-K dated  May 28, 1999). |
| 10.39  |   | 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).                                                                                                                                                                                                                                                                                                                                                                              |
| 10.40  |   | 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).                                                                                                                                                                                                                                                                                                                                                                   |
| 10.41  |   | 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).                                                                                                                                                                                                                                                                |
| 10.42  |   | 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).                                                                                                                                                                                                                                                             |
| 10.43  |   | 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).                                                                                                                                                                                                                                                                                                        |
| 10.44  |   | 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).                                                                                                                                                                                                                                                                                |
| 10.45  |   | Aircraft  Sale and Purchase Agreement dated as of March 4, 2005 by and between Guitar  Center, Inc., a Delaware corporation, and Taxi Aereo De Veracruz, S.A. de  C.V., a corporation organized under the laws of Mexico, regarding a Falcon 50  aircraft (Incorporated by reference to Exhibit 10.01 to the Company’s Current  Report on Form 8-K dated March 10, 2005).                                                                                                                                                                                                                                                                                         |

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| 10.46 |   | 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).                                                       |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.47 |   | 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). |
| 10.48 |   | 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).                                                                                                                                       |
| 10.49 |   | Third Amendment to  Second Amended and Restated Loan and Security Agreement, effective  February 8, 2005 (Incorporated by reference to Exhibit 10.01 of the  Company’s Current Report on Form 8-K dated February 8, 2005).                                                                                                                                                                                                   |
| 12.1  |   | Ratio of Earnings to  Fixed Charges (Filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                 |
| 21.1  |   | Material subsidiaries of  the Registrant as of December 31, 2003 (Filed herewith).                                                                                                                                                                                                                                                                                                                                                               |
| 23.1  |   | Consent of Registered  Public Accounting Firm (KPMG LLP) (Filed herewith).                                                                                                                                                                                                                                                                                                                                                                            |
| 24.1  |   | Power of Attorney  (included on page 53).                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31    |   | Certification of the  Company’s Chief Executive Officer and Chief Financial Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 (Filed herewith).                                                                                                                                                                                                                                                                            |
| 32    |   | Certification of the  Company’s Chief Executive Officer and Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 (Filed herewith).                                                                                                                                                                                                                                                                            |

----

*                    Managementcontract or other compensation plan or arrangement.

52

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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 this 8thday of March 2005.
|        | 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, BruceRoss, 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 and otherdocuments in connection therewith with the Securities and Exchange Commission,hereby ratifying and confirming all that each of said attorneys-in-fact, or hissubstitute or substitutes may do or cause to be done by virtue hereof.

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, thisReport has been signed below by the following persons on behalf of theRegistrant and in the capacities and on the dates indicated.
|                                   | **Name** | ** **                                      | ** ** | ** **          | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|-----------------------------------|----------|-------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/  MARTY ALBERTSON    |     | Chief Executive Officer  and Director           |       | March 8,  2005 |
| Marty Albertson                   |     |                                            |       |                |
| /s/  BRUCE ROSS         |     | Executive Vice President  and Chief             |       | March 8,  2005 |
| Bruce Ross                        |     | Financial Officer (Principal Financial Officer) |       |                |
| /s/  DAVID  ROBSON |     | Vice President of Finance  (Principal           |       | March 8,  2005 |
| David Robson                      |     | Accounting Officer)                             |       |                |
| /s/  CHRIS GOROG        |     | Director                                        |       | March 8,  2005 |
| Chris Gorog                       |     |                                            |       |                |
| /s/  GEORGE JONES       |     | Director                                        |       | March 8,  2005 |
| George Jones                      |     |                                            |       |                |
| /s/  LARRY LIVINGSTON   |     | Director                                        |       | March 8,  2005 |
| Larry Livingston                  |     |                                            |       |                |

53

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| /s/  GEORGE MRKONIC |   | Director                        |   | March 8,  2005 |
|-------------------------------|--------|---------------------------------|--------|---------------------|
| George Mrkonic                |   |                            |   |                |
| /s/  KENNETH REISS  |   | Director                        |   | March 8,  2005 |
| Kenneth Reiss                 |   |                            |   |                |
| /s/  WALTER  ROSSI  |   | Director                        |   | March 8, 2005  |
| Walter Rossi                  |   |                            |   |                |
| /s/  PETER STARRETT |   | Director                        |   | March 8,  2005 |
| Peter Starrett                |   |                            |   |                |
| /s/  LARRY THOMAS   |   | Director and Chairman  Emeritus |   | March 8,  2005 |
| Larry Thomas                  |   |                            |   |                |

 

54

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**INDEX** TO FINANCIAL STATEMENTS
| Report of Independent  Registered Public Accounting Firm                                                         |       | 56           |
|------------------------------------------------------------------------------------------------------------------|------------|--------------|
| Consolidated  Balance Sheets as of December 31, 2004 and 2003                                               |       | 57           |
| Consolidated  Statements of Income for the years ended December 31, 2004, 2003 and  2002                    |       | 58           |
| Consolidated  Statements of Stockholders’ Equity for the years ended December 31,  2004, 2003 and 2002 |       | 59           |
| Consolidated  Statements of Cash Flows for the years ended December 31, 2004, 2003 and  2002                |       | 60           |
| Notes  to Consolidated Financial Statements                                                                      |       | 61           |
| ** **                                                                                                       | ** ** | **Schedule** |
| Financial  Statement Schedule:                                                                                   |       |         |
| Valuation and Qualifying  Accounts                                                                               |       | II-1         |

 

55

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**REPORT** OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and StockholdersGuitar Center, Inc.:

We have audited the consolidated balance sheets ofGuitar Center, Inc. and subsidiaries as of December 31, 2004 and2003, and the related consolidated statements of income, stockholders’ equity,and cash flows for each of the years in the three year period ended December 31,2004. In connection with our audits of the consolidated financial statements,we also have audited the related financial statement schedule. Theseconsolidated financial statements and financial statement schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these consolidated financial statements and financial statementschedule 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 statementsreferred to above present fairly, in all material respects, the financialposition of Guitar Center, Inc. and subsidiaries as of December 31,2004 and 2003, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2004, inconformity with U.S. generally accepted accounting principles. Also in ouropinion, the related financial statement schedule, when considered in relationto the basic consolidated financial statements taken as a whole, presentsfairly, in all material respects, the information set forth therein.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of Guitar Center, Inc.’sinternal control over financial reporting as of December 31, 2004, basedon criteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO), andour report dated March 9, 2005, expressed an unqualified opinion onmanagement’s assessment of, and the effective operation of, internal controlover financial reporting.
| /s/ KPMG LLP            |
|-------------------------|
| Los Angeles, California |
| March 9, 2005      |

 

56

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**GUITAR CENTER, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands, except per share data)**
| ** **                                                                                                                                              | ** ** | **December 31,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                              |       |                        |       |                        |       |   |   |   |   |
| Current assets:                                                                                                                                         |       |                        |       |                        |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                               |       |                        | $          | 60,453                      |       |   |   | $ | 5,350 |   |   |
| Investments in marketable securities                                                                                                                    |       |                        | 3,810      |                        |       |   | — |   |   |
| Accounts receivable, less allowance for doubtful  accounts $1,708 and $3,489, respectively                                                              |       |                        | 27,627     |                        |       |   | 23,814 |   |   |
| Merchandise inventories                                                                                                                                 |       |                        | 314,961    |                        |       |   | 288,873 |   |   |
| Prepaid expenses and deposits                                                                                                                           |       |                        | 13,367     |                        |       |   | 11,543 |   |   |
| Deferred income taxes                                                                                                                                   |       |                        | 5,552      |                        |       |   | 5,631 |   |   |
| Total current  assets                                                                                                                                   |       |                        | 425,770    |                        |       |   | 335,211 |   |   |
| Property and  equipment, net                                                                                                                            |       |                        | 97,349     |                        |       |   | 93,347 |   |   |
| Investments in  marketable securities                                                                                                                   |       |                        | 16,997     |                        |       |   | — |   |   |
| Goodwill                                                                                                                                                |       |                        | 26,474     |                        |       |   | 25,995 |   |   |
| Deposits and  other assets, net                                                                                                                         |       |                        | 8,003      |                        |       |   | 6,318 |   |   |
|                                                                                                                                                    |       |                        | $          | 574,593                     |       |   |   | $ | 460,871 |   |   |
| **Liabilities  and stockholders’ equity**                                                                                                          |       |                        |       |                        |       |   |   |   |   |
| Current liabilities:                                                                                                                                    |       |                        |       |                        |       |   |   |   |   |
| Accounts payable                                                                                                                                        |       |                        | $          | 49,771                      |       |   |   | $ | 47,778 |   |   |
| Accrued expenses and other current liabilities                                                                                                          |       |                        | 83,606     |                        |       |   | 71,616 |   |   |
| Merchandise advances                                                                                                                                    |       |                        | 22,534     |                        |       |   | 17,104 |   |   |
| Total current  liabilities                                                                                                                              |       |                        | 155,911    |                        |       |   | 136,498 |   |   |
| Other long-term  liabilities                                                                                                                            |       |                        | 6,943      |                        |       |   | 5,982 |   |   |
| Deferred income  taxes                                                                                                                                  |       |                        | 5,057      |                        |       |   | 4,220 |   |   |
| Long-term debt                                                                                                                                          |       |                        | 100,000    |                        |       |   | 100,000 |   |   |
| Total liabilities                                                                                                                                       |       |                        | 267,911    |                        |       |   | 246,700 |   |   |
| Stockholders’ equity:                                                                                                                              |       |                        |       |                        |       |   |   |   |   |
| Preferred stock; 5,000 authorized, none issued and  outstanding                                                                                         |       |                        | —     |                        |       |   | — |   |   |
| Common stock, $0.01 par value, authorized 55,000  shares, issued and outstanding 25,359 at December 31, 2004 and 23,998 at  December 31, 2003 |       |                        | 254        |                        |       |   | 240 |   |   |
| Additional paid in capital                                                                                                                              |       |                        | 305,305    |                        |       |   | 276,233 |   |   |
| Retained earnings                                                                                                                                       |       |                        | 1,123      |                        |       |   | (62,302 | ) |   |
| Stockholders’  equity                                                                                                                              |       |                        | 306,682    |                        |       |   | 214,171 |   |   |
|                                                                                                                                                    |       |                        | $          | 574,593                     |       |   |   | $ | 460,871 |   |   |

 

*See accompanying notes to consolidated financialstatements.*

57

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**GUITAR CENTER, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF INCOME(In thousands, except per share data)**
| ** **                                    | ** ** | **Year ended December 31,** | ** ** |
|-----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                    | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net sales                                     |       | $                                          | 1,513,172  |   | $ | 1,275,059 |   | $ | 1,100,889 |   |
| Cost of goods  sold, buying and occupancy     |       | 1,087,899                                  |       | 931,014 |   | 810,474 |   |
| Gross profit                                  |       | 425,273                                    |       | 344,045 |   | 290,415 |   |
| Selling, general  and administrative expenses |       | 317,585                                    |       | 271,996 |   | 236,537 |   |
| Operating income                              |       | 107,688                                    |       | 72,049 |   | 53,878 |   |
| Interest expense, net                         |       | 5,390                                      |       | 12,540 |   | 13,077 |   |
| Income before  income taxes                   |       | 102,298                                    |       | 59,509 |   | 40,801 |   |
| Income taxes                                  |       | 38,873                                     |       | 22,649 |   | 15,545 |   |
| Net income                                    |       | $                                          | 63,425     |   | $ | 36,860 |   | $ | 25,256 |   |
| Net income per  share                         |       |                                       |       |   |   |   |   |
| Basic                                         |       | $                                          | 2.55       |   | $ | 1.59 |   | $ | 1.12 |   |
| Diluted                                       |       | $                                          | 2.29       |   | $ | 1.47 |   | $ | 1.09 |   |
| Weighted average  shares outstanding          |       |                                       |       |   |   |   |   |
| Basic                                         |       | 24,856                                     |       | 23,255 |   | 22,491 |   |
| Diluted                                       |       | 28,976                                     |       | 26,119 |   | 23,130 |   |

 

*See accompanying notes to consolidated financialstatements.*

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**GUITAR CENTER, INC. ANDSUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands)**
| ** **                                                           | ** ** | **Number of  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid in  Capital** | ** ** | **Retained  Earnings  (Accumulated  Deficit)** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------|------------|-------------------|------------|---------------------------------------|------------|------------------------------------------------|------------|-----------|------------|
| Balance at  December 31, 2001                                   |       |                       | 22,315     |              |       |                                  | $          | 223                                            |       |      | $          | 248,063 |   |   | $ | (124,418 | ) |   | $ | 123,868 |   |
| Exercise of employee stock options                                   |       |                       | 207        |              |       |                                  | 2          |                                           |       | 2,436     |       |   | — |   |   | 2,438 |   |
| Issuance of stock for acquisition                                    |       |                       | 145        |              |       |                                  | 1          |                                           |       | 2,347     |       |   | — |   |   | 2,348 |   |
| Stock issued under employee stock purchase plan                      |       |                       | 79         |              |       |                                  | 1          |                                           |       | 1,017     |       |   | — |   |   | 1,018 |   |
| Net income                                                           |       |                       | —     |              |       |                                  | —     |                                           |       | —    |       |   | 25,256 |   |   | 25,256 |   |
| Balance at  December 31, 2002                                   |       |                       | 22,746     |              |       |                                  | 227        |                                           |       | 253,863   |       |   | (99,162 | ) |   | 154,928 |   |
| Exercise of employee stock options, including tax  benefit of $4,091 |       |                       | 1,203      |              |       |                                  | 12         |                                           |       | 21,462    |       |   | — |   |   | 21,474 |   |
| Stock issued under employee stock purchase plan                      |       |                       | 49         |              |       |                                  | 1          |                                           |       | 908       |       |   | — |   |   | 909 |   |
| Net income                                                           |       |                       | —     |              |       |                                  | —     |                                           |       | —    |       |   | 36,860 |   |   | 36,860 |   |
| 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 |   |

 

*See accompanying notes to consolidated financialstatements.*

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**GUITAR CENTER, INC.AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF CASH FLOWS(In thousands)**
| ** **                                                                                      | ** ** | **Year ended December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                      | ** ** | **2004**                                   | ** ** | **2003** | ** ** | **2002** | ** ** |
| **Operating activities:**                                                                       |       |                                       |       |   |   |   |   |
| Net income                                                                                      |       | $                                          | 63,425     |   | $ | 36,860 |   | $ | 25,256 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:              |       |                                       |       |   |   |   |   |
| Depreciation and  amortization                                                                  |       | 22,304                                     |       | 20,620 |   | 16,860 |   |
| Loss on sale and disposal  of property and equipment                                            |       | —                                     |       | — |   | 384 |   |
| Amortization of deferred  financing fees                                                        |       | 1,045                                      |       | 938 |   | 664 |   |
| Write-off of deferred  financing fees                                                           |       | —                                     |       | 722 |   | — |   |
| Deferred income taxes                                                                           |       | 916                                        |       | 1,314 |   | (1,564 | ) |
| Tax benefit from exercise  of stock options                                                     |       | 9,756                                      |       | 4,091 |   | — |   |
| Changes in operating assets and liabilities:                                                    |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                             |       | (3,341                                     | )          | (4,052 | ) | 231 |   |
| Merchandise inventories                                                                         |       | (24,281                                    | )          | 3,220 |   | (37,947 | ) |
| Prepaid expenses and  deposits                                                                  |       | (1,824                                     | )          | (2,917 | ) | (1,747 | ) |
| Deposits and other assets                                                                       |       | (2,869                                     | )          | (657 | ) | (124 | ) |
| Accounts payable                                                                                |       | 1,994                                      |       | (22,967 | ) | (7,896 | ) |
| Accrued expenses and  other current liabilities                                                 |       | 11,990                                     |       | 17,320 |   | 15,059 |   |
| Other long-term  liabilities                                                                    |       | 961                                        |       | 291 |   | 1,975 |   |
| Merchandise advances                                                                            |       | 5,430                                      |       | 3,222 |   | 1,097 |   |
| Net cash provided  by operating activities                                                      |       | 85,506                                     |       | 58,005 |   | 12,248 |   |
| **Investing activities:**                                                                       |       |                                       |       |   |   |   |   |
| Purchase of property and  equipment                                                             |       | (26,151                                    | )          | (24,245 | ) | (26,309 | ) |
| Purchase of  available-for-sale securities                                                      |       | (20,807                                    | )          | — |   | — |   |
| Acquisition of business,  net of cash acquired                                                  |       | (2,775                                     | )          | — |   | (5,932 | ) |
| Net cash used in  investing activities                                                          |       | (49,733                                    | )          | (24,245 | ) | (32,241 | ) |
| **Financing activities:**                                                                       |       |                                       |       |   |   |   |   |
| Net change in revolving  debt facility                                                          |       | —                                     |       | (82,690 | ) | 5,786 |   |
| Proceeds from exercise of  stock options                                                        |       | 17,795                                     |       | 17,383 |   | 2,438 |   |
| Proceeds from stock  issued under employee purchase plan                                        |       | 1,535                                      |       | 909 |   | 1,018 |   |
| Net proceeds from Senior  Convertible Note                                                      |       | —                                     |       | 96,875 |   | — |   |
| Payments on Senior Note                                                                         |       | —                                     |       | (66,667 | ) | — |   |
| Payments under capital  lease                                                                   |       | —                                     |       | (151 | ) | (798 | ) |
| Net cash provided  by (used in) financing activities                                            |       | 19,330                                     |       | (34,341 | ) | 8,444 |   |
| Net increase  (decrease) in cash and cash equivalents                                           |       | 55,103                                     |       | (581 | ) | (11,549 | ) |
| Cash and cash  equivalents at beginning of year                                                 |       | 5,350                                      |       | 5,931 |   | 17,480 |   |
| Cash and cash  equivalents at end of period                                                     |       | $                                          | 60,453     |   | $ | 5,350 |   | $ | 5,931 |   |
| **Non-cash investing activities:**                                                              |       |                                       |       |   |   |   |   |
| Acquisition of businesses, in which the fair value of  assets and liabilities were as  follows: |       |                                       |       |   |   |   |   |
| Fair value of assets  acquired                                                                  |       | $                                          | 2,528      |   | $ | — |   | $ | 4,774 |   |
| Liabilities assumed                                                                             |       | (157                                       | )          | — |   | (1,515 | ) |
| Goodwill                                                                                        |       | 404                                        |       | — |   | 5,021 |   |
| Common stock issued                                                                             |       | —                                     |       | — |   | (2,348 | ) |
| Cash paid for acquisition                                                                       |       | 2,775                                      |       | — |   | 5,932 |   |
| Cash acquired in acquisition                                                                    |       | —                                     |       | — |   | — |   |
| Net cash paid for  acquisition                                                                  |       | $                                          | 2,775      |   | $ | — |   | $ | 5,932 |   |
| **Non-cash financing activities:**                                                              |       |                                       |       |   |   |   |   |
| Issuance of Common  stock in connection with business acquisitions                              |       | $                                          | —     |   | $ | — |   | $ | 2,348 |   |
| **Supplemental disclosure of cash flow  information:**                                          |       |                                       |       |   |   |   |   |
| Cash paid during the year for:                                                                  |       |                                       |       |   |   |   |   |
| Interest                                                                                        |       | $                                          | 4,665      |   | $ | 12,808 |   | $ | 11,953 |   |
| Income taxes                                                                                    |       | $                                          | 27,611     |   | $ | 15,931 |   | $ | 17,798 |   |

 

*See accompanying notes to consolidated financialstatements.*

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2004**

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

*Nature of Business*

Guitar Center, Inc.and subsidiaries (the “Company” or “we”) operates a chain of retail stores anda direct response unit which sells musical instruments, primarily guitars,amplifiers, percussion instruments, keyboards, live-sound/DJ and recordingequipment, and band and orchestral instruments. At December 31, 2004, weoperated 136 Guitar Center stores and 19 American Music stores in major citiesthroughout the United States, with 23 of the stores located in California.

*Principles ofConsolidation*

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

*Reclassifications*

Reclassifications havebeen made to prior year amounts to conform with the current year’spresentation.

*Cash and CashEquivalents*

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

*Investments*

Marketable securities thatwe have are classified as “available-for-sale” and recorded at fair value.Unrealized gains and losses, net of related tax effect, are excluded fromearnings and are reported as a separate component of other comprehensive incomeuntil realized. Realized gains and losses from the sale of available-for-salesecurities are determined on a specific-identification basis.

*MerchandiseInventories*

Inventories, includingused merchandise and vintage guitars, are valued at the lower of cost using thefirst-in, first-out (FIFO) method or market . Applicable costsassociated 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. Rental inventories arevalued at the lower of cost or market using the specific identification methodand are depreciated on a straight-line basis while out under the rentalagreement for rent-to-own sales. We receive price protection credits and vendorrebates from vendors, which are accounted for as a component 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 as an effective reduction in cost of goods sold at the timethe related item of inventory is sold. None of these credits are recorded asrevenue.

61

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

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

*Property andEquipment*

Property and equipment isrecorded at cost. Depreciation is computed using the straight-line methodover the estimated useful lives of the assets; generally five years forfurniture and fixtures, computer equipment and vehicles, 15 years for buildingsand 15 years or the life of the lease, whichever is less, for leaseholdimprovements. Maintenance and repair costs are expensed as they are incurred,while renewals and betterments are capitalized.

*Goodwill*

Goodwill represents theexcess of the purchase price over the fair value of the net assets acquiredresulting from business acquisitions and was historically amortized over a 20to 30 year period using the straight-line method. In 2002, we adopted SFAS No. 142which no longer requires the periodic amortization of goodwill. As of December 31,2004 we had unamortized goodwill in the amount of $26.4 million and unamortizedidentifiable intangible assets in the amount of $325,000. Our policy is to testfor impairment on an annual basis, or more frequently when triggering eventsoccur. We have tested goodwill and intangible assets for impairment under theprovisions of SFAS No. 142 and these tests indicated that there was noimpairment as of December 31, 2004.

*Impairment andDisposal Long-Lived Assets*

Long-lived assetsand definite-lived intangibles assets are reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. Recoverability of assets to be held and used ismeasured by a comparison of the carrying amount of the assets to futureundiscounted net cash flows expected to be generated by said assets. If suchassets are considered to be impaired, the impairment to be recognized is theamount by which the carrying amount of the assets exceeds the fair value of theassets. Assets to be disposed of are reported at the lower of the carryingamount or fair value less selling costs. No impairment was identified for theyears ended December 31, 2004, 2003 and 2002.

*MerchandiseAdvances*

Merchandise advancesrepresent layaway deposits which are recorded as a liability pendingconsummation of the sale when the full purchase price is received from thecustomer, outstanding gift certificates which are recorded as a liability untilredemption by the customer, credit on account for customer returns and specialorders.

*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, any amounts in excess ofthese are 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 $2.8 million and $0.7 million at December 31, 2004and $2.0 million and $0.8 million at December 31, 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

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

2003,respectively. Self-insurance reserve for workers’ compensation amounted to $0.8million at December 31, 2002. The balances are included in accruedexpenses and other current liabilities in the accompanying consolidated balancesheets.

*Revenue Recognition*

Retail sales arerecognized at the time of sale, net of a provision for estimated returns. Bandinstrument rentals are recognized on a straight-line basis over the term of therental agreement. The terms of the majority of our rental agreements do notexceed 30 months. Direct response sales are recognized when the products areestimated to be received by the customers, net of a provision for estimatedreturns. Direct response items sold to customers are received, on average,three days after shipment. Return allowances are estimated using historicalexperience.

*Advertising Costs*

We expense Guitar Center’s and American Music’sadvertising as incurred. Advertising expense included in the consolidatedstatements of income for the years ended December 31, 2004, 2003 and 2002is $34.0 million, $29.6 million, and $24.7 million, respectively. Mail ordercatalog costs are capitalized on a catalog by catalog basis and are amortizedover the expected period of future benefits, not to exceed five months, underthe provisions of AICPA Statement of Position 93-7, *“Reporting of Advertising Costs.”*  Capitalized mail order catalog costs at December 31,2004, 2003 and 2002 were $4.5 million, $3.1 million and $1.9 million,respectively. The realizability of the capitalized mail order catalog costs areevaluated at each balance sheet date by comparing the carrying amount of suchassets on a cost-pool-by-cost-pool basis to the probable remaining future netrevenues expected to result directly from such advertising. If the carryingamounts of such deferred mail order catalog costs exceed the remaining futurenet revenues that probably will be realized from such catalog, the excesscapitalized amount is written down and expensed in the current period. Therewas no write-down of capitalized mail order catalog costs for the years ended December 31,2004, 2003 and 2002.

We receive cooperativeadvertising allowances from manufacturers in order to subsidize qualifyingadvertising and similar promotional expenditures we make relating to the vendor’sproducts. These advertising allowances are recognized as a reduction to selling,general and administrative expense when we incur the advertising expenseeligible for the credit. We recognized cooperative advertising allowances of$6.4 million, $5.1 million and $4.9 million for the years ended December 31,2004, 2003 and 2002, 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.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

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

*Income Taxes*

We account for income taxes under Statement ofFinancial Accounting Standards No. 109, *“Accountingfor Income Taxes*” (SFAS No. 109). 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-Based Compensation*

We adopted SFAS No. 123,“*Accounting for Stock-Based Compensation,”*whichpermits entities to recognize as expense over the vesting period the fair valueof all stock-based awards on the date of grant. Alternatively, SFAS No. 123allows entities to continue to apply the provisions of Accounting PrinciplesBoard (“*APB”*) Opinion No. 25 “*Accounting for Stock Issued to Employees**,”*and related interpretations and provide pro forma netincome and pro forma earnings per share disclosures for employee stock optionas if the fair-value-based method defined in SFAS No. 123 hadbeen applied. We have elected to continue to apply the provisions of APBOpinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123.As such, compensation expense for stock options issued to employees is recordedon the date of grant only if the current market price of the underlying stockexceeded the exercise price. Had we determined compensation cost based upon thefair value at the grant date for our stock options under SFAS No. 123 usingthe Black Scholes option pricing model, pro forma net income and pro forma net 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**1. Nature of Business and Significant Accounting Policies(Continued)**

income per share, including the following weightedaverage assumptions used in these calculations, would have been as follows:
| ** **                                                                                                                                                 | ** ** | **December 31,**                                                                | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                 | ** ** | **2004**                                                                             | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                                                                 | ** ** | **($ in thousands, except per share  data—unaudited)** | ** ** |
| Net income, as reported                                                                                                                                    |       | $                                                                                    | 63,425     |   | $ | 36,860 |   | $ | 25,256 |   |
| Deduct:   Total  stock-based employee compensation expense determined under fair value based  methods for all awards, net of related tax effects |       | 6,271                                                                                |       | 4,821 |   | 4,485 |   |
| Pro forma net income                                                                                                                                       |       | $                                                                                    | 57,154     |   | $ | 32,039 |   | $ | 20,771 |   |
| Earnings per share:                                                                                                                                        |       |                                                                                 |       |   |   |   |   |
| Basic—as reported                                                                                                                                     |       | $                                                                                    | 2.55       |   | $ | 1.59 |   | $ | 1.12 |   |
| Basic—pro forma                                                                                                                                       |       | $                                                                                    | 2.30       |   | $ | 1.38 |   | $ | 0.92 |   |
| Diluted—as reported                                                                                                                                   |       | $                                                                                    | 2.29       |   | $ | 1.47 |   | $ | 1.09 |   |
| Diluted—pro forma                                                                                                                                     |       | $                                                                                    | 2.07       |   | $ | 1.29 |   | $ | 0.90 |   |
| Risk free interest rate                                                                                                                                    |       | 3.9                                                                                  | %          | 3.8 | % | 3.6 | % |
| Expected lives                                                                                                                                             |       | 6.70                                                                                 |       | 6.92 |   | 7.00 |   |
| Expected volatility                                                                                                                                        |       | 59.6                                                                                 | %          | 62.9 | % | 65.9 | % |
| Expected dividends                                                                                                                                         |       | —                                                                               |       | — |   | — |   |

 

*Earnings Per Share*

The following tablesummarizes the reconciliation of basic to diluted weighted average shares forthe years ended December 31, 2004, 2003 and 2002:
| ** **                                          | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                          | ** ** | **(in thousands)** | ** ** |
| Basic shares                                        |       | 24,856                  |       | 23,255   |       | 22,491   |       |
| Dilutive effect of  options outstanding             |       | 1,228                   |       | 1,306    |       | 639      |       |
| Dilutive effect of  conversion of Convertible Notes |       | 2,892                   |       | 1,558    |       | —   |       |
| Diluted shares                                      |       | 28,976                  |       | 26,119   |       | 23,130   |       |

 

For the years ended December 31,2004, 2003 and 2002, the only potential common stock outstanding with theCompany are stock options and the Senior Convertible Notes. For the year ended December 31,2004, all options outstanding had a dilutive effect. For the year ended December 31,2003, 223,000 shares at prices ranging from $28.30 to $30.70 were outstandingbut were excluded from the computation of diluted earnings per share becausethe exercise price of these options was greater than the average market priceof our Common Stock. For the year ended December 31, 2002, options topurchase 2,146,000 shares at prices ranging from $15.31 to $28.56 wereoutstanding but were not included in the computation of diluted earnings pershare because the exercise price of these options was greater than the averagemarket price of our Common Stock.

For the year ended December 31,2004, the 2.9 million shares of common stock issuable upon conversion of the 4%Senior Convertible Notes issued in June 2003 (reflecting an effectiveconversion price of $34.58) are deemed to be potential common stock and aredeemed to be outstanding for the purposes of calculating diluted earnings pershare under the “if-converted” method of accounting which 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

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

also provides that therelated after-tax interest expense, including amortization of deferredfinancing costs, for the period is added back to net income. For the year endedDecember 31, 2003, the 1.6 million weighted average shares of common stockissuable upon conversion of the 4% Senior Convertible Notes were included inthe calculation of earnings per share from the period of June 16, 2003,the issuance date of the Notes, to December 31, 2003, under the “if-converted”method.

In July 2004, theEmerging Issues Task Force (“EITF”) reached a consensus that contingentlyconvertible debt instruments, such as our 4% Senior Convertible Notes, shouldbe included in the computation of diluted earnings per share under theif-converted method regardless of whether the market price trigger (or othercontingent feature) has been met. The consensus must be applied by retroactiverestatement based on the term in effect on the last day of the fiscal period inwhich the consensus becomes effective. This consensus became effective for allfinancial statements issued after December 15, 2004. Accordingly, weretroactively restated all earnings per share measures for all periods to reflectthe 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 $7.7 million and $7.6million at December 31, 2004 and 2003, respectively. Credit losses havehistorically been within our expectations.

*Fair Value ofFinancial Instruments*

The fair value of ourrevolving line of credit reflects the fair value based upon current ratesavailable to us for similar debt. As of December 31, 2004 the fair valueof our 4% Senior Convertible Notes was $151 million, based on quotedmarket prices.

*Use of Estimates inthe Preparation of Financial Statements*

The preparation offinancial statements in conformity with generally accepted accountingprinciples requires us to make estimates and assumptions that affect thereported amounts of assets and liabilities and disclosure of contingent assetsand 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.

*New AccountingPronouncements*

In January 2003, the Financial AccountingStandards Board issued FASB Interpretation No. 46, *“Consolidationof Variable Interest Entities” (FIN 46).*This interpretationclarifies the application of Accounting Research Bulletin No. 51, *“Consolidated Financial Statements” (ARB 51),* and requirescompanies to evaluate variable interest entities for specific characteristicsto determine whether additional consolidation and disclosure requirements apply.This interpretation was immediately applicable for variable interest entitiescreated after January 31, 2003, and applies to the first fiscal year orinterim period 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

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

beginning after June 15,2003 for variable interest entities acquired prior to February 1, 2003.The adoption of this interpretation did not have any impact on our financialposition or results of operations. In December 2003, the FASB revised FIN46 to exempt certain entities from its requirements and to clarify certainissues arising during the implementation of FIN 46. The adoption of thisrevised interpretation in the first quarter of 2004 did not have any impact onour consolidated financial statements.

In May 2003, the FinancialAccounting Standards Board issued Statement No. 150*, “Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity” (SFAS No. 150).*The statement establishes standards forhow an issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. It requires that an issuerclassify a financial instrument that is within its scope as a liability (or anasset in some circumstances). It is generally effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003.  We adopted this standard effectiveJuly 1, 2003, and it did not have a material effect on our consolidatedfinancial statements.

In July 2004, the Emerging Issues Task Force (“EITF”)reached a consensus on Issue No. 04-8, “Accounting Issues Related toCertain Features of Contingently Convertible Debt and the Effect on DilutedEarnings per Share” (“EITF No. 04-8”). The Task Force reached a consensusthat contingently convertible debt instruments, such as our 4% SeniorConvertible Notes,  should be included inthe computation of diluted earnings per share under the if-converted method regardlessof whether the market price trigger (or other contingent feature) has been met.The EITF 04-8 consensus must be applied by retroactive restatement based on theterm in effect on the last day of the fiscal period in which the consensusbecomes effective. This consensus became effective for all financial statementsissued after December 15, 2004. Accordingly, we retroactively restated allearnings per share measures for all periods to reflect the consensus.

In December 2004,the FASB issued SFAS No. 123 (revised 2004) *“Share-BasedPayment.”* SFAS No. 123Rrequires that the cost from all share-based payment transactions, includingstock options, be recognized in the financial statements at fair value. SFAS123R is effective for public companies in the first  interim period after June 15, 2005. Wewill adopt the provisions of this statement in the third quarter of 2005 whichwill have an impact on our consolidated financial statements. We anticipateadopting SFAS No. 123R using the modified prospective method, which willnot require the restatement of prior periods.

**2. Acquisitions**

In February 2002,we acquired the inventory and assumed the customer credit liabilities of MusicLoft East, Inc., a single store located in Raleigh, North Carolina. Inconnection with the purchase we paid $488,000 in cash, acquired assets with afair value of $369,000, and assumed liabilities of $146,000. Goodwill in theamount of $265,000 was recorded.

On June 14,2002, we acquired M&M Music, a five-store band instrument retailerheadquartered in Valdosta, Georgia. Under the terms of the agreement, weacquired the stock of M&M Music for total consideration of $6.0 million incash and stock. We acquired assets with a fair value of $4.4 million andassumed liabilities and paid expenses of $1.3 million. Goodwill in the amountof $2.9 million was recorded.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**2. Acquisitions(Continued)**

On July 23,2004, we acquired one store and related assets of Karnes Music in the Chicagoarea. In connection with the purchase we paid $2.7 million in cash, acquiredassets with a fair value of $2.5 million and assumed liabilities of $0.2million. Goodwill in the amount of $0.4 million was recorded.

The resultsof operations and the assets of the Music Loft East, Inc., M&M Musicand Karnes Music were not material to Guitar Center’s historical consolidatedfinancial statements and, as such, pro-forma financial information is notpresented. The results of operations for each of these entities are included inGuitar Center’s consolidated financial statements from the dates of theacquisition.

Goodwillwas recorded on Music Loft Inc., M&M Music and Karnes Music acquisitions inthe amount of the total consideration paid in excess of the fair value of theidentifiable assets acquired. In accordance with SFAS 142, we no longeramortize goodwill and intangible assets with an indefinite useful life on astated basis but rather perform annual testing of the goodwill for impairment,with no charge to income except to the extent of any such impairment.

The changes in our goodwill balanceare summarized as follows:
| ** **              | ** ** | **Balance at  beginning      of year    ** | ** ** | **Additions** | ** ** | **Deductions** | ** ** | **Balance   at end  of year** | ** ** |
|-------------------------|------------|----------------------------------------------------------------------------------------------|------------|---------------|------------|----------------|------------|----------------------------------------------|------------|
| December 31,  2004 |       |                                                                                         | $          | 25,995        |       |           |       | 479                                          |       |   |   | — |   |   | $ | 26,474 |   |
| December 31, 2003  |       |                                                                                         | $          | 25,995        |       |           |       | —                                       |       |   |   | — |   |   | $ | 25,995 |   |

 

**3. Subsequent Event**

On February 8, 2005, two of our subsidiariesentered into an Agreement and Plan of Merger by and among Guitar Center Stores, Inc.,a wholly owned subsidiary of the Company (“GCSI”) , GCSI Acqusition Corp., aMaryland corporation, Music & Arts Center, Inc., a Marylandcorporation (“MAC”), and the common stockholders of MAC (the “Stockholders”),pursuant to which it is contemplated that MAC will become a wholly ownedsubsidiary of GCSI. MAC is a privately-held musical instruments retailer basedin Maryland which primarily addresses the beginning musician, with an emphasison rentals, music lessons and band and orchestra instrument sales. MAC’soperations include approximately 60 retail locations and seven educationalsupport centers.

The purchase price for the stock of MAC is $90 million,subject to adjustment for the actual level at closing of working capital and aterm note of MAC due to its bank, and seller transaction expenses. In addition,we are assuming designated debt and other deferred obligations, presentlyestimated at approximately $8 million. The purchase consideration for the stockof MAC is all cash, with $7 million to be held in an escrow account for 18months as partial security for the Stockholders’ indemnification obligations inthe event of a breach of a representation, warranty, covenant or agreementcontained in the Merger Agreement or any related instrument. The MergerAgreement also includes representations and warranties of the parties andcovenants and agreements regarding the operation of the business of MAC duringthe period from the execution of the Merger Agreement to closing.

The Merger Agreement may be terminated by GCSI or MAC uponcertain designated uncured breaches, or if the transaction is not closed by April 15,2005, however each has a further unilateral right to extend that terminationdate to May 15, 2005 if certain specified conditions, generally relatingto clearance 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**3. Subsequent Event(Continued)**

under the antitrust or competitionlaws, receipt of third party consents and court proceedings, have not beensatisfied.

**4. MerchandiseInventories**

Themajor classes of merchandise inventories are as follows:
| ** **              | ** ** | **December 31,**   | ** ** |
|-------------------------|------------|-------------------------|------------|
| ** **              | ** ** | **2004**                | ** ** | **2003** | ** ** |
| ** **              | ** ** | **(in thousands)** | ** ** |
| Major goods             |       |                    | $          | 187,902 |   |   | $ | 181,218 |   |
| Band instruments        |       |                    | 25,125     |   |   | 22,199 |   |
| Associated accessories  |       |                    | 59,721     |   |   | 56,265 |   |
| Vintage guitars         |       |                    | 10,831     |   |   | 10,150 |   |
| Used merchandise        |       |                    | 19,121     |   |   | 15,601 |   |
| General accessories     |       |                    | 17,479     |   |   | 8,814 |   |
|                    |       |                    | 320,179    |   |   | 294,247 |   |
| Less inventory reserves |       |                    | 5,218      |   |   | 5,374 |   |
|                    |       |                    | $          | 314,961 |   |   | $ | 288,873 |   |

 

Major goods includestringed merchandise, percussion, keyboards, live-sound/DJ and recordingequipment. Band instruments include horns, flutes, brass and woodwindinstruments. Associated accessories are comprised of accessories to major goodsand band instruments. General accessories include other merchandise such asapparel, cables and books.

**5. Propertyand Equipment**

Propertyand equipment consists of the following:
| ** **                                      | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2004**                | ** ** | **2003** | ** ** |
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| Land                                            |       | $                       | 2,946      |   | $ | 2,946 |   |
| Buildings                                       |       | 9,766                   |       | 9,426 |   |
| Furniture and fixtures                          |       | 24,526                  |       | 21,606 |   |
| Computer equipment                              |       | 58,174                  |       | 47,271 |   |
| Leasehold improvements                          |       | 97,776                  |       | 84,816 |   |
| Construction in progress                        |       | 4,076                   |       | 6,384 |   |
|                                            |       | 197,264                 |       | 172,449 |   |
| Less accumulated  depreciation and amortization |       | 99,915                  |       | 79,102 |   |
|                                            |       | $                       | 97,349     |   | $ | 93,347 |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**6. Revolving Line ofCredit and Debt**

In February of 2005, we amended our creditfacility with a syndicate of banks led by Wells Fargo Retail Finance. Thecredit facility permits borrowings up to $125 million, and may be increased to$150 million at our option, subject to borrowing base limitations. The actualamount available is tied to our inventory and receivable base, and repaymentobligations under the credit facility are secured by liens on our principalassets. Borrowing options are prime rate (5.25% at December 31, 2004) plusapplicable prime margin, or London Interbank Offered Rate, or LIBOR (six monthrate at December 31, 2004 was 2.78%) plus applicable LIBOR margin. Theapplicable prime and LIBOR margins are based upon levels of excess availabilityand adjusted quarterly. If excess availability is greater than $20 million, theapplicable prime margin is 0.00% and applicable LIBOR margin is 1.0%. If excessavailability is less than or equal to $20 million and greater than $10 million,the applicable prime margin is 0.00% and the applicable LIBOR margin is 1.25%.If excess availability is less than or equal to $10 million, the applicableprime margin is 0.00% and the applicable LIBOR margin is 1.5%. An unused fee of0.25% is assessed on the unused portion of the credit facility. The agreementunderlying the credit facility includes significant restrictive negativecovenants. Among other things, these covenants restrict our ability to incurdebt and issue specified equity instruments, incur liens on our assets, makeany significant change in our corporate structure or the nature of ourbusiness, dispose of assets, make guaranties, prepay debt, engage in a changein control transaction, pay dividends, make investments or acquisitions, engagein transactions with affiliates and incur capital expenditures, and alsorequire that we satisfy a minimum availability test. The minimum availabilitytest requires that we maintain $10 million of reserved availability under theagreement based on its borrowing base limitations. The amount we disclose inour public reports from time to time as available to borrow under the agreement($111 million at December 31, 2004) is already reduced by this requiredreserve and outstanding letters of credit, and thus represents a net amountavailable under the agreement. The agreement also includes representations andwarranties which must be true each time we borrow funds under the creditfacility and affirmative covenants. The full text of the contractualrequirements imposed by this financing is set forth in the Amended and RestatedLoan and Security Agreement and restated amendments which have been filed withthe Securities and Exchange Commission. We were in compliance with suchrequirements as of December 31, 2004. Subject to limited cure periods, thelenders under our credit facility may demand repayment of these borrowingsprior to stated maturity upon the occurrence of specified events, including ifwe breach the terms of the agreement, suffer a material adverse change, engage ina change in control transaction, suffer a significant adverse legal judgment,default on other significant obligations, or in the event of specified eventsof insolvency. The credit agreement matures in December 2010.

On June 16, 2003, we completed the issuance of$100 million principal amount of 4.00% Senior Convertible Notes due 2013 (theNotes). Of the net proceeds from the offering, approximately $68.2 million wasused in July 2003 to retire all outstanding Senior Notes and pay therelated redemption premium, and the balance was used to reduce the amountoutstanding under our credit agreement and pay offering expenses. The Notesbear interest at the rate of 4.00% per annum, subject to the payment ofcontingent interest under certain circumstances, and are convertible intoshares of common stock at a conversion price of $34.58 per share, subject toadjustment under specified circumstances. Under the contingent conversionfeature of the Notes, subject to certain exceptions, they are not convertibleinto common stock unless and until the trading price of the common stockreaches at least $41.50 for a specified period or designated corporate eventsoccur. The final maturity of the Notes is July 2013, 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**6.Revolving Line of Credit and Debt (Continued)**

although holders mayrequire us to repurchase the Notes at their election in July 2008, July 2010or upon the occurrence of a change in control, in each case for a purchaseprice equal to the original principal amount plus accrued interest. We may callthe Notes for redemption commencing in July 2006 subject to the payment ofa redemption premium of 1.6% if redeemed prior to July 2007 and 0.8% ifredeemed prior to July 2008 (thereafter there is no redemption premium).The indenture governing the Notes does not limit our ability to incurindebtedness or otherwise substantively restrict the operation of our businessto any significant degree. Subject to limited cure periods, the holders of theNotes may demand repayment of these borrowings prior to the stated maturityupon the occurrence of specified events, including if we fail to pay interestor principal when due, fail to satisfy our conversion obligation, if anotherobligation of ours having an outstanding principal amount in excess of $15million is accelerated prior to stated maturity and upon the occurrence ofspecified events of insolvency.

In July 2003, we called for the redemption of$66.7 million of Senior Notes outstanding. Interest expense in 2003 includesthe related redemption premium and the write-off of deferred financing costsassociated with the Senior Notes redeemed of $1.9 million.

For the years ended December 31,2004, 2003 and 2002, $1,045,000, $938,000 and $664,000 of amortization ofdeferred financing fees was included in interest expense. Capitalized deferredfinancing fees at December 31, 2004 and 2003 were $3.6 million and $4.6million and related accumulated amortization was $1.0 million and $3.8 million,respectively.

**7. Segment Information**

Our reportable business segments are Guitar Centerstores, American Music stores and direct response (Musician’s Friend’s catalogand Internet). Management evaluates segment performance based primarily on netsales and income (loss) before income taxes. Accounting policies of thesegments are the same as the accounting policies for the consolidated Company.There are no differences between the measurements of profits or losses orassets of the reportable segments and those of the Company on a consolidatedbasis. The company business segments under SFAS No. 131 are consistent with itsreporting units under SFAS No. 142.

Netsales, depreciation and amortization, income before income taxes, capitalexpenditures and total assets are summarized as follows for the years ended December 31,2004, 2003 and 2002 (in thousands):
| ** **                     | ** ** | **  Guitar Center    2004** | ** ** | **  American Music    2004** | ** ** | **  Direct Response    2004** | ** ** | **Total** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Net sales                      |       |                                                 | $          | 1,161,511                                             |       |                                                   |       | $         | 40,400     |   |   |   | $ | 311,261 |   |   | $ | 1,513,172 |   |
| Depreciation and  amortization |       |                                                 | 18,671     |                                                  |       |                                                   | 1,469      |      |       |   | 2,164 |   |   | 22,304 |   |
| Income before  income taxes    |       |                                                 | 72,789     |                                                  |       |                                                   | (7,228     | )         |       |   | 36,737 |   |   | 102,298 |   |
| Capital  expenditures          |       |                                                 | 21,240     |                                                  |       |                                                   | 1,272      |      |       |   | 3,639 |   |   | 26,151 |   |
| Total assets                   |       |                                                 | $          | 424,030                                               |       |                                                   |       | $         | 63,365     |   |   |   | $ | 87,198 |   |   | $ | 574,593 |   |

 

71

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**7.Segment Information (Continued)**
| ** **                     | ** ** | **  Guitar Center    2003** | ** ** | **  American Music    2003** | ** ** | **  Direct Response    2003** | ** ** | **Total** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Net sales                      |       |                                                 | $          | 978,962                                               |       |                                                   |       | $         | 38,225     |   |   |   | $ | 257,872 |   |   | $ | 1,275,059 |   |
| Depreciation and  amortization |       |                                                 | 16,721     |                                                  |       |                                                   | 1,233      |      |       |   | 2,666 |   |   | 20,620 |   |
| Income before  income taxes    |       |                                                 | 40,736     |                                                  |       |                                                   | (7,894     | )         |       |   | 26,667 |   |   | 59,509 |   |
| Capital  expenditures          |       |                                                 | 20,710     |                                                  |       |                                                   | 1,954      |      |       |   | 1,581 |   |   | 24,245 |   |
| Total assets                   |       |                                                 | $          | 355,668                                               |       |                                                   |       | $         | 64,071     |   |   |   | $ | 41,132 |   |   | $ | 460,871 |   |

 
| ** **                     | ** ** | **  Guitar Center    2002** | ** ** | **  American Music    2002** | ** ** | **  Direct Response    2002** | ** ** | **Total** | ** ** |
|--------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------------|------------|--------------------------------------------------------|------------|-----------|------------|
| Net sales                      |       |                                                 | $          | 859,618                                               |       |                                                   |       | $         | 32,525     |   |   |   | $ | 208,746 |   |   | $ | 1,100,889 |   |
| Depreciation and  amortization |       |                                                 | 14,071     |                                                  |       |                                                   | 717        |      |       |   | 2,072 |   |   | 16,860 |   |
| Income before  income taxes    |       |                                                 | 31,730     |                                                  |       |                                                   | (4,522     | )         |       |   | 13,593 |   |   | 40,801 |   |
| Capital  expenditures          |       |                                                 | 19,142     |                                                  |       |                                                   | 4,051      |      |       |   | 3,116 |   |   | 26,309 |   |
| Total assets                   |       |                                                 | $          | 353,037                                               |       |                                                   |       | $         | 57,240     |   |   |   | $ | 42,122 |   |   | $ | 452,399 |   |

 

**8. Investment Securities**

Investmentsecurities available-for-sale classified as current and long-term as of December 31,2004 are as follows:
| ** **                        | ** ** | **December 31, 2004**             | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|
| ** **                        | ** ** | **  Amortized    Cost** | ** ** | **Interest  Earned** | ** ** | **Amort. Of  Disc/Premium** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| ** **                        | ** ** | **(in thousands)**                     | ** ** |
| General  Obligation Municipal     |       |                                        | $          | 1,724 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 1,724 |   |
| Municipal Revenue                 |       |                                        | 2,086      |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 2,086 |   |
| Short-term  investment securities |       |                                        | $          | 3,810 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 3,810 |   |
| General  Obligation Municipal     |       |                                        | $          | 1,386 |   |   |   | $ | 1 |   |   |   | $ | (1 | ) |   |   | $ | — |   |   |   | $ | — |   |   | $ | 1,386 |   |
| Municipal Revenue                 |       |                                        | 15,611     |   |   |   | 2 |   |   |   | (2 | ) |   |   | — |   |   |   | — |   |   | 15,611 |   |
| Long-term investment  securities  |       |                                        | $          | 16,997 |   |   |   | $ | 3 |   |   |   | $ | (3 | ) |   |   | $ | — |   |   |   | $ | — |   |   | $ | 16,997 |   |

 

Thecontractual maturities of debt securities available-for-sale at December 31,2004, are shown below. Expected maturities will differ from contractualmaturities because we have the right to recall or repay obligations with orwithout call or prepayment penalties.
| ** **                                 | ** ** | **Amortized Cost** | ** ** | **   Fair Value   ** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|---------------------------------------------------------|------------|
| ** **                                 | ** ** | **(in thousands)** | ** ** |
| Investment  securities available-for-sale: |       |                    |       |                                                    |       |   |   |   |   |
| Due within one  year                       |       |                    | $          | 3,810                                                   |       |   |   | $ | 3,811 |   |   |
| Due after one  year through three years    |       |                    | 14,608     |                                                    |       |   | 14,609 |   |   |
| Due 2014                                   |       |                    | 1,263      |                                                    |       |   | 1,264 |   |   |
| Due 2017                                   |       |                    | 1,126      |                                                    |       |   | 1,127 |   |   |
| Total                                      |       |                    | $          | 20,807                                                  |       |   |   | $ | 20,811 |   |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**8.Investment Securities (Continued)**

We had no sales of investmentsin 2004. Gross unrealized gains and losses were immaterial, and not recordedfor year ended December 31, 2004. We had no investments at December 31,2003.

**9. Lease Commitments**

We lease offices, most of our retail store facilities,our distribution centers and various personal property used in our businessunder operating leases which expire at varying dates through December 2018.Generally, the agreements contain provisions which require us to pay for normalrepairs and maintenance, property taxes and insurance.

Thetotal minimum lease commitment at December 31, 2004, under operatingleases, is as follows:
| **Year ended December 31** | ** ** | ** **              | ** ** | **Amount** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                                | ** ** | **(in thousands)** | ** ** |
| 2005                                      |       |                    | $          | 37,271     |       |   |
| 2006                                      |       |                    | 32,660     |       |       |
| 2007                                      |       |                    | 30,628     |       |       |
| 2008                                      |       |                    | 28,585     |       |       |
| 2009                                      |       |                    | 22,474     |       |       |
| Thereafter                                |       |                    | 64,742     |       |       |
|                                      |       |                    | $          | 216,360    |       |   |

 

Total rent expenseincluded in the consolidated statements of income for the years ended December 31,2004, 2003 and 2002 is $38.2 million, $31.7 million and $26.3 millionrespectively.

**10. 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 fifteen percent oftheir compensation.  At our discretion,we can make matching contributions to the Plan, which will be a uniformpercentage of the eligible employees’ contributions. We may also, at ourdiscretion, make profit-sharing contributions to the Plan. The profit-sharingcontributions are allocated based on the relative compensation of all eligibleemployees. Contribution expense was $2.1 million, $2.1 million, $1.2 millionfor the years ended December 31, 2004, 2003 and 2002, respectively.

**11. Stock Option andPurchase Plans**

*1996 PerformanceStock Option Plan*

In June 1996, weadopted the 1996 Performance Stock Option Plan (as amended, the “1996 Plan”),which provided for the granting of options to officers and key employees. Underthe 1996 Plan, the number of options available for grant was 713,782, with amaximum term of ten years and an exercise price equal to the fair market value($10.89 per share) of the underlying stock at the date of grant. The optionsgenerally vested ratably over three years. As of December 31, 2004, optionsto purchase 39,923 shares of common stock were outstanding and exercisable. At December 31,2004, no shares were available for grant under the 1996 Plan.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**11. Stock Option andPurchase Plans (Continued)**

*Management StockOption Agreements*

In June 1996, wegranted options to two officers to purchase 795,970 shares at an exercise priceof $10.89 per share with a term of ten years. Under the terms of the option agreements,the conditions for full, accelerated vesting occurred during 1997. Noadditional options are available for grant under this plan. At December 31,2004, options to purchase 27,073 shares of common stock were outstanding andexercisable.

*1997 EquityParticipation Plan*

In January 1997, the 1997 Equity ParticipationPlan (as amended, the “1997 Plan”) was adopted. Under the 1997 Plan, we maygrant options to purchase up to 4,000,000 shares of common stock. Optionsgranted under the 1997 Plan vest ratably over various terms with a maximum lifeof ten years. As of December 31, 2004, options to purchase 2,378,821shares of common stock were outstanding under the 1997 Plan, and 1,599,173shares were exercisable with exercise prices ranging from $8.34 to $39.98 and aweighted average exercise price of $20.06. At December 31, 2004, 31,229shares were available for grant.

Included in the optionsoutstanding are outstanding options to purchase 88,489 shares of common stockthat were assumed in 1999 in connection with the merger with Musician’s Friend.

*2004 IncentiveStock Award Plan*

In February 2004, the2004 Incentive Stock Award Plan was adopted. The 2004 plan is an omnibus planwhich provides for issuance of stock options, stock appreciation rights,restricted stock, deferred stock, dividend equivalents, performance awards andstock payments, or any combination thereof. Under the 2004 Plan, we may grantoptions to purchase up to 1,400,000 shares of common stock. Options grantedunder the plan vest over various terms with a maximum life of ten years and anexercise price equal to the fair market value of the underlying stock at thedate of grant. As of December 31, 2004, options to purchase 582,000 sharesof common stock were outstanding under the 2004 Plan, but were not exercisable.At December 31, 2004, 806,100 shares were available for grant.

*Employee StockPurchase Plan*

In April 2001, the Employee Stock Purchase Plan(the “ESPP Plan”) was adopted. The ESPP Plan is a tax-qualified employee stockpurchase plan which authorizes 500,000 shares of our common stock, $0.01 parvalue, for issuance under the plan. Under the ESPP Plan, participants aregranted options to purchase our common stock at a price which is eighty-fivepercent of the stock’s fair market value on either the first or last day of theoffering period, whichever price is lower. The options are then automaticallyexercised on the last business day of the offering period. The participantspurchase the shares through payroll deductions. As of December 31, 2004,175,477 shares had been purchased under the ESPP Plan at a weighted-averageprice of $19.36 per share.

We apply APB Opinion No. 25 in accounting for ourplans. No stock-based employee compensation cost is reflected in net income, asall options granted under those plans had an exercise price equal to the marketvalue of the underlying common stock on the date of grant.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**11. StockOption and Purchase Plans (Continued)**

Stock option activity forall plans during the periods presented is as follows:
| ** **                         | ** ** | **No. of Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|------------------------------------|------------|-----------------------------|------------|------------------------------------------------|------------|
| Balance at  December 31, 2001 |       |                        | 4,232,860  |                                           |       |   | $ | 14.43 |   |   |
| Granted                            |       |                        | 559,869    |                                           |       |   | 16.94 |   |   |
| Exercised                          |       |                        | (206,675   | )                                              |       |   | 12.10 |   |   |
| Forfeited                          |       |                        | (188,091   | )                                              |       |   | 16.88 |   |   |
| Balance at  December 31, 2002 |       |                        | 4,397,963  |                                           |       |   | 14.75 |   |   |
| Granted                            |       |                        | 510,927    |                                           |       |   | 27.34 |   |   |
| Exercised                          |       |                        | (1,203,087 | )                                              |       |   | 14.45 |   |   |
| Forfeited                          |       |                        | (92,871    | )                                              |       |   | 20.02 |   |   |
| Balance at  December 31, 2003 |       |                        | 3,612,932  |                                           |       |   | 16.54 |   |   |
| Granted                            |       |                        | 804,100    |                                           |       |   | 39.78 |   |   |
| Exercised                          |       |                        | (1,313,555 | )                                              |       |   | 13.55 |   |   |
| Forfeited                          |       |                        | (75,660    | )                                              |       |   | 29.83 |   |   |
| Balance at  December 31, 2004 |       |                        | 3,027,817  |                                           |       |   | $ | 23.68 |   |   |

 

Thefollowing is a summary of stock options outstanding and exercisable at December 31,2004:
| ** **                    | ** ** | **Outstanding** | ** ** | **Exercisable**             | ** ** |
|-------------------------------|------------|-----------------|------------|-----------------------------|------------|
| **Range of  Exercise Prices** | ** ** | ** **      | ** ** | **Number of  Options** | ** ** | **Weighted  Average Years  Remaining** | ** ** | **Weighted  Average Exercise  Price** | ** ** | **Number of  Options** | ** ** | **Weighted  Average Exercise  Price** | ** ** |
| $8.34 to $10.89               |       |            | 291,708    |                        |       | 4.38 |   |   |   | $ | 10.63 |   |   | 291,708 |   |   | $ | 10.61 |   |   |
| $13.44 to $17.73              |       |            | 1,164,908  |                        |       | 6.77 |   |   |   | $ | 15.81 |   |   | 902,151 |   |   | $ | 15.62 |   |   |
| $18.25 to $20.75              |       |            | 329,018    |                        |       | 3.66 |   |   |   | $ | 19.72 |   |   | 326,685 |   |   | $ | 19.72 |   |   |
| $21.96 to $39.98              |       |            | 1,242,183  |                        |       | 8.94 |   |   |   | $ | 35.18 |   |   | 145,625 |   |   | $ | 27.31 |   |   |
| $8.34 to $39.98               |       |            | 3,027,817  |                        |       | 7.09 |   |   |   | $ | 23.68 |   |   | 1,666,169 |   |   | $ | 16.57 |   |   |
|                               |            |                 |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

In December 2004,the FASB issued SFAS No. 123 (revised 2004) “Share-Based Payment.” SFAS No. 123Rrequires that the cost from all share-based payment transactions, includingstock options, be recognized in the financial statements at fair value. We willadopt the provisions of this statement in the third quarter of 2005 which willhave an impact on our consolidated financial statements.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**12. Income Taxes**

Totalincome taxes for the years ended December 31, 2004, 2003 and 2002 consistof:
| **2004**   | ** ** | ** **              | ** ** | **Current** | ** ** | **Deferred** | ** ** | **Total** | ** ** |
|------------|------------|-------------------------|------------|-------------|------------|--------------|------------|-----------|------------|
| ** ** | ** ** | **(in thousands)** | ** ** |
| Federal    |       | $                       | 34,332     |        | $          | 793          |       | $         | 35,125     |   |
| State      |       | 3,625                   |       | 123         |       | 3,748        |       |
|       |       | $                       | 37,957     |        | $          | 916          |       | $         | 38,873     |   |

 
| **2003**   | ** ** | ** **              | ** ** | **Current** | ** ** | **Deferred** | ** ** | **Total** | ** ** |
|------------|------------|-------------------------|------------|-------------|------------|--------------|------------|-----------|------------|
| ** ** | ** ** | **(in thousands)** | ** ** |
| Federal    |       | $                       | 19,231     |        | $          | 1,005        |       | $         | 20,236     |   |
| State      |       | 2,104                   |       | 309         |       | 2,413        |       |
|       |       | $                       | 21,335     |        | $          | 1,314        |       | $         | 22,649     |   |

 
| **2002**   | ** ** | ** **              | ** ** | **Current** | ** ** | **Deferred** | ** ** | **Total** | ** ** |
|------------|------------|-------------------------|------------|-------------|------------|--------------|------------|-----------|------------|
| ** ** | ** ** | **(in thousands)** | ** ** |
| Federal    |       | $                       | 15,066     |        | $          | (1,364       | )          | $         | 13,702     |   |
| State      |       | 2,043                   |       | (200        | )          | 1,843        |       |
|       |       | $                       | 17,109     |        | $          | (1,564       | )          | $         | 15,545     |   |

 

Actualincome taxes for 2004, 2003 and 2002 differ from the statutory tax rate of 35% asapplied to income before income taxes as follows:
| ** **                                      | ** ** | **2004**                | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| Expected income  tax expense                    |       | $                       | 35,804     |     | $          | 20,827   |       | $ | 14,280 |   |
| State income  taxes, net of federal tax benefit |       | 2,436                   |       | 1,459    |       | 1,181    |       |
| Non deductible  items                           |       | 402                     |       | 273      |       | 153      |       |
| Change in  valuation allowance                  |       | —                  |       | —   |       | 19       |       |
| Other                                           |       | 231                     |       | 90       |       | (88      | )          |
| Actual income tax  expense                      |       | $                       | 38,873     |     | $          | 22,649   |       | $ | 15,545 |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**12.Income Taxes (Continued)**

The tax effects oftemporary differences that give rise to significant portions of deferred taxassets and liabilities are presented below:
| ** **                                               | ** ** | **2004**                | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                               | ** ** | **(in thousands)** | ** ** |
| Deferred tax assets:                                     |       |                    |       |     |       |
| State net operating loss carryforwards                   |       | $                       | 38         |     | $          | 155 |   |
| Accrued liabilities                                      |       | 2,752                   |       | 3,808    |       |
| Merchandise inventories                                  |       | 2,340                   |       | 2,148    |       |
| Capital loss (Musician.com)                              |       | 1,138                   |       | 1,150    |       |
| Total gross  deferred tax assets                         |       | 6,268                   |       | 7,261    |       |
| Deferred tax  liabilities:                               |       |                    |       |     |       |
| Depreciation                                             |       | 2,940                   |       | 3,559    |       |
| Other                                                    |       | 1,694                   |       | 1,152    |       |
| Total gross  deferred liabilities                        |       | 4,634                   |       | 4,711    |       |
| Deferred tax  assets, net of deferred tax liabilities    |       | 1,634                   |       | 2,550    |       |
| Less valuation  allowance—capital loss carryforward |       | (1,139                  | )          | (1,139   | )          |
| Net deferred tax assets                                  |       | $                       | 495        |     | $          | 1,411 |   |

 

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 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$9.8 and $4.1 million of a benefit in 2004 and 2003, respectively. The benefitderived from such exercises or dispositions in the prior years was notmaterial.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**13.Accrued Expenses and Other Current Liabilities**
| ** **                    | ** ** | **December 31,**   | ** ** |
|-------------------------------|------------|-------------------------|------------|
| ** **                    | ** ** | **2004**                | ** ** | **2003** | ** ** |
| ** **                    | ** ** | **(in thousands)** | ** ** |
| Wages, salaries  and benefits |       | $                       | 29,320     |   | $ | 22,145 |   |
| Sales tax payable             |       | 11,894                  |       | 10,290 |   |
| Accrued income  taxes         |       | 7,576                   |       | 6,988 |   |
| Accrued  advertising          |       | 6,038                   |       | 4,884 |   |
| Provision for  sales returns  |       | 5,335                   |       | 6,430 |   |
| Accrued insurance             |       | 3,520                   |       | 2,847 |   |
| Unearned revenue              |       | 3,358                   |       | 2,660 |   |
| Accrued real  estate tax      |       | 2,165                   |       | 1,814 |   |
| Accrued  professional fees    |       | 2,030                   |       | 742 |   |
| Accrued interest              |       | 1,880                   |       | 2,200 |   |
| Accrued freight               |       | 988                     |       | 1,993 |   |
| Accrued catalog  costs        |       | 882                     |       | 1,696 |   |
| Accrued utilities             |       | 887                     |       | 228 |   |
| Other                         |       | 7,733                   |       | 6,699 |   |
|                          |       | $                       | 83,606     |   | $ | 71,616 |   |

 

**14. Legal**

We are involved in various claims and legal actionsarising in the ordinary course of our business and, while the results of theproceedings cannot be predicted with certainty, we believe that the finaloutcome of such matters will not have a material adverse effect on ourconsolidated financial position or results of operations.

On October 13, 2004, a putative class actionlawsuit entitled Carlos Rodriguez v. The Guitar Center, Inc. [sic], Case No. GC322958,was filed in the Superior Court of the State of California for the County ofLos Angeles. The lawsuit was filed by an individual purporting to represent allhourly retail store employees employed by us within the State of California. OnDecember 15, 2004, a putative class action lawsuit entitled James McClainet. al. v. Guitar Center Stores, Inc., Case No. BC326002, was filedin the Superior Court of the State of California for the County of Los Angeles.The lawsuit was filed by three individuals purporting to represent all hourlyretail store employees employed by us within the State of California. Amongother things, the lawsuits allege that we improperly failed to document andenforce break-time and lunch-time periods for such employees and seek anunspecified amount of damages, penalties and attorneys’ fees. In the Rodriguezcase, we have filed an answer to the plaintiff’s complaint and are in theprocess of responding to the plaintiff’s requests for discovery. The McClaincomplaint has not been served on us, and we have not responded to thecomplaint.

While we believe theselawsuits are without merit and intend to defend them vigorously, they may,regardless of the outcome, result in substantial expenses and damages to us andmay significantly divert the attention of our management. There can be noassurance that we will be able to achieve a favorable settlement of theselawsuits or obtain a favorable resolution of such lawsuits if they are notsettled. An unfavorable resolution of these lawsuits could have a materialadverse effect on our business, financial 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2004**

**14. Legal(Continued)**

conditionand results of operations. Regardless of the outcome, the costs and expensesincurred by us to defend these lawsuits could also have a material adverseeffect on our business, financial condition and results of operations.

**15. QuarterlyFinancial Data (unaudited)**
| ** **                      | ** ** | **2004**                                                           | ** ** |
|---------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                      | ** ** | **First**                                                          | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **                      | ** ** | **(in thousands, except per share data)** | ** ** |
| Net sales                       |       | $                                                                  | 349,703    |   | $ | 339,622 |   | $ | 354,909 |   | $ | 468,938 |   | $ | 1,513,172 |   |
| Gross profit                    |       | $                                                                  | 94,683     |   | $ | 94,213 |   | $ | 97,941 |   | $ | 138,436 |   | $ | 425,273 |   |
| Net income                      |       | $                                                                  | 11,780     |   | $ | 12,144 |   | $ | 12,411 |   | $ | 27,090 |   | $ | 63,425 |   |
| Net income per  share (diluted) |       | $                                                                  | 0.44       |   | $ | 0.45 |   | $ | 0.45 |   | $ | 0.95 |   | $ | 2.29 |   |

 
| ** **                      | ** ** | **2003**                                  | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|
| ** **                      | ** ** | **First**                                 | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| ** **                      | ** ** | **(in thousands, except per share data)** | ** ** |
| Net sales                       |       | $                                         | 287,542    |   | $ | 291,600 |   | $ | 300,112 |   | $ | 395,805 |   | $ | 1,275,059 |   |
| Gross profit                    |       | $                                         | 74,656     |   | $ | 75,550 |   | $ | 79,851 |   | $ | 113,988 |   | $ | 344,045 |   |
| Net income                      |       | $                                         | 5,277      |   | $ | 6,150 |   | $ | 5,781 |   | $ | 19,652 |   | $ | 36,860 |   |
| Net income per share  (diluted) |       | $                                         | 0.22       |   | $ | 0.25 |   | $ | 0.23 |   | $ | 0.73 |   | $ | 1.47 |   |

 

The diluted earnings per share for 2003 has beenrestated to conform to EITF 04-08, *“Accounting Issues Relatedto Certain Features of Contingently Convertible Debt and the Effect on DilutedEarnings per Share”.*See Earnings per Share under Note 1 to ourfinancial statements.

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**Schedule II**

**GUITARCENTER, INC. AND SUBSIDIARIESVALUATION AND QUALIFYING ACCOUNTSYears ended December 31, 2004 and 2003(amounts in thousands)**
|                                     | ** ** | **Balance at  beginning  of year** | ** ** | **Additions  charged to  operations** | ** ** | **Deductions  from  Allowance** | ** ** | **Balance  at end  of year** | ** ** |
|-------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------|------------|---------------------------------|------------|----------------------------------------|------------|
| December 31, 2004              |       |                                         |       |                                       |       |                            |       |                                   |       |   |   |   |   |   |   |
| Allowance for doubtful  receivables |       |                                         | $          | 1,708                                      |       |                            |       | 4,126                                  |       |   |   | 2,345 |   |   | $ | 3,489 |   |
| December 31, 2003              |       |                                         |       |                                       |       |                            |       |                                   |       |   |   |   |   |   |   |
| Allowance for  doubtful receivables |       |                                         | $          | 1,083                                      |       |                            |       | 625                                    |       |   |   | — |   |   | $ | 1,708 |   |

 

II-1

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