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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

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FORM 10-KFor Annual and Transition Reports Pursuant to
Section 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, 2000
or

|/ / | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|--- | ----------------------------------------------------------------------------------------

For the transition period from  to

Commission file number 000-22207

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GUITAR CENTER, INC.

(Exact name of registrant as specified in charter)

Delaware(State or other jurisdiction of
incorporation or organization)

95-4600862(I.R.S. Employer Identification Number)5155 Clareton Drive
Agoura Hills, California

91301(Zip Code)(Address of principal executive offices)


Registrant's telephone number, including area code:(818) 735-8800

Securities
registered pursuant to 12(b) of the Act: None

Securities
registered pursuant to 12(g) of the Act: Common Stock, $.01 par value(Title of Class)

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Check
if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of
Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this
Form / /

As
of March 12, 2001, the aggregate market value of voting stock held by nonaffiliates of the Company was approximately $206,243 (based upon the
last reported sales price of the Common Stock on such date as reported by the Nasdaq National Market). Shares of Common Stock held by each executive officer, director, holder of greater than 10% of
the outstanding Common Stock of the Registrant and person or entity known to the Registrant to be affiliates of the foregoing have been excluded in that such persons may be deemed to be affiliates.
This assumption regarding affiliate status is not necessarily a conclusive determination for other purposes.

Check
whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the
past 90 days. Yes /x/  No / /

As
of March 12, 2001 there were 22,105,854 shares of Common Stock, par value $.01 per share, outstanding.

Portions
of the Proxy Statement for the annual stockholders' meeting scheduled to be held on April 26, 2001 are incorporated by reference into
Part III.

The
Exhibit Index appears on page 28.

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PART I

Item 1. BUSINESS

Company History

Guitar Center, Inc. was founded in 1964 in Hollywood, California. Our flagship Hollywood store currently is one of the nation's largest and
best-known retail stores of its kind with approximately 30,600 square feet of retail space. The Hollywood store features one of the largest used and vintage guitar collections in the
United States, attracting buyers and collectors from around the world. In front of the Hollywood store is the Rock Walk which memorializes over 70 famous musicians and music pioneers. The Rock Walk
attracts several tour buses daily and has helped to create international recognition of the Guitar Center name. In 1972, we opened our second store in San Francisco to capitalize on the emerging San
Francisco rock 'n roll scene. By this time, our inventory had been expanded to include drums, keyboards, accessories and pro-audio and recording equipment.

Throughout
the 1980s, we expanded by opening nine stores in five major markets, including Chicago, Dallas and Minneapolis. Since 1990, we have continued our new store expansion and
have focused on building the infrastructure necessary to manage our strategically planned growth. Current executive officers and key managers have been with our company for an average of
11 years and two of such executive officers (Mr. Larry Thomas, our Chairman and Co-Chief Executive Officer, and Mr. Marty Albertson, our President and
Co-Chief Executive Officer) effectively assumed full operating control in 1992. Since then, we have focused on developing and realizing our long-term goal of expanding our
position as the leading music products retailer throughout the United States.

In
May of 1999, we merged with Musician's Friend, Inc. in a stock for stock transaction. Musician's Friend operates the largest direct response channel (catalog and
e-commerce) in the musical instruments industry in the United States. Robert Eastman, Chief Executive Officer of Musician's Friend, has been with the company for 17 years.

Presently,
our executive offices are located at 5155 Clareton Drive, Agoura Hills, California 91301, and our telephone number is (818) 735-8800. Effective
April 16, 2001, our executive offices will be located at
5795 Lindero Canyon Road, Westlake Village, California 91362; our phone number will not change. We maintain several corporate websites, including www.guitarcenter.com, however none of the information
contained on our websites is incorporated by reference in this annual report. Whenever we refer to the "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.

Business

As of December 31, 2000, we operated 83 stores, consisting of 79 stores in 42 major U.S. markets, including, among others, areas in or near Los Angeles,
San Francisco, Chicago, Miami, Houston, Dallas, Detroit, Boston, Minneapolis, Seattle, Phoenix, Atlanta, New York and Cleveland, and four stores in secondary markets. From 1996 to 2000, our net sales
grew at an annual compound growth rate of 31.9%, principally due to comparable store sales growth averaging 10% per year, the opening of new stores, and a 31.0% increase in the direct response
channel. We achieved comparable store sales growth of 7%, 10% and 13% for the fiscal years ended December 31, 2000, 1999 and 1998, respectively.

For
the fiscal years ended December 31, 2000, 1999 and 1998, we had net income of $22.5 million, $18.3 million and $16.4 million, respectively.



We offer a unique retail concept in the music products industry, combining an interactive, hands-on shopping experience with superior customer
service and a broad selection of brand name,

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high-quality products at guaranteed low prices. We create an entertaining and exciting atmosphere in our stores with bold and dramatic merchandise presentations, highlighted by bright,
multi-colored lighting, high ceilings, music and videos. We believe approximately 74% of our sales are to professional and aspiring musicians who generally view the purchase of music products as a
career necessity. These sophisticated customers rely upon our knowledgeable and highly trained salespeople to answer technical questions and to assist in product demonstrations.

Our
standard prototype store generally ranges in size from 12,000 to 20,000 square feet (as compared to a typical music products retail store which averages approximately 3,200 square
feet) and is designed to encourage customers to hold and play instruments. In late 2000 we opened our first new store using
a smaller format. Early results from this unit are encouraging and we plan to open additional stores using this format of approximately 8,000 to 10,000 square feet to serve secondary markets. Each
large format store carries an average of 7,000 core SKUs and our small format stores carry an average of 5,000 core SKUs, which management believes is significantly greater than a typical music
products retail store, and is organized into five departments, each focused on one product category. These departments cater to a musician's specific product needs and are staffed by specialized
salespeople, many of whom are practicing musicians. We believe this retail concept differentiates us from our competitors and encourages repeat business.

The
following summarizes certain key operating statistics of our stores and is based upon the stores operated by us for the full year ended December 31:

2000

1999Number of stores operated for the full year


69


56Average net sales per square foot

$
535

$
555Average net sales per store


8,720,000


8,908,000Average store-level operating income (1)


945,000


1,015,000Average store-level operating income margin (1)


10.8
%

11.4
%


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Our
retail growth strategy is to continue to increase our presence in our existing markets and to open new stores in strategically selected markets. We will continue to pursue our
strategy of clustering stores in major markets to take advantage of operating and advertising efficiencies and to build awareness of our name in new markets. We opened a total of 14 stores in 2000
(including one acquired unit), and
presently expect to open approximately 12 to 14 stores in 2001 and approximately 12 to 16 stores in 2002. We also intend to build a distribution center during 2001, with plans to commence operation in
early 2002. This initiative will require significant financial and managerial resources for the next several quarters. We have committed substantial resources to building and continually upgrading a
corporate infrastructure and management information system that we believe can support our needs, including our expansion plans, for the foreseeable future.



Our Musician's Friend unit is using its established catalog business to build an integrated e-commerce/catalog business. Through Musician's Friend,
we offer musicians a shopping experience that satisfies the need for technical product information, confirmation of needs by a live person, quick and efficient service, and a musician-based staff for
after sale support. The catalog presents a fresh assortment of products and promotions throughout the year, mixing big name products with unique and practical offerings. Our website,
www.musiciansfriend.com, offers all that is shown in the catalog and more, supported by the same service and staff.

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The Musician's Friend business is supported by three distribution centers located in Medford, Oregon, Knoxville, Tennessee and Kansas City, Missouri, and a telephone call center
located in Salt Lake City, Utah.

Our
call center staff receive product and customer service training in the state-of-the-art call center facility. Extensive product information,
including technical information, product features and benefits, and real-time stocking information is available to the staff on their desktop systems via our intranet and
back-end information systems. A staff of over 200 associates is trained and ready to respond to questions to help ensure that customers can purchase confidently. Web site visitors are
treated to a constantly updated and evolving, information rich shopping experience that includes product availability and purchase recommendations generated through collaborative filtering processes.
Questions regarding products can be submitted electronically, or the musician can call our support center directly.

Orders,
whether taken electronically or by an associate in our call center, are processed by our automated transaction system and generally ship within 24 hours. Sophisticated
inventory planning systems help ensure that products are in-stock resulting in an initial line item fill rate at time of order in excess of 87%. In 2000, we linked our web site to UPS and
FedEx tracking engines to provide customers the online ability to monitor the status of their orders.

The
focus of the Musician's Friend business strategy is to increase market share in the non-bricks and mortar retail segment of our industry. Our mailing and email lists
give us a significant base from which to grow. Our catalog circulation, which is broader than any other direct-mail circulation in this industry, provides a unique advertising and
marketing platform for e-commerce. In addition, Musician's Friend enjoys significant customer loyalty as evidenced by a high rate of repeat purchases by customers; over one third of
Musician's Friend customers place a second order within six months of their first order.

Our
business plan is to continue to leverage our leading industry position and the infrastructure in place, and build on that base to support the rapid growth in
e-commerce. We believe that our leadership position and established direct marketing model leverages both internet and direct mail mechanics to provide a significant competitive advantage.

Industry Overview

The United States retail market for music products in 1999 was estimated in a study byMusic USAmagazine to be
approximately $6.8 billion in net sales, representing a five-year compound annual growth rate of 5.2%. The broadly defined music products market, according to the National
Association of Music Merchants, or NAMM, includes retail sales of string and fretted instruments, sound reinforcement and recording equipment, drums, keyboards, print music, pianos, organs, and school
band and orchestral instruments. Products currently offered by us include categories of products which account for approximately $4.9 billion of this market, representing a
five-year compound annual growth rate of 6.6%. The music products market, as currently defined by NAMM, however, does not include the significant used and vintage product markets or the
computer software and apparel markets in which we actively participate.

The
industry is highly fragmented with the nation's leading five music products retailers, as measured by the number of stores operated by such retailers (i.e., Guitar
Center/Musician's Friend, Sam Ash Music Corp., MARS Music, Brook Mays/H&H, and Hermes Music), accounting for approximately 18.6% of the industry's estimated total sales. Furthermore, 90% of the
industry's estimated 5,900 retailers operate only one or two stores. A typical music products store averages approximately 3,200 square feet and generates an average of approximately
$1.0 million in annual net sales. In contrast, one of our stores generally averages between 12,000 and 20,000 square feet and in

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2000 generated an average of approximately $8.7 million in annual net sales for stores open the full year.

Over
the past ten years, technological advances in the industry have resulted in dramatic changes to the nature of music-related products. Manufacturers have combined computers and
microprocessor technologies with musical equipment to create a new generation of products capable of high grade sound processing and reproduction. Products featuring this technology are available in a
variety of forms and have broad applications across most of our music product categories. Most importantly, rapid technological advances have resulted in the continued introduction of higher quality
products offered at lower prices and this trend is continuing. Today an individual consumer can affordably create a home recording studio which interacts with personal computers and is capable of
producing high-quality digital recordings. Until recently, this type of powerful sound processing capability was expensive and was typically purchased only by professional sound recording
studios.

Business Strategy



The goal in the retail stores is to continue to expand our position as the leading music products retailer throughout the United States. The principal elements
of our business strategy are as follows:



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The goal of the e-commerce/catalog business unit is to capitalize and expand on our leadership position. Comprehensive direct marketing, analysis
and leveraging of the extensive customer information available on our information systems are used to define effective marketing campaigns. The presentation of an extensive selection of products and
maintenance of an effective degree of continual and informative contact with prospects and customers provide the attention grabbing content that generate results. In 2000, we circulated over
11 million catalogs and sent over 26.1 million e-mails to prospects and customers. This resulted in more than a 42% increase in orders as compared to 1999. The call center
took over 1.8 million calls during the year.



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Merchandising

Our merchandising concept differentiates us from most of our competitors. We offer our merchandise at guaranteed low prices and utilize aggressive marketing
and advertising to attract new customers and maintain existing customer loyalty. The principal elements of our merchandising philosophy are as follows:



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Retail Store Operations

To facilitate our strategy of accelerated but controlled growth, we have centralized many key aspects of our store operations, including the development of
policies and procedures, accounting systems, training programs, store layouts, purchasing and replenishment, advertising and pricing. Such centralization effectively utilizes the experience and
resources of our headquarters staff to establish a high level of consistency throughout all of our stores.

Retail
store operations are led by our Senior Vice President of Sales and ten regional sales managers. Store management is comprised of a store manager, a sales manager, an operations
manager, two assistant store managers and five department managers. Each store also has a warehouse manager and a sales staff that ranges from 20 to 40 employees.

We
ensure that store managers are well-trained and experienced individuals who will maintain our store concept and philosophy. Each manager completes an extensive training
program that instills the values of operating as a business owner, and only experienced store employees are promoted to the position of store manager. We seek to encourage responsiveness and
entrepreneurship at each store by providing store managers with a relatively high degree of autonomy relating to operations, personnel and merchandising. Managers play an integral role in the
selection and presentation of merchandise, as well as the promotion of our reputation.

We
view our employees as long-term members of our team. We encourage employee development by providing the salesforce with extensive training and the opportunity to
increase both compensation and responsibility level through increased product knowledge and performance. Our aggressive growth strategy provides employees with the ability to move into operations,
sales and store management positions, an opportunity which management believes is not available at most other music retailers. As we open new stores, key in-store management positions are
primarily filled by the qualified and experienced employees from existing stores. By adopting a "promotion from within" strategy, we maintain a well trained, loyal, and enthusiastic sales force that
is motivated by our strong opportunities for advancement. Larry Thomas and Marty Albertson, our Chairman and Co-Chief Executive Officer and President and Co-Chief Executive
Officer, respectively, began their careers as salespersons at Guitar Center.

Marketing and Promotion

We maintain two unique and proprietary databases (one for Guitar Center and one for Musician's Friend) containing information on over 5 million
customers. We believe that these databases assist in generating repeat business by targeting customers based on their purchasing history and by permitting us to establish and maintain personal
relationships with our customers.

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For the retail stores, our advertising and promotion strategy is designed to enhance the Guitar Center name and increase consumer awareness and loyalty. The
advertising and promotional campaigns are developed around "events" designed to attract significant store traffic and exposure. We regularly plan large promotional events including the Green Tag Sale
in March, the Anniversary Sale in August, and the Guitar-a-thon in November. We believe that our special events have a broad reach as many of them have occurred annually during
the past twenty years. These events are often coordinated with product demonstrations, interactive displays, clinics and in-store artist appearances.

As
we enter new markets, we initiate an advertising program, including mail and radio promotions, television and Internet campaigns, and other special grand opening activities,
designed to accelerate sales volume for each new store. Radio advertising plays a significant part in our store-opening campaign to generate excitement and create customer awareness.



For e-commerce and catalog customers, we maintain a stream of communication in electronic and print media, presenting them with an optimal and
refreshed mix of offers. Extensive analysis of customer behavior and transactions along with the industry expertise of the merchandising staff provide the marketing staff with offers carefully
targeted for optimal response. Cooperative marketing relations with key industry suppliers ensure that Musician's Friend customers are kept current with trends presented by the latest music gear.

The
same transactional databases that make accurate market targeting available for catalog and email circulation are enhanced by the information archived from our website traffic.
With the use of an analytical engine developed by Net Perceptions, and continued development of additional tools, our merchandising and marketing departments are able to present product and
promotional offerings to prospects with an improved likelihood of triggering purchases.

Our
plans for Musician's Friend include the development of catalogs targeted towards particular segments of the musician market. The first such catalog, which is oriented to
percussion instruments, is expected to be mailed during the first quarter of 2001.

We
are also examining opportunities to use the Internet to expand further the reach of our brands. These opportunities are being created by the rapid development of content and
community sites oriented towards music and musicians. For example, we have a strategic marketing relationship with musician.com, a community site oriented to the needs of professional and aspiring
musicians, which involves Musician's Friend as the exclusive e-commerce partner for musician.com and its affiliates guitar.com in the merchandise categories served by us. We also own a
passive minority equity interest in musician.com.

Customer Service



Exceptional customer service is fundamental to our operating strategy. With the rapid changes in technology and continuous new product introductions, customers
depend on salespeople to offer expert advice and to assist with product demonstrations. We believe that our well-trained and highly knowledgeable sales force differentiates us from our
competitors and is critical to maintaining customer confidence and loyalty. Our employees are typically musicians who are selected and trained to understand the needs of our customers. Salespeople
specialize in one of our five product categories and begin training on their first day of employment. Sales and management training programs are implemented on an ongoing basis to maintain and
continually improve the level of customer service and sales support in the stores. Based on examination results, an employee is given a rating which

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determines his or her salary and level of responsibility. We believe that our employee testing program impresses upon our salespeople a sense of professionalism and reduces employee turnover by
providing salespeople with the opportunity to increase their salaries by advancing through the certification program. We believe that due to our emphasis on training, we are able to attract and retain
well-qualified, highly motivated salespeople committed to providing superior customer service. In addition, each salesperson (in the keyboards and pro-audio and recording
departments) is certified by a technical advisory board after satisfactory completion of an extensive training program.

Our
customer base consists of the professional or aspiring musician who makes or hopes to make a living through music and the amateur musician or hobbyist who views music as
recreation. Management estimates that professional and aspiring musicians, who view the purchase of musical products as a career necessity, represent approximately 68% of our customer base, and
account for approximately 74% of our sales. These customers make frequent visits to a store and develop relationships with the sales force. We generate repeat business and are successful in utilizing
our unique and proprietary database to market selectively to these customers based on past buying patterns. In addition, we service touring professionals, providing customized products for musical
artists.



Musician's Friend maintains a staff of over 200 call center and customer service associates, staffing the call center
24-hours-a-day, seven-days-a-week. Customers can contact agents via phone, e-mail or fax for questions regarding
products, technical information, recommendations or the status of their accounts. Most of the staff is comprised of musicians who are given extensive and ongoing product training. The Salt Lake City
call center houses an extensive product demonstration area and training facility. Weekly product training is conducted by in-house technical staff as well as manufacturers'
representatives.

We
maintain a database of product information for use by the agents in our call center which is always available on our corporate intranet. The intranet also makes operational and
instructional information available to agents, minimizing their downtime and maximizing their ability to service customer needs effectively. All of this information, along with customer account
information, is available in real time, giving agents the ability to keep customers constantly up to date.

The
web site is updated hourly with new product information so customers can work with the latest available information. As this is an area that is constantly evolving, customers are
continually presented with new and more extensive information. In addition, the collaborative filtering process results in customized product recommendation to customers browsing the web site.

To
provide the customer with a high degree of satisfaction, we offer a 45-day satisfaction guaranteed return policy and 45-day lowest price guarantee. All
information regarding transactions and customer accounts is stored in a database accessible by customer service representatives, ensuring that they can provide customers with timely and accurate
information regarding their accounts.

For
customers that have registered e-mail addresses with us, we offer automated order and shipment verification. This provides customers with UPS or Fed Ex order tracking
information as soon as their shipment has been processed.

Order Fulfillment

Musician's Friend orders are fulfilled out of company-operated distribution centers located in Knoxville, Tennessee, Medford, Oregon and our newest facility in
Kansas City, Missouri. For orders handled by the call center, associates are presented with inventory information in the distribution center geographically closest to the customer, as well as
alternate locations. E-commerce orders are processed automatically through the closest stocking warehouse to the customer. Credit card

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authorization and fraud management systems are automated, minimizing delays in processing. The distribution centers process orders taken before 5 p.m. Eastern time for same-day
shipping of in-stock items, minimizing delays in delivery to customers. Orders ship primarily by UPS and Fed Ex. During 2000, our initial line item fill rate was 87%.

All
returns are routed to the Kansas City warehouse in order to consolidate the handling of this merchandise. Returned and blemished products are sold through an outlet store located
in the Kansas City facility and by offering such products at reduced prices on the musiciansfriend.com web site.

Purchasing, Distribution and Inventory Control

Purchasing.We believe we have excellent relationships with our vendors and, in many instances, are the vendor's
largest customer. Given our high volume, we are generally able to receive prompt order fulfillment and access to our vendors' premium products. We maintain a centralized buying group comprised of
merchandise managers, buyers, planners and distributors. Merchandise managers and buyers are responsible for the selection and development of product assortments and the negotiation of prices and
terms. The planners and distributors are responsible for maintaining inventory levels and allocating the merchandise to the stores and direct response distribution centers. We use two merchandise
replenishment systems (one for retail stores and one for the direct response business) which automatically analyze and forecast sales trends for each SKU using various statistical models, supporting
the buyers by predicting merchandise requirements. This has resulted in limited "out of stock" positions.

Our
business and expansion plans are dependent to a significant degree upon our vendors. As we believe is customary in the industry, we do not have any long-term supply
contracts with our vendors. Please see "Risks Related to the BusinessWe Depend on Suppliers."

Distribution.At the present time we do not have a central warehouse/distribution center and each of our vendors drop
ship directly to each of our retail stores. Our retail operations have reached a sufficient size that we believe there is an opportunity to reduce chainwide inventory levels and therefore reduce
working capital requirements by operating a central warehouse/distribution center to service the retail stores. We intend during 2001 to build a central warehouse/distribution center for our retail
store operations with a view towards the facility commencing operation in early 2002. We have hired an experienced logistics executive and are actively considering possible sites. Migration from our
present "drop-ship" model to a centralized distribution model is an important development in our operating strategy and will require significant financial and managerial resources for the
next several quarters.

The
direct response unit presently operates three distribution facilities, located in Knoxville, Tennessee, Medford, Oregon, and Kansas City, Missouri.

Inventory Control.We have invested significant time and resources in our inventory control system at the retail stores
and believe we have one of the most sophisticated systems in the music products retail industry. We believe the vast majority of music product retailers do not use a computerized inventory management
system. We perform inventory cycle counts daily, both to measure shrinkage and to update the perpetual inventory on a store-by-store basis. As appropriate, we also stock
balance inventory among stores to assure proper distribution of product and to control overall inventory levels. Our inventory shrinkage level has historically been low, which we attribute to our
sophisticated system controls and strong corporate culture.

Retail Store Site Selection

We believe we have developed unique and, what historically have been, highly effective selection criteria to identify prospective store sites. In evaluating
the suitability of a particular location, we

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concentrate on the demographics of our target customer as well as traffic patterns and specific site characteristics such as visibility, accessibility, traffic volume, shopping patterns and
availability of adequate parking. Stores are typically located in free-standing locations to maximize their outside exposure and signage.

Management Information Systems



We have invested significant resources in management information systems that provide real-time information. The systems have been designed to
integrate all major aspects of our business, including sales, gross margins, inventory levels, purchase order management, automated replenishment and merchandise planning. Our highly sophisticated
management information systems provide us with the ability to monitor all critical aspects of activity on a real-time basis. Our system capabilities include inter-store transactions,
vendor analysis, serial number tracking, inventory analysis and commission sales reporting. We believe that the system we have developed will enable us to continue to improve customer service and
operational efficiency and support our needs for the immediately foreseeable future.



Musician's Friend maintains an extensive transaction processing system as well as systems supporting e-commerce, operations and marketing analysis,
and internal support information. All transaction and inventory information is available real-time. The e-commerce web site is updated during the day through a firewall,
providing a high degree of security for our internal systems. During 2000 we completed phase one of a security and redundancy enhancement program for our web systems, relocating related hardware and
software to Bellingham, Washington. Dedicated systems are used for inventory planning and for web site analysis.

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

Competition

We are in direct competition with two other major retail chains within the music industrySam Ash of New York, New York and Music and Recording
Superstores (MARS) of Miami, Florida. In addition, we compete with various direct response companies such as American Music Supply, Sam Ash Music, and Sweetwater Sound. As of December 31, 2000
we were in direct competition with Sam Ash in 18 of
our markets and with MARS in 25 of our markets. In recent years, Sam Ash and MARS have continued to open new stores, and we believe they will continue to do so in the future. We expect that there will
be additional competitive overlap in new and existing Guitar Center markets. There is, however, room for consolidation within the music industry as the top ten retailers (including Guitar
Center/Musician's Friend, Sam Ash and MARS) only account for an estimated 23% of the market compared to an estimated 60% market share held by the top ten specialty retailers in the consumer
electronics, home improvement and toy industries.

We
believe that the ability to compete successfully in our markets is determined by several factors, including breadth and quality of product selection, pricing, effective merchandise
presentation, customer service, store location and proprietary database marketing programs. Customer satisfaction is paramount to our operating strategy and we believe that providing knowledgeable and
friendly customer service gives us a competitive advantage. The store environment is designed to be an entertaining and exciting environment in which to shop. In an effort to exceed customer
expectations,

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our stores provide a number of services not generally offered by most competitors, including the ability to hold and use merchandise, product demonstrations and extensive product selection.
Salespeople are highly trained and specialize in one of our five product areas. Salespeople are certified by an outside technical advisory board, based on extensive training and product knowledge
testing. We believe that this certification process has increased the professionalism of our employees while reducing turnover. Customers are encouraged to help themselves to the displayed instruments
and to seek the assistance of the professional salespeople.

Certain
factors, however, could materially and adversely affect our ability to compete successfully in our markets, including, among others, the expansion by us into new markets in
which our competitors are already established, competitors' expansion into markets in which we are currently operating, the adoption by competitors of innovative store formats and retail sales methods
or the entry into our market by competitors with substantial financial or other resources. See "Risks Related to the BusinessWe May Be Unable to Meet Our Growth Strategy" and
"We Have Competitors."

Employees

As of December 31, 2000, we employed 3,525 people, of whom 2,641 were hourly employees and 884 were salaried. None of our employees are covered by a
collective bargaining agreement. We believe that we enjoy good employee relations.

Service Marks

We have registered the GUITAR CENTER, ROCK WALK, MUSICIAN'S FRIEND, ROGUE, AXMAN, PULSE PERCUSSION, PARADISE, GUITARMAN and RAM service marks with the United
States Patent and Trademark Office. We believe that these service marks have become important components of our merchandising and marketing strategy. The loss of the GUITAR CENTER or MUSICIAN'S FRIEND
service mark could have a material adverse effect on our business.

Risks Related to the Business

Described below are some of the risks and uncertainties facing our company. There may be additional risks that we do not presently know of or that we currently
consider immaterial. All of these risks could adversely affect our business, results of operations, liquidity and financial position.

We May Be Unable to Meet Our Growth Strategy.

Our retail store growth strategy includes opening new stores and increasing sales at existing locations. We intend to pursue an aggressive expansion strategy
by opening additional stores in new and existing markets. As of December 31, 2000, we operated 83 stores. We opened 14 stores in 2000 and 13 stores in 1999, and plan to open approximately 12 to
14 stores in 2001 and approximately 12 to 16 stores in 2002. Our expansion plan depends on a number of factors, including:



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We cannot assure that we will achieve our store expansion goals or that our new stores will achieve sales or profitability levels similar to our existing stores. Our expansion
strategy includes clustering stores in existing markets. This may result in the transfer of sales to the new store and a reduction in the profitability of an existing store. In addition to the factors
noted above, expansion to new markets may present unique competitive and merchandising challenges, including:



Historically,
we have achieved significant sales growth in existing stores. Our quarterly comparable stores sales results have fluctuated significantly in the past. Sales growth for
comparable periods, excluding net sales attributable to stores not open for 14 months was as follows:

2000

1999

1998Quarter 1

8
%
10
%
18
%Quarter 2

7
%
7
%
14
%Quarter 3

6
%
11
%
10
%Quarter 4

7
%
11
%
11
%Full Year

7
%
10
%
13
%


A
variety of factors affect our comparable store sales results, including:



Our
management is presently anticipating comparable store sales growth of 5% to 7% for the immediate future, although fluctuations will undoubtedly take place from period to period.

We
also believe that our expansion may be accelerated by the acquisition of existing music product retailers. In the ordinary course of our business, we regularly consider, evaluate
and enter into negotiations related to potential acquisition opportunities. We may pay for these acquisitions in cash or securities (including equity securities), or a combination of both. We cannot
assure that attractive acquisition targets will be available at reasonable prices or that we will be successful in any such transaction. Acquisitions involve a number of special risks, including:



13

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We Depend on Suppliers.

We depend significantly on our suppliers for both our existing stores and the direct response unit and our expansion goals. We do not have any
long-term contracts with our suppliers, which we believe is customary in our industry. If we failed to maintain our relationships with our key brand name vendors, we believe this could
have a material adverse effect on our business. We believe we currently have
adequate supply sources; however, we cannot assure sufficient quantities or the appropriate mix of products will be available in the future to supply our existing stores and expansion plans. This risk
is especially prevalent in new markets where our vendors have existing agreements with other dealers and thereby may be unwilling or unable to meet our requirements.

We Have Competitors.

Our industry is fragmented and highly competitive. We compete with many different types of retailers, including conventional retailers, as well as other
catalog and e-commerce retailers, who sell many or most of the items we sell. We anticipate increased competition in our existing markets and planned new markets as other large format
music product retailers execute their announced growth plans. Additionally, our expansion to new markets will be inhibited by established competitors in those markets. If our competitors adopt a new,
innovative store format or retail selling method, or if a new competitor with substantial financial or other resources enters the market place, then we may fail to achieve market position gains or may
lose market share.

We Depend on Key Personnel.

Our success depends to a significant extent on the services of Larry Thomas, our Chairman and Co-CEO, and Marty Albertson, our President and
Co-CEO, and Robert Eastman the CEO of our wholly owned Musician's Friend, Inc. as well as our ability to attract and retain additional key personnel with the skills necessary to
manage our existing business and growth plans. The loss of one or more of these individuals or other key personnel could have a material adverse effect on our business, results of operations,
liquidity and financial position. In June 1996, we entered into a five-year employment contract with both Mr. Thomas and Mr. Albertson. Additionally, we carry key man
insurance on the lives of Mr. Thomas and Mr. Albertson in the amounts of $5.0 million and $3.5 million, respectively. 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, we will depend upon our ability to retain and promote existing personnel to
senior management, and we must attract and retain new personnel with the skills and expertise to manage our business. If we cannot hire, retain, and promote qualified personnel, our business, results
of operations, financial condition and prospects could be adversely affected.

Our Retail Operations are Concentrated in California.

As of December 31, 2000, 19 of our 83 stores were located in California and generated 29.0% and 30.7% of our retail sales for 2000 and 1999,
respectively. Although we have opened stores in other
areas of the United States, a significant percentage of our net sales and results of operations will likely remain concentrated in California for the foreseeable future. As a result, our results of
operations and financial condition are heavily dependent upon general consumer trends and other general economic conditions in California and are subject to other regional risks, including
earthquakes. We do maintain certain earthquake insurance, but such policies carry significant deductibles and other restrictions.

14

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Economic Conditions Could Adversely Impact Industry Results; Changing Consumer Preferences Could Also Adversely Impact Us.

Our business is sensitive to consumer spending patterns, which can be affected by prevailing economic conditions. A downturn in economic conditions in one or
more of our markets could have a material adverse effect on our results of operations, financial condition, business and prospects. Although we attempt to stay informed of consumer preferences for
musical products and accessories typically offered for sale in our stores, any sustained failure on our part to identify and respond to trends would have a material adverse effect on our results of
operations, financial condition, business and prospects.

We Must Manage Efficiently the Expansion of our Web site and the Systems that Process Orders in Our Direct Response Business.

Our direct response business, particularly our e-commerce business, will require significant investments to respond to anticipated growth and
competitive pressures. If we fail to rapidly upgrade our web site in order to accommodate increased traffic, we may lose customers, which would reduce our net sales. Furthermore, if we fail to expand
the computer systems that we use to process and ship customer orders and process payments, we may not be able to successfully distribute customer orders. As a result, we could lose customers and our
net sales could be reduced. We may experience difficulty in improving and maintaining such systems if our employees or contractors that develop or maintain our computer systems become unavailable to
us. We have experienced periodic systems interruptions, which we believe will continue to occur, while enhancing and expanding these computer systems.

We Intend to Implement a New Distribution Center for the Retail Stores which Presents Operational Risks and Will Require a Significant Investment.

We intend during 2001 to build a central warehouse/distribution center for our retail store operations with a view towards the facility commencing operation in
early 2002. Migration from our present
"drop-ship" model to a centralized distribution model is an important development in our operating strategy and will require significant financial and managerial resources for the next
several quarters. This program involves risks that could include the need to expend greater funds than presently budgeted or disruptions in retail store operations if inventory is not timely provided
in the required quantities.

Net Sales of our E-Commerce Business Could Decrease If Our Online Security Measures Fail.

Our relationships with our e-commerce customers may be adversely affected if the security measures that we use to protect their personal
information, such as credit card numbers, are ineffective. If, as a result, we lose many customers, our net sales could decrease. We rely on security and authentication technology that we license from
third parties. With this technology, we perform real-time credit card authorization and verification with our bank. We cannot predict whether events or developments will result in a
compromise or breach of the technology we use to protect a customer's personal information. Furthermore, our servers may be vulnerable to computer viruses, physical or electronic break-ins
and similar disruptions. We may need to expend significant additional capital and other resources to protect against a security breach or to alleviate problems caused by 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 delays in introducing new services, products and enhancements, our e-commerce customers may forego the use of our services and
use those of our competitors. To remain

15

---

competitive, we must continue to enhance and improve the functionality and features of our online store. The Internet and the online commerce industry are rapidly changing. If competitors introduce
new products and services embodying new technologies, or if new industry standards and practices emerge, our existing website and proprietary technology and systems may become obsolete. To develop our
website and other proprietary technology entails significant technical and business risks. We may use new technologies ineffectively or we may fail to adapt our website, our transaction processing
systems and our computer network to meet customer requirements or emerging industry standards. In addition, the success of e-commerce may result in greater efficiency and lower prices,
which could have an adverse effect on selling prices and margins in our retail store business and in our catalog business and generally constrain profitability in the specialty retail business.

We May Need To Change The Manner In Which We Conduct Our Business If Government Regulation Increases.

The adoption or modification of laws or regulations relating to the Internet could adversely affect the manner in which we currently conduct our
e-commerce business. For example, laws related to the taxation of online commercial activity remain in flux. In addition, the growth and development of the market for online commerce may
lead to more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on us. Laws and regulations directly applicable to communications or commerce
over the Internet are becoming more prevalent. The law of the Internet, however, remains largely unsettled, even in areas where there has been some legislative action. It may take years to determine
whether and how existing laws such as those governing intellectual property, consumer privacy, taxation of e-commerce transactions and the like are interpreted and enforced. Any adverse
change in any of these laws or in the interpretation or scope of existing laws could have a material adverse effect on our results of operations, financial condition or prospects.

The Ownership of NOLs Related to the Musician's Friend Business May be Recaptured.

The former stockholders of the Musician's Friend business are involved in a tax audit with the Internal Revenue Service regarding the conduct of the business
prior to the merger with Guitar Center. Those proceedings may result in NOLs that have previously been recognized by us in our consolidated financial statements being deemed to be the property of the
former stockholders. This issue is not resolved as of the date of this annual report and we can provide no assurance as to the ultimate outcome of this matter. However, an unfavorable resolution of
this matter would result in a charge to our financial statements and the payment of taxes previously offset with the credits.

We Have an Investment in an Internet Community Company that Could Result in Future Charges to our Financial Statements.

We have an investment of approximately $3.3 million in the equity of the operator of musician.com and guitar.com, Internet community sites oriented
towards musicians. We are carrying this investment at cost, and this value was recently validated by third party financing by several venture capital firms. However, if in the future we determine that
the fair market value of these shares has been permanently reduced to less than our cost, we would be required under generally accepted accounting principles to recognize a charge to our financial
statements.

We Have a Limited History of Trading on the Nasdaq National Market; Our Stock Price Could be Volatile.

We began trading on the Nasdaq National Market on March 14, 1997. The market price of our shares of common stock has been subject to significant
fluctuations in response to our operating results and other factors, including announcements by our competitors, and those fluctuations will likely continue in the future. In addition, the stock
market in recent years has experienced significant price

16

---

and volume fluctuations that often have been unrelated or disproportionate to the operating performance of particular companies. These fluctuations, as well as a shortfall in sales or earnings
compared to public market analysts' expectations, changes in analysts' recommendations or projections, and general economic and market conditions, may adversely affect the market price of our common
stock.

Forward-Looking Statements and Associated Risks.

This annual report contains forward-looking statements, relating to, among other things, future results of operations, growth plans (including, without
limitation, the number and timing of new store openings and the growth of our e-commerce business), sales, gross margin and expense trends, capital requirements and general industry and
business conditions applicable to us. These statements are based largely on our current expectations and are subject to a number of risks and uncertainties. Our actual results could differ materially
from these forward-looking statements. In addition to the other risks described elsewhere in this section, important factors to consider in evaluating these statements include changes in external
competitive market factors, changes in our business strategy or an inability to execute our strategy due to unanticipated changes in the music products industry or the economy in general, the
emergence of new or growing specialty retailers of music products and various other competitive factors that may prevent us from competing successfully in existing or future markets. In light of these
risks and uncertainties, we can not assure you that the forward-looking statements contained in this annual report will in fact be realized. Further, we do not undertake any duty to update the
forward-looking statements contained in this annual report, particularly those related to management's future estimates which are subject to revision due to changes in the business environment that we
face.

Item 2. PROPERTIES

We lease all but three of our stores and presently intend to lease all new locations. We lease our call center facility in Salt Lake City, Utah and the
distribution centers, in Knoxville, Tennessee and Kansas
City, Missouri. The terms of the store leases are generally for 10 years and typically allow us to renew for two additional five-year terms. Most of the leases require us to pay
property tax, utilities, normal repairs, common area maintenance and insurance expenses.

We
lease our corporate offices of approximately 35,700 square feet, which are located at 5155 Clareton Drive, Agoura Hills, California 91301. During April 2001, we will
relocate these offices to 69,600 square feet of leased space located at 5795 Lindero Canyon Road, Westlake Village, California 91362. Our direct response business is headquartered in a facility we own
located at 931 Chevy Way, Medford, Oregon 97504.

17

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Store Locations

The table below sets forth certain information concerning our retail stores as of December 31, 2000:

|Store               |                      | Year
Opened |      | Gross
Square
Feet |        | Status
|------------------- | -------------------- | ----------- | ---- | ----------------- | ------ | ------
|ARIZONA             |                      |             |      |                   |        |       
|                    | Phoenix              |             | 1997 |                   | 13,600 |       
|                    | Tempe                |             | 1997 |                   | 12,100 |       
|SOUTHERN CALIFORNIA |                      |             |      |                   |        |       
|                    | Hollywood            |             | 1964 |                   | 30,600 |       
|                    | San Diego (1)        |             | 1973 |                   | 23,200 |       
|                    | Fountain Valley      |             | 1980 |                   | 16,800 |       
|                    | Sherman Oaks         |             | 1982 |                   | 18,700 |       
|                    | Covina               |             | 1985 |                   | 15,400 |       
|                    | Southbay             |             | 1985 |                   | 14,500 |       
|                    | San Bernardino (2)   |             | 1993 |                   | 15,000 |       
|                    | Brea                 |             | 1995 |                   | 14,900 |       
|                    | San Marcos           |             | 1996 |                   | 14,900 |       
|                    | Rancho Cucamonga     |             | 1999 |                   | 15,000 |       
|                    | El Toro              |             | 1999 |                   | 16,300 |       
|                    | Oxnard               |             | 2000 |                   | 14,000 |       
|                    | Bakersfield          |             | 2000 |                   | 8,000  |       
|NORTHERN CALIFORNIA |                      |             |      |                   |        |       
|                    | San Francisco        |             | 1972 |                   | 11,900 |       
|                    | San Jose             |             | 1978 |                   | 14,200 |       
|                    | El Cerrito (3)       |             | 1983 |                   | 11,300 |       
|                    | Concord              |             | 1996 |                   | 15,800 |       
|                    | Fresno               |             | 2000 |                   | 15,500 |       
|                    | Sacramento           |             | 2000 |                   | 15,800 |       
|COLORADO            |                      |             |      |                   |        |       
|                    | Denver               |             | 1998 |                   | 16,800 |       
|                    | Englewood            |             | 1998 |                   | 16,800 |       
|                    | Arvada               |             | 1999 |                   | 15,700 |       
|CONNECTICUT         |                      |             |      |                   |        |       
|                    | Manchester           |             | 1999 |                   | 16,000 |       
|FLORIDA             |                      |             |      |                   |        |       
|                    | North Miami area     |             | 1996 |                   | 20,900 |       
|                    | South Miami area     |             | 1996 |                   | 14,700 |       
|                    | West Palm Beach (4)  |             | 2001 |                   | 15,000 |       
|GEORGIA             |                      |             |      |                   |        |       
|                    | Atlanta              |             | 1997 |                   | 23,600 |       
|                    | Marietta             |             | 1997 |                   | 22,800 |       
|IDAHO               |                      |             |      |                   |        |       
|                    | Boise (4)            |             | 2001 |                   | 10,800 |       
|ILLINOIS            |                      |             |      |                   |        |       
|                    | South Chicago        |             | 1979 |                   | 13,800 |       
|                    | North Chicago        |             | 1981 |                   | 11,000 |       
|                    | Central Chicago      |             | 1988 |                   | 20,500 |       
|                    | Villa Park           |             | 1996 |                   | 15,000 |       
|                    | Highland Park (4)    |             | 2001 |                   | 15,200 |       
|INDIANA             |                      |             |      |                   |        |       
|                    | Indianapolis (4)     |             | 2001 |                   | 15,600 |       
|LOUISIANA           |                      |             |      |                   |        |       
|                    | New Orleans          |             | 1999 |                   | 19,700 |       
|MARYLAND            |                      |             |      |                   |        |       
|                    | Towson               |             | 1998 |                   | 14,600 |       
|                    | Rockville(5)         |             | 2000 |                   | 24,000 |       
|MASSACHUSETTS       |                      |             |      |                   |        |       
|                    | Boston               |             | 1994 |                   | 12,600 |       
|                    | Danvers              |             | 1996 |                   | 14,600 |       
|                    | Natick               |             | 1997 |                   | 15,100 |       
|                    | N. Attleboro         |             | 1998 |                   | 16,800 |       
|MICHIGAN            |                      |             |      |                   |        |       
|                    | Detroit              |             | 1994 |                   | 10,100 |       
|                    | Southfield           |             | 1996 |                   | 18,800 |       
|                    | Canton               |             | 1998 |                   | 16,800 |       
|MINNESOTA           |                      |             |      |                   |        |       
|                    | Twin Cities          |             | 1988 |                   | 15,000 |       
|                    | Edina                |             | 1997 |                   | 15,700 |       
|MISSOURI            |                      |             |      |                   |        |       
|                    | N. St. Louis         |             | 1999 |                   | 15,700 |       
|                    | Bridgeton            |             | 1999 |                   | 15,000 |       
|NEVADA              |                      |             |      |                   |        |       
|                    | Las Vegas            |             | 1998 |                   | 20,000 |       
|NEW JERSEY          |                      |             |      |                   |        |       
|                    | Springfield          |             | 1998 |                   | 20,000 |       
|                    | E. Brunswick         |             | 1998 |                   | 20,000 |       
|                    | Totowa               |             | 1999 |                   | 15,600 |       
|                    | Paramus              |             | 1999 |                   | 14,100 |       
|                    | Cherry Hill (4)      |             | 2001 |                   | 15,800 |       
|NEW YORK            |                      |             |      |                   |        |       
|                    | Carle Place          |             | 1998 |                   | 22,800 |       
|                    | Queens               |             | 1999 |                   | 19,000 |       
|                    | Larchmont            |             | 1999 |                   | 15,300 |       
|                    | Commack              |             | 2000 |                   | 16,000 |       
|                    | Buffalo              |             | 2000 |                   | 15,000 |       
|                    | Rochester (4)        |             | 2001 |                   | 15,300 |       
|OHIO                |                      |             |      |                   |        |       
|                    | Cleveland            |             | 1997 |                   | 15,600 |       
|                    | Mayfield Heights     |             | 1998 |                   | 15,400 |       
|                    | Cincinnati           |             | 1998 |                   | 18,500 |       
|OKLAHOMA            |                      |             |      |                   |        |       
|                    | Oklahoma City        |             | 2000 |                   | 15,200 |       
|OREGON              |                      |             |      |                   |        |       
|                    | Eugene               |             | 1996 |                   | 7,700  |       
|                    | Clackamas            |             | 2000 |                   | 15,600 |       
|                    | Beaverton            |             | 2000 |                   | 15,300 |       
|PENNSYLVANIA        |                      |             |      |                   |        |       
|                    | Philadelphia         |             | 2000 |                   | 15,200 |       
|                    | Plymouth Meeting (4) |             | 2001 |                   | 14,900 |       
|                    | Monroeville (4)      |             | 2001 |                   | 14,000 |       
|TENNESSEE           |                      |             |      |                   |        |       
|                    | Knoxville            |             | 1998 |                   | 15,000 |       
|TEXAS               |                      |             |      |                   |        |       
|                    | Dallas               |             | 1989 |                   | 12,700 |       
|                    | Arlington            |             | 1991 |                   | 19,200 |       
|                    | South Houston        |             | 1993 |                   | 14,700 |       
|                    | North Houston        |             | 1994 |                   | 14,700 |       
|                    | Central Dallas       |             | 1998 |                   | 17,800 |       
|                    | Clearlake            |             | 1998 |                   | 15,000 |       
|                    | Austin               |             | 2000 |                   | 15,200 |       
|                    | Plano                |             | 2000 |                   | 15,500 |       
|UTAH                |                      |             |      |                   |        |       
|                    | Salt Lake City       |             | 1998 |                   | 15,000 |       
|VIRGINIA            |                      |             |      |                   |        |       
|                    | Fairfax              |             | 1999 |                   | 15,600 |       
|                    | Seven Corners        |             | 1999 |                   | 15,400 |       
|                    | Virginia Beach       |             | 2000 |                   | 16,000 |       
|WASHINGTON          |                      |             |      |                   |        |       
|                    | Tukwila              |             | 1997 |                   | 18,000 |       
|                    | Kirkland             |             | 1997 |                   | 20,200 |       
|                    | Seattle              |             | 1997 |                   | 18,300 |       
|                    | Lynnwood             |             | 1998 |                   | 14,000 |       
|                    | Tacoma (4)           |             | 2001 |                   | 15,600 |       

---

18

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Item 3. Legal Proceedings

We are not a party to any material legal proceedings and are not aware of any pending or threatened litigation that, if decided adversely to the Company, would
reasonably be expected to have a material adverse effect on our financial condition. Please see "Item 7. Management's Discussion and Analysis of Financial Condition and Results of
OperationsIncome Taxes" for discussion of a tax matter with which we are indirectly involved.

Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of security holders during the fiscal quarter ended December 31, 2000.

PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters

Market Information

Our common 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 the
common stock for the calendar quarters indicated:

2000

1999High

Low

High

LowFirst Quarter

$
11.44

$
8.50

$
29.88

$
15.81Second Quarter


14.81


10.00


20.88


9.19Third Quarter


15.44


10.25


12.88


7.69Fourth Quarter


14.44


10.13


11.13


8.00


As
of March 5, 2001, there were 148 stockholders of record, excluding the number of beneficial owners whose shares were held in street name. We believe that the number of
beneficial holders is significantly in excess of such amount based on the security position listings we obtain from time to time for the purpose of facilitating mailings to our stockholders.

Dividend Policy

We currently intend to retain any earnings to provide funds for the operation and expansion of our business and for the servicing and repayment of indebtedness
and do not intend to pay cash dividends on our common stock in the foreseeable future. Under the terms of the indenture governing our senior notes, we are not permitted to pay any dividends on the
common stock unless certain financial ratio tests and other conditions are satisfied. In addition, our bank facility with Foothill Capital contains certain covenants which, among other things, limit
the payment of cash dividends on the capital stock of the Company. See "Item 7. Management's Discussion and Analysis of Financial Condition and
Results of OperationsLiquidity and Capital Resources." Any determination to pay cash dividends on the common stock in the future will be at the sole discretion of our Board of Directors.

19

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Item 6. Selected Financial Data

The selected financial data for the fiscal years ended December 31, 2000, 1999, 1998, 1997 and 1996 has been derived from our audited
consolidated financial statements. The selected historical financial data should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations, our
consolidated financial statements and the notes thereto included elsewhere in this annual report.

|                                                                                                                            |              | Fiscal Year Ended December 31, |        
|--------------------------------------------------------------------------------------------------------------------------- | ------------ | ------------------------------ | -------
|
|
|INCOME STATEMENT DATA:                                                                                                      |              |                                |        
|Net sales                                                                                                                   |              | $                              | 785,671
|Cost of goods sold                                                                                                          |              |                                | 580,749
|                                                                                                                            |              |                                |        
|                                                                                                                            | Gross profit |                                |        
|Selling, general and administrative expenses                                                                                |              |                                | 156,698
|Transaction expense and other                                                                                               |              |                                |       
|Deferred compensation expense (1)                                                                                           |              |                                |       
|                                                                                                                            |              |                                |        
|Operating income (loss)                                                                                                     |              | $                              | 48,224 
|                                                                                                                            |              |                                |        
|Other (income)                                                                                                              |              |                                |       
|Interest expense, net                                                                                                       |              |                                | 12,466 
|                                                                                                                            |              |                                |        
|                                                                                                                            |              | $                              | 12,466 
|                                                                                                                            |              |                                |        
|Income (loss) before provision for income taxes, extraordinary loss and cumulative effect of change in accounting principle |              |                                | 35,758 
|Income tax expense (benefit)                                                                                                |              |                                | 13,304 
|                                                                                                                            |              |                                |        
|Income (loss) before extraordinary loss and cumulative effect of change in accounting principle                             |              | $                              | 22,454 
|                                                                                                                            |              |                                |        
|Extraordinary loss on early extinguishment of debt, net of tax $1,679                                                       |              |                                |       
|Cumulative effect of change in accounting principle to write-off pre-opening costs, net of tax $578                         |              |                                |       
|                                                                                                                            |              |                                |        
|Net income (loss)                                                                                                           |              | $                              | 22,454 
|                                                                                                                            |              |                                |        
|Net income per share (diluted)                                                                                              |              | $                              | 1.01   
|                                                                                                                            |              |                                |        
|Weighted average shares outstanding (2)                                                                                     |              |                                | 22,247 
|                                                                                                                            |              |                                |        
|OPERATING DATA:                                                                                                             |              |                                |        
|Net sales per gross square foot (3) (thousands)                                                                             |              | $                              | 535    
|Net sales growth                                                                                                            |              |                                | 27     
|Increase in comparable store sales (4)                                                                                      |              |                                | 7      
|Stores open at end of period                                                                                                |              |                                | 83     
|Ratio of earnings to fixed charges (5)                                                                                      |              |                                | 3.0    
|BALANCE SHEET AND CASH FLOW DATA:                                                                                           |              |                                |        
|Net working capital                                                                                                         |              | $                              | 94,034 
|Property and equipment, net                                                                                                 |              |                                | 65,861 
|Total assets                                                                                                                |              |                                | 325,569
|Total long-term and revolving debt (including current portion)                                                              |              |                                | 103,783
|Senior preferred stock                                                                                                      |              |                                |       
|Junior preferred stock                                                                                                      |              |                                |       
|Stockholders' equity (deficit)                                                                                              |              |                                | 103,463
|Capital expenditures                                                                                                        |              | $                              | 17,862 

---

20

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Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

General

We operated 79 retail locations in 42 major markets and 4 stores in secondary markets as of December 31, 2000. We also operate the largest direct
response channel (Musician's Friend catalog and Internet) in the musical instruments industry in the United States. From 1996 to 2000, our net sales grew at an annual compound growth rate of 31.9%,
principally due to the comparable store sales growth of our Guitar Center stores averaging 10% per year, the opening of new stores, and a 31.0%, per year increase in the direct response channel. We
believe such volume increases are the result of the continued success of the implementation of our business strategy, continued growth in the music products industry and increasing consumer awareness
of the Guitar Center and Musician's Friend brand names. We achieved comparable store sales growth of 7%, 10% and 13% for the fiscal years ended December 31, 2000, 1999 and 1998, respectively.
As indicated below, we do not expect comparable store sales to continue to increase at historical rates.

We
opened fourteen stores this year, one of which was acquired from Veneman Music in May 2000. Presently, we expect to open approximately 12 to 14 stores in 2001 and 12 to 16
stores in 2002. In preparation for these additional stores, we have dedicated a substantial amount of resources over the past several years to building the infrastructure necessary to support a large,
national chain. We have established centralized operating and financial controls and have implemented an extensive training program to ensure a high level of customer service in our stores. We will
continue to pursue our strategy of clustering stores in major markets to take advantage of operating and advertising efficiencies and to build awareness of the Guitar Center name in new markets. In
some markets this clustering strategy results in some transfer of sales from existing stores to new locations, thereby adversely affecting comparable store sales statistics.

As
we enter new markets, we expect that we will initially incur higher administrative and promotional costs per store than is currently experienced in established markets. We expect
competition to continue to increase as other music product retailers attempt to execute national growth strategies. Our business strategy will also emphasize opportunities to grow our direct response
business, particularly opportunities to increase our Internet activities. We expect to continue to make significant investments in the e-commerce and related business activities of Guitar
Center and Musician's Friend.

The
following table sets forth historical income statement data as a percentage of net sales:

Fiscal Year Ended
December 31,2000

1999

1998Net sales

100.0
%
100.0
%
100.0
%Gross profit

26.1

26.3

27.2Selling, general and administrative expenses

19.9

20.7

22.3Transaction and conversion costs



0.8

Operating income

6.2

4.8

4.9Interest expense, net

1.6

1.7

2.0Interest expense to related parties



0.1

0.3Other (income)





(0.1
)Income before income taxes and cumulative effect of change in accounting principle

4.6

3.0

2.7Income taxes (benefit)

1.7

(0.1
)
(0.7
)Income before cumulative effect of change in accounting principle

2.9
%
3.1
%
3.4
%


21

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Fiscal 2000 Compared to Fiscal 1999

Net sales for the year ended December 31, 2000 increased 26.7% to $786 million, compared with $620 million last year. Net sales from
retail stores for fiscal 2000 totaled $652 million, a 21.6% increase from $537 million in fiscal 1999. Sales from new stores contributed $79 million and represent 69% of the total
increase in retail store sales. Comparable store sales for the full year increased 7%. The increase in comparable store sales was due to aggressive pricing on certain elements of inventory and good
store sales performance due to the effect of successful promotions. Our management is presently anticipating comparable store sales growth of 5% to 7% for the immediate future, although fluctuations
will undoubtedly take place from period to period. The foregoing statement is a forward-looking statement and is subject to the qualifications set forth below under "Forward-Looking Statements;
Business Risks." Net sales from the direct response channel totaled $133 million in year 2000, a $50 million increase from 1999. Catalog sales increased 32% to $88 million in 2000
from $67 million in 1999. Internet sales for the year increased 170% to $45 million from $16 million last year. Direct response results reflect the increase in average order size,
sales facilitated by the third-party credit card introduced in the third quarter of 1999 and the impact of Net Perceptions selling software installed in the first quarter of 2000.

Gross
profit dollars for the year ended December 31, 2000 compared to 1999 increased 25.5% to $205 million from $163 million. Gross profit as a percentage of net
sales for the year ended December 31, 2000 compared to 1999 decreased to 26.1% from 26.3%. Gross profit margin percentage for the retail stores in 2000 after buying and occupancy costs was
25.3% compared to 26.0% in 1999. The reduction in gross profit margin relates to increased occupancy costs caused by the number of immature stores in the total store base, increased freight expense as
a result of opening new stores farther from some of our key vendors and higher shrink losses. The gross profit margin for the direct response division was 29.8% for 2000 compared to 28.7% in 1999. The
increase is principally due to improved selling margin.

Selling,
general and administrative expenses for fiscal 2000 increased 22.0% to $156.7 million from $128.4 million in fiscal 1999. As a percentage of net sales, selling,
general and administrative expenses for fiscal 2000 decreased to 19.9% from 20.7% in fiscal 1999. Selling, general and administrative expenses for the retail stores in 2000 and in 1999, inclusive of
pre-opening costs and corporate general and administrative expenses, were 19.5% of net sales. These results reflect the leveraging of corporate and administrative expenses offset by
additional advertising and marketing expenses, and higher store level selling, general and administrative expenses due to the number of stores that are less than two years old. Selling, general and
administrative expenses for the direct response division were 22.4% of sales compared to 28.8% last year. The improvement largely reflects the leveraging of corporate overhead and marketing expenses
as a result of the 59.8% increase in sales compared to 1999.

Transaction
and store conversion costs totaled $4.7 million, or 0.8% of sales, during the year ended December 31, 1999. No similar costs were incurred in 2000.

Operating
income for fiscal 2000 increased 59.7% to $48.2 million from $30.2 million in fiscal 1999. The increase is principally due to the increase in operating income
from the direct response unit and the absence of transaction expenses compared to 1999. As a percentage of sales, operating income was 6.2% and 4.8% in the years ended December 31, 2000 and
1999, respectively.

Interest
expense, net for fiscal 2000 increased to $12.5 million from $11.2 million in fiscal 1999. Interest expense consisted primarily of interest on our Senior Notes
and borrowings under the line of credit for additions to inventory and capital expenditures for our store expansions.

In
2000, income taxes were recorded at normal income tax rates, whereas in 1999 an income tax benefit was recorded due to the reduction of the valuation reserve on the Company's
deferred tax asset, net of current federal and state income taxes. We anticipate that in the future the income tax rate will be approximately 38%.

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In the first quarter of 1999, a charge to operations of $1.7 million, net of tax of $0.6 million, was incurred for the cumulative effect of a change in accounting
principle to expense pre-opening costs. No similar charge was incurred in 2000.

Net
income for fiscal 2000 increased to $22.5 million from $18.3 million in fiscal 1999. The increase was principally due to an increase in operating income from the
direct response unit, the absence of transaction expenses compared to prior year, and the cumulative effect of the change in accounting principle as discussed above.

Fiscal 1999 Compared to Fiscal 1998

Net sales for the year ended December 31, 1999 increased 28% to $620 million, compared with $486 million in 1998. Net sales from retail
stores for fiscal 1999 totaled $537 million, a 31% increase from $411 million in fiscal 1998. Sales from new stores contributed $91 million and represent 73% of the total increase
in retail store sales. Comparable store sales for the full year increased 10%. The increase
in comparable store sales was primarily attributable to increases in unit sales rather than increases in prices or changes in the mix of sales between the product categories. Such volume increases
were primarily the result of the continued success of the implementation of our business strategy, continued strong growth in the music products industry and increasing consumer awareness of the
Guitar Center name. Catalog sales decreased 5% to $67 million in 1999 from $70 million in 1998, due in part to a change in credit card programs, and its resulting effect on average order
size. The new third-party credit card was introduced on October 20, 1999. E-commerce sales for the year increased 319% to $17 million from $4 million in 1998.

Gross
profit dollars for the year ended December 31, 1999 compared to 1998 increased 23% to $163.3 million from $132.2 million. Gross profit as a percentage of
net sales for the year ended December 31, 1999 compared to 1998 decreased to 26.3% from 27.2%. Gross profit margin percentage for the retail stores in 1999 after buying and occupancy costs was
26.0% compared to 27.7% in 1998. The reduction in gross profit margin is related to increased occupancy costs due to the number of stores less than two years old (29 stores out of 69 stores), actions
taken to clear out merchandise at former Musician's Friend locations, increased freight expense as more stores were opened on the East Coast, and a change in assortment and aggressive pricing on
inventory that we wanted to move. The gross profit margin for the direct response division was 28.7% for 1999 compared to 24.8% in 1998. In 1998, significant markdowns were required to clear excess
direct response inventories. Markdowns of the same magnitude were not required in 1999. Additionally, during 1998 higher than average inventory shrink occurred in the Musician's Friend distribution
facilities.

Selling,
general and administrative expenses for fiscal 1999 increased 18.4% to $128.4 million from $108.4 million in fiscal 1998. As a percentage of net sales, selling,
general and administrative expenses for fiscal 1999 decreased to 20.7% from 22.3% in fiscal 1998. Selling, general and administrative expenses for the retail stores in 1999, inclusive of
pre-opening costs and corporate general and administrative expenses, were 19.5% of sales compared to 20.2% in 1998. These results reflect the leveraging of corporate expenses, partially
offset by higher store level selling, general and administrative expense due to the number of stores that are less than two years old. Selling, general and administrative expenses for the direct
response division were 28.8% of sales compared to 34.2% in 1998. In 1998 Musician's Friend incurred substantial bad debt expense related to an in-house installment credit program. This
program was substantially terminated in the fourth quarter of 1998.

Transaction
and store conversion costs totaled $4.7 million, or 0.8% of sales, during the year ended December 31, 1999. These costs relate to the acquisition of
Musician's Friend during the second quarter of 1999 and principally include financial advisory fees ($1.3 million), legal and accounting fees ($1.2 million), a severance accrual for a
former Musician's Friend executive ($0.8 million), as well as costs associated with the conversion of Musician's Friend stores to Guitar Center stores.

23

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Operating income for fiscal 1999 increased 27.0% to $30.2 million from $23.8 million in fiscal 1998.

Interest
expense, net for fiscal 1999 increased to $11.2 million from $10.8 million in fiscal 1998. Interest expense consisted principally of interest on our Senior
Notes and borrowings under the line of credit. Interest expense includes interest to related parties on our subordinated notes of $0.5 million and $1.3 million for the years ended
December 31, 1999 and 1998, respectively.

Income
tax benefit in 1999 was recorded due to the reduction of the valuation reserve on the Company's deferred tax asset, net of current federal and state income taxes.

In
the first quarter of 1999, a charge to operations of $1.7 million, net of tax of $0.6 million, was incurred for the cumulative effect of a change in accounting
principle to expense pre-opening costs.

Net
income for fiscal 1999 increased to $18.3 million from $16.4 million in fiscal 1998.

Liquidity and Capital Resources

Our need for liquidity will arise primarily from interest payable on indebtedness and the funding of capital expenditures and working capital requirements, as
well as investments and possible acquisitions. We have historically financed our operations through internally generated funds and borrowings under our credit facilities. We have no mandatory payments
of principal on the $66.7 million of Senior Notes outstanding prior to their final maturity in 2006. As of December 31, 2000, we had $35.9 million outstanding under the 2000
Credit Facility, excluding $1.9 million outstanding on standby letters of credit, and had available borrowings of $61.4 million. The 2000 credit facility permits borrowings up to
$100 million ($99.2 million at December 31, 2000) and can be increased (at our election) up to $150 million, subject to compliance with the terms of the loan agreement. The
credit facility is secured by certain assets and the actual amount available is tied to our inventory and receivable base. A fee of 0.25% is assessed on the unused portion of the 2000 credit facility.
Borrowings bear interest at either the prime rate (9.5% at December 31, 2000) plus 0.5% or at LIBOR (6.5% at December 31, 2000) plus 1.5%. The agreement underlying the 2000 credit
facility includes certain restrictive covenants. We were in compliance with such requirements as of December 31, 2000.

For
the year ended December 31, 2000, cash provided by operating activities was $36.5 million, most of which represented cash income from operations, net of additions to
inventory. Cash used in investing
activities totaled $23.4 million, which primarily consisted of capital expenditures for retail store expansions, computer equipment purchases and the launching of our Kansas City warehouse for
our direct response unit ($1.1 million), the acquisition of Veneman Music Company ($2.2 million), and an investment in a non-consolidated entity ($3.3 million). Cash
used in financing activities totaled $7.0 million, which consisted principally of paying down our credit facilities.

Inventory
increased from $161 million to $199 million, or 24.1%. The increase in inventory was required principally to support existing sales growth and the opening of
new retail locations. Inventory per square foot at retail stores was $130 in 2000 compared to $133 in 1999. Inventory increased from $16.4 million to $25.0 million, or 52.3% for the
direct response division. The increase in inventory was required principally to support future sales. Our ongoing objective is to improve inventory performance by refining our replenishment processes
and systems, and through improved planning, presentation, and display of inventories in our retail stores.

We
intend to pursue an aggressive growth strategy by opening additional stores in new and existing markets. During 2000, we opened fourteen new stores, one of which was acquired from
Veneman Music Company in the second quarter of 2000. Each new large format Guitar Center store typically has required approximately $1.8 million for gross inventory. Historically, our cost of
capital improvements for an average large format Guitar Center store has been approximately $850,000, consisting of leasehold improvements, fixtures and equipment. We incur higher costs in some
geographic areas, particularly the Northeast. We have developed a smaller format Guitar Center store to operate in

24

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secondary markets or sites that we do not believe will support our large format unit. The first of these units was opened in late 2000. Our small format stores will incur approximately $400,000 in
capital expenditures and require approximately $800,000 in inventory.

During
2001, we expect to incur approximately $20 million to $21 million in capital expenditures.

We
are also currently evaluating additional capital and strategic requirements related to improving our fulfillment facilities and technology and pursuing new opportunities in the
e-commerce activities of Guitar Center and Musician's Friend, and related businesses. The initiatives related to fulfillment include leasing a new distribution facility for Musician's
Friend in Kansas City, which is operational, and our plan to construct a distribution facility to support the retail business. The construction and operation of the retail distribution facility will
require the expenditure of significant capital, as well as the development of a team of key employees to manage this new function. We will also continue to make significant investments in information
technology across our businesses and will incur costs and make investments designed to expand the reach of the Guitar Center and Musician's Friend brands on
the Internet. The costs of these initiatives and other investments related to our businesses will continue to be significant and are not included in our capital expenditure budget noted above.

Our
expansion strategy is to continue to increase our market share in existing markets and to penetrate strategically selected new markets. We opened a total of 14 stores in 2000 and
13 stores in 1999, and currently anticipate opening approximately 12 to 14 stores in 2001. Some of these stores will be new smaller format units designed for secondary markets. We also believe there
may be attractive opportunities to expand by selectively acquiring existing music products retailers. However, in the music industry there are only a small number of companies that would strategically
and financially be a beneficial opportunity for us to acquire. Our "average" store is 15,000 square feet, carrying 7,000 SKUs and generating first year sales of $5.5 million, whereas the
"average" industry store is 3,200 square feet, carrying 2,500 SKUs and generating sales of $1.0 million. We may also consider acquisitions which are complementary to other parts of our
business, such as our direct response division, if attractive opportunities can be identified.

Our
capital resources and liquidity are expected to be provided by net cash flow from operations and additional borrowings under the 2000 Credit Facility. Depending upon market
conditions, we may also incur additional indebtedness or issue equity securities. There can be no assurance that such additional capital, if and when required, will be available on terms acceptable to
us, if at all.

Newly Issued Accounting Pronouncements

In March 2000, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 44 (Interpretation 44), Accounting for Certain Transactions Involving Stock
Compensation.Interpretation 44 provides criteria for the recognition of compensation expense in
certain stock-based compensation arrangements that are accounted for under Accounting Principles Board Opinion No. 25,Accounting for Stock-Based Compensation.Interpretation 44 is effective July
 1, 2000, with certain provisions that are effective retroactively to December 15, 1998 and January 12, 2000.
Interpretation 44 is not expected to have an impact on our financial statements.

Seasonality

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

Income Taxes

The former stockholders of the Musician's Friend business are involved in a tax audit with the Internal Revenue Service regarding the conduct of the business
prior to the merger with Guitar Center. Those proceedings may result in NOLs that have previously been recognized by us in our consolidated

25

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financial statements being deemed to be the property of the former stockholders. Guitar Center has filed a protective claim with the stockholders that such a loss of tax benefit would be subject to
indemnification under the express terms of the Agreement and Plan of Merger among the parties dated May 13, 1999. If such NOLs were lost and the indemnification claim asserted and paid, we
would be obligated to pay prior period federal income taxes previously offset by the use of NOLs, but would be entitled to an offsetting recovery of common stock held in escrow under the Agreement and
Plan of Merger. This issue is not resolved as of the date of this report and we can provide no assurance as to the ultimate outcome of this matter. Given the high level of uncertainty that surrounds
this matter, no provision has been made in our financial statements.

Inflation

We believe that the relatively moderate rates of inflation experienced in recent years have not had a significant impact on our net sales or profitability.

Forward-Looking Statements; Business Risks

This annual report contains certain forward-looking statements, relating to, among other things, future results of operations, growth plans (including, without
limitation, the number and timing of new store openings and the growth of our e-commerce business), sales, gross margin and expense trends, capital requirements and general industry and
business conditions applicable to us. These statements are based largely on our current expectations and are subject to a number of risks and uncertainties. Our actual results could differ materially
from these forward-looking statements. In addition to the other risks described elsewhere in this annual report, important factors to consider in evaluating these statements include changes in
external competitive market factors, changes in our business strategy or an inability to execute our strategy due to unanticipated changes in the music products industry or the economy in general, the
emergence of new or growing specialty retailers of music products and various other competitive factors that may prevent us from competing successfully in existing or future markets. In light of these
risks and uncertainties, many of which are described in greater detail in "Item 1.
BusinessRisks Related to the Business," we can not assure you that the forward-looking statements contained in this annual report will in fact be realized. Further, we do not undertake
any duty to update the forward-looking statements contained in this annual report, particularly those related to management's future estimates which are subject to revision due to changes in the
business environment that we face.

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Substantially all of our outstanding indebtedness is represented by $66.7 million principal amount of Senior Notes due 2006 with a fixed interest rate
of 11% and our line of credit which has a variable rate of interest generally consisting of stated premiums above the London Interbank Offered Rate, or LIBOR. At December 31, 2000, we had
$35.9 million outstanding under the line of credit. To the extent prevailing short-term interest rates fluctuate, the interest expense we incur on the line of credit will change
with a resulting effect (positive or negative) on our financial position, results of operations and cash flows. However, based on the balances outstanding under the line of credit at
year-end 2000, such a fluctuation would have to be relatively significant to have a material financial impact on us. We do not use derivative financial instruments in our investment
portfolio. Presently, we do not carry significant cash balances as any cash in excess of our daily operating needs is used to reduce our line of credit borrowings.

Item 8. Financial Statements and Supplementary Data

See the index included at "Item 14. Exhibits, Financial Statement Schedules and Reports on Form 10-K."

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Item 9. Changes and Disagreements With Accountants on Accounting and Financial Disclosure

Not Applicable

PART III

Item 10. Directors and Officers of the Registrant

The information required by this item is incorporated by reference to the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), in connection with the Company's annual meeting of stockholders.

Item 11. Executive Compensation

The information required by this item is incorporated by reference to the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
under the Exchange Act in connection with the Company's annual meeting of stockholders.

Item 12. Security Ownership of Certain Beneficial Owners and Management

The information required by this item is incorporated by reference to the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
under the Exchange Act in connection with the Company's annual meeting of stockholders.

Item 13. Certain Relationships and Related Transactions

The information required by this item is incorporated by reference to the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
under the Exchange Act in connection with the Company's annual meeting of stockholders.

PART IV

Item 14. Exhibits, Financial Statement Schedule, and Reports on Form 8-K

Index
to Financial Statements  Page F-1

Schedule IIValuation
and Qualifying Accounts  Page II-1

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

27

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INDEX TO EXHIBITS

|Exhibit
Number |  | Description                                                                                                                                                                                                                                                                          
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|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            |  | The Company's Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.7 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))                                                                                                                
|4.1            |  | Indenture dated as of July 2, 1996 by and between the Company and U.S. Trust Company of California as trustee (Incorporated by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-1 (Registration No.
333-10491))                                            
|4.2            |  | Form of Restricted Stock Agreements dated as of May 1, 1996 between the Company and certain members of management (Incorporated by reference to Exhibit 4.2 of the Company's Registration Statement on Form S-1 (Registration
No. 333-10491))                                        
|4.3            |  | Form of Stock Certificate (Incorporated by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))                                                                                                                                
|10.1           |  | Recapitalization Agreement dated May 1, 1996 by and among the Company and the stockholders named therein (Incorporated by reference to Exhibit 10.1 of the Company's Registration Statement on Form S-1 (Registration No.
333-10491)                                                 
|10.2           |  | Registration Rights Agreement dated June 5, 1996 among the Company and the stockholders named therein (Incorporated by reference to Exhibit 10.2 of the Company's Registration Statement on Form S-1 (Registration No.
333-10491))                                                   
|10.3           |  | Tax Indemnification Agreement dated as of May 1, 1996 by and among the Company, Ray Scherr, and the individuals identified on the signature pages thereto (Incorporated by reference to Exhibit 10.3 of the Company's
Registration Statement on Form S-1 (Registration No. 333-10491)
|10.4*          |  | Employment Agreement dated June 5, 1996 between the Company and Lawrence Thomas (Incorporated by reference to Exhibit 10.5 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))                                                                         
|10.5*          |  | 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))                                                                                   
|10.6*          |  | Employment Agreement dated June 5, 1996 between the Company and Marty Albertson (Incorporated by reference to Exhibit 10.6 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))                                                                         
|10.7*          |  | Employment Agreement dated June 5, 1996 between the Company and Bruce Ross, as amended (Incorporated by reference to Exhibit 10.7 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))                                                                  
|10.8*          |  | Employment Agreement dated June 5, 1996 between the Company and Raymond Scherr (Incorporated by reference to Exhibit 10.8 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))                                                                          
|10.9*          |  | Employment Agreement dated June 5, 1996 between the Company and Barry Soosman, as amended (Incorporated by reference to Exhibit 10.9 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))                                                               
|10.10          |  | Securities Purchase Agreement dated June 5, 1996 by and among the Company and the parties named therein (Incorporated by reference to Exhibit 10.10 of the Company's Registration Statement on Form S-1 (Registration No.
333-10491))                                                
|10.11*         |  | 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))                                                 

28

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|10.12  |  | Credit Agreement dated August 14, 1997 between the Company and Wells Fargo Bank, N.A. (Incorporated by reference to Exhibit 10.36 of the Company's Quarterly Report on Form 10-Q for the quarter ended September 30,
1997                                                             
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.15  |  | Registration Rights Agreement dated July 2, 1996 by and among the Company, Chase Securities Inc. and Donaldson, Lufkin & Jenrette Securities Corporation (Incorporated by reference to Exhibit 10.15 of the Company's
Registration Statement on Form S-1 (Registration No. 333-10491))
|10.16* |  | Management Stock Option Agreement dated June 5, 1996 by and between the Company and Lawrence Thomas (Incorporated by reference to Exhibit 10.16 of the Company's Registration Statement on Form S-1 (Registration No.
333-10491))                                                     
|10.17* |  | 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))                                                     
|10.18  |  | Registration Agreement dated June 5, 1996 among the Company and the parties named therein (Incorporated by reference to Exhibit 10.11 contained in Registration Statement on Form S-1 (File No. 333-10491))                                                                           
|10.19  |  | Stockholders Agreement dated June 5, 1996 among the Company, and the investors listed therein (Incorporated by reference to Exhibit 10.19 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))                                                           
|10.20* |  | Amendment No. 1 to Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.24 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))                                                                              
|10.21* |  | Form of Employee Stock Purchase Plan Agreement (Incorporated by reference to Exhibit 10.25 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))                                                                                                          
|10.22* |  | Amended 1997 Equity Participation Plan (Incorporated by reference to Exhibit 10.22 of the Company's Annual Report on Form 10-K (Registration No. 000-22207) for the fiscal year ended December 31, 1998)                                                                              
|10.23  |  | Stockholders Consent dated as of January 24, 1997 by and among the Company and certain of its stockholders (Incorporated by reference to Exhibit 10.27 of the Company's Registration Statement on Form S-1 (Registration No.
333-20931))                                              
|10.24* |  | 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))                                                                                 
|10.25* |  | Management Stock Repurchase Agreement (Incorporated by reference to Exhibit 10.29 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))                                                                                                                   
|10.26* |  | 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))                                                                          
|10.27* |  | 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))                                              
|10.28* |  | 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))                                           
|10.29* |  | 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 (Registration No. 000-22207) for the fiscal
year ended December 31, 1998)                                          

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|10.30* |  | 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 (Registration No.
000-22207) for the period ending June 30, 1999).                                                                                                                                                                                                                                                                                                                                                                           
|------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.31* |  | Amended and Restated Employment Agreement dated July 1, 1998 between the Company and Bruce Ross (Incorporated by reference to Exhibit 10.29 of the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for
the period ending September 30, 1998).                                                                                                                                                                                                                                                                                                                                                                                      
|10.32* |  | Amended and Restated Employment Agreement dated July 1, 1998 between the Company and Barry Soosman (Incorporated by reference to Exhibit 10.30 of the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207)
for the period ending September 30, 1998).                                                                                                                                                                                                                                                                                                                                                                                   
|10.33* |  | Agreement and Plan of Merger dated May 13, 1999 by and among the Company, EMIC Acquisition Corporation, Musician's Friend, Inc. and the Stockholders of Musician's Friend, Inc. (Incorporated by reference to Exhibit 2.1 of
the Company's Current Report on Form 8-K dated May 28, 1999 (Registration No. 000-22207)).                                                                                                                                                                                                                                                                                                                                 
|10.34* |  | 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 (Registration No. 000-22207)).
|10.35  |  | Loan and Security Agreement entered into as of December 17, 1999 between and among Foothill Capital Corporation and the other lenders identified therein, Guitar Center, Inc., and Musician's Friend, Inc. (Incorporated by
reference to Exhibit 10.[35][36] of the Company's Annual Report on Form 10-K (Registration No. 000-22207) for the fiscal year ended December 31, 1999)                                                                                                                                                                                                                                                                      
|10.36* |  | Form of 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.[35][36] of the Company's
Annual Report on Form 10-K (Registration No. 000-22207) for the fiscal year ended December 31, 1999)                                                                                                                                                                                                                                                                                                                              
|12.1   |  | Ratio of Earnings to Fixed Charges                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|21.1   |  | Material subsidiaries of the Registrant as of December 31, 2000:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|       |  | Musician's Friend, Inc., a Delaware corporation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|       |  | Guitar Center Stores, Inc., a Delaware corporation.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|23.1   |  | Consent of Independent Auditors (KPMG LLP)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              
|23.2   |  | Consent of Independent Auditors (PricewaterhouseCoopers LLP)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|24.1   |  | Power of Attorney (included on page S-1)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Report to be
signed on its behalf by the undersigned, thereunto duly authorized as of this 12th day of March 2001.

| |  | GUITAR CENTER, INC.
| |  | -------------------
| |  |                    

KNOW
ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Larry Thomas, Marty Albertson and Bruce Ross, as his
attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendment to this Report on Form 10-K, and to file the
same, with exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said
attorneys-in-fact, or his substitute or substitutes may do or cause to be done by virtue hereof.

Pursuant
to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.

|Name                              |  | Title                                                                                                        |  | Date   
|--------------------------------- |  | ------------------------------------------------------------------------------------------------------------ |  | -------
|                                  |  |                                                                                                              |  |        
|/s/LARRY THOMASLarry Thomas       |  | Chairman & Co-Chief Executive Officer and Director (Principal Executive Officer)                             |  | 3/12/01
|/s/MARTY ALBERTSONMarty Albertson |  | President & Co-Chief Executive Officer and Director                                                          |  | 3/12/01
|/s/BRUCE ROSSBruce Ross           |  | Executive Vice President, Chief Financial Officer and Secretary (Principal Financial and Accounting Officer) |  | 3/12/01
|/s/STEVEN BURGESteven Burge       |  | Director                                                                                                     |  | 3/12/01
|/s/DAVID FERGUSONDavid Ferguson   |  | Director                                                                                                     |  | 3/12/01
|                                  |  |                                                                                                              |  |        

31

---

|/s/HARVEY KIBELHarvey Kibel     |  | Director |  | 3/12/01
|------------------------------- |  | -------- |  | -------
|/s/PETER STARRETTPeter Starrett |  | Director |  | 3/12/01
|/s/JEFFREY WALKERJeffrey Walker |  | Director |  | 3/12/01

32

---



INDEX TO FINANCIAL STATEMENTS

|Report of Independent Auditors (KPMG LLP)                                                            |                                   | 34      
|---------------------------------------------------------------------------------------------------- | --------------------------------- | --------
|Report of Independent Auditors (PricewaterhouseCoopers LLP)                                          |                                   | 35      
|Management's Responsibility for Financial Statements                                                 |                                   | 36      
|Consolidated Balance Sheets as of December 31, 2000 and 1999                                         |                                   | 37      
|Consolidated Statements of Income for the years ended
December 31, 2000, 1999 and 1998               |                                   | 38      
|Consolidated Statements of Stockholders' Equity for the years ended
December 31, 2000, 1999 and 1998 |                                   | 39      
|Consolidated Statements of Cash Flows for the years ended
December 31, 2000, 1999 and 1998           |                                   | 40      
|Notes to Consolidated Financial Statements                                                           |                                   | 41      
|                                                                                                     |                                   | Schedule
|Financial Statement Schedule:                                                                        |                                   |         
|                                                                                                     | Valuation and Qualifying Accounts |         

33

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REPORT OF INDEPENDENT AUDITORS

The
Board of Directors and Stockholders
Guitar Center, Inc. and subsidiaries:

We
have audited the accompanying consolidated balance sheets of Guitar Center, Inc. and subsidiaries as of December 31, 2000 and 1999 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, 2000. In connection with our audits of the consolidated
financial statements, we also have audited the consolidated financial statement schedule as listed in the accompanying index. These consolidated financial statements and the consolidated financial
statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and the consolidated financial statement
schedule based on our audits. We did not audit the financial statements of Musician's Friend, Inc., a wholly-owned subsidiary, which financial statements reflect total revenues constituting
19 percent of the year ended December 31, 1998 consolidated totals. Those financial statements were audited by other auditors whose report has been furnished to us, and our opinion,
insofar as it relates to the amounts included for Musician's Friend, Inc., is based solely on the report of the other auditors.

We
conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In
our opinion, based on our audits and the report of the other auditor, the consolidated financial statements referred to above present fairly, in all material respects, the
financial position of Guitar Center, Inc. and subsidiary as of December 31, 2000 and 1999 and the results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 2000 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related consolidated
financial statement schedule, when considered in relation to the basic consolidated
financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

KPMG
LLP

Los
Angeles, California
February 8, 2001

34

---

REPORT OF INDEPENDENT AUDITORS

To
the Board of Directors and Shareholders of
Musician's Friend, Inc.

In
our opinion, the statements of operations, of changes in accumulated deficit and of cash flows of Musician's Friend, Inc. for the year ended December 31, 1998 (not
presented separately herein) present fairly, in all material respects, the results of operations and cash flows of Musician's Friend, Inc. for the year ended December 31, 1998, in
conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with auditing standards generally accepted in the United States of
America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the
overall financial statement presentation. We believe that our audit provides a reasonable basis for the opinion expressed above. We have not audited the financial statements of Musician's
Friend, Inc. for any period subsequent to December 31, 1998.

PricewaterhouseCoopers
LLP

Portland,
Oregon
May 28, 1999

35

---

MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS

We are responsible for the preparation of our consolidated financial statements and related information appearing in this Annual Report. We believe that the
consolidated financial statements fairly reflect the form and substance of transactions and that the financial statements reasonably present our financial position and results of operations in
conformity with generally accepted accounting principles. We also have included in our financial statements amounts that are based on estimates and judgments which we believe are reasonable under the
circumstances.

The
independent accountants audit our consolidated financial statements in accordance with generally accepted auditing standards and provide an objective, independent review of the
fairness of reported operating results and financial position.

The
Board of Directors of the Company has an Audit Committee composed of three non-management Directors. The Committee meets periodically with financial management and the
independent accountants to review accounting, internal control, auditing and financial reporting matters.

| |  | Larry Thomas                          |  | Bruce Ross                                        
| |  | ------------------------------------- |  | --------------------------------------------------
| |  | Chairman & Co-Chief
Executive Officer |  | Executive Vice President & Chief Financial Officer

Los
Angeles, California
February 8, 2001

36

---



GUITAR CENTER, INC. AND SUBSIDIARIES        CONSOLIDATED BALANCE SHEETS        (In thousands, except per share data)

|                                                                      |                                                                                                                                                                     | December 31,
2000          |         | December 31,
1999 |        
|--------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------- | ----------------- | -------
|ASSETS                                                                |                                                                                                                                                                     |                            |         |                   |        
|Current assets:                                                       |                                                                                                                                                                     |                            |         |                   |        
|                                                                      | Cash and cash equivalents                                                                                                                                           |                            | $       | 12,934            |        
|                                                                      | Accounts receivable, less allowance for doubtful accounts $834 (2000) and $1,143 (1999)                                                                             |                            |         | 20,490            |        
|                                                                      | Merchandise inventories, less reserve $3,225 (2000) and $2,060 (1999)                                                                                               |                            |         | 199,287           |        
|                                                                      | Prepaid expenses and deposits                                                                                                                                       |                            |         | 5,148             |        
|                                                                      | Deferred income tax                                                                                                                                                 |                            |         | 5,931             |        
|                                                                      |                                                                                                                                                                     |                            |         |                   |        
|Total current assets                                                  |                                                                                                                                                                     |                            | 243,790 |                   |        
|Property and equipment, net                                           |                                                                                                                                                                     |                            | 65,861  |                   |        
|Deferred income tax                                                   |                                                                                                                                                                     |                            |        |                   |        
|Goodwill, net of accumulated amortization $884 (2000) and $665 (1999) |                                                                                                                                                                     |                            | 5,367   |                   |        
|Deposits and other assets, non-current                                |                                                                                                                                                                     |                            | 10,551  |                   |        
|                                                                      |                                                                                                                                                                     |                            |         |                   |        
|                                                                      |                                                                                                                                                                     | $                          | 325,569 |                   | $      
|                                                                      |                                                                                                                                                                     |                            |         |                   |        
|LIABILITIES AND STOCKHOLDERS' EQUITY                                  |                                                                                                                                                                     |                            |         |                   |        
|Current liabilities:                                                  |                                                                                                                                                                     |                            |         |                   |        
|                                                                      | Accounts payable                                                                                                                                                    |                            | $       | 72,301            |        
|                                                                      | Accrued expenses and other current liabilities                                                                                                                      |                            |         | 30,580            |        
|                                                                      | Merchandise advances                                                                                                                                                |                            |         | 10,512            |        
|                                                                      | Revolving line of credit                                                                                                                                            |                            |         | 35,868            |        
|                                                                      | Current portion of long-term debt                                                                                                                                   |                            |         | 495               |        
|                                                                      |                                                                                                                                                                     |                            |         |                   |        
|Total current liabilities                                             |                                                                                                                                                                     |                            | 149,756 |                   |        
|Other long-term liabilities                                           |                                                                                                                                                                     |                            | 2,770   |                   |        
|Deferred tax liability                                                |                                                                                                                                                                     |                            | 2,160   |                   |        
|Long-term debt                                                        |                                                                                                                                                                     |                            | 67,420  |                   |        
|                                                                      |                                                                                                                                                                     |                            |         |                   |        
|Total liabilities                                                     |                                                                                                                                                                     |                            | 222,106 |                   |        
|Stockholders' equity:                                                 |                                                                                                                                                                     |                            |         |                   |        
|                                                                      | Preferred Stock; authorized 5,000 shares at December 31, 2000 and December 31, 1999, none issued and outstanding                                                    |                            |         |                  |        
|                                                                      | Common Stock, $0.01 par value per share, authorized 55,000 shares, issued and outstanding 22,087 at December 31, 2000 and 22,023 at December 31, 1999, respectively |                            |         | 221               |        
|                                                                      | Additional paid in capital                                                                                                                                          |                            |         | 244,693           |        
|                                                                      | Accumulated deficit                                                                                                                                                 |                            |         | (141,451          | )      
|                                                                      |                                                                                                                                                                     |                            |         |                   |        
|                                                                      |                                                                                                                                                                     | Total stockholders' equity |         |                   | 103,463
|                                                                      |                                                                                                                                                                     |                            |         |                   |        
|                                                                      |                                                                                                                                                                     | $                          | 325,569 |                   | $      
|                                                                      |                                                                                                                                                                     |                            |         |                   |        

See
accompanying notes to consolidated financial statements.

37

---



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

|                                                                                                       |         | Year ended December 31, |        
|------------------------------------------------------------------------------------------------------ | ------- | ----------------------- | -------
|
|Net sales                                                                                              |         | $                       | 785,671
|Cost of goods sold, buying and occupancy                                                               |         |                         | 580,749
|                                                                                                       |         |                         |        
|Gross profit                                                                                           |         |                         | 204,922
|Selling, general and administrative expenses                                                           |         |                         | 156,698
|Transaction and conversion costs                                                                       |         |                         |       
|                                                                                                       |         |                         |        
|Operating income                                                                                       |         |                         | 48,224 
|Interest expense, net                                                                                  |         |                         | 12,466 
|Interest expense to related party                                                                      |         |                         |       
|Other (income)                                                                                         |         |                         |       
|                                                                                                       |         |                         |        
|Income before income taxes and cumulative effect of change in accounting principle                     |         |                         | 35,758 
|Income tax expense (benefit)                                                                           |         |                         | 13,304 
|                                                                                                       |         |                         |        
|Income before cumulative effect of change in accounting principle                                      |         |                         | 22,454 
|Cumulative effect of change in accounting principle to write-off
pre-opening costs, net of tax of $578 |         |                         |       
|                                                                                                       |         |                         |        
|Net income                                                                                             |         | $                       | 22,454 
|                                                                                                       |         |                         |        
|Net income per share                                                                                   |         |                         |        
|                                                                                                       | Basic   |                         | $      
|                                                                                                       |         |                         |        
|                                                                                                       | Diluted |                         | $      
|                                                                                                       |         |                         |        
|Weighted average shares outstanding                                                                    |         |                         |        
|                                                                                                       | Basic   |                         |        
|                                                                                                       |         |                         |        
|                                                                                                       | Diluted |                         |        
|                                                                                                       |         |                         |        

See
accompanying notes to consolidated financial statements.

38

---



GUITAR CENTER, INC. AND SUBSIDIARIES        CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY        (In thousands)

|                             |                                                     | Preferred
Stock |   | Common
Stock |   | Warrants |    | Additional
Paid in
Capital |       | Retained
Earnings
(Deficit) |   | Total   |       
|---------------------------- | --------------------------------------------------- | --------------- | - | ------------ | - | -------- | -- | -------------------------- | ----- | --------------------------- | - | ------- | ------
|Balance at December 31, 1997 |                                                     | $               |  |              | $ | 193      |    | $                          | 6,500 |                             | $ | 220,514 |       
|                             | Exercise of warrants/cost of
underwriting           |                 |   |             |   |          | 8  |                            |       | (6,500                      | ) |         | 6,394 
|                             | Exercise of employee stock options                  |                 |   |             |   |          |   |                            |       |                            |   |         | 860   
|                             | Tax benefit from exercise of
employee stock options |                 |   |             |   |          |   |                            |       |                            |   |         | 427   
|                             | Distribution to beneficiaries                       |                 |   |             |   |          |   |                            |       |                            |   |         |      
|                             | Net income                                          |                 |   |             |   |          |   |                            |       |                            |   |         |      
|                             |                                                     |                 |   |              |   |          |    |                            |       |                             |   |         |       
|Balance at December 31, 1998 |                                                     |                 |  |              |   | 201      |    |                            |      |                             |   | 228,195 |       
|                             | Exercise of employee stock options                  |                 |   |             |   |          |   |                            |       |                            |   |         | 208   
|                             | Issuance of stock for merger                        |                 |   |             |   |          | 20 |                            |       |                            |   |         | (20   
|                             | Contribution of land and building                   |                 |   |             |   |          |   |                            |       |                            |   |         | 1,750 
|                             | Conversion of related party debt to
equity          |                 |   |             |   |          |   |                            |       |                            |   |         | 13,870
|                             | Net income                                          |                 |   |             |   |          |   |                            |       |                            |   |         |      
|                             |                                                     |                 |   |              |   |          |    |                            |       |                             |   |         |       
|Balance at December 31, 1999 |                                                     |                 |  |              |   | 221      |    |                            |      |                             |   | 244,003 |       
|                             | Exercise of employee stock options                  |                 |   |             |   |          |   |                            |       |                            |   |         | 690   
|                             | Net income                                          |                 |   |             |   |          |   |                            |       |                            |   |         |      
|                             |                                                     |                 |   |              |   |          |    |                            |       |                             |   |         |       
|Balance at December 31, 2000 |                                                     | $               |  |              | $ | 221      |    | $                          |      |                             | $ | 244,693 |       
|                             |                                                     |                 |   |              |   |          |    |                            |       |                             |   |         |       

See
accompanying notes to consolidated financial statements.

39

---



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

|                                                                                            |                                                                                    | Year ended December 31, |        
|------------------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------- | ----------------------- | -------
|
|OPERATING ACTIVITIES:                                                                       |                                                                                    |                         |        
|Net income                                                                                  |                                                                                    | $                       | 22,454 
|Adjustments to reconcile net income to net cash provided by
(used in) operating activities: |                                                                                    |                         |        
|                                                                                            | Depreciation and amortization                                                      |                         |        
|                                                                                            | Amortization of deferred financing fees                                            |                         |        
|                                                                                            | Loss (gain) on sale of property                                                    |                         |        
|                                                                                            | Change in deferred tax asset                                                       |                         |        
|                                                                                            | Tax benefit from exercise of stock options                                         |                         |        
|                                                                                            | Cumulative effect of change in accounting principle
to write-off pre-opening costs |                         |        
|Changes in operating assets and liabilities:                                                |                                                                                    |                         |        
|                                                                                            | Accounts receivable                                                                |                         |        
|                                                                                            | Merchandise inventories                                                            |                         |        
|                                                                                            | Prepaid expenses and deposits                                                      |                         |        
|                                                                                            | Other assets                                                                       |                         |        
|                                                                                            | Accounts payable                                                                   |                         |        
|                                                                                            | Accrued expenses and other current liabilities                                     |                         |        
|                                                                                            | Other long-term liabilities                                                        |                         |        
|                                                                                            | Merchandise advances                                                               |                         |        
|                                                                                            |                                                                                    |                         |        
|Net cash provided by (used in) operating activities                                         |                                                                                    |                         | 36,491 
|INVESTING ACTIVITIES:                                                                       |                                                                                    |                         |        
|Proceeds from sale of equipment                                                             |                                                                                    |                         |       
|Purchase of property and equipment                                                          |                                                                                    |                         | (17,862
|Investment in non-consolidated entity                                                       |                                                                                    |                         | (3,307 
|Acquisition of businesses, net of cash                                                      |                                                                                    |                         | (2,206 
|                                                                                            |                                                                                    |                         |        
|Net cash used in investing activities                                                       |                                                                                    |                         | (23,375
|FINANCING ACTIVITIES:                                                                       |                                                                                    |                         |        
|Net change in revolving debt facility                                                       |                                                                                    |                         | (6,902 
|Proceeds from exercise of stock options                                                     |                                                                                    |                         | 690    
|Warrant underwriting                                                                        |                                                                                    |                         |       
|Borrowings under related party debt                                                         |                                                                                    |                         |       
|Distributions to beneficiaries                                                              |                                                                                    |                         |       
|Payments under capital lease                                                                |                                                                                    |                         | (743   
|                                                                                            |                                                                                    |                         |        
|Net cash (used in) provided by financing activities                                         |                                                                                    |                         | (6,955 
|Net increase (decrease) in cash and cash equivalents                                        |                                                                                    |                         | 6,161  
|Cash and cash equivalents at beginning of year                                              |                                                                                    |                         | 6,773  
|                                                                                            |                                                                                    |                         |        
|Cash and cash equivalents at end of period                                                  |                                                                                    | $                       | 12,934 
|                                                                                            |                                                                                    |                         |        
|NON-CASH INVESTING ACTIVITIES:                                                              |                                                                                    |                         |        
|Borrowings under capital leases                                                             |                                                                                    |                         |       
|Contribution of land and building                                                           |                                                                                    |                         |       
|Related party debt converted to equity                                                      |                                                                                    |                         |       
|NON-CASH FINANCING ACTIVITIES:                                                              |                                                                                    |                         |        
|Issuance of Common Stock in connection with the merger                                      |                                                                                    |                         |       
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                                            |                                                                                    |                         |        
|                                                                                            | Cash paid during the year for:                                                     |                         |        
|                                                                                            |                                                                                    | Interest                |        
|                                                                                            |                                                                                    | Income taxes            |        

See accompanying notes to consolidated financial statements.

40

---



GUITAR CENTER, INC. AND SUBSIDIARIES        NOTES TO CONSOLIDATED FINANCIAL STATEMENTS        December 31, 2000

1. Nature of Business and Significant Accounting Policies



Guitar Center, Inc. and subsidiaries (the "Company") operates a chain of retail stores and a direct response unit which sell musical instruments,
primarily guitars, amplifiers, percussion instruments, keyboards and pro-audio and recording equipment. At December 31, 2000, we operated 83 stores in major cities throughout the
United States with 19 of the stores located in California.



The consolidated financial statements include the financial statements of Guitar Center, Inc. and our wholly-owned subsidiaries. All significant
intercompany balances and transactions have been eliminated in consolidation.

We
account for investments where we own less than 20% of the voting common stock under the cost method of accounting.



Certain reclassifications have been made to prior year amounts to conform with the current year's presentation.



Inventories, including used merchandise and vintage guitars, are valued at the lower of cost or market using the first-in, first-out
(FIFO) method.



Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets;
generally five years for furniture and fixtures, computer equipment and vehicles, 15 years for buildings and 15 years or the life of the lease, whichever is less, for leasehold
improvements. Maintenance and repair costs are expensed as they are incurred, while renewals and betterments are capitalized.



Effective January 1, 1999, we adopted AICPA Statement of Position 98-5, "Reporting on the Costs of
Start-up Activities,"which requires all store pre-opening costs to be expensed as incurred. As a result of this adoption, we recorded a charge for the
cumulative effect of this change in accounting principle of $1,074,000 (net of taxes of $578,000), or $0.05 per basic and diluted share, in the Statement of Income for the year ending
December 31, 1999.



We expense retail advertising as incurred. Mail order catalog costs are capitalized on a catalog by catalog basis and are amortized over the expected period of
future benefits, not to exceed five months, under the provisions of AICPA Statement of Position 93-7,"Reporting of Advertising Costs."Advertising

41

---

expense included in the Statements of Income for the years ended December 31, 2000, 1999 and 1998 is $27,868,000, $24,566,000 and $17,775,000, respectively.



Merchandise advances primarily represent layaway deposits which are recorded as a liability pending consummation of the sale when the full purchase price is
received from the customer and outstanding gift certificates which are recorded as a liability until redemption by the customer.



Retail sales are recognized at the time of sale, net of a provision for estimated returns. Catalog and e-commerce sales are recognized when the
related products are shipped to customers, net of a provision for estimated returns.



We account for income taxes under Statement of Financial Accounting Standards No. 109,"Accounting for Income
Taxes" (SFAS 109). Under the asset and liability method of SFAS 109, deferred income tax assets and liabilities are recognized for the future tax consequences
attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax
rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS 109, the effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

In
assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The
ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider the
scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment.



Goodwill represents the excess of the purchase price over the fair value of the net assets acquired resulting from business combinations and is being amortized
on a straight-line basis over 20 to 30 years.



We lease certain store locations under operating leases that provide for annual payments that increase over the life of the leases. The aggregate of the
minimum annual payments are expensed on a straight-line basis over the term of the related lease. The amount by which straight-line rent expense exceeds actual lease payment
requirements in the early years of the leases is accrued as deferred minimum rent and reduced in later years when the actual cash payment requirements exceed the straight-line expense.

42

---



Our deposits are with various high quality financial institutions. Customer purchases are transacted generally using cash or credit cards. In certain
instances, we grant credit for larger purchases, generally to professional musicians, under normal trade terms. Trade accounts receivable were approximately $1,854,000 and $2,670,000 at
December 31, 2000 and 1999, respectively. Credit losses have historically been within our expectations.



The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect
the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual results could differ from our estimates.



For the purposes of balance sheet classification and the statement of cash flows, we consider all highly liquid investments that are both readily convertible
into cash and mature within 90 days of their date of purchase to be cash equivalents.



Long-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to future net cash flows expected to
be generated by said assets. If such assets are considered to be impaired, the impairment to be recognized is the amount by which the carrying amount of the assets exceeds the fair value of the
assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less selling costs.



Prior to January 1, 1996, we accounted for our stock option plan in accordance with the provisions of Accounting Principles Board ("APB") Opinion
No. 25,Accounting for Stock Issued to Employees,and
related interpretations. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On January 1,
1996, we adopted SFAS No. 123,Accounting for Stock-Based Compensation,which permits entities to recognize as expense over the vesting period
the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro
forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS
No. 123 had been applied. We have elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123.

43

---



The following table summarizes the reconciliations of Basic to Diluted Weighted Average Shares as required by SFAS No. 128 for the years ended
December 31, 2000, 1999 and 1998:

2000

1999

1998(in thousands)Basic shares

22,047

22,020

21,676Common stock equivalentsdilutive effect of options
outstanding

200

289

1,175Diluted shares

22,247

22,309

22,851


Net
income is the same for diluted and basic per share data. Options to purchase 1.4 million shares of Common Stock at prices ranging from $12.33 to $28.56 per common share
were outstanding during 2000 but were not included in the computation of diluted earnings per share because the option's exercise price was greater than the average market price of the common share.



The carrying amount of our financial instruments, which principally include cash, accounts receivable, accounts payable and accrued expenses, approximates fair
value due to the relatively short maturity of such instruments.

The
fair value of our short-term instruments reflects the fair value based upon current rates available to us for similar debt. As of December 31, 2000 the fair
value of our long-term debt instrument was $60.0 million, based on quoted market prices.

Our
cost basis investment is valued at cost which approximates fair value as determined through comparison to other third party investors. We will periodically recognize permanent
impairment, if any.

2. Merger

On May 28, 1999, we acquired all of the stock of Musician's Friend, Inc., pursuant to a merger agreement. Each share of Musician's Friend Common
Stock was converted into approximately 10.02 shares of Guitar Center Common Stock. In total, 1.9 million shares of Common Stock were issued.

Under
the terms of the merger agreement, 30% of the total shares issued were placed in escrow for general indemnification purposes and for indemnification against damages related to
specific tax issues. In the first quarter of 2000, the 10% general escrow was resolved whereby 50,002 shares of Common Stock were returned to Guitar Center and the balance released to the former
Musician's Friend stockholders.

The
merger was accounted for under the pooling of interests method. Accordingly, our financial statements have been restated for all periods to include the results of Musician's
Friend.

44

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GUITAR CENTER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

December 31, 2000

3. Merchandise Inventories

The major classes of merchandise inventories are as follows:

December 31,2000

1999(in thousands)Major goods

$
137,321

$
109,037Associated accessories


37,778


31,276Vintage guitars


4,925


4,785Used merchandise


9,977


6,130General accessories


9,286


9,343$
199,287

$
160,571


Major
goods includes stringed merchandise, percussion, keyboards and pro-audio and recording equipment. Associated accessories are comprised of accessories to major goods.
General accessories includes other merchandise such as apparel, cables and books.

4. Property and Equipment

Property
and equipment consists of the following:

December 31,2000

1999(in thousands)Land

$
2,996

$
2,996Buildings


9,649


9,490Furniture and fixtures


13,726


10,936Computer equipment


22,143


17,656Leasehold improvements


52,531


41,713Construction in progress


307


1,016101,352


83,807Less accumulated depreciation


35,491


25,633$
65,861

$
58,174


5. Debt

At December 31, 2000, we had outstanding $66.7 million of Senior Notes. The Senior Notes are unsecured and pay interest at 11% on a
semi-annual basis. The Senior Notes are not entitled to the benefit of a sinking fund. The Senior Notes may be redeemed, in whole or in part, at our option, at any time after
July 1, 2001 at prices declining from 105.5% to 100.0% of the principal amount redeemed, plus accrued and unpaid interest. The holders of the Senior Notes have the right to require us to
repurchase their Senior Notes at 101% of the principal amount thereof, plus accrued and unpaid interest, upon the occurrence of a change of control, as defined. The Senior Notes mature on
July 1, 2006.

In
the fourth quarter of 1999, we terminated our prior credit facility (the "1999 Facility") and entered into a new five-year revolving credit facility which permits
borrowings of up to $100 million,

45

---

subject to borrowing base limitations ($99.2 million at December 31, 2000). The amount available can be increased at our election up to $150 million, subject to compliance with
the terms of the loan agreement. We were in compliance with such covenants at December 31, 2000. A fee of 0.25% is assessed on the unused portion of the facility. Borrowings bear interest at
either the prime rate (9.5% at December 31, 2000) plus 0.5% or at LIBOR (6.5% at December 31, 2000) plus 1.5% at our option, with interest due monthly. At December 31, 2000, we
had $35.9 million outstanding on the line of credit and $1.9 million outstanding on standby letters of credit. At December 31, 2000, we had $61.4 million available
borrowings under the line of credit.

The
new credit facility is secured by certain assets of our Company, and the actual amount available is tied to the amount of our working capital base, as defined in the loan
agreement. The financing was arranged through Foothill Capital Corporation, which is a member of the Wells Fargo group of companies.

6. Transaction and Conversion Costs

Transaction and store conversion costs totaled $4.7 million during the twelve months ended December 31, 1999. These costs relate to the merger
with Musician's Friend during the second quarter of 1999 and principally include financial advisory fees ($1.3 million), legal and accounting fees ($1.2 million), a severance accrual for
a former Musician's Friend executive ($0.8 million), and certain costs associated with the conversion of Musician's Friend stores to the Guitar Center format.

7. Segment Information

In accordance with the requirements of Statement of Financial Accounting Standards No. 131,"Disclosures about Segments of an
Enterprise and Related Information,"our reportable business segments are retail (stores) and direct response (catalog and Internet). We evaluate segment performance based
primarily on sales and income before income taxes and cumulative effect of change in accounting principle.

Sales,
depreciation and amortization, income (loss) before income taxes and cumulative effect of change in accounting principle, capital expenditures, and total assets are summarized
as follows for the twelve months ended December 31, 2000, 1999 and 1998 (in thousands):

|                                                                                          |  | Retail
2000 |         | Direct Response
2000 |   | Total   |  | Retail
1999 |         | Direct Response
1999 |   | Total  
|----------------------------------------------------------------------------------------- |  | ----------- | ------- | -------------------- | - | ------- |  | ----------- | ------- | -------------------- | - | -------
|Sales                                                                                     |  | $           | 652,341 |                      | $ | 133,330 |  | $           | 785,671 |                      | $ | 536,650
|Depreciation and amortization                                                             |  |             | 10,077  |                      |   | 966     |  |             | 11,043  |                      |   | 7,450  
|Income (loss) before income taxes and cumulative effect of change in accounting principle |  |             | 27,992  |                      |   | 7,766   |  |             | 35,758  |                      |   | 22,551 
|Capital expenditures                                                                      |  |             | 16,693  |                      |   | 1,169   |  |             | 17,862  |                      |   | 16,372 
|Total assets                                                                              |  | $           | 290,972 |                      | $ | 34,597  |  | $           | 325,569 |                      | $ | 241,247

46

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|                                                                                         |  | Retail
1998 |         | Direct Response
1998 |   | Total 
|---------------------------------------------------------------------------------------- |  | ----------- | ------- | -------------------- | - | ------
|Sales                                                                                    |  | $           | 411,377 |                      | $ | 74,337
|Depreciation and amortization                                                            |  |             | 4,568   |                      |   | 425   
|Income(loss) before income taxes and cumulative effect of change in accounting principle |  |             | 22,549  |                      |   | (9,291
|Capital expenditures                                                                     |  |             | 20,150  |                      |   | 1,528 
|Total assets                                                                             |  | $           | 190,328 |                      | $ | 17,730

8. Investment in Non-Consolidated Entity

During 2000, we invested through a wholly owned subsidiary, Musician's Choice, Inc., approximately $3.3 million in a non-consolidated
entity, Musician.com Internet Network, Inc. ("Musician.com"). As of December 31, 2000, we owned approximately 14.2% of the voting common stock of Musician.com. As of that date we also
owned additional shares of non-voting common stock and non-voting preferred stock with a liquidation preference of $2.7 million. Musician.com operates community based
musician websites offering a wide range of services to empower amateur and professional musicians. We account for this investment under the cost method will periodically and recognize permanent
impairments in value, if any.

9. Lease Commitments

We lease offices, most of our retail store facilities, and two of our distribution centers under various operating leases which expire at varying dates through
December 2015. Generally, the agreements contain provisions which require us to pay for normal repairs and maintenance, property taxes and insurance.

The
total minimum lease commitment at December 31, 2000, under operating leases, is as follows:

Year ended December 31

Amount(in thousands)2001

$
17,7332002


18,0412003


17,9382004


17,5442005


17,570Thereafter

$
67,844


Total
rent expense included in the statements of income for the years ended December 31, 2000, 1999 and 1998 is $15,587,000, $11,749,000, and $7,759,000, respectively.

10. Benefit Plans



We have a Profit Sharing Plan (the "Plan") which covers substantially all Guitar Center employees who meet a minimum employment requirement. Our Board of
Directors can elect to contribute up to

47

---

15% of the participants' compensation for any plan year, subject to a maximum of $30,000 per participant. Effective January 1, 2001, the Profit Sharing Plan year end changed to
December 31 from October 31. Accordingly, vesting was accelerated by one year for all participants. For the Plan years ended October 31, 2000 and 1999 we declared total
contributions of $414,000 and $274,000, respectively, which are included in accrued liabilities. In 2000 and 1999, $200,000 and $244,000, respectively, of Plan assets that had been forfeited by
terminated employees, were reallocated to participants.



As of January 2001, we instituted a 401(k) plan which is available to substantially all Guitar Center employees. Employees may contribute portions of
their wages on a tax-deferred basis to the plan. Employees immediately vest 100% in their own contributions.

11. Stock Option Plans



In June 1996, we adopted the 1996 Performance Stock Option Plan (as amended, the "1996 Plan"), which provided for the granting of options to officers
and key employees. The number of options granted were 1,503,323 with an exercise price equal to the fair market value ($10.89 per share) of the underlying stock at the date of grant and generally
vested ratably over three years. No further options are available for grant under the 1996 Plan.



In June 1996, we granted options to two officers to purchase 795,969 shares at an exercise price of $10.89 per share. Under the terms of the option
agreements, the conditions for full accelerated vesting occurred during 1997. No additional options are available for grant under this plan.



In January 1997, the 1997 Equity Participation Plan (the "1997 Plan") was adopted. Under the 1997 Plan, we may grant options to purchase up to 2,725,000
shares of Common Stock, $.01 par value ("Common Stock");provided, however,that grants to any one individual may not exceed 250,000 shares of Common
Stock in any calendar year. Options granted under the 1997 Plan vest ratably over various terms. As of December 31, 2000, 2,438,286 options had been granted under the 1997 Plan.

In
connection with the merger with Musician's Friend, stock options to purchase 250,505 shares of Common Stock were assumed. The assumed stock options have exercise prices of $19.96
to $21.96 per share, with a weighted average exercise price of $20.31.

48

---

GUITAR CENTER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

December 31, 2000

11. Stock Option Plans (Continued)

We
apply APB Opinion No. 25 in accounting for our plans. Had we determined compensation cost based upon the fair value at the grant date for our stock options under SFAS
No. 123 using the Black
Scholes option pricing model, pro forma net income and pro forma net income per share, including the following weighted average assumptions used in these calculations, would have been as follows:

2000

December 31,
1999

1998(in thousands, except per share data-unaudited)Pro forma net income

$
21,632

$
14,359

$
13,958Pro forma net income per share (basic)

$
0.98

$
0.65

$
0.64Pro forma net income per share (diluted)

$
0.97

$
0.64

$
0.61Risk free interest rate


5.2
%

6.2
%

4.5
%Expected lives


10.0


10.0


10.0Expected volatility


60.0
%

82.0
%

70.0
%Expected dividends











Stock
option activity for all plans during the periods presented is as follows:

No. of Shares

Weighted Average
Exercise PriceBalance at December 31, 1997

1,519,968

$
11.04Granted

1,027,959


20.87Exercised

(78,545
)

10.89Forfeited

(30,825
)

18.89Expired




Balance at December 31, 1998

2,438,557


15.09Granted

495,319


17.51Exercised

(19,069
)

10.89Forfeited

(123,951
)

20.05Expired




Balance at December 31, 1999

2,790,856


15.33Granted

915,008


11.10Exercised

(63,541
)

10.89Forfeited

(164,702
)

18.74Expired




Balance at December 31, 2000

3,477,621

$
14.13


At
December 31, 2000, the outstanding stock options had an exercise price ranging from $8.34 to $28.56 per share and a remaining contractual life of
6-10 years.

At
December 31, 2000, the number of stock options exercisable was 1,956,578 which had exercise prices ranging from $8.34 to $28.56.

49

---

12. Income Taxes

Total income tax (benefit) before cumulative effect of change in accounting principle for the years ended December 31, 2000, 1999 and 1998 consists of:

2000

Current

Deferred

TotalFederal

$
3,454

$
8,332

$
11,786State


1,148


370


1,518$
4,602

$
8,702

$
13,304


1999

Current

Deferred

TotalFederal

$
929

$
(1,710
)
$
(781
)State


721


(331
)

390$
1,650

$
(2,041
)
$
(391
)


1998

Current

Deferred

TotalFederal

$
1,636

$
(5,431
)
$
(3,795
)State


640





640$
2,276

$
(5,431
)
$
(3,155
)


Actual
income tax (benefit) for 2000, 1999 and 1998 differs from the statutory tax rate of 35% as applied to income before income taxes and cumulative effect of change in accounting
principle as follows:

2000

1999

1998(in thousands)Expected income tax expense

$
12,515

$
6,636

$
4,640State income taxes, net of federal tax benefit


892


428


605Non deductible items


106


1,586


552Current use of NOL





(1,896
)

(1,096
)Change in valuation allowance





(7,145
)

(7,856
)Other


(209
)




Actual income tax expense (benefit)

$
13,304

$
(391
)
$
(3,155
)


50

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GUITAR CENTER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

December 31, 2000

12. Income Taxes (Continued)

The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities are presented below:

2000

1999(in thousands)Deferred tax assets:Federal net operating loss carryforwards

$
4,155

$
9,743State net operating loss carryforwards


177


324Deferred compensation


855


609Accrued liabilities


1,602


1,318Inventory reserves


3,582


2,735Alternative minimum tax carryforward


880


632Total gross deferred tax assets


11,251


15,361Deferred tax liabilitiesDepreciation


6,774


2,353Other


706


535Total gross deferred liabilities


7,480


2,888Deferred tax assets, net of deferred tax liabilities


3,771


12,473Less valuation allowance





Net deferred tax assets

$
3,771

$
12,473


In
assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be
realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We
consider scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable income and
projections of future taxable income over the periods in which the deferred tax assets are deductible, management believes it is more likely than not that we will realize the benefits of these
deductible differences. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward periods
are reduced. In order to fully realize the deferred tax assets, we will need to generate future taxable income of approximately $11.9 million prior to the expiration of the net operating loss
carryforwards in 2011.

From
1994 through 1997, the Musician's Friend business was operated by Musician's Friend Trust, an Oregon business trust (the "Trust"), which, as a trust, claimed it was not subject
to federal and state income taxes. Accordingly, Musician's Friend has not recorded provisions for income taxes during this period since the Trust's income or loss was attributable to the individual
beneficiaries of the Trust and its related trusts.

During
1998, the Internal Revenue Service ("IRS") took the position that the Trust was an association which is taxable as a corporation and not as a trust. Accordingly, the IRS
asserted that the Trust was required to file its tax returns and pay income taxes at corporate rates in effect. Alternatively,

51

---

the IRS contended that the Trust and related beneficiaries were formed to avoid federal income taxes which were legally owed by the Trust and the individuals involved. As a result, the IRS issued
reports to the Trust claiming taxes due of $4,443,000 for the years 1994 - 1996, with penalties aggregating $1,286,000 and related interest. No claims relating to 1997 have
been quantified to date in the IRS reports. The Musician's Friend business was operated as an S corporation for years prior to 1994. Accordingly, Musician's Friend's taxable income for 1994 and prior
years had been attributed to the owners. Effective January 1, 1998, the Trust contributed the Musician's Friend business to a Delaware corporation taxable as a C corporation. By the express
terms of the contribution agreement, that corporation did not assume any liability of the Trust or its beneficiaries for prior period taxes.

The
Trust is currently contesting the positions of the IRS. Guitar Center has not provided for income tax expense related to this matter in its consolidated financial statements
because its subsidiary, Musician's Friend, Inc., did not assume any liabilities related to this dispute when it was formed in January 1998 and therefore Guitar Center believes the
liability related to any resolution of this matter properly resides with the Trust and its beneficiaries. Pursuant to the merger agreement, 20% of the shares otherwise issuable to the former
stockholders of Musician's Friend have been placed in escrow pending resolution of this matter.

The
proceedings with the IRS may result in net operating losses (NOLs) that have previously been recognized by us in our consolidated financial statements being deemed to be the
property of the former stockholders. Guitar Center has filed a protective claim with the stockholders that such a loss of tax benefit would be subject to indemnification under the express terms of the
Agreement and Plan of
Merger among the parties dated May 13, 1999. If such NOLs were lost and the indemnification claim asserted and paid, we would be obligated to pay prior period federal income taxes previously
offset by the use of NOLs, but would be entitled to an offsetting recovery of common stock held in escrow under the Agreement and Plan of Merger. This issue is not resolved as of the date of this
report and we can provide no assurance as to the ultimate outcome of this matter. Given the high level of uncertainty that surrounds this matter, no provision has been made in our financial
statements.

13. Accrued Expenses and Other Current Liabilities

December 31,2000

1999(in thousands)Wages, salaries and benefits

$
7,903

$
5,758Sales tax payable


7,407


5,701Accrued interest


3,860


3,788Other


11,410


8,199$
30,580

$
23,446


52

---

14. Preferred Stock



We have authorized 5,000,000 shares of Preferred Stock. All outstanding shares (Senior Preferred Shares) were redeemed in conjunction with our initial public
offering in 1997.

In
connection with the issuance of the Senior Preferred Stock, the holders received detachable warrants (in addition to the Senior Preferred Stock) for the aggregate
$20.0 million paid. The warrants were exchangeable for 676,325 shares of Common Stock and were to expire on June 5, 2006. The market value of the warrants at issuance was deemed to be
$6.5 million with the Senior Preferred Stock valued at $13.5 million. The warrants were exercisable at a price of $0.01 per share. On June 3, 1998, the warrants were exercised and
converted into shares of Common Stock on a cashless exercise basis. The effect to our total stockholders' equity was immaterial.

15. Legal

We are not a party to any material legal proceedings and are not aware of any pending or threatened litigation that, if decided adversely to us, would
reasonably be expected to have a material adverse effect on our financial condition or results of operations.

16. Quarterly Financial Data (unaudited)

|                               |  | Fiscal 2000
|------------------------------ |  | -----------
|
|
|Net sales                      |  | $          
|Gross profit                   |  | $          
|Net income                     |  | $          
|Net income per share (diluted) |  | $          

|                                      |  | Fiscal 1999
|------------------------------------- |  | -----------
|
|
|Net sales                             |  | $          
|Gross profit                          |  | $          
|Net income (loss)                     |  | $          
|Net income (loss) per share (diluted) |  | $          

53

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SCHEDULE II

GUITAR CENTER, INC. AND SUBSIDIARY        VALUATION AND QUALIFYING ACCOUNTS        Years ended December 31, 2000 and 1999        (amounts in thousands)

|                  |                                            | Balance at
beginning
of year |   | Additions
charged to
operations |  | Deductions
from
Allowance |  | Other |  | Balance
at end
of year
|----------------- | ------------------------------------------ | ---------------------------- | - | ------------------------------- |  | ------------------------- |  | ----- |  | ----------------------
|December 31, 2000 |                                            |                              |   |                                 |  |                           |  |       |  |                       
|                  | Allowance for doubtful receivables         |                              | $ | 1,143                           |  |                          |  | 309   |  |                      
|                  | Allowance for obsolescence & damaged goods |                              | $ | 2,060                           |  | 1,165                     |  |      |  |                      
|December 31, 1999 |                                            |                              |   |                                 |  |                           |  |       |  |                       
|                  | Allowance for doubtful receivables         |                              | $ | 3,455                           |  |                          |  | 2,312 |  |                      
|                  | Allowance for obsolescence & damaged goods |                              | $ | 2,094                           |  |                          |  | 34    |  |                      

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