**United States**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-K**

**x**                               ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**For the fiscal year ended December 31, 2005**

**OR**

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

**For the transition period from                           to                           **

**Commission file number 000-22207**

**GUITARCENTER, INC.**

(Exactname of registrant as specified in charter)

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

 

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

Securities registeredpursuant to 12(b) of the Act:

**None**

Securities registeredpursuant to 12(g) of the Act:

**CommonStock, $.01 par value**

(Titleof Class)

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

Yes x                    No o

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

Yes o                     No x

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

Yes x                    No o

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

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

Yes o                     No x

Asof June 30, 2005, the aggregate market value of the registrant’s commonstock held by non-affiliates of the registrant was approximately $1,485,000,000based on the average bid and asked price as reported on the NASDAQ NationalMarket. Shares of Common Stock held by each executive officer, director andeach person or entity known to the Registrant to be affiliates of the foregoinghave been excluded in that such persons may be deemed to be affiliates. Thisassumption regarding affiliate status is not necessarily a conclusivedetermination for other purposes.

Asof March 7, 2006, there were 26,234,774 shares of Common Stock, par value$0.01 per share, outstanding.

**DOCUMENTS INCORPORATED BY REFERENCE**

Portionsof the Definitive Proxy Statement for the annual stockholders’ meetingscheduled to be held on April 28, 2006 are incorporated by reference into Part III.

 

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**PART I**

**Item1. BUSINESS**

**Introduction**

Guitar Center, Inc. is the leading United Statesretailer of guitars, amplifiers, percussion instruments, keyboards andpro-audio and recording equipment. As of December 31, 2005, our retailstore subsidiary operated 161 Guitar Center stores across the United States,with 126 stores in 50 primary markets, 34 stores in secondary markets andone tertiary market store. In addition, as of December 31, 2005, our Music &Arts Center division operated 81 stores specializing in band instruments forsale and rental, serving teachers, band directors, college professors andstudents. We are also the largest direct response retailer of musicalinstruments in the United States through our wholly owned subsidiary, Musician’sFriend, Inc., and its catalog and website, www.musiciansfriend.com.

We are a Delawarecorporation with principal executive offices located at 5795 Lindero CanyonRoad, Westlake Village, California 91362, and our telephone number is (818) 735-8800.We maintain several corporate websites, including www.guitarcenter.com. However,none of the information contained on our websites is incorporated into thisannual report. Whenever we refer to the “Company” or “us,” or use the terms “we”or “our” in this annual report, we are referring to Guitar Center, Inc.and its subsidiaries.

**History**

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

In May 1999, we acquired Musician’s Friend, Inc.,an Oregon-based direct response retailer of musical instruments. Musician’sFriend is the largest direct response retailer of musical instruments in theUnited States, through its catalog and e-commerce website.

In April 2001, weacquired American Music Group, Ltd. and its related companies, a musicalinstrument retailer specializing in the sale and rental of band instruments andaccessories and serving the student and family market. In April 2005, weacquired Music & Arts Center, Inc., a Maryland-based musicalinstruments retailer which primarily serves the beginning musician andemphasizes rentals, music lessons and band and orchestra instrument sales. Subsequentto the Music & Arts Center acquisition, our American Music and Music &Arts Center businesses were combined into a new division of our retail storesubsidiary that operates under the Music & Arts Center name. Our Music &Arts Center stores are primarily located in the Northeast, Mid-Atlantic andSouthern regions of the United States.

**Industry Overview**

The United States retail market for music products in2004 was estimated in a study by the National Association of Music Merchants,or NAMM, to be approximately $7.4 billion in net sales. The broadlydefined music products market, according to NAMM, includes retail sales ofstring and fretted instruments, sound reinforcement and recording equipment,drums, keyboards, print music, pianos, organs, and school band and orchestralinstruments. Products currently offered by us include categories of productswhich account for approximately $6.7 billion of the retail market formusic products. According to The Music Trades magazine, the industry is highlyfragmented with the nation’s five leading music products retailers accountingfor approximately 32.8% of the industry’s estimated total sales in 2004.

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

**Business Overview**

During 2005, we operatedthree reportable segments under the classifications of Guitar Center stores, directresponse and Music & Arts Center.

***Guitar Center Stores***

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

Our primary market format Guitar Center stores aredesigned to serve major metropolitan population centers. Our standard primarymarket format Guitar Center store generally ranges in size from 12,000 to30,000 square feet. In late 2000, we opened our first secondary market formatstore to serve metropolitan areas that previously were not served by our primarymarket format stores. Our standard secondary market format Guitar Center storegenerally ranges in size from 8,000 to 10,000 square feet. In late 2005, weopened our first tertiary market format store to serve smaller populationcenters. Our tertiary market format stores generally are expected to beapproximately 5,000 square feet.

In 2005, we opened a total of 25 Guitar Center stores,including 12 primary market stores, 12 secondary market stores and onetertiary market store. We presently expect to open approximately 35 to 40additional Guitar Center stores in 2006, including eight to 10 primary marketstores, 25 to 28 secondary market stores and two tertiary market stores.

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

| ** **                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------------------------------------|------------|----------|------------|----------|------------|
| Number of stores  operated for the full year |       | 136      |       | 122      |       |
| Average net sales  per square foot           |       | $        | 599        |     | $          | 585 |   |
| Average net sales  per store                 |       | $        | 9,214,000  |     | $          | 9,184,000 |   |
| Average store-level  operating income        |       | $        | 1,502,000  |     | $          | 1,347,000 |   |
| Average store-level  operating income margin |       | 16.3     | %          | 14.7     | %          |

 

These key operatingstatistics are based upon results of Guitar Center stores in operation for atleast 12 months as of December 31, 2005 and 2004, respectively. Averagenet sales per square foot is a measure of sales efficiency based on squarefootage. Average net sales per store represents the average result of 

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storesopen at least 12 months, and is typically affected by the opening of secondarymarket format stores which generate lower levels of sales. Although thesesmaller format stores generate lower levels of sales, these stores cost less tobuild, stock and operate than our large format stores. Store-level operating incomeand margin includes individual store revenue and expenses plus allocatedrebates, cash discounts and purchasing department salaries (based uponindividual store sales).

***Direct Response***

Our Musician’s Friend subsidiary, which we operate asa separate business unit, is a direct response e-commerce and catalogbusiness. Musician’s Friend offers musicians a shopping experience thatincludes technical product information, confirmations by a live person, quickand efficient sales and service and a musician-based staff for after-salesupport. Musician’s Friend’s catalog and website offer an assortment ofproducts and promotions throughout the year, mixing brand name products withunique and practical offerings.

Our direct responsebusiness is based in Medford, Oregon and is supported by a customer contactcenter located in Salt Lake City, Utah and a distribution facility located inKansas City, Missouri. The Kansas City distribution center also houses anoutlet store for selling returns and blemished product.

***Music & Arts Center***

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

As of December 31,2005, Music & Arts Center operated 81 retail stores. Existing Music &Arts Center stores range from 1,400 to 12,000 square feet, with a target storesize of approximately 4,000 square feet. Our Music & Arts Centerbusiness is based in Frederick, Maryland and is supported there by adistribution facility and call center, along with additional call centers inLiverpool, New York and Horsham, Pennsylvania.

**Strategy**

***Guitar Center Stores***

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

***Direct Response***

Our direct response growthstrategy is to increase our market share in the direct response segment of theindustry, particularly relating to the Internet portion of the direct responsebusiness. While our catalogs remain an important marketing tool, we are focusedmore on Internet marketing, technology and 

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infrastructurethan we have been in the past. Our core strategies include personalization andone-to-one marketing that delivers products and services customized to thespecific needs of musicians. Additionally, we are focused on technology andinfrastructure that enhances our website user experience, improves our businessagility, increases our ‘speed to market’ and further differentiates us from thecompetition. In our back office, we are making investments to improve ouranalytic tools and enhance our data warehouse.

***Music &Arts Center***

Our Music & ArtsCenter growth strategy is to increase market share by acquiring complementarybusinesses and expanding our existing business. We believe there are a varietyof acquisition opportunities in the fragmented band instruments market thatcould be a good fit into our Music & Arts Center business, and wecontinue to aggressively pursue these acquisition opportunities. In addition,we expect to continue expanding the existing Music & Arts Centerbusiness by selectively opening new stores in existing and new markets.

**Merchandising**

***Guitar CenterStores***

Our primary market GuitarCenter stores carry an average of 7,500 core stock keeping units, or SKUs, oursecondary market Guitar Center stores carry an average of 5,000 core SKUs andour tertiary market Guitar Center stores are expected to carry an average of4,000 core SKUs. Our core SKUs represent our consistent and established productlines which are considered staple products for our customers.

Ourstores are organized into five departments (guitars and amplifiers, drums,keyboards, pro audio and recording and accessories), with each departmentfocused on one product category. These departments address our customer’sspecific product needs and are staffed by specialized salespeople, many of whomthemselves are practicing musicians. Our trade-in policy provides musicianswith an alternative form of payment and the convenience of selling a usedinstrument and purchasing a new one at a single location. Used products arebought and priced to sell by store managers who are trained and knowledgeablein the used musical instrument market.

·       *Guitars andAmplifiers*. Our guitar and amplifiers department carries awide variety of new, used and vintage electric, acoustic, classical and bassguitars. Major manufacturers including Fender, Gibson, Taylor, Martin, PRS,Yamaha, Ovation and Ibanez are well represented in popular models and colors. Anumber of our stores also carry other stringed instruments such as banjos andmandolins. We also offer an extensive selection of guitar sound processingunits and products that allow guitars to interface with a personal computer. Theseproducts serve crossover demand from the traditional guitarist into newcomputer-related sound products.

We offer an extensiveselection of electric, acoustic and bass guitar amplifiers, including a varietyof boutique and vintage amplifiers with prices ranging from $50 to $5,000. Wecarry amplifiers from most major manufacturers, including Marshall, Fender,Crate, Ampeg, Vox, S.W.R. and Mesa Boogie.

·       *Drums*. Our drum department carries a range ofpercussion instruments, from drum kits to congas, bongos and other rhythmic andelectronic percussion products. We also carry a selection of vintage and usedpercussion instruments. We carry name brands such as Drum Workshop, Sabian,Pearl, Yamaha, Tama and Zildjian.

·       *Keyboards*. We carry a wide selection of keyboardproducts and computer peripheral and software packages. Our keyboard productline covers a wide range of manufacturers, including Roland, Casio, Korg andYamaha.

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·       *Pro Audio*. Our pro audio department carrieslive-sound, DJ and recording equipment for musicians at every level, from thecasual hobbyist to the professional recording engineer. We maintain a broadselection of computer-related recording products, including sound cards, soundlibraries and composition and recording software. Our products range fromrecording accessories to state-of-the-art digital recordingsystems. We also carry a large assortment of professional stage audio, DJ andlighting equipment for small traveling bands, mobile DJs, private clubs andlarge touring professional bands. Our pro audio brand name manufacturersinclude Digidesign, JBL, Sony, Mackie, Shure, Tascam, Yamaha, Roland and Apple.

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

***Direct Response***

Our direct responsebusiness offers primarily new merchandise through its catalogs and on-linethrough its websites. In addition, our direct response business offers returnedand blemished merchandise through its outlet store in Kansas City, Missouri,and on-line through its Musician’s Friend website.

Our direct responsebusiness offers a product mix that includes the same categories as thoseoffered by our Guitar Center stores, including guitars and amplifiers, drums,keyboard, pro audio and accessories. In addition, our direct response businessoffers a range of private label products and band and orchestra instruments andaccessories that primarily are targeted at intermediate and professionalmusicians. Our direct response catalogs generally offer an average ofapproximately 5,000 SKUs and approximately 38,000 SKUs are offered on ourwebsites. We believe that the breadth of SKUs offered by our direct responsebusiness differentiates it from many of its competitors.

***Music &Arts Center***

Our Music & ArtsCenter business focuses on the student and family music market, particularlyband and orchestra instruments. These stores offer band and orchestralinstruments and related accessories for sale and rental, musical instrumentlessons and a limited assortment of guitars, amplifiers, percussioninstruments, keyboards, live-sound/DJ and recording equipment. Our Music &Arts Center stores offer a full range of brass and woodwind band instrumentsincluding trumpets, flutes, clarinets, trombones, saxophones, piccolos, Frenchhorns, flugelhorns, cornets, baritones and related music accessories. Thesestores also offer a full range of stringed instruments, such as violins,violas, cellos, string basses and related accessories. These stores carry awide range of sheet music. Name brand manufacturers carried at Music &Arts Center stores include Leblanc, Jupiter, Gemeinhardt, Selmer, Buffet,Ludwig, Conn, Yamaha and Rico.

**Operations**

***Guitar CenterStores***

To facilitate our growthstrategy, we have centralized many key aspects of our Guitar Center storeoperations, including the development of policies and procedures, accountingsystems, training programs, store site selection, store layouts, purchasing andreplenishment, advertising and pricing. This centralization utilizes theexperience and resources of our headquarters staff to establish consistencythroughout our stores.

Our Executive VicePresident of Stores, Senior Vice President of Operations, four regional salesmanagers, four regional operations managers, 17 district sales managers and 17district operation managers manage the Guitar Center stores. Store managementfor our primary and secondary market 

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storesgenerally is comprised of a store manager, a sales manager, an operationsmanager, two assistant store managers and five department managers. Each storealso has a warehouse manager and a commissioned sales staff that ranges from 20to 40 employees. We expect that our tertiary market stores generally will bemanaged by a store manager, two assistant managers and a sales staff thatranges from seven to 15 employees.

We provide ongoingtraining to our store managers and instill in the managers the values ofoperating as a business owner. We seek to encourage responsiveness andentrepreneurship at each store by providing store managers with a high degreeof autonomy relating to operations, personnel and merchandising. Managers alsoplay an integral role in the presentation of merchandise and the promotion andprotection of our reputation.

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

***Direct Response***

Musician’s Friendoperations are managed by an Executive Vice President of Operations, a VicePresident of Supply Management and a Vice President of Contact Center.

***Music &Arts Center***

Music & ArtsCenters’ operations are managed by a Senior Vice President of Operations, aSenior Vice President of Sales and regional, district and store level managers.Store management generally is comprised of a store manager, assistant storemanager, one or more educational representatives and related sales and supportstaff.

**Marketing andPromotion**

Our proprietary databasesare a central element of our marketing and promotion programs. We maintainthree unique and proprietary databases that we have developed for GuitarCenter, Musician’s Friend and Music & Arts Centers. Included in thesedatabases is information on approximately 12 million of our Guitar Centerstores customers, approximately seven million of our direct response customersand approximately 336 thousand of our Music & Arts Center customers. Webelieve that these databases assist us in identifying customer prospects, ingenerating repeat business by targeting customers based on their purchasinghistory and by permitting us to establish and maintain personal relationshipswith our customers.

***Guitar CenterRetail***

Our advertising andpromotion strategy for our Guitar Center stores is designed to enhance theGuitar Center name and increase customer awareness and loyalty. Our advertisingand promotional campaigns generally are developed around “events” designed toattract significant store traffic and exposure. We regularly plan largepromotional events including the Green Tag Sale in March, the Anniversary Salein August and the Guitar-a-thon in November/December. Theseevents often are coordinated with product demonstrations, interactive displays,clinics and in-store artist appearances. We also conduct specialevents that focus on practicing musicians, such as our annual Guitarmageddon,Drumoff and DJ Spinoff.

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As we enter new markets weinitiate an advertising program, including mail and radio promotions,television and Internet campaigns and other special grand opening activities. Eachelement of this advertising program is designed to accelerate sales volume foreach new store. Radio advertising plays a significant part in our store openingcampaign to generate interest and create customer awareness.

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

***Direct Response***

Our direct responsebusiness maintains regular communication in electronic and print media. Weperform an extensive analysis of customer behavior and transactions, and theindustry expertise of our merchandising staff provides our marketing staff withoffers that are targeted for optimal customer response.

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

Our direct responsestrategy includes the development of catalogs targeted towards particularsegments of the musician market. For example, Musician’s Friend produces twosmall catalogs, the LMI Catalog, which is oriented toward young, school-agedchildren, and the Giardinelli catalog which is targeted to band and orchestracustomers. Our direct response business also targets specific customers withkeyboard, percussion and DJ specialty catalogs.

We believe that there maybe Internet-based opportunities to expand the reach of our brands. We haveexpanded our Internet presence to include the www.harmony-central.com andwww.musician.com web sites. These opportunities are being created in part bythe rapid development of auction, content and community sites oriented towardsmusic and musicians. As part of these opportunities, we are expanding ourcustomer-focused marketing strategy to include personalization and one-to-onemarketing designed to deliver products and services customized to specificneeds of our musician and aspiring musician customers. We also are completingthe installation of a sophisticated internal search and comparison shoppingengine that we believe will improve user functionality and enhance searchcapabilities. We believe that these engines, along with several other plannedadvancements and improvements to our website, will continue to enhance the userexperience, improve our business agility, increase our ‘speed to market’ and differentiateus from the competition.

***Music &Arts Center***

Our advertising effortsfor the Music & Arts Center stores are focused primarily on the schoolband and orchestra market and community. For instrument rentals, advertisingand promotional campaigns are developed around “rental nights” designed todisplay our orchestral and band instruments at elementary and middle schools. Theseevents attract band directors, music educators, parents and students. Our keypromotional events are held primarily from August through October. Inaddition to rental nights, we have education representatives that travel aroundthe country to promote and educate band directors on our 

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instrumentsand our sales and rental programs. We maintain long-term relationships witheducators in order to provide visibility to our products and obtain access tostudent musicians.

**Customer Service**

***Guitar CenterStores***

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

***Direct Response***

Our Musician’s Friendcustomer contact staff receives product and customer service training in ourSalt Lake City, Utah contact center facility. Extensive product information,including technical information, product features and benefits and real-timestocking information is available to the staff on their desktop systems viaintranet and back-end information systems. Most of the staff is comprised ofmusicians who are given extensive and ongoing product training, and thefacility houses an extensive product demonstration area and training facility.As of December 31, 2005, we had 170 full-time and 72 part-timecustomer service employees, staffing the contact center 24 hours a day, sevendays a week. Our customer service telephone staff for returns is located in theKansas City, Missouri distribution center where they are closer to the returnsprocess while assisting customers.

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

***Music &Arts Center***

Sales at ourMusic & Arts Center stores are conducted primarily through salesmade by our educational sales representatives and sales made over thecounter at our retail stores. The majority of our educational representativesales force is comprised of music teachers who are experienced band andorchestra instructors. The customer service functions relating to sales madeby our educational representatives generally are conducted by ourcentralized call center. The customer service functions relating to sales madeover the counter at our retail stores generally are conducted by our retailstaff, who provide a full service retail experience for our customers.

**Purchasing**

We believe that we haveexcellent relationships with our vendors and, in many instances, we are ourvendors’ largest customer. Given our high volume, we are generally able toreceive prompt order fulfillment and access to our vendors’ premium products.Guitar Center, Musician’s Friend and Music & Arts Center maintaincentralized buying groups. Our centralized buyers include merchandise managers,buyers, planners, forecasters, replenishers and allocators. Merchandisemanagers and buyers are responsible for the selection and development ofproduct assortments and the negotiation of prices and terms. The planners,forecasters, replenishers and allocators are responsible for maintaininginventory levels and allocating the merchandise to the retail distributioncenter, stores and direct response fulfillment center. Guitar Center andMusician’s Friend use merchandise replenishment systems which automatically 

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analyzeand forecast sales trends for each SKU using various statistical models,supporting the buyers by predicting merchandise requirements.

Our business and expansionplans are dependent to a significant degree upon our vendors. As we believe iscustomary in the industry, we do not have any long-term supply contractswith our vendors. Please see “Risk Factor”—*We depend on a relativelysmall number of manufacturers, suppliers and common carriers, and theirinability to supply our requirements could adversely impact our business.”*

**Distributionand Inventory Control**

***Guitar CenterStores***

Our distribution center inthe Indianapolis, Indiana area supports our Guitar Center retail storeoperations. Nearly all product flows through the distribution facility, withthe exception of special orders, which generally are drop shipped to our stores.A portion of the costs of operating this facility are absorbed into our GuitarCenter merchandise inventories and recognized as an element of cost of goodssold when the related inventory is sold. We have numerous commitments necessaryto support the operations of the facility, including a lease on the facility.We are in the process of expanding this facility from approximately 505,000square feet to approximately 713,000 square feet, planned to be completed in2006.

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

***Direct Response***

Musician’s Friend ordersare fulfilled out of our Kansas City, Missouri distribution center. Thisfacility is near capacity and we are in the advanced planning stage ofexploring opportunities to replace and significantly expand our direct responsedistribution capabilities.

Orders, whether takenelectronically or by an associate in our customer contact center, are processedby our automated transaction system. In 2003, initiatives were completed toimprove inventory management and reduce outbound shipping costs. We haveimplemented sophisticated inventory planning systems to increase the level ofin-stock products with the goal of maintaining a high initial line item fillrate. The initial line item fill rate reflects the percentage of items orderedby our customers that we are able to supply in the initial shipment to thatconsumer. Split shipments of a single order impose additional shipping,handling and materials costs on us when compared to being able to fulfill anentire order in a single shipment. The technology on our website also permitsour customers to monitor their orders online by accessing the UPS and FedExtracking services.

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

***Music &Arts Centers***

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

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**Retail Store SiteSelection**

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

**Information Technology**

***Guitar Center Stores***

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

We are in the process ofdeveloping and implementing a data warehouse, a new point-of-sale system andenhanced data center infrastructure solutions for our Guitar Center stores. Thenew data warehouse will consolidate key operational information into onecentral location for more efficient analysis. The data warehouse is presentlyscheduled to begin operation in late 2006 and will enable us to improve ourmarketing techniques and inventory planning. The new point-of-sales system willreplace the current sales processing solution which is built on an aginginfrastructure and is difficult to enhance for future business requirements. Thepoint-of-sale system is presently scheduled to begin operation in 2007 and willprovide us with enhanced sales and inventory tracking capabilities. The newdata center infrastructure will augment the current operations center byproviding increased capacity, improved service levels and improved recovery flexibility.The data center infrastructure is presently scheduled to begin operation inlate 2006 and will improve the ability to support anticipated business growthand new technology initiatives.

***Direct Response***

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

We are in the process of developing and implementing anew multi-channel retail transaction processing solution that when implementedwill function as the core retail platform, supporting merchandising, inventorymanagement, order management, order entry, distribution center operations andvarious other major multi-channel direct response business functions. Thissystem is presently scheduled to begin operation in 2007 and will provide amore flexible and efficient retail platform supporting continued growthobjectives, possible international expansion and various other direct responseenhancements.

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

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***Music & Arts Center Stores***

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

**Competition**

The retail musical instrument industry is highlycompetitive and fragmented. Our stores compete against other large and smallmusical instrument retailers, online music retailers, on-line auctions,direct-to-consumer alternatives and a growing number of large mass merchants. Anumber of large mass merchants, including Wal-Mart, Best Buy, Target and Costcohave begun to sell musical instruments in categories that we compete in,including entry-level guitars, electronic keyboards and band instruments. BestBuy also recently opened a store-within-a-store concept for musical instrumentswhich includes a significantly expanded selection of products. These retailerscould represent a significant source of future competition for our retail and directresponse businesses, particularly if these retailers expand their product linesbeyond entry-level merchandise.

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

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

**Employees**

As of December 31,2005, we employed 8,154 people, of whom 6,852 were hourly employees and 1,302were salaried. None of our employees are covered by a collective bargainingagreement. We believe that we enjoy good employee relations.

**Brand Names and Service Marks**

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

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**Available Information**

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

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

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

We make available free of charge on our website ourAnnual Report on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K and amendments to these reports filed orfurnished pursuant to Section 13(a) or 15(d) of the ExchangeAct, as soon as reasonably practicable after we electronically file thesedocuments with or furnish them to the Securities and Exchange Commission. Wealso make available free of charge on our website the charters of the AuditCommittee, Compensation Committee and Nominating and Corporate GovernanceCommittee, as well as the Corporate Governance Guidelines and Code of BusinessConduct and Ethics (including any amendment to or waiver from a provision ofthe Code of Business Conduct and Ethics) adopted by our Board of Directors.

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

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

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

**Item 1A. RISK FACTORS**

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

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

Our retail store growth strategy includes opening and/oracquiring new stores in new and existing markets and increasing sales atexisting locations. As of December 31, 2005 we operated 161 Guitar Centerstores. We opened a total of 25 Guitar Center stores in 2005, including 12primary market stores, 12 secondary market stores and one tertiary market store.We presently expect to open approximately 35 to 40 additional Guitar Centerstores in 2006, including eight to 10 primary market stores, 25 to 28 secondarymarket stores and two tertiary market stores. As of December 31, 2005, wealso operated 81 Music & Arts Center stores. Our retail growthstrategy also involves increasing the number of Music & Arts Centerstores through acquisitions and opening approximately three to five new stores.

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

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

·       identificationof suitable retail sites and appropriate acquisition candidates;

·       negotiationof acceptable lease terms;

·       hiring,training and retention of skilled personnel;

·       availabilityof adequate capital;

·       sufficientmanagement and financial resources to support the new locations;

·       vendorsupport; and

·       successfulintegration of newly-acquired businesses, including the continued integrationof the Music & Arts Center business.

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

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

If we face material delaysin introducing new services, products and enhancements, our e-commercecustomers may forego the use of our services and use those of our competitors. Toremain competitive, we must continue to enhance and improve the functionalityand features of our online store and the efficiency and effectiveness of ouradvertising strategies, including evaluating and implementing effective searchengine technologies, on-line advertising and affiliate programs. The Internetand the online commerce industry are rapidly changing. If competitors introducenew products and services embodying new technologies, or if new industrystandards and practices emerge, our existing website and proprietary technologyand systems may become obsolete. To develop our website and other proprietarytechnology entails significant technical and business risks. We may use newtechnologies ineffectively or we may fail to adapt our website, our transactionprocessing systems and our computer network to meet customer requirements oremerging industry standards. In addition, our e-commerce operations may requiregreater efficiency, lower prices, expanded advertising requirements throughsearch engines and other parties, and other competitive factors such as freeshipping or extended warranties or return periods in order to competesuccessfully. Each of these factors could have an adverse effect on sellingprices and margins in our business and generally constrain our profitability.

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

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

·       significantstart-up costs, including promotion and advertising;

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

·       managementof stores in distant locations or foreign countries;

·       availabilityof desirable product lines; and

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

Any of these factors maylead to a shortfall in revenues or an increase in costs with respect to theoperation of these stores. If we are not able to operate these storesprofitably, or to our expected level of performance, our results of operationscould be adversely affected.

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

Historically,we have achieved significant sales growth in existing Guitar Center stores. Ourquarterly comparable stores sales results have fluctuated significantly in thepast. Sales growth for comparable periods, excluding net sales attributable tostores not open for 14 months, was as follows for our Guitar Center retailstores:

| ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------|------------|----------|------------|----------|------------|----------|------------|
| Quarter 1  |       |     | 5.3        | %        |       | 11.0     | %          | 4.0 | % |
| Quarter 2  |       |     | 7.0        |     |       | 8.3      |       | 5.2 |   |
| Quarter 3  |       |     | 6.9        |     |       | 9.0      |       | 7.0 |   |
| Quarter 4  |       |     | 4.6        |     |       | 10.3     |       | 10.2 |   |
| Full Year  |       |     | 5.8        | %        |       | 9.7      | %          | 6.9 | % |

 

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

·       competition;

·       economicconditions, including in particular discretionary consumer spending;

·       consumerand music trends;

·       changesin our merchandise mix;

·       productdistribution; and

·       timingand effectiveness of our promotional events.

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

*Our failure tomaintain and expand our distribution centers could adversely impact ourbusiness.*

We are in the process ofsignificantly expanding our Guitar Center distribution center to increase ourcapacity to support continued expansion. We anticipate making additionalcapital investments of $8 to $10 million and we expect to incur increasedrent starting during the third quarter of 2006. In addition, the lease for ourdirect response distribution center expires in June 2007. We are exploringopportunities to replace and expand our direct response distributioncapabilities to coincide with the expiration of the lease 

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on ourcurrent facility. This expansion also is expected to require a significantcapital commitment. Our failure to complete our expansions and replacements ontime and on budget may result in the need for us to expend additional capitaland may impair the efficient operation of our distribution system, which couldmaterially adversely impact our business, results of operations, financialcondition and prospects.

*Our growth plans depend on our completion ofacquisitions, and our inability to address the special risks associated withthese transactions could adversely impact our business.*

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

·       diversionof our management’s attention;

·       integrationof acquired businesses with our business; and

·       unanticipatedlegal liabilities and other circumstances or events.

The failure to identifycomplementary acquisitions, the failure to obtain favorable pricing on thoseacquisitions or the occurrence of any special risks involved in acquisitionscould have a material adverse effect on our ability to achieve our growthstrategy, and our results of operations could be materially affected as aresult.

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

We are in the process ofdeveloping and implementing a data warehouse, new point-of-sale system and datacenter infrastructure for our Guitar Center stores as well as a newmulti-channel retail system for our direct response business. The developmentand implementation of these two initiatives requires significant managementattention and capital resources. Our failure to effectively develop andimplement these initiatives on a timely basis could lead to the distraction ofour management and the need to expend additional capital resources. Such afailure could reduce the quantity or quality of operating data available to ourmanagement necessary to run our business efficiently and as a result couldadversely impact our business, results of operations, financial condition andprospects.

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

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

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

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

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

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

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

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

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

A number of large massmerchants, including Wal-Mart, Best Buy, Target and Costco, have begun to sellmusical instruments in categories that we compete in, including entry-levelguitars, electronic keyboards and band instruments. Best Buy also recentlyopened a store-within-a-store concept for musical instruments which includes asignificantly expanded selection of products.These retailers could represent a 

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significantsource of future competition for our retail and direct response businesses,particularly if these retailers expand their product lines beyond entry-levelmerchandise.

*We must grow our Music & Arts Center businessin order to reach profitability and earn an acceptable return on thatinvestment.*

We intend to use our Music &Arts Center business as a platform to develop and grow a family music storeconcept that emphasizes band instruments and select “combo” products sold byour Guitar Center stores such as guitars, keyboards, pro audio, drums andaccessories. This business has been developed over the past five years throughthe acquisitions of American Music Group, Music & Arts Center and anumber of smaller acquisitions. We face the normal challenges of anyacquisition, such as integration of personnel and systems as well as the needto learn, understand and further develop this business. As this segment of ourbusiness grows, our need to understand this business and operate it profitablybecomes increasingly important to our consolidated results of operations. A keycomponent of the growth strategy of our Music & Arts Center businessis the acquisition of complementary businesses. We believe that a critical elementin allowing us to effectively pursue this strategy is the development andimplementation of information systems that will enable the efficient andeffective integration of existing and newly-acquired businesses. These systemsare critical in operating and controlling significant business processes,including sales, rentals, store operations, inventory levels, purchase ordermanagement, special orders and other transactions. Our current systems are inan early stage of development and will require significant additional resourcesto develop and implement. Failure to execute on the requirements andinitiatives described above could have a material adverse effect or our resultsof operations and prospects, could result in a poor or no return on ourinvestments in this business and potentially require us to recognize animpairment in the significant amount of goodwill recorded in our acquisitions.

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

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

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

Section 404 of the Sarbanes-Oxley Act of 2002, orSection 404, requires our management to report on, and our independentregistered public accounting firm to attest to, the effectiveness of ourinternal control over financial reporting. We have implemented an ongoingprogram to perform the system and process evaluation and testing necessary tocontinue to comply with these requirements. Accordingly, we must continue toincur significant expenses and devote management resources to Section 404compliance as necessary. Further, effective internal controls and proceduresare necessary for us to provide reliable financial reports. If our internalcontrols and procedures become ineffective, we may not be able to providereliable financial reports, and our business and operating results could beharmed.

We completed theacquisition of Music & Arts Center, Inc. in April 2005. OurMusic & Arts Center business is not required to comply with theprovisions of Section 404 until December 31, 2006. We are in theprocess of implementing an ongoing program to perform the system and processevaluation and testing necessary to comply with these requirements. We expectto incur significant expenses and to devote significant management resources toSection 404 compliance for our Music & Arts Center businessduring 2006. Even after incurring these expenses, we cannot be assured that ourMusic & Arts Center business 

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will beable to attain Section 404 compliance. If we are unable to develop,implement and test internal controls and systems that will enable our Music &Arts Center business to attain Section 404 compliance on a timely basis,our business and operating results could be harmed and stockholders could loseconfidence in our financial reporting which could have a negative marketreaction.

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

As of December 31,2005, our corporate headquarters as well as 24 of our 161 Guitar Center storeswere located in California. Although we have opened and acquired stores inother areas of the United States, a significant percentage of our net sales andresults of operations will likely remain concentrated in California for theforeseeable future. As a result, our results of operations and financialcondition are heavily dependent upon general consumer trends and other generaleconomic conditions in California and are subject to other regional risks,including earthquakes. We do maintain earthquake insurance, but such policiescarry significant deductibles and other restrictions.

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

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

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

Our success depends to a significant extent on theservices of members of our senior management. The loss of one or more of theseindividuals or other key personnel could have a material adverse effect on ourbusiness, results of operations, liquidity and financial position. Historically,we have promoted employees from within our organization to fill senioroperations, sales and store management positions. In order to achieve ourgrowth plans, we depend upon our ability to retain and promote existingpersonnel to senior management, and we must attract and retain new personnelwith the skills and expertise to manage our business. If we cannot hire, retainand promote qualified personnel, our business, results of operations, financialcondition and prospects could be adversely affected.

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

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

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

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

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

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

*We face riskscreated by litigation, governmental proceedings, labor disputes orenvironmental matters.*

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

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

We rely on our computer hardware and software systemsfor the efficient operation of our retail stores and direct response business. Ourinformation systems provide our management with real-time inventory, sales andcost information that is essential to the operation of our business. Due to ournumber of stores, geographic diversity and other factors, we would be unable togenerate this information in a timely and accurate manner in the event ourhardware or software systems were unavailable. These systems are vulnerable todamage or interruption from a number of factors, including earthquake, fire,flood and other natural disasters and power loss, computer systems failure, orsecurity breaches, Internet and telecommunications or data network failure.

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

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

A significant decrease inour operating results could adversely affect our ability to maintain compliancewith required covenants under our credit facility. If these covenants are notcomplied with, our lenders will have the option to require immediate repaymentof all amounts outstanding under the credit facility, if any, or may limitfuture borrowings under the credit facility. The most likely result wouldrequire us to renegotiate certain terms of the credit agreement, obtain awaiver from the lenders, or obtain a new credit agreement with another group oflenders, which may contain different terms or may not be available at all. A failureto maintain, renegotiate or replace our credit facility could materially impactour liquidity.

*The expensing ofstock options will reduce our future reported earnings.*

The FASB has recentlyissued new accounting standards requiring all publicly traded companies tobegin recording compensation expense related to all unvested and newly grantedstock options prospectively for interim periods beginning after June 15,2005. Currently, we include such expenses on a pro forma basis in the notes toour quarterly and annual financial statements in accordance with accountingprinciples generally accepted in the United States and do not includecompensation expense related to stock options in our reported earnings in thefinancial statements. We have adopted FAS 123R using the modified prospectivemethod beginning January 1, 2006. The new standards may have the effect ofreducing our reported earnings in our financial statements, which may lead to anegative market reaction.

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

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

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

From time to time, we release projections and similarguidance regarding our future performance that represent our management’sestimates as of the date of release. These projections, which are forward-lookingstatements, are prepared by our management and are qualified by, and subjectto, the assumptions and the other information contained or referred to in therelease. Our projections are not prepared with a view toward compliance withpublished guidelines of the American Institute of Certified Public Accountants,and neither our registered public accountants nor any other independent expertor outside party compiles or examines the projections and, accordingly, no suchperson expresses any opinion or any other form of assurance with respectthereto.

Projections are based upon a number of assumptions andestimates that, while presented with numerical specificity, are inherently subjectto significant business, economic and competitive uncertainties 

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and contingencies, many ofwhich are beyond our control and are based upon specific assumptions withrespect to future business decisions, some of which will change. We generallystate possible outcomes as high and low ranges which are intended to provide asensitivity analysis as variables are changed but are not intended to representthat actual results could not fall outside of the suggested ranges. Theprincipal reason that we release this data is to provide a basis for ourmanagement to discuss our business outlook with analysts and investors. We donot accept any responsibility for any projections or reports published by anysuch persons.

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

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

**Item 1B. UNRESOLVED STAFF COMMENTS**

None.

**Item 2. PROPERTIES**

We lease our corporate offices of approximately 69,600square feet, which are located at 5795 Lindero Canyon Road, Westlake Village,California. The lease for this property expires in April 2009. On September 28,2005 we purchased the property located adjacent to our current corporateoffices to provide growth space for our corporate staff. The property consistsof three buildings that have an aggregate of approximately 96,000 square feet. Thedistribution center for our Guitar Center stores is located in a leasedfacility in the Indianapolis, Indiana area. We are in the process of expandingthis facility from 505,000 square feet to approximately 713,000 square feet. Wepresently anticipate this expansion to be completed in 2006. On November 2,2005, we entered into an amendment to the lease for this facility that extendsthe term of the lease for a period of 12 years from the substantial completionof construction of the expansion to the facility.

Our direct response business is headquartered in afacility of 45,000 square feet that we own located at 931 Chevy Way, Medford,Oregon. We lease approximately 25,500 square feet of office space in Salt LakeCity, Utah, for our direct response customer contact center facility. Thislease expires in December 2008. We lease facilities of approximately241,000 square feet and 110,000 square feet for use as a central distributioncenter for our direct response division in Kansas City, Missouri. This leaseexpires in June 2007 and we are currently in the advanced planning stagesof exploring opportunities to replace these facilities and significantly expandour distribution capabilities.

Our Music & Arts Center business isheadquartered in a leased facility located at 4626 Wedgewood Blvd., Frederick,Maryland. The lease for this property expires in December 2012. We alsolease a distribution facility of approximately 60,000 square feet in Frederick,Maryland and call center facilities of approximately 5,000 aggregate squarefeet in Liverpool, New York and Horsham, Pennsylvania. The leases for thesefacilities expire in January 2009 and September 2010, respectively.

22

----

**Inconnection with our retail business, as of December 31, 2005, we leasedapproximately 2,404,000 square feet for our 161 Guitar Center stores andapproximately 332,000 square feet for our 81 Music & Arts Centerstores. The initial lease terms for our retail stores typically range from 10-15years and allow us to renew for two additional five-year terms. Most of theleases require us to pay property tax, utilities, normal repairs, common areamaintenance and insurance expenses.**

**Store Locations**

The table below sets forthinformation concerning our Guitar Center and Music & Arts Centerretail stores as of December 31, 2005:

| **Store**                | ** ** | ** ** | ** ** | **Year   Opened** | ** ** | **Gross   Square   Feet** | ** ** | **Status** | ** ** |
|--------------------------|------------|------------|------------|-------------------|------------|---------------------------|------------|------------|------------|
| **Guitar Center Stores** |       | ** ** |       |              |       |                      |       |
| *Alabama*                |       |       |       |              |       |                      |       |
| Mobile                   |       | 2004       |       | 11,200            |       | Lease                     |       |
| Birmingham               |       | 2005       |       | 15,900            |       | Lease                     |       |
| Montgomery (1)           |       | 2006       |       | 13,500            |       | Lease                     |       |
| *Arizona*                |       |       |       |              |       |                      |       |
| Phoenix                  |       | 1997       |       | 13,600            |       | Lease                     |       |
| Tempe                    |       | 1997       |       | 14,500            |       | Lease                     |       |
| Tucson                   |       | 2001       |       | 15,000            |       | Lease                     |       |
| Scottsdale               |       | 2003       |       | 17,500            |       | Lease                     |       |
| *Arkansas*               |       |       |       |              |       |                      |       |
| Little Rock              |       | 2002       |       | 8,700             |       | Lease                     |       |
| *Southern California*    |       |       |       |              |       |                      |       |
| Hollywood                |       | 1964       |       | 30,600            |       | Own                       |       |
| San Diego                |       | 1973       |       | 15,100            |       | Lease                     |       |
| Fountain  Valley         |       | 1980       |       | 16,800            |       | Lease                     |       |
| Sherman Oaks             |       | 1982       |       | 18,700            |       | Lease                     |       |
| Covina                   |       | 1985       |       | 15,400            |       | Lease                     |       |
| Southbay                 |       | 1985       |       | 14,500            |       | Lease                     |       |
| San Bernardino           |       | 1993       |       | 15,000            |       | Lease                     |       |
| Brea                     |       | 1995       |       | 14,900            |       | Lease                     |       |
| San Marcos               |       | 1996       |       | 14,700            |       | Lease                     |       |
| Rancho Cucamonga         |       | 1999       |       | 15,000            |       | Lease                     |       |
| El Toro                  |       | 1999       |       | 16,300            |       | Lease                     |       |
| Oxnard                   |       | 2000       |       | 14,000            |       | Lease                     |       |
| Bakersfield              |       | 2000       |       | 8,000             |       | Lease                     |       |
| Palmdale                 |       | 2001       |       | 12,000            |       | Lease                     |       |
| Pasadena                 |       | 2002       |       | 19,400            |       | Lease                     |       |
| Cerritos                 |       | 2003       |       | 15,400            |       | Lease                     |       |
| Northridge               |       | 2005       |       | 15,100            |       | Lease                     |       |
| Murrieta (1)             |       | 2006       |       | 15,000            |       | Lease                     |       |
| *Northern California*    |       |       |       |              |       |                      |       |
| San Francisco            |       | 1972       |       | 30,400            |       | Lease                     |       |
| San Jose (2)             |       | 1978       |       | 31,200            |       | Lease                     |       |
| El Cerrito (3)           |       | 1983       |       | 12,000            |       | Lease                     |       |
| Concord                  |       | 1996       |       | 15,800            |       | Lease                     |       |
| Fresno                   |       | 2000       |       | 15,500            |       | Lease                     |       |
| Sacramento               |       | 2000       |       | 15,800            |       | Lease                     |       |
| Modesto                  |       | 2001       |       | 9,000             |       | Lease                     |       |
| Gilroy (1)               |       | 2006       |       | 10,200            |       | Lease                     |       |
| *Colorado*               |       | ** ** |       |              |       |                      |       |
| Denver                   |       | 1998       |       | 16,800            |       | Lease                     |       |
| Englewood                |       | 1998       |       | 16,800            |       | Lease                     |       |
| Arvada                   |       | 1999       |       | 15,700            |       | Lease                     |       |
| Colorado Springs         |       | 2002       |       | 8,600             |       | Lease                     |       |
| Pueblo                   |       | 2005       |       | 5,400             |       | Lease                     |       |
| *Connecticut*            |       |       |       |              |       |                      |       |
| Manchester               |       | 1999       |       | 16,000            |       | Lease                     |       |
| Orange                   |       | 2002       |       | 15,400            |       | Lease                     |       |
| *Florida*                |       |       |       |              |       |                      |       |
| North Miami area         |       | 1996       |       | 20,900            |       | Lease                     |       |
| South Miami area         |       | 1996       |       | 17,200            |       | Lease                     |       |
| West Palm Beach          |       | 2001       |       | 15,200            |       | Lease                     |       |
| Orlando                  |       | 2002       |       | 15,300            |       | Lease                     |       |
| Lakeland                 |       | 2003       |       | 12,800            |       | Lease                     |       |
| Tampa                    |       | 2003       |       | 15,000            |       | Lease                     |       |
| Ft. Myers                |       | 2004       |       | 13,300            |       | Lease                     |       |
| Orlando                  |       | 2005       |       | 15,000            |       | Lease                     |       |
| Jacksonville             |       | 2005       |       | 15,000            |       | Lease                     |       |
| Tallahassee              |       | 2005       |       | 8,300             |       | Lease                     |       |
| Pensacola                |       | 2005       |       | 9,600             |       | Lease                     |       |
| Clearwater (1)           |       | 2006       |       | 15,000            |       | Lease                     |       |
| *Georgia*                |       |       |       |              |       |                      |       |
| Atlanta                  |       | 1997       |       | 23,600            |       | Own                       |       |
| Marietta                 |       | 1997       |       | 22,800            |       | Lease                     |       |
| Lawrenceville            |       | 2004       |       | 16,200            |       | Lease                     |       |
| *Idaho*                  |       |       |       |              |       |                      |       |
| Boise                    |       | 2001       |       | 10,800            |       | Lease                     |       |
| *Illinois*               |       |       |       |              |       |                      |       |
| South Chicago            |       | 1979       |       | 13,800            |       | Lease                     |       |
| North Chicago            |       | 1981       |       | 11,000            |       | Lease                     |       |
| Central Chicago          |       | 1988       |       | 20,500            |       | Lease                     |       |
| Villa Park               |       | 1996       |       | 15,000            |       | Lease                     |       |

23

----

 

| Highland Park                 |   | 2001       |   | 15,200 |   | Lease  |   |
|-------------------------------|--------|------------|--------|--------|--------|--------|--------|
| Peoria                        |   | 2004       |   | 10,200 |   | Lease  |   |
| Naperville                    |   | 2004       |   | 15,000 |   | Lease  |   |
| Rockford (1)                  |   | 2006       |   | 10,000 |   | Lease  |   |
| Country Club Hills  (1)  |   | 2006       |   | 15,000 |   | Lease  |   |
| Algonquin (1)                 |   | 2006       |   | 12,000 |   | Lease  |   |
| Joliet (1)                    |   | 2006       |   | 8,300  |   | Lease  |   |
| *Indiana*                     |   | ** ** |   |   |   |   |   |
| Indianapolis                  |   | 2001       |   | 15,600 |   | Lease  |   |
| Hobart                        |   | 2003       |   | 12,000 |   | Lease  |   |
| South Bend                    |   | 2004       |   | 8,000  |   | Lease  |   |
| Ft. Wayne                     |   | 2005       |   | 14,000 |   | Lease  |   |
| Terre Haute (1)               |   | 2006       |   | 5,500  |   | Lease  |   |
| Evansville (1)                |   | 2006       |   | 10,000 |   | Lease  |   |
| Greenwood (1)                 |   | 2006       |   | 15,000 |   | Lease  |   |
| *Iowa*                        |   |       |   |   |   |   |   |
| Des Moines                    |   | 2005       |   | 10,100 |   | Lease  |   |
| *Kansas*                      |   |       |   |   |   |   |   |
| Wichita                       |   | 2005       |   | 10,000 |   | Lease  |   |
| Overland Park                 |   | 2005       |   | 15,000 |   | Lease  |   |
| *Louisiana*                   |   |       |   |   |   |   |   |
| New Orleans                   |   | 1999       |   | 19,700 |   | Lease  |   |
| Baton Rouge                   |   | 2004       |   | 10,200 |   | Lease  |   |
| *Maine*                       |   |       |   |   |   |   |   |
| Portland (1)                  |   | 2006       |   | 12,200 |   | Lease  |   |
| *Maryland*                    |   |       |   |   |   |   |   |
| Towson                        |   | 1998       |   | 14,600 |   | Lease  |   |
| Rockville (4)                 |   | 2000       |   | 24,000 |   | Lease  |   |
| Glen Burnie                   |   | 2004       |   | 15,300 |   | Lease  |   |
| *Massachusetts*               |   |       |   |   |   |   |   |
| Boston                        |   | 1994       |   | 12,600 |   | Lease  |   |
| Danvers                       |   | 1996       |   | 14,600 |   | Lease  |   |
| Natick                        |   | 1997       |   | 15,100 |   | Lease  |   |
| N. Attleboro                  |   | 1998       |   | 16,800 |   | Lease  |   |
| Millbury (1)                  |   | 2006       |   | 11,500 |   | Lease  |   |
| *Michigan*                    |   |       |   |   |   |   |   |
| Detroit                       |   | 1994       |   | 16,500 |   | Lease  |   |
| Southfield                    |   | 1996       |   | 18,800 |   | Lease  |   |
| Canton                        |   | 1998       |   | 16,800 |   | Lease  |   |
| Grand Rapids                  |   | 2002       |   | 11,400 |   | Lease  |   |
| Saginaw                       |   | 2003       |   | 13,900 |   | Lease  |   |
| Kalamazoo                     |   | 2004       |   | 12,700 |   | Lease  |   |
| Flint                         |   | 2005       |   | 10,000 |   | Lease  |   |
| Allen Park (1)                |   | 2006       |   | 17,000 |   | Lease  |   |
| *Minnesota*                   |   |       |   |   |   |   |   |
| Twin Cities                   |   | 1988       |   | 15,000 |   | Lease  |   |
| Edina                         |   | 1997       |   | 15,700 |   | Lease  |   |
| *Mississippi*                 |   |       |   |   |   |   |   |
| Jackson                       |   | 2005       |   | 9,400  |   | Lease  |   |
| *Missouri*                    |   |       |   |   |   |   |   |
| N. St. Louis                  |   | 1999       |   | 15,700 |   | Lease  |   |
| Bridgeton                     |   | 1999       |   | 15,000 |   | Lease  |   |
| Independence                  |   | 2005       |   | 15,400 |   | Lease  |   |
| *Nebraska*                    |   |       |   |   |   |   |   |
| Lincoln (1)                   |   | 2006       |   | 8,600  |   | Lease  |   |
| *Nevada*                      |   |       |   |   |   |   |   |
| Las Vegas                     |   | 1998       |   | 20,000 |   | Lease  |   |
| Summerlin                     |   | 2005       |   | 14,900 |   | Lease  |   |
| *New Hampshire*               |   |       |   |   |   |   |   |
| Nashua                        |   | 2004       |   | 10,200 |   | Lease  |   |
| *New Jersey*                  |   | ** ** |   |   |   |   |   |
| Springfield                   |   | 1998       |   | 20,000 |   | Lease  |   |
| E. Brunswick                  |   | 1998       |   | 20,000 |   | Lease  |   |
| Totowa                        |   | 1999       |   | 15,600 |   | Lease  |   |
| Paramus                       |   | 1999       |   | 14,100 |   | Lease  |   |
| Cherry Hill                   |   | 2001       |   | 15,800 |   | Lease  |   |
| Atlantic City                 |   | 2002       |   | 10,300 |   | Lease  |   |
| *New Mexico*                  |   |       |   |   |   |   |   |
| Albuquerque                   |   | 2004       |   | 11,600 |   | Lease  |   |
| *New York*                    |   |       |   |   |   |   |   |
| Carle Place                   |   | 1998       |   | 22,800 |   | Lease  |   |
| Queens                        |   | 1999       |   | 19,000 |   | Lease  |   |
| Larchmont                     |   | 1999       |   | 15,300 |   | Lease  |   |
| Commack                       |   | 2000       |   | 16,000 |   | Lease  |   |
| Buffalo                       |   | 2000       |   | 15,000 |   | Lease  |   |
| Rochester                     |   | 2001       |   | 15,300 |   | Lease  |   |
| Albany                        |   | 2003       |   | 14,000 |   | Lease  |   |
| Manhattan                     |   | 2003       |   | 30,000 |   | Lease  |   |
| Syracuse                      |   | 2005       |   | 16,000 |   | Lease  |   |
| Brooklyn                      |   | 2005       |   | 22,800 |   | Lease  |   |
| *North Carolina*              |   |       |   |   |   |   |   |
| Charlotte                     |   | 2002       |   | 15,200 |   | Lease  |   |
| Raleigh                       |   | 2002       |   | 15,900 |   | Lease  |   |
| Durham (1)                    |   | 2006       |   | 15,000 |   | Lease  |   |
| *Ohio*                        |   |       |   |   |   |   |   |
| Cleveland                     |   | 1997       |   | 15,600 |   | Lease  |   |
| Mayfield Heights              |   | 1998       |   | 15,400 |   | Lease  |   |
| Cincinnati                    |   | 1998       |   | 18,500 |   | Lease  |   |
| Columbus                      |   | 2002       |   | 17,600 |   | Lease  |   |
| Toledo                        |   | 2004       |   | 11,900 |   | Lease  |   |
| Akron                         |   | 2005       |   | 10,500 |   | Lease  |   |
| Youngstown                    |   | 2005       |   | 10,000 |   | Lease  |   |
| *Oklahoma*                    |   |       |   |   |   |   |   |
| Oklahoma City                 |   | 2000       |   | 15,200 |   | Lease  |   |
| Tulsa                         |   | 2005       |   | 14,200 |   | Lease  |   |
| *Oregon*                      |   |       |   |   |   |   |   |

24

----

 

| Medford                          |   | 1987       |   | 11,900 |   | Lease  |   |
|----------------------------------|--------|------------|--------|--------|--------|--------|--------|
| Eugene                           |   | 1996       |   | 10,000 |   | Lease  |   |
| Clackamas                        |   | 2000       |   | 15,600 |   | Lease  |   |
| Beaverton                        |   | 2000       |   | 15,300 |   | Lease  |   |
| *Pennsylvania*                   |   |       |   |   |   |   |   |
| Philadelphia                     |   | 2000       |   | 15,200 |   | Lease  |   |
| Plymouth Meeting                 |   | 2001       |   | 14,900 |   | Lease  |   |
| Monroeville                      |   | 2001       |   | 14,000 |   | Lease  |   |
| Harrisburg                       |   | 2003       |   | 10,200 |   | Lease  |   |
| Pittsburgh                       |   | 2005       |   | 15,800 |   | Lease  |   |
| *Rhode Island*                   |   |       |   |   |   |   |   |
| Warwick                          |   | 2003       |   | 14,000 |   | Lease  |   |
| *South Carolina*                 |   |       |   |   |   |   |   |
| Greenville                       |   | 2005       |   | 9,500  |   | Lease  |   |
| Charleston                       |   | 2005       |   | 9,400  |   | Lease  |   |
| *Tennessee*                      |   | ** ** |   |   |   |   |   |
| Knoxville                        |   | 1998       |   | 15,000 |   | Lease  |   |
| Memphis                          |   | 2003       |   | 15,500 |   | Lease  |   |
| Nashville                        |   | 2003       |   | 20,000 |   | Lease  |   |
| Chattanooga                      |   | 2005       |   | 10,300 |   | Lease  |   |
| *Texas*                          |   |       |   |   |   |   |   |
| Dallas                           |   | 1989       |   | 18,400 |   | Lease  |   |
| Arlington                        |   | 1991       |   | 19,200 |   | Lease  |   |
| South Houston                    |   | 1993       |   | 14,700 |   | Lease  |   |
| North Houston                    |   | 1994       |   | 14,700 |   | Lease  |   |
| Central Dallas                   |   | 1998       |   | 17,800 |   | Lease  |   |
| Clearlake                        |   | 1998       |   | 15,000 |   | Lease  |   |
| Austin                           |   | 2000       |   | 15,200 |   | Lease  |   |
| Plano                            |   | 2000       |   | 15,500 |   | Lease  |   |
| Corpus Christi                   |   | 2002       |   | 10,500 |   | Lease  |   |
| Ft. Worth                        |   | 2004       |   | 12,500 |   | Lease  |   |
| South Austin                     |   | 2005       |   | 13,400 |   | Lease  |   |
| El Paso (1)                      |   | 2006       |   | 17,000 |   | Lease  |   |
| Lubbock (1)                      |   | 2006       |   | 9,600  |   | Lease  |   |
| *Utah*                           |   |       |   |   |   |   |   |
| Salt Lake City                   |   | 1998       |   | 15,000 |   | Lease  |   |
| Ogden                            |   | 2002       |   | 7,500  |   | Lease  |   |
| *Virginia*                       |   |       |   |   |   |   |   |
| Fairfax                          |   | 1999       |   | 15,600 |   | Lease  |   |
| Seven Corners                    |   | 1999       |   | 15,400 |   | Lease  |   |
| Virginia Beach                   |   | 2000       |   | 16,000 |   | Lease  |   |
| Fredericksburg                   |   | 2003       |   | 9,400  |   | Lease  |   |
| Richmond                         |   | 2003       |   | 13,700 |   | Lease  |   |
| *Washington*                     |   |       |   |   |   |   |   |
| Tukwila                          |   | 1997       |   | 18,000 |   | Lease  |   |
| Kirkland                         |   | 1997       |   | 20,200 |   | Lease  |   |
| Seattle                          |   | 1997       |   | 18,300 |   | Lease  |   |
| Lynnwood                         |   | 1998       |   | 14,000 |   | Lease  |   |
| Tacoma                           |   | 2001       |   | 15,600 |   | Lease  |   |
| Spokane                          |   | 2001       |   | 12,800 |   | Lease  |   |
| *Wisconsin*                      |   |       |   |   |   |   |   |
| Brookfield                       |   | 2004       |   | 15,000 |   | Lease  |   |
| Madison (1)                      |   | 2006       |   | 11,500 |   | Lease  |   |
| Appleton (1)                     |   | 2006       |   | 10,000 |   | Lease  |   |
| **Music & Arts Center** |   |       |   |   |   |   |   |
| *Arizona*                        |   |       |   |   |   |   |   |
| Phoenix                          |   | 1987       |   | 6,000  |   | Lease  |   |
| Mesa                             |   | 1995       |   | 4,100  |   | Lease  |   |
| Tucson                           |   | 2004       |   | 1,600  |   | Lease  |   |
| North Tucson                     |   | 2005       |   | 3,600  |   | Lease  |   |
| *Colorado*                       |   |       |   |   |   |   |   |
| Englewood                        |   | 2000       |   | 4,000  |   | Lease  |   |
| Loveland                         |   | 2001       |   | 1,300  |   | Lease  |   |
| Littleton                        |   | 2002       |   | 3,500  |   | Lease  |   |
| Westminster                      |   | 2002       |   | 3,800  |   | Lease  |   |
| *Connecticut*                    |   |       |   |   |   |   |   |
| East Hartford                    |   | 1993       |   | 6,100  |   | Lease  |   |
| Avon                             |   | 2002       |   | 2,100  |   | Lease  |   |
| Vernon                           |   | 2003       |   | 2,700  |   | Lease  |   |
| West Hartford                    |   | 2003       |   | 3,000  |   | Lease  |   |
| Waterford                        |   | 2005       |   | 2,600  |   | Lease  |   |
| *Delaware*                       |   |       |   |   |   |   |   |
| Wilmington                       |   | 2000       |   | 3,000  |   | Lease  |   |
| *Florida*                        |   |       |   |   |   |   |   |
| Longwood                         |   | 1986       |   | 4,600  |   | Lease  |   |
| Jupiter                          |   | 1995       |   | 2,500  |   | Lease  |   |
| Jacksonville                     |   | 2002       |   | 1,600  |   | Lease  |   |
| *Georgia*                        |   |       |   |   |   |   |   |
| North Fulton                     |   | 1996       |   | 3,800  |   | Lease  |   |
| Lawrenceville                    |   | 1997       |   | 5,000  |   | Lease  |   |
| Snellville                       |   | 1997       |   | 3,500  |   | Lease  |   |
| Peachtree                        |   | 2001       |   | 2,700  |   | Lease  |   |
| Valdosta                         |   | 2002       |   | 10,000 |   | Lease  |   |
| Albany                           |   | 2002       |   | 7,200  |   | Lease  |   |
| East Cobb                        |   | 2004       |   | 2,700  |   | Lease  |   |
| *Illinois*                       |   |       |   |   |   |   |   |
| Naperville                       |   | 2003       |   | 6,000  |   | Lease  |   |
| Itasca (5)                       |   | 2004       |   | 5,100  |   | Lease  |   |
| *Massachusetts*                  |   |       |   |   |   |   |   |
| Norwood                          |   | 1980       |   | 6,200  |   | Lease  |   |
| Greenfield                       |   | 1982       |   | 7,200  |   | Lease  |   |
| *Maryland*                       |   | ** ** |   |   |   |   |   |
| Bel Air                          |   | 1993       |   | 1,900  |   | Lease  |   |
| Ellicott City                    |   | 1994       |   | 4,200  |   | Lease  |   |
| Rockville                        |   | 1994       |   | 3,000  |   | Lease  |   |
| Frederick                        |   | 1996       |   | 3,500  |   | Lease  |   |

25

----

 

| Germantown       |   | 1997   |   | 3,200  |   | Lease  |   |
|------------------|--------|--------|--------|--------|--------|--------|--------|
| Timonium         |   | 1997   |   | 3,300  |   | Lease  |   |
| Severna Park     |   | 1998   |   | 2,600  |   | Lease  |   |
| South Howard     |   | 1999   |   | 2,700  |   | Lease  |   |
| Hagerstown       |   | 2001   |   | 4,500  |   | Lease  |   |
| Bowie            |   | 2004   |   | 3,300  |   | Lease  |   |
| *Maine*          |   |   |   |   |   |   |   |
| West Falmouth    |   | 1973   |   | 4,700  |   | Lease  |   |
| *North Carolina* |   |   |   |   |   |   |   |
| Burlington       |   | 2001   |   | 5,900  |   | Lease  |   |
| Cary             |   | 2003   |   | 2,800  |   | Lease  |   |
| Huntersville     |   | 2003   |   | 2,400  |   | Lease  |   |
| North Charlotte  |   | 2003   |   | 2,100  |   | Lease  |   |
| Charlotte        |   | 2005   |   | 3,500  |   | Lease  |   |
| *New Hampshire*  |   |   |   |   |   |   |   |
| Manchester       |   | 2004   |   | 11,400 |   | Lease  |   |
| *New Jersey*     |   |   |   |   |   |   |   |
| Pennsauken       |   | 2000   |   | 6,000  |   | Lease  |   |
| Marlton          |   | 2003   |   | 2,000  |   | Lease  |   |
| Princeton        |   | 2003   |   | 3,000  |   | Lease  |   |
| *Nevada*         |   |   |   |   |   |   |   |
| Henderson        |   | 2002   |   | 4,800  |   | Lease  |   |
| Summerlin        |   | 2005   |   | 4,000  |   | Lease  |   |
| *New York*       |   |   |   |   |   |   |   |
| Syracuse         |   | 1970   |   | 6,100  |   | Lease  |   |
| Pittsford        |   | 1975   |   | 7,200  |   | Lease  |   |
| New York Mills   |   | 1999   |   | 4,600  |   | Lease  |   |
| *Pennsylvania*   |   |   |   |   |   |   |   |
| Lancaster        |   | 1993   |   | 5,600  |   | Lease  |   |
| Plymouth Meeting |   | 1994   |   | 3,100  |   | Lease  |   |
| Horsham (6)      |   | 1998   |   | 4,000  |   | Lease  |   |
| Exton            |   | 2000   |   | 3,500  |   | Lease  |   |
| Doylestown       |   | 2004   |   | 3,600  |   | Lease  |   |
| Newton Square    |   | 2004   |   | 3,200  |   | Lease  |   |
| *South Carolina* |   |   |   |   |   |   |   |
| Columbia         |   | 1999   |   | 6,400  |   | Lease  |   |
| Spartanburg      |   | 2002   |   | 3,600  |   | Lease  |   |
| Charleston       |   | 2004   |   | 2,000  |   | Lease  |   |
| *Tennessee*      |   |   |   |   |   |   |   |
| Murfreesbro      |   | 1993   |   | 5,000  |   | Lease  |   |
| Cool Springs     |   | 2001   |   | 3,800  |   | Lease  |   |
| Hendersonville   |   | 2002   |   | 3,200  |   | Lease  |   |
| *Texas*          |   |   |   |   |   |   |   |
| Houston          |   | 2003   |   | 8,800  |   | Lease  |   |
| *Virginia*       |   |   |   |   |   |   |   |
| Springfield      |   | 1989   |   | 3,000  |   | Lease  |   |
| Richmond         |   | 1990   |   | 5,000  |   | Lease  |   |
| Oakton           |   | 1991   |   | 3,000  |   | Lease  |   |
| Midlothian       |   | 1994   |   | 1,300  |   | Lease  |   |
| Virginia Beach   |   | 1995   |   | 4,000  |   | Lease  |   |
| Manassas         |   | 1997   |   | 3,300  |   | Lease  |   |
| McLean           |   | 1997   |   | 1,600  |   | Lease  |   |
| Kempsville       |   | 1998   |   | 2,600  |   | Lease  |   |
| Sterling         |   | 1998   |   | 2,800  |   | Lease  |   |
| Yorktown         |   | 1998   |   | 3,400  |   | Lease  |   |
| Woodbridge       |   | 1999   |   | 3,400  |   | Lease  |   |
| Chesapeake       |   | 2000   |   | 3,600  |   | Lease  |   |
| Baileys          |   | 2001   |   | 3,000  |   | Lease  |   |
| Burke            |   | 2002   |   | 2,000  |   | Lease  |   |
| Charlottesville  |   | 2002   |   | 2,400  |   | Lease  |   |

 

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(1)          We have signed leasesfor these locations and presently expect each to open in 2006.

(2)          Represents storesrelocated in 2005.

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

(4)          Excludes 24,000 squarefeet consisting of a basement warehouse space.

(5)          Excludes 20,600 squarefeet consisting of warehouse space.

(6)          Excludes13,500 square feet consisting of warehouse space.

**Item 3. LEGAL PROCEEDINGS**

On November 29, 2005, a case was filed against us andother defendants, including our Chief Executive Officer, in the United StatesDistrict Court for the Southern District of Florida. The complaint asserts,among other things, violations of the Federal Racketeering Influenced andCorrupt Organization Act (RICO) and a corresponding Florida statute, Sections 1and 2 of the Sherman Antitrust Act, Section 2 of the Clayton Act (as amended bythe Robinson-Patman Act), the Antidumping Act of 1916, the Florida AntitrustAct of 1980, and the Florida Deceptive and Unfair Trade Practices Act, as wellas tortious 

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interference with businessrelationship under Florida law and civil conspiracy under Florida law by someor all of the identified defendants in connection with the claimed inability ofAce Pro Sound and Recording, L.L.C. to obtain vendor lines for its store. Thecomplaint purports to be made as a class action on behalf of all current andformer retail sellers of musical instruments and/or sound equipment and/orrecording equipment with stores located in geographical regions in the UnitedStates wherein some or all of the defendants have carried on business, andseeks compensatory damages, treble damages, punitive damages, injunctive reliefand attorneys fees. Service relating to the complaint was made on us on January12, 2006 and a responsive pleading is due in March 2006.

While we believe this lawsuit is without merit andintend to defend it vigorously, it may, regardless of the outcome, result insubstantial expenses and damages to us and may significantly divert theattention of our management. There can be no assurance that we will be able toachieve a favorable settlement of this lawsuit or obtain a favorable resolutionof this lawsuit if it is not settled. An unfavorable resolution of this lawsuitcould have a material adverse effect on our business, financial condition andresults of operations. Regardless of the outcome, the costs and expenses incurredby us to defend this lawsuit could adversely impact our financial condition.

On May 6, 2005, a lawsuit entitled Farnam StreetFinancial, Inc. v. Guitar Center, Inc., Case No. CT 05-6546, was filed inthe Fourth Judicial District in the State of Minnesota for the County ofHennepin. The lawsuit, which was filed by a Minnesota corporation, allegedbreach of contract in connection with the lease of certain equipment located inour corporate office and retail stores. Among other things, the lawsuit allegedthat we breached the contract by our failure to comply with the terms andconditions in connection with the return of the equipment and soughtapproximately $4.5 million of damages and attorneys’ fees. We reached asettlement in this matter during a mediation held on January 16, 2006.

On October 13, 2004, a putative class action lawsuitentitled Carlos Rodriguez v. The Guitar Center, Inc. [sic], Case No.GC322958, was filed in the Superior Court of the State of California for theCounty of Los Angeles. The lawsuit was filed by an individual purporting torepresent all hourly retail store employees employed by us within the State ofCalifornia. On December 15, 2004, a putative class action lawsuit entitledJames McClain et. al. v. Guitar Center Stores, Inc., Case No. BC326002, wasfiled in the Superior Court of the State of California for the County of LosAngeles. The lawsuit was filed by three individuals purporting to represent allhourly retail store employees employed by us within the State of California.Among other things, the lawsuits alleged that we improperly failed to documentand enforce break-time and lunch-time periods for such employees and sought anunspecified amount of damages, penalties and attorneys’ fees.

On December 15, 2005 we reached preliminary agreementto settle these two purported class action lawsuits. Under the terms of theproposed settlement, which is subject to final documentation and courtapproval, we will make cash payments of up to $3.5 million to fully resolveclaims by eligible class members, including payments to class members and paymentsfor plaintiff attorneys’ fees and the costs of a third-party administrator.

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

**Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

No matters were submitted to a vote of securityholders during the fiscal quarter ended December 31, 2005.

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**PART II**

**Item5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS ANDISSUER PURCHASES OF EQUITY SECURITIES.**

**Market Information**

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

| ** **     | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $        | 60.58      |     | $          | 50.84 |   | $ | 37.14 |   | $ | 30.49 |   |
| Second Quarter |       | 62.06    |       | 47.17    |       | 46.46 |   | 36.04 |   |
| Third Quarter  |       | 65.00    |       | 53.88    |       | 45.91 |   | 40.02 |   |
| Fourth Quarter |       | 62.20    |       | 48.20    |       | 53.37 |   | 43.04 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

As of December 31,2005, there were 500 stockholders of record, excluding the number of beneficialowners whose shares were held in street name. We believe that the number ofbeneficial holders is significantly in excess of such amount based on thesecurity position listings we obtain from time to time for the purpose offacilitating mailings to our stockholders.

**Dividend Policy**

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

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**Item 6. SELECTED FINANCIAL DATA**

Theselected data presented below under the captions “Income Statement Data” and “BalanceSheet and Other Data” for, and as of the end of, each of the years in thefive-year periods ended December 31, 2005, are derived from theconsolidated financial statements of Guitar Center, Inc. and subsidiaries,which financial statements have been audited by KPMG LLP, independentregistered public accounting firm. The consolidated financial statements as of December 31,2005 and 2004, and for each of the years in the three-year period ended December 31,2005, and the report thereon, are included elsewhere in this annual report. Theselected historical financial data should be read in conjunction withManagement’s Discussion and Analysis of Financial Condition and Results ofOperations, our consolidated financial statements and the notes theretoincluded elsewhere in this annual report.

| ** **                                                           | ** ** | **Year Ended December 31,**               | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                           | ** ** | **2005**                                                 | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                           | ** ** | **(in thousands, except per  share and operating data)** | ** ** |
| **Income Statement Data:**                                           |       |                                                     |       |   |   |   |   |   |   |   |   |
| Net sales                                                            |       | $                                                        | 1,782,499  |   | $ | 1,513,172 |   | $ | 1,275,059 |   | $ | 1,100,889 |   | $ | 949,284 |   |
| Cost of goods sold                                                   |       | 1,262,097                                                |       | 1,087,899 |   | 931,014 |   | 810,474 |   | 702,310 |   |
| Gross profit                                                         |       | 520,402                                                  |       | 425,273 |   | 344,045 |   | 290,415 |   | 246,974 |   |
| Selling, general and administrative expenses                         |       | 388,380                                                  |       | 317,585 |   | 271,996 |   | 236,537 |   | 200,748 |   |
| Operating income                                                     |       | 132,022                                                  |       | 107,688 |   | 72,049 |   | 53,878 |   | 46,226 |   |
| Other expense:                                                       |       |                                                     |       |   |   |   |   |   |   |   |   |
| Other expense                                                        |       | —                                                   |       | — |   | — |   | — |   | 3,539 |   |
| Interest expense, net                                                |       | 7,339                                                    |       | 5,390 |   | 12,540 |   | 13,077 |   | 13,411 |   |
| Total other expense                                                  |       | 7,339                                                    |       | 5,390 |   | 12,540 |   | 13,077 |   | 16,950 |   |
| Income before income taxes                                           |       | 124,683                                                  |       | 102,298 |   | 59,509 |   | 40,801 |   | 29,276 |   |
| Income taxes                                                         |       | 48,005                                                   |       | 38,873 |   | 22,649 |   | 15,545 |   | 12,243 |   |
| Net income                                                           |       | $                                                        | 76,678     |   | $ | 63,425 |   | $ | 36,860 |   | $ | 25,256 |   | $ | 17,033 |   |
| Net income per share (diluted)                                       |       | $                                                        | 2.67       |   | $ | 2.29 |   | $ | 1.47 |   | $ | 1.09 |   | $ | 0.75 |   |
| Diluted Weighted average shares outstanding (1)                 |       | 29,846                                                   |       | 28,976 |   | 26,119 |   | 23,130 |   | 22,700 |   |
| **Operating Data:**                                                  |       |                                                     |       |   |   |   |   |   |   |   |   |
| Guitar Center net sales per gross square foot (2)               |       | $                                                        | 599        |   | $ | 585 |   | $ | 560 |   | $ | 546 |   | $ | 537 |   |
| Net sales growth                                                     |       | 17.8                                                     | %          | 18.7 | % | 15.8 | % | 16.0 | % | 19.4 | % |
| Increase in Guitar Center comparable store  sales (3)           |       | 5.8                                                      | %          | 9.7 | % | 6.9 | % | 6.5 | % | 5.5 | % |
| Guitar Center stores open at end of period                           |       | 161                                                      |       | 136 |   | 122 |   | 108 |   | 96 |   |
| Ratio of earnings to fixed charges (4)                               |       | 6.5x                                                     |       | 6.6x |   | 3.5x |   | 2.8x |   | 2.4x |   |
| Net cash provided by operating activities (thousands)                |       | $                                                        | 65,710     |   | $ | 85,506 |   | $ | 58,005 |   | $ | 12,248 |   | $ | 16,511 |   |
| EBITDA (thousands) (5)                                               |       | $                                                        | 161,022    |   | $ | 129,992 |   | $ | 92,669 |   | $ | 70,738 |   | $ | 57,693 |   |
| **Balance Sheet and Other Data:**                                    |       |                                                     |       |   |   |   |   |   |   |   |   |
| Net working capital                                                  |       | $                                                        | 287,098    |   | $ | 269,859 |   | $ | 198,713 |   | $ | 110,825 |   | $ | 90,113 |   |
| Property and equipment, net                                          |       | 149,209                                                  |       | 97,349 |   | 93,347 |   | 89,702 |   | 81,056 |   |
| Total assets                                                         |       | 780,190                                                  |       | 574,593 |   | 460,871 |   | 452,399 |   | 404,684 |   |
| Total long-term and revolving debt (including current  portion) |       | 132,266                                                  |       | 100,000 |   | 100,000 |   | 149,590 |   | 144,466 |   |
| Stockholders’ equity                                            |       | 404,817                                                  |       | 306,682 |   | 214,171 |   | 154,928 |   | 123,868 |   |
| Capital  expenditures                                                |       | 75,493                                                   |       | 26,151 |   | 24,245 |   | 26,309 |   | 24,697 |   |

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(1)    Weightedaverage shares represents shares calculated on a diluted basis. For the years endedDecember 31, 2005 and 2004, the 2.9 million shares of common stockissuable upon conversion of the 4% Senior Convertible Notes issued in June 2003(reflecting an effective conversion price of $34.58) are deemed to be potentialcommon stock and are deemed to be outstanding for the purposes of calculatingdiluted earnings per share under the “if-converted” method of accounting underwhich the after-tax interest expense, including amortization of deferredfinancing costs, for the year is added back to net income. For the year ended December 31,2003, 1.6 million shares of common stock were deemed to be potential commonstock and are included in the calculation of earnings per share representingthe weighted average 

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shares issuable upon theconversion of the 4% Senior Convertible Notes for the period of June 16,2003, the issuance date of the Notes, to December 31, 2003, under the “if-converted”method. The diluted earnings per share for 2003 has been restated to conform toEITF 04-08, *Accounting Issues Related to CertainFeatures of Contingently Convertible Debt and the Effect on Diluted Earningsper Share.*

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

(3)    Comparesnet sales for the comparable periods, excluding net sales attributable tostores not open for 14 months as of the end of the latter reporting period. Allreferences in this annual report to comparable store sales results are based onthis calculation methodology. This calculation is presented for Guitar Centerretail stores only, excluding Music & Arts Center retail stores.

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

(5)    Represents net income before interest expense, incometaxes, and depreciation and amortization expense. The reconciliation fromreported net income to EBITDA is as follows:

| **EBITDA**                     | ** ** | ** ** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|--------------------------------|------------|------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Net income as  reported        |       | $          | 76,678     |     | $          | 63,425   |       | $        | 36,860     |     | $          | 25,256   |       | $ | 17,033 |   |
| Income taxes                   |       | 48,005     |       | 38,873   |       | 22,649   |       | 15,545   |       | 12,243   |       |
| Interest expense               |       | 7,339      |       | 5,390    |       | 12,540   |       | 13,077   |       | 13,411   |       |
| Depreciation and  amortization |       | 29,000     |       | 22,304   |       | 20,620   |       | 16,860   |       | 15,006   |       |
| EBITDA                         |       | $          | 161,022    |     | $          | 129,992  |       | $        | 92,669     |     | $          | 70,738   |       | $ | 57,693 |   |

 

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

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**Item7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

**General**

Guitar Center, Inc. is the leading United Statesretailer of guitars, amplifiers, percussion instruments, keyboards andpro-audio and recording equipment. As of December 31, 2005, our retailstore subsidiary operated 161 Guitar Center stores across the United States,with 126 stores in 50 primary markets, 34 stores in secondary markets and onetertiary market store. In addition, as of December 31, 2005, our Music &Arts Center division operated 81 stores specializing in band instruments forsale and rental, serving thousands of teachers, band directors, collegeprofessors and students. We are also the largest direct response retailer of musicalinstruments in the United States through our wholly owned subsidiary, Musician’sFriend, Inc., and its catalog and website, www.musiciansfriend.com.

In 2005, we opened a total of 25 Guitar Center stores,including 12 primary market stores, 12 secondary market stores and onetertiary market store. We presently expect to open approximately 35 to 40additional Guitar Center stores in 2006, including eight to 10 primary marketstores, 25 to 28 secondary market stores and two tertiary market stores.

As we enter newmarkets, we expect that we will initially incur higher administrative andpromotional costs per store than is currently experienced in establishedmarkets. We expect competition to continue to increase as other music productretailers attempt to execute national growth strategies. Our business strategywill also emphasize opportunities to continue to grow each of our brands,including further acquisitions if attractive candidates can be located forreasonable prices.

From 2001 to 2005, our netsales grew at an annual compound growth rate of 17%, principally due to thecomparable store sales growth of our retail stores averaging 7% per year, theopening of new stores, and a 21% per year increase in the direct responsechannel. We believe such volume increases are the result of the continuedsuccess of the implementation of our business strategy, continued growth in themusic products industry and increasing consumer awareness of the Guitar Center,Musician’s Friend and Music & Arts Center brand names. Our retailstores achieved comparable store sales growth of 5.4%, 9.4%, and 7.0% for thefiscal years ended December 31, 2005, 2004 and 2003, respectively. Webelieve this growth reflects the strength of our merchandise selection,effective advertising and promotion, and well-trained and committed personnel.

**Executive Summary**

Consolidated net sales in 2005 increased 17.8% to $1.8billion from $1.5 billion in 2004. Consolidated net income in 2005 increased20.9% to $76.7 million, or $2.67 per diluted share, from $63.4 million, or$2.29 per diluted share, in 2004.

During 2005, our Guitar Center stores generated 5.8%comparable store sales growth and an increase of 13.2% in total net salescompared to 2004. Sales from new stores totaled $85.3 million and represented55.9% of the overall increase in sales. We opened 25 new Guitar Center storesin 2005.

Musician’s Friend, our direct response unit, generatedan increase in net sales of 17.3% in 2005 compared to 2004. Within the overallsales increase for direct response, our web-based sales grew at a rate of 27.3%in 2005, reflecting an increased consumer preference in using the web to placeorders. Our initial order fill rate improved to 93.3% in 2005 from 92.3% in2004. Initial order fill rate reflects the percentage of items ordered by ourcustomers that we are able to supply in the initial shipment to that customer. Grossprofit margins decreased by 2.5% of net sales due primarily to increased onlinecompetition leading, in particular, to expanded free freight offers in 2005. Weare also spending more on internet search engine advertising in order to drivemore traffic to our site.

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We completed our acquisition on April 15, 2005 ofMusic & Arts Center, Inc., a Maryland-based musical instrumentretailer with an emphasis on the beginning musician. At the time ofacquisition, Music & Arts Center, Inc. operated 61 retaillocations primarily located in the Northeast, Mid-Atlantic and Southern regionsof the United States. The acquired business was combined with our formerAmerican Music business into a new division of our retail store subsidiary thatoperates under the Music & Arts Center name.

Financial results prior toApril 15, 2005 for our Music & Arts Center business reflect only ourformer American Music stores and do not include results from the acquiredbusiness. However, comparable sales for the year are computed using thecombined comparable sales of Music & Arts Center, Inc., andAmerican Music stores. Primarily as a result of this acquisition, the net salesfor the Music & Arts Center business increased from $40.4 million in2004 to $103.1 million in 2005. Comparable sales for the year decreased 0.3%which is inclusive of a decrease of 16.1% at the American Music locations,offset by a 9.6% increase in comparable sales at the Music & ArtsCenter locations. Comparable sales decreased at American Music principally dueto the reduction in low margin institutional sales which is not part of ourongoing Music & Arts Center strategy. We saw gross margin expand to41.8% for the year ended December 31, 2005 compared to 34.8% for the sameperiod in 2004. This margin expansion is principally due to improved productmix and better pricing under the Music & Arts Center business andelimination of the institutional sales.

**Discussionof Critical Accounting Policies**

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

*Valuation ofInventory*

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

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*Valuation ofLong-Lived Assets*

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

·       Significantunderperformance relative to historical or projected operating results;

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

·       Significantnegative industry or economic trends; and

·       Significantdecline in stock value for a sustained period.

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

Our assessment regardingthe existence of impairment factors is based on market conditions and theoperational performance of our business. Our review of factors present and theresulting appropriate carrying value of our goodwill, intangibles and other long-livedassets are subject to judgments and estimates that management is required tomake.

*Sales Returns*

As part of our “satisfactionguaranteed” policy, we allow Guitar Center customers to return productgenerally within 30 days after the date of purchase, and we allow Musician’sFriend customers to return product within 45 days. Music & Arts Centercustomers have 14 business days from the date of purchase to return product. Weregularly review and revise, when deemed necessary, our estimates of salesreturns based upon historical trends. While our estimates during the past fewyears have approximated actual results, actual returns may differ significantlyfrom estimate, either favorably or unfavorably, if factors such as economicconditions or the competitive environment differ from our expectations.

*Credits and OtherVendor Allowances*

We receive cooperativeadvertising allowances (i.e., an allowance from the manufacturer to subsidizequalifying advertising and similar promotional expenditures we make relating tothe vendor’s products), price protection credits (i.e., credits from vendorswith respect to in-stock inventory if the vendor subsequently lowers theirwholesale price for such products) and vendor rebates (i.e., credits or rebatesprovided by vendors based on the purchase of specified products and paid at alater date). Cooperative advertising allowances are recognized as a reductionto selling, general, and administrative expense when 

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we incurthe advertising expense eligible for the credit. We recognized cooperativeadvertising allowances of $10.1 million, $6.4 million and $5.1 million for theyears ended December 31, 2005, 2004 and 2003, respectively, recorded as anoffset to selling, general and administrative expense. Price protection creditsand vendor rebates are accounted for as a reduction of the cost of merchandiseinventory and are recorded at the time the credit or rebate is earned. Theeffect of price protection credits and vendor rebates is recognized in theincome statement at the time the related inventory is sold as a reduction incost of goods sold. The reserve against rebates receivable is determined byspecifically identifying uncollectible accounts through an aging review and ananalysis of vendor relationships. We received payments for vendor rebates of$30.6 million, $20.9 million and $11.0 million for the years ended December 31,2005, 2004 and 2003, respectively. We earned and recognized vendor rebates of$28.3 million, $23.2 million and $17.6 million for the years ended December 31,2005, 2004 and 2003, respectively. None of these credits are recorded asrevenue.

**Results of Operations**

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

| ** **                                    | ** ** | **Fiscal Year Ended  December 31,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                                     |       | 100.0                                              | %          | 100.0 | % | 100.0 | % |
| Gross profit                                  |       | 29.2                                               |       | 28.1 |   | 27.0 |   |
| Selling, general  and administrative expenses |       | 21.8                                               |       | 21.0 |   | 21.3 |   |
| Operating income                              |       | 7.4                                                |       | 7.1 |   | 5.7 |   |
| Interest expense,  net                        |       | 0.4                                                |       | 0.3 |   | 1.0 |   |
| Income before income  taxes                   |       | 7.0                                                |       | 6.8 |   | 4.7 |   |
| Income taxes                                  |       | 2.7                                                |       | 2.6 |   | 1.8 |   |
| Net income                                    |       | 4.3                                                | %          | 4.2 | % | 2.9 | % |

 

**Fiscal 2005 Compared to Fiscal 2004**

Net sales for the year ended December 31, 2005increased 17.8% to $1.8 billion, compared with $1.5 billion in 2004.

Net sales from Guitar Center stores for fiscal 2005totaled $1.3 billion, a 13.2% increase from $1.2 billion in fiscal 2004. Netsales from new stores contributed $85.3 million and represented 55.9% of thetotal increase in retail store sales. Comparable Guitar Center store sales forthe full year increased 5.8%. Comparable store sales are defined as sales forthe comparable periods, excluding net sales attributable to stores not open for14 months as of the end of the reporting period. We believe that comparable storesales are a more useful indicator of store performance than the change in totalnet sales, since comparable store sales exclude the effects of changes in thenumber of stores open.

The financial information of the Music & ArtsCenter division for the year ended December 31, 2005 includes the resultsof American Music for the entire year and Music & Arts Center from thetime of its acquisition on April 15, 2005 through December 31, 2005,while the 2004 results include only American Music. However, comparable storesales for the year ended December 31, 2005 is computed using thecomparable store sales of American Music stores for the year ended December 31,2005 combined with comparable store sales for the Music & Arts Center, Inc.stores for the period from April 15, 2005 through December 31, 2005.Net sales from Music & Arts Center for 2005 totaled $103.1 millioncompared to $40.4 million in 2004. The increase in net sales is primarily dueto the acquisition of Music & Arts Center, Inc. Comparable sales foronly American Music locations decreased 16.1%, while comparable sales for only 

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Music & ArtsCenter locations, increased 9.6%, resulting in the combined comparable salesdecrease of 0.3%. Comparable sales decreased at American Music principally dueto the reduction in low margin institutional sales which is not part of ourongoing Music & Arts Center strategy.

Net sales from the direct response channel totaled$365.1 million in 2005, a $53.8 million, or 17.3%, increase from 2004. Theincrease primarily reflects the benefits from increased advertising, freefreight incentives and improved leveraging of an expanding buyer file offsetsomewhat by competitors’ expanded free shipping programs and increasedcompetition. We continued to face increased competition. We expect this trendof increased competition in the direct response channel and its negative impacton that segment’s net sales and gross margin to continue for the foreseeablefuture. Sales from the contact center, which represents sales placed via phone,live chat, mail and e-mail, increased 4.8% to $145.2 million in 2005 from$138.5 million in 2004. Internet sales from orders placed via the Musician’sFriend, Giardinelli and affiliate web sites increased 27.3% to $219.9 millionin 2005 from $172.8 million in 2004. The growth of web-based sales reflects thecontinued trend of our catalog customers’ preference in using the web to placetheir orders, the success of web-based promotions and that the web siteincludes a more complete inventory presentation than our catalogs.

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

Gross profit as a percentage of net sales for theGuitar Center stores was 28.0% compared with 26.7% for each of the years ended December 31,2005 and 2004. The increase is due to higher selling margin of 1.2% and reducedfreight of 0.1%. We define selling margin as net sales less the cost of theassociated merchandise charged by the vendor plus the associated inventorycosts from fulfilling inventory through our distribution center. The cost ofmerchandise inventory is net of all associated vendor discounts and rebates.Freight is not included in selling margin.

The gross profit margin for the Music & ArtsCenter division was 41.8% for the year ended December 31, 2005 compared to34.8% for the same period in 2004. The increase in gross profit margin is dueto higher selling margin 9.6% and reduced freight 0.4%, offset by increasedshrink 1.4% and higher occupancy costs 1.0%. During the second quarter of 2005,we recorded a charge of $588,000 to cost of sales, or 0.6% of sales, for theMusic & Arts Center division, reflecting a reduction of the value ofcertain inventories previously in our American Music assortment that wediscontinued upon the acquisition of Music & Arts Center, Inc.Otherwise the improved selling margin was driven by a change in product mix andbetter pricing under the Music & Arts Center business as compared tothe American Music business in 2004. We discontinued our low margininstitutional sales which are not part of our ongoing Music & ArtsCenter strategy.

Gross profit margin for the direct response divisionwas 29.8% for the year ended December 31, 2005 compared to 32.3% for thesame period in 2004. The 2005 selling margin was significantly impacted byexpanded free freight offers made during the year in response to the increasedcompetition and due to lower selling margin driven by increased onlinecompetition.

Selling, general and administrative expenses for 2005increased 22.3% to $388.4 million from $317.6 million in fiscal 2004.As a percentage of net sales, selling, general and administrative expenses for2005 increased to 21.8% from 21.0% in 2004.

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

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Selling, general and administrative expenses for Music &Arts Center were 47.9% of sales for 2005 compared to 46.2% for the same periodin 2004. Excluding acquisition related charges of $2.9 million, selling,general and administrative expenses were 45.1% of sales for 2005 compared to46.2% for the same period in 2004. The charge of $2.9 million represents theelimination of a redundant point of sales system, severance costs and movingcosts to relocate certain American Music employees to the Music & ArtsCenter corporate office in Maryland. The decrease is due to improved leveragingon the higher revenue base of the combined businesses of Music & ArtsCenter and American Music. The reductions as a percentage of sales were inpayroll 2.2%, travel costs 1.2%, supplies 0.4%, computer maintenance 0.3% andinsurance 0.4%, offset by higher advertising 1.8%, amortization of intangibles0.7%, depreciation 0.4%, credit card expense 0.3%, and consulting fees 0.2% .

Selling, general and administrative expenses for thedirect response division were 21.2% of sales for 2005 compared to 20.7% for thesame period in 2004. The increase was driven by advertising expense related toprograms to increase web traffic 1.2%, offset by reduced credit card expense0.1%, reduced bad debt expense 0.1%, leveraging of payroll 0.3% and insurancecosts 0.1%, and lower consulting fees 0.1%.

Operating income increased 22.6% to $132.0 million in2005 from $107.7 million in 2004. This increase reflects the strong performanceof the Guitar Center stores in 2005, with increased sales of 13.2%, increasedgross profit as a percentage of sales of 1.3%, and leveraging of selling,general and administrative expenses as a percentage of sales by 0.3%, whencompared to 2004. This was offset by a decline in the direct response operatingincome of $4.7 million, or down 13.0%, from 2005 compared to 2004. Weexperienced increased competition in our direct response unit, resulting inlower selling margins and higher marketing and advertising costs. The directresponse unit gross profit as a percentage of sales decreased 2.5% whileselling general and administrative expenses as a percentage of sales increased0.5% for 2005 compared to 2004. Music & Arts Center operating loss asa percentage of sales improved from negative 11.4% of sales in 2004 to negative6.1% of sales in 2005. Excluding acquisition related charges, Music &Arts Center operating loss as a percentage of sales was negative 2.7% of salesin 2005.

Interest expense, net for 2005 increased to$7.3 million from $5.4 million in 2004. The increase is primarily dueto interest on borrowings related to the acquisition of Music & ArtsCenter, Inc., increased inventory levels at our Guitar Center retailstores and purchases of a corporate office building and other property andequipment.

For the year ended December 31, 2005, a $48.0million provision for income taxes was recorded compared to $38.9 million forthe same period in 2004, based on effective tax rates of approximately 38.5%and 38.0%, respectively. There was a change in the effective tax rate as aresult of higher blended state income tax rates as well as $0.5 million innon-deductible costs associated with our California wage and hour class actionsettlement.

Net income for 2005increased to $76.7 million from $63.4 million in 2004 as a result ofthe combinations of factors described above.

**Fiscal 2004 Compared to Fiscal 2003**

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

Net sales from Guitar Center stores for fiscal 2004totaled $1.162 billion, an 18.6% increase from $979.0 million in fiscal 2003. Salesfrom new stores contributed $87.8 million and represented 48.1% of the totalincrease in retail store sales. Comparable Guitar Center store sales for thefull year increased 9.8%. Comparable store sales are defined as sales for thecomparable periods, excluding net sales attributable to stores not open for 14months as of the end of the reporting period. We believe that comparable storesales are a more useful indicator of store performance than the change in totalnet sales, since comparable store 

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sales exclude the effectsof changes in the number of stores open. The increase in comparable store saleswas due to positive response to our advertising and marketing strategy for ourGuitar Center stores. Total advertising and marketing expense increased from$28.5 million to $33.5 million in 2004. Net sales from American Music for 2004totaled $40.4 million, a 5.7% increase from $38.2 million in 2003. ComparableAmerican Music sales for 2005 increased 1.0%.

Net sales from the direct response channel totaled$311.3 million in 2004, a $53.4 million, or 20.7%, increase from 2003. Thisincrease primarily reflects the improved performance of catalog circulationstrategies. Sales from the contact center, which represents sales placed viaphone, live chat, mail and e-mail, increased 17.0% to $138.5 million from$118.4 million in 2003. Internet sales from orders placed via the Musician’sFriend and Giardinelli web sites increased 23.9% to $172.8 million from $139.5million for the same period last year. The growth of web-based sales reflects thecontinued trend of our catalog customers’ preference in using the web to placetheir orders, the success of web-based promotions, and that the web siteincludes a more complete inventory presentation than our catalogs.

Gross profit for the year ended December 31, 2004compared to 2003 increased 23.6% to $425.3 million from $344.0 million. Grossprofit as a percentage of net sales for the year ended December 31, 2004compared to 2003 increased to 28.1% from 27.0%. Gross profit as a percentage ofnet sales for the Guitar Center stores was 26.7% compared with 25.3% for theyear ended December 31, 2004 and 2003. The increase is due to higherselling margin 1.2%, leveraged occupancy costs 0.2% due to the strongcomparable store sales increase, and lower inventory shrink 0.1%. We defineselling margin as net sales less the cost of the associated merchandise chargedby the vendor plus the associated inventory costs from fulfilling inventorythrough our distribution center. The cost of merchandise inventory is net ofall associated vendor discounts and rebates. Freight is not included in sellingmargin. The gross profit margin for American Music was 34.8% compared to 35.7%for the same period last year. The decrease is due to lower selling margin 0.9%and an increase in occupancy costs 0.4%, partially offset by a decrease ininventory shrink 0.2% and freight costs 0.2%. The gross profit margin for thedirect response division was 32.3% for 2004 compared to 32.1% in 2003. Theincrease is due to higher selling margin 0.1% and reduction in inventory shrink0.1%.

Selling, general and administrative expenses for 2004increased 16.8% to $317.6 million from $272.0 million in fiscal 2003.As a percentage of net sales, selling, general and administrative expenses for2004 decreased to 21.0% from 21.3% in 2003. The overall increase is due to theoperation of 136 Guitar Center stores in 2004 compared to 122 Guitar Centerstores in 2003. Selling, general and administrative expenses as a percentage ofsales for the Guitar Center stores were 20.2% for both December 31, 2004and 2003. The unchanged percentage reflects reduced general insurance 0.1% andlower computer repairs and maintenance 0.1%, offset by an increase in bonuscosts 0.2%. Selling, general and administrative expenses for American Music were46.2% of sales compared to 48.0% last year. The decrease is primarily due todecreased advertising expense 1.8%, bad debt expense 0.7%, and medicalinsurance 0.6%, partially offset by increases in depreciation and amortization0.5% and salary costs 0.6%.

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

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

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Interest expense, net for 2004 decreased to$5.4 million from $12.5 million in 2003. The reduction in interestexpense is due primarily to the retirement of $67 million in 11% senior notesthrough a $100 million 4% convertible bond offering completed in June 2003and the use of cash flow from operations to pay off our line of creditborrowings. Accordingly, included in interest expense for 2003 are theredemption premium of $1.2 million and the write-off of deferred financingcosts of $0.7 million associated with the Senior Notes redeemed in July 2003for a total of $1.9 million.

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

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

**Liquidity and Capital Resources**

**Disclosuresabout Contractual Obligations and Commercial Commitments**

Thefollowing table aggregates the material contractual obligations and commercialcommitments that affect our financial condition and liquidity as ofDecember 31, 2005:

| ** **                                 | ** ** | **Payments Due by Period  (In thousands)** | ** ** |
|--------------------------------------------|------------|----------------------------------------------------------------|------------|
| **Contractual Cash Obligations** | ** ** | ** **                                                     | ** ** | **Total** | ** ** | **Less than  1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **After 5  Years** | ** ** |
| Long-term  obligations (1)                 |       | $                                                              | 132,266    |   |   | $ | 32,266 |   |   | $ | 100,000 |   | $ | — |   | $ | — |   |
| Operating lease obligations (2)            |       | 252,878                                                        |       |   | 44,457 |   |   | 79,654 |   | 55,858 |   | 72,909 |   |
| Total                                      |       | $                                                              | 385,144    |   |   | $76,723 |   |   | $ | 179,654 |   | $ | 55,858 |   | $ | 72,909 |   |
|                                            |            |                                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Long-term debt consistsof the $100 million principal amount of 4% Senior Convertible Notes due in 2013and $32.3 million of revolving line of credit. In July 2008 and July 2010,holders may at their election require us to purchase all of the notes at 100%of the principal amount, plus any accrued interest, including contingentinterest.

(2)          Operating leasecommitments consist principally of real property leases for our corporateoffices, retail store facilities and distribution centers. These leasesfrequently include options which permit us to extend the terms beyond theinitial fixed lease term. We also have rented personal property throughoperating leases. Payments for these lease commitments are provided for by cashflows generated from operations. Please see Note 8 to the consolidatedfinancial statements.

Our need for liquidity will arise primarily from thefunding of capital expenditures, working capital requirements and payments onour indebtedness, as well as possible acquisitions. We have historicallyfinanced our operations primarily through internally generated funds and borrowingsunder our credit facilities. Please see Item 1A. “Risk Factors” for adiscussion of factors which could reasonably likely result in a decrease in theamount of internally generated funds available to finance capital expendituresand working capital requirements. As of December 31, 2005, we had $32.3million in borrowings under our credit facility and had available borrowings of$75.6 million (net of $7.1 million of outstanding letters of credit).

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In February of 2005, we amended our creditfacility with a syndicate of banks led by Wells Fargo Retail Finance. Thecredit facility permits borrowings up to $125 million (which may be increasedto $150 million at our option), subject to borrowing base limitations. Theactual amount available is tied to our inventory and receivable base, and ourobligations under the credit facility are secured by liens on our principalassets. Borrowing options are prime rate (7.25% at December 31, 2005) plusapplicable prime margin, or London Interbank Offered Rate or LIBOR (twelvemonth rate at December 31, 2005 was 4.8%), plus applicable LIBOR margin.The applicable prime and LIBOR margins are based upon levels of excessavailability and adjusted quarterly. If excess availability is greater than $20million, the applicable prime margin is 0.00% and applicable LIBOR margin is1.0%. If excess availability is less than or equal to $20 million and greaterthan $10 million, the applicable prime margin is 0.00% and the applicable LIBORmargin is 1.25%. If excess availability is less than or equal to $10 million,the applicable prime margin is 0.00% and the applicable LIBOR margin is 1.5%.An unused fee of 0.25% is assessed on the unused portion of the creditfacility. The agreement underlying the credit facility includes significantrestrictive negative covenants. Among other things, these covenants restrict orprohibit our ability to incur debt and issue specified equity instruments,incur liens on our assets, make any significant changes in our corporatestructure or the nature of our business, dispose of assets, make guaranties,prepay debt, engage in a change in control transaction, pay dividends, makeinvestments or acquisitions, engage in transactions with affiliates and incurcapital expenditures, and also require that we satisfy a minimum availabilitytest. The minimum availability test requires that we maintain $10 million ofreserved availability under the agreement based on its borrowing baselimitations. The amount we disclose in our public reports from time to time asavailable to borrow under the agreement is already reduced by this requiredreserve and outstanding letters of credit, and thus represents a net amountavailable under the agreement. The agreement also includes representations andwarranties which must be true each time we borrow funds under the creditfacility and affirmative covenants. The full text of the contractualrequirements imposed by this financing is set forth in the Amended and RestatedLoan and Security Agreement and related amendments which have been filed withthe Securities and Exchange Commission. Subject to limited cure periods, thelenders under our credit facility may demand repayment of these borrowingsprior to stated maturity upon the occurrence of specified events, including ifwe breach the terms of the agreement, suffer a material adverse change, engagein a change in control transaction, suffer a significant adverse legaljudgment, default on other significant obligations, or in the event ofspecified events of insolvency. The credit agreement matures in December 2010.

On June 16, 2003, we completed the issuance of$100 million principal amount of 4.00% Senior Convertible Notes due 2013. Theconvertible notes bear interest at the rate of 4.00% per annum, subject to thepayment of contingent interest under certain circumstances commencing January 15,2006, and are convertible into shares of common stock at a conversion price of$34.58 per share, subject to adjustment under specified circumstances. Underthe contingent conversion feature of the convertible notes, subject to certainexceptions, they are not convertible into common stock unless and until thetrading price of the common stock reaches at least $41.50 for a specifiedperiod in advance of each quarterly conversion period or designated corporateevents occur. As of December 31, 2005, the convertible notes wereconvertible for the current quarterly conversion period. The convertible noteswill also become convertible upon the occurrence of specified corporatetransactions and other events described in the indenture. The final maturity ofthe convertible notes is July 2013, although holders may require us torepurchase the Notes at their election in July 2008, July 2010 orupon the occurrence of a change in control, in each case for a purchase priceequal to the original principal amount plus accrued interest. The indenturegoverning the convertible notes does not limit our ability to incurindebtedness or otherwise substantively restrict the operation of our businessto any significant degree. Subject to limited cure periods, the holders of theconvertible notes may demand repayment of these borrowings prior to the statedmaturity upon the occurrence of specified events, including if we fail to payinterest or principal when due, if we fail to satisfy our conversionobligation, if another obligation of ours having an outstanding principalamount in excess 

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of $15 million isaccelerated prior to stated maturity and upon the occurrence of specifiedevents of insolvency.

For the years ended December 31, 2005, 2004 and2003, $1.0 million, $1.0 million and $0.9 million of amortization of deferredfinancing fees was included in interest expense. Capitalized deferred financingfees at December 31, 2005 and 2004 were $2.5 million and $3.6 million andrelated accumulated amortization was $2.1 million and $1.0 million,respectively.

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

The terms of our significant financing agreements,including those related to our credit facility, the convertible notes and theequipment lease facilities described above, are not dependent on any change inour credit rating. We believe that the key company-specific factors affectingour ability to maintain our existing debt and lease financing relationships andto access such capital in the future are our present and expected levels ofprofitability and cash flow from operations, our working capital and fixedasset collateral bases, our expected level of capital expenditures, and thelevel of our equity capital relative to the level of debt obligations. Inaddition, as noted above, our existing agreements include significantrestrictions on future financings, including among others, limits on the amountof indebtedness that we may incur and whether or not such indebtedness may besecured by any of our assets.

As is the case with most multi-unit retailers,substantially all of the real property used in our business is leased underoperating lease agreements. Please see Item 2. Properties, “—Disclosures AboutContractual Obligations and Commercial Commitments” and Note 8 to theConsolidated Financial Statements. We anticipate making additional capitalinvestments of $8.0 million to $10.0 million in connection with the expansionof our Guitar Center stores distribution center and we expect to incurincreased rent expense for that facility starting during the third quarter of2006.

Net cash provided by operating activities was $65.7million for the year ended December 31, 2005 compared to $85.5 million forthe same period last year. The largest use of cash was an increase ininventories of $74.2 million. The increase in inventories was primarily due to theopening of 25 new Guitar Center retail stores and carrying somewhat higherinventory levels at our existing stores.

Cash used in investing activities increased to $157.8million for the year ended December 31, 2005 compared to $49.7 million forthe same period last year. The investing activities for the year ended December 31,2005 consisted primarily of the purchase of Music & Arts Center, Inc.for approximately $93.0 million, a new corporate office building for $12.2million, a corporate airplane for $10.6 million, capital expenditures for storeexpansions and remodels of $36.8 million compared to $16.8 million in the priorperiod, and computer equipment purchases of $12.2 million in the current periodcompared to $7.4 million in the same period last year. Additionally, wereceived net proceeds from the sale of available-for-sale securities of $20.2million.

Cash provided by financing activities totaled $46.1million for the year ended December 31, 2005 compared to $19.3 millionused in the same period last year. The cash provided by financing activitiesconsists primarily of the borrowings under our credit facility of $32.3 millionand remaining from the net proceeds received from the exercise of stock optionsand other employee purchases of our common stock. The increase in borrowingswas required to support the Music & Arts Center, Inc. acquisitionand the capital spending described above.

We believe that our current operating cash flow,working capital, cash on hand, borrowings available under our credit facilityand other sources of liquidity we believe are available to us will besufficient to 

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meet our obligations inthe ordinary course of business over the next 12 months, including capitalexpenditures and new store openings.

Our known capital resource and liquidity requirementsfor 2006 are expected to be primarily provided by net cash flow from operationsand borrowings available under our credit facility. Traditionally, we haveexperienced the largest use of cash from operating activities in the latterpart of the third quarter and in the fourth quarter due to the build up ofinventory to support the holiday season, resulting in additional borrowingsunder our line of credit. We believe that our peak seasonal liquidity needsduring 2006 during this period will exceed our projected net cash flow fromoperations and borrowings currently available under our existing creditfacility. We are in discussions with our lending syndicate regarding anincrease in the amount of maximum borrowings permitted under our creditfacility. However, these discussions are preliminary in nature and there is noassurance that an increase in the borrowings under credit facility will beavailable to us.

Depending upon market conditions, we may also elect orbe required to raise additional capital in the form of common or preferredequity, debt or convertible securities for the purpose of providing additionalcapital to fund working capital needs or continued growth of our existingbusiness, or to refinance existing obligations including the senior convertibledebentures which may be called for redemption at our election commencing in July 2006.Any such financing activity will be dependent upon many factors, including ourliquidity needs, market conditions and prevailing market terms, and we cannotassure you that future external financing for us will be available onattractive terms or at all. If we require but are unable to obtain additionalliquidity on favorable terms, we may be required to curtail our 2006 growthplans and our financial condition and results of operations would likely bematerially adversely impacted.

We intend to pursue an aggressive growth strategy byopening additional stores in new and existing markets. Each new primary marketformat Guitar Center store typically has required approximately $2.0 to $2.5million for gross inventory. Historically, our cost of capital improvements fora primary market format Guitar Center store has been approximately $1.1 millionconsisting of leasehold improvements, fixtures and equipment. We incur highercosts in some geographic areas, particularly the Northeast, and when we build alarger flagship store. We have developed secondary market Guitar Center storesto build in sites that we do not believe will support our primary market formatunits. We have opened 36 secondary market stores between late 2000 and December 31,2005. Our secondary market stores have typically required approximately $1.7million to $2.0 million for gross inventory and approximately $850,000 incapital expenditures. In late 2005, we opened our first tertiary market formatstore to serve smaller population centers. Our tertiary market format storeshave required approximately $1.0 million for gross inventory and approximately$500,000 in capital expenditures. We expect the future costs to build newGuitar Center stores to rise from these historical amounts as we haveexperienced significant increases in the cost of construction.

We are also anticipating additional capital andstrategic requirements related to improving our fulfillment facilities,upgrading our technology and systems, including a data warehouse and newpoint-of-sale system and pursuing new opportunities in the e-commerceactivities of our retail and direct response divisions as well as relatedbusinesses. We also continue to make significant investments in informationtechnology across our businesses and to incur costs and make investmentsdesigned to expand the reach of our businesses on the Internet. The costs ofthese initiatives and other investments related to our businesses will continueto be significant.

Throughout our history, wehave primarily grown organically. However, we also believe there may beattractive opportunities to expand by selectively acquiring existing musicproducts retailers or other complimentary businesses, if attractiveopportunities can be identified. We believe that our growth at Music &Arts Center will in large part be driven through many small acquisitions. Whilewe cannot provide assurance that we will complete any further acquisitiontransactions, in the ordinary course of our business 

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weinvestigate and engage in negotiations regarding such opportunities.Acquisitions will be financed with cash on hand, drawings under our existingcredit facilities, expansion of our credit facilities, issuance of debt orequity securities, or a combination, depending upon transaction size and marketconditions, among other things.

**New Accounting Pronouncements**

In May 2005, the Financial Accounting StandardsBoard, or FASB, issued Statement of Financial Accounting Standards (“SFAS”) No. 154,*Accounting Changes and Error Corrections,*whichreplaces*Accounting Principles Board (“APB”) Opinion No. 20,Accounting Changes,* and supersedes FASB Statement No. 3, *Reporting Accounting Changes in Interim Financial Statements—anamendment of APB Opinion No. 28.* SFAS 154 requiresretrospective application to prior periods’ financial statements of changes inaccounting principle, unless it is impracticable to determine either theperiod-specific effects or the cumulative effect of the change. When it isimpracticable to determine the period-specific effects of an accounting changeon one or more individual prior periods presented, SFAS 154 requires that thenew accounting principle be applied to the balances of assets and liabilitiesas of the beginning of the earliest period for which retrospective applicationis practicable and that a corresponding adjustment be made to the openingbalance of retained earnings for that period rather than being reported in anincome statement. When it is impracticable to determine the cumulative effectof applying a change in accounting principle to all prior periods, SFAS 154requires that the new accounting principle be applied as if it were adoptedprospectively from the earliest date practicable. SFAS 154 will be effectivefor accounting changes and corrections of errors made in fiscal years beginningafter December 15, 2005. This statement does not change the transitionprovisions of any existing accounting pronouncements, including those that arein a transition phase as of the effective date of this statement. We do notexpect the provisions of the SFAS 154 to have a significant impact on ourconsolidated financial statements.

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs—An Amendment of ARB No. 43,Chapter 4.*SFAS No. 151 amends the guidance in AccountingResearch Bulletin (“ARB”) No. 43, Chapter 4, *InventoryPricing*, to clarify the accounting for abnormal amounts of idlefacility expense, freight, handling costs, and wasted material (spoilage).Among other provisions, the new rule requires that items such as idlefacility expense, excessive spoilage, double freight, and rehandling costs berecognized as current-period charges regardless of whether they meet thecriterion of “so abnormal” as stated in ARB No. 43. Additionally, SFAS 151requires that the allocation of fixed production overheads to the costs ofconversion be based on the normal capacity of the production facilities. SFAS No. 151is effective for fiscal years beginning after June 15, 2005 and isrequired to be adopted in the first quarter of fiscal 2006. We do not expectthe adoption of SFAS No. 151 to have a material impact on our consolidatedfinancial statements.

In December 2004, the FASB issued FASB Statement No. 123(revised 2004) *Share-Based Payment,* or SFAS123R, which is a revision of FASB Statement No. 123, Accounting forStock-Based Compensation. SFAS 123R supersedes APB opinion No. 25,Accounting for Stock Issued to employees, and amends FASB Statement No. 95,Statement of Cash Flows. Generally, the approach in SFAS 123R is similar to theapproach described in Statement 123. However, SFAS 123R requires allshare-based payments to employees, including grants of employee stock options,to be recognized in the income statement based on their fair values rather thanpro forma footnote disclosure. SFAS No. 123Ris effective for public companies in the first fiscal year beginning on orafter January 1, 2006.

SFAS 123R requires measurement of the cost ofshare-based payment transactions to employees at the fair value of the award onthe grant date and recognition of expense over the requisite service or vestingperiod. SFAS 123R allows implementation using a modified version of prospectiveapplication, under which compensation expense for the unvested portion ofpreviously granted awards and all new awards will be recognized on or after thedate of adoption. FAS 123R also allows companies to implement 

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by restating previouslyissued financial statements, basing the amounts on the expense previouslycalculated and reported in their pro forma footnote disclosures required underFAS 123. We will adopt FAS 123R using the modified prospective method beginningJanuary 1, 2006. The impact of adopting FAS 123R on our consolidatedresults of operations is not expected to differ materially from the pro formadisclosures currently required by FAS 123 (see “Employee stock-basedcompensation”). In addition, FAS 123R requires classification of the taxbenefit from the exercise of stock options in cash flows from financingactivities, rather than cash flows from operating activities. In 2005, cashflows from operating activities included a cash inflow of $7.6 million relatedto tax benefits from the exercise of stock options.

In July 2005, the FASB issued an exposure draftof a proposed interpretation*, Accounting for UncertainTax Positions—an Interpretation of FASB Statement No. 109.*Theproposed interpretation would apply to all open tax positions accounted for inaccordance with SFAS No. 109, including those acquired in businesscombinations. In October 2005, the FASB decided to postpone issuance ofthe final interpretation until fiscal year 2006. The Company will evaluate theimpact of any change in accounting standard on the Company’s financial positionand results of operations when the final interpretation is issued.

In June 2005, the Emerging Issues Task Force(“EITF”) issued EITF Issue 05-6, *Determining theAmortization Period for Leasehold Improvements Purchased after Lease Inceptionor Acquired in a Business Combination.* The EITF reached a consensusthat the amortization period for leasehold improvements acquired in a businesscombination or acquired subsequent to lease inception should be based on the lesserof the useful life of the leasehold improvements or the period of the leaseincluding all renewal periods that are reasonably assured of exercise at thetime of the acquisition. This consensus is consistent with the Company’s policyregarding leasehold improvements. The adoption of EITF Issue 05-6 did nothave a material impact on our consolidated financial statements.

In October 2005, the FASB issued FASB StaffPosition (“FSP”) No. FAS 13-1 (“FSP13-1”), *Accounting for Rental Costs Incurred during the Construction Period,*whichrequires that rental costs associated with ground or building operating leasesthat are incurred during a construction period be recognized as rental expense.These rental costs shall be included in income from continuing operations. Theeffective date of this FSP guidance is the first reporting period beginningafter December 15, 2005. Early adoption is permitted for financialstatements or interim financial statements that have not yet been issued. Theadoption of FSP 13-1 will not have a material impact on our consolidatedfinancial statements.

In March 2005, theFASB issued FASB Interpretation No. 47 (“FIN 47”), *Accountingfor Conditional Asset Retirement Obligations*, which is aninterpretation of SFAS No. 143 (“SFAS 143”), *Accountingfor Asset Retirement Obligations*. FIN 47 clarifies terminologywithin SFAS 143 and requires an entity to recognize a liability for the fairvalue of a conditional asset retirement obligation when incurred if theliability’s fair value can be reasonably estimated. FIN 47 is effective forfiscal years ending after December 15, 2005. The adoption of FIN 47 didnot have a material impact on our consolidated financial statements.

**Seasonality**

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

**Inflation**

We believe that therelatively moderate rates of inflation experienced in recent years have not hada significant impact on our net sales or profitability. However, in 2006 we anticipatethat rising steel, lumber, 

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concrete,labor, fuel and freight costs may increase expenses related to opening,remodeling, operating and relocating our stores, expanding our distributioncenter and operating our business.

**Forward-LookingStatements; Business Risks**

This annual report contains forward-looking statementsrelating to, among other things, future results of operations, growth andinvestment plans, sales, trends in gross margin, growth in the Internet portionof our direct response business and other factors affecting growth in sales andearnings. Specific forward-looking statements are provided regarding ourmanagement’s current views regarding comparable store sales, new storeopenings, capital expenditure levels and the dates new facilities and systemswill become operational. Statements regarding new store openings are basedlargely on our current expectations and are necessarily subject to associatedbusiness risks related to, among other things, the identification of suitablesites or acquisition opportunities, the timely construction, staffing andmerchandising of those stores and other matters, some of which are outside ofour control. Comparable store sales growth is highly dependent upon the stateof the economy, the effectiveness of our sales and promotion strategies, andthe effect of competition, including other national operators of music productsstores attempting to implement national growth strategies. Statements regardingthe dates new facilities and systems will become operational are dependent uponthird parties and events beyond our control, such as the availability of thirdparty consulting resources, construction delays, technology development delaysand other events. Sales and earnings trends are also affected by many otherfactors including, among others, world and national political events, generaleconomic conditions, the effectiveness of our promotion and merchandising strategies,changes in the music products industry, retail sales trends and the emergenceof new or growing specialty retailers of music products.

In light of these risks, there can be no assurancethat the forward-looking statements contained in this report will in fact berealized. The statements made by us in this report represent our views as ofthe date of this report, and it should not be assumed that the statements madeherein remain accurate as of any future date. We do not presently intend toupdate these statements and undertake no duty to any person to affect any suchupdate under any circumstances.

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

**Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

We do not have any assetsor liabilities which, in our view, impose upon us significant market riskexcept for our outstanding indebtedness represented by $100 million principalamount of our convertible notes with a fixed interest rate of 4% (subject tocontingent interest commencing January 15, 2006) and our credit facilitywhich has a variable rate of interest generally consisting of stated premiumsabove LIBOR. As of December 31, 2005, the fair value of our 4% SeniorConvertible Notes was $148 million, based on quoted market prices. At December 31,2005, we had $32.3 million in outstanding borrowings under our credit facility.To the extent prevailing short-term interest rates fluctuate, the interestexpense we incur on our credit facility will change with a resulting effect(positive or negative) on our financial position, results of operations andcash flows. We do not use derivative financial instruments in our investmentportfolio. Historically, we have not carried significant cash balances and anycash in excess of our daily operating needs has been used to reduce ourborrowings. Excess cash is generally invested in short-term, high qualityinterest bearing investments.

**Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA**

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

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**Item9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND**FINANCIAL DISCLOSURE

Not Applicable

**Item 9A. CONTROLS AND PROCEDURES**

**Disclosure Controls andProcedures**

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in our reportsfiled pursuant to the Exchange Act is recorded, processed, summarized andreported within the time periods specified in the Securities and ExchangeCommission’s rules and forms and that such information is accumulated andcommunicated to our management, including our Chief Executive Officer and ChiefFinancial Officer, as appropriate, to allow for timely decisions regardingrequired disclosure. In designing and evaluating the disclosure controls andprocedures, management recognizes that any controls and procedures, no matterhow well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and management is required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

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

**Management’s Report on Internal Control Over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rules 13a-15(e) and 15d-15(e).Under the supervision and with the participation of our management, includingour principal executive officer and principal financial officer, we conductedan assessment of the effectiveness of our internal control over financialreporting based on the framework in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission.Based on our evaluation under the framework in Internal Control—IntegratedFramework, our management concluded that our internal control over financialreporting was effective as of December 31, 2005.

GuitarCenter, Inc. acquired Music & Arts Center, Inc., on April 15,2005, and management excluded from its assessment of the effectiveness ofGuitar Center, Inc.’s internal control over financial reporting as of December 31,2005, Music & Arts Center internal control over financial reportingassociated with total assets of $197.0 million and total revenues of $103.1million included in the consolidated financial statements of Guitar Center, Inc.and subsidiaries as of and for the year ended December 31, 2005.

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

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

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**Changes in Internal Control Over Financial Reporting**

Our management’sassessment of the effectiveness of our internal control over financialreporting as of December 31, 2005 has been audited by KPMG LLP, anindependent registered public accounting firm, as stated in their report whichis included herein.

**Report of Independent Registered Public AccountingFirm**

The Boardof Directors and StockholdersGuitar Center, Inc.:

We haveaudited management’s assessment, included in the accompanying Management’s Reporton Internal Controls, that Guitar Center, Inc. maintained effectiveinternal control over financial reporting as of December 31, 2005, basedon criteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO). GuitarCenter, Inc.’s management is responsible for maintaining effectiveinternal control over financial reporting and for its assessment of theeffectiveness of internal control over financial reporting. Our responsibilityis to express an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

Weconducted our audit in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that weplan and perform the audit to obtain reasonable assurance about whethereffective internal control over financial reporting was maintained in allmaterial respects. Our audit included obtaining an understanding of internalcontrol over financial reporting, evaluating management’s assessment, testingand evaluating the design and operating effectiveness of internal control, andperforming such other procedures as we considered necessary in thecircumstances. We believe that our audit provides a reasonable basis for ouropinion.

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

Because ofits inherent limitations, internal control over financial reporting may not preventor detect misstatements. Also, projections of any evaluation of effectivenessto future periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

In ouropinion, management’s assessment that Guitar Center, Inc. maintainedeffective internal control over financial reporting as of December 31,2005, is fairly stated, in all material respects, based on criteria establishedin Internal Control—Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO). Also, in our opinion, GuitarCenter, Inc. maintained, in all material respects, effective internalcontrol over financial reporting as of December 31, 2005, based oncriteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO).

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GuitarCenter, Inc. acquired Music & Arts Center, Inc., on April 15,2005, and management excluded from its assessment of the effectiveness ofGuitar Center, Inc’s internal control over financial reporting as of December 31,2005, Music & Arts Center’s internal control over financial reportingassociated with total assets of $197,045,000 and total revenues of $103,116,000included in the consolidated financial statements of Guitar Center, Inc.and subsidiaries as of and for the year ended December 31, 2005. Our auditof internal control over financial reporting of Guitar Center, Inc. alsoexcluded an evaluation of the internal control over financial reporting ofMusic & Arts Center.

We also have audited, in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates), the consolidated balance sheets of Guitar Center, Inc. andsubsidiaries as of December 31, 2005 and 2004, and the relatedconsolidated statements of income, stockholders’ equity, and cash flows foreach of the years in the three-year period ended December 31, 2005, andour report dated March 9, 2006 expressed an unqualified opinion on thoseconsolidated financial statements.
| /s/ KPMG LLP             |
|--------------------------|
| Los Angeles,  California |
| March 9, 2006            |

 

**Item 9B. OTHER INFORMATION**

Not Applicable

**PART III**

**Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THEREGISTRANT**

We have adopted a code of business conduct and ethics,or code of conduct, containing general guidelines for conducting our businessconsistent with the highest standards of business ethics. The code of conductis designed to qualify as a “code of ethics” within the meaning ofSection 406 of the Sarbanes-Oxley Act of 2002 and therules promulgated thereunder as well as under applicable rules of theNasdaq National Market. The code is available on the investor relations sectionof our website (www.guitarcenter.com), under subsection captioned “CorporateGovernance.” To the extent required by law or the rules of the NASDAQNational Market, any amendments to, or waivers from, any provision of the codewill be promptly disclosed publicly. To the extent permitted by suchrequirements, we intend to make such public disclosure by posting the relevantmaterial on the corporate governance page of the investor relationssection of our website in accordance with SEC rules.

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

**Item 11. EXECUTIVE COMPENSATION**

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

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

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

**Item 13. CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

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

**Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES**

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

**PART IV**

**Item 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES**

(a)           Documents filed as partof this Report:

1.                Thefollowing financial statements for the Company are included as part of thisReport:

| Index to Financial  Statements | Page 56 |
|--------------------------------|--------------|

 

2.                Thefollowing financial statement schedule for the Company is included as part ofthis Report:

| Schedule II—Valuation and Qualifying Accounts | Page II-1 |
|----------------------------------------------------|----------------|

 

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

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

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**INDEX TO EXHIBITS**

| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                              | ** ** | **Description** |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 2.1              |       | Agreement and Plan of  Merger, dated as of February 8, 2005, by and among Guitar Center  Stores, Inc., a Delaware corporation, GCSI Acqusition Corp., a Maryland  corporation, Music & Arts Center, Inc., a Maryland corporation,  and the common stockholders of Music & Arts Center, Inc.  (Incorporated by reference to Exhibit 10.2 of the Company’s Current  Report on Form 8-K dated February 8, 2005). |
| 3.1              |       | Restated  Certificate of Incorporation (Incorporated by reference to Exhibit 3.5  of the Company’s Registration Statement on Form S-1; Registration  No. 333-20931).                                                                                                                                                                                                                                                                                |
| 3.2              |       | Amended and  Restated Bylaws (Filed herewith)                                                                                                                                                                                                                                                                                                                                                                                                                           |
| 4.1              |       | Indenture dated  as of June 10, 2003 by and between the Company and BNY Western Trust  Company as trustee (Incorporated by reference to Exhibit 4.1 of the  Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 2003).                                                                                                                                                                                                |
| 4.2              |       | Form of  Indenture (Incorporated by reference to Exhibit 4.3 of the Company’s  Registration Statement on Form S-3; Registration No. 333-65220).                                                                                                                                                                                                                                                                                                |
| 4.3              |       | Form of  Stock Certificate (Incorporated by reference to Exhibit 4.4 of the  Company’s Registration Statement on Form S-1; Registration  No. 333-20931).                                                                                                                                                                                                                                                                                       |
| 4.4              |       | Form of  Officer’s Certificate pursuant to Section 2.02 of the Indenture  governing the Senior Convertible Notes due 2013 (Incorporated by reference to  Exhibit 4.1 to the Company’s Current Report on Form 8-K dated  June 13, 2003).                                                                                                                                                                                              |
| 4.5              |       | Form of  Global Note relating to the Senior Convertible Notes due 2013 (Incorporated  by reference to Exhibit 4.2 to the Company’s Current Report on  Form 8-K dated June 13, 2003).                                                                                                                                                                                                                                                           |
| 10.1*            |       | The Company’s  Amended and Restated 1996 Performance Stock Option Plan (Incorporated by  reference to Exhibit 10.5 of the Company’s Registration Statement on  Form S-1; Registration No. 333-20931).                                                                                                                                                                                                                                          |
| 10.2*            |       | Modification to  Amended and Restated 1996 Performance Stock Option Plan (Incorporated by  reference to Exhibit 10.28 of the Company’s Registration Statement on  Form S-1; Registration No. 333-20931).                                                                                                                                                                                                                                            |
| 10.3*            |       | Amendment  No. 2 to the Amended and Restated 1996 Performance Stock Option Plan  (Incorporated by reference to Exhibit 10.30 of the Company’s  Registration Statement on Form S-1; Registration No. 333-20931).                                                                                                                                                                                                                                |
| 10.4*            |       | Amendment  No. 3 to Amended and Restated 1996 Performance Stock Option Plan  (Incorporated by reference to Exhibit 10.29 of the Company’s Annual  Report on Form 10-K for the fiscal year ended December 31,  1998).                                                                                                                                                                                                                           |
| 10.5*            |       | Amended 1997  Equity Participation Plan (Incorporated by reference to Exhibit 10.22 of  the Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 1998).                                                                                                                                                                                                                                                                     |
| 10.6*            |       | Amendment to the  1997 Equity Participation Plan approved by stockholders at the 2000 Annual  Meeting of Stockholders (Incorporated by reference to Exhibit 10.36 of  the Company’s Annual Report on Form 10-K for the fiscal year ended  December 31, 1999).                                                                                                                                                                                       |
| 10.7*            |       | Amendment to the 1997  Equity Participation Plan approved by stockholders at the 2001 Annual Meeting  of Stockholders (Incorporated by reference to Exhibit 10.37 to the  Company’s Quarterly Report on Form 10-Q for the period ended  March 31, 2001).                                                                                                                                                                                            |

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| 10.8*  |   | Amendment to the 1997 Equity Participation Plan  approved July 26, 2001 (Incorporated by reference to Exhibit 10.42  to the Company’s Quarterly Report on Form 10-Q for the period  ended September 30, 2001).                                         |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.9*  |   | Amendment to the 1997 Equity Participation Plan approved  by stockholders at the 2003 Annual Meeting of Stockholders (Incorporated by  reference to Exhibit 10.40 to the Company’s Quarterly Report on  Form 10-Q for the period ended March 31, 2003).     |
| 10.10* |   | Amendment to the 1997 Equity Participation Plan approved  April 29, 2004 (Incorporated by reference to Exhibit 10.5 to the  Company’s Quarterly Report on Form 10-Q for the period ended  June 30, 2004).                                              |
| 10.11* |   | Form of  Employee Stock Purchase Plan as approved by stockholders at the 2001 Annual  Meeting of Stockholders (Incorporated by reference to Exhibit 10.38 to  the Company’s Quarterly Report Form 10-Q for the period ended  March 31, 2001).          |
| 10.12* |   | 2004 Guitar  Center, Inc. Incentive Stock Award Plan (Incorporated by reference to  the Definitive 2004 Proxy Statement as filed on Schedule 14A).                                                                                                                         |
| 10.13* |   | Form of  Amendment to the 2004 Guitar Center, Inc. Incentive Stock Award Plan  (Incorporated by reference to Exhibit 99.1 of the Company’s Current  Report on Form 8-K dated March 11, 2005).                                                     |
| 10.14* |   | Form of  Stock Option Agreement under the 2004 Guitar Center, Inc. Incentive  Stock Award Plan (Incorporated by reference to Exhibit 10.1 to the  Company’s Quarterly Report on Form 10-Q for the period ended  September 30, 2004).              |
| 10.15* |   | Form of  Restricted Stock Agreement under the 2004 Guitar Center, Inc. Incentive  Stock Award Plan (Incorporated by reference to Exhibit 10.2 to the  Company’s Quarterly Report on Form 10-Q for the period ended  September 30, 2004).          |
| 10.16* |   | Form of  Non-Employee Director Restricted Stock Agreement under the 2004 Guitar  Center, Inc. Incentive Stock Award Plan (Incorporated by reference to  Exhibit 10.5 of the Company’s Current Report on Form 8-K  dated July 28, 2005).                |
| 10.17* |   | Form of  Deferred Stock Agreement under the 2004 Guitar Center, Inc. Incentive  Stock Award Plan (Incorporated by reference to Exhibit 10.3 to the Company’s  Quarterly Report on Form 10-Q for the period ended  September 30, 2004).            |
| 10.18* |   | Guitar  Center, Inc. Senior Executive Performance Bonus Plan (Incorporated by  reference to Exhibit 10.35 to the Company’s Quarterly Report on  Form 10-Q for the period ended March 31, 2003).                                                        |
| 10.19* |   | Guitar  Center, Inc. 2005 Long Term Incentive Plan (Incorporated by reference to  Exhibit 10.2 of the Company’s Current Report on Form 8-K  dated July 28, 2005).                                                                                      |
| 10.20* |   | Form of  Indemnification Agreement between the Company and each of its directors and  executive officers (Filed herewith).                                                                                                                                                 |
| 10.21* |   | Compensation  Committee Non-Employee Director Equity Compensation Policy (Incorporated by  reference to Exhibit 10.4 of the Company’s Current Report on Form 8-K  dated July 28, 2005).                                                                     |
| 10.22* |   | Second Amended and  Restated Employment Agreement, dated as of October 8, 2004, between  Guitar Center, Inc. and Marty Albertson (Incorporated by reference to  Exhibit 99.1 of the Company’s Current Report on Form 8-K  dated October 8, 2004). |

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| 10.23* |   | Amendment No. 1 to Second Amended and Restated  Employment Agreement made effective as of July 28, 2005 between Guitar  Center, Inc., and Marty Albertson (Incorporated by reference to  Exhibit 10.3 of the Company’s Current Report on Form 8-K  dated July 28, 2005).                                                                                                |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.24* |   | Third Amended and  Restated Employment Agreement dated July 1, 2003 between Guitar  Center, Inc. and Bruce Ross (Incorporated by reference to  Exhibit 10.45 to the Company’s Quarterly Report on Form 10-Q  for the period ended September 30, 2003).                                                                                                                       |
| 10.25* |   | Amendment No. 1 dated January 1, 2004 to  Third Amended and Restated Employment Agreement between Guitar  Center, Inc. and Bruce Ross (Incorporated by reference to  Exhibit 10.1 to the Company’s Quarterly Report on Form 10-Q  for the period ended June 30, 2004).                                                                                                  |
| 10.26* |   | Transition  Agreement between Guitar Center, Inc. and Bruce L. Ross, dated effective  as of February 10, 2006 (Incorporated by reference to Exhibit 10.2  of the Company’s Current Report on Form 8-K dated  February 10, 2006).                                                                                                                                             |
| 10.27* |   | Third Amended and  Restated Employment Agreement between Musician’s Friend, Inc. and Robert  V. Eastman, dated effective as of January 1, 2006 (Incorporated by  reference to Exhibit 10.1 of the Company’s Current Report on Form 8-K  dated January 30, 2006).                                                                                                        |
| 10.28* |   | Employment Agreement, dated as of April 15,  2005, by and between Music & Arts Center, Inc., a Maryland  corporation, and Kenneth O’Brien (Incorporated by reference to  Exhibit 99.3 of the Company’s Current Report on Form 8-K  dated April 15, 2005).                                                                                                      |
| 10.29* |   | Agreement Not To  Compete, dated as of April 15, 2005, by and between Guitar Center  Stores, Inc., a Delaware corporation, and Kenneth O’Brien (Incorporated  by reference to Exhibit 99.4 of the Company’s Current Report on  Form 8-K dated April 15, 2005).                                                                                                          |
| 10.30* |   | Form of  Executive Severance Benefits Agreement between Guitar Center, Inc.,  Musician’s Friend, Inc. or Guitar Center Stores, Inc. and our  executive officers not party to employment agreements (Incorporated by  reference to Exhibit 10.1 to the Company’s Quarterly Report on  Form 10-Q for the period ended June 30, 2004).                           |
| 10.31  |   | Lease Agreement,  dated as of August 15, 2001, by and between Guitar Center  Stores, Inc. and Eaglepoint Partners Two, LLC (Incorporated by reference  to Exhibit 10.27 to the Company’s Annual Report on Form 10-K  for the year ended December 31, 2001).                                                                                                                  |
| 10.32  |   | Master Lease  Agreement, dated as of March 4, 2002, between Guitar Center, Inc.  and General Electric Capital Corporation (Incorporated by reference to  Exhibit 10.31 to the Company’s Quarterly Report on Form 10-Q  for the quarterly period ended March 31, 2002).                                                                                                       |
| 10.33  |   | Standard  Industrial/Commercial Single-Tenant Lease by and between The J. David  Gladstone Institutes, a Charitable Trust, as lessor and Guitar Center, Inc.  as lessee relating to 5795 Lindero Canyon Road, Westlake Village, California  (Incorporated by reference to Exhibit 10.36 to the Company’s Quarterly  Report on Form 10-Q for the period ended March 31, 2003).     |
| 10.34  |   | Addendum to  Industrial/Commercial Single-Tenant Lease by and between The J. David  Gladstone Institutes, a Charitable Trust, as lessor and Guitar  Center, Inc. as lessee relating to 5795 Lindero Canyon Road, Westlake  Village, California (Incorporated by reference to Exhibit 10.37 to the  Company’s Quarterly Report on Form 10-Q for the period ended  March 31, 2003). |

51

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| 10.35 |   | Standard Commercial Lease by and between Mid-West  Terminal Warehouse Company as lessor and Musician’s Friend, Inc. as  lessee relating to 1491 North Universal Avenue, Kansas City, Missouri  (Incorporated by reference to Exhibit 10.38 to the Company’s Quarterly  Report on Form 10-Q for the period ended March 31, 2003).                                                                                        |
|-------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.36 |   | Addendum to  Commercial Lease Agreement by and between Mid-West Terminal Warehouse  Company, Inc. as lessor and Musician’s Friend, Inc. as lessee  relating to 1491 North Universal Avenue, Kansas City, Missouri (Incorporated  by reference to Exhibit 10.39 to the Company’s Quarterly Report on  Form 10-Q for the period ended March 31, 2003).                                                               |
| 10.37 |   | Agreement and  Escrow Instructions for Purchase of Real Estate, dated as of July 29,  2005, by and between Guitar Center, Inc. and John and Denise Gooden  (Incorporated by reference to Exhibit 10.1 of the Company’s Current  Report on Form 8-K dated July 28, 2005).                                                                                                                                                |
| 10.38 |   | First Amendment to Lease dated November 2,  2005, by and between Brownsburg Music LLC and Guitar Center Stores, Inc.  (Incorporated by reference to Exhibit 10.1 of the Company’s Current  Report on Form 8-K dated November 2, 2005).                                                                                                                                                                                  |
| 10.39 |   | Aircraft Sale and  Purchase Agreement dated as of March 4, 2005 by and between Guitar  Center, Inc., a Delaware corporation, and Taxi Aereo De Veracruz, S.A.  de C.V., a corporation organized under the laws of Mexico, regarding a Falcon  50 aircraft (Incorporated by reference to Exhibit 10.01 to the Company’s  Current Report on Form 8-K dated March 10, 2005).                                               |
| 10.40 |   | Aircraft Time  Sharing Agreement between Guitar Center, Inc. and Marty Albertson, dated  February 15, 2006 (Incorporated by reference to Exhibit 10.1 of the  Company’s Current Report on Form 8-K dated February 10,  2006).                                                                                                                                                                                           |
| 10.41 |   | Second Amended  and Restated Loan and Security Agreement entered into as of December 21,  2001, between and among the Company, Guitar Center Stores, Inc.,  Musician’s Friend, Inc. and the lenders identified therein (Incorporated  by reference to Exhibit 10.30 to the Company’s Annual Report on  Form 10-K for the year ended December 31, 2001).                                                       |
| 10.42 |   | Consent and  Amendment, dated as of June 9, 2003, by and among, Wells Fargo Retail  Finance, LLC, as the arranger and administrative agent, the lenders named  therein, and Guitar Center, Inc., Guitar Center Stores, Inc. and  Musician’s Friend, Inc., as borrowers (Incorporated by reference to  Exhibit 10.42 to the Company’s Quarterly Report on Form 10-Q  for the period ended June 30, 2003). |
| 10.43 |   | Second Amendment  to Second Amended and Restated Loan and Security Agreement between Guitar  Center, Inc. and Wells Fargo Retail Finance, LLC (Incorporated by  reference to Exhibit 10.36 of the Company’s Annual Report on  Form 10-K for the fiscal year ended December 31, 2003).                                                                                                                                        |
| 10.44 |   | Third Amendment  to Second Amended and Restated Loan and Security Agreement, effective  February 8, 2005 (Incorporated by reference to Exhibit 10.1 of the  Company’s Current Report on Form 8-K dated February 8, 2005).                                                                                                                                                                                                    |
| 12.1  |   | Ratio of Earnings  to Fixed Charges (Filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                 |
| 21.1  |   | Material  subsidiaries of the Registrant as of December 31, 2005 (Filed herewith).                                                                                                                                                                                                                                                                                                                                                               |
| 23.1  |   | Consent of Independent  Registered Public Accounting Firm (KPMG LLP) (Filed herewith).                                                                                                                                                                                                                                                                                                                                                                |
| 24.1  |   | Power of Attorney  (Included on page 54).                                                                                                                                                                                                                                                                                                                                                                                                        |
| 31.1  |   | Certification of  the Company’s Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 (Filed herewith).                                                                                                                                                                                                                                                                                                        |

52

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| 31.2 |   | Certification of the  Company’s Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002 (Filed herewith). |
|------|--------|------------------------------------------------------------------------------------------------------------------------------------------------|
| 32.1 |   | Certification of  the Company’s Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (Filed herewith). |
| 32.2 |   | Certification of the  Company’s Chief Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 (Filed herewith). |

----

*                    Management contractor other compensation plan or arrangement.

53

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, as amended, the Registrant has duly caused this Report to be signed onits behalf by the undersigned, thereunto duly authorized as of this 9th day ofMarch 2006.

|        | GUITAR CENTER, INC.                     |
|--------|-----------------------------------------|
|   | /s/   MARTY  ALBERTSON             |
|   | Marty Albertson                         |
|   | *Chairman  and Chief Executive Officer* |

 

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

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, this Reporthas been signed below by the following persons on behalf of the Registrant andin the capacities and on the dates indicated.

|                                 | **Name** | ** **                                      | ** ** |                | **Title** | ** ** | ** ** |  | **Date** | ** ** |
|---------------------------------|----------|-------------------------------------------------|------------|----------------|-----------|------------|------------|--|----------|------------|
| /s/  MARTY ALBERTSON  |     | Chief Executive Officer  and Director           |       | March  9, 2006 |
| Marty Albertson                 |     |                                            |       |           |
| /s/  BRUCE ROSS       |     | Executive Vice President  and Chief             |       | March  9, 2006 |
| Bruce Ross                      |     | Financial Officer (Principal Financial Officer) |       |           |
| /s/  DAVID ROBSON     |     | Senior Vice President of  Finance               |       | March  9, 2006 |
| David Robson                    |     | (Principal Accounting Officer)                  |       |           |
| /s/  LARRY LIVINGSTON |     | Director                                        |       | March  9, 2006 |
| Larry Livingston                |     |                                            |       |           |
| /s/  BOB MARTIN       |     | Director                                        |       | March  9, 2006 |
| Bob Martin                      |     |                                            |       |           |
| /s/  PAT MACMILLAN    |     | Director                                        |       | March  9, 2006 |
| Pat MacMillan                   |     |                                            |       |           |

54

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| /s/  GEORGE MRKONIC |   | Director |   | March  9, 2006 |
|-------------------------------|--------|----------|--------|----------------|
| George Mrkonic                |   |     |   |           |
| /s/  KENNETH REISS  |   | Director |   | March 9, 2006  |
| Kenneth Reiss                 |   |     |   |           |
| /s/  WALTER ROSSI   |   | Director |   | March  9, 2006 |
| Walter Rossi                  |   |     |   |           |
| /s/  PETER STARRETT |   | Director |   | March  9, 2006 |
| Peter Starrett                |   |     |   |           |
| /s/  PAUL  TARVIN   |   | Director |   | March 9, 2006  |
| Paul Tarvin                   |   |     |   |           |

 

 

55

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**INDEXTO FINANCIAL STATEMENTS**

| Report of Independent  Registered Public Accounting Firm                                                                   | 57           |   |
|----------------------------------------------------------------------------------------------------------------------------|--------------|--------|
| Consolidated Balance Sheets  as of December 31, 2005 and 2004                                                         | 58           |   |
| Consolidated Statements of  Income for the years ended December 31, 2005, 2004 and 2003                               | 59           |   |
| Consolidated Statements of  Stockholders’ Equity for the years ended December 31, 2005, 2004 and 2003  | 60           |   |
| Consolidated Statements of  Cash Flows for the years ended December 31, 2005, 2004 and 2003                           | 61           |   |
| Notes to Consolidated Financial Statements                                                                                 | 62           |   |
| ** **                                                                                                                 | **Schedule** |
| Financial Statement Schedule:                                                                                              |         |
| Valuation and  Qualifying Accounts                                                                                         | II-1         |   |

 

 

56

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directors and StockholdersGuitar Center, Inc.:

We have audited the accompanying consolidated balancesheets of Guitar Center, Inc. and subsidiaries as of December 31,2005 and 2004, and the related consolidated statements of income, stockholders’equity, and cash flows for each of the years in the three-year period ended December 31,2005. These consolidated financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on theseconsolidated financial statements based on our audits.

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

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Guitar Center, Inc. and subsidiaries as of December 31,2005 and 2004, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2005, inconformity with U.S. generally accepted accounting principles.

Wealso have audited, in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the effectiveness of Guitar Center, Inc.’sinternal control over financial reporting as of December 31, 2005, basedon criteria established in Internal Control—Integrated Framework issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO), andour report dated March 9, 2006 expressed an unqualified opinion onmanagement’s assessment of, and the effective operation of, internal controlover financial reporting.
| /s/ KPMG LLP            |   |
|-------------------------|--------|
| Los Angeles, California |
| March 9, 2006      |

 

57

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**GUITARCENTER, INC. AND SUBSIDIARIESCONSOLIDATED BALANCE SHEETS(In thousands, except per share data)**

| ** **                                                                                                                                              | ** ** | **December 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                                                              |       |                        |       |                        |       |   |   |   |   |
| Current assets:                                                                                                                                         |       |                        |       |                        |       |   |   |   |   |
| Cash and cash equivalents                                                                                                                               |       |                        | $          | 14,529                      |       |   |   | $ | 60,453 |   |   |
| Investments in marketable securities                                                                                                                    |       |                        | —     |                        |       |   | 3,810 |   |   |
| Accounts receivable, less allowance for doubtful  accounts $4,931 and $3,489, respectively                                                              |       |                        | 40,844     |                        |       |   | 27,627 |   |   |
| Merchandise inventories                                                                                                                                 |       |                        | 445,771    |                        |       |   | 314,961 |   |   |
| Prepaid expenses and deposits                                                                                                                           |       |                        | 15,533     |                        |       |   | 13,367 |   |   |
| Deferred income taxes                                                                                                                                   |       |                        | 13,492     |                        |       |   | 5,552 |   |   |
| Total current  assets                                                                                                                                   |       |                        | 530,169    |                        |       |   | 425,770 |   |   |
| Property and  equipment, net                                                                                                                            |       |                        | 149,209    |                        |       |   | 97,349 |   |   |
| Investments in  marketable securities                                                                                                                   |       |                        | —     |                        |       |   | 16,997 |   |   |
| Goodwill                                                                                                                                                |       |                        | 85,929     |                        |       |   | 26,474 |   |   |
| Deposits and  other assets, net                                                                                                                         |       |                        | 14,883     |                        |       |   | 8,003 |   |   |
|                                                                                                                                                    |       |                        | $          | 780,190                     |       |   |   | $ | 574,593 |   |   |
| **Liabilities  and stockholders’ equity**                                                                                                          |       |                        |       |                        |       |   |   |   |   |
| Current liabilities:                                                                                                                                    |       |                        |       |                        |       |   |   |   |   |
| Accounts payable                                                                                                                                        |       |                        | $          | 79,497                      |       |   |   | $ | 49,771 |   |   |
| Accrued expenses and other current liabilities                                                                                                          |       |                        | 106,181    |                        |       |   | 83,606 |   |   |
| Merchandise advances                                                                                                                                    |       |                        | 25,127     |                        |       |   | 22,534 |   |   |
| Borrowing under revolving line of credit                                                                                                                |       |                        | 32,266     |                        |       |   | — |   |   |
| Total current  liabilities                                                                                                                              |       |                        | 243,071    |                        |       |   | 155,911 |   |   |
| Other long-term  liabilities                                                                                                                            |       |                        | 11,995     |                        |       |   | 6,943 |   |   |
| Deferred income  taxes                                                                                                                                  |       |                        | 20,307     |                        |       |   | 5,057 |   |   |
| Long-term debt                                                                                                                                          |       |                        | 100,000    |                        |       |   | 100,000 |   |   |
| Total liabilities                                                                                                                                       |       |                        | 375,373    |                        |       |   | 267,911 |   |   |
| Stockholders’ equity:                                                                                                                              |       |                        |       |                        |       |   |   |   |   |
| Preferred stock; 5,000 authorized, none issued and  outstanding                                                                                         |       |                        | —     |                        |       |   | — |   |   |
| Common stock, $0.01 par value, authorized 55,000  shares, issued and outstanding 26,092 at December 31, 2005 and 25,359 at  December 31, 2004 |       |                        | 261        |                        |       |   | 254 |   |   |
| Additional paid-in capital                                                                                                                              |       |                        | 326,755    |                        |       |   | 305,305 |   |   |
| Retained earnings                                                                                                                                       |       |                        | 77,801     |                        |       |   | 1,123 |   |   |
| Stockholders’  equity                                                                                                                              |       |                        | 404,817    |                        |       |   | 306,682 |   |   |
|                                                                                                                                                    |       |                        | $          | 780,190                     |       |   |   | $ | 574,593 |   |   |

 

*See accompanying notes toconsolidated financial statements.*

58

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

| ** **                                                                       | ** ** | **Year ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                                                                        |       | $                                          | 1,782,499  |   | $ | 1,513,172 |   | $ | 1,275,059 |   |
| Cost of goods  sold, buying and occupancy                                        |       | 1,262,097                                  |       | 1,087,899 |   | 931,014 |   |
| Gross profit                                                                     |       | 520,402                                    |       | 425,273 |   | 344,045 |   |
| Selling, general  and administrative expenses                                    |       | 388,380                                    |       | 317,585 |   | 271,996 |   |
| Operating income                                                                 |       | 132,022                                    |       | 107,688 |   | 72,049 |   |
| Interest expense,  net of interest income of $1,108, $189 and $122, respectively |       | 7,339                                      |       | 5,390 |   | 12,540 |   |
| Income before  income taxes                                                      |       | 124,683                                    |       | 102,298 |   | 59,509 |   |
| Income taxes                                                                     |       | 48,005                                     |       | 38,873 |   | 22,649 |   |
| Net income                                                                       |       | $                                          | 76,678     |   | $ | 63,425 |   | $ | 36,860 |   |
| Net income per  share:                                                           |       |                                       |       |   |   |   |   |
| Basic                                                                            |       | $                                          | 2.96       |   | $ | 2.55 |   | $ | 1.59 |   |
| Diluted                                                                          |       | $                                          | 2.67       |   | $ | 2.29 |   | $ | 1.47 |   |
| Weighted average  shares outstanding:                                            |       |                                       |       |   |   |   |   |
| Basic                                                                            |       | 25,873                                     |       | 24,856 |   | 23,255 |   |
| Diluted                                                                          |       | 29,846                                     |       | 28,976 |   | 26,119 |   |

 

*See accompanying notes toconsolidated financial statements.*

59

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**GUITARCENTER, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands)**

| ** **                                                           | ** ** | **Number of  Shares** | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings  (Accumulated  Deficit)** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------------------------------|------------|-----------|------------|
| Balance at  December 31, 2002                                   |       |                       | 22,746     |              |       |                             | $          | 227                                            |       |      | $          | 253,863 |   |   | $ | (99,162 | ) |   | $ | 154,928 |   |
| Exercise of employee stock options, including tax  benefit of $4,091 |       |                       | 1,203      |              |       |                             | 12         |                                           |       | 21,462    |       |   | — |   |   | 21,474 |   |
| Stock issued under employee stock purchase plan                      |       |                       | 49         |              |       |                             | 1          |                                           |       | 908       |       |   | — |   |   | 909 |   |
| Net income                                                           |       |                       | —     |              |       |                             | —     |                                           |       | —    |       |   | 36,860 |   |   | 36,860 |   |
| Balance at  December 31, 2003                                   |       |                       | 23,998     |              |       |                             | 240        |                                           |       | 276,233   |       |   | (62,302 | ) |   | 214,171 |   |
| Exercise of employee stock options, including tax  benefit of $9,756 |       |                       | 1,313      |              |       |                             | 14         |                                           |       | 27,537    |       |   | — |   |   | 27,551 |   |
| Stock issued under employee stock purchase plan                      |       |                       | 48         |              |       |                             | —     |                                           |       | 1,535     |       |   | — |   |   | 1,535 |   |
| Net income                                                           |       |                       | —     |              |       |                             | —     |                                           |       | —    |       |   | 63,425 |   |   | 63,425 |   |
| Balance at  December 31, 2004                                   |       |                       | 25,359     |              |       |                             | 254        |                                           |       | 305,305   |       |   | 1,123 |   |   | 306,682 |   |
| Exercise of employee stock options, including tax  benefit of $7,591 |       |                       | 687        |              |       |                             | 7          |                                           |       | 19,418    |       |   | — |   |   | 19,425 |   |
| Stock issued under employee stock purchase plan                      |       |                       | 46         |              |       |                             | —     |                                           |       | 2,032     |       |   | — |   |   | 2,032 |   |
| Net income                                                           |       |                       | —     |              |       |                             | —     |                                           |       | —    |       |   | 76,678 |   |   | 76,678 |   |
| Balance at  December 31, 2005                                   |       |                       | 26,092     |              |       |                             | $          | 261                                            |       |      | $          | 326,755 |   |   | $ | 77,801 |   |   | $ | 404,817 |   |

 

*See accompanying notes toconsolidated financial statements.*

60

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**GUITAR CENTER, INC. AND SUBSIDIARIESCONSOLIDATED STATEMENTSOF CASH FLOWS(In thousands)**

| ** **                                                                                     | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                     | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Operating activities:**                                                                      |       |                                       |       |   |   |   |   |
| Net income                                                                                     |       | $                                          | 76,678     |   | $ | 63,425 |   | $ | 36,860 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities:             |       |                                       |       |   |   |   |   |
| Depreciation and  amortization                                                                 |       | 29,000                                     |       | 22,304 |   | 20,620 |   |
| Loss on sale and  disposal of property and equipment                                           |       | 1,849                                      |       | — |   | — |   |
| Amortization of  deferred financing fees                                                       |       | 1,045                                      |       | 1,045 |   | 938 |   |
| Write-off of  deferred financing fees                                                          |       | —                                     |       | — |   | 722 |   |
| Deferred income  taxes                                                                         |       | (5,476                                     | )          | 916 |   | 1,314 |   |
| Tax benefit from  exercise of stock options                                                    |       | 7,591                                      |       | 9,756 |   | 4,091 |   |
| Changes in operating assets and liabilities, net of  acquisitions:                             |       |                                       |       |   |   |   |   |
| Accounts  receivable                                                                           |       | (7,415                                     | )          | (3,341 | ) | (4,052 | ) |
| Merchandise  inventories                                                                       |       | (74,188                                    | )          | (24,281 | ) | 3,220 |   |
| Prepaid expenses  and deposits                                                                 |       | (862                                       | )          | (1,824 | ) | (2,917 | ) |
| Deposits and other  assets                                                                     |       | (733                                       | )          | (2,869 | ) | (657 | ) |
| Accounts payable                                                                               |       | 16,215                                     |       | 1,994 |   | (22,967 | ) |
| Accrued expenses  and other current liabilities                                                |       | 19,397                                     |       | 11,990 |   | 17,320 |   |
| Other long-term  liabilities                                                                   |       | 4,314                                      |       | 961 |   | 291 |   |
| Merchandise  advances                                                                          |       | (1,705                                     | )          | 5,430 |   | 3,222 |   |
| Net cash provided  by operating activities                                                     |       | 65,710                                     |       | 85,506 |   | 58,005 |   |
| **Investing activities:**                                                                      |       |                                       |       |   |   |   |   |
| Purchase of  property and equipment                                                            |       | (75,493                                    | )          | (26,151 | ) | (24,245 | ) |
| Purchase of  available-for-sale securities                                                     |       | (27,305                                    | )          | (20,807 | ) | — |   |
| Proceeds from the  sale of available-for-sale securities                                       |       | 47,460                                     |       | — |   | — |   |
| Acquisition of  businesses, net of cash acquired                                               |       | (102,428                                   | )          | (2,775 | ) | — |   |
| Net cash used in  investing activities                                                         |       | (157,766                                   | )          | (49,733 | ) | (24,245 | ) |
| **Financing activities:**                                                                      |       |                                       |       |   |   |   |   |
| Net change in  revolving line of credit                                                        |       | 32,266                                     |       | — |   | (82,690 | ) |
| Proceeds from  exercise of stock options                                                       |       | 11,834                                     |       | 17,795 |   | 17,383 |   |
| Proceeds from  stock issued under employee purchase plan                                       |       | 2,032                                      |       | 1,535 |   | 909 |   |
| Net proceeds from  Senior Convertible Note                                                     |       | —                                     |       | — |   | 96,875 |   |
| Payments on Senior  Note                                                                       |       | —                                     |       | — |   | (66,667 | ) |
| Payments under  capital lease                                                                  |       | —                                     |       | — |   | (151 | ) |
| Net cash provided  by (used in) financing activities                                           |       | 46,132                                     |       | 19,330 |   | (34,341 | ) |
| Net (decrease)  increase in cash and cash equivalents                                          |       | (45,924                                    | )          | 55,103 |   | (581 | ) |
| Cash and cash  equivalentsat beginning of year                                                 |       | 60,453                                     |       | 5,350 |   | 5,931 |   |
| Cash and cash  equivalentsat end of period                                                     |       | $                                          | 14,529     |   | $ | 60,453 |   | $ | 5,350 |   |
| **Non-cash investing activities:**                                                             |       |                                       |       |   |   |   |   |
| Acquisition of businesses, in which the fair value of  assets and liabilities were as follows: |       |                                       |       |   |   |   |   |
| Current assets                                                                                 |       | $                                          | 6,386      |   | $ | 2,528 |   | $ | — |   |
| Inventory                                                                                      |       | 57,655                                     |       | — |   | — |   |
| Property and  equipment                                                                        |       | 3,428                                      |       | — |   | — |   |
| Other assets                                                                                   |       | 10,014                                     |       | — |   | — |   |
| Goodwill                                                                                       |       | 59,455                                     |       | 404 |   | — |   |
| Total assets  acquired                                                                         |       | 136,938                                    |       | 2,932 |   | — |   |
| Current  liabilities                                                                           |       | (21,724                                    | )          | (157 | ) | — |   |
| Deferred tax  liability                                                                        |       | (12,048                                    | )          | — |   | — |   |
| Other long-term  liabilities                                                                   |       | (738                                       | )          | — |   | — |   |
| Total liabilities  assumed                                                                     |       | (34,510                                    | )          | (157 | ) | — |   |
| Net assets  acquired                                                                           |       | $                                          | 102,428    |   | $ | 2,775 |   | $ | — |   |
| **Supplemental disclosures of cash flow  information:**                                        |       |                                       |       |   |   |   |   |
| Cash paid during the year  for:                                                                |       |                                       |       |   |   |   |   |
| Interest                                                                                       |       | $                                          | 6,005      |   | $ | 4,665 |   | $ | 12,808 |   |
| Income taxes                                                                                   |       | $                                          | 34,747     |   | $ | 27,611 |   | $ | 15,931 |   |

 

*Seeaccompanying notes to consolidated financial statements.*

61

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2005**

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

*Nature of Business*

Guitar Center, Inc.is the leading United States retailer of guitars, amplifiers, percussioninstruments, keyboards and pro-audio and recording equipment. As of December 31,2005, our retail subsidiary operated 161 Guitar Center stores across the UnitedStates, with 126 stores in 50 primary markets, 34 stores in secondary marketsand one tertiary market store. In addition, as of December 31, 2005, ourMusic & Arts Center division operated 81 stores specializing in bandinstruments for sale and rental, serving thousands of teachers, band directors,college professors and students. We are also the largest direct responseretailer of musical instruments in the United States through our wholly ownedsubsidiary, Musician’s Friend, Inc., and its catalog and website,www.musiciansfriend.com.

*Principles ofConsolidation*

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

*Use of Estimates inthe Preparation of Financial Statements*

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

*Cash and CashEquivalents*

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

*Investments*

Marketable securities areclassified as “available-for-sale” and recorded at fair value. Unrealized gainsand losses, net of related tax effect, are excluded from earnings and arereported as a separate component of other comprehensive income until realized.Realized gains and losses from the sale of available-for-sale securities aredetermined on a specific-identification basis.

*Accounts Receivable*

In the normal course ofbusiness, the Company grants credit directly to certain customers, after acredit analysis based on financial and other criteria and generally requires nocollateral. Accounts receivable are recorded net of an allowance for doubtfulaccounts. The Company maintains allowances for doubtful accounts for estimatedlosses that result from the inability of its customers to make their requiredpayments. The Company bases its allowances on analysis of the aging of accountsreceivable at the date of the financial statements, assessments of historicalcollections trends and an evaluation of the impact of current economicconditions.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

*MerchandiseInventories*

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

*Property andEquipment*

Property and equipment arerecorded at cost. Depreciation is computed using the straight-line methodover the estimated useful lives of the assets; generally five years forfurniture and fixtures, computer equipment and vehicles, and 15 years forbuildings. Leasehold improvements are amortized over the shorter of theirestimated useful lives or the terms of the related leases. Corporate aircraftis depreciated over 10 years with a 50% salvage value. Maintenance and repaircosts are expensed as they are incurred, while renewals and betterments arecapitalized.

*Goodwill and OtherIntangibles*

Goodwill represents theexcess of the purchase price over the fair value of the net assets acquiredresulting from business acquisitions. In 2002, we adopted SFAS No. 142, *Goodwill and Other Intangible Assets*, which eliminated thesystematic amortization of goodwill. As of December 31, 2005 and 2004 wehad unamortized goodwill in the amount of $85.9 million and $26.5 million,respectively. We also had unamortized identifiable intangible assets withindefinite lives in the amount of $5.3 million and $325,000, as of December 31,2005 and 2004, respectively. Our policy is to test for impairment on an annualbasis, or more frequently when triggering events occur. We have tested goodwilland intangible assets for impairment under the provisions of SFAS No. 142and these tests indicated that there was no impairment as of December 31, 2005.

*Impairment andDisposal of Long-Lived Assets*

We account for theimpairment or disposal of long-lived assets in accordance with SFAS No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets*, which requires long-lived assets, such asproperty and equipment, to be evaluated for impairment whenever events orchanges in circumstances indicate the carrying value of an asset may not berecoverable. Recoverability of assets to be held and used is measured by acomparison of the carrying amount of the assets to future undiscounted net cashflows expected to be generated by said assets. If such assets are considered tobe impaired, the impairment to be recognized is the amount by which thecarrying amount of the assets exceeds the fair value of the assets. Assets tobe disposed of are reported at the lower of the carrying amount or fair valueless selling costs. No impairment was identified for the years ended December 31,2005, 2004 and 2003.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

*MerchandiseAdvances*

Merchandise advancesrepresent layaway deposits which are recorded as a liability pendingconsummation of the sale when the full purchase price is received from thecustomer, outstanding gift certificates or gift cards which are recorded as aliability until redemption by the customer, credit on account for customerreturns and special orders.

*Self-InsuranceReserves*

We maintain aself-insurance program for workers’ compensation of up to $250,000 per claimand medical insurance of up to $150,000 per claim, with any amounts in excessof these covered by stop-loss insurance coverage. Estimated costs under theseprograms, including incurred but not reported claims, are recorded as expensesbased upon actuarially determined historical experience and trends of paid andincurred claims. Self-insurance reserves for workers’ compensation and medicalinsurance amounted to $3.3 million and $1.0 million at December 31, 2005and $2.8 million and $0.7 million at December 31, 2004, respectively. Thebalances are included in accrued expenses and other current liabilities in theaccompanying consolidated balance sheets.

*Revenue Recognition*

Retail sales arerecognized at the time of sale, net of a provision for estimated returns. Bandinstrument rentals are recognized on a straight-line basis over the term of therental agreement, unless a trial period is offered, in which circumstances therental income for the trial period is amortized over the trial period. Theterms of the majority of our rental agreements do not exceed 36 months. Trialperiods are usually from one to four months. Direct response sales arerecognized when the products are estimated to be received by the customers, netof a provision for estimated returns. Direct response items sold to customersare estimated to be received, on average, three days after shipment. Returnallowances are estimated using historical experience.

*Advertising Costs*

We expense Guitar Center’s and Music & ArtsCenter’s advertising costs as incurred. Advertising costs included in theconsolidated statements of income for the years ended December 31, 2005,2004 and 2003 is $36.6 million, $34.0 million, and $29.6 million, respectively.Musician’s Friend’s non-catalog advertising costs for the years ended December 31,2005, 2004 and 2003 were $12.6 million, $5.5 million and $3.7 million,respectively. Mail order catalog costs are capitalized on a catalog by catalogbasis and are amortized over the expected period of future benefits, not toexceed five months, under the provisions of AICPA Statement of Position 93-7,*Reporting of Advertising Costs.*Capitalizedmail order catalog costs included in prepaid expenses and deposits at December 31,2005, 2004 and 2003 were $1.8 million, $4.5 million and $3.1 million,respectively. The realizability of the capitalized mail order catalog costs, areevaluated at each balance sheet date by comparing the carrying amount of suchassets on a cost-pool-by-cost-pool basis to the probable remaining future netrevenues expected to result directly from such advertising. If the carryingamounts of such deferred mail order catalog costs exceed the remaining futurenet revenues that probably will be realized from such catalog, the excesscapitalized amount is written 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

down and expensed in thecurrent period. There was no write-down of capitalized mail order catalog costsfor the years ended December 31, 2005, 2004 and 2003.

We receive cooperativeadvertising allowances from manufacturers in order to subsidize qualifyingadvertising and similar promotional expenditures we make relating to the vendor’sproducts. These advertising allowances are recognized as a reduction toselling, general and administrative expense when we incur the advertising costseligible for the credit. Guitar Center, Musician’s Friend and Music &Arts Center recognized cooperative advertising allowances of $10.1 million,$6.4 million and $5.1 million for the years ended December 31, 2005, 2004and 2003, respectively.

*Rent Expense*

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

*Income Taxes*

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

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

*Stock-BasedCompensation*

In July 2005,our Board of Directors approved the Guitar Center, Inc. 2005 Long-TermIncentive Plan. Historically, we have provided equity-based incentives to oursenior management solely in the form of stock options issued understockholder-approved plans. The purpose of the long- term incentive plan is 

65

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

to provide equityincentives to senior management that include not only stock options or similargrants, but also a performance share program that measures performance on amulti-year basis. The performance period under the long- term incentive planbegan on July 1, 2005 and ends on December 31, 2007. The targetnumber of performance shares potentially issuable under the plan is expected tobe approximately 260,000 with the actual number of shares being between zeroand 520,000 depending on the Company’s actual performance. Under the terms ofthe plan, there may be stock option grants to the participants of the plan thatwill be for a term of ten years and will vest over three to four years in equalannual installments. Through December 31, 2005, the Company has accountedfor the long- term incentive plan using the variable plan accounting methodestablished by Accounting Principles Board Opinion (“APB”) No. 25, *Accounting for Stock Issued to Employees* and relatedinterpretations. Commencing January 2006, all our stock-based compensationplans will be accounted for under SFAS 123R. Details of the plan were includedin the 8-K we filed on July 28, 2005.

We have adopted SFAS No. 123, *Accounting for Stock-Based Compensation,* which permitsentities to recognize as expense over the vesting period the fair value of allstock-based awards on the date of grant. Alternatively, SFAS No. 123allows entities to continue to apply the provisions of APB 25,*Accounting for Stock Issued to Employees,* and relatedinterpretations and provide pro forma net income and pro forma income per sharedisclosures for employee stock options as if the fair-value-basedmethod defined in SFAS No. 123 had been applied. We have elected tocontinue to apply the provisions of APB 25 and provide the pro forma disclosureprovisions of SFAS No. 123.

In December 2004, the Financial AccountingStandards Board issued SFAS No. 123 (revised 2004) *Share-BasedPayment* (“SFAS No. 123R”). SFAS No. 123R requires that thecost from all share-based payment transactions, including stock options, berecognized in the financial statements at fair value. SFAS No. 123Ris effective for public companies in the first fiscal year beginning after June 15,2005. We will adopt the provisions of this statement effective January 1,2006. We will adopt SFAS 123R using the modified prospective method beginning January 1,2006, pursuant to which we will not restate any prior periods.

In the second quarter of 2005, we converted to alattice-based binomial model from a Black-Scholes model, which our managementbelieves to be a superior method for valuing the impact of different employeeoption exercise patterns under various economic and market conditions. Theconversion was implemented beginning with grants issued during the secondquarter of 2005. The fair value of our grants issued prior to the secondquarter of 2005 was determined using best-estimate assumptions effective as ofthe grant date using the Black-Scholes model.

We granted 109,000 options in the third quarter of2005. Assumptions used to determine the fair value of options granted duringthe third quarter of 2005 using the lattice-based binomial model were developedin consultation with an outside valuation specialist. The lattice-basedbinomial model requires the input of several assumptions including expectedvolatility, dividend yield, and risk-free rate of return, as well as certainassumptions regarding exercise behavior. Unlike the Black-Scholes model wherethe expected term is an input assumption, the expected-term is an outputvariable of the lattice-based binomial model. For fiscal year 2004, the Companyreflected a volatility assumption of 59.6% for stock options granted during thefiscal year. This was based on the historical price of our stock over theexpected life of the option. Using the lattice model the expected volatilityassumption was developed based on an analysis of historical 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

prices of our stock andoptions traded in the open market. The volatility of historical prices forfiscal year 2005 was 52% while the volatility for open market exchanged optionsissued “near-the-money” was 32%. Therefore, a best-estimate range of 32% to 52%was developed. When no point in a range is more or less likely to be the bestestimate, SFAS No. 123 directs the use of an average. This implies that42% is the best estimate volatility assumption for the Company. The risk freeinterest rate varies by duration, from 3.5% to 4.0%.

Assumptions were developed separately for our seniormanagement from the other participants of our stock plans, since seniormanagement’s exercise behavior is expected to differ materially from the otherparticipants.

Under APB 25, compensationexpense for stock options issued to employees is recorded on the date of grantonly if the current market price of the underlying stock exceeds the exerciseprice. Had we determined compensation cost based upon the fair value at thegrant date for our stock options using the methodologies described above, proforma net income and pro forma net income per share, including the followingweighted average assumptions used in these calculations, would have been asfollows for the period ended December 31, 2005, 2004 and 2003:

| ** **                                                                                                                                     | ** ** | **December 31,**                                                                | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                     | ** ** | **2005**                                                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                     | ** ** | **($ in thousands, except per share  data—unaudited)** | ** ** |
| Net income, as  reported                                                                                                                       |       | $                                                                                    | 76,678     |   | $ | 63,425 |   | $ | 36,860 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value based  methods for all awards, net of related tax effects |       | $                                                                                    | 6,608      |   | $ | 6,271 |   | $ | 4,821 |   |
| Pro forma net  income                                                                                                                          |       | $                                                                                    | 70,070     |   | $ | 57,154 |   | $ | 32,039 |   |
| Earnings per share:                                                                                                                            |       |                                                                                 |       |   |   |   |   |
| Basic—as reported                                                                                                                         |       | $                                                                                    | 2.96       |   | $ | 2.55 |   | $ | 1.59 |   |
| Basic—pro forma                                                                                                                           |       | $                                                                                    | 2.71       |   | $ | 2.30 |   | $ | 1.38 |   |
| Diluted—as  reported                                                                                                                      |       | $                                                                                    | 2.67       |   | $ | 2.29 |   | $ | 1.47 |   |
| Diluted—pro forma                                                                                                                         |       | $                                                                                    | 2.44       |   | $ | 2.07 |   | $ | 1.29 |   |
| Risk free  interest rate                                                                                                                       |       | 3.8                                                                                  | %          | 3.9 | % | 3.8 | % |
| Expected lives                                                                                                                                 |       | 5.82                                                                                 |       | 6.70 |   | 6.92 |   |
| Expected  volatility                                                                                                                           |       | 42.0                                                                                 | %          | 59.6 | % | 62.9 | % |
| Expected dividends                                                                                                                             |       | —                                                                               |       | — |   | — |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

*Earnings Per Share*

The following tablesummarizes the reconciliation of basic to diluted weighted average shares forthe years ended December 31, 2005, 2004, 2003:

| ** **                                          | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                          | ** ** | **(in thousands)** | ** ** |
| Basic shares                                        |       | 25,873                  |       | 24,856   |       | 23,255   |       |
| Dilutive effect  of options outstanding             |       | 1,081                   |       | 1,228    |       | 1,306    |       |
| Dilutive effect  of conversion of Convertible Notes |       | 2,892                   |       | 2,892    |       | 1,558    |       |
| Diluted shares                                      |       | 29,846                  |       | 28,976   |       | 26,119   |       |

 

Calculationof diluted earnings per share:

| ** **                                                                  | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                                                  | ** ** | **(in thousands)** | ** ** |
| Net income, as  reported                                                    |       | $                       | 76,678     |     | $          | 63,425   |       | $ | 36,860 |   |
| Add back  interest, net of tax, on 4% Senior Convertible Notes(a)           |       | 2,907                   |       | 2,931    |       | 1,540    |       |
| Net income  excluding interest expense on 4% Senior Convertible Notes       |       | 79,585                  |       | 66,356   |       | 38,400   |       |
| Basic weighted  average shares outstanding                                  |       | 25,873                  |       | 24,856   |       | 23,255   |       |
| Dilutive effect  of stock options outstanding                               |       | 1,081                   |       | 1,228    |       | 1,306    |       |
| Incremental  shares on assumed conversion of 4% Senior Convertible Notes(b) |       | 2,892                   |       | 2,892    |       | 1,558    |       |
| Dilutive weighted  average shares outstanding                               |       | 29,846                  |       | 28,976   |       | 26,119   |       |
| Dilutive income per  share                                                  |       | $                       | 2.67       |     | $          | 2.29     |       | $ | 1.47 |   |

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(a)    Representsthe interst expense, including amortization of deferred financing costs, on the4% Senior Convertible Notes, net of tax, using an effective tax rate for 2005of 38.5% and for 2004 of 38.0%.

(b)   Representsthe number of incremental common shares resulting from the conversion of the 4%Senior Convertible Notes.

For the years ended December 31, 2005, 2004 and2003, the only potential common stock outstanding with the Company are stockoptions and the Senior Convertible Notes. For the year ended December 31,2005, options to acquire 261,479 shares at prices ranging from $58.83 to $64.66were outstanding but were excluded from the computation of diluted earnings pershare because the exercise price of these options was greater than the averagemarket price of our Common Stock. For the year ended December 31, 2004,all options outstanding had a dilutive effect. For the year ended December 31,2003, options to acquire 223,000 shares at prices ranging from $28.30 to $30.70were outstanding but were excluded from the  computation of diluted earnings per sharebecause the exercise price of these options was greater than the average marketprice of our common stock.

For the years ended December 31, 2005 and 2004,the 2.9 million shares of common stock issuable upon conversion of the 4%Senior Convertible Notes issued in June 2003 (reflecting an effective 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

conversion price of$34.58) are deemed to be potential common stock and are deemed to beoutstanding for the purposes of calculating diluted earnings per share underthe “if-converted” method of accounting under which the after-tax interestexpense, including amortization of deferred financing costs, for the year isadded back to net income. For the year ended December 31, 2003, 1.6million shares of common stock were deemed to be potential common stock and areincluded in the calculation of earnings per share representing the weightedaverage shares for the period of June 16, 2003, the issuance date of theNotes, to December 31, 2003, under the “if-converted” method.

In July 2004, theEmerging Issues Task Force (“EITF”) reached a consensus on Issue No. 04-8,*Accounting Issues Related to Certain Features ofContingently Convertible Debt and the Effect on Diluted Earnings per Share*(EITF No. 04-8) that contingently convertible debt instruments, suchas our 4% Senior Convertible Notes, should be included in the computation ofdiluted earnings per share under the if-converted method regardless of whetherthe market price trigger (or other contingent feature) has been met. Theconsensus must be applied by retroactive restatement based on the term ineffect on the last day of the fiscal period in which the consensus becomeseffective. This consensus became effective for all financial statements issuedafter December 15, 2004. Accordingly, we retroactively restated allearnings per share measures for all periods to reflect the consensus.

*Concentration ofCredit Risk*

Our cash deposits are withvarious high quality financial institutions. Customer purchases generally aretransacted using cash or credit cards. In limited instances, we grant creditfor larger purchases, generally to professional musicians, under normal tradeterms. Trade accounts receivable were approximately $10.5 million and $7.7million at December 31, 2005 and 2004, respectively. Credit losses havehistorically been within our expectations.

*Fair Value ofFinancial Instruments*

The principal amount ofour revolving line of credit reflects the fair value based upon current ratesavailable to us for similar debt. Based on quoted market prices, the fair valueof our 4% Senior Convertible Notes was $148 million and $151 million as ofDecember 31, 2005 and 2004, respectively. The book value of all otherfinancial instruments is representative of their fair values.

*New AccountingPronouncements*

In May 2005, the Financial Accounting StandardsBoard, or FASB, issued Statement of Financial Accounting Standards (“SFAS”) No. 154,*Accounting Changes and Error Corrections,*whichreplaces**Accounting Principles Board (“APB”) OpinionNo. 20, *Accounting Changes*, andsupersedes FASB Statement No. 3, *Reporting AccountingChanges in Interim Financial Statements—an amendment of APB Opinion No. 28.*SFAS 154 requires retrospective application to prior periods’ financialstatements of changes in accounting principle, unless it is impracticable todetermine either the period-specific effects or the cumulative effect of thechange. When it is impracticable to determine the period-specific effects of anaccounting change on one or more individual prior periods presented, SFAS 154requires that the new accounting principle be applied to the balances of assetsand liabilities as of the beginning of the earliest period for whichretrospective application is practicable and that a corresponding adjustment bemade to 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

the opening balance of retainedearnings for that period rather than being reported in an income statement.When it is impracticable to determine the cumulative effect of applying achange in accounting principle to all prior periods, SFAS 154 requires that thenew accounting principle be applied as if it were adopted prospectively fromthe earliest date practicable. SFAS 154 will be effective for accountingchanges and corrections of errors made in fiscal years beginning after December 15,2005. This statement does not change the transition provisions of any existingaccounting pronouncements, including those that are in a transition phase as ofthe effective date of this statement. We do not expect the provisions of theSFAS 154 to have a significant impact on our consolidated financial statements.

In November 2004, the FASB issued SFAS No. 151,*Inventory Costs - An Amendment of ARB No. 43,Chapter 4.*SFAS No. 151 amends the guidance in AccountingResearch Bulletin (“ARB”) No. 43, Chapter 4, *InventoryPricing*, to clarify the accounting for abnormal amounts of idlefacility expense, freight, handling costs, and wasted material (spoilage).Among other provisions, the new rule requires that items such as idlefacility expense, excessive spoilage, double freight, and rehandling costs berecognized as current-period charges regardless of whether they meet thecriterion of “so abnormal” as stated in ARB No. 43. Additionally,SFAS 151 requires that the allocation of fixed production overhead to the costsof conversion be based on the normal capacity of the production facilities.SFAS No. 151 is effective for fiscal years beginning after June 15,2005 and is required to be adopted in the first quarter of fiscal 2006. We donot expect the adoption of SFAS No. 151 to have a material impact on ourconsolidated financial statements.

In December 2004, the FASB issued FASB Statement No. 123(revised 2004) *Share-Based Payment,* or SFAS123R, which is a revision of FASB Statement No. 123, *Accountingfor Stock-Based Compensation*. SFAS 123R supersedes APB opinion No. 25,*Accounting for Stock Issued to employees*,and amends FASB Statement No. 95, *Statement of Cash Flows*.Generally, the approach in SFAS 123R is similar to the approach described inStatement 123. However, SFAS 123R requires all share-based payments toemployees, including grants of employee stock options, to be recognized in theincome statement based on their fair values rather than pro forma footnotedisclosure. SFAS No. 123R iseffective for public companies in the first fiscal year beginning on or after January 1,2006.

SFAS 123R requires measurement of the cost ofshare-based payment transactions to employees at the fair value of the award onthe grant date and recognition of expense over the requisite service or vestingperiod. SFAS 123R allows implementation using a modified version of prospectiveapplication, under which compensation expense for the unvested portion ofpreviously granted awards and all new awards will be recognized on or after thedate of adoption. FAS 123R also allows companies to implement by restatingpreviously issued financial statements, basing the amounts on the expensepreviously calculated and reported in their pro forma footnote disclosuresrequired under FAS 123. We will adopt FAS 123R using the modified prospectivemethod beginning January 1, 2006. The impact of adopting FAS 123R onour consolidated results of operations is not expected to differ materiallyfrom the pro forma disclosures currently required by FAS 123 (see “Employeestock-based compensation”). In addition, FAS 123R requires classificationof the tax benefit from the exercise of stock options in cash flows fromfinancing activities, rather than cash flows from operating activities. In2005, cash flows from operating activities included a cash inflow of $7.6million related to tax benefits from the exercise of stock options.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

In July 2005, theFASB issued an exposure draft of a proposed interpretation*, Accountingfor Uncertain Tax Positions—an Interpretation of FASB Statement No. 109.*Theproposed interpretation would apply to all open tax positions accounted for inaccordance with SFAS No. 109, including those acquired in business combinations.In October 2005, the FASB decided to postpone issuance of the finalinterpretation until fiscal year 2006. The Company will evaluate the impact ofany change in accounting standard on the Company’s financial position andresults of operations when the final interpretation is issued.

In June 2005, the Emerging Issues Task Force(“EITF”) issued EITF Issue 05-6, *Determining theAmortization Period for Leasehold Improvements Purchased after Lease Inceptionor Acquired in a Business Combination.* The EITF reached a consensusthat the amortization period for leasehold improvements acquired in a businesscombination or acquired subsequent to lease inception should be based on thelesser of the useful life of the leasehold improvements or the period of thelease including all renewal periods that are reasonably assured of exercise atthe time of the acquisition. This consensus is consistent with the Company’spolicy regarding leasehold improvements. The adoption of EITF Issue 05-6did not have a material impact on our consolidated financial statements.

In October 2005, the FASB issued FASB StaffPosition (“FSP”) No. FAS 13-1 (“FSP13-1”), *Accounting for Rental Costs Incurred during the Construction Period,*whichrequires that rental costs associated with ground or building operating leasesthat are incurred during a construction period be recognized as rental expense.These rental costs shall be included in income from continuing operations. Theeffective date of this FSP guidance is the first reporting period beginningafter December 15, 2005. Early adoption is permitted for financialstatements or interim financial statements that have not yet been issued. Theadoption of FSP 13-1 will not have a material impact on our consolidatedfinancial statements.

In March 2005, the FASB issued FASBInterpretation No. 47 (“FIN 47”), *Accounting for ConditionalAsset Retirement Obligations*, which is an interpretation of SFASNo. 143 (“SFAS 143”), *Accounting for AssetRetirement Obligations*. FIN 47 clarifies terminology within SFAS 143and requires an entity to recognize a liability for the fair value of aconditional asset retirement obligation when incurred if the liability’s fairvalue can be reasonably estimated. FIN 47 is effective for fiscal years endingafter December 15, 2005. The adoption of FIN 47 did not have a materialimpact on our consolidated financial statements.

**2.**Acquisitions**

On April 15, 2005, we completed the acquisitionof Music & Arts Center, Inc., a Maryland-based musicalinstruments retailer with an emphasis on the beginning musician. At the time ofthe acquisition, Music & Arts Center, Inc. operated 61 retaillocations, primarily located in the Northeast, Mid-Atlantic and Southernregions of the U.S. The acquired business and our existing American Music Groupbusiness have been combined into a new division under the Music & ArtsCenter name.

On June 10, 2005, our Musician’s Friend unitcompleted the asset acquisition of Harmony-Central.com, an Internet content andinformation site. The acquired company is separately maintained and operated byMusician’s Friend as Harmony Central Group, LLC. The results of operations andthe assets of Harmony-Central.com were not material to Guitar Center’shistorical consolidated financial statements 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**2. Acquisitions(Continued)**

and, as such, pro-formafinancial information is not presented. The results of operations are includedin Guitar Center’s consolidated financial statements from the date of theacquisition.

On July 18, 2005, our Music & Arts Centerdivision completed the asset acquisition of John W. Coffey MusicCo., Inc., band instruments retailer in Norwood, Massachusetts. CoffeyMusic services the greater Boston, Massachusetts metropolitan area. The resultsof operations and the assets of Coffey Music were not material to GuitarCenter’s historical consolidated financial statements and, as such, pro-formafinancial information is not presented. The results of operations are includedin Guitar Center’s consolidated financial statements from the date of theacquisition.

We acquired Music & Arts Center, Coffey and Band InstrumentExchange to expand our existing presence in the band and orchestra instrumentbusiness. Harmony Central was purchased to drive traffic to our direct responseInternet website.

The aggregate purchaseprice of the acquisitions was approximately $102.4 million and was funded fromcash on hand and drawings under our line of credit. The aggregate purchaseprice was allocated to the following assets acquired and liabilities assumed attheir estimated fair value (in thousands):

| Current assets                 |   | $       | 5,587   |   |
|--------------------------------|--------|---------|---------|--------|
| Inventory                      |   | 57,655  |    |
| Property &  equipment |   | 3,692   |    |
| Intangible assets              |   | 10,549  |    |
| Goodwill                       |   | 59,455  |    |
| Total assets acquired          |   | 136,938 |    |
| Current  liabilities           |   | (21,724 | )       |
| Deferred tax  liability        |   | (12,048 | )       |
| Other long-term  liabilities   |   | (738    | )       |
| Total liabilities assumed      |   | (34,510 | )       |
| Total purchase price           |   | $       | 102,428 |   |

 

The purchase price allocation between goodwill anddeferred tax liability may change pending the filing of the finalpre-acquisition income tax returns for Music & Arts Center.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**2.**Acquisitions(Continued)**

The purchase price allocation described above resultedin our recording approximately $59 million in goodwill, which is not beingamortized, but will be evaluated for impairment annually or when a triggeringevent occurs which may require an impairment test. For California income tax,the entire amount of acquired $59 million in goodwill is deductible. For allother states and Federal, approximately $4 million in goodwill is deductible.

Theacquired intangible assets are summarized as follows:

| ** **                                             | ** ** | **Gross  Carrying  Amount** | ** ** |
|--------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                             | ** ** | **(in thousands)**     | ** ** |
| **Year ending December 31, 2005:** | ** ** |                        | ** ** | ** ** |   |
| Intangible assets                                      | ** ** |                        | ** ** | ** ** |   |
| Amortized                                              |       |                        |       | ** ** |   |
| Trademark                                              |       |                        | $          | 110 | ** ** |   |
| Customer contracts                                     |       |                        | 3,740      | ** ** |   |
| Covenant not to compete                                |       |                        | 1,460      | ** ** |   |
| Other                                                  |       |                        | 239        | ** ** |   |
| Unamortized  trademark                                 |       |                        | 5,000      | ** ** |   |
| Total intangible assets                                |       |                        | $          | 10,549 | ** ** |   |
| Aggregate amortization expense                         |       |                        | $          | 2,248 | ** ** |   |
| Estimated  amortization expense                        |       |                        |       | ** ** |   |
| For the year ended 12/31/2006                          |       |                        | $          | 2,529 | ** ** |   |
| For the year ended 12/31/2007                          |       |                        | $          | 431 | ** ** |   |
| For the year ended 12/31/2008                          |       |                        | $          | 215 | ** ** |   |
| For the year  ended 12/31/2009                         |       |                        | $          | 126 | ** ** |   |

 

The changes in our goodwill balanceare summarized as follows:

| ** **                        | ** ** | **Balance at  beginning  of year** | ** ** | **Additions** | ** ** | **Deductions** | ** ** | **Balance  at end  of year** | ** ** |
|-----------------------------------|------------|----------------------------------------------|------------|---------------|------------|----------------|------------|----------------------------------------|------------|
| **Year ending December 31:** |       |                                         |       |          |       |           |       |                                   |       |   |   |   |   |   |   |
| 2005                              |       |                                         | $          | 26,474        |       |           |       | 59,455                                 |       |   |   | — |   |   | $ | 85,929 |   |
| 2004                              |       |                                         | $          | 25,995        |       |           |       | 479                                    |       |   |   | — |   |   | $ | 26,474 |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**2. Acquisitions(Continued)**

Results of operations forthe Music & Arts Center are included in the consolidated financialstatements since April 15, 2005, the date of acquisition. The followingtable summarizes pro forma financial information assuming the Music &Arts Center, Inc. acquisition had occurred as of the beginning of theperiods presented below:

| ** **        | ** ** | **December 31,**                                          | ** ** |
|-------------------|------------|----------------------------------------------------------------|------------|
| ** **        | ** ** | **2005**                                                       | ** ** | **2004** | ** ** |
| ** **        | ** ** | **(in thousands, except per  share data)** | ** ** |
| Net sales         |       | $                                                              | 1,808,945  |   | $ | 1,597,489 |   |
| Net income        |       | 73,707                                                         |       | 64,154 |   |
| Income per share: |       |                                                           |       |   |   |
| Basic             |       | 2.85                                                           |       | 2.58 |   |
| Diluted           |       | 2.57                                                           |       | 2.32 |   |
|                   |            |                                                                |            |  |  |  |  |

 

Included in pro forma net income for the year ended December 31,2005 are after-tax charges of $3.6 million ($0.12 per diluted share) forbonus payments and legal fees associated with the acquisition. These chargeswere incurred prior to the acquisition on April 15, 2005. In addition, inconjunction with the acquisition, after-tax charges of $2.1 million ($0.07 perdiluted share) were incurred primarily from the elimination of a redundantpoint of sales system, severance costs, moving costs to relocate certainAmerican Music employees to the Music & Arts Center corporate officein Maryland and the write down of inventory carried at American Music resultingfrom a change in inventory assortment. These charges were incurred during theperiod of April 15, 2005 through June 30, 2005.

The pro forma informationis not necessarily indicative of the operating results that would have occurredhad the acquisition been made at the beginning of the periods presented nor arethey necessarily indicative of any future operating results.

**3. Merchandise Inventories**

Themajor classes of merchandise inventories are as follows:

| ** **                              | ** ** | **December 31,**   | ** ** |
|-----------------------------------------|------------|-------------------------|------------|
| ** **                              | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                              | ** ** | **(in thousands)** | ** ** |
| Major goods                             |       | $                       | 246,260    |   | $ | 187,902 |   |
| Band instruments                        |       | 79,378                  |       | 25,125 |   |
| Accessories                             |       | 97,950                  |       | 77,200 |   |
| Vintage guitars                         |       | 11,795                  |       | 10,831 |   |
| Used major goods                        |       | 20,056                  |       | 19,121 |   |
|                                    |       | 455,439                 |       | 320,179 |   |
| Less inventory  reserves for writedowns |       | 9,668                   |       | 5,218 |   |
|                                    |       | $                       | 445,771    |   | $ | 314,961 |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**3. MerchandiseInventories (Continued)**

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

**4. Property and Equipment**

Propertyand equipment consists of the following:

| ** **                                      | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| Land                                            |       | $                       | 7,666      |   | $ | 2,946 |   |
| Buildings                                       |       | 20,091                  |       | 9,766 |   |
| Furniture and  fixtures                         |       | 30,656                  |       | 23,896 |   |
| Transportation  equipment                       |       | 12,402                  |       | 630 |   |
| Computer  equipment                             |       | 73,877                  |       | 58,174 |   |
| Leasehold  improvements                         |       | 123,992                 |       | 97,776 |   |
| Construction in  progress                       |       | 5,965                   |       | 4,076 |   |
|                                            |       | 274,649                 |       | 197,264 |   |
| Less accumulated  depreciation and amortization |       | 125,440                 |       | 99,915 |   |
|                                            |       | $                       | 149,209    |   | $ | 97,349 |   |

 

**5. Revolving Line ofCredit and Debt**

In February of 2005, we amended our creditfacility with a syndicate of banks led by Wells Fargo Retail Finance. Thecredit facility permits borrowings up to $125 million (which may be increasedto $150 million at our option), subject to borrowing base limitations. Theactual amount available is tied to our inventory and receivable base, and ourobligations under the credit facility are secured by liens on our principalassets. Borrowing options are prime rate (7.25% at December 31, 2005) plusapplicable prime margin, or London Interbank Offered Rate or LIBOR (twelvemonth rate at December 31, 2005 was 4.8%), plus applicable LIBOR margin.The applicable prime and LIBOR margins are based upon levels of excessavailability and adjusted quarterly. If excess availability is greater than $20million, the applicable prime margin is 0.00% and applicable LIBOR margin is1.0%. If excess availability is less than or equal to $20 million and greaterthan $10 million, the applicable prime margin is 0.00% and the applicable LIBORmargin is 1.25%. If excess availability is less than or equal to $10 million,the applicable prime margin is 0.00% and the applicable LIBOR margin is 1.5%.An unused fee of 0.25% is assessed on the unused portion of the creditfacility. The agreement underlying the credit facility includes significantrestrictive negative covenants. Among other things, these covenants restrict orprohibit our ability to incur debt and issue specified equity instruments,incur liens on our assets, make any significant changes in our corporatestructure or the nature of our business, dispose of assets, make guaranties,prepay debt, engage in a change in control transaction, pay dividends, make investmentsor acquisitions, engage in transactions with affiliates and incur capitalexpenditures, and also require that we satisfy a minimum availability test. Theminimum availability test requires that we maintain $10 million of reservedavailability under the agreement based on its borrowing base limitations. Theamount we disclose in our public reports from time 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**5. RevolvingLine of Credit and Debt (Continued)**

to time as available toborrow under the agreement is already reduced by this required reserve andoutstanding letters of credit, and thus represents a net amount available underthe agreement. The agreement also includes representations and warranties whichmust be true each time we borrow funds under the credit facility andaffirmative covenants. The full text of the contractual requirements imposed bythis financing is set forth in the Amended and Restated Loan and SecurityAgreement and related amendments which have been filed with the Securities andExchange Commission. Subject to limited cure periods, the lenders under ourcredit facility may demand repayment of these borrowings prior to statedmaturity upon the occurrence of specified events, including if we breach theterms of the agreement, suffer a material adverse change, engage in a change incontrol transaction, suffer a significant adverse legal judgment, default onother significant obligations, or in the event of specified events ofinsolvency. The credit agreement matures in December 2010.

Traditionally, we have experienced the largest use ofcash from operating activities in the latter part of third quarter and in thefourth quarter due to the build up of inventory to support the holiday season,resulting in additional borrowings under our line of credit. We believe thatour peak liquidity needs during 2006 during these periods will exceed our netcash flow from operations and borrowings currently available under our creditfacility. We are in discussions with our lending syndicate regarding increasingthe amount of borrowings under our credit facility to cover this shortfall. However,these discussions are preliminary in nature and there is no assurance that anincrease in the borrowings under credit facility will be available to us.

On June 16, 2003, we completed the issuance of$100 million principal amount of 4.00% Senior Convertible Notes due 2013. Theconvertible notes bear interest at the rate of 4.00% per annum, subject to thepayment of contingent interest under certain circumstances commencing January 15,2006, and are convertible into shares of common stock at a conversion price of$34.58 per share, subject to adjustment under specified circumstances. Underthe contingent conversion feature of the convertible notes, subject to certainexceptions, they are not convertible into common stock unless and until thetrading price of the common stock reaches at least $41.50 for a specifiedperiod in advance of each quarterly conversion period or designated corporateevents occur. As of December 31, 2005, the convertible notes wereconvertible for the current quarterly conversion period. The convertible noteswill also become convertible upon the occurrence of specified corporatetransactions and other events described in the indenture. The final maturity ofthe convertible notes is July 2013, although holders may require us torepurchase the Notes at their election in July 2008, July 2010 orupon the occurrence of a change in control, in each case for a purchase priceequal to the original principal amount plus accrued interest. The indenturegoverning the convertible notes does not limit our ability to incurindebtedness or otherwise substantively restrict the operation of our businessto any significant degree. Subject to limited cure periods, the holders of theconvertible notes may demand repayment of these borrowings prior to the statedmaturity upon the occurrence of specified events, including if we fail to payinterest or principal when due, if we fail to satisfy our conversionobligation, if another obligation of ours having an outstanding principalamount in excess of $15 million is accelerated prior to stated maturity andupon the occurrence of specified events of insolvency.

For the years ended December 31,2005, 2004 and 2003, $1.0 million, $1.0 million and $0.9 million ofamortization of deferred financing fees was included in interest expense.Capitalized deferred financing 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**5. RevolvingLine of Credit and Debt (Continued)**

fees at December 31,2005 and 2004 were $2.5 million and $3.6 million and related accumulatedamortization was $2.1 million and $1.0 million, respectively.

**6. Segment Information**

Our reportable business segments are Guitar Centerstores, Music & Arts Center stores and Musician’s Friend directresponse (contact center and Internet). Prior to the acquisition of Music &Arts Center, Inc., that segment was referred to as American Music stores.Both brands have similar operations and there has been no change to theinternal structure of the overall organization. Therefore, there has been nochange in the nature of the company segment reporting. Management evaluatessegment performance based primarily on net sales and income (loss) beforeincome taxes. Accounting policies of the segments are the same as theaccounting policies for the consolidated company. There are no differencesbetween the measurements of profits or losses or assets of the reportablesegments and those of the company on a consolidated basis. Our businesssegments under SFAS No. 131, *Disclosuresabout Segments of an Enterprise and Related Information,* areconsistent with our reporting units under SFAS No. 142*, Goodwill and Other Intangible Assets.*SFASNo. 131 establishes standards for the reporting of operating segmentinformation in annual financial statements and in interim financial reportsissued to shareholders. SFAS No. 142 requires that goodwill no longerbe amortized, reclassifications between goodwill and other intangible assets bemade based upon certain criteria, and, once allocated to reporting units (thebusiness segment level, or one level below), that tests for impairment ofgoodwill be performed at least annually. We will continue to evaluate goodwillannually or whenever events and circumstances indicate that there may be animpairment of the asset value.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**6. SegmentInformation (Continued)**

Net sales, depreciationand amortization, income (loss) before income tax (benefit), capitalexpenditures and total assets are summarized as follows for the years ended December 31,2005, 2004 and 2003 (in thousands):

| ** **                                 | ** ** | **Guitar Center** | ** ** | **Music & Arts (1)** | ** ** | **Direct Response** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|--------------------------|------------|------------|------------|
| ** **                                 | ** ** | **2005**               | ** ** | **2005**                                | ** ** | **2005**                 | ** ** | **Total**  | ** ** |
| Net sales                                  |       |                   | $          | 1,314,277                               |       |                     |       | $          | 103,116    |   |   |   | $ | 365,106 |   |   | $ | 1,782,499 |   |
| Depreciation and  amortization             |       |                   | 22,157     |                                    |       |                     | 4,312      |       |       |   | 2,531 |   |   | 29,000 |   |
| Income (loss)  before income tax (benefit) |       |                   | 105,809    |                                    |       |                     | (14,095    | )          |       |   | 32,969 |   |   | 124,683 |   |
| Capital expenditures                       |       |                   | 67,964     |                                    |       |                     | 1,130      |       |       |   | 6,399 |   |   | 75,493 |   |
| Total assets                               |       |                   | $          | 512,802                                 |       |                     |       | $          | 197,045    |   |   |   | $ | 70,343 |   |   | $ | 780,190 |   |

 

| ** **                                 | ** ** | **Guitar Center** | ** ** | **Music & Arts (1)** | ** ** | **Direct Response** | ** ** | ** ** | ** ** |
|--------------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|--------------------------|------------|------------|------------|
| ** **                                 | ** ** | **2004**               | ** ** | **2004**                                | ** ** | **2004**                 | ** ** | **Total**  | ** ** |
| Net sales                                  |       |                   | $          | 1,161,511                               |       |                     |       | $          | 40,400     |   |   |   | $ | 311,261 |   |   | $ | 1,513,172 |   |
| Depreciation and  amortization             |       |                   | 18,671     |                                    |       |                     | 1,469      |       |       |   | 2,164 |   |   | 22,304 |   |
| Income (loss)  before income tax (benefit) |       |                   | 72,789     |                                    |       |                     | (7,228     | )          |       |   | 36,737 |   |   | 102,298 |   |
| Capital  expenditures                      |       |                   | 21,240     |                                    |       |                     | 1,272      |       |       |   | 3,639 |   |   | 26,151 |   |
| Total assets                               |       |                   | $          | 451,677                                 |       |                     |       | $          | 63,365     |   |   |   | $ | 59,551 |   |   | $ | 574,593 |   |

 

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

----

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

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**7. Investment Securities**

Investment securities available-for-sale classified ascurrent and long-term as of December 31, 2004 are as follows:

| ** **                       | ** ** | **December 31, 2004** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **Amortized  Cost**             | ** ** | **Interest  Earned** | ** ** | **Amort. Of   Disc/Premium** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
| ** **                       | ** ** | **(in thousands)**         | ** ** |
| General Obligation Municipal     |       |                            | $          | 1,724 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 1,724 |   |
| Municipal Revenue                |       |                            | 2,086      |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   | 2,086 |   |
| Short-term investment securities |       |                            | $          | 3,810 |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | 3,810 |   |
| General Obligation Municipal     |       |                            | $          | 1,386 |   |   |   | $ | 1 |   |   |   | $ | (1 | ) |   |   | $ | — |   |   |   | $ | — |   |   | $ | 1,386 |   |
| Municipal Revenue                |       |                            | 15,611     |   |   |   | 2 |   |   |   | (2 | ) |   |   | — |   |   |   | — |   |   | 15,611 |   |
| Long-term investment securities  |       |                            | $          | 16,997 |   |   |   | $ | 3 |   |   |   | $ | (3 | ) |   |   | $ | — |   |   |   | $ | — |   |   | $ | 16,997 |   |

 

We had no investments at December 31,2005. We had no sales of investments in 2004. Gross unrealized gains and losseswere immaterial.

**8. Lease Commitments**

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

The total minimum leasecommitment at December 31, 2005, under operating leases, is as follows:

| **Year ended December 31** | ** ** | ** **              | ** ** | **Amount** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|------------|------------|
| ** **                                | ** ** | **(in thousands)** | ** ** |
| 2006                                      |       |                    | $          | 44,457     |       |   |
| 2007                                      |       |                    | 41,346     |       |       |
| 2008                                      |       |                    | 38,308     |       |       |
| 2009                                      |       |                    | 31,228     |       |       |
| 2010                                      |       |                    | 24,630     |       |       |
| Thereafter                                |       |                    | 72,909     |       |       |
|                                      |       |                    | $          | 252,878    |       |   |

 

Total rent expenseincluded in the consolidated statements of income for the years ended December 31,2005, 2004 and 2003 is $45.4 million, $38.2 million and $33.8 millionrespectively.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**9. Employee Benefit Plan**

We have a definedcontribution 401(k) plan with a 401(a) profit-sharing component (the“Plan”) maintained for the exclusive benefit of eligible employees and theirbeneficiaries. Eligible employees can contribute from one to seventy-fivepercent of their compensation. At our discretion, we can make matchingcontributions to the Plan, which will be a uniform percentage of the eligibleemployees’ contributions. We may also, at our discretion, make profit-sharingcontributions to the Plan. The profit-sharing contributions are allocated basedon the relative compensation of all eligible employees. Contribution expensewas $3.6 million, $2.1 million, $2.1 million for the years endedDecember 31, 2005, 2004 and 2003, respectively.

**10. Stock Option and Purchase Plans**

*1996 PerformanceStock Option Plan*

In June 1996, weadopted the 1996 Performance Stock Option Plan (as amended, the “1996 Plan”),which provided for the granting of options to officers and key employees. Underthe 1996 Plan, the number of options available for grant was 713,782, with amaximum term of ten years and an exercise price equal to the fair market value ofthe underlying stock at the date of grant. The options generally vested ratablyover three years. As of December 31, 2005, options to purchase 16,528shares of common stock were outstanding and exercisable. At December 31,2005, no shares were available for grant under the 1996 Plan and theoutstanding options expire in June 2006.

*1997 Equity ParticipationPlan*

In January 1997, the 1997 Equity ParticipationPlan (as amended, the “1997 Plan”) was adopted. Under the 1997 Plan, we maygrant options to purchase up to 4,000,000 shares of common stock. Optionsgranted under the 1997 Plan vest ratably over various terms with a maximum lifeof ten years. As of December 31, 2005, options to purchase 1,794,501shares of common stock were outstanding under the 1997 Plan, and 1,378,223shares were exercisable with exercise prices ranging from $8.34 to $53.83 and aweighted average exercise price of $22.31. At December 31, 2005, 14,626shares were available for grant.

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

*2004 IncentiveStock Award Plan*

In February 2004, the2004 Incentive Stock Award Plan was adopted (as amended, the 2004 Plan). The2004 Plan is an omnibus plan which provides for issuance of stock options,stock appreciation rights, restricted stock, deferred stock, dividendequivalents, performance awards and stock payment, or any combination thereof. Underthe 2004 Plan, we may grant options to purchase up to 2,100,000 shares ofcommon stock. Options granted under the plan vest over various terms with amaximum life of ten years and an exercise price equal to the fair market valueof the underlying stock at the date of grant. As of December 31, 2005,options to purchase 991,365 shares of common stock were outstanding under the2004 Plan, and 107,816 were exercisable with exercise prices ranging from$39.98 to $64.66 and a weighted average exercise price of $49.72. At December 31,2005, 1,055,695 shares were available for grant.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

*Long Term IncentivePlan*

On July 28, 2005, the Long Term Incentive Plan,or LTIP, was approved effective July 1, 2005. The purpose of the LTIP isto provide equity incentives to senior management that include not only stockoptions or similar grants, but also a performance share program that measuresperformance on a multi-year basis.

The performance period under the LTIP began on July 1,2005 and ends on December 31, 2007. Awards under the LTIP will be madeunder the 2004 Plan or any successor plan. It is expected that each participantwill receive an annual grant of stock options under the 2004 Plan. All suchoptions will be for a term of ten years and will generally vest over four yearsin equal annual installments, except for options granted to Mr. Albertson,our CEO, which will vest over three years consistent with his preexistingemployment agreement. The exercise price will be the fair market value of theunderlying common stock on the date of grant. At the time of the initialadoption of the LTIP, we granted options to acquire an aggregate of 109,000shares of common stock to participants.

Under the LTIP, participants also may receiveperformance awards in the form of common stock. Whether or not performanceshares are earned by the participants will be determined based upon whether ornot we achieve specified objective performance goals during the ten quarterperformance period of the LTIP. The target number of performance sharespotentially issuable under the LTIP is expected to be 260,076, with the actualnumber of shares ultimately issuable to be between zero and twice such amount,depending on actual performance. The compensation committee also has thediscretion to make cash payments in lieu of performance shares. Individuals whobecome LTIP participants after initial adoption may receive a prorated award.

Under the terms of theCompany’s long-term incentive plan, a stock-based compensation expense is onlyrecorded if the Company expects to meet or exceed the relevant earningstargets. Since we had not achieved the target as of the end of 2005, no accrualis necessary. A catch-up accrual would be required if future results put usback on track to achieve the planned targets.

*Employee StockPurchase Plan*

In April 2001, the Employee Stock Purchase Plan(the “ESPP Plan”) was adopted. The ESPP Plan is a tax-qualified employee stockpurchase plan which authorizes 500,000 shares of our common stock, $0.01 parvalue, for issuance under the plan. Under the ESPP Plan, participants aregranted options to purchase our common stock at a price which is eighty-fivepercent of the stock’s fair market value on either the first or last day of theoffering period, whichever price is lower. The options are then automaticallyexercised on the last business day of the offering period. The participantspurchase the shares through payroll deductions. As of December 31, 2005,221,913 shares had been purchased under the ESPP Plan at a weighted-averageprice of $24.47 per share.

We apply APB 25 in accounting for our plans. Nostock-based employee compensation cost is reflected in net income, as alloptions granted under those plans had an exercise price equal to the marketvalue of the underlying common stock on the date of grant.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

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

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

| ** **                         | ** ** | **No. of Shares** | ** ** | **Weighted Average  Exercise Price** | ** ** |
|------------------------------------|------------|-----------------------------|------------|------------------------------------------------|------------|
| Balance at December 31,  2002 |       |                        | 4,397,963  |                                           |       |   | $ | 14.75 |   |   |
| Granted                            |       |                        | 510,927    |                                           |       |   | 27.34 |   |   |
| Exercised                          |       |                        | (1,203,087 | )                                              |       |   | 14.45 |   |   |
| Forfeited                          |       |                        | (92,871    | )                                              |       |   | 20.02 |   |   |
| Balance at  December 31, 2003 |       |                        | 3,612,932  |                                           |       |   | 16.54 |   |   |
| Granted                            |       |                        | 804,100    |                                           |       |   | 39.78 |   |   |
| Exercised                          |       |                        | (1,313,555 | )                                              |       |   | 13.55 |   |   |
| Forfeited                          |       |                        | (75,660    | )                                              |       |   | 29.83 |   |   |
| Balance at  December 31, 2004 |       |                        | 3,027,817  |                                           |       |   | 23.68 |   |   |
| Granted                            |       |                        | 551,500    |                                           |       |   | 59.52 |   |   |
| Exercised                          |       |                        | (687,089   | )                                              |       |   | 17.22 |   |   |
| Forfeited                          |       |                        | (89,834    | )                                              |       |   | 37.42 |   |   |
| Balance at  December 31, 2005 |       |                        | 2,802,394  |                                           |       |   | $ | 31.94 |   |   |

 

Thefollowing is a summary of stock options outstanding and exercisable at December 31,2005:

| ** **                                  | ** ** | **Outstanding** | ** ** | **Exercisable**             | ** ** |
|---------------------------------------------|------------|-----------------|------------|-----------------------------|------------|
| **Range of Exercise Prices** | ** ** | ** **      | ** ** | **Number of  Options** | ** ** | **Weighted  Average Years  Remaining** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Number of  Options** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| $8.34 to $10.89                             |       |            | 167,123    |                        |       | 3.88 |   |   |   | $ | 10.59 |   |   | 167,123 |   |   | $ | 10.59 |   |   |
| $13.44 to $17.73                            |       |            | 752,485    |                        |       | 5.90 |   |   |   | $ | 16.01 |   |   | 696,993 |   |   | $ | 15.93 |   |   |
| $18.25 to $20.75                            |       |            | 255,632    |                        |       | 2.77 |   |   |   | $ | 19.70 |   |   | 255,632 |   |   | $ | 19.70 |   |   |
| $21.96 to $39.98                            |       |            | 1,095,904  |                        |       | 8.04 |   |   |   | $ | 35.47 |   |   | 382,819 |   |   | $ | 33.13 |   |   |
| $53.08 to $64.66                            |       |            | 531,250    |                        |       | 9.49 |   |   |   | $ | 59.82 |   |   | 0 |   |   | $ | 0 |   |   |
| $8.34 to $64.66                             |       |            | 2,802,394  |                        |       | 7.01 |   |   |   | $ | 31.94 |   |   | 1,502,567 |   |   | $ | 20.36 |   |   |
|                                             |            |                 |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**11.**IncomeTaxes

Totalincome taxes for the years ended December 31, 2005, 2004 and 2003 consistof:

| **2005**   | ** ** | ** **              | ** ** | **Current** | ** ** | **Deferred** | ** ** | **Total** | ** ** |
|------------|------------|-------------------------|------------|-------------|------------|--------------|------------|-----------|------------|
| ** ** | ** ** | **(in thousands)** | ** ** |
| Federal    |       | $                       | 48,391     |        | $          | (5,223       | )          | $         | 43,168     |   |
| State      |       | 5,090                   |       | (253        | )          | 4,837        |       |
|       |       | $                       | 53,481     |        | $          | (5,476       | )          | $         | 48,005     |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**11. IncomeTaxes (Continued)**

| **2004**   | ** ** | ** **              | ** ** | **Current** | ** ** | **Deferred** | ** ** | **Total** | ** ** |
|------------|------------|-------------------------|------------|-------------|------------|--------------|------------|-----------|------------|
| ** ** | ** ** | **(in thousands)** | ** ** |
| Federal    |       | $                       | 34,332     |        | $          | 793          |       | $         | 35,125     |   |
| State      |       | 3,625                   |       | 123         |       | 3,748        |       |
|       |       | $                       | 37,957     |        | $          | 916          |       | $         | 38,873     |   |

 

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

 

Actualincome taxes for 2005, 2004 and 2003 differ from the statutory tax rate of 35%as applied to income before income taxes as follows:

| ** **                                      | ** ** | **2005**                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|----------|------------|----------|------------|
| ** **                                      | ** ** | **(in thousands)** | ** ** |
| Expected income  tax expense                    |       | $                       | 43,641     |     | $          | 35,804   |       | $ | 20,827 |   |
| State income  taxes, net of federal tax benefit |       | 3,317                   |       | 2,436    |       | 1,459    |       |
| Non deductible  items                           |       | 1,508                   |       | 402      |       | 273      |       |
| Change in  valuation allowance                  |       | (52                     | )          | —   |       | —   |       |
| Other                                           |       | (409                    | )          | 231      |       | 90       |       |
| Actual income tax expense                       |       | $                       | 48,005     |     | $          | 38,873   |       | $ | 22,649 |   |

 

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

| ** **                                                      | ** ** | **2005**                | ** ** | **2004** | ** ** |
|-----------------------------------------------------------------|------------|-------------------------|------------|----------|------------|
| ** **                                                      | ** ** | **(in thousands)** | ** ** |
| Deferred tax assets:                                            |       |                    |       |     |       |
| State net operating loss carryforward                           |       | $                       | 41         |     | $          | 38 |   |
| Accrued liabilities                                             |       | 7,893                   |       | 3,174    |       |
| Merchandise inventories                                         |       | 5,568                   |       | 2,340    |       |
| Capital loss carryover                                          |       | 1,181                   |       | 1,138    |       |
| Total gross  deferred tax assets                                |       | 14,683                  |       | 6,690    |       |
| Deferred tax  liabilities:                                      |       |                    |       |     |       |
| Depreciation                                                    |       | $                       | (13,551    | )        | $          | (2,940 | ) |
| Intangibles                                                     |       | (4,820                  | )          | —   |       |
| Other                                                           |       | (1,936                  | )          | (2,117   | )          |
| Total gross  deferred tax liabilities                           |       | (20,307                 | )          | (5,057   | )          |
| Net deferred tax  assets/(liabilities) and net operating losses |       | (5,624                  | )          | 1,633    |       |
| Less valuation  allowance                                       |       | (1,191                  | )          | (1,138   | )          |
| Net deferred tax  assets/(liabilities)                          |       | $                       | (6,815     | )        | $          | 495 |   |

 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**11. IncomeTaxes (Continued)**

In assessing the realizability of deferred tax assets,management considers whether it is more likely than not that some portion orall of the deferred tax assets will not be realized. The ultimate realizationof deferred tax assets is dependent upon the generation of future taxableincome during the periods in which those temporary differences becomedeductible. We consider scheduled reversal of deferred tax liabilities,projected future taxable income and tax planning strategies in making thisassessment. Based upon the level of historical taxable income and projectionsof future taxable income over the periods which the deferred tax assets aredeductible, management believes it is more likely than not that we will realizethe benefits of these deductible differences. The amount of the deferred tax assetsconsidered realizable, however, could be reduced in the near term if estimatesof future taxable income during the carryforward periods are reduced. Thevaluation allowance for 2005 and 2004 consists of capital loss carryforwardsand state net operating losses.

The Company accounts forthe tax benefit resulting from the employee exercises of non-qualifying stockoptions or the disqualified disposition of incentive stock options as areduction in income tax payable and an increase to additional paid-in capitalin the accompanying consolidated financial statements. The Company recorded$7.6 million, $9.8 million and $4.1 million of a benefit in 2005, 2004 and2003, respectively.

**12.Accrued Expenses and Other Current Liabilities**

**Thecomponents of accrued expenses and other current liabilities are as follows:**

| ** **                    | ** ** | **December 31,**   | ** ** |
|-------------------------------|------------|-------------------------|------------|
| ** **                    | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                    | ** ** | **(in thousands)** | ** ** |
| Wages, salaries and  benefits |       | $                       | 30,564     |   | $ | 29,320 |   |
| Sales tax payable             |       | 12,813                  |       | 11,894 |   |
| Accrued income taxes          |       | 18,846                  |       | 7,576 |   |
| Accrued advertising           |       | 8,193                   |       | 6,038 |   |
| Provision for sales  returns  |       | 5,007                   |       | 5,335 |   |
| Accrued insurance             |       | 4,310                   |       | 3,520 |   |
| Unearned revenue              |       | 5,802                   |       | 3,358 |   |
| Accrued real estate tax       |       | 1,847                   |       | 2,165 |   |
| Accrued professional  fees    |       | 4,281                   |       | 2,030 |   |
| Accrued interest              |       | 2,169                   |       | 1,880 |   |
| Accrued freight               |       | 1,432                   |       | 988 |   |
| Accrued catalog costs         |       | 369                     |       | 882 |   |
| Accrued utilities             |       | 922                     |       | 887 |   |
| Other                         |       | 9,626                   |       | 7,733 |   |
|                          |       | $                       | 106,181    |   | $ | 83,606 |   |

 

**13. Legal**

On November 29, 2005,a case was filed against us and other defendants, including our Chief ExecutiveOfficer, in the United States District Court for the Southern District ofFlorida. The complaint asserts, among other things, violations of the FederalRacketeering Influenced and Corrupt Organization Act (RICO) and a correspondingFlorida statute, Sections 1 and 2 of the Sherman Antitrust Act, Section 2 

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**13. Legal(Continued)**

of theClayton Act (as amended by the Robinson-Patman Act), the Antidumping Act of1916, the Florida Antitrust Act of 1980, and the Florida Deceptive and UnfairTrade Practices Act, as well as tortious interference with businessrelationship under Florida law and civil conspiracy under Florida law by someor all of the identified defendants in connection with the claimed inability ofAce Pro Sound and Recording, L.L.C. to obtain vendor lines for its store. Thecomplaint purports to be made as a class action on behalf of all current andformer retail sellers of musical instruments and/or sound equipment and/orrecording equipment with stores located in geographical regions in the UnitedStates wherein some or all of the defendants have carried on business, andseeks compensatory damages, treble damages, punitive damages, injunctive reliefand attorneys fees. Service relating to the complaint was made on us on January 12,2006 and a responsive pleading is due in March 2006.

While we believe thislawsuit is without merit and intend to defend it vigorously, it may, regardlessof the outcome, result in substantial expenses and damages to us and maysignificantly divert the attention of our management. There can be no assurancethat we will be able to achieve a favorable settlement of this lawsuit orobtain a favorable resolution of this lawsuit if it is not settled. Anunfavorable resolution of this lawsuit could have a material adverse effect onour business, financial condition and results of operations. Regardless of theoutcome, the costs and expenses incurred by us to defend this lawsuit couldadversely impact our financial condition.

On May 6, 2005, alawsuit entitled Farnam Street Financial, Inc. v. GuitarCenter, Inc., Case No. CT 05-6546, was filed in the FourthJudicial District in the State of Minnesota for the County of Hennepin. Thelawsuit, which was filed by a Minnesota corporation, alleged breach of contractin connection with the lease of certain equipment located in our corporateoffice and retail stores. Among other things, the lawsuit alleged that webreached the contract by our failure to comply with the terms and conditions inconnection with the return of the equipment and sought approximately $4.5million of damages and attorneys’ fees. We reached a settlement in this matterduring a mediation held on January 16, 2006. Pursuant to the terms of thesettlement agreement, we paid the plaintiff approximately $1 million for a fullrelease and settlement of all claims, which were accrued for as of December 31,2005.

On October 13, 2004, a putative class actionlawsuit entitled Carlos Rodriguez v. The Guitar Center, Inc. [sic], Case No. GC322958,was filed in the Superior Court of the State of California for the County ofLos Angeles. The lawsuit was filed by an individual purporting to represent allhourly retail store employees employed by us within the State of California. OnDecember 15, 2004, a putative class action lawsuit entitled James McClainet. al. v. Guitar Center Stores, Inc., Case No. BC326002, was filedin the Superior Court of the State of California for the County of Los Angeles.The lawsuit was filed by three individuals purporting to represent all hourlyretail store employees employed by us within the State of California.  Among other things, the lawsuits alleged thatwe improperly failed to document and enforce break-time and lunch-time periodsfor such employees and sought an unspecified amount of damages, penalties andattorneys’ fees.

On December 15, 2005 we reached preliminaryagreement to settle these two purported class action lawsuits. Under the termsof the proposed settlement, which is subject to final documentation and courtapproval, we will make cash payments of up to $3.5 million to fully resolveclaims by eligible class members, including payments to class members andpayments for plaintiff attorneys’ fees and the costs of a third-partyadministrator, an estimate of which were accrued for as of December 31,2005.

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**GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued) December 31, 2005**

**13. Legal(Continued)**

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

**14. QuarterlyFinancial Data (unaudited)**

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

 

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

 

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**ScheduleII**

**GUITARCENTER, INC. AND SUBSIDIARIESVALUATION AND QUALIFYING ACCOUNTSYears ended December 31, 2005, 2004 and 2003(amounts in thousands)**

| ** **                          | ** ** | **Balance at  beginning  of year** | ** ** | **Additions  charged to  operations** | ** ** | **Deductions  from  Allowance** | ** ** | **Balance  at end  of year** | ** ** |
|-------------------------------------|------------|----------------------------------------------|------------|--------------------------------------------|------------|---------------------------------|------------|----------------------------------------|------------|
| December 31, 2005              |       |                                         |       |                                       |       |                            |       |                                   |       |   |   |   |   |   |   |
| Allowance for doubtful receivables  |       |                                         | $          | 3,489                                      |       |                            |       | 4,027                                  |       |   |   | 2,585 |   |   | $ | 4,931 |   |
| December 31, 2004              |       |                                         |       |                                       |       |                            |       |                                   |       |   |   |   |   |   |   |
| Allowance for doubtful receivables  |       |                                         | $          | 1,708                                      |       |                            |       | 4,126                                  |       |   |   | 2,345 |   |   | $ | 3,489 |   |
| December 31, 2003              |       |                                         |       |                                       |       |                            |       |                                   |       |   |   |   |   |   |   |
| Allowance for  doubtful receivables |       |                                         | $          | 1,083                                      |       |                            |       | 625                                    |       |   |   | — |   |   | $ | 1,708 |   |

 

II-1

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