**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 
| **ý** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004** |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                        |
| **o**      | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                               |

 

**COMMISSIONFILE NUMBER 001-11911**

 

**STEINWAY MUSICAL INSTRUMENTS, INC.**

(Exactname of registrant as specified in its charter)

 

| **DELAWARE**                                                               |   | **35-1910745**                        |
|----------------------------------------------------------------------------|--------|---------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization)           |   | (I.R.S. Employer  Identification No.) |
|                                                                       |   |                                  |
| **800  South Street, Suite 305  Waltham, Massachusetts**                   |   | **02453**                             |
| (Address of Principal  Executive Offices)                                  |   | (Zip Code)                            |
|                                                                       |   |                                  |
| Registrant’s telephone number including area code: **(781) 894-9770** |

 

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

Yes ý    No o

 

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

Yes ý    No o

 
| Number of shares of Common  Stock issued and outstanding as of April 28, 2004: |   | Class A  |   | 477,952   |   |
|--------------------------------------------------------------------------------|--------|----------|--------|-----------|--------|
|                                                                           |   | Ordinary |   | 7,479,577 |   |
|                                                                           |   | Total    |   | 7,957,529 |   |

 

 

----

 

###### **STEINWAY MUSICALINSTRUMENTS, INC. AND SUBSIDIARIES**

**FORM 10-Q**

**INDEX**

 
| **PART  I.** | **UNAUDITED  FINANCIAL INFORMATION**                                                            |   |
|--------------|-------------------------------------------------------------------------------------------------|--------|
|         |                                                                                            |   |
| **Item 1.**  | **Consolidated and Condensed  Consolidated Financial Statements:**                              |   |
|         |                                                                                            |   |
|         | Consolidated  Statements of Income  Three months ended March 31, 2004 and March 29, 2003        |   |
|         |                                                                                            |   |
|         | Condensed  Consolidated Balance Sheets  March 31, 2004 and December 31,2003                     |   |
|         |                                                                                            |   |
|         | Consolidated Statements of  Cash Flows  Three months ended March 31, 2004 and March 29, 2003    |   |
|         |                                                                                            |   |
|         | Consolidated  Statement of Stockholders’ Equity  Three months ended March 31, 2004         |   |
|         |                                                                                            |   |
|         | Notes to Condensed Consolidated  Financial Statements                                           |   |
|         |                                                                                            |   |
| **Item 2.**  | **Management’s Discussion and Analysis of  Financial Condition and Results of Operations** |   |
|         |                                                                                            |   |
| **Item 3.**  | **Quantitative and Qualitative Disclosures about  Market Risk**                                 |   |
|         |                                                                                            |   |
| **Item 4.**  | **Controls and Procedures**                                                                     |   |
|         |                                                                                            |   |
| **PART II.** | **OTHER INFORMATION**                                                                           |   |
|         |                                                                                            |   |
| **Item 2.**  | **Changes in Securities and Use  of Proceeds**                                                  |   |
|         |                                                                                            |   |
| **Item 6.**  | **Exhibits and Reports on Form 8-K**                                                            |   |
|         |                                                                                            |   |
|         | **Signatures**                                                                                  |   |

 

2

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# **ITEM 1**                  CONSOLIDATED ANDCONDENSED CONSOLIDATED FINANCIAL STATEMENTS

# ** **

**STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**Unaudited**

**(In Thousands Except Share and Per Share Amounts)**

 
|                         |   | **Three  Months Ended** |   |
|------------------------------|--------|-------------------------|--------|
|                         |   | **March 31,  2004**     |   | **March 29,  2003** |   |
|                         |   |                    |   |   |   |
| Net sales                    |   | $                       | 90,061 |   | $ | 82,509 |   |
| Cost of sales                |   | 64,336                  |   | 61,677 |   |
|                         |   |                    |   |   |   |
| Gross Profit                 |   | 25,725                  |   | 20,832 |   |
|                         |   |                    |   |   |   |
| Operating  expenses:         |   |                    |   |   |   |
| Sales and  marketing         |   | 11,294                  |   | 11,013 |   |
| General and  administrative  |   | 6,014                   |   | 5,954 |   |
| Amortization of  intangibles |   | 291                     |   | 289 |   |
| Other operating  expenses    |   | 28                      |   | 172 |   |
| Total operating  expenses    |   | 17,627                  |   | 17,428 |   |
|                         |   |                    |   |   |   |
| Income from  operations      |   | 8,098                   |   | 3,404 |   |
|                         |   |                    |   |   |   |
| Other income,  net           |   | (612                    | )      | (621 | ) |
| Interest income              |   | (637                    | )      | (618 | ) |
| Interest expense             |   | 3,778                   |   | 3,590 |   |
|                         |   |                    |   |   |   |
| Income before  income taxes  |   | 5,569                   |   | 1,053 |   |
|                         |   |                    |   |   |   |
| Income taxes                 |   | 2,225                   |   | 370 |   |
|                         |   |                    |   |   |   |
| Net income                   |   | $                       | 3,344  |   | $ | 683 |   |
|                         |   |                    |   |   |   |
| Earnings per  share:         |   |                    |   |   |   |
| Basic                        |   | $                       | 0.41   |   | $ | 0.08 |   |
| Diluted                      |   | $                       | 0.39   |   | $ | 0.08 |   |
|                         |   |                    |   |   |   |
| Weighted average  shares:    |   |                    |   |   |   |
| Basic                        |   | 8,210,407               |   | 8,906,238 |   |
| Diluted                      |   | 8,519,707               |   | 8,906,418 |   |

 

See notes to condensed consolidated financial statements.

 

3

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**STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**Unaudited**

**(In Thousands)**

 
|                                                                                                                         |   | **March 31,  2004** |    | **December  31,  2003** |   |
|------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|---------|-------------------------|--------|
|                                                                                                                         |   |                |    |                    |   |
| ASSETS:                                                                                                                      |   |                |    |                    |   |
| Current assets:                                                                                                              |   |                |    |                    |   |
| Cash                                                                                                                         |   | $                   | 45,050  |                    | $      | 42,283 |   |
| Accounts, notes  and leases receivable, net of allowance for bad debts of $10,015 and $9,944  in 2004 and 2003, respectively |   | 84,037              |    | 76,403                  |   |
| Inventories                                                                                                                  |   | 155,284             |    | 152,029                 |   |
| Prepaid expenses  and other current assets                                                                                   |   | 4,436               |    | 4,533                   |   |
| Deferred tax  assets                                                                                                         |   | 12,973              |    | 13,022                  |   |
| Total current  assets                                                                                                        |   | 301,780             |    | 288,270                 |   |
|                                                                                                                         |   |                |    |                    |   |
| Property, plant  and equipment, net of accumulated depreciation of $64,709 and $63,952 in 2004  and 2003, respectively       |   | 97,615              |    | 98,937                  |   |
| Trademarks                                                                                                                   |   | 10,230              |    | 10,319                  |   |
| Goodwill                                                                                                                     |   | 31,383              |    | 31,665                  |   |
| Other  intangibles, net                                                                                                      |   | 5,595               |    | 5,782                   |   |
| Other assets                                                                                                                 |   | 11,288              |    | 10,692                  |   |
|                                                                                                                         |   |                |    |                    |   |
| TOTAL ASSETS                                                                                                                 |   | $                   | 457,891 |                    | $      | 445,665 |   |
|                                                                                                                         |   |                |    |                    |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                                   |   |                |    |                    |   |
| Current  liabilities:                                                                                                        |   |                |    |                    |   |
| Current portion  of long-term debt                                                                                           |   | $                   | 11,129  |                    | $      | 10,638 |   |
| Accounts payable                                                                                                             |   | 12,055              |    | 11,554                  |   |
| Other current  liabilities                                                                                                   |   | 45,655              |    | 39,112                  |   |
| Total current  liabilities                                                                                                   |   | 68,839              |    | 61,304                  |   |
|                                                                                                                         |   |                |    |                    |   |
| Long-term debt                                                                                                               |   | 215,066             |    | 185,964                 |   |
| Deferred tax  liabilities                                                                                                    |   | 25,251              |    | 25,565                  |   |
| Other  non-current liabilities                                                                                               |   | 20,081              |    | 20,197                  |   |
| Total  liabilities                                                                                                           |   | 329,237             |    | 293,030                 |   |
|                                                                                                                         |   |                |    |                    |   |
| Commitments and  contingent liabilities                                                                                      |   |                |    |                    |   |
|                                                                                                                         |   |                |    |                    |   |
| Stockholders’  equity:                                                                                                  |   |                |    |                    |   |
| Common stock                                                                                                                 |   | 10                  |    | 10                      |   |
| Additional  paid-in capital                                                                                                  |   | 79,525              |    | 74,626                  |   |
| Retained  earnings                                                                                                           |   | 100,064             |    | 96,720                  |   |
| Accumulated  other comprehensive loss, net                                                                                   |   | (3,509              | )       | (2,868                  | )      |
| Treasury stock,  at cost                                                                                                     |   | (47,436             | )       | (15,853                 | )      |
| Total  stockholders’ equity                                                                                             |   | 128,654             |    | 152,635                 |   |
|                                                                                                                         |   |                |    |                    |   |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                             |   | $                   | 457,891 |                    | $      | 445,665 |   |

 

See notes to condensed consolidated financial statements.

 

4

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**STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**Unaudited**

**(In Thousands)**

 
|                                                                          |   | **Three  Months Ended** |   |
|-------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                          |   | **March 31,  2004**     |   | **March  29,  2003** |   |
| Cash flows from  operating activities:                                        |   |                    |   |   |   |
| Net income                                                                    |   | $                       | 3,344  |   | $ | 683 |   |
| Adjustments to  reconcile net income to cash flows from operating activities: |   |                    |   |   |   |
| Depreciation and  amortization                                                |   | 2,703                   |   | 2,818 |   |
| Amortization of  bond premium                                                 |   | (42                     | )      | — |   |
| Deferred tax  benefit                                                         |   | (127                    | )      | (123 | ) |
| Debt issuance  costs                                                          |   | (105                    | )      | — |   |
| Other                                                                         |   | 31                      |   | 63 |   |
| Changes in  operating assets and liabilities:                                 |   |                    |   |   |   |
| Accounts, notes  and leases receivable                                        |   | (7,706                  | )      | (7,824 | ) |
| Inventories                                                                   |   | (3,955                  | )      | 417 |   |
| Prepaid expenses  and other current assets                                    |   | 430                     |   | 213 |   |
| Accounts payable                                                              |   | 517                     |   | (2,937 | ) |
| Other current  liabilities                                                    |   | 6,819                   |   | 4,457 |   |
| Other assets                                                                  |   | (924                    | )      | 246 |   |
| Cash flows from  operating activities                                         |   | 985                     |   | (1,987 | ) |
|                                                                          |   |                    |   |   |   |
| Cash flows from  investing activities:                                        |   |                    |   |   |   |
| Capital  expenditures                                                         |   | (904                    | )      | (747 | ) |
| Proceeds from  disposals of fixed assets                                      |   | 76                      |   | — |   |
| Cash flows from  investing activities                                         |   | (828                    | )      | (747 | ) |
|                                                                          |   |                    |   |   |   |
| Cash flows from  financing activities:                                        |   |                    |   |   |   |
| Borrowings under  lines of credit                                             |   | 8,230                   |   | 4,157 |   |
| Repayments under  lines of credit                                             |   | (7,896                  | )      | (3,794 | ) |
| Repayments of  long-term debt                                                 |   | (1,640                  | )      | (1,619 | ) |
| Proceeds from  issuance of common stock                                       |   | 4,257                   |   | — |   |
| Cash flows from  financing activities                                         |   | 2,951                   |   | (1,256 | ) |
|                                                                          |   |                    |   |   |   |
| Effect of  foreign exchange rate changes on cash                              |   | (341                    | )      | 25 |   |
|                                                                          |   |                    |   |   |   |
| Increase  (decrease) in cash                                                  |   | 2,767                   |   | (3,965 | ) |
| Cash, beginning  of period                                                    |   | 42,283                  |   | 19,099 |   |
|                                                                          |   |                    |   |   |   |
| Cash, end of  period                                                          |   | $                       | 45,050 |   | $ | 15,134 |   |
|                                                                          |   |                    |   |   |   |
| Supplemental  Cash Flow Information                                           |   |                    |   |   |   |
| Interest paid                                                                 |   | $                       | 316    |   | $ | 391 |   |
| Taxes paid                                                                    |   | $                       | 2,760  |   | $ | 2,285 |   |
|                                                                          |   |                    |   |   |   |
| Non-cash  transaction:                                                        |   |                    |   |   |   |
| Purchase of  common stock by issuance of bonds                                |   | $                       | 31,583 |   | $ | — |   |

 

See notes to condensed consolidated financial statements.

 

5

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**STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

**Unaudited**

**(In Thousands Except Share Data)**

 
|                                                    |   | **Common  Stock** |   | **Additional  Paid-In  Capital** |   | **Retained  Earnings** |   | **Accumulated  Other  Comprehensive  Loss** |    | **Treasury  Stock** |   | **Total  Stockholders’  Equity** |   |
|---------------------------------------------------------|--------|-------------------|--------|----------------------------------|--------|------------------------|--------|---------------------------------------------|---------|---------------------|--------|---------------------------------------|--------|
|                                                    |   |              |   |                             |   |                   |   |                                        |    |                |   |                                  |   |
| Balance,  December 31, 2003                             |   | $                 | 10     |                             | $      | 74,626                 |   | $                                           | 96,720  |                | $      | (2,868                                | )      | $ | (15,853 | ) | $ | 152,635 |   |
| Comprehensive  income:                                  |   |              |   |                             |   |                   |   |                                        |    |                |   |                                  |   |
| Net income                                              |   |              |   |                             |   | 3,344                  |   |                                        |    |                |   | 3,344                                 |   |
| Foreign currency  translation adjustment                |   |              |   |                             |   |                   |   | (493                                        | )       |                |   | (493                                  | )      |
| Additional minimum  pension liability, net              |   |              |   |                             |   |                   |   | (148                                        | )       |                |   | (148                                  | )      |
| Total  comprehensive income                             |   |              |   |                             |   |                   |   |                                        |    |                |   | 2,703                                 |   |
| Exercise of  231,035 options for shares of common stock |   |              |   | 4,257                            |   |                   |   |                                        |    |                |   | 4,257                                 |   |
| Tax benefit of  options exercised                       |   |              |   | 642                              |   |                   |   |                                        |    |                |   | 642                                   |   |
| Purchase of  1,271,450 shares of common stock           |   |              |   |                             |   |                   |   |                                        |    | (31,583             | )      | (31,583                               | )      |
| Balance, March  31, 2004                                |   | $                 | 10     |                             | $      | 79,525                 |   | $                                           | 100,064 |                | $      | (3,509                                | )      | $ | (47,436 | ) | $ | 128,654 |   |

 

6

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**STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**NOTESTO CONSOLIDATED****AND CONDENSED CONSOLIDATED**

**FINANCIAL STATEMENTS**

**MARCH 31, 2004**

**Unaudited**

**(Tabular Amounts In Thousands Except Share and Per ShareData)**

 

**(1)**   **Basis of Presentation**

 

The accompanyingcondensed consolidated financial statements of Steinway Musical Instruments,Inc. and subsidiaries (the “Company”) for the three months ended March 31, 2004and March 29, 2003 are unaudited.  Inthe opinion of management, these statements have been prepared on the samebasis as the audited consolidated financial statements as of and for the yearended December 31, 2003, and include all adjustments which are of a normal andrecurring nature, necessary for the fair presentation of financial position,results of operations and cash flows for the interim period.  You should read the condensed consolidatedfinancial statements in conjunction with the consolidated financial statementsand notes thereto contained in the Company’s Annual Report on Form 10-K for thefiscal year ended December 31, 2003 filed with the Securities and ExchangeCommission.  The results of operationsfor the three months ended March 31, 2004 are not necessarily indicative of theresults that may be expected for the entire year.

 

Throughout this report“we”, “us”, and “our” refer to Steinway Musical Instruments, Inc. andsubsidiaries taken as a whole.

 

**(2)**   **Summary of Significant Accounting Policies**

 

*Principles of Consolidation -*Our consolidated financial statementsinclude the accounts of all direct and indirect subsidiaries, all of which arewholly-owned, including The Steinway Piano Company, Inc. (“Steinway”) andConn-Selmer, Inc. (“Conn-Selmer”). Significant intercompany balances have been eliminated in consolidation.

 

*Stock-basedCompensation* - Wehave an employee stock purchase plan (“Purchase Plan”) and a stock option plan(“Stock Plan”).  As permitted underaccounting principles generally accepted in the United States of America, wehave elected to continue to follow the intrinsic value method in accounting forour stock-based employee compensation arrangements.

 

7

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The following table illustrates the effect on net income and earningsper share as if we had applied the fair value method to measure stock-basedemployee compensation:

 
|                                                                                                                                          |   | **Three  Months Ended** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|
|                                                                                                                                          |   | **March 31,  2004**     |       | **March 29,  2003** |   |
|                                                                                                                                          |   |                    | ** ** |   | ** ** |
| Net income, as  reported                                                                                                                      |   | $                       | 3,344      |   | $ | 683 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair-value based  method for all awards, net of related tax effects |   | (254                    | )          | (220 | ) |
|                                                                                                                                          |   |                    |       |   |   |
| Pro forma net  income                                                                                                                         |   | $                       | 3,090      |   | $ | 463 |   |
| Earnings per  share:                                                                                                                          |   |                    |       |   |   |
| Basic - as  reported                                                                                                                          |   | $                       | 0.41       |   | $ | 0.08 |   |
| Basic - pro  forma                                                                                                                            |   | $                       | 0.38       |   | $ | 0.05 |   |
|                                                                                                                                          |   |                    |       |   |   |
| Diluted - as  reported                                                                                                                        |   | $                       | 0.39       |   | $ | 0.08 |   |
| Diluted - pro  forma                                                                                                                          |   | $                       | 0.36       |   | $ | 0.05 |   |

 

We measured the fairvalue of options on their grant date, including the valuation of the optionfeature implicit in our Purchase Plan using the Black-Scholes option-pricingmodel.  Key assumptions used to applythis pricing model are as follows:

 
|                                                                              |   | **Three  Months Ended** |   |
|-----------------------------------------------------------------------------------|--------|-------------------------|--------|
|                                                                              |   | **March 31,  2004**     |   | **March 29,  2003** |   |
| Weighted-average  interest rates                                                  |   | 1.26%                   |   | 2.59% |   |
| Weighted-average  expected life of option feature in the Purchase Plan (in years) |   | 0.33                    |   | 0.33 |   |
| Weighted-average  expected life of option grants (in years)                       |   | —                  |   | 6 |   |
| Expected  volatility of underlying stock                                          |   | 27%                     |   | 25% |   |

 

The weighted-average fair value of options on their grant date is asfollows:

 
|                             |   | **Three  Months Ended** |   |
|----------------------------------|--------|-------------------------|--------|
|                             |   | **March 31,  2004**     |   | **March 29,  2003** |   |
|                             |   |                    |   |   |   |
| Stock Plan                       |   | —                  |   | $ | 4.77 |   |
| Option feature  in Purchase Plan |   | $                       | 4.09   |   | $ | 4.78 |   |
|                                  |        |                         |        |  |  |  |  |

 

8

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It should be noted thatthe Black-Scholes option-pricing model was designed to value readily tradableoptions with relatively short lives and no vesting restrictions.  In addition, option valuation models requirethe input of highly subjective assumptions including the expected pricevolatility.  Because the options grantedare not tradable and have contractual lives of up to ten years, and becausechanges in the subjective input assumptions can materially affect the fairvalue estimate, in our opinion, the existing models do not provide a reliablemeasure of the fair value of the options issued under either the Stock Plan orPurchase Plan.

 

*Earnings per Common Share –*We compute basic earnings per share using theweighted-average number of common shares outstanding during each period.  Diluted earnings per common share reflectsthe effect of our outstanding options using the treasury stock method, exceptwhen such options would be antidilutive.

 

A reconciliation of the weighted-average shares used for the basic anddiluted computations is as follows:

 
|                              |   | **Three  Months Ended** |   |
|-----------------------------------|--------|-------------------------|--------|
|                              |   | **March 31,  2004**     |   | **March 29,  2003** |   |
| Weighted-average  shares:         |   |                    |   |   |   |
| For basic  earnings per share     |   | 8,210,407               |   | 8,906,238 |   |
| Dilutive effect  of stock options |   | 309,300                 |   | 180 |   |
| For diluted  earnings per share   |   | 8,519,707               |   | 8,906,418 |   |

 

All outstanding optionswere included in the computation of diluted net earnings per common share forthe three months ended March 31, 2004. Options to purchase 1,069,000 shares of common stock at prices rangingfrom $14.73 to $21.94 per share were outstanding during the three months endedMarch 29, 2003, but were not included in the computation of diluted earningsper share because the exercise prices of the options were greater than theaverage market price of the common shares.

 

*Comprehensive Income –*Comprehensive income is comprised offoreign currency translation adjustments, additional minimum pensionliabilities, and unrealized gains and losses on certain long-term assets.  The components of accumulated othercomprehensive loss are as follows:

 
|               |   | **Foreign  Currency  Translation  Adjustment** |   | **Gain/(Loss)  on  Long-term  Assets** |   | **Tax Impact  of  Gain/(Loss) on  Long-term  Assets** |   | **Additional  Minimum  Pension  Liability** |   | **Tax Impact  of  Additional  Minimum  Pension  Liability** |   | **Accumulated  Other  Comprehensive  Loss** |   |
|--------------------|--------|------------------------------------------------|--------|----------------------------------------|--------|-------------------------------------------------------|--------|---------------------------------------------|--------|-------------------------------------------------------------|--------|---------------------------------------------|--------|
|               |   |                                           |   |                                   |   |                                                  |   |                                        |   |                                                        |   |                                        |   |
| December 31,  2003 |   | $                                              | 1,226  |                                   | $      | 73                                                    |   | $                                           | (29    | )                                                           | $      | (6,853                                      | )      | $ | 2,715 |   | $ | (2,868 | ) |
| Activity           |   | (493                                           | )      | —                                 |   | —                                                |   | (211                                        | )      | 63                                                          |   | (641                                        | )      |
| March 31, 2004     |   | $                                              | 733    |                                   | $      | 73                                                    |   | $                                           | (29    | )                                                           | $      | (7,064                                      | )      | $ | 2,778 |   | $ | (3,509 | ) |

 

9

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*New Accounting Pronouncements –*InDecember 2003, the Financial Accounting Standards Board (“FASB”) revisedStatement of Financial Accounting Standard (“SFAS”) No. 132, “Employers’Disclosures about Pensions and Other Postretirement Benefits.”  SFAS No. 132 requires additional disclosureabout the assets, obligations, cash flows, and net periodic benefit cost ofdefined benefit pension plans and other defined benefit postretirementplans.  This statement also requiresdisclosure about the types of plan assets, investment strategy, measurementdates, plan obligations, and cash flows. SFAS No. 132 is effective for fiscal years ending after December 15,2003. Disclosure of information about foreign plans required by this statementis effective for fiscal years ending after June 15, 2004.  Interim period disclosures for both domesticand foreign plans required by this statement are effective for periodsbeginning after December 15, 2003, and are included in Note 11.

 

In January 2004, the FASB issued FASB Statement ofPosition (“FSP”) Financial Accounting Standard 106-1, “Accounting andDisclosure Requirements Related to the Medicare Prescription Drug, Improvementand Modernization Act of 2003.”  ThisFSP provides temporary guidance concerning the recently enacted MedicarePrescription Drug, Improvement and Modernization Act of 2003 (the “Act”), whichintroduces a prescription drug benefit under Medicare Part D as well as afederal subsidy to sponsors of retiree health care benefit plans that provide abenefit that is at least actuarially equivalent to Medicare Part D.  The FSP permits a sponsor of apostretirement health care plan that provides a prescription drug benefit tomake a one-time election to defer recognizing the effects of the Act andproviding the required disclosures.  TheFSP is effective for annual financial statements ending on or after December 7,2003.  Under our plan, eligible hourlyretirees and their dependents are only entitled to postretirement health carebenefits until they are eligible for Medicare. Therefore, the FSP is not applicable to our plan and will not have anyimpact on its financial position, results of operations, or cash flows.

 

*Reclassifications* – Certain prior yearamounts have been reclassified to conform to the current year presentation.

 

**(3)**   **Inventories**

 
|            |   | **March 31,  2004** |    | **December  31,  2003** |   |
|-----------------|--------|---------------------|---------|-------------------------|--------|
|            |   |                |    |                    |   |
| Raw materials   |   | $                   | 22,135  |                    | $      | 21,268 |   |
| Work in process |   | 48,207              |    | 50,620                  |   |
| Finished goods  |   | 84,942              |    | 80,141                  |   |
| Total           |   | $                   | 155,284 |                    | $      | 152,029 |   |

 

**(4)**   **Goodwill, Trademarks, and Other Intangible Assets**

 

We ceased to recordamortization expense on our goodwill and trademark assets on January 1, 2002.  We test our goodwill and trademark assetsfor impairment annually, or on an interim basis if events or circumstancesindicate that the fair value of an asset has decreased below its carryingvalue.  At July 27, 2003 we evaluatedour goodwill and trademark assets and determined that the fair value had notdecreased below the carrying value and, accordingly, we have made no impairmentadjustments.

 

10

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The changes in net carrying amounts of goodwill andtrademarks are as follows:

 
|                                 |   | **Piano  Segment** |   | **Band  Segment** |   |
|--------------------------------------|--------|--------------------|--------|-------------------|--------|
| Goodwill:                            |   |               |   |              |   |
| Beginning  balance December 31, 2003 |   | $                  | 23,110 |              | $      | 8,555 |   |
| Foreign currency  translation impact |   | (282               | )      | —            |   |
| Ending Balance  March 31, 2004       |   | $                  | 22,828 |              | $      | 8,555 |   |
|                                 |   |               |   |              |   |
| Trademarks:                          |   |               |   |              |   |
| Beginning  balance December 31, 2003 |   | $                  | 7,648  |              | $      | 2,671 |   |
| Foreign currency  translation impact |   | (89                | )      | —            |   |
| Ending Balance  March 31, 2004       |   | $                  | 7,559  |              | $      | 2,671 |   |

 

We also carry certain intangible assets that are amortized, whichconsist of the following:

 
|                            |   | **March 31,  2004** |   | **December  31,  2003** |   |
|---------------------------------|--------|---------------------|--------|-------------------------|--------|
|                            |   |                |   |                    |   |
| Gross deferred  financing costs |   | $                   | 9,397  |                    | $      | 9,293 |   |
| Accumulated  amortization       |   | (3,875              | )      | (3,596                  | )      |
| Deferred  financing costs, net  |   | $                   | 5,522  |                    | $      | 5,697 |   |
|                            |   |                |   |                    |   |
| Gross covenants  not to compete |   | $                   | 250    |                    | $      | 250 |   |
| Accumulated  amortization       |   | (177                | )      | (165                    | )      |
| Covenants not to  compete, net  |   | $                   | 73     |                    | $      | 85 |   |

 

The weighted-average amortization period for deferred financing costsis 9.1 years, and the weighted-average amortization period of covenants not tocompete is 5.0 years.  Totalamortization expense is as follows:

 
|                  |   | **Three  Months Ended** |   |
|-----------------------|--------|-------------------------|--------|
|                  |   | **March 31,  2004**     |   | **March 29,  2003** |   |
|                  |   |                    |   |   |   |
| Amortization  expense |   | $                       | 291    |   | $ | 289 |   |
|                       |        |                         |        |  |  |  |  |

 

11

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The following table shows the total estimatedamortization expense for 2004 and the next five succeeding fiscal years:

 

Estimated amortization expense:

 
| 2004 |   | $     | 1,059  |   |
|------|--------|-------|--------|--------|
| 2005 |   | 1,002 |   |
| 2006 |   | 967   |   |
| 2007 |   | 967   |   |
| 2008 |   | 822   |   |
| 2009 |   | 472   |   |

 

**(5)**   **Other Current Liabilities**

 
|                                  |   | **March 31,  2004** |   | **December 31,  2003** |   |
|---------------------------------------|--------|---------------------|--------|------------------------|--------|
|                                  |   |                |   |                   |   |
| Accrued payroll  and related benefits |   | $                   | 21,187 |                   | $      | 16,986 |   |
| Current portion  of pension liability |   | 2,156               |   | 2,663                  |   |
| Accrued warranty  expense             |   | 2,559               |   | 2,602                  |   |
| Accrued interest                      |   | 7,044               |   | 2,706                  |   |
| Deferred income                       |   | 4,094               |   | 4,161                  |   |
| Income and other  taxes payable       |   | 962                 |   | 1,889                  |   |
| Other accrued  expenses               |   | 7,653               |   | 8,105                  |   |
| Total                                 |   | $                   | 45,655 |                   | $      | 39,112 |   |

 

Accrued warrantyexpense is generally recorded at the time of sale for instruments which have awarranty period ranging from five to ten years.  The accrued expense recorded is based on a percentage of salesand is adjusted periodically following an analysis of actual warranty claimactivity.  Accrued warranty expense forinstruments that have a warranty period of one year is recorded based on warrantyreturn trends.

 

12

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The accrued warrantyexpense activity for the three months ended March 31, 2004 and the year endedDecember 31, 2003 is as follows:

 
|                     |   | **March  31,  2004** |   | **December  31,  2003** |   |
|--------------------------|--------|---------------------------|--------|-------------------------|--------|
|                     |   |                      |   |                    |   |
| Beginning  balance       |   | $                         | 2,602  |                    | $      | 2,357 |   |
| Additions                |   | 290                       |   | 1,361                   |   |
| Claims and  reversals    |   | (321                      | )      | (1,314                  | )      |
| Foreign exchange  impact |   | (12                       | )      | 198                     |   |
| Ending balance           |   | $                         | 2,559  |                    | $      | 2,602 |   |

 

**(6)  Long-Term Debt**

 

Long-term debt consists of the following:

 
|                                                     |   | **March 31,  2004** |    | **December  31,  2003** |   |
|----------------------------------------------------------|--------|---------------------|---------|-------------------------|--------|
| Term loans                                               |   | $                   | 45,538  |                    | $      | 47,178 |   |
| 8.75% Senior  Notes                                      |   | 174,345             |    | 145,345                 |   |
| Unamortized bond  premium                                |   | 1,772               |    | —                  |   |
| Open account  loans, payable on demand to a foreign bank |   | 4,540               |    | 4,079                   |   |
| Total                                                    |   | 226,195             |    | 196,602                 |   |
| Less current portion                                     |   | 11,129              |    | 10,638                  |   |
| Long-term debt                                           |   | $                   | 215,066 |                    | $      | 185,964 |   |

 

Scheduled payments of long-term debt are as follows:

 
|   |               |   | **March 31,  2004** |    | **December  31,  2003** |   |
|--------|--------------------|--------|---------------------|---------|-------------------------|--------|
|   | Remainder of  2004 |   | $                   | 9,484   |                    | $      | 10,638 |   |
|   | 2005               |   | 7,184               |    | 7,179                   |   |
|   | 2006               |   | 8,337               |    | 8,333                   |   |
|   | 2007               |   | 8,380               |    | 8,376                   |   |
|   | 2008               |   | 16,693              |    | 16,731                  |   |
|   | Thereafter         |   | 174,345             |    | 145,345                 |   |
|   | Total              |   | $                   | 224,423 |                    | $      | 196,602 |   |

 

**(7)**   **Stockholders’ Equity**

 

Our common stockis comprised of two classes: Class A and Ordinary.  With the exception of disparate voting power, both classes aresubstantially identical.  Each share ofClass A common stock entitles the holder to 98 votes.  Holders of Ordinary common stock are entitled to one vote per share.

 

13

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Class A common stock shall automatically convert to Ordinary commonstock if, at any time, the Class A common stock is not owned by an originalClass A holder.  The Chairman and ChiefExecutive Officer own 100% of the Class A common shares, representingapproximately 86% of the combined voting power of the Class A common stock andOrdinary common stock.

 

On February 4,2004 we purchased 1,271,450 shares of our Ordinary common stock from AIGRetirement Services, Inc. (formerly AIG SunAmerica), our largest institutionalshareholder.  In exchange, we issued$29.0 million in principal amount of our 8.75% Senior Notes due 2011 under ourexisting indenture.  We issued thesebonds at a premium of 106.3%.  Thistransaction resulted in an increase to our treasury stock of $31.6 million.

 

**(8)**   **Facility Rationalization Charges –Band Segment**

 

In 2003, we began a facility rationalization project to eliminateexcess manufacturing capacity in our band segment.  As part of this project, we closed our woodwind manufacturingfacility in Nogales, Arizona in November 2003. We also announced that in 2004 we would be closing one of our woodwindmanufacturing facilities in Elkhart, Indiana and transferring that plant’sproduction to other company-owned facilities. This facility was closed on April 1, 2004.  As a result of this closure, we recorded charges of $1.4 millionin severance and related expenses in 2004. We anticipate incurring an additional $0.1 million in severance expensesin 2004.

 

The severance liability associated with the band segment’s facilityrationalization project is as follows:

 

Facility rationalization severance liability:

 
| Balance at  January 1, 2003         |   | $     | — |   |
|-------------------------------------|--------|-------|--------|--------|
| Additions  charged to cost of sales |   | 1,683 |   |
| Payments                            |   | (525  | )      |
| Balance January  1, 2004            |   | 1,158 |   |
| Additions  charged to cost of sales |   | 1,412 |   |
| Payments                            |   | (323  | )      |
| Balance at March  31, 2004          |   | $     | 2,247  |   |

 

**(9)**   **Other Income, Net**

 
|                         |   | **Three  Months Ended** |   |
|------------------------------|--------|-------------------------|--------|
|                         |   | **March 31,  2004**     |   | **March 29,  2003** |   |
|                         |   |                    |   |   |   |
| West 57th  building income   |   | $                       | (1,163 | ) | $ | (1,163 | ) |
| West 57th  building expenses |   | 814                     |   | 814 |   |
| Foreign exchange  gains, net |   | (258                    | )      | (104 | ) |
| Miscellaneous                |   | (5                      | )      | (168 | ) |
| Other income,  net           |   | $                       | (612   | ) | $ | (621 | ) |

 

14

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**(10)**         **Commitments and Contingent Liabilities**

 

We are involved incertain legal proceedings regarding environmental matters, which are describedbelow.  Further, in the ordinary courseof business, we are party to various legal actions that we believe are routinein nature and incidental to the operation of our business.  While the outcome of such actions cannot bepredicted with certainty, we believe that, based on our experience in dealingwith these matters, their ultimate resolution will not have a material adverseimpact on our business, financial condition, or results of operations.

 

We operated manufacturingfacilities at certain locations where hazardous substances (includingchlorinated solvents) were used.  Webelieve that an entity that formerly operated one such facility may havereleased hazardous substances at such location, which we leased through July2001.  We did not contribute to therelease.  Further, we have a contractualindemnity from certain stockholders of this entity.  This facility is not the subject of a legal proceeding thatinvolves us, nor, to our knowledge, is the facility subject toinvestigation.  However, no assurancecan be given that legal proceedings will not arise in the future and that suchindemnitors would make the payments described in the indemnity.

 

We operate othermanufacturing facilities which were previously owned by Philips ElectronicsNorth America Corporation (“Philips”). Philips agreed to indemnify us for any and all losses, damages,liabilities and claims relating to environmental matters resulting from certainactivities of Philips occurring prior to December 29, 1988 (the “EnvironmentalIndemnity Agreement”).  Philips hasfully performed its obligations under the Environmental Indemnity Agreement,which terminates on December 29, 2008. Four matters covered by the Environmental Indemnity Agreement arecurrently pending.  Philips has enteredinto Consent Orders with the Environmental Protection Agency (“EPA”) for onesite and the North Carolina Department of Environment, Health and NaturalResources for a second site, whereby Philips has agreed to pay requiredresponse costs.  On October 22, 1998, wewere joined as defendant in an action involving a site formerly occupied by abusiness we acquired in Illinois. Philips has accepted the defense of this action pursuant to the terms ofthe Environmental Indemnity Agreement. For the fourth site, the EPA has notified us it intends to carry out thefinal remediation itself.  The EPAestimates that this remedy has a present net cost of approximately $14.5million. The EPA has named over 40 persons or entities as potentiallyresponsible parties at this Elkhart, Indiana site, including four Conn-Selmerpredecessor entities.  For two of theseentities, which were previously owned by Philips, this matter has been tenderedto Philips pursuant to the Environmental Indemnity Agreement.  Our potential liability at any of thesesites is affected by several factors including, but not limited to, the methodof remediation, our portion of the materials in the site relative to the othernamed parties, the number of parties participating, and the financialcapabilities of the other potentially responsible parties once the relativeshare has been determined.  No assurancecan be given, however, that additional environmental issues will not requireadditional, currently unanticipated investigation, assessment or remediationexpenditures or that Philips will make payments that it is obligated to makeunder the Environmental Indemnity Agreement.

 

We are also continuing anexisting environmental remediation program at a facility acquired in 2000.  We currently estimate that this project willtake eighteen years to complete, at a total cost of approximately $1.1million.  We have accrued approximately$0.8 million for the estimated remaining cost of this remediation program,which represents the present value total cost using a discount rate of

 

15

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5.0%.  Asummary of expected payments associated with this project is as follows:

 

|       |   | **Environmental  Payments** |   |
|------------|--------|-----------------------------|--------|
| 2004       |   | $                           | 176    |   |
| 2005       |   | 81                          |   |
| 2006       |   | 81                          |   |
| 2007       |   | 81                          |   |
| 2008       |   | 56                          |   |
| Thereafter |   | 673                         |   |
| Total      |   | $                           | 1,148  |   |

 

The matters describedabove and our other liabilities and compliance costs arising underenvironmental laws are not expected to have a material impact on our capitalexpenditures, earnings or competitive position.  However, some risk of environmental liability is inherent in thenature of our current and former businesses and we might, in the future, incurmaterial costs to meet current or more stringent compliance, cleanup or other obligationspursuant to environmental laws.

 

**(11)**         **Retirement Plans**

 

We have defined benefitpension plans covering the majority of our employees, including certainemployees in foreign countries.   Thecomponents of net periodic pension cost for these plans are as follows:

 
|                                |   | **Domestic  Plans**     |   | **Foreign  Plans**      |   |
|-------------------------------------|--------|-------------------------|--------|-------------------------|--------|
|                                |   | **Three  Months Ended** |   | **Three  Months Ended** |   |
|                                |   | **March 31,  2004**     |   | **March 29,  2003**     |   | **March 31,  2004** |   | **March 29,  2003** |   |
| Service cost                        |   | $                       | 286    |                    | $      | 91 |   | $ | 167 |   | $ | 169 |   |
| Interest cost                       |   | 1,033                   |   | 288                     |   | 322 |   | 287 |   |
| Expected return  on plan assets     |   | (1,401                  | )      | (286                    | )      | (68 | ) | (58 | ) |
| Amortization of  prior service cost |   | 212                     |   | 66                      |   | 0 |   | 0 |   |
| Amortization of  net loss           |   | 88                      |   | 61                      |   | 19 |   | 10 |   |
| Net periodic  benefit cost          |   | $                       | 218    |                    | $      | 220 |   | $ | 440 |   | $ | 408 |   |

 

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We provide postretirementhealth care and life insurance benefits to eligible hourly retirees and theirdependents.  The components of netperiodic pension cost for these benefits are as follows:

 
|                                   |   | **Three  Months Ended** |   |
|----------------------------------------|--------|-------------------------|--------|
|                                   |   | **March 31,2004**       |   | **March 29,2003** | ** ** |
| Service cost                           |   | $                       | 19     |   | $ | 18 |   |
| Interest cost                          |   | 38                      |   | 35 |   |
| Amortization of  transition obligation |   | 13                      |   | 11 |   |
| Amortization of  net loss              |   | 5                       |   | 4 |   |
| Net  postretirement benefit cost       |   | $                       | 75     |   | $ | 68 |   |

 

We anticipate domestic pension plan contributions ofapproximately $3.3 million for the current year.  As of March 31, 2004 we have contributed $0.7 million to theseplans.

 

**(12)**         **Segment Information**

 

We have identified tworeportable segments: the piano segment and the band and orchestral instrumentsegment.  We consider these two segmentsreportable as they are managed separately and the operating results of eachsegment are separately reviewed and evaluated by our senior management on aregular basis.  Management and the chiefoperating decision maker use income from operations as a meaningful measurementof profit or loss for the segments. Income from operations for the reportable segments includes certaincorporate costs allocated to the segments based primarily on revenue, as wellas intercompany profit.  Amountsreported as “Other & Elim” include those corporate costs that were notallocated to the reportable segments and the remaining intercompany profitelimination.

 

The following tables present information about ouroperating segments for the three-month period ended March 31, 2004 and March29, 2003:

 
|                             |   | **Piano  Segment** |   | **Band and  Orchestral Segment** |   | **Other** |   | **Consol** |   |
|----------------------------------|--------|--------------------|--------|----------------------------------|--------|-----------|--------|------------|--------|
| **Three months ended 2004**      |   | **U.S.**           |   | **Germany**                      |   | **Other** |   | **Total**  |   | **U.S.** |   | **Other** |   | **Total** |   | **& Elim** |   | **Total** |   |
| Net sales to  external customers |   | $                  | 26,741 |                             | $      | 10,388    |   | $          | 8,588  |   | $ | 45,717 |   | $ | 43,181 |   | $ | 1,163 |   | $ | 44,344 |   | $ | — |   | $ | 90,061 |   |
| Income (loss)  from operations   |   | 2,252              |   | 1,556                            |   | 1,152     |   | 4,960      |   | 3,789 |   | 35 |   | 3,824 |   | (686 | ) | 8,098 |   |
|                                  |        |                    |        |                                  |        |           |        |            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                             |   | **Piano Segment** |   | **Band and Orchestral Segment** |   | **Other** |   | **Consol** |   |
|----------------------------------|--------|-------------------|--------|---------------------------------|--------|-----------|--------|------------|--------|
| **Three months ended 2003**      |   | **U.S.**          |   | **Germany**                     |   | **Other** |   | **Total**  |   | **U.S.** |   | **Other** |   | **Total** |   | **& Elim** |   | **Total** |   |
| Net sales to  external customers |   | $                 | 20,414 |                            | $      | 10,002    |   | $          | 5,519  |   | $ | 35,935 |   | $ | 45,458 |   | $ | 1,116 |   | $ | 46,574 |   | $ | — |   | $ | 82,509 |   |
| Income (loss)  from operations   |   | 273               |   | 1,331                           |   | 794       |   | 2,398      |   | 1,529 |   | 63 |   | 1,592 |   | (586 | ) | 3,404 |   |
|                                  |        |                   |        |                                 |        |           |        |            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

17

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**(13)**         **Summary of Guarantees**

 

During 2001, we completed a $150.0 million 8.75%Senior Note offering.  At the end of2002, we repurchased $4.7 million of these Senior Notes at 99.25%.  On February 4, 2004, we issued an additional$29.0 million of these Senior Notes at 106.3%.

 

Our payment obligations under the 8.75% Senior Notesare fully and unconditionally guaranteed on a joint and several basis byConn-Selmer, Steinway, and certain other of our direct and indirectwholly-owned subsidiaries, each a Guarantor (the “GuarantorSubsidiaries”).  These subsidiariesrepresent all of our (the “Issuer”) operations conducted in the UnitedStates.  The remaining subsidiaries, whichdo not guarantee the 8.75% Senior Notes, represent non-U.S. operations (the“Non Guarantor Subsidiaries”).

 

The following condensed consolidating supplementarydata illustrates the financial position, results of operations, and cash flowsof the Guarantor Subsidiaries and the Non Guarantor Subsidiaries.  Separate complete financial statements ofthe respective Guarantors would not provide additional material informationthat would be useful in assessing the financial composition of the GuarantorSubsidiaries.  No single GuarantorSubsidiary has any significant legal restrictions on the ability of investorsor creditors to obtain access to its assets in event of default on theguarantee other than its subordination to senior indebtedness.

 

We record investments insubsidiaries on the cost method for purposes of the supplemental consolidatingpresentation.  Earnings of subsidiariesare therefore not reflected in the parent company’s investment accounts andearnings.  The principal eliminationentries eliminate investments in subsidiaries and intercompany balances andtransactions.

 

18

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**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATING STATEMENTS OF INCOME**

**THREE MONTHS ENDED MARCH 31, 2004**

**Unaudited**

**(In Thousands)**

 
|                               |   | **Issuer  of Notes** |   | **Guarantor  Subsidiaries** |   | **Non  Guarantor  Subsidiaries** |   | **Reclass/  Eliminations** |   | **Consolidated** |   |
|------------------------------------|--------|----------------------|--------|-----------------------------|--------|----------------------------------|--------|----------------------------|--------|------------------|--------|
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Net sales                          |   | $                    | — |                        | $      | 72,695                           |   | $                          | 21,056 |             | $      | (3,690 | ) | $ | 90,061 |   |
| Cost of sales                      |   | —               |   | 54,533                      |   | 13,392                           |   | (3,589                     | )      | 64,336           |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Gross profit                       |   | —               |   | 18,162                      |   | 7,664                            |   | (101                       | )      | 25,725           |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Operating  expenses:               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Sales and  marketing               |   | —               |   | 8,212                       |   | 3,064                            |   | 18                         |   | 11,294           |   |
| General and  administrative        |   | 1,360                |   | 3,119                       |   | 1,535                            |   | —                     |   | 6,014            |   |
| Amortization of  intangible assets |   | 116                  |   | 174                         |   | 1                                |   | —                     |   | 291              |   |
| Other operating  (income) expense  |   | (895                 | )      | 620                         |   | 321                              |   | (18                        | )      | 28               |   |
| Total operating  expenses          |   | 581                  |   | 12,125                      |   | 4,921                            |   | —                     |   | 17,627           |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Income (loss)  from operations     |   | (581                 | )      | 6,037                       |   | 2,743                            |   | (101                       | )      | 8,098            |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Other income,  net                 |   | —               |   | (357                        | )      | (255                             | )      | —                     |   | (612             | )      |
| Interest income                    |   | (3,657               | )      | (5,553                      | )      | (29                              | )      | 8,602                      |   | (637             | )      |
| Interest expense                   |   | 3,634                |   | 8,660                       |   | 86                               |   | (8,602                     | )      | 3,778            |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Income (loss)  before income taxes |   | (558                 | )      | 3,287                       |   | 2,941                            |   | (101                       | )      | 5,569            |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Income taxes                       |   | (217                 | )      | 1,330                       |   | 1,153                            |   | (41                        | )      | 2,225            |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Net income  (loss)                 |   | $                    | (341   | )                           | $      | 1,957                            |   | $                          | 1,788  |             | $      | (60 | ) | $ | 3,344 |   |

 

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**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATING STATEMENTS OF INCOME**

**THREE MONTHS ENDED MARCH 29, 2003**

**Unaudited**

**(In Thousands)**

 
|                               |   | **Issuer  of Notes** |   | **Guarantor  Subsidiaries** |   | **Non  Guarantor  Subsidiaries** |   | **Reclass/  Eliminations** |   | **Consolidated** |   |
|------------------------------------|--------|----------------------|--------|-----------------------------|--------|----------------------------------|--------|----------------------------|--------|------------------|--------|
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Net sales                          |   | $                    | — |                        | $      | 68,622                           |   | $                          | 17,063 |             | $      | (3,176 | ) | $ | 82,509 |   |
| Cost of sales                      |   | —               |   | 54,096                      |   | 10,709                           |   | (3,128                     | )      | 61,677           |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Gross profit                       |   | —               |   | 14,526                      |   | 6,354                            |   | (48                        | )      | 20,832           |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Operating  expenses:               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Sales and  marketing               |   | —               |   | 8,294                       |   | 2,731                            |   | (12                        | )      | 11,013           |   |
| General and  administrative        |   | 1,204                |   | 3,542                       |   | 1,208                            |   | —                     |   | 5,954            |   |
| Amortization of  intangible assets |   | 113                  |   | 175                         |   | 1                                |   | —                     |   | 289              |   |
| Other operating  (income) expense  |   | (800                 | )      | 734                         |   | 226                              |   | 12                         |   | 172              |   |
| Total operating  expenses          |   | 517                  |   | 12,745                      |   | 4,166                            |   | —                     |   | 17,428           |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Income (loss)  from operations     |   | (517                 | )      | 1,781                       |   | 2,188                            |   | (48                        | )      | 3,404            |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Other (income)  loss, net          |   | —               |   | (535                        | )      | (86                              | )      | —                     |   | (621             | )      |
| Interest income                    |   | (3,657               | )      | (5,205                      | )      | (28                              | )      | 8,272                      |   | (618             | )      |
| Interest expense                   |   | 3,281                |   | 8,505                       |   | 76                               |   | (8,272                     | )      | 3,590            |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Income (loss)  before income taxes |   | (141                 | )      | (984                        | )      | 2,226                            |   | (48                        | )      | 1,053            |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Income taxes                       |   | (49                  | )      | (451                        | )      | 894                              |   | (24                        | )      | 370              |   |
|                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Net income (loss)                  |   | $                    | (92    | )                           | $      | (533                             | )      | $                          | 1,332  |             | $      | (24 | ) | $ | 683 |   |

 

20

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**MARCH 31, 2004**

**Unaudited**

**(In Thousands)**

 
|                                             |   | **Issuer  of Notes** |   | **Guarantor  Subsidiaries** |   | **Non  Guarantor  Subsidiaries** |   | **Reclass/  Eliminations** |   | **Consolidated** |   |
|--------------------------------------------------|--------|----------------------|--------|-----------------------------|--------|----------------------------------|--------|----------------------------|--------|------------------|--------|
| ASSETS                                           |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Current assets:                                  |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Cash                                             |   | $                    | — |                        | $      | 12,258                           |   | $                          | 5,012  |             | $      | 27,780 |   | $ | 45,050 |   |
| Accounts, notes  and leases receivable, net      |   | —               |   | 70,369                      |   | 13,668                           |   | —                     |   | 84,037           |   |
| Inventories                                      |   | —               |   | 120,319                     |   | 36,197                           |   | (1,232                     | )      | 155,284          |   |
| Prepaid expenses  and other current assets       |   | 565                  |   | 2,752                       |   | 1,119                            |   | —                     |   | 4,436            |   |
| Deferred tax  assets                             |   | —               |   | 8,162                       |   | 4,840                            |   | (29                        | )      | 12,973           |   |
| Total current  assets                            |   | 565                  |   | 213,860                     |   | 60,836                           |   | 26,519                     |   | 301,780          |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Property, plant  and equipment, net              |   | 176                  |   | 81,092                      |   | 16,347                           |   | —                     |   | 97,615           |   |
| Investment in  subsidiaries                      |   | 69,643               |   | 241,488                     |   | —                           |   | (311,131                   | )      | —           |   |
| Trademarks                                       |   | —               |   | 6,280                       |   | 3,950                            |   | —                     |   | 10,230           |   |
| Goodwill                                         |   | —               |   | 18,795                      |   | 12,588                           |   | —                     |   | 31,383           |   |
| Other  intangibles, net                          |   | 3,286                |   | 2,304                       |   | 5                                |   | —                     |   | 5,595            |   |
| Other assets                                     |   | 1,424                |   | 9,247                       |   | 617                              |   | —                     |   | 11,288           |   |
| TOTAL ASSETS                                     |   | $                    | 75,094 |                        | $      | 573,066                          |   | $                          | 94,343 |             | $      | (284,612 | ) | $ | 457,891 |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY       |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Current  liabilities:                            |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Current portion  of long-term debt               |   | $                    | — |                        | $      | 6,589                            |   | $                          | 4,540  |             | $      | — |   | $ | 11,129 |   |
| Accounts payable                                 |   | 369                  |   | 8,706                       |   | 2,980                            |   | —                     |   | 12,055           |   |
| Other current  liabilities                       |   | (11,608              | )      | 43,555                      |   | 14,051                           |   | (343                       | )      | 45,655           |   |
| Total current  liabilities                       |   | (11,239              | )      | 58,850                      |   | 21,571                           |   | (343                       | )      | 68,839           |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Long-term debt                                   |   | 176,173              |   | 11,113                      |   | —                           |   | 27,780                     |   | 215,066          |   |
| Intercompany                                     |   | (119,676             | )      | 123,808                     |   | (4,132                           | )      | —                     |   | —           |   |
| Deferred tax  liabilities                        |   | —               |   | 16,324                      |   | 8,927                            |   | —                     |   | 25,251           |   |
| Other  non-current liabilities                   |   | 811                  |   | 1,552                       |   | 17,718                           |   | —                     |   | 20,081           |   |
| Total  liabilities                               |   | 46,069               |   | 211,647                     |   | 44,084                           |   | 27,437                     |   | 329,237          |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Stockholders’  equity                       |   | 29,025               |   | 361,419                     |   | 50,259                           |   | (312,049                   | )      | 128,654          |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY |   | $                    | 75,094 |                        | $      | 573,066                          |   | $                          | 94,343 |             | $      | (284,612 | ) | $ | 457,891 |   |

 

21

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATING BALANCE SHEETS**

**DECEMBER 31, 2003**

**Unaudited**

**(In Thousands)**

 
|                                             |   | **Issuer  of Notes** |   | **Guarantor  Subsidiaries** |   | **Non  Guarantor  Subsidiaries** |   | **Reclass/  Eliminations** |   | **Consolidated** |   |
|--------------------------------------------------|--------|----------------------|--------|-----------------------------|--------|----------------------------------|--------|----------------------------|--------|------------------|--------|
| ASSETS                                           |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Current assets:                                  |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Cash                                             |   | $                    | — |                        | $      | 12,255                           |   | $                          | 8,792  |             | $      | 21,236 |   | $ | 42,283 |   |
| Accounts, notes  and leases receivable, net      |   | —               |   | 63,180                      |   | 13,209                           |   | 14                         |   | 76,403           |   |
| Inventories                                      |   | —               |   | 117,922                     |   | 35,238                           |   | (1,131                     | )      | 152,029          |   |
| Prepaid expenses  and other current assets       |   | 660                  |   | 2,833                       |   | 1,040                            |   | —                     |   | 4,533            |   |
| Deferred tax  assets                             |   | —               |   | 8,157                       |   | 4,894                            |   | (29                        | )      | 13,022           |   |
| Total current  assets                            |   | 660                  |   | 204,347                     |   | 63,173                           |   | 20,090                     |   | 288,270          |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Property, plant  and equipment, net              |   | 172                  |   | 82,131                      |   | 16,634                           |   | —                     |   | 98,937           |   |
| Investment in  subsidiaries                      |   | 69,643               |   | 237,821                     |   | —                           |   | (307,464                   | )      | —           |   |
| Trademarks                                       |   | —               |   | 6,280                       |   | 4,039                            |   | —                     |   | 10,319           |   |
| Goodwill                                         |   | —               |   | 18,795                      |   | 12,870                           |   | —                     |   | 31,665           |   |
| Other  intangibles, net                          |   | 3,297                |   | 2,478                       |   | 7                                |   | —                     |   | 5,782            |   |
| Other assets                                     |   | 1,478                |   | 8,591                       |   | 623                              |   | —                     |   | 10,692           |   |
| TOTAL ASSETS                                     |   | $                    | 75,250 |                        | $      | 560,443                          |   | $                          | 97,346 |             | $      | (287,374 | ) | $ | 445,665 |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY       |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Current  liabilities:                            |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Current portion  of long-term debt               |   | $                    | — |                        | $      | 6,559                            |   | $                          | 4,079  |             | $      | — |   | $ | 10,638 |   |
| Accounts payable                                 |   | 123                  |   | 7,881                       |   | 3,550                            |   | —                     |   | 11,554           |   |
| Other current  liabilities                       |   | (14,261              | )      | 39,572                      |   | 14,103                           |   | (302                       | )      | 39,112           |   |
| Total current  liabilities                       |   | (14,138              | )      | 54,012                      |   | 21,732                           |   | (302                       | )      | 61,304           |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Long-term debt                                   |   | 145,369              |   | 19,359                      |   | —                           |   | 21,236                     |   | 185,964          |   |
| Intercompany                                     |   | (112,543             | )      | 116,840                     |   | (4,311                           | )      | 14                         |   | —           |   |
| Deferred tax  liabilities                        |   | —               |   | 16,384                      |   | 9,181                            |   | —                     |   | 25,565           |   |
| Other  non-current liabilities                   |   | 515                  |   | 1,720                       |   | 17,962                           |   | —                     |   | 20,197           |   |
| Total  liabilities                               |   | 19,203               |   | 208,315                     |   | 44,564                           |   | 20,948                     |   | 293,030          |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Stockholders’  equity                       |   | 56,047               |   | 352,128                     |   | 52,782                           |   | (308,322                   | )      | 152,635          |   |
|                                             |   |                 |   |                        |   |                             |   |                       |   |             |   |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY |   | $                    | 75,250 |                        | $      | 560,443                          |   | $                          | 97,346 |             | $      | (287,374 | ) | $ | 445,665 |   |

 

22

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATINGSTATEMENTS OF CASH FLOWS**

**THREE MONTHS ENDED MARCH 31, 2004**

**Unaudited**

**(In Thousands)**

 
|                                                                                 |   | **Issuer  of Notes** |   | **Guarantor  Subsidiaries** |   | **Non  Guarantor  Subsidiaries** |   | **Reclass/  Eliminations** |   | **Consolidated** |   |
|--------------------------------------------------------------------------------------|--------|----------------------|--------|-----------------------------|--------|----------------------------------|--------|----------------------------|--------|------------------|--------|
| Cash flows from  operating activities:                                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Net income  (loss)                                                                   |   | $                    | (341   | )                           | $      | 1,957                            |   | $                          | 1,788  |             | $      | (60 | ) | $ | 3,344 |   |
| Adjustments to  reconcile net income (loss) to cash flows from operating activities: |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Depreciation and  amortization                                                       |   | 131                  |   | 2,147                       |   | 425                              |   | —                     |   | 2,703            |   |
| Amortization of  bond premium                                                        |   | (42                  | )      | —                      |   | —                           |   | —                     |   | (42              | )      |
| Deferred tax  benefit                                                                |   | —               |   | (65                         | )      | (62                              | )      | —                     |   | (127             | )      |
| Debt issuance  costs                                                                 |   | (105                 | )      | —                      |   | —                           |   | —                     |   | (105             | )      |
| Other                                                                                |   | —               |   | (76                         | )      | 107                              |   | —                     |   | 31               |   |
| Changes in  operating assets and liabilities:                                        |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Accounts, notes  and leases receivable                                               |   | —               |   | (7,175                      | )      | (531                             | )      | —                     |   | (7,706           | )      |
| Inventories                                                                          |   | —               |   | (2,704                      | )      | (1,352                           | )      | 101                        |   | (3,955           | )      |
| Prepaid expenses  and other current assets                                           |   | 149                  |   | 352                         |   | (71                              | )      | —                     |   | 430              |   |
| Accounts payable                                                                     |   | 246                  |   | 825                         |   | (554                             | )      | —                     |   | 517              |   |
| Other current  liabilities                                                           |   | 2,822                |   | 3,815                       |   | 223                              |   | (41                        | )      | 6,819            |   |
| Other assets                                                                         |   | 3                    |   | (927                        | )      | —                           |   | —                     |   | (924             | )      |
| Cash flows from  operating activities                                                |   | 2,863                |   | (1,851                      | )      | (27                              | )      | —                     |   | 985              |   |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Cash flows from  investing activities:                                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Capital  expenditures                                                                |   | (19                  | )      | (627                        | )      | (258                             | )      | —                     |   | (904             | )      |
| Proceeds from  disposal of fixed assets                                              |   | —               |   | 76                          |   | —                           |   | —                     |   | 76               |   |
| Cash flows from  investing activities                                                |   | (19                  | )      | (551                        | )      | (258                             | )      | —                     |   | (828             | )      |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Cash flows from  financing activities:                                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Borrowings under  lines of credit                                                    |   | 32                   |   | —                      |   | 1,654                            |   | 6,544                      |   | 8,230            |   |
| Repayments under  lines of credit                                                    |   | —               |   | (6,576                      | )      | (1,320                           | )      | —                     |   | (7,896           | )      |
| Repayments of  long-term debt                                                        |   | —               |   | (1,640                      | )      | —                           |   | —                     |   | (1,640           | )      |
| Proceeds from  issuance of stock                                                     |   | 4,257                |   | —                      |   | —                           |   | —                     |   | 4,257            |   |
| Intercompany  transactions                                                           |   | (7,133               | )      | 10,621                      |   | (3,488                           | )      | —                     |   | —           |   |
| Cash flows from  financing activities                                                |   | (2,844               | )      | 2,405                       |   | (3,154                           | )      | 6,544                      |   | 2,951            |   |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Effect of  exchange rate changes on cash                                             |   | —               |   | —                      |   | (341                             | )      | —                     |   | (341             | )      |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Increase  (decrease) in cash                                                         |   | —               |   | 3                           |   | (3,780                           | )      | 6,544                      |   | 2,767            |   |
| Cash, beginning  of period                                                           |   | —               |   | 12,255                      |   | 8,792                            |   | 21,236                     |   | 42,283           |   |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Cash, end of  period                                                                 |   | $                    | — |                        | $      | 12,258                           |   | $                          | 5,012  |             | $      | 27,780 |   | $ | 45,050 |   |

 

23

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATINGSTATEMENTS OF CASH FLOWS**

**THREE MONTHS ENDED MARCH 29, 2003**

**Unaudited**

**(In Thousands)**

 
|                                                                                 |   | **Issuer  of Notes** |   | **Guarantor  Subsidiaries** |   | **Non  Guarantor  Subsidiaries** |   | **Reclass/  Eliminations** |   | **Consolidated** |   |
|--------------------------------------------------------------------------------------|--------|----------------------|--------|-----------------------------|--------|----------------------------------|--------|----------------------------|--------|------------------|--------|
| Cash flows from  operating activities:                                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Net income  (loss)                                                                   |   | $                    | (92    | )                           | $      | (533                             | )      | $                          | 1,332  |             | $      | (24 | ) | $ | 683 |   |
| Adjustments to  reconcile net income (loss) to cash flows from operating activities: |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Depreciation and  amortization                                                       |   | 127                  |   | 2,308                       |   | 383                              |   | —                     |   | 2,818            |   |
| Deferred tax  benefit                                                                |   | —               |   | (66                         | )      | (57                              | )      | —                     |   | (123             | )      |
| Other                                                                                |   | —               |   | 20                          |   | 43                               |   | —                     |   | 63               |   |
| Changes in  operating assets and liabilities:                                        |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Accounts, notes  and leases receivable                                               |   | —               |   | (7,313                      | )      | (414                             | )      | (97                        | )      | (7,824           | )      |
| Inventories                                                                          |   | —               |   | 1,863                       |   | (1,494                           | )      | 48                         |   | 417              |   |
| Prepaid expenses  and other current assets                                           |   | (43                  | )      | 407                         |   | (151                             | )      | —                     |   | 213              |   |
| Accounts payable                                                                     |   | 73                   |   | (2,720                      | )      | (368                             | )      | 78                         |   | (2,937           | )      |
| Other current  liabilities                                                           |   | 1,610                |   | 1,444                       |   | 1,427                            |   | (24                        | )      | 4,457            |   |
| Other assets                                                                         |   | 6                    |   | 240                         |   | —                           |   | —                     |   | 246              |   |
| Cash flows from  operating activities                                                |   | 1,681                |   | (4,350                      | )      | 701                              |   | (19                        | )      | (1,987           | )      |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Cash flows from  investing activities:                                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Capital  expenditures                                                                |   | (2                   | )      | (486                        | )      | (259                             | )      | —                     |   | (747             | )      |
| Cash flows from  investing activities                                                |   | (2                   | )      | (486                        | )      | (259                             | )      | —                     |   | (747             | )      |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Cash flows from  financing activities:                                               |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Borrowings under  lines of credit                                                    |   | —               |   | 3,517                       |   | 640                              |   | —                     |   | 4,157            |   |
| Repayments under  lines of credit                                                    |   | (2                   | )      | (3,162                      | )      | (277                             | )      | (353                       | )      | (3,794           | )      |
| Repayment of  long-term debt                                                         |   | —               |   | (1,619                      | )      | —                           |   | —                     |   | (1,619           | )      |
| Intercompany  transactions                                                           |   | (1,677               | )      | 6,489                       |   | (4,831                           | )      | 19                         |   | —           |   |
| Cash flows from  financing activities                                                |   | (1,679               | )      | 5,225                       |   | (4,468                           | )      | (334                       | )      | (1,256           | )      |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Effect of  exchange rate changes on cash                                             |   | —               |   | —                      |   | 25                               |   | —                     |   | 25               |   |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Increase  (decrease) in cash                                                         |   | —               |   | 389                         |   | (4,001                           | )      | (353                       | )      | (3,965           | )      |
| Cash, beginning  of period                                                           |   | —               |   | 1,166                       |   | 6,736                            |   | 11,197                     |   | 19,099           |   |
|                                                                                 |   |                 |   |                        |   |                             |   |                       |   |             |   |
| Cash, end of  period                                                                 |   | $                    | — |                        | $      | 1,555                            |   | $                          | 2,735  |             | $      | 10,844 |   | $ | 15,134 |   |

 

24

----

 

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

 

**(Tabular Amounts in Thousands Except Share and Per ShareData)**

 

**Introduction**

 

We are a world leader in the design, manufacture,marketing, and distribution of high-quality musical instruments.  Our piano division concentrates on thehigh-end grand piano segment of the industry, handcrafting Steinway pianos inNew York and Germany.  We also offerupright pianos and two mid-priced lines of pianos under the Boston and Essexbrand names.  Moreover, we are thelargest domestic producer of band and orchestral instruments and offer acomplete line of brasswind, woodwind, percussion and stringed instruments andrelated accessories with well-known brand names such as Bach,  Selmer, C.G. Conn, King, and Ludwig.  We sell our products through dealers anddistributors worldwide.  Our pianocustomer base consists of professional artists, amateur pianists, andinstitutions such as concert halls, universities, and music schools.  Our band and orchestral instrument customerbase consists primarily of middle school and high school students, but alsoincludes adult amateur and professional musicians.

 

**CriticalAccounting Policies**

 

The nature of ourbusiness - the production and sale of musical instruments - is such that itrarely involves application of highly complex or subjective accountingprinciples.  The accounting policiesthat are subject to significant management estimates are those normally foundin traditional businesses and include inventory reserves, accounts receivablereserves, reserves on notes receivable, and warranty reserves.  We have significant experience and data onwhich to base these estimates. Historical information is adjusted for specific uncertainties, such asnew product introductions, and contemporaneous information, such as pricefluctuations.  Management regularlyperforms assessments of the underlying assumptions and believes that theyprovide a reasonable basis for the estimates contained in our financialstatements.

 

**Forward-LookingStatements**

 

Certain statementscontained in this document are “forward-looking statements” within the meaningof Section 21E of the Securities and Exchange Act of 1934, as amended.  These forward-looking statements representour present expectations or beliefs concerning future events.  We caution that such statements arenecessarily based on certain assumptions which are subject to risks and uncertaintieswhich could cause actual results to differ materially from those indicated inthis report.  These risk factorsinclude, but are not limited to, the following:  changes in general economic conditions; geopolitical events;increased competition; work stoppages and slowdowns; exchange rate fluctuations;variations in the mix of products sold; market acceptance of new bandinstrument product and distribution strategies; ability of suppliers to meetdemand; and fluctuations in effective tax rates resulting from shifts insources of income.  Further informationon these risk factors is included in our Annual Report on Form 10-K for theyear ended December 31, 2003, our Final Prospectus filed in August 1996, andRegistration Statement No. 333-62790 filed in June 2001, particularly in thesections entitled “Risk Factors.”  Weencourage you to read those descriptions carefully.  We caution investors not to place undue reliance on theforward-looking statements contained in this report.  These statements, like all statements contained in this report, speakonly as of the date of this report (unless another date is indicated) and weundertake no obligation to update or revise the statements except as requiredby law.

 

25

----

 

**Resultsof Operations**

 

*ThreeMonths Ended March 31, 2004 Compared to Three Months Ended March 29, 2003*

 
|                        |   | **Quarter  Ended**  |   |   |   | **Change**          |   |
|-----------------------------|--------|---------------------|--------|--------|--------|---------------------|--------|
|                        |   | **March 31,  2004** |   |   |   | **March 29,  2003** |   |   |   | **$** |   | **%** |   |
|                        |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Net sales                   |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Band                        |   | $                   | 44,344 |   |   |                | $      | 46,574 |   |   |   | (2,230 | ) | (4.8 | ) |
| Piano                       |   | 45,717              |   |   |   | 35,935              |   |   |   | 9,782 |   | 27.2 |   |
| Total sales                 |   | 90,061              |   |   |   | 82,509              |   |   |   | 7,552 |   | 9.2 |   |
|                        |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Cost of sales               |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Band                        |   | 34,316              |   |   |   | 37,582              |   |   |   | (3,266 | ) | (8.7 | ) |
| Piano                       |   | 30,020              |   |   |   | 24,095              |   |   |   | 5,925 |   | 24.6 |   |
| Total cost of  sales        |   | 64,336              |   |   |   | 61,677              |   |   |   | 2,659 |   | 4.3 |   |
|                        |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Gross profit                |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Band                        |   | 10,028              |   | 22.6%  |   | 8,992               |   | 19.3% |   | 1,036 |   | 11.5 |   |
| Piano                       |   | 15,697              |   | 34.3%  |   | 11,840              |   | 32.9% |   | 3,857 |   | 32.6 |   |
| Total gross  profit         |   | 25,725              |   |   |   | 20,832              |   |   |   | 4,893 |   | 23.5 |   |
|                        |   | 28.6%               |   |   |   | 25.2%               |   |   |   |   |   |   |   |
|                        |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Operating  expenses         |   | 17,627              |   |   |   | 17,428              |   |   |   | 199 |   | 1.1 |   |
|                        |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Income from  operations     |   | 8,098               |   |   |   | 3,404               |   |   |   | 4,694 |   | 137.9 |   |
|                        |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Other income,  net          |   | (612                | )      |   |   | (621                | )      |   |   | 9 |   | (1.4 | ) |
| Net interest  expense       |   | 3,141               |   |   |   | 2,972               |   |   |   | 169 |   | 5.7 |   |
|                        |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Income before  income taxes |   | 5,569               |   |   |   | 1,053               |   |   |   | 4,516 |   | 428.9 |   |
|                        |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Income taxes                |   | 2,225               |   | 40.0%  |   | 370                 |   | 35.1% |   | 1,855 |   | 501.4 |   |
|                        |   |                |   |   |   |                |   |   |   |   |   |   |   |
| Net income                  |   | $                   | 3,344  |   |   |                | $      | 683 |   |   |   | 2,661 |   | 389.6 |   |

 

*Overview –*The net results for the first quarter are on par with ourexpectations.  Although our banddivision performance was constrained by some of our suppliers not being able tofully meet our short-term order demands, we are pleased with the preliminaryresults of our new product introduction and channel distributionstrategies.  In addition, we were ableto substantially complete our facility rationalization project, closing one of ourwoodwind manufacturing facilities on April 1, 2004 and consolidating theproduction into another facility.

 

26

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Our piano division was ableto significantly improve performance over the year ago quarter.  Domestically, our retail performance improvedsignificantly, aided in part by our two new retail facilities, which were fullyoperational for the period.  Ourdomestic wholesale business also showed improvements, and overseas we were ableto capitalize on the recent improvements in the Asian economy.

 

*Net Sales –*The increase in net sales of $7.6 million resulted from a 21% increasein Steinway grand unit shipments, the majority of which occurred domestically,as well as $2.5 million in benefit attributable to foreign exchange.  An increase in Boston product shipments of15% also contributed to the sales improvement. A 10% decrease in unit shipments, resulting primarily from lower orderrates from school music dealers, contributed to the band and orchestralinstrument sales drop of $2.2 million. Although preliminary results from our new product strategy are positive,we are still aligning product availability with product demand, and ourbackorder position on certain imported products also negatively impacted sales.

 

*G**ross Profit–* Gross profit increased $4.9 million as both the piano and bandsegments experienced improvements in gross margins.  Piano margins increased from 32.9% to 34.3% due primarily to theincrease in domestic retail sales and a favorable product mix sold by ourGerman division, which offset a $0.4 million negative impact of foreignexchange on inventory purchased by our Japanese division.  In 2003, band gross profit was adverselyimpacted by $1.9 million in payments to employees in accordance with expiredlabor contracts and $0.9 million from work stoppages at two of our plants.  In 2004, gross profit was negativelyimpacted by $1.4 million in severance costs associated with the closure of oneof our woodwind manufacturing facilities. The decrease in these atypical charges, coupled with the increase insales of higher margin imported products, resulted in the band division’s grossmargin improvement from 19.3% to 22.6% for the period.

 

*Operating Expenses* – The increase inoperating expenses of $0.2 million occurred principally as a result of $0.6million from foreign currency translation. Excluding this impact, operating expenses decreased slightly.  On a per segment basis, piano sales andmarketing expenses increased $0.4 million due to our two new retail stores, butthis was offset by savings by the band segment resulting from administrativestaff reductions and lower sales and marketing expenses.

 

*Interest Expense and Other Income, Net -*Otherexpenses increased $0.2 million to $2.5 million due to the additional interestexpense resulting from our issuance of an additional $29.0 million in 8.75%Senior Notes in February, 2004.

 

*Income Taxes* –**Our effective tax rate is significantly impacted by ourability to utilize foreign tax credits. The amount of such credit utilization is based on the ratio of foreignsource to total income computed solely on a tax, as opposed to book, reportingbasis.  As a result of the strengtheningof our domestic piano and band divisions and changes in tax legislation incertain states in which we do business, our effective tax rate has increasedfrom 35.1% to 40.0% in the current period.

 

**Liquidityand Capital Resources**

 

We have relied primarily upon cash provided byoperations, supplemented as necessary by seasonal borrowings under our workingcapital line, to finance our operations, repay long-term indebtedness and fundcapital expenditures.

 

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Our statements of cash flows for the three monthsended March 31, 2004 and March 29, 2003 are summarized as follows:

 
|                                                                         |   | **2004** |   | **2003** |   | **Change** |   |
|------------------------------------------------------------------------------|--------|----------|--------|----------|--------|------------|--------|
| Net income:                                                                  |   | $        | 3,344  |     | $      | 683        |   | $ | 2,661 |   |
| Changes in  operating assets and liabilities                                 |   | (4,819   | )      | (5,428   | )      | (609       | )      |
| Other  adjustments to reconcile net income to cash from operating activities |   | 2,460    |   | 2,758    |   | (298       | )      |
| Cash flows from  operating activities                                        |   | 985      |   | (1,987   | )      | 2,972      |   |
|                                                                         |   |     |   |     |   |       |   |
| Cash flows from  investing activities                                        |   | (828     | )      | (747     | )      | (81        | )      |
|                                                                         |   |     |   |     |   |       |   |
| Cash flows from  financing activities                                        |   | 2,951    |   | (1,256   | )      | 4,207      |   |
|                                                                              |        |          |        |          |        |            |        |  |  |  |

 

The 2004 increase in cashflows from operating activities of $3.0 million occurred as a result of the$2.7 million increase in net income, as well as the $0.6 million increase incash provided by the changes in operating assets and liabilities.  We used an additional $4.4 million toreplenish inventory and obtain sourced product in the current period.  However, this was offset by increases inaccounts payable and accrued expenses resulting from timing of payments tovendors and severance costs.

 

The decrease in cashflows from investing activities of $0.1 million is primarily due to increasedcapital expenditures.  The increase incash flows from financing activities of $4.2 million resulted primarily fromproceeds from stock option exercises of $4.3 million.

 

## **Borrowing Availability andActivities**

 

Our real estate termloan, acquisition term loan and domestic seasonal borrowing requirements areaccommodated through a committed credit facility with a syndicate of domesticlenders (the “Credit Facility”).  TheCredit Facility provides us with a potential borrowing capacity of up to $85.0million in revolving credit loans, based on eligible accounts receivable andinventory balances.  The acquisitionterm loan and revolving credit loan portions of the Credit Facility bearinterest at average 30-day LIBOR plus 1.75%, and the real estate term loanbears interest at average 30-day LIBOR plus 1.5%.   The Credit facility expires on September 14, 2008.  As of March 31, 2004, there were no revolvingcredit loans outstanding and availability based on eligible accounts receivableand inventory balances, net of letter of credit deductions of $3.0 million, wasapproximately $82.0 million.  Openaccount loans with foreign banks also provide for borrowings by Steinway’sforeign subsidiaries of up to €17.3 million ($21.3 million at the March 31,2004 exchange rate).  A portion of theopen account loans can be converted into a maximum of £0.5 million ($0.9million at the March 31, 2004 exchange rate) for use by our UK branch and ¥600million ($5.7 million at the March 31, 2004 exchange rate) for use by ourJapanese subsidiary.  We had $4.5million in foreign loans outstanding as of March 31, 2004.

 

On February 4, 2004 we purchased 1,271,450 shares ofour Ordinary common stock directly from our largest institutionalshareholder.  In exchange, we issued$29.0 million in principal amount of our 8.75% Senior Notes due 2011 under theexisting indenture.  We issued thesebonds at a premium of 106.3%.  This transactionresulted in an increase to our treasury stock of $31.6 million.

 

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Our bond indenture contains limitations based on netincome (among other things) on the amount of discretionary repurchases we maymake of our Ordinary common stock.  As aresult of the February 4th stock repurchase, we have approached thecurrent limitation.  Although thislimitation will increase over time, we currently have no short-term plans torepurchase additional Ordinary common stock either directly from shareholdersor on the open market.

 

Our long-term financingconsists primarily of $174.3 million of 8.75% Senior Notes and $45.5 million ofterm loans outstanding under the Credit Facility. Our debt agreements containcovenants that place certain restrictions on us, including our ability to incuradditional indebtedness, to make investments in other entities and to pay cashdividends.  We were in compliance withall such covenants as of March 31, 2004.

 

We intend to continue ourfocus on debt repayment, market share expansion, working capital management,and improving our production efficiency. Our facility rationalization project, which was started in 2003, issubstantially complete, as we closed one of our Elkhart, Indiana woodwindmanufacturing facilities on April 1, 2004.   We have an additional annual interest requirement of $2.5 million as aresult of the $29.0 million bond issuance described above. We do not expect anyresidual effects from our facility rationalization project or our additionalinterest obligations to have a material impact on our liquidity.  We are not aware of any other trends,demands, commitments, or costs of resources that are expected to materiallyimpact liquidity or capital resources. Therefore, we believe that cash on hand, together with cash flowsanticipated from operations and available borrowings under the Credit Facility,will be adequate to meet existing debt service requirements, fund continuingcapital requirements and satisfy working capital and general corporate needsfor the next twelve months.

 

We have reserved 721,750shares of our existing treasury stock to be utilized for the exercise of stockoptions under our Amended and Restated 1996 Stock Plan.  To date, these shares have not been utilizedin any stock option exercises.  Theseoptions will have no impact on our cash flow or the number of sharesoutstanding unless and until the options are exercised.

 

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**Contractual Obligations**

 

The following tableprovides a summary of our contractual obligations at March 31, 2004.

 
|                             |   | **Payments  due by period** |    |
|----------------------------------|--------|-----------------------------|---------|
| **Contractual Obligations**      |   | **Total**                   |    | **Less than  1 year** |   | **1 - 3  years** |   | **3 - 5  years** |   | **More than  5 years** |   |
|                             |   |                        |    |   |   |   |   |   |   |   |   |
| Long-term debt  (1)              |   | $                           | 224,423 |   | $ | 11,129 |   | $ | 15,950 |   | $ | 22,999 |   | $ | 174,345 |   |
| Operating leases  (2)            |   | 276,038                     |    | 5,135 |   | 8,827 |   | 7,366 |   | 254,710 |   |
| Purchase  obligations (3)        |   | 11,875                      |    | 11,527 |   | 234 |   | 114 |   | — |   |
| Other long-term  liabilities (4) |   | 18,529                      |    | 1,512 |   | 3,023 |   | 3,023 |   | 10,971 |   |
| Total                            |   | $                           | 530,865 |   | $ | 29,303 |   | $ | 28,034 |   | $ | 33,502 |   | $ | 440,026 |   |

 

**Notes toContractual Obligations:**

 

----

(1) The nature ofour long-term debt obligations is described more fully in the “BorrowingAvailability and Activities” section of “Liquidity and Capital Resources.”

(2) Approximately$259.1 million of our operating lease obligations are attributable to theninety-nine year land lease associated with the purchase of Steinway Hall; theremainder is attributable to the leasing of other facilities and equipment.

(3) Purchaseobligations consist of firm purchase commitments for raw materials, importedproducts, and equipment.

(4) Our otherlong-term liabilities consist primarily of pension obligations.

 

**NewAccounting Pronouncements**

 

In December 2003, theFASB revised SFAS No. 132, “Employers’ Disclosures about Pensions and OtherPostretirement Benefits.”  SFAS No. 132requires additional disclosure about the assets, obligations, cash flows, andnet periodic benefit cost of defined benefit pension plans and other definedbenefit postretirement plans.  Thisstatement also requires disclosure about the types of plan assets, investmentstrategy, measurement dates, plan obligations, and cash flows.  SFAS No. 132 is effective for fiscal yearsending after December 15, 2003. Disclosure of information about foreign plans required by this statementis effective for fiscal years ending after June 15, 2004.  Interim period disclosures for both domesticand foreign plans required by this statement are effective for periodsbeginning after December 15, 2003, and are included in Note 11.

 

In January 2004, the FASBissued FSP Financial Accounting Standard 106-1, “Accounting and DisclosureRequirements Related to the Medicare Prescription Drug, Improvement andModernization Act of 2003.”  This FSPprovides temporary guidance concerning the recently enacted MedicarePrescription Drug, Improvement and Modernization Act of 2003 (the “Act”), whichintroduces a prescription drug benefit under Medicare Part D as well as afederal subsidy to sponsors of retiree health care benefit plans that provide abenefit that is at least actuarially equivalent to Medicare Part D.  The FSP permits a sponsor of apostretirement health care plan that provides a prescription drug benefit tomake a one-time election to defer recognizing the effects of the Act andproviding the required disclosures.  TheFSP is effective for annual financial statements ending on or after December 7,2003.  Under our plan, eligible hourlyretires and their dependents are only entitled to postretirement health carebenefits until they are eligible for Medicare. Therefore, the FSP is not applicable to our plan and will not have anyimpact on its financial position, results of operations, or cash flows.

 

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**ITEM 3**   QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

** **

**We are exposed to market risk associated with changes inforeign currency exchange rates and interest rates.  We mitigate our foreign currency exchange rate risk bymaintaining foreign currency cash balances and holding forward foreign currencycontracts.  These contracts are used asa hedge against foreign currency transactions and are not used for trading orspeculative purposes.  The fair value ofthe forward foreign currency exchange contracts is sensitive to changes inforeign currency exchange rates.  Theimpact of an adverse change in foreign currency exchange rates would not bematerially different than that disclosed in the our Annual Report on Form 10-Kfor the year ended December 31, 2003.**

** **

**Our revolving loans and term loans bear interest at ratesthat fluctuate with changes in LIBOR. As such, our interest expense on our revolving loans and term loans andthe fair value of our fixed long-term debt are sensitive to changes in marketinterest rates.  The effect of anadverse change in market interest rates on our interest expense would not bematerially different than that disclosed in our Annual Report on Form 10-K forthe year ended December 31, 2003.**

** **

**The majority of our long-term debt is at a fixed interestrate.  Therefore, the associatedinterest expense is not sensitive to fluctuations in market interestrates.  However, the fair value of ourfixed interest debt would be sensitive to market rate changes.  Such fair value changes may affect ourdetermination whether to retain, replace, or retire this debt.**

** **

**ITEM 4**   CONTROLS AND PROCEDURES

** **

As of the end of the period covered by this report, we evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)). Ourdisclosure controls and procedures are the controls and other procedures thatwe designed to ensure that we record, process, summarize and report in a timelymanner the information we must disclose in reports that we file with or submitto the SEC. Our Chief Executive Officer and Chief Financial Officer reviewedand participated in this evaluation. Based on this evaluation the ChiefExecutive Officer and Chief Financial Officer concluded that our disclosurecontrols were effective.  In designingthe Company’s disclosure controls and procedures, the Company’s managementrecognizes that any controls, no matter how well designed and operated, canonly provide reasonable, not absolute, assurance of achieving the desiredcontrol objectives.  During the fiscalquarter covered by this report, there have not been any significant changes inour internal accounting controls or in other factors that could significantlyaffect those controls.

 

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**PART II**         **OTHERINFORMATION**

 

#### **ITEM 2**           CHANGES IN SECURITIES AND USE OF PROCEEDS

 
|                                  |   | **(a)**                                  |   | **(b)**                            |   | **(c)**                                                                                   |   | **(d)**                                                                                                               |   |
|---------------------------------------|--------|------------------------------------------|--------|------------------------------------|--------|-------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------|--------|
| **Period**                            |   | **Total  Number  of  Shares  Purchased** |   | **Average  Price Paid  Per Share** |   | **Total  Number of  Shares Purchased as  Part of Publicly  Announced Plans or  Programs** |   | **Maximum  Number (or  Approximate Dollar Value) of  Shares that May Yet Be  Purchased Under the Plans or  Programs** |   |
|                                  |   |                                     |   |                               |   |                                                                                      |   |                                                                                                                  |   |
| February 1  -  February 29, 2004 |   | 1,271,450                                |   | $                                  | 24.84  |                                                                                      | — |                                                                                                                  | $      | 9,146,742 |   |
|                                       |        |                                          |        |                                    |        |                                                                                           |        |                                                                                                                       |        |  |  |

 

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(a)     On February 4, 2004 we purchased1,271,450 shares of our Ordinary common stock from AIG Retirement Services,Inc. (formerly AIG SunAmerica), our largest institutional shareholder.  This purchase, which was authorized by theBoard of Directors, was not made on the open market pursuant to our previouslyannounced stock purchase program. This transaction resulted in an increase toour treasury stock of $31.6 million.

 

(d)   On November 4, 1997, theBoard of Directors authorized open market purchases of up to $25,000,000 of theCompany’s Ordinary common stock, either directly or indirectly through asubsidiary, at such prices and in such increments as deemed reasonable andappropriate.

 

**ITEM 6**           **EXHIBITS ANDREPORTS ON FORM 8-K**

 

(a)   Exhibits

 

31.1   Certificationof the Principal Executive Officer pursuant to Section 302 of theSarbanes-Oxley Act of 2002

 

31.2   Certificationof the Principal Financial Officer pursuant to Section 302 of theSarbanes-Oxley Act of 2002

 

32.1   Certification of the PrincipalExecutive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

32.2   Certification of the PrincipalFinancial Officer pursuant to 18 U.S. C. Section 1350, as adopted pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

32

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(b)   Reports on Form 8-K

 

During the quarter ended March 31, 2004 we filed orfurnished the following reports on Form 8-K:

 

(i)    On February 4, 2004, theCompany filed a Current Report on Form 8-K that included a press release issuedon the same day announcing that it repurchased 1,271,450 shares of its ordinarycommon stock in exchange for $29.0 million in principal amount of its 8.75%Senior Notes, which were issued at 106.3%.

 

(ii)   On February 6, 2004, theCompany filed a Current Report on Form 8-K stating that the Company had itscredit outlook revised from ‘stable’ to ‘negative’ by Standard and Poor’sRatings Services.  At the same time, theCompany’s corporate credit rating of ‘BB’ and the Company’s senior unsecureddebt rating of ‘B+’ were affirmed.

 

(iii)  On February 10, 2004, theCompany filed a Current Report on Form 8-K stating that the Company had itscredit outlook revised from ‘stable’ to ‘negative’ by Moody’s InvestorsService.  The Ba3 rating for theCompany’s $145 million 8.75% Senior Notes due 2011, the senior unsecured issuerrating of ‘B1’ and the senior implied rating of ‘Ba3’ were affirmed.

 

(iv)  On February 26, 2004, the Company filed a CurrentReport on Form 8-K that included a press release issued on the same date announcingits earnings for the quarter and year ended December 31, 2003.

 

(v)   On March 5, 2004, the Company filed a Current Reporton Form 8-K detailing disclosures made during a presentation to investors andanalysts on March 5, 2004.

 

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Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrants have duly caused this report to be signedon their behalf by the undersigned, thereunto duly authorized.

 

 
|              | STEINWAY MUSICAL INSTRUMENTS, INC.              |
|-------------------|-------------------------------------------------|
|              |                                            |
|              |  /s/ Dana D.  Messina                      |   |
|              | Dana D. Messina                                 |
|              | Director, President and Chief Executive Officer |
|              |                                            |
|              |  /s/ Dennis  M. Hanson                     |   |
|              | Dennis M. Hanson                                |
|              | Senior Executive Vice President and             |
|              | Chief Financial Officer                         |
|              |
|              |
| Date: May 6, 2004 |

 

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