**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

 

**FORM 10-Q**

 

**ý****                                ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**FOR THE QUARTERLY PERIOD ENDEDSEPTEMBER 30, 2005**

 

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

 

**COMMISSIONFILE NUMBER 001-11911**

 

**STEINWAYMUSICAL INSTRUMENTS, INC.**

(Exact name ofregistrant 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 telephonenumber including area code: **(781) 894-9770**

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements during thepast 90 days.

Yes ý    No o

 

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

Yes ý    No o

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes o    No ý

 
| Number of shares of  Common Stock issued and outstanding as of November 3, 2005**:** |   | Class A  |   | 477,952   |
|--------------------------------------------------------------------------------------|--------|----------|--------|-----------|
|                                                                                 |   | Ordinary |   | 7,627,658 |
|                                                                                 |   | Total    |   | 8,105,610 |

 

 

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###### **STEINWAY MUSICAL INSTRUMENTS, 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 and nine months ended September 30, 2005 and September 30, 2004 |       |
|         |                                                                                                            |       |
|         | Condensed Consolidated  Balance Sheets  September 30, 2005 and December 31, 2004                                |       |
|         |                                                                                                            |       |
|         | Consolidated Statements of  Cash Flows  Nine months ended September 30, 2005 and September 30, 2004             |       |
|         |                                                                                                            |       |
|         | Consolidated Statement of  Stockholders’ Equity  Nine months ended September 30, 2005                      |       |
|         |                                                                                                            |       |
|         | Notes to Consolidated and  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 6.**  | **Exhibits**                                                                                                    |       |
|         |                                                                                                            |       |
| ** **   | **Signatures**                                                                                                  | ** ** |

 

2

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**ITEM 1****                                CONSOLIDATEDAND CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

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

**CONSOLIDATED STATEMENTS OF INCOME**

**Unaudited**

**(In Thousands Except Share andPer Share Amounts)**

 
| ** **                         | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                         | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                          |       | $                                    | 95,914     |                                | $          | 94,653 |   | $ | 277,017 |   | $ | 268,402 |   |
| Cost of sales                      |       | 68,418                               |       | 68,757                              |       | 197,698 |   | 192,378 |   |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Gross profit                       |       | 27,496                               |       | 25,896                              |       | 79,319 |   | 76,024 |   |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Operating expenses:                |       |                                 |       |                                |       |   |   |   |   |
| Sales and  marketing               |       | 10,587                               |       | 10,465                              |       | 32,991 |   | 32,298 |   |
| General and  administrative        |       | 7,217                                |       | 7,358                               |       | 21,152 |   | 19,771 |   |
| Amortization of intangible  assets |       | 280                                  |       | 269                                 |       | 846 |   | 815 |   |
| Other operating  expenses          |       | 74                                   |       | 207                                 |       | 207 |   | 232 |   |
| Total operating expenses           |       | 18,158                               |       | 18,299                              |       | 55,196 |   | 53,116 |   |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Income from operations             |       | 9,338                                |       | 7,597                               |       | 24,123 |   | 22,908 |   |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Other income, net                  |       | (467                                 | )          | (806                                | )          | (873 | ) | (2,152 | ) |
| Interest income                    |       | (674                                 | )          | (512                                | )          | (2,367 | ) | (1,740 | ) |
| Interest expense                   |       | 4,236                                |       | 4,202                               |       | 12,764 |   | 11,994 |   |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Income before income taxes         |       | 6,243                                |       | 4,713                               |       | 14,599 |   | 14,806 |   |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Income tax provision               |       | 2,500                                |       | 1,885                               |       | 5,840 |   | 5,920 |   |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Net income                         |       | $                                    | 3,743      |                                | $          | 2,828 |   | $ | 8,759 |   | $ | 8,886 |   |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Earnings per  share:               |       |                                 |       |                                |       |   |   |   |   |
| Basic                              |       | $                                    | 0.46       |                                | $          | 0.35 |   | $ | 1.09 |   | $ | 1.10 |   |
| Diluted                            |       | $                                    | 0.45       |                                | $          | 0.34 |   | $ | 1.06 |   | $ | 1.06 |   |
|                               |       |                                 |       |                                |       |   |   |   |   |
| Weighted average shares:           |       |                                 |       |                                |       |   |   |   |   |
| Basic                              |       | 8,088,022                            |       | 7,998,481                           |       | 8,057,106 |   | 8,055,457 |   |
| Diluted                            |       | 8,284,461                            |       | 8,282,498                           |       | 8,267,581 |   | 8,385,558 |   |

 

See notes to consolidatedand condensed consolidated financial statements.

 

3

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**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**Unaudited**

**(InThousands)**

** **
| ** **                                                                                                             | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                                                                                                             | ** ** | ** **              | ** ** | ** **             | ** ** |
| ASSETS                                                                                                                 |       |                    |       |                   |       |
| Current assets:                                                                                                        |       |                    |       |                   |       |
| Cash                                                                                                                   |       | $                       | 21,012     |                   | $          | 27,372 |   |
| Accounts, notes  and other receivables, net of allowances of $12,286 and $13,271 in 2005 and  2004, respectively       |       | 93,424                  |       | 88,059                 |       |
| Inventories                                                                                                            |       | 173,981                 |       | 172,346                |       |
| Prepaid expenses  and other current assets                                                                             |       | 6,773                   |       | 5,937                  |       |
| Deferred tax  assets                                                                                                   |       | 14,584                  |       | 15,047                 |       |
| Total current assets                                                                                                   |       | 309,774                 |       | 308,761                |       |
|                                                                                                                   |       |                    |       |                   |       |
| Property, plant  and equipment, net of accumulated depreciation of $73,953 and $70,473 in 2005  and 2004, respectively |       | 97,502                  |       | 102,944                |       |
| Trademarks                                                                                                             |       | 13,291                  |       | 12,325                 |       |
| Goodwill                                                                                                               |       | 30,273                  |       | 31,854                 |       |
| Other intangibles, net                                                                                                 |       | 4,533                   |       | 5,290                  |       |
| Other assets                                                                                                           |       | 13,584                  |       | 16,371                 |       |
|                                                                                                                   |       |                    |       |                   |       |
| TOTAL ASSETS                                                                                                           |       | $                       | 468,957    |                   | $          | 477,545 |   |
|                                                                                                                   |       |                    |       |                   |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                              |       |                    |       |                   |       |
| Current liabilities:                                                                                                   |       |                    |       |                   |       |
| Current portion  of long-term debt                                                                                     |       | $                       | 13,902     |                   | $          | 14,212 |   |
| Accounts payable                                                                                                       |       | 14,803                  |       | 14,789                 |       |
| Other current  liabilities                                                                                             |       | 41,539                  |       | 43,892                 |       |
| Total current liabilities                                                                                              |       | 70,244                  |       | 72,893                 |       |
|                                                                                                                   |       |                    |       |                   |       |
| Long-term debt                                                                                                         |       | 201,816                 |       | 208,580                |       |
| Deferred tax liabilities                                                                                               |       | 25,132                  |       | 26,240                 |       |
| Other non-current liabilities                                                                                          |       | 22,819                  |       | 24,279                 |       |
| Total liabilities                                                                                                      |       | 320,011                 |       | 331,992                |       |
|                                                                                                                   |       |                    |       |                   |       |
| Commitments and contingent liabilities                                                                                 |       |                    |       |                   |       |
|                                                                                                                   |       |                    |       |                   |       |
| Stockholders’ equity:                                                                                             |       |                    |       |                   |       |
| Common stock                                                                                                           |       | 10                      |       | 10                     |       |
| Additional  paid-in capital                                                                                            |       | 82,884                  |       | 81,129                 |       |
| Retained  earnings                                                                                                     |       | 121,346                 |       | 112,587                |       |
| Accumulated  other comprehensive loss                                                                                  |       | (7,858                  | )          | (737                   | )          |
| Treasury stock,  at cost                                                                                               |       | (47,436                 | )          | (47,436                | )          |
| Total stockholders’ equity                                                                                        |       | 148,946                 |       | 145,553                |       |
|                                                                                                                   |       |                    |       |                   |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                        |       | $                       | 468,957    |                   | $          | 477,545 |   |

 

See notes to consolidatedand condensed consolidated financial statements.

 

4

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**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**Unaudited**

**(InThousands)**

 
| ** **                                                                    | ** ** | **Nine Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| Cash flows from  operating activities:                                        |       |                                |       |   |   |
| Net income                                                                    |       | $                                   | 8,759      |   | $ | 8,886 |   |
| Adjustments to  reconcile net income to cash flows from operating activities: |       |                                |       |   |   |
| Depreciation and  amortization                                                |       | 8,544                               |       | 8,153 |   |
| Amortization of  bond premium                                                 |       | (189                                | )          | (167 | ) |
| Deferred tax  benefit                                                         |       | (328                                | )          | (323 | ) |
| Tax benefit from  stock option exercises                                      |       | 151                                 |       | 814 |   |
| Other                                                                         |       | (39                                 | )          | 105 |   |
| Changes in  operating assets and liabilities:                                 |       |                                |       |   |   |
| Accounts, notes  and other receivables                                        |       | (4,566                              | )          | (17,308 | ) |
| Inventories                                                                   |       | (7,852                              | )          | (4,221 | ) |
| Prepaid expenses  and other assets                                            |       | 957                                 |       | (5,678 | ) |
| Accounts payable                                                              |       | 439                                 |       | 14 |   |
| Other  liabilities                                                            |       | (3,398                              | )          | 2,041 |   |
| Cash flows from  operating activities                                         |       | 2,478                               |       | (7,684 | ) |
|                                                                          |       |                                |       |   |   |
| Cash flows from  investing activities:                                        |       |                                |       |   |   |
| Capital  expenditures                                                         |       | (3,582                              | )          | (3,192 | ) |
| Proceeds from  disposals of fixed assets                                      |       | 1,379                               |       | 76 |   |
| Acquisition of  subsidiary, net of cash acquired                              |       | —                              |       | (35,309 | ) |
| Cash flows from  investing activities                                         |       | (2,203                              | )          | (38,425 | ) |
|                                                                          |       |                                |       |   |   |
| Cash flows from  financing activities:                                        |       |                                |       |   |   |
| Borrowings under  lines of credit                                             |       | 134,073                             |       | 66,875 |   |
| Repayments under  lines of credit                                             |       | (134,839                            | )          | (48,928 | ) |
| Debt issuance  costs                                                          |       | —                              |       | (105 | ) |
| Repayments of term  loan debt                                                 |       | (5,650                              | )          | (4,984 | ) |
| Proceeds from  issuance of common stock                                       |       | 1,604                               |       | 5,441 |   |
| Cash flows from  financing activities                                         |       | (4,812                              | )          | 18,299 |   |
|                                                                          |       |                                |       |   |   |
| Effect of  exchange rate changes on cash                                      |       | (1,823                              | )          | (355 | ) |
|                                                                          |       |                                |       |   |   |
| Decrease in cash                                                              |       | (6,360                              | )          | (28,165 | ) |
| Cash, beginning  of year                                                      |       | 27,372                              |       | 42,283 |   |
|                                                                          |       |                                |       |   |   |
| Cash, end of  period                                                          |       | $                                   | 21,012     |   | $ | 14,118 |   |
|                                                                          |       |                                |       |   |   |
| Supplemental  Cash Flow Information                                           |       |                                |       |   |   |
| Interest paid                                                                 |       | $                                   | 10,539     |   | $ | 8,928 |   |
| Taxes paid                                                                    |       | $                                   | 8,408      |   | $ | 7,453 |   |
|                                                                          |       |                                |       |   |   |
| Non-cash  transaction:                                                        |       |                                |       |   |   |
| Purchase of  common stock by issuance of bonds                                |       | $                                   | —     |   | $ | 31,583 |   |

 

See notes to consolidatedand condensed consolidated financial statements.

 

5

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**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENT OF STOCKHOLDERS’ EQUITY**

**Unaudited**

**(InThousands Except Share Data)**

** **
| ** **                                             | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Loss** | ** ** | **Treasury  Stock** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|--------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|---------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|
|                                                   |       |              |       |                             |       |                   |       |                                        |       |                |       |                                  |       |
| Balance, January  1, 2005                              |       | $                 | 10         |                             | $          | 81,129                 |       | $                                           | 112,587    |                | $          | (737                                  | )          | $ | (47,436 | ) | $ | 145,553 |   |
| Comprehensive  income:                                 |       |              |       |                             |       |                   |       |                                        |       |                |       |                                  |       |
| Net income                                             |       |              |       |                             |       | 8,759                  |       |                                        |       |                |       | 8,759                                 |       |
| Foreign currency  translation adjustment               |       |              |       |                             |       |                   |       | (7,138                                      | )          |                |       | (7,138                                | )          |
| Unrealized  holding gain on marketable securities, net |       |              |       |                             |       |                   |       | 17                                          |       |                |       | 17                                    |       |
| Total  comprehensive income                            |       |              |       |                             |       |                   |       |                                        |       |                |       | 1,638                                 |       |
| Issuance of  20,663 shares of common stock             |       |              |       | 519                              |       |                   |       |                                        |       |                |       | 519                                   |       |
| Exercise of 55,700  options for shares of common stock |       |              |       | 1,085                            |       |                   |       |                                        |       |                |       | 1,085                                 |       |
| Tax benefit of  options exercised                      |       |              |       | 151                              |       |                   |       |                                        |       |                |       | 151                                   |       |
| Balance,  September 30, 2005                           |       | $                 | 10         |                             | $          | 82,884                 |       | $                                           | 121,346    |                | $          | (7,858                                | )          | $ | (47,436 | ) | $ | 148,946 |   |

 

See notes toconsolidated and condensed consolidated financial statements.

 

6

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**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

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

**FINANCIALSTATEMENTS**

**SEPTEMBER30, 2005**

**Unaudited**

**(TabularAmounts In Thousands Except Share and Per Share Data)**

 

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

 

The accompanying consolidated and condensedconsolidated financial statements of Steinway Musical Instruments, Inc. andsubsidiaries (the “Company”) for the three and nine months ended September 30,2005 and 2004 are unaudited.  In theopinion of management, these statements have been prepared on the same basis asthe audited consolidated financial statements as of and for the year endedDecember 31, 2004, 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 periods.  You should read the consolidated andcondensed consolidated financial statements in conjunction with theconsolidated financial statements and notes thereto contained in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2004 filed with theSecurities and Exchange Commission (“SEC”). The results of operations for the three and nine months ended September30, 2005 are not necessarily indicative of the results that may be expected forthe entire year.

 

Throughoutthis report “we,” “us,” and “our” refer to Steinway Musical Instruments, Inc.and subsidiaries taken as a whole.

 

**(2)****         Summary of SignificantAccounting Policies**

 

*Principles of Consolidation -*Ourconsolidated financial statements include the accounts of all direct andindirect subsidiaries, all of which are wholly-owned, including The SteinwayPiano Company, Inc. (“Steinway”) and Conn-Selmer, Inc. (“Conn-Selmer”).  Significant intercompany balances have beeneliminated in consolidation.

 

*Use of Estimates*- The preparation of financial statements inconformity with accounting principles generally accepted in the UnitedStates of America necessarily requires us to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, the disclosure ofcontingent assets and liabilities at the date of the financial statements, andthe reported amounts of revenues and expenses during the reporting period.  Actual results could differ from thoseestimates.

 

*Income Taxes* - We provide for income taxes using anasset and liability approach.  We computedeferred income tax assets and liabilities for differences between thefinancial statement and tax bases of assets and liabilities that will result intaxable or deductible amounts in the future based on enacted tax laws and ratesapplicable to the periods in which the differences are expected to affecttaxable income.  We establish valuationallowances when necessary to reduce deferred tax assets to the amount that morelikely than not will be realized.

 

*Stock-based Compensation*- We have an employee stock purchase plan (“Purchase Plan”) and a stock optionplan (“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 tableillustrates the effect on net income and earnings per share as if we hadapplied the fair value method to measure stock-based employee compensation:

 
| ** **                                                                                                                     | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                     | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Net income, as  reported                                                                                                       |       | $                                    | 3,743      |                                | $          | 2,828 |   | $ | 8,759 |   | $ | 8,886 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair-value based  method, net of related tax effects |       | (228                                 | )          | (257                                | )          | (700 | ) | (765 | ) |
|                                                                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Pro forma net  income                                                                                                          |       | $                                    | 3,515      |                                | $          | 2,571 |   | $ | 8,059 |   | $ | 8,121 |   |
|                                                                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Earnings per  share:                                                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Basic - as  reported                                                                                                           |       | $                                    | 0.46       |                                | $          | 0.35 |   | $ | 1.09 |   | $ | 1.10 |   |
| Basic - pro  forma                                                                                                             |       | $                                    | 0.43       |                                | $          | 0.32 |   | $ | 1.00 |   | $ | 1.01 |   |
|                                                                                                                           |       |                                 |       |                                |       |   |   |   |   |
| Diluted - as  reported                                                                                                         |       | $                                    | 0.45       |                                | $          | 0.34 |   | $ | 1.06 |   | $ | 1.06 |   |
| Diluted - pro  forma                                                                                                           |       | $                                    | 0.43       |                                | $          | 0.31 |   | $ | 0.98 |   | $ | 0.97 |   |

 

We measured the fair value of options on their grantdate, including the valuation of the option feature implicit in our PurchasePlan, using the Black-Scholes option-pricing model.  There were 40,000 stock option awards issued duringthe three and nine months ended September 30, 2005.  There were no stock option awards issued duringthe three and nine months ended September 30, 2004.

 

*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 theweighted-average shares used for the basic and diluted computations is asfollows:

 
| ** **                        | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                        | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| For basic  earnings per share     |       | 8,088,022                            |       | 7,998,481                           |       | 8,057,106 |   | 8,055,457 |   |
| Dilutive effect  of stock options |       | 196,439                              |       | 284,017                             |       | 210,475 |   | 330,101 |   |
| For diluted  earnings per share   |       | 8,284,461                            |       | 8,282,498                           |       | 8,267,581 |   | 8,385,558 |   |

 

All outstanding options were included in thecomputation of diluted net earnings per common share for the three and ninemonths ended September 30, 2005 and 2004 because the exercise prices of theoutstanding options were less than the average market price of our commonshares.

 

8

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*Accumulated Other ComprehensiveIncome (Loss)* – Accumulated other comprehensive income (loss)is comprised of net income, foreign currency translation adjustments,additional minimum pension liabilities, and unrealized gains and losses onavailable-for-sale (“AFS”) marketable securities.  The components of accumulated othercomprehensive loss are as follows:

 
| ** **                   | ** ** | **Foreign Currency  Translation  Adjustment** | ** ** | **Unrealized  Holding  Gain/(Loss) on  AFS Securities** | ** ** | **Tax Impact of  Unrealized  Holding  Gain/(Loss) on  AFS Securities** | ** ** | **Additional  Minimum  Pension  Liability** | ** ** | **Tax Impact of  Additional  Minimum  Pension  Liability** | ** ** | **Accumulated Other  Comprehensive  Loss** | ** ** |
|------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------|------------|
|                         |       |                                          |       |                                                    |       |                                                                   |       |                                        |       |                                                       |       |                                       |       |
| Balance, January  1, 2005    |       | $                                             | 5,746      |                                                    | $          | 157                                                                    |       | $                                           | (63        | )                                                          | $          | (10,802                                    | )          | $ | 4,225 |   | $ | (737 | ) |
| Activity                     |       | (7,138                                        | )          | 28                                                      |       | (11                                                                    | )          | —                                      |       | —                                                     |       | (7,121                                     | )          |
| Balance,  September 30, 2005 |       | $                                             | (1,392     | )                                                       | $          | 185                                                                    |       | $                                           | (74        | )                                                          | $          | (10,802                                    | )          | $ | 4,225 |   | $ | (7,858 | ) |

 

*Recent Accounting Pronouncements* – In December 2004, the FinancialAccounting Standards Board (“FASB”) revised Statement of Financial AccountingStandards (“SFAS”) No. 123 and issued SFAS No. 123R, “Share-Based Payments”(SFAS No. 123R). This accounting standard, which was originally effective forinterim and annual periods beginning after June 15, 2005, requires therecognition of compensation expense related to stock options using the fairvalue method.  In April 2005, the SECrevised the first required compliance date to fiscal years beginning after June15, 2005.  We plan to adopt SFAS No. 123Rin the first quarter of 2006 using the modified prospective application method.Based on current outstanding awards, expected participation in the PurchasePlan consistent with past patterns, and no significant changes in the number ofshares of outstanding stock, we anticipate an impact on basic earnings pershare of approximately $0.10 - $0.12 in additional stock compensation expensein 2006.  The actual amount will beimpacted by changes in the aforementioned factors, as well as finalization ofour estimated forfeiture rates and other assumptions.

 

InNovember 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment ofARB No. 43, Chapter 4” (SFAS No. 151). This accounting standard, which iseffective for annual periods beginning after June 15, 2005, requires thatabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterials (spoilage) should be recognized as current-period charges. Theadoption of SFAS No. 151 is not expected to have a material effect on ourfinancial position or results of operations.

 

In June2005, the FASB ratified Emerging Issues Task Force (“EITF”) Issue 05-05, “Accountingfor Early Retirement Programs With Specific Features (Such as Terms specifiedin Altersteilzeit Early Retirement Arrangements)” which addresses theaccounting for the transitional early retirement program in Germany.  Salary components of this plan should berecognized over the period from which the program begins until the end of theactive service period.  Additionally, aportion of the salary that is deferred under certain arrangements should bediscounted if payment is expected to be deferred for a period longer than oneyear.  This treatment is effective forfiscal years beginning after December 15, 2005. The application of EITF 05-05 is not expected to have a material impacton our financial position or results of operations.

 

*Reclassifications* – Certain prior year amounts have been reclassifiedto conform to the current year presentation.

 

9

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

 
| ** **      | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------|------------|-------------------------|------------|------------------------|------------|
|            |       |                    |       |                   |       |
| Raw materials   |       | $                       | 23,007     |                   | $          | 23,439 |   |
| Work in process |       | 53,639                  |       | 54,612                 |       |
| Finished goods  |       | 97,335                  |       | 94,295                 |       |
| Total           |       | $                       | 173,981    |                   | $          | 172,346 |   |

 

**(4)****         Goodwill, Trademarks, andOther Intangible Assets**

 

Intangibleassets other than goodwill and indefinite-lived trademarks are amortized on astraight-line basis over their estimated useful lives.  Deferred financing costs are amortized overthe repayment periods of the underlying debt. We test our goodwill and indefinite-lived trademark assets forimpairment annually, or on an interim basis if events or circumstances indicatethat the fair value of an asset has decreased below its carrying value.  At July 31, 2005, we evaluated these assetsand determined that the fair value had not decreased below the carrying valueand, accordingly, no impairments have been recognized since we ceasedamortization.  The changes in carryingamounts of goodwill and trademarks are as follows:

 
| ** **                                                       | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** | **Total** | ** ** |
|------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|-----------|------------|
| Goodwill:                                                        |       |              |       |             |       |      |       |
| Balance, January  1, 2005                                        |       | $                 | 23,299     |             | $          | 8,555     |       | $ | 31,854 |   |
| Foreign currency  translation impact                             |       | (1,581            | )          | —           |       | (1,581    | )          |
| Balance,  September 30, 2005                                     |       | $                 | 21,718     |             | $          | 8,555     |       | $ | 30,273 |   |
|                                                             |       |              |       |             |       |      |       |
| Trademarks:                                                      |       |              |       |             |       |      |       |
| Balance, January  1, 2005                                        |       | $                 | 7,964      |             | $          | 4,361     |       | $ | 12,325 |   |
| Additions based  on purchase price allocation to acquired assets |       | —            |       | 1,463            |       | 1,463     |       |
| Foreign currency  translation impact                             |       | (497              | )          | —           |       | (497      | )          |
| Balance,  September 30, 2005                                     |       | $                 | 7,467      |             | $          | 5,824     |       | $ | 13,291 |   |

 

OnAugust 12, 2004 we acquired substantially all of the assets and assumed theoperating liabilities of G. Leblanc Corporation (“Leblanc”) of Wisconsin, ahigh-quality band instrument manufacturer. We allocated a portion of the purchase price, which was finalized inJune 2005, to trademarks.

 

10

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Wealso carry certain intangible assets that are amortized.  Once fully amortized, these assets areremoved from both the gross and accumulated amortization balance.  These assets consist of the following:

 
| ** **                      | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------|------------|-------------------------|------------|------------------------|------------|
|                            |       |                    |       |                   |       |   |   |
| Gross deferred  financing costs |       | $                       | 8,715      |                   | $          | 8,627 |   |
| Accumulated  amortization       |       | (4,569                  | )          | (3,834                 | )          |
| Deferred  financing costs, net  |       | $                       | 4,146      |                   | $          | 4,793 |   |
|                            |       |                    |       |                   |       |
| Gross covenants  not to compete |       | $                       | 500        |                   | $          | 750 |   |
| Accumulated  amortization       |       | (113                    | )          | (253                   | )          |
| Covenants not to  compete, net  |       | $                       | 387        |                   | $          | 497 |   |

 

The weighted-averageamortization period for deferred financing costs is 9 years, and theweighted-average amortization period of covenants not to compete is 5years.  Total amortization expense, whichincludes amortization of deferred financing costs, is as follows:

 
| ** **           | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|----------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **           | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                 |       |                                 |       |                                |       |   |   |   |   |
| Amortization expense |       | $                                    | 280        |                                | $          | 269 |   | $ | 846 |   | $ | 815 |   |
|                      |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |

 

 

The followingtable shows the total estimated amortization expense for 2005 and the next fivesucceeding fiscal years:

 
| Estimated  amortization expense: |   |   |   |
|----------------------------------|--------|--------|--------|
|                             |   |   |   |
| 2005                             |   | $      | 1,117  |   |
| 2006                             |   | 1,084  |   |
| 2007                             |   | 1,084  |   |
| 2008                             |   | 939    |   |
| 2009                             |   | 548    |   |
| 2010                             |   | 466    |   |
|                                  |        |        |        |  |

 

11

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

 
| ** **                            | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------|------------|-------------------------|------------|------------------------|------------|
| ** **                            | ** ** | ** **              | ** ** | ** **             | ** ** |
| Accrued payroll  and related benefits |       | $                       | 17,858     |                   | $          | 18,072 |   |
| Current portion  of pension liability |       | 1,462                   |       | 2,811                  |       |
| Accrued warranty  expense             |       | 2,049                   |       | 2,139                  |       |
| Accrued interest                      |       | 7,081                   |       | 3,257                  |       |
| Deferred income                       |       | 4,356                   |       | 4,468                  |       |
| Other accrued  expenses               |       | 8,733                   |       | 13,145                 |       |
| Total                                 |       | $                       | 41,539     |                   | $          | 43,892 |   |

 

Accrued warrantyexpense is recorded at the time of sale for instruments that have a warrantyperiod ranging from one to ten years.  The accrued expense recorded isgenerally calculated on a percentage of warranty costs to sales based on ourwarranty history and is adjusted periodically following an analysis of actualwarranty claims.

 

The accruedwarranty expense activity for the nine months ended September 30, 2005 and2004, and the year ended December 31, 2004 is as follows:

 
| ** **                           | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------|------------|-------------------------|------------|-------------------------|------------|------------------------|------------|
| Beginning balance                    |       | $                       | 2,139      |                    | $          | 2,602                  |       | 2,602 |   |
| Additions                            |       | 719                     |       | 840                     |       | 932                    |       |
| Claims and  reversals                |       | (720                    | )          | (1,064                  | )          | (1,455                 | )          |
| Foreign currency  translation impact |       | (89                     | )          | (5                      | )          | 60                     |       |
| Ending balance                       |       | $                       | 2,049      |                    | $          | 2,373                  |       | 2,139 |   |

 

**(6)****        ****Long-Term Debt**

 

Long-term debt consistsof the following:

 
| ** **                             | ** ** | **September 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------|------------|-------------------------|------------|------------------------|------------|
| Term loans                             |       | $                       | 33,973     |                   | $          | 39,623 |   |
| 8.75% Senior  Notes                    |       | 174,345                 |       | 174,345                |       |
| Unamortized bond  premium              |       | 1,395                   |       | 1,584                  |       |
| Open account  loans, payable on demand |       | 6,005                   |       | 7,240                  |       |
| Total                                  |       | 215,718                 |       | 222,792                |       |
| Less: current  portion                 |       | 13,902                  |       | 14,212                 |       |
| Long-term debt                         |       | $                       | 201,816    |                   | $          | 208,580 |   |

 

12

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Scheduled payments oflong-term debt are as follows:

 

| ** **         | ** ** | **September 30,  2005** | ** ** |
|--------------------|------------|-------------------------|------------|
| Remainder of  2005 |       | $                       | 7,974      |   |
| 2006               |       | 7,913                   |       |
| 2007               |       | 7,992                   |       |
| 2008               |       | 16,099                  |       |
| 2009               |       | —                  |       |
| Thereafter         |       | 174,345                 |       |
| Total              |       | $                       | 214,323    |   |

 

**(7)****        ****Stockholders’ Equity**

 

Our common stock is comprised of two classes: Class A andOrdinary.  With the exception ofdisparate voting power, both classes are substantially identical.  Each share of Class A common stock entitlesthe holder to 98 votes.  Holders ofOrdinary common stock are entitled to one vote per share.  Class A common stock shall automaticallyconvert to Ordinary common stock if, at any time, the Class A common stock isnot owned by an original Class A holder. As of September 30, 2005 our Chairman and Chief Executive Officer owned100% of the Class A common shares, representing approximately 86% of thecombined voting power of the Class A common stock and Ordinary common stock.

 

**(8)****        ****Other (Income) Expense, Net**

** **
| ** **                            | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                            | ** ** | **2005**                             | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                  |       |                                 |       |                                |       |   |   |   |   |
| West 57th  building income            |       | $                                    | (1,163     | )                                   | $          | (1,164 | ) | $ | (3,490 | ) | $ | (3,490 | ) |
| West 57th  building expenses          |       | 819                                  |       | 813                                 |       | 2,450 |   | 2,441 |   |
| Foreign exchange  (gains) losses, net |       | (90                                  | )          | (27                                 | )          | 352 |   | (110 | ) |
| Miscellaneous                         |       | (33                                  | )          | (428                                | )          | (185 | ) | (993 | ) |
| Other income,  net                    |       | $                                    | (467       | )                                   | $          | (806 | ) | $ | (873 | ) | $ | (2,152 | ) |

 

**(9)****         Commitments andContingent Liabilities**

 

We areinvolved in certain legal proceedings regarding environmental matters, whichare described below.  Further, in theordinary course of business, we are party to various legal actions that webelieve are routine in nature and incidental to the operation of ourbusiness.  While the outcome of suchactions cannot be predicted with certainty, we believe that, based on ourexperience in dealing with these matters, their ultimate resolution will nothave a material adverse impact on our business, financial condition, or resultsof operations.

 

Weoperated manufacturing facilities at certain locations where hazardoussubstances (including chlorinated solvents) were used.  We believe that an entity that formerlyoperated one such facility may have released hazardous substances at suchlocation, which we leased through July 2001. We did not contribute to the release. Further, we have a contractual indemnity from certain stockholders ofthis

 

13

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entity.  Thisfacility is not the subject of a legal proceeding that involves us, nor, to ourknowledge, is the facility subject to investigation.  However, no assurance can be given that legalproceedings will not arise in the future and that such indemnitors would makethe payments described in the indemnity.

 

Weoperate other manufacturing facilities which were previously owned by PhilipsElectronics North America Corporation (“Philips”).  Philips agreed to indemnify us for any andall losses, damages, liabilities and claims relating to environmental mattersresulting from certain activities of Philips occurring prior to December 29,1988 (the “Environmental Indemnity Agreement”). Philips has fully performed its obligations under the EnvironmentalIndemnity Agreement, which terminates on December 29, 2008.  Four matters covered by the EnvironmentalIndemnity Agreement are currently pending. Philips has entered into Consent Orders with the EnvironmentalProtection Agency (“EPA”) for one site and the North Carolina Department ofEnvironment, Health and Natural Resources for a second site, whereby Philipshas agreed to pay required response costs. On October 22, 1998, we were joined as defendant in an action involvinga site formerly occupied by a business we acquired in Illinois.  Philips has accepted the defense of thisaction pursuant to the terms of the Environmental Indemnity Agreement.  For the fourth site, the EPA has notified us itintends to carry out the final remediation itself.  The EPA estimates that this remedy has anestimated cost of approximately $14.5 million. The EPA has named over 40persons or entities as potentially responsible parties (“PRP”) at this Elkhart,Indiana site, including four Conn-Selmer predecessor entities.  The four entities, along with other principalPRPs have been involved as a PRP group in the ongoing negotiations with thesite owner, the largest contributor, and the EPA in an attempt to reach asettlement and release PRP group members from further potential liability.  We expect a decision on the proposedsettlement to be reached within the next twelve months.  For two of these entities, which werepreviously owned by Philips, this matter has been tendered to Philips pursuantto the Environmental Indemnity Agreement.

 

Our potentialliability at any of these sites is affected by several factors including, butnot limited to, the method of remediation, our portion of the materials in thesite relative to that of the other named parties, the number of partiesparticipating, and the financial capabilities of the other potentiallyresponsible parties once the relative share has been determined.  No assurance can be given, however, thatadditional environmental issues will not require additional, currentlyunanticipated investigation, assessment or remediation expenditures or thatPhilips will make payments that it is obligated to make under the EnvironmentalIndemnity Agreement.

 

We arecontinuing an existing environmental remediation program at a facility weacquired in 2000.  We estimate that thisproject will take eighteen years to complete, at a total cost of approximately$0.9 million.  We have accruedapproximately $0.7 million for the estimated remaining cost of this remediationprogram, which represents the present value total cost using a discount rate of4.5%.  A summary of expected paymentsassociated with this project is as follows:

 
| ** ** | ** ** | **Environmental  Payments** | ** ** |
|------------|------------|-----------------------------|------------|
| 2005       |       | 70                          |       |
| 2006       |       | 129                         |       |
| 2007       |       | 68                          |       |
| 2008       |       | 49                          |       |
| 2009       |       | 49                          |       |
| Thereafter |       | 539                         |       |
| Total      |       | $                           | 904        |   |
|            |            |                             |            |  |

 

14

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In 2004, we acquiredmanufacturing facilities from G. Leblanc Corporation, now Grenadilla, Inc. (“Grenadilla”),for which environmental remediation programs had already been established.  In connection with the acquisition, weassumed the existing accrued liability of approximately $0.8 million for thecost of these remediation programs. Recent soil and groundwater test results and discussions with stateregulatory officials indicate an increase in costs at two of these facilitiesis likely.  Pursuant to the purchase andsale agreement we are able to seek indemnification from Grenadilla and a claimagainst the escrow for such additional costs. The escrow currently has a remaining balance of approximately $4.0million and is available for claims until February 2006.  Based on our assessment during the threemonths ended September 30, 2005, we have increased our accrual for the cost ofthese remediation programs by approximately $2.3 million and will seek to claimrecovery of such amount from the escrow prior to February 2006.  We have recorded a corresponding receivablefor this amount and anticipate full collection from the escrow for these costs.

 

Thematters described above and our other liabilities and compliance costs arisingunder environmental laws are not expected to have a material impact on ourcapital expenditures, earnings, or competitive position in any individualyear.  However, some risk ofenvironmental liability is inherent in the nature of our current and formerbusiness and we might, in the future, incur material costs to meet current ormore stringent compliance, cleanup, or other obligations pursuant toenvironmental laws.

 

**(10)****                         ****Retirement Plans**

 

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

 
| ** **                          | ** ** | **Domestic Plans**      | ** ** | **Foreign Plans**       | ** ** |
|-------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                          | ** ** | **Three Months Ended**  | ** ** | **Three Months Ended**  | ** ** |
| ** **                          | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
| Service cost                        |       | $                       | 296        |                    | $          | 179 |   | $ | 171 |   | $ | 164 |   |
| Interest cost                       |       | 881                     |       | 648                     |       | 329 |   | 316 |   |
| Expected return  on plan assets     |       | (1,312                  | )          | (873                    | )          | (70 | ) | (67 | ) |
| Amortization of  prior service cost |       | 157                     |       | 134                     |       | — |   | — |   |
| Amortization of  net loss           |       | 74                      |       | 62                      |       | — |   | 19 |   |
| Net periodic  benefit cost          |       | $                       | 96         |                    | $          | 150 |   | $ | 430 |   | $ | 432 |   |

 

15

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| ** **                          | ** ** | **Domestic Plans**      | ** ** | **Foreign Plans**       | ** ** |
|-------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                          | ** ** | **Nine Months Ended**   | ** ** | **Nine Months Ended**   | ** ** |
| ** **                          | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
| Service cost                        |       | $                       | 548        |                    | $          | 618 |   | $ | 510 |   | $ | 493 |   |
| Interest cost                       |       | 2,013                   |       | 2,233                   |       | 984 |   | 950 |   |
| Expected return  on plan assets     |       | (2,876                  | )          | (3,016                  | )          | (218 | ) | (201 | ) |
| Amortization of  prior service cost |       | 309                     |       | 459                     |       | — |   | — |   |
| Amortization of  net loss           |       | 302                     |       | 201                     |       | 1 |   | 57 |   |
| Net periodic  benefit cost          |       | $                       | 296        |                    | $          | 495 |   | $ | 1,277 |   | $ | 1,299 |   |

 

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**  | ** ** | **Nine Months Ended**   | ** ** |
|----------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                             | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** | **September 30,  2005** | ** ** | **September 30,  2004** | ** ** |
| Service cost                           |       | $                       | 10         |                    | $          | 11 |   | $ | 30 |   | $ | 50 |   |
| Interest cost                          |       | 32                      |       | 26                      |       | 97 |   | 103 |   |
| Amortization of  transition obligation |       | 11                      |       | 9                       |       | 34 |   | 34 |   |
| Amortization of  net loss              |       | —                  |       | 2                       |       | — |   | 11 |   |
| Net  postretirement benefit cost       |       | $                       | 53         |                    | $          | 48 |   | $ | 161 |   | $ | 198 |   |

 

We anticipate domesticpension plan contributions of approximately $2.0 million for the currentyear.  As of September 30, 2005 we havemade contributions of approximately $1.5 million to this plan.  Our anticipated contributions to the pensionplan of our U.K. subsidiary approximate $0.3 million for the current year.  As of September 30, 2005, we have madecontributions of less than $0.2 million to this plan.  The pension plans of our German subsidiariesdo not hold any assets and pay participant benefits as incurred.  Expected 2005 benefit payments under theseplans are $1.0 million.  For the ninemonths ended September 30, 2005, we have made benefit payments of $0.7 millionunder these plans.

 

**(11)         Segment Information**

 

Wehave identified two reportable segments: the piano segment and the band andorchestral instrument segment.  Weconsider these two segments reportable as they are managed separately and theoperating results of each segment are separately reviewed and evaluated by oursenior management on a regular basis. Management and the chief operating decision maker use income fromoperations as a meaningful measurement of profit or loss for the segments.  Income from operations for the reportablesegments includes certain corporate costs allocated to the segments basedprimarily on revenue, as well as intercompany profit.  Amounts reported as “Other & Elim”include those corporate costs that were not allocated to the reportablesegments and the remaining intercompany profit elimination.

 

16

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The following tablespresent information about our operating segments for the three and nine monthsended September 30, 2005 and 2004:

 
| ** **                       | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** | **Other** | ** ** | **Consol** | ** ** |
|----------------------------------|------------|-------------------|------------|------------------|------------|-----------|------------|------------|------------|
| **Three months ended 2005**      | ** ** | **U.S.**          | ** ** | **Germany**      | ** ** | **Other** | ** ** | **Total**  | ** ** | **U.S.** | ** ** | **Other** | ** ** | **Total** | ** ** | **& Elim** | ** ** | **Total** | ** ** |
| Net sales to  external customers |       | $                 | 28,781     |             | $          | 11,858    |       | $          | 8,332      |   | $ | 48,971 |   | $ | 44,923 |   | $ | 2,020 |   | $ | 46,943 |   | $ | — |   | $ | 95,914 |   |
| Income (loss)  from operations   |       | 2,890             |       | 3,241            |       | 588       |       | 6,719      |       | 2,827 |   | 263 |   | 3,090 |   | (471 | ) | 9,338 |   |
|                                  |            |                   |            |                  |            |           |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                       | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** | **Other** | ** ** | **Consol** | ** ** |
|----------------------------------|------------|-------------------|------------|------------------|------------|-----------|------------|------------|------------|
| **Three months ended 2004**      | ** ** | **U.S.**          | ** ** | **Germany**      | ** ** | **Other** | ** ** | **Total**  | ** ** | **U.S.** | ** ** | **Other** | ** ** | **Total** | ** ** | **& Elim** | ** ** | **Total** | ** ** |
| Net sales to  external customers |       | $                 | 31,518     |             | $          | 8,638     |       | $          | 7,445      |   | $ | 47,601 |   | $ | 45,286 |   | $ | 1,766 |   | $ | 47,052 |   | $ | — |   | $ | 94,653 |   |
| Income (loss)  from operations   |       | 4,505             |       | 1,610            |       | 408       |       | 6,523      |       | 2,159 |   | 175 |   | 2,334 |   | (1,260 | ) | 7,597 |   |
|                                  |            |                   |            |                  |            |           |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                       | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** | **Other** | ** ** | **Consol** | ** ** |
|----------------------------------|------------|-------------------|------------|------------------|------------|-----------|------------|------------|------------|
| **Nine months ended 2005**       | ** ** | **U.S.**          | ** ** | **Germany**      | ** ** | **Other** | ** ** | **Total**  | ** ** | **U.S.** | ** ** | **Other** | ** ** | **Total** | ** ** | **& Elim** | ** ** | **Total** | ** ** |
| Net sales to  external customers |       | $                 | 80,187     |             | $          | 35,911    |       | $          | 23,041     |   | $ | 139,139 |   | $ | 132,441 |   | $ | 5,437 |   | $ | 137,878 |   | $ | — |   | $ | 277,017 |   |
| Income (loss)  from operations   |       | 7,240             |       | 8,589            |       | 1,410     |       | 17,239     |       | 8,990 |   | (8 | ) | 8,982 |   | (2,098 | ) | 24,123 |   |
|                                  |            |                   |            |                  |            |           |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                       | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** | **Other** | ** ** | **Consol** | ** ** |
|----------------------------------|------------|-------------------|------------|------------------|------------|-----------|------------|------------|------------|
| **Nine months ended 2004**       | ** ** | **U.S.**          | ** ** | **Germany**      | ** ** | **Other** | ** ** | **Total**  | ** ** | **U.S.** | ** ** | **Other** | ** ** | **Total** | ** ** | **& Elim** | ** ** | **Total** | ** ** |
| Net sales to  external customers |       | $                 | 84,478     |             | $          | 30,421    |       | $          | 23,352     |   | $ | 138,251 |   | $ | 126,167 |   | $ | 3,984 |   | $ | 130,151 |   | $ | — |   | $ | 268,402 |   |
| Income (loss)  from operations   |       | 9,081             |       | 5,031            |       | 2,079     |       | 16,191     |       | 8,979 |   | 233 |   | 9,212 |   | (2,495 | ) | 22,908 |   |
|                                  |            |                   |            |                  |            |           |            |            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**(12)         Summary of Guarantees**

 

Our payment obligationsunder our 8.75% Senior Notes are fully and unconditionally guaranteed on ajoint and several basis by Conn-Selmer, Steinway, and certain other of ourdirect and indirect wholly-owned subsidiaries, each a Guarantor (the “GuarantorSubsidiaries”).  These subsidiariesrepresent all of our (the “Issuer”) operations conducted in the UnitedStates.  The remaining subsidiaries,which do not guarantee the 8.75% Senior Notes, represent non-U.S. operations(the “Non Guarantor Subsidiaries”).

 

The following condensedconsolidating supplementary data illustrates the financial position, results ofoperations, and cash flows of the Guarantor Subsidiaries and the Non Guarantor Subsidiaries.  Separate complete financial statements of therespective Guarantors would not provide additional material information thatwould be useful in assessing the financial composition of the Guarantor Subsidiaries.  No single Guarantor Subsidiary has anysignificant legal restrictions on the ability of investors or creditors toobtain access to its assets in event of default on the guarantee other than itssubordination to senior indebtedness.

 

Werecord investments in subsidiaries on the cost method for purposes of thesupplemental consolidating presentation. Earnings of subsidiaries are therefore not reflected in the parentcompany’s investment accounts and earnings. The principal elimination entries eliminate investments in subsidiariesand intercompany balances and transactions.

 

17

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. ANDSUBSIDIARIES**

**CONSOLIDATINGSTATEMENTS OF INCOME**

**THREEMONTHS ENDED SEPTEMBER 30, 2005**

**Unaudited**

**(InThousands)**

** **
| ** **                         | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net sales                          |       | $                    | —     |                        | $          | 76,532                           |       | $                          | 23,446     |             | $          | (4,064 | ) | $ | 95,914 |   |
| Cost of sales                      |       | —               |       | 58,202                      |       | 14,259                           |       | (4,043                     | )          | 68,418           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Gross profit                       |       | —               |       | 18,330                      |       | 9,187                            |       | (21                        | )          | 27,496           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Operating  expenses:               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Sales and  marketing               |       | —               |       | 7,406                       |       | 3,181                            |       | —                     |       | 10,587           |       |
| General and  administrative        |       | 1,807                |       | 3,829                       |       | 1,581                            |       | —                     |       | 7,217            |       |
| Amortization of  intangible assets |       | 116                  |       | 160                         |       | 4                                |       | —                     |       | 280              |       |
| Other operating  (income) expense  |       | (1,452               | )          | 1,137                       |       | 389                              |       | —                     |       | 74               |       |
| Total operating  expenses          |       | 471                  |       | 12,532                      |       | 5,155                            |       | —                     |       | 18,158           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss)  from operations     |       | (471                 | )          | 5,798                       |       | 4,032                            |       | (21                        | )          | 9,338            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Other income,  net                 |       | —               |       | (291                        | )          | (176                             | )          | —                     |       | (467             | )          |
| Interest income                    |       | (3,668               | )          | (6,311                      | )          | (67                              | )          | 9,372                      |       | (674             | )          |
| Interest expense                   |       | 3,854                |       | 9,626                       |       | 128                              |       | (9,372                     | )          | 4,236            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss)  before income taxes |       | (657                 | )          | 2,774                       |       | 4,147                            |       | (21                        | )          | 6,243            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income tax  provision (benefit)    |       | 929                  |       | 32                          |       | 1,552                            |       | (13                        | )          | 2,500            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income  (loss)                 |       | $                    | (1,586     | )                           | $          | 2,742                            |       | $                          | 2,595      |             | $          | (8 | ) | $ | 3,743 |   |

 

18

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. ANDSUBSIDIARIES**

**CONSOLIDATINGSTATEMENTS OF INCOME**

**THREEMONTHS ENDED SEPTEMBER 30, 2004**

**Unaudited**

**(InThousands)**

** **
| ** **                         | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net sales                          |       | $                    | —     |                        | $          | 80,822                           |       | $                          | 18,198     |             | $          | (4,367 | ) | $ | 94,653 |   |
| Cost of sales                      |       | —               |       | 61,962                      |       | 11,058                           |       | (4,263                     | )          | 68,757           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Gross profit                       |       | —               |       | 18,860                      |       | 7,140                            |       | (104                       | )          | 25,896           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Operating  expenses:               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Sales and  marketing               |       | —               |       | 7,321                       |       | 3,144                            |       | —                     |       | 10,465           |       |
| General and  administrative        |       | 2,465                |       | 3,470                       |       | 1,423                            |       | —                     |       | 7,358            |       |
| Amortization of  intangible assets |       | 116                  |       | 152                         |       | 1                                |       | —                     |       | 269              |       |
| Other operating  (income) expense  |       | (1,356               | )          | 1,121                       |       | 442                              |       | —                     |       | 207              |       |
| Total operating  expenses          |       | 1,225                |       | 12,064                      |       | 5,010                            |       | —                     |       | 18,299           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss)  from operations     |       | (1,225               | )          | 6,796                       |       | 2,130                            |       | (104                       | )          | 7,597            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Other (income)  expense, net       |       | 4                    |       | (449                        | )          | (361                             | )          | —                     |       | (806             | )          |
| Interest income                    |       | (3,661               | )          | (5,534                      | )          | (48                              | )          | 8,731                      |       | (512             | )          |
| Interest expense                   |       | 3,853                |       | 9,019                       |       | 61                               |       | (8,731                     | )          | 4,202            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss)  before income taxes |       | (1,421               | )          | 3,760                       |       | 2,478                            |       | (104                       | )          | 4,713            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income tax  provision (benefit)    |       | (554                 | )          | 1,511                       |       | 942                              |       | (14                        | )          | 1,885            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income  (loss)                 |       | $                    | (867       | )                           | $          | 2,249                            |       | $                          | 1,536      |             | $          | (90 | ) | $ | 2,828 |   |

 

19

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. ANDSUBSIDIARIES**

**CONSOLIDATINGSTATEMENTS OF INCOME**

**NINEMONTHS ENDED SEPTEMBER 30, 2005**

**Unaudited**

**(InThousands)**

** **
| ** **                         | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net sales                          |       | $                    | —     |                        | $          | 221,248                          |       | $                          | 67,812     |             | $          | (12,043 | ) | $ | 277,017 |   |
| Cost of sales                      |       | —               |       | 167,204                     |       | 42,574                           |       | (12,080                    | )          | 197,698          |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Gross profit                       |       | —               |       | 54,044                      |       | 25,238                           |       | 37                         |       | 79,319           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Operating  expenses:               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Sales and  marketing               |       | —               |       | 23,443                      |       | 9,548                            |       | —                     |       | 32,991           |       |
| General and  administrative        |       | 5,469                |       | 10,998                      |       | 4,685                            |       | —                     |       | 21,152           |       |
| Amortization of  intangible assets |       | 349                  |       | 484                         |       | 13                               |       | —                     |       | 846              |       |
| Other operating  (income) expense  |       | (3,720               | )          | 2,811                       |       | 1,116                            |       | —                     |       | 207              |       |
| Total operating  expenses          |       | 2,098                |       | 37,736                      |       | 15,362                           |       | —                     |       | 55,196           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss)  from operations     |       | (2,098               | )          | 16,308                      |       | 9,876                            |       | 37                         |       | 24,123           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Other income,  net                 |       | (8                   | )          | (765                        | )          | (100                             | )          | —                     |       | (873             | )          |
| Interest income                    |       | (11,000              | )          | (18,573                     | )          | (228                             | )          | 27,434                     |       | (2,367           | )          |
| Interest expense                   |       | 11,568               |       | 28,347                      |       | 283                              |       | (27,434                    | )          | 12,764           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss)  before income taxes |       | (2,658               | )          | 7,299                       |       | 9,921                            |       | 37                         |       | 14,599           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income tax  provision (benefit)    |       | 1,820                |       | (34                         | )          | 4,016                            |       | 38                         |       | 5,840            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income  (loss)                 |       | $                    | (4,478     | )                           | $          | 7,333                            |       | $                          | 5,905      |             | $          | (1 | ) | $ | 8,759 |   |

 

20

----

 

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

**CONSOLIDATINGSTATEMENTS OF INCOME**

**NINEMONTHS ENDED SEPTEMBER 30, 2004**

**Unaudited**

**(InThousands)**

** **
| ** **                         | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net sales                          |       | $                    | —     |                        | $          | 220,016                          |       | $                          | 59,344     |             | $          | (10,958 | ) | $ | 268,402 |   |
| Cost of sales                      |       | —               |       | 166,069                     |       | 37,248                           |       | (10,939                    | )          | 192,378          |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Gross profit                       |       | —               |       | 53,947                      |       | 22,096                           |       | (19                        | )          | 76,024           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Operating  expenses:               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Sales and  marketing               |       | —               |       | 23,005                      |       | 9,275                            |       | 18                         |       | 32,298           |       |
| General and  administrative        |       | 5,290                |       | 10,012                      |       | 4,469                            |       | —                     |       | 19,771           |       |
| Amortization of  intangible assets |       | 348                  |       | 464                         |       | 3                                |       | —                     |       | 815              |       |
| Other operating  (income) expense  |       | (3,137               | )          | 2,318                       |       | 1,069                            |       | (18                        | )          | 232              |       |
| Total operating  expenses          |       | 2,501                |       | 35,799                      |       | 14,816                           |       | —                     |       | 53,116           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss)  from operations     |       | (2,501               | )          | 18,148                      |       | 7,280                            |       | (19                        | )          | 22,908           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Other (income)  expense, net       |       | 4                    |       | (1,102                      | )          | (1,054                           | )          | —                     |       | (2,152           | )          |
| Interest income                    |       | (10,975              | )          | (16,655                     | )          | (146                             | )          | 26,036                     |       | (1,740           | )          |
| Interest expense                   |       | 11,339               |       | 26,482                      |       | 209                              |       | (26,036                    | )          | 11,994           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss)  before income taxes |       | (2,869               | )          | 9,423                       |       | 8,271                            |       | (19                        | )          | 14,806           |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income tax  provision (benefit)    |       | (1,118               | )          | 3,799                       |       | 3,237                            |       | 2                          |       | 5,920            |       |
|                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income  (loss)                 |       | $                    | (1,751     | )                           | $          | 5,624                            |       | $                          | 5,034      |             | $          | (21 | ) | $ | 8,886 |   |

 

21

----

 

**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATING BALANCE SHEETS**

**SEPTEMBER30, 2005**

**Unaudited**

**(InThousands)**

** **
| ** **                                       | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
| ASSETS                                           |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Current assets:                                  |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash                                             |       | $                    | —     |                        | $          | 47,757                           |       | $                          | 11,860     |             | $          | (38,605 | ) | $ | 21,012 |   |
| Accounts, notes  and other receivables, net      |       | —               |       | 83,437                      |       | 9,987                            |       | —                     |       | 93,424           |       |
| Inventories                                      |       | —               |       | 131,156                     |       | 44,236                           |       | (1,411                     | )          | 173,981          |       |
| Prepaid expenses  and other current assets       |       | 369                  |       | 5,148                       |       | 1,256                            |       | —                     |       | 6,773            |       |
| Deferred tax  assets                             |       | —               |       | 9,689                       |       | 4,895                            |       | —                     |       | 14,584           |       |
| Total current  assets                            |       | 369                  |       | 277,187                     |       | 72,234                           |       | (40,016                    | )          | 309,774          |       |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Property, plant  and equipment, net              |       | 204                  |       | 80,024                      |       | 17,274                           |       | —                     |       | 97,502           |       |
| Investment in  subsidiaries                      |       | 69,643               |       | 252,642                     |       | —                           |       | (322,285                   | )          | —           |       |
| Trademarks                                       |       | —               |       | 9,319                       |       | 3,858                            |       | 114                        |       | 13,291           |       |
| Goodwill                                         |       | —               |       | 17,973                      |       | 12,300                           |       | —                     |       | 30,273           |       |
| Other  intangibles, net                          |       | 2,589                |       | 1,868                       |       | 76                               |       | —                     |       | 4,533            |       |
| Other assets                                     |       | 3,368                |       | 7,544                       |       | 2,672                            |       | —                     |       | 13,584           |       |
| TOTAL ASSETS                                     |       | $                    | 76,173     |                        | $          | 646,557                          |       | $                          | 108,414    |             | $          | (362,187 | ) | $ | 468,957 |   |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY       |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Current  liabilities:                            |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Current portion  of long-term debt               |       | $                    | —     |                        | $          | 7,897                            |       | $                          | 6,005      |             | $          | — |   | $ | 13,902 |   |
| Accounts payable                                 |       | 435                  |       | 10,911                      |       | 3,457                            |       | —                     |       | 14,803           |       |
| Other current  liabilities                       |       | 7,033                |       | 20,908                      |       | 13,871                           |       | (273                       | )          | 41,539           |       |
| Total current  liabilities                       |       | 7,468                |       | 39,716                      |       | 23,333                           |       | (273                       | )          | 70,244           |       |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Long-term debt                                   |       | 175,740              |       | 64,681                      |       | —                           |       | (38,605                    | )          | 201,816          |       |
| Intercompany                                     |       | (136,773             | )          | 134,847                     |       | 2,111                            |       | (185                       | )          | —           |       |
| Deferred tax  liabilities                        |       | 74                   |       | 18,695                      |       | 6,363                            |       | —                     |       | 25,132           |       |
| Other  non-current liabilities                   |       | 1,105                |       | 2,123                       |       | 19,591                           |       | —                     |       | 22,819           |       |
| Total  liabilities                               |       | 47,614               |       | 260,062                     |       | 51,398                           |       | (39,063                    | )          | 320,011          |       |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Stockholders’  equity                       |       | 28,559               |       | 386,495                     |       | 57,016                           |       | (323,124                   | )          | 148,946          |       |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY |       | $                    | 76,173     |                        | $          | 646,557                          |       | $                          | 108,414    |             | $          | (362,187 | ) | $ | 468,957 |   |

 

22

----

** **

**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONDENSED CONSOLIDATING BALANCE SHEETS**

**DECEMBER31, 2004**

**Unaudited**

**(InThousands)**

** **
| ** **                                       | ** ** | **Issuer  Of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
| ASSETS                                           |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Current assets:                                  |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash                                             |       | $                    | —     |                        | $          | 44,990                           |       | $                          | 14,238     |             | $          | (31,856 | ) | $ | 27,372 |   |
| Accounts, notes  and other receivables, net      |       | —               |       | 74,805                      |       | 13,254                           |       | —                     |       | 88,059           |       |
| Inventories                                      |       | —               |       | 127,577                     |       | 46,034                           |       | (1,265                     | )          | 172,346          |       |
| Prepaid expenses  and other current assets       |       | 1,007                |       | 3,956                       |       | 974                              |       | —                     |       | 5,937            |       |
| Deferred tax  assets                             |       | —               |       | 9,695                       |       | 5,352                            |       | —                     |       | 15,047           |       |
| Total current  assets                            |       | 1,007                |       | 261,023                     |       | 79,852                           |       | (33,121                    | )          | 308,761          |       |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Property, plant  and equipment, net              |       | 181                  |       | 83,713                      |       | 19,072                           |       | (22                        | )          | 102,944          |       |
| Investment in  subsidiaries                      |       | 69,643               |       | 278,513                     |       | —                           |       | (348,156                   | )          | —           |       |
| Trademarks                                       |       | —               |       | 7,625                       |       | 4,700                            |       | —                     |       | 12,325           |       |
| Goodwill                                         |       | —               |       | 17,973                      |       | 13,881                           |       | —                     |       | 31,854           |       |
| Other  intangibles, net                          |       | 2,938                |       | 2,352                       |       | —                           |       | —                     |       | 5,290            |       |
| Other assets                                     |       | 3,126                |       | 10,241                      |       | 3,004                            |       | —                     |       | 16,371           |       |
| TOTAL ASSETS                                     |       | $                    | 76,895     |                        | $          | 661,440                          |       | $                          | 120,509    |             | $          | (381,299 | ) | $ | 477,545 |   |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY       |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Current  liabilities:                            |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Current portion  of long-term debt               |       | $                    | —     |                        | $          | 6,972                            |       | $                          | 7,240      |             | $          | — |   | $ | 14,212 |   |
| Accounts payable                                 |       | 677                  |       | 10,716                      |       | 3,396                            |       | —                     |       | 14,789           |       |
| Other current  liabilities                       |       | 5,618                |       | 21,950                      |       | 16,635                           |       | (311                       | )          | 43,892           |       |
| Total current  liabilities                       |       | 6,295                |       | 39,638                      |       | 27,271                           |       | (311                       | )          | 72,893           |       |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Long-term debt                                   |       | 175,929              |       | 64,507                      |       | —                           |       | (31,856                    | )          | 208,580          |       |
| Intercompany                                     |       | (137,549             | )          | 139,993                     |       | (2,444                           | )          | —                     |       | —           |       |
| Deferred tax  liabilities                        |       | 63                   |       | 18,843                      |       | 7,334                            |       | —                     |       | 26,240           |       |
| Other  non-current liabilities                   |       | 892                  |       | 1,784                       |       | 21,603                           |       | —                     |       | 24,279           |       |
| Total  liabilities                               |       | 45,630               |       | 264,765                     |       | 53,764                           |       | (32,167                    | )          | 331,992          |       |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Stockholders’  equity                       |       | 31,265               |       | 396,675                     |       | 66,745                           |       | (349,132                   | )          | 145,553          |       |
|                                             |       |                 |       |                        |       |                             |       |                       |       |             |       |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY |       | $                    | 76,895     |                        | $          | 661,440                          |       | $                          | 120,509    |             | $          | (381,299 | ) | $ | 477,545 |   |

 

23

----

 

**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATING STATEMENTS OF CASH FLOWS**

**NINEMONTHS ENDED SEPTEMBER 30, 2005**

**Unaudited**

**(InThousands)**

** **
| ** **                                                                           | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
| Cash flows from  operating activities:                                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income  (loss)                                                                   |       | $                    | (4,478     | )                           | $          | 7,333                            |       | $                          | 5,905      |             | $          | (1 | ) | $ | 8,759 |   |
| Adjustments to  reconcile net income (loss) to cash flows from operating activities: |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Depreciation and  amortization                                                       |       | 413                  |       | 6,714                       |       | 1,415                            |       | 2                          |       | 8,544            |       |
| Amortization of  bond premium                                                        |       | (189                 | )          | —                      |       | —                           |       | —                     |       | (189             | )          |
| Deferred tax  expense (benefit)                                                      |       | 11                   |       | (142                        | )          | (197                             | )          | —                     |       | (328             | )          |
| Tax benefit from  stock option exercises                                             |       | 151                  |       | —                      |       | —                           |       | —                     |       | 151              |       |
| Other                                                                                |       | —               |       | (64                         | )          | 25                               |       | —                     |       | (39              | )          |
| Changes in  operating assets and liabilities:                                        |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Accounts, notes  and other receivables                                               |       | —               |       | (6,767                      | )          | 2,201                            |       | —                     |       | (4,566           | )          |
| Inventories                                                                          |       | —               |       | (4,225                      | )          | (3,773                           | )          | 146                        |       | (7,852           | )          |
| Prepaid expenses  and other assets                                                   |       | 413                  |       | 1,060                       |       | (516                             | )          | —                     |       | 957              |       |
| Accounts payable                                                                     |       | (242                 | )          | 195                         |       | 486                              |       | —                     |       | 439              |       |
| Other  liabilities                                                                   |       | 1,628                |       | (4,374                      | )          | (690                             | )          | 38                         |       | (3,398           | )          |
| Cash flows from  operating activities                                                |       | (2,293               | )          | (270                        | )          | 4,856                            |       | 185                        |       | 2,478            |       |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash flows from  investing activities:                                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Capital  expenditures                                                                |       | (87                  | )          | (2,689                      | )          | (806                             | )          | —                     |       | (3,582           | )          |
| Proceeds from  disposal of fixed assets                                              |       | —               |       | 954                         |       | 425                              |       | —                     |       | 1,379            |       |
| Cash flows from  investing activities                                                |       | (87                  | )          | (1,735                      | )          | (381                             | )          | —                     |       | (2,203           | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash flows from  financing activities:                                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Borrowings under  lines of credit                                                    |       | —               |       | 138,671                     |       | 2,151                            |       | (6,749                     | )          | 134,073          |       |
| Repayments under  lines of credit                                                    |       | —               |       | (131,922                    | )          | (2,917                           | )          | —                     |       | (134,839         | )          |
| Repayments of  term loan debt                                                        |       | —               |       | (5,650                      | )          | —                           |       | —                     |       | (5,650           | )          |
| Proceeds from  issuance of common stock                                              |       | 1,604                |       | —                      |       | —                           |       | —                     |       | 1,604            |       |
| Intercompany  transactions                                                           |       | 776                  |       | 3,673                       |       | (4,264                           | )          | (185                       | )          | —           |       |
| Cash flows from  financing activities                                                |       | 2,380                |       | 4,772                       |       | (5,030                           | )          | (6,934                     | )          | (4,812           | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Effect of  exchange rate changes on cash                                             |       | —               |       | —                      |       | (1,823                           | )          | —                     |       | (1,823           | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Decrease in cash                                                                     |       | —               |       | 2,767                       |       | (2,378                           | )          | (6,749                     | )          | (6,360           | )          |
| Cash, beginning  of year                                                             |       | —               |       | 44,990                      |       | 14,238                           |       | (31,856                    | )          | 27,372           |       |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash, end of  period                                                                 |       | $                    | —     |                        | $          | 47,757                           |       | $                          | 11,860     |             | $          | (38,605 | ) | $ | 21,012 |   |

 

24

----

** **

**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATING STATEMENTS OF CASH FLOWS**

**NINEMONTHS ENDED SEPTEMBER 30, 2004**

**Unaudited**

**(InThousands)**

** **
| ** **                                                                           | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
| Cash flows from  operating activities:                                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income  (loss)                                                                   |       | $                    | (1,751     | )                           | $          | 5,624                            |       | $                          | 5,034      |             | $          | (21 | ) | $ | 8,886 |   |
| Adjustments to  reconcile net income (loss) to cash flows from operating activities: |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Depreciation and  amortization                                                       |       | 394                  |       | 6,486                       |       | 1,273                            |       | —                     |       | 8,153            |       |
| Amortization of  bond premium                                                        |       | (167                 | )          | —                      |       | —                           |       | —                     |       | (167             | )          |
| Deferred tax  benefit                                                                |       | —               |       | (175                        | )          | (148                             | )          | —                     |       | (323             | )          |
| Tax benefit from  stock option exercises                                             |       | 814                  |       | —                      |       | —                           |       | —                     |       | 814              |       |
| Other                                                                                |       | —               |       | (13                         | )          | 118                              |       | —                     |       | 105              |       |
| Changes in  operating assets and liabilities:                                        |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Accounts, notes  and other receivables                                               |       | —               |       | (20,647                     | )          | 3,339                            |       | —                     |       | (17,308          | )          |
| Inventories                                                                          |       | —               |       | 1,799                       |       | (6,039                           | )          | 19                         |       | (4,221           | )          |
| Prepaid expenses  and other assets                                                   |       | (1,301               | )          | (1,936                      | )          | (2,441                           | )          | —                     |       | (5,678           | )          |
| Accounts payable                                                                     |       | 481                  |       | (169                        | )          | (298                             | )          | —                     |       | 14               |       |
| Other  liabilities                                                                   |       | 1,544                |       | (17                         | )          | 512                              |       | 2                          |       | 2,041            |       |
| Cash flows from  operating activities                                                |       | 14                   |       | (9,048                      | )          | 1,350                            |       | —                     |       | (7,684           | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash flows from  investing activities:                                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Capital  expenditures                                                                |       | (45                  | )          | (2,482                      | )          | (665                             | )          | —                     |       | (3,192           | )          |
| Proceeds from  disposal of fixed assets                                              |       | —               |       | 76                          |       | —                           |       | —                     |       | 76               |       |
| Acquisition of  subsidiary, net of cash acquired                                     |       | —               |       | (35,309                     | )          | —                           |       | —                     |       | (35,309          | )          |
| Cash flows from  investing activities                                                |       | (45                  | )          | (37,715                     | )          | (665                             | )          | —                     |       | (38,425          | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash flows from  financing activities:                                               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Borrowings under  lines of credit                                                    |       | 661                  |       | 80,031                      |       | 7,419                            |       | (21,236                    | )          | 66,875           |       |
| Repayments under  lines of credit                                                    |       | —               |       | (41,289                     | )          | (7,639                           | )          | —                     |       | (48,928          | )          |
| Debt issuance  costs                                                                 |       | (105                 | )          | —                      |       | —                           |       | —                     |       | (105             | )          |
| Repayments of term  loan debt                                                        |       | —               |       | (4,984                      | )          | —                           |       | —                     |       | (4,984           | )          |
| Proceeds from  issuance of common stock                                              |       | 5,441                |       | —                      |       | —                           |       | —                     |       | 5,441            |       |
| Intercompany  transactions                                                           |       | (5,966               | )          | 6,346                       |       | (380                             | )          | —                     |       | —           |       |
| Cash flows from  financing activities                                                |       | 31                   |       | 40,104                      |       | (600                             | )          | (21,236                    | )          | 18,299           |       |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Effect of  exchange rate changes on cash                                             |       | —               |       | 58                          |       | (413                             | )          | —                     |       | (355             | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Decrease in cash                                                                     |       | —               |       | (6,601                      | )          | (328                             | )          | (21,236                    | )          | (28,165          | )          |
| Cash, beginning  of year                                                             |       | —               |       | 12,255                      |       | 8,792                            |       | 21,236                     |       | 42,283           |       |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash, end of  period                                                                 |       | $                    | —     |                        | $          | 5,654                            |       | $                          | 8,464      |             | $          | — |   | $ | 14,118 |   |

 

25

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| **ITEM 2** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|------------|-------------------------------------------------------------------------------------------------|

**(TabularAmounts in Thousands Except Share and Per Share Data)**

**Introduction**

 

We are a world leader inthe design, manufacture, marketing, and distribution of high-quality musicalinstruments.  Our piano divisionconcentrates on the high-end grand piano segment of the industry, handcraftingSteinway pianos in New York and Germany. We also offer upright pianos and two mid-priced lines of pianos underthe Boston and Essex brand names.  We arealso the largest domestic producer of band and orchestral instruments and offera complete line of brass, woodwind, percussion and string instruments andrelated accessories with well-known brand names such as Bach, Selmer, C.G.Conn, Leblanc, King, and Ludwig.  We sellour products through dealers and distributors worldwide. Our piano customerbase consists of professional artists, amateur pianists, and institutions suchas 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.

 

**Critical Accounting Estimates**

 

Theapplication of many accounting policies involves estimates and assumptions thathave a material impact on our reported results. We establish reserves for inventory, workers’ compensation, warrantyclaims, accounts receivable, notes receivable, (including recourse reserveswhen our customers have financed notes receivable with a third party), all of whichare developed using estimates.  We havesignificant experience and data on which to base these estimates.  Historical information is adjusted forspecific uncertainties, such as new product introductions, and contemporaneousinformation, such as price fluctuations. We regularly perform assessments of the underlying assumptions we use. 

 

Theimpairment (if any) and recoverability of long-lived assets, the selection ofassumptions used to determine pension expense or income, the allocation ofpurchase price for businesses acquired, and certain components of our taxprovision calculation, such as valuation allowances on deferred tax assets, theability to utilize foreign tax credits, and income tax contingencies are basedon estimates that require a greater degree of management judgment. 

 

Wehave made certain assumptions regarding the collectibility of recovery claimsfrom escrow from environmental remediation costs pertaining to facilities thatwe acquired in 2004. Although we anticipate full collection from the escrowfunds, no assurance can be given that additional environmental issues will notrequire additional, currently unanticipated investigation, assessment, orremediation expenditures; that such expenditures will be discovered prior totermination of the claim period in February 2006; that such expenditures willnot exceed the amount available in escrow; that we can successfully claim anyaccrued or additional costs through the escrow; or that the indemnitor willagree to or have the ability to pay any such expenditures that either surviveor exceed the escrow.

 

Webelieve the assumptions made by management provide a reasonable basis for theestimates reflected in our financial statements.

 

**Forward-Looking Statements**

 

Certain statements contained in this document are “forward-lookingstatements” within the meaning of Section 21E of the Securities and ExchangeAct of 1934, as amended.  Theseforward-looking statements represent our present expectations or beliefsconcerning future events.  We cautionthat such statements are necessarily based on certain assumptions which aresubject to risks and uncertainties which could cause actual results to differmaterially from those indicated in this report. These risk factors include, 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; marketacceptance of new band instrument product and distribution strategies; abilityof suppliers to meet demand; fluctuations in effective tax rates resulting fromshifts in sources of income; and the ability to successfully integrate andoperate acquired businesses.  Furtherinformation on these risk factors is included in our Annual Report on Form 10-Kfor the year ended December 31, 2004, our Final Prospectus filed in August1996, and Registration Statement No. 333-62790 filed in June 2001, particularlyin the sections entitled “Risk Factors.” We encourage you to read those descriptions carefully.  We caution investors not to place unduereliance on

 

26

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the forward-lookingstatements 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.

 

**Resultsof Operations**

 

*Three Months Ended September 30,2005 Compared to Three Months Ended September 30, 2004*

* *
| ** **                  | ** ** | **Three Months Ended September 30,** | ** ** | ** ** | ** ** | **Change**        | ** ** |
|-----------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| ** **                  | ** ** | **2005**                             | ** ** | ** ** | ** ** | **2004**          | ** ** | ** ** | ** ** | **$** | ** ** | **%** | ** ** |
|                        |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Net sales                   |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Band                        |       | $                                    | 46,943     |       |       |              | $          | 47,052 |   |   |   | (109 | ) | (0.2 | ) |
| Piano                       |       | 48,971                               |       |       |       | 47,601            |       |   |   | 1,370 |   | 2.9 |   |
| Total sales                 |       | 95,914                               |       |       |       | 94,653            |       |   |   | 1,261 |   | 1.3 |   |
|                        |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Cost of sales               |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Band                        |       | 37,231                               |       |       |       | 38,456            |       |   |   | (1,225 | ) | (3.2 | ) |
| Piano                       |       | 31,187                               |       |       |       | 30,301            |       |   |   | 886 |   | 2.9 |   |
| Total cost of  sales        |       | 68,418                               |       |       |       | 68,757            |       |   |   | (339 | ) | (0.5 | ) |
|                        |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Gross profit                |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Band                        |       | 9,712                                |       | 20.7%      |       | 8,596             |       | 18.3% |   | 1,116 |   | 13.0 |   |
| Piano                       |       | 17,784                               |       | 36.3%      |       | 17,300            |       | 36.3% |   | 484 |   | 2.8 |   |
| Total gross  profit         |       | 27,496                               |       |       |       | 25,896            |       |   |   | 1,600 |   | 6.2 |   |
|                        |       | 28.7%                      |       |       |       | 27.4%   |       |   |   |   |   |   |   |
|                        |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Operating  expenses         |       | 18,158                               |       |       |       | 18,299            |       |   |   | (141 | ) | (0.8 | ) |
|                        |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Income from  operations     |       | 9,338                                |       |       |       | 7,597             |       |   |   | 1,741 |   | 22.9 |   |
|                        |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Other income,  net          |       | (467                                 | )          |       |       | (806              | )          |   |   | 339 |   | (42.1 | ) |
| Net interest  expense       |       | 3,562                                |       |       |       | 3,690             |       |   |   | (128 | ) | (3.5 | ) |
|                        |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Income before  income taxes |       | 6,243                                |       |       |       | 4,713             |       |   |   | 1,530 |   | 32.5 |   |
|                        |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Income taxes                |       | 2,500                                |       | 40.0%      |       | 1,885             |       | 40.0% |   | 615 |   | 32.6 |   |
|                        |       |                                 |       |       |       |              |       |   |   |   |   |   |   |
| Net income                  |       | $                                    | 3,743      |       |       |              | $          | 2,828 |   |   |   | 915 |   | 32.4 |   |
|                             |            |                                      |            |            |            |                   |            |  |  |  |  |  |  |  |  |  |

 

27

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*Overview -*Band divisionrevenues remained stable as incremental sales of Leblanc instruments offset thedecrease in some of our other instrument brands. We continue to have moredemand for certain instruments, such as flutes and clarinets, than we haveavailable for shipment. However, inefficiencies from training new woodwindplant personnel have decreased, and production levels have improved.  Despite supply issues for certain woodwindand sourced products, margins continue to show improvement, contributing to anincrease in overall band operating profit over the prior period.

 

Domestic piano revenuesdeclined on downturns in both wholesale and retail demand.  However, this was more than offset by theincrease in overseas piano revenue, which was generated primarily in ourEuropean markets.  Margins remainedconsistent with the prior period, and overall piano operating profit improvedslightly over the prior period.

 

*Net Sales–*The increase in net sales of $1.3 million resulted fromimproved performance in the piano segment. Although Steinway grand units shipped by our overseas divisionsincreased 25%, domestic Steinway grand unit shipments decreased 15%, whichresulted in an overall unit decrease of 6%. The annual sales price increase onSteinway products and a favorable shift in mix towards larger, higher pricedunits sold by our German division caused an overall revenue improvement for thepiano segment.  Total unit sales of bandand orchestral, string, and percussion instruments were consistent with theprior period.  As a result, band segmentrevenues remained flat.

 

*GrossProfit –* Gross profit improved $1.6 million driven by anincrease in piano sales and band gross margin improvements.  In an effort to control inventories, we shut downproduction for an additional week at our domestic piano manufacturing facility,which resulted in underabsorption of overhead of approximately $0.5million.  However, strong mix andwholesale demand in higher margin Eastern European territories helped maintainthe piano margins of 36.3%. Band gross margins improved from 18.3% to 20.7% inthe period.  Lower charges ($0.3 millionas opposed to $0.9 million) arising from the sell through of purchased Leblancinventory, which was written up to fair value upon acquisition, were theprimary cause of the increase.  Priceincreases on certain instruments also contributed to the margin improvement.

 

*OperatingExpenses* – Although administrative costs such as salaries andtravel increased, overall operating expenses decreased $0.1 million, dueprimarily to the $0.7 million decrease in professional service fees associatedwith Sarbanes-Oxley compliance efforts during the period.  These fees have been more ratably incurred in2005, whereas in 2004 the costs were heavily weighted towards the latter halfof the year.

 

*InterestExpense and Other Income, Net –*These other expensesincreased only $0.2 million to $3.1 million, as foreign exchange gains and netinterest expense were consistent with the prior period.

 

*IncomeTaxes* –**Our effectivetax rate of 40% is consistent with the prior comparative period.

 

28

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*Nine**Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004*

 
| ** **                  | ** ** | **Nine Months Ended September 30,** | ** ** | ** ** | ** ** | **Change**  | ** ** |
|-----------------------------|------------|-------------------------------------|------------|------------|------------|-------------|------------|
| ** **                  | ** ** | **2005**                            | ** ** | ** ** | ** ** | **2004**    | ** ** | ** ** | ** ** | **$** | ** ** | **%** | ** ** |
|                        |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Net sales                   |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Band                        |       | $                                   | 137,878    |       |       |        | $          | 130,151 |   |   |   | 7,727 |   | 5.9 |   |
| Piano                       |       | 139,139                             |       |       |       | 138,251     |       |   |   | 888 |   | 0.6 |   |
| Total sales                 |       | 277,017                             |       |       |       | 268,402     |       |   |   | 8,615 |   | 3.2 |   |
|                        |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Cost of sales               |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Band                        |       | 108,754                             |       |       |       | 102,616     |       |   |   | 6,138 |   | 6.0 |   |
| Piano                       |       | 88,944                              |       |       |       | 89,762      |       |   |   | (818 | ) | (0.9 | ) |
| Total cost of  sales        |       | 197,698                             |       |       |       | 192,378     |       |   |   | 5,320 |   | 2.8 |   |
|                        |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Gross profit                |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Band                        |       | 29,124                              |       | 21.1%      |       | 27,535      |       | 21.2% |   | 1,589 |   | 5.8 |   |
| Piano                       |       | 50,195                              |       | 36.1%      |       | 48,489      |       | 35.1% |   | 1,706 |   | 3.5 |   |
| Total gross  profit         |       | 79,319                              |       |       |       | 76,024      |       |   |   | 3,295 |   | 4.3 |   |
|                        |       | 28.6%                          |       |       |       | 28.3%  |       |   |   |   |   |   |   |
|                        |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Operating  expenses         |       | 55,196                              |       |       |       | 53,116      |       |   |   | 2,080 |   | 3.9 |   |
|                        |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Income from  operations     |       | 24,123                              |       |       |       | 22,908      |       |   |   | 1,215 |   | 5.3 |   |
|                        |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Other income,  net          |       | (873                                | )          |       |       | (2,152      | )          |   |   | 1,279 |   | (59.4 | ) |
| Net interest  expense       |       | 10,397                              |       |       |       | 10,254      |       |   |   | 143 |   | 1.4 |   |
|                        |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Income before  income taxes |       | 14,599                              |       |       |       | 14,806      |       |   |   | (207 | ) | (1.4 | ) |
|                        |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Income taxes                |       | 5,840                               |       | 40.0%      |       | 5,920       |       | 40.0% |   | (80 | ) | (1.4 | ) |
|                        |       |                                |       |       |       |        |       |   |   |   |   |   |   |
| Net income                  |       | $                                   | 8,759      |       |       |        | $          | 8,886 |   |   |   | (127 | ) | (1.4 | ) |

 

*Overview –*Sales of Leblancinstruments drove the band division’s revenue improvement for the period.  Sales of other band instruments were lower asavailability of newly introduced sourced-product and certain woodwindinstruments fell short of demand. Production disruptions caused by training new personnel at the woodwindmanufacturing facility decreased in the third quarter.

 

Although piano sales wererelatively flat for the period, piano division operating profit improved,primarily as a result of gross margin improvements.

 

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*Net Sales–*The increase in net sales of $8.6 million was driven by theincrease in band sales.  Piano divisionsales were up slightly as the strong European wholesale performance andfavorable product mix mitigated the domestic sales decrease of $4.7million.  Standard price increases onSteinway and Boston product helped mitigate the impact of lower unit shipments,which were down 5%.  Our band divisionsales increased $7.7 million as a result of incremental Leblanc product salesof $13.9 million.  Band and orchestralunit sales increased 8% boosted by sales of Leblanc models, which were morereadily accessible for shipment than some of our woodwind and sourced products.

 

*GrossProfit –* Gross profit improved $3.3 million, fueled by theimprovement in piano division margins and band division sales.  Piano margins increased from 35.1% to 36.1%despite lower domestic sales at both the retail and wholesale levels.  Wholesale shipments to high-marginterritories and a sales mix of larger, higher margin Steinway grand unitsshipped by our German operations were the primary cause of theimprovement.  Band gross margins declinedslightly from 21.2% to 21.1% in the period. Atypical charges affecting margin in 2005 totaled $1.5 million, comprisedof charges from the sell through of purchased Leblanc inventory, which waswritten up to fair value upon acquisition. Atypical charges affecting margin in 2004 included $1.4 million inseverance costs associated with the closure of one of our woodwindmanufacturing facilities and $0.9 million due to the sell through of Leblancinventories.  Despite the decrease inatypical charges, gross margins declined primarily as a result of the factorydisruptions caused by production ramp-up efforts and new workforce training atour domestic woodwind manufacturing facility.

 

*OperatingExpenses* – Operating expenses increased $2.1 million,primarily due to incremental costs of $0.9 million associated with Leblanc, themajority of which were incurred in the early part of the year.  Sales and marketing costs associated withpromotional efforts and commissions as well as administrative costs associatedwith salaries and travel also contributed to the increase.

 

*InterestExpense and Other Income, Net –*These other expensesincreased $1.4 million to $9.5 million during the period.  This resulted from reclassification ofcertain items and the $0.5 million shift from foreign currency gains to foreigncurrency losses.  Net interest expenseincreased slightly ($0.1 million) due to higher interest rates.  Borrowings on our domestic line of credit werepaid off in September.

 

*IncomeTaxes* –**Our effectivetax rate of 40% is consistent with the prior comparative period.

 

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**Liquidity and Capital Resources**

 

We have relied primarilyupon cash provided by operations, supplemented as necessary by seasonalborrowings under our working capital line, to finance our operations, repaylong-term indebtedness and fund capital expenditures.

 

Our statements of cashflows for the nine months ended September 30, 2005 and 2004 are summarized asfollows:

 
| ** **                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **Change** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
| Net income:                                                                    |       | $        | 8,759      |     | $          | 8,886      |       | $ | (127 | ) |
| Changes in  operating assets and liabilities                                   |       | (14,420  | )          | (25,152  | )          | 10,732     |       |
| Other  adjustments to reconcile net income to cash   from operating activities |       | 8,139    |       | 8,582    |       | (443       | )          |
| Cash flows from  operating activities                                          |       | 2,478    |       | (7,684   | )          | 10,162     |       |
|                                                                           |       |     |       |     |       |       |       |
| Cash flows from  investing activities                                          |       | (2,203   | )          | (38,425  | )          | 36,222     |       |
|                                                                           |       |     |       |     |       |       |       |
| Cash flows from  financing activities                                          |       | (4,812   | )          | 18,299   |       | (23,111    | )          |
|                                                                                |            |          |            |          |            |            |            |  |  |  |

 

Cashflows generated from operating activities increased $10.2 million basedprimarily on an increase in cash collections of receivables by our banddivision. The use of cash for investing activities decreased $36.2 million, as$35.3 million was used to fund an acquisition in 2004.  The remainder of the reduction resulted fromsales of acquired assets, including a manufacturing facility in Wisconsin andproperty in France.  Cash provided by financingactivities decreased $23.1 million compared to the prior period.  In 2004, we had outstanding borrowings of$18.2 million on our domestic line of credit, which were used to fund anacquisition, whereas we have no outstanding domestic line of credit borrowingsin the current period.  In addition,proceeds from the issuance of stock dropped $3.8 million in the current period.

## ** **

## **Borrowing Availability and Activities**

 

Ourreal estate term loan, acquisition term loan and domestic seasonal borrowingrequirements are accommodated through a committed credit facility with asyndicate of domestic lenders (the “Credit Facility”).  The Credit Facility provides us with apotential borrowing capacity of up to $85.0 million in revolving credit loans,based on eligible accounts receivable and inventory balances.  The acquisition term loan and revolvingcredit loan portions of the Credit Facility bear interest at average 30-dayLIBOR plus 1.75%, and the real estate term loan bears interest at average30-day LIBOR plus 1.5%.  The Creditfacility expires on September 14, 2008. As of September 30, 2005 there were no revolving credit loansoutstanding, and remaining availability based on eligible accounts receivableand inventory balances was approximately $82.7 million net of letters of creditof $2.3 million.  We also have certainnon-domestic credit facilities originating from two German banks that providefor borrowings by foreign subsidiaries of up to €16.5 million ($19.8 million atthe September 30, 2005 exchange rate), net of borrowing restrictions of €0.9million ($1.1 million at the September 30, 2005 exchange rate) and are payableon demand.  These borrowings arecollateralized by most of the assets of the borrowing subsidiaries.  A portion of the loans can be converted intoa maximum of £0.5 million ($0.9 million at the September 30, 2005 exchangerate) for use by our U.K. branch and ¥300 million ($2.6 million at theSeptember 30, 2005 exchange rate) for use by our Japanese subsidiary. OurChinese subsidiary also has the ability to convert the equivalent of up to €1.8million into U.S. dollars or Chinese renminbi ($2.2

 

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million at the September30, 2005 exchange rate).  Theseborrowings bear interest at LIBOR plus 1%. We had $1.6 million outstanding asof September 30, 2005 on one of these credit facilities.  In January 2005, our Japanese subsidiaryentered into a separate revolving loan agreement that provides additionalborrowing capacity of up to ¥500 million ($4.4 million at the September 30,2005 exchange rate) based on eligible inventory balances. The revolving loanagreement bears interest at an average 30-day Tokyo Interbank Offered Rate (“TIBOR”)plus 0.875% and expires on January 31, 2010. As of September 30, 2005, we had $4.4 million outstanding on thisrevolving loan agreement.

 

OnFebruary 4, 2004 we purchased 1,271,450 shares of our Ordinary common stockdirectly from our then largest institutional shareholder.  In exchange, we issued $29.0 million in principalamount of our 8.75% Senior Notes due 2011 under the existing indenture.  We issued these bonds at a premium of106.3%.  This transaction increased ourtreasury stock by $31.6 million.

 

Ourbond indenture contains limitations based on net income (among other things) onthe amount of discretionary repurchases we may make of our Ordinary commonstock.  Although our availability underthese limitations has increased over time as we have earned income, we currentlyhave no short-term plans to repurchase additional Ordinary common stock eitherdirectly from shareholders or on the open market.

 

Ourlong-term financing consists primarily of $174.3 million of 8.75% Senior Notes,and $34.0 million of term loans outstanding under the Credit Facility. Our debtagreements contain covenants that place certain restrictions on us, includingour ability to incur additional indebtedness, to make investments in otherentities and to pay cash dividends.  Wewere in compliance with all such covenants as of September 30, 2005.

 

We arenot aware of any other trends, demands, commitments, or costs of resources thatare expected to materially impact liquidity or capital resources.  Therefore, we believe that cash on hand,together with cash flows anticipated from operations and available borrowingsunder the Credit Facility, will be adequate to meet existing debt servicerequirements, fund continuing capital requirements and satisfy working capitaland general corporate needs for the next twelve months.

 

Wehave reserved 721,750 shares of our existing treasury stock to be utilized forthe exercise of outstanding stock options under our Amended and Restated 1996Stock Plan.  These options will have noimpact on our cash flow or the number of shares outstanding unless and until theoptions are exercised.

 

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**Contractual Obligations**

 

The followingtable provides a summary of our contractual obligations at September 30, 2005:

 
| ** **                       | ** ** | **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)              |       | $                          | 304,917    |   | $ | 31,301 |   | $ | 59,462 |   | $ | 31,325 |   | $ | 182,829 |   |
| Operating leases  (2)            |       | 269,859                    |       | 4,778 |   | 8,213 |   | 7,710 |   | 249,158 |   |
| Purchase  obligations (3)        |       | 14,088                     |       | 13,624 |   | 464 |   | — |   | — |   |
| Other long-term  liabilities (4) |       | 22,941                     |       | 3,340 |   | 3,713 |   | 3,205 |   | 12,683 |   |
| Total                            |       | $                          | 611,805    |   | $ | 53,043 |   | $ | 71,852 |   | $ | 42,240 |   | $ | 444,670 |   |

 

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**Notes toContractual Obligations:**

 
| (1) | Long-term debt  represents long-term debt obligations, the fixed interest on our Notes, and  the variable interest on our other loans.   We estimated the variable interest obligation using the  September 30, 2005 applicable rates.   The nature of our debt obligations is described more fully in the “Borrowing  Availability and Activities” section of “Liquidity and Capital Resources.” |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Approximately  $255.9 million of our operating lease obligations are attributable to the  ninety-nine year land lease associated with the purchase of Steinway Hall;  the remainder is attributable to the leasing of other facilities and  equipment.                                                                                                                                                                               |
| (3) | Purchase  obligations consist of firm purchase commitments for raw materials, imported  products, and tooling.                                                                                                                                                                                                                                                                                                                       |
| (4) | Other long-term  liabilities consist primarily of the long-term portion of our pension  obligations and obligations under employee and consultant agreements.                                                                                                                                                                                                                                                                        |

 

 

**RecentAccounting Pronouncements**

 

InDecember 2004, the Financial Accounting Standards Board (“FASB”) revisedStatement of Financial Accounting Standards (“SFAS”) No. 123 and issued SFASNo. 123R, “Share-Based Payments” (SFAS No. 123R). This accounting standard,which was originally effective for interim and annual periods beginning afterJune 15, 2005, requires the recognition of compensation expense related to stockoptions using the fair value method.  InApril 2005, the SEC revised the first required compliance date to fiscal yearsbeginning after June 15, 2005.  We planto adopt SFAS No. 123R in the first quarter of 2006 using the modifiedprospective application method. Based on current outstanding awards, expectedparticipation in the Purchase Plan consistent with past patterns, and nosignificant changes in the number of shares of outstanding stock, we anticipatean impact on basic earnings per share of approximately $0.10 - $0.12 inadditional stock compensation expense in 2006. The actual amount will be impacted by changes in the aforementionedfactors, as well as finalization of our estimated forfeiture rates and otherassumptions.

 

InNovember 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment ofARB No. 43, Chapter 4” (SFAS No. 151). This accounting standard, which iseffective for annual periods beginning after June 15, 2005, requires thatabnormal amounts of idle facility expense, freight, handling costs, and wastedmaterials (spoilage) should be recognized as current-period charges. Theadoption of SFAS No. 151 is not expected to have a material effect on ourfinancial position or results of operations.

 

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InJune 2005, the FASB ratified Emerging Issues Task Force (“EITF”) Issue 05-05, “Accountingfor Early Retirement Programs With Specific Features (Such as Terms specifiedin Altersteilzeit Early Retirement Arrangements)” which addresses theaccounting for the transitional early retirement program in Germany.  Salary components of this plan should berecognized over the period from which the program begins until the end of theactive service period.  Additionally, aportion of the salary that is deferred under certain arrangements should bediscounted if payment is expected to be deferred for a period longer than oneyear.  This treatment is effective forfiscal years beginning after December 15, 2005. The application of EITF 05-05 is not expected to have a material impacton our financial position or results of operations.

 

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**ITEM 3           QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**We are exposed to market riskassociated with changes in foreign currency exchange rates and interestrates.  We mitigate a portion of ourforeign currency exchange rate risk by maintaining foreign currency cashbalances and holding option and forward foreign currency contracts.  They are not designated as hedges foraccounting purposes.  These contractsrelate primarily to intercompany transactions and are not used for trading orspeculative purposes.  The fair value ofthe option and forward foreign currency exchange contracts is sensitive tochanges in foreign currency exchange rates. The impact of an adverse change in foreign currency exchange rates wouldnot be materially different than that disclosed in the our Annual Report onForm 10-K for the year ended December 31, 2004.**

 

**Our revolving loans and term loansbear interest at rates that fluctuate with changes in LIBOR and TIBOR.  As such, our interest expense on ourrevolving loans and term loans and the fair value of our fixed long-term debtare sensitive to changes in market interest rates.  The effect of an adverse change in marketinterest rates on our interest expense would not be materially different thanthat disclosed in our Annual Report on Form 10-K for the year ended December31, 2004.**

 

**The majority of our long-term debtis at a fixed interest rate.  Therefore,the associated interest expense is not sensitive to fluctuations in marketinterest rates.  However, the fair valueof our fixed interest debt would be sensitive to market rate changes.  Such fair value changes may affect our decisionwhether to retain, replace, or retire this debt.**

 

**ITEM 4           CONTROLS AND PROCEDURES**

 

As ofthe end of the period covered by this report, we evaluated the effectiveness ofthe design and operation of our disclosure controls and procedures (as definedin Exchange Act Rules 13a-15(e) and 15d-15(e)). Our disclosure controls andprocedures are the controls and other procedures that we designed to ensurethat we record, process, summarize and report in a timely manner theinformation we must disclose in reports that we file with or submit to the SEC.Our Chief Executive Officer and Chief Financial Officer reviewed andparticipated in this evaluation. Based on this evaluation the Chief ExecutiveOfficer and Chief Financial Officer concluded that our disclosure controls andprocedures 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.

 

Duringthe quarter covered by this report, there were no significant changes in ourinternal controls that materially affected, or are reasonably likely tomaterially affect, the Company’s internal control over financial reporting.

 

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**PART II****                 OTHER INFORMATION**

 

**ITEM 6                   EXHIBITS**

 

(i)                                     Exhibits

 
| 10.1   | Labor Contract  Agreement between Musser Division and Carpenter Local 1027  Mill-Cabinet-Industrial Division affiliate of Chicago Regional Council of  Carpenters of the United Brotherhood of Carpenters and Joiners of America |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                             |
| 10.2   | Labor Contract  Agreement between Frank Holton Company and Local No. M94 of the International  Brotherhood of Boilermakers, Iron Shipbuilders, Blacksmiths, Forgers, and  Helpers                                                |
|   |                                                                                                                                                                                                                             |
| 31.1   | Certification of the  Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002                                                                                                                     |
|   |                                                                                                                                                                                                                             |
| 31.2   | Certification of the  Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act  of 2002                                                                                                                     |
|   |                                                                                                                                                                                                                             |
| 32.1   | Certification of the  Principal Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                      |
|   |                                                                                                                                                                                                                             |
| 32.2   | Certification of the  Principal Financial Officer pursuant to 18 U.S. C. Section 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                     |

 

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Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on their behalf by the undersigned, thereuntoduly 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:  November 9, 2005

 

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