**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

**FORM10-Q**

 

**ý****                                ****QUARTERLY REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THEQUARTERLY PERIOD ENDED JUNE 30, 2004**

 

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

 

**COMMISSION FILE NUMBER 001-11911**

 

**STEINWAYMUSICAL INSTRUMENTS, INC.**

(Exact name of registrant as specified in itscharter)

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

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements during the past 90 days.

Yes  ý   No  o

 

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

Yes  ý   Noo

 
| Number of  shares of Common Stock issued and outstanding as of August 2, 2004**:** |   | Class A  |   | 477,952   |
|------------------------------------------------------------------------------------|--------|----------|--------|-----------|
|                                                                               |   | Ordinary |   | 7,523,595 |
|                                                                               |   | Total    |   | 8,001,547 |

 

 

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**STEINWAY MUSICAL INSTRUMENTS, INC. ANDSUBSIDIARIES**

**FORM 10-Q**

**INDEX**

 
| **PART I.**  | **UNAUDITED FINANCIAL INFORMATION**                                                                                     |       |
|--------------|-------------------------------------------------------------------------------------------------------------------------|------------|
|         |                                                                                                                    |       |
| **Item 1.**  | **Consolidated and Condensed Consolidated  Financial Statements:**                                                      |       |
|         |                                                                                                                    |       |
|         | Consolidated Statements of Income  Three months and six months ended June 30, 2004 and June 28, 2003                    |       |
|         |                                                                                                                    |       |
|         | Condensed Consolidated Balance Sheets  June 30, 2004 and December 31, 2003                                              |       |
|         |                                                                                                                    |       |
|         | Consolidated Statements of Cash Flows  Six months ended June 30, 2004 and June 28, 2003                                 |       |
|         |                                                                                                                    |       |
|         | Consolidated Statement of Stockholders’  Equity  Three months and six months ended June 30, 2004 and June 28, 2003 |       |
|         |                                                                                                                    |       |
|         | Notes to Condensed Consolidated Financial  Statements                                                                   |       |
|         |                                                                                                                    |       |
| **Item 2.**  | **Management’s Discussion and Analysis of  Financial Condition and Results of Operations**                         |       |
|         |                                                                                                                    |       |
| **Item 3.**  | **Quantitative  and Qualitative Disclosures about Market Risk**                                                         | ** ** |
| ** **   | ** **                                                                                                              | ** ** |
| **Item  4.** | **Controls and Procedures**                                                                                             | ** ** |
| ** **   | ** **                                                                                                              | ** ** |
| **PART II.** | **OTHER INFORMATION**                                                                                                   |       |
|         |                                                                                                                    |       |
| **Item 4.**  | **Submission of Matters to a Vote of Security  Holders**                                                                |       |
|         |                                                                                                                    |       |
| **Item 6.**  | **Exhibits and Reports on Form 8-K**                                                                                    |       |
|         |                                                                                                                    |       |
|         | **Signatures**                                                                                                          |       |

 

2

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

 

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

**CONSOLIDATEDSTATEMENTS OF INCOME**

**Unaudited**

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

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                        | ** ** | **June 30, 2004**      | ** ** | **June 28, 2003**    | ** ** | **June 30, 2004** | ** ** | **June 28, 2003** | ** ** |
| Net sales                         |       | $                      | 83,688     |                 | $          | 78,035 |   | $ | 173,749 |   | $ | 160,544 |   |
| Cost of sales                     |       | 59,285                 |       | 55,322               |       | 123,621 |   | 116,999 |   |
|                              |       |                   |       |                 |       |   |   |   |   |
| Gross Profit                      |       | 24,403                 |       | 22,713               |       | 50,128 |   | 43,545 |   |
|                              |       |                   |       |                 |       |   |   |   |   |
| Operating expenses:               |       |                   |       |                 |       |   |   |   |   |
| Sales and marketing               |       | 10,539                 |       | 10,944               |       | 21,833 |   | 21,957 |   |
| General and administrative        |       | 6,399                  |       | 5,535                |       | 12,413 |   | 11,489 |   |
| Amortization of intangibles       |       | 255                    |       | 288                  |       | 546 |   | 577 |   |
| Other operating expenses (income) |       | (3                     | )          | 136                  |       | 25 |   | 308 |   |
| Total operating expenses          |       | 17,190                 |       | 16,903               |       | 34,817 |   | 34,331 |   |
|                              |       |                   |       |                 |       |   |   |   |   |
| Income from operations            |       | 7,213                  |       | 5,810                |       | 15,311 |   | 9,214 |   |
|                              |       |                   |       |                 |       |   |   |   |   |
| Other income, net                 |       | (734                   | )          | (712                 | )          | (1,346 | ) | (1,333 | ) |
| Interest income                   |       | (591                   | )          | (503                 | )          | (1,228 | ) | (1,121 | ) |
| Interest expense                  |       | 4,014                  |       | 3,510                |       | 7,792 |   | 7,100 |   |
|                              |       |                   |       |                 |       |   |   |   |   |
| Income before income taxes        |       | 4,524                  |       | 3,515                |       | 10,093 |   | 4,568 |   |
|                              |       |                   |       |                 |       |   |   |   |   |
| Income taxes                      |       | 1,810                  |       | 1,355                |       | 4,035 |   | 1,725 |   |
|                              |       |                   |       |                 |       |   |   |   |   |
| Net income                        |       | $                      | 2,714      |                 | $          | 2,160 |   | $ | 6,058 |   | $ | 2,843 |   |
|                              |       |                   |       |                 |       |   |   |   |   |
| Earnings per share:               |       |                   |       |                 |       |   |   |   |   |
| Basic                             |       | $                      | 0.34       |                 | $          | 0.24 |   | $ | 0.75 |   | $ | 0.32 |   |
| Diluted                           |       | $                      | 0.33       |                 | $          | 0.24 |   | $ | 0.72 |   | $ | 0.32 |   |
|                              |       |                   |       |                 |       |   |   |   |   |
| Weighted average shares:          |       |                   |       |                 |       |   |   |   |   |
| Basic                             |       | 7,957,483              |       | 8,906,238            |       | 8,083,945 |   | 8,906,238 |   |
| Diluted                           |       | 8,340,726              |       | 8,906,238            |       | 8,436,605 |   | 8,906,252 |   |

 

See notes to consolidated andcondensed consolidated financial statements.

 

3

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

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**Unaudited**

**(In Thousands)**

 
| ** **                                                                                                                   | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ASSETS:                                                                                                                      |       |               |       |                   |       |
| Current assets:                                                                                                              |       |               |       |                   |       |
| Cash                                                                                                                         |       | $                  | 30,323     |                   | $          | 42,283 |   |
| Accounts, notes and leases receivable, net  of allowance for bad debts of  $10,044 and $9,944 in 2004 and 2003, respectively |       | 84,653             |       | 76,403                 |       |
| Inventories                                                                                                                  |       | 159,384            |       | 152,029                |       |
| Prepaid expenses and other current assets                                                                                    |       | 4,687              |       | 4,533                  |       |
| Deferred tax assets                                                                                                          |       | 12,974             |       | 13,022                 |       |
| Total current assets                                                                                                         |       | 292,021            |       | 288,270                |       |
|                                                                                                                         |       |               |       |                   |       |
| Property, plant and equipment, net of  accumulated depreciation of $66,223  and $63,952 in 2004 and 2003, respectively       |       | 95,912             |       | 98,937                 |       |
| Trademarks                                                                                                                   |       | 10,195             |       | 10,319                 |       |
| Goodwill                                                                                                                     |       | 31,275             |       | 31,665                 |       |
| Other intangibles, net                                                                                                       |       | 5,340              |       | 5,782                  |       |
| Other assets                                                                                                                 |       | 15,426             |       | 10,692                 |       |
|                                                                                                                         |       |               |       |                   |       |
| TOTAL ASSETS                                                                                                                 |       | $                  | 450,169    |                   | $          | 445,665 |   |
|                                                                                                                         |       |               |       |                   |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                    |       |               |       |                   |       |
| Current liabilities:                                                                                                         |       |               |       |                   |       |
| Current portion of long-term debt                                                                                            |       | $                  | 10,501     |                   | $          | 10,638 |   |
| Accounts payable                                                                                                             |       | 12,258             |       | 11,554                 |       |
| Other current liabilities                                                                                                    |       | 37,540             |       | 39,112                 |       |
| Total current liabilities                                                                                                    |       | 60,299             |       | 61,304                 |       |
|                                                                                                                         |       |               |       |                   |       |
| Long-term debt                                                                                                               |       | 213,312            |       | 185,964                |       |
| Deferred tax liabilities                                                                                                     |       | 25,125             |       | 25,565                 |       |
| Other non-current liabilities                                                                                                |       | 20,157             |       | 20,197                 |       |
| Total liabilities                                                                                                            |       | 318,893            |       | 293,030                |       |
|                                                                                                                         |       |               |       |                   |       |
| Commitments and contingent liabilities                                                                                       |       |               |       |                   |       |
|                                                                                                                         |       |               |       |                   |       |
| Stockholders’ equity:                                                                                                   |       |               |       |                   |       |
| Common stock                                                                                                                 |       | 10                 |       | 10                     |       |
| Additional paid-in capital                                                                                                   |       | 79,952             |       | 74,626                 |       |
| Retained earnings                                                                                                            |       | 102,778            |       | 96,720                 |       |
| Accumulated other comprehensive loss                                                                                         |       | (4,028             | )          | (2,868                 | )          |
| Treasury stock, at cost                                                                                                      |       | (47,436            | )          | (15,853                | )          |
| Total stockholders’ equity                                                                                              |       | 131,276            |       | 152,635                |       |
|                                                                                                                         |       |               |       |                   |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                              |       | $                  | 450,169    |                   | $          | 445,665 |   |

 

See notes to consolidated andcondensed consolidated financial statements.

 

4

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

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**Unaudited**

**(In Thousands)**

 
| ** **                                                                    | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                    | ** ** | **June 30,  2004**   | ** ** | **June 28,  2003** | ** ** |
| Cash flows from operating activities:                                         |       |                 |       |   |   |
| Net income                                                                    |       | $                    | 6,058      |   | $ | 2,843 |   |
| Adjustments to reconcile net income to cash  flows from operating activities: |       |                 |       |   |   |
| Depreciation and amortization                                                 |       | 5,338                |       | 5,546 |   |
| Amortization of bond premium                                                  |       | (105                 | )          | — |   |
| Deferred tax benefit                                                          |       | (218                 | )          | (252 | ) |
| Debt issuance costs                                                           |       | (105                 | )          | — |   |
| Other                                                                         |       | (28                  | )          | 179 |   |
| Changes in operating assets and  liabilities:                                 |       |                 |       |   |   |
| Accounts, notes and leases receivable                                         |       | (8,463               | )          | (11,393 | ) |
| Inventories                                                                   |       | (9,231               | )          | (3,463 | ) |
| Prepaid expenses and other assets                                             |       | (3,935               | )          | 1,476 |   |
| Accounts payable                                                              |       | 753                  |       | (2,382 | ) |
| Other liabilities                                                             |       | (781                 | )          | 657 |   |
| Cash flows from operating activities                                          |       | (10,717              | )          | (6,789 | ) |
|                                                                          |       |                 |       |   |   |
| Cash flows from investing activities:                                         |       |                 |       |   |   |
| Capital expenditures                                                          |       | (2,052               | )          | (1,675 | ) |
| Proceeds from disposals of fixed assets                                       |       | 76                   |       | — |   |
| Cash flows from investing activities                                          |       | (1,976               | )          | (1,675 | ) |
|                                                                          |       |                 |       |   |   |
| Cash flows from financing activities:                                         |       |                 |       |   |   |
| Borrowings under lines of credit                                              |       | 10,349               |       | 6,365 |   |
| Repayments under lines of credit                                              |       | (10,491              | )          | (6,121 | ) |
| Repayments of long-term debt                                                  |       | (3,352               | )          | (3,240 | ) |
| Proceeds from issuance of common stock                                        |       | 4,594                |       | — |   |
| Cash flows from financing activities                                          |       | 1,100                |       | (2,996 | ) |
|                                                                          |       |                 |       |   |   |
| Effect of foreign exchange rate changes on  cash                              |       | (367                 | )          | 88 |   |
|                                                                          |       |                 |       |   |   |
| Decrease in cash                                                              |       | (11,960              | )          | (11,372 | ) |
| Cash, beginning of period                                                     |       | 42,283               |       | 19,099 |   |
|                                                                          |       |                 |       |   |   |
| Cash, end of period                                                           |       | $                    | 30,323     |   | $ | 7,727 |   |
|                                                                          |       |                 |       |   |   |
| Supplemental Cash Flow Information                                            |       |                 |       |   |   |
| Interest paid                                                                 |       | $                    | 8,488      |   | $ | 7,344 |   |
| Taxes paid                                                                    |       | $                    | 5,695      |   | $ | 4,179 |   |
|                                                                          |       |                 |       |   |   |
| Non-cash transaction:                                                         |       |                 |       |   |   |
| Purchase of common stock by issuance of  bonds                                |       | $                    | 31,583     |   | $ | — |   |

 

See notes to consolidated andcondensed consolidated financial statements.

 

5

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

**CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY**

**Unaudited**

**(In Thousands Except Share Data)**

 
| ** **                                              | ** ** | **Common  Stock** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Loss** | ** ** | **Treasury  Stock** | ** ** | **Total  Stockholders’  Equity** | ** ** |
|---------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|------------------------|------------|---------------------------------------------|------------|---------------------|------------|---------------------------------------|------------|
|                                                    |       |              |       |                             |       |                   |       |                                        |       |                |       |                                  |       |
| Balance, December 31, 2003                              |       | $                 | 10         |                             | $          | 74,626                 |       | $                                           | 96,720     |                | $          | (2,868                                | )          | $ | (15,853 | ) | $ | 152,635 |   |
| Comprehensive income:                                   |       |              |       |                             |       |                   |       |                                        |       |                |       |                                  |       |
| Net income                                              |       |              |       |                             |       | 6,058                  |       |                                        |       |                |       | 6,058                                 |       |
| Foreign currency translation adjustment                 |       |              |       |                             |       |                   |       | (1,029                                      | )          |                |       | (1,029                                | )          |
| Additional minimum pension liability, net               |       |              |       |                             |       |                   |       | (146                                        | )          |                |       | (146                                  | )          |
| Unrealized loss on certain long-term  investments, net  |       |              |       |                             |       |                   |       | 15                                          |       |                |       | 15                                    |       |
| Total comprehensive income                              |       |              |       |                             |       |                   |       |                                        |       |                |       | 4,898                                 |       |
| Exercise of 231,835 options for shares of  common stock |       |              |       | 4,594                            |       |                   |       |                                        |       |                |       | 4,594                                 |       |
| Tax benefit of options exercised                        |       |              |       | 732                              |       |                   |       |                                        |       |                |       | 732                                   |       |
| Purchase of 1,271,450 shares of common  stock           |       |              |       |                             |       |                   |       |                                        |       | (31,583             | )          | (31,583                               | )          |
| Balance, June 30, 2004                                  |       | $                 | 10         |                             | $          | 79,952                 |       | $                                           | 102,778    |                | $          | (4,028                                | )          | $ | (47,436 | ) | $ | 131,276 |   |

 

See notes to consolidated andcondensed consolidated financial statements.

 

6

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

**NOTES TO CONSOLIDATED AND CONDENSED CONSOLIDATED**

**FINANCIAL STATEMENTS**

**JUNE 30, 2004**

 

**Unaudited**

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

 

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

 

The accompanyingcondensed consolidated financial statements of Steinway Musical Instruments,Inc. and subsidiaries (the “Company”) for the three months and six months endedJune 30, 2004 and****June 28, 2003are unaudited.  In the opinion ofmanagement, these statements have been prepared on the same basis as theaudited consolidated financial statements as of and for the year ended December31, 2003, and include all adjustments which are of a normal and recurringnature, necessary for the fair presentation of financial position, results ofoperations and cash flows for the interim period.  You should read the condensed consolidatedfinancial statements in conjunction with the consolidated financial statementsand notes thereto contained in the Company’s Annual Report on Form 10-K for thefiscal year ended December 31, 2003 filed with the Securities and ExchangeCommission.  The results of operationsfor the three months and six months ended June 30, 2004 are not necessarilyindicative of the results that may be expected for the entire year.

 

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

 

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

 

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

 

*Stock-based Compensation* - We have an employee stock purchaseplan (“Purchase Plan”) and a stock option plan (“Stock Plan”).  As permitted under accounting principlesgenerally accepted in the United States of America, we have elected to continueto follow the intrinsic value method in accounting for our stock-based employeecompensation arrangements.

 

7

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The following table illustratesthe effect on net income and earnings per share as if we had applied the fairvalue method to measure stock-based employee compensation:

 
| ** **                                                                                                                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                                    | ** ** | **June 30,  2004**     | ** ** | **June 28,  2003**   | ** ** | **June 30,  2004** | ** ** | **June 28,  2003** | ** ** |
|                                                                                                                                          |       |                   |       |                 |       |   |   |   |   |
| Net income, as reported                                                                                                                       |       | $                      | 2,714      |                 | $          | 2,160 |   | $ | 6,058 |   | $ | 2,843 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair-value based method for all awards,  net of related tax effects |       | (253                   | )          | (217                 | )          | (507 | ) | (437 | ) |
|                                                                                                                                          |       |                   |       |                 |       |   |   |   |   |
| Pro forma net income                                                                                                                          |       | $                      | 2,461      |                 | $          | 1,943 |   | $ | 5,551 |   | $ | 2,406 |   |
| Earnings per share:                                                                                                                           |       |                   |       |                 |       |   |   |   |   |
| Basic - as reported                                                                                                                           |       | $                      | 0.34       |                 | $          | 0.24 |   | $ | 0.75 |   | $ | 0.32 |   |
| Basic - pro forma                                                                                                                             |       | $                      | 0.31       |                 | $          | 0.22 |   | $ | 0.69 |   | $ | 0.27 |   |
|                                                                                                                                          |       |                   |       |                 |       |   |   |   |   |
| Diluted - as reported                                                                                                                         |       | $                      | 0.33       |                 | $          | 0.24 |   | $ | 0.72 |   | $ | 0.32 |   |
| Diluted - pro forma                                                                                                                           |       | $                      | 0.30       |                 | $          | 0.22 |   | $ | 0.66 |   | $ | 0.27 |   |

 

We measuredthe fair value of options on their grant date, including the valuation of theoption feature implicit in our Purchase Plan, using the Black-Scholesoption-pricing model.  Key assumptionsused to apply this pricing model are as follows:

 
| ** **                                                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                        | ** ** | **June 30,  2004**     | ** ** | **June 28,  2003**   | ** ** | **June 30,  2004** | ** ** | **June 28,  2003** | ** ** |
| Weighted-average interest rates                                                   |       | 1.26%                  |       | 1.86%                |       | 1.26% |   | 2.39% |   |
|                                                                              |       |                   |       |                 |       |   |   |   |   |
| Weighted-average expected life of option  feature in the Purchase Plan (in years) |       | 0.08                   |       | 0.08                 |       | 0.08 |   | 0.08 |   |
| Weighted-average expected life of option  grants (in years)                       |       | —                 |       | —               |       | — |   | 6 |   |
| Expected volatility of underlying stock                                           |       | 27%                    |       | 27%                  |       | 27% |   | 27% |   |

 

The weighted-average fair valueof options on their grant date is as follows:

 
| ** **                      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                      | ** ** | **June 30,****2004**   | ** ** | **June 28,****2003** | ** ** | **June 30,****2004** | ** ** | **June 28,****2003** | ** ** |
| Stock Plan                      |       | —                 |       | —               |       | — |   | $ | 4.77 |   |
| Option feature in Purchase Plan |       | $                      | 4.09       |                 | $          | 4.78 |   | $ | 4.09 |   | $ | 4.78 |   |
|                                 |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 

It should be noted thatthe Black-Scholes option-pricing model was designed to value readily tradableoptions with relatively short lives and no vesting restrictions.  In addition, option valuation models requirethe input of highly subjective assumptions including the expected pricevolatility.  Because the options grantedare

 

8

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not tradable and have contractual lives of up to tenyears, and because changes in the subjective input assumptions can materiallyaffect the fair value estimate, in our opinion, the existing models do notprovide a reliable measure of the fair value of the options issued under eitherthe Stock Plan or Purchase Plan.

 

*Earnings per Common Share –*We compute basic earnings per shareusing the weighted-average number of common shares outstanding during eachperiod.  Dilutedearnings per common share reflects the effect of our outstanding optionsusing the treasury stock method, except when such options would beantidilutive.

 

A reconciliation of theweighted-average shares used for the basic and diluted computations is asfollows:

 
| ** **                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                       | ** ** | **June 30,  2004**     | ** ** | **June 28,  2003**   | ** ** | **June 30,  2004** | ** ** | **June 28,  2003** | ** ** |
| Weighted-average shares:         |       |                   |       |                 |       |   |   |   |   |
| For basic earnings per share     |       | 7,957,483              |       | 8,906,238            |       | 8,083,945 |   | 8,906,238 |   |
| Dilutive effect of stock options |       | 383,243                |       | —               |       | 352,660 |   | 14 |   |
| For diluted earnings per share   |       | 8,340,726              |       | 8,906,238            |       | 8,436,605 |   | 8,906,252 |   |

 

Alloutstanding options were included in the computation of diluted net earningsper common share for the three months and six months ended June 30, 2004.  Options to purchase 1,068,400 shares ofcommon stock at prices ranging from $14.73 to $21.94 per share and options topurchase 1,058,400 shares of common stock at prices ranging from $18.55 to$21.94 were outstanding during the three months and six months ended June 28,2003, respectively, but were not included in the computation of dilutedearnings per share because the exercise prices of the options were greater thanthe average market price of the common shares.

 

*Comprehensive Income –*Comprehensive income is comprised of net income, foreigncurrency translation adjustments, additional minimum pension liabilities, andunrealized gains and losses on certain long-term assets.  The components of accumulated othercomprehensive loss are as follows:

 
| ** **        | ** ** | **Foreign  Currency  Translation  Adjustment** | ** ** | **Gain/(Loss) on  Long-term  Assets** | ** ** | **Tax Impact of  Gain/(Loss) on  Long-term  Assets** | ** ** | **Additional  Minimum  Pension  Liability** | ** ** | **Tax Impact of  Additional  Minimum  Pension  Liability** | ** ** | **Accumulated Other  Comprehensive  Loss** | ** ** |
|-------------------|------------|------------------------------------------------|------------|---------------------------------------|------------|------------------------------------------------------|------------|---------------------------------------------|------------|------------------------------------------------------------|------------|--------------------------------------------|------------|
|              |       |                                           |       |                                  |       |                                                 |       |                                        |       |                                                       |       |                                       |       |
| December 31, 2003 |       | $                                              | 1,226      |                                  | $          | 73                                                   |       | $                                           | (29        | )                                                          | $          | (6,853                                     | )          | $ | 2,715 |   | $ | (2,868 | ) |
| Activity          |       | (1,029                                         | )          | 25                                    |       | (10                                                  | )          | (209                                        | )          | 63                                                         |       | (1,160                                     | )          |
| June 30, 2004     |       | $                                              | 197        |                                  | $          | 98                                                   |       | $                                           | (39        | )                                                          | $          | (7,062                                     | )          | $ | 2,778 |   | $ | (4,028 | ) |

 

*NewAccounting Pronouncements –*In December 2003, the Financial Accounting StandardsBoard (“FASB”) revised Statement of Financial Accounting Standard (“SFAS”) No.132, “Employers’ Disclosures about Pensions and Other PostretirementBenefits.”  SFAS No. 132 requiresadditional disclosure about the assets, obligations, cash flows, and netperiodic benefit cost of defined benefit pension plans and other definedbenefit postretirement plans.  Thisstatement also requires disclosure about the types of plan assets, investmentstrategy, measurement dates, plan obligations, and cash flows.  SFAS No. 132 is effective for fiscal yearsending after December 15, 2003. Disclosure of information about foreign plansrequired by this statement is effective for fiscal years ending after June 15,2004.  Interim period disclosures forboth domestic and foreign plans required by this statement are effective forperiods beginning after December 15, 2003, and are included in Note 11.

 

9

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

 

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

 
| ** **      | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------|------------|--------------------|------------|------------------------|------------|
|            |       |               |       |                   |       |
| Raw materials   |       | $                  | 18,347     |                   | $          | 21,268 |   |
| Work in process |       | 49,006             |       | 50,620                 |       |
| Finished goods  |       | 92,031             |       | 80,141                 |       |
| Total           |       | $                  | 159,384    |                   | $          | 152,029 |   |

 

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

 

We ceased to recordamortization expense on our goodwill and trademark assets on January 1, 2002.  We test our goodwill and trademark assets forimpairment annually, or on an interim basis if eventsor circumstances indicate that the fair value of an asset has decreased belowits carrying value.  At July 27, 2003 weevaluated our goodwill and trademark assets and determined that the fair valuehad not decreased below the carrying value and, accordingly, we have made noimpairment adjustments.

 

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

 
| ** **                          | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** |
|-------------------------------------|------------|-------------------|------------|------------------|------------|
| Goodwill:                           |       |              |       |             |       |
| Balance at December 31, 2003        |       | $                 | 23,110     |             | $          | 8,555 |   |
| Foreign currency translation impact |       | (390              | )          | —           |       |
| Balance at June 30, 2004            |       | $                 | 22,720     |             | $          | 8,555 |   |
|                                |       |              |       |             |       |
| Trademarks:                         |       |              |       |             |       |
| Balance at December 31, 2003        |       | $                 | 7,648      |             | $          | 2,671 |   |
| Foreign currency translation impact |       | (124              | )          | —           |       |
| Balance at June 30, 2004            |       | $                 | 7,524      |             | $          | 2,671 |   |

 

10

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We also carry certainintangible assets that are amortized. Once fully amortized, these assets are removed from both the gross andaccumulated amortization balance.  Theseassets consist of the following:

 
| ** **                     | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------|------------|--------------------|------------|------------------------|------------|
|                           |       |               |       |                   |       |
| Gross deferred financing costs |       | $                  | 8,653      |                   | $          | 9,293 |   |
| Accumulated amortization       |       | (3,373             | )          | (3,596                 | )          |
| Deferred financing costs, net  |       | $                  | 5,280      |                   | $          | 5,697 |   |
|                           |       |               |       |                   |       |
| Gross covenants not to compete |       | $                  | 250        |                   | $          | 250 |   |
| Accumulated amortization       |       | (190               | )          | (165                   | )          |
| Covenants not to compete, net  |       | $                  | 60         |                   | $          | 85 |   |

 

The weighted-averageamortization period for deferred financing costs is 9.1 years, and theweighted-average amortization period of covenants not to compete is 5.0years.  Total amortization expense is asfollows:

 
| ** **           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------|------------|------------------------|------------|----------------------|------------|
| ** **           | ** ** | **June 30,  2004**     | ** ** | **June 28,  2003**   | ** ** | **June 30,  2004** | ** ** | **June 28,  2003** | ** ** |
|                 |       |                   |       |                 |       |   |   |   |   |
| Amortization expense |       | $                      | 255        |                 | $          | 288 |   | $ | 546 |   | $ | 577 |   |
|                      |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 

The following table showsthe total estimated amortization expense for 2004 and the next five succeedingfiscal years:

 

Estimatedamortization expense:

 
| 2004 |   | $     | 1,058  |   |
|------|--------|-------|--------|--------|
| 2005 |   | 1,002 |   |
| 2006 |   | 967   |   |
| 2007 |   | 967   |   |
| 2008 |   | 822   |   |
| 2009 |   | 472   |   |

 

11

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

 
| ** **                           | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------|------------|--------------------|------------|------------------------|------------|
|                                 |       |               |       |                   |       |
| Accrued payroll and related benefits |       | $                  | 18,185     |                   | $          | 16,986 |   |
| Current portion of pension liability |       | 1,558              |       | 2,663                  |       |
| Accrued warranty expense             |       | 2,325              |       | 2,602                  |       |
| Accrued interest                     |       | 3,237              |       | 2,706                  |       |
| Deferred income                      |       | 4,306              |       | 4,161                  |       |
| Other accrued expenses               |       | 7,929              |       | 9,994                  |       |
| Total                                |       | $                  | 37,540     |                   | $          | 39,112 |   |

 

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

 

The accrued warrantyexpense activity for the six months ended June 30, 2004 and the year endedDecember 31, 2003 is as follows:

 
| ** **              | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------|------------|--------------------|------------|------------------------|------------|
| Beginning balance       |       | $                  | 2,602      |                   | $          | 2,357 |   |
| Additions               |       | 520                |       | 1,361                  |       |
| Claims and reversals    |       | (774               | )          | (1,314                 | )          |
| Foreign exchange impact |       | (23                | )          | 198                    |       |
| Ending balance          |       | $                  | 2,325      |                   | $          | 2,602 |   |

 

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

 

Long-term debt consists of thefollowing:

 
| ** **                                               | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|----------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| Term loans                                               |       | $                  | 43,826     |                   | $          | 47,178 |   |
| 8.75% Senior Notes                                       |       | 174,345            |       | 145,345                |       |
| Unamortized bond premium                                 |       | 1,709              |       | —                 |       |
| Open account loans, payable on demand to a  foreign bank |       | 3,933              |       | 4,079                  |       |
| Total                                                    |       | 223,813            |       | 196,602                |       |
| Less current portion                                     |       | 10,501             |       | 10,638                 |       |
| Long-term debt                                           |       | $                  | 213,312    |                   | $          | 185,964 |   |

 

12

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Scheduled payments of long-termdebt are as follows:

 
| ** **        | ** ** | **June 30,  2004** | ** ** |
|-------------------|------------|--------------------|------------|
| Remainder of 2004 |       | $                  | 7,218      |   |
| 2005              |       | 7,159              |       |
| 2006              |       | 8,315              |       |
| 2007              |       | 8,361              |       |
| 2008              |       | 16,706             |       |
| Thereafter        |       | 174,345            |       |
| Total             |       | $                  | 222,104    |   |

 

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

 

Our common stockis comprised of two classes: Class A and Ordinary.  With the exception of disparate voting power,both classes are substantially identical. Each share of Class A common stock entitles the holder to 98 votes.  Holders of Ordinary common stock are entitledto one vote per share.  Class A commonstock shall automatically convert to Ordinary common stock if, at any time, theClass A common stock is not owned by an original Class A holder.  The Chairman and Chief Executive Officer own100% of the Class A common shares, representing approximately 86% of thecombined voting power of the Class A common stock and Ordinary common stock.

 

On February 4,2004 we purchased 1,271,450 shares of our Ordinary common stock from AIGRetirement Services, Inc. (formerly AIG SunAmerica), ourlargest institutional shareholder.  Inexchange, we issued $29.0 million in principal amount of our 8.75% Senior Notesdue 2011 under our existing indenture. We issued these bonds at a premium of 106.3%.  This transaction resulted in an increase toour treasury stock of $31.6 million.

 

13

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

 

In 2003, we began a facility rationalization project to eliminateexcess manufacturing capacity in our band segment.  As part of this project, we closed ourwoodwind manufacturing facility in Nogales, Arizona in November 2003.  We also announced that in 2004 we would closeone of our woodwind manufacturing facilities in Elkhart, Indiana and transferthat plant’s production to other company-owned facilities.  This facility was closed on April 1,2004.  As a result of this closure, werecorded charges of $1.4 million in severance and related expenses through June30, 2004.  We expect to incur anadditional $0.1 million in severance expenses during the remainder of 2004.

 

The severance liability andrelated activity associated with the band segment’s facility rationalizationproject is as follows:

 
| Facility rationalization severance  liability: |   |   |   |
|------------------------------------------------|--------|--------|--------|
| Balance at January 1, 2003                     |   | $      | — |   |
| Additions charged to cost of sales             |   | 1,683  |   |
| Payments                                       |   | (525   | )      |
| Balance January 1, 2004                        |   | 1,158  |   |
| Additions charged to cost of sales             |   | 1,444  |   |
| Payments                                       |   | (2,514 | )      |
| Balance at June 30, 2004                       |   | $      | 88     |   |

 

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

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                           | ** ** | **June 30,  2004**     | ** ** | **June 28,  2003**   | ** ** | **June 30,  2004** | ** ** | **June 28,  2003** | ** ** |
|                                 |       |                   |       |                 |       |   |   |   |   |
| West 57th building income            |       | $                      | (1,163     | )                    | $          | (1,163 | ) | $ | (2,326 | ) | $ | (2,326 | ) |
| West 57th building expenses          |       | 814                    |       | 814                  |       | 1,628 |   | 1,628 |   |
| Foreign exchange (gains) losses, net |       | 175                    |       | (286                 | )          | (83 | ) | (390 | ) |
| Miscellaneous                        |       | (560                   | )          | (77                  | )          | (565 | ) | (245 | ) |
| Other income, net                    |       | $                      | (734       | )                    | $          | (712 | ) | $ | (1,346 | ) | $ | (1,333 | ) |

 

**(10)****                          Commitmentsand Contingent Liabilities**

 

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

 

We operated manufacturingfacilities at certain locations where hazardous substances (includingchlorinated solvents) were used.  Webelieve that an entity that formerly operated one such facility may havereleased hazardous substances at such location, which we leased through July2001.  We did not contribute to

 

14

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the release. Further, we have a contractual indemnity from certain stockholders ofthis entity.  This facility is not thesubject of a legal proceeding that involves us, nor, to our knowledge, is thefacility subject to investigation. However, no assurance can be given that legal proceedings will not arisein the future and that such indemnitors would make the payments described inthe indemnity.

 

We operate othermanufacturing facilities which were previously owned by Philips ElectronicsNorth America Corporation (“Philips”). Philips agreed to indemnify us for any and all losses, damages,liabilities and claims relating to environmental matters resulting from certainactivities of Philips occurring prior to December 29, 1988 (the “EnvironmentalIndemnity Agreement”).  Philips has fullyperformed its obligations under the Environmental Indemnity Agreement, whichterminates on December 29, 2008.  Fourmatters covered by the Environmental Indemnity Agreement are currently pending.  Philips has entered into Consent Orders withthe Environmental Protection Agency (“EPA”) for one site and the North CarolinaDepartment of Environment, Health and Natural Resources for a second site,whereby Philips has agreed to pay required response costs.  On October 22, 1998, we were joined asdefendant in an action involving a site formerly occupied by a business weacquired in Illinois.  Philips hasaccepted the defense of this action pursuant to the terms of the EnvironmentalIndemnity Agreement.  For the fourthsite, the EPA has notified us it intends to carry out the final remediationitself.  The EPA estimates that thisremedy has a present net cost of approximately $14.5 million. The EPA has namedover 40 persons or entities as potentially responsible parties at this Elkhart,Indiana site, including four Conn-Selmer predecessor entities.  For two of these entities, which werepreviously owned by Philips, this matter has been tendered to Philips pursuantto the Environmental Indemnity Agreement. Our potential liability at any of these sites is affected by severalfactors including, but not limited to, the method of remediation, our portionof the materials in the site relative to that of the other named parties, thenumber of parties participating, and the financial capabilities of the otherpotentially responsible parties once the relative share has beendetermined.  No assurance can be given,however, that additional environmental issues will not require additional,currently unanticipated investigation, assessment or remediation expendituresor that Philips will make payments that it is obligated to make under theEnvironmental Indemnity Agreement.

 

We are also continuing anexisting environmental remediation program at a facility we acquired in2000.  We currently 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 of5.1%.  A summary of expected paymentsassociated with this project is as follows:

 
| ** ** | ** ** | **Environmental  Payments** | ** ** |
|------------|------------|-----------------------------|------------|
| 2004       |       | $                           | 150        |   |
| 2005       |       | 63                          |       |
| 2006       |       | 63                          |       |
| 2007       |       | 63                          |       |
| 2008       |       | 43                          |       |
| Thereafter |       | 515                         |       |
| Total      |       | $                           | 897        |   |

 

The matters describedabove and our other liabilities and compliance costs arising underenvironmental laws are not expected to have a material impact on our capitalexpenditures, earnings or competitive position. However, some risk of environmental liability is inherent in the natureof our current and former businesses

 

15

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and we might, in the future, incur materialcosts to meet current or more stringent compliance, cleanup or otherobligations pursuant to environmental laws.

 

**(11)         Retirement Plans**

 

We have defined benefit pension plans covering the majority of ouremployees, including certain employees in foreign countries.   The components of net periodic pension costfor these plans are as follows:

 
| ** **                         | ** ** | **Domestic Plans**     | ** ** | **Foreign Plans**      | ** ** |
|------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                         | ** ** | **Three Months Ended** | ** ** | **Three Months Ended** | ** ** |
| ** **                         | ** ** | **June 30,  2004**     | ** ** | **June 28,  2003**     | ** ** | **June 30,  2004** | ** ** | **June 28,  2003** | ** ** |
| Service cost                       |       | $                      | 153        |                   | $          | 261 |   | $ | 162 |   | $ | 185 |   |
| Interest cost                      |       | 552                    |       | 830                    |       | 312 |   | 298 |   |
| Expected return on plan assets     |       | (743                   | )          | (822                   | )          | (66 | ) | (67 | ) |
| Amortization of prior service cost |       | 114                    |       | 189                    |       | — |   | — |   |
| Amortization of net loss           |       | 52                     |       | 175                    |       | 19 |   | 22 |   |
| Net periodic benefit cost          |       | $                      | 128        |                   | $          | 633 |   | $ | 427 |   | $ | 438 |   |

 
| ** **                         | ** ** | **Domestic Plans**   | ** ** | **Foreign Plans**    | ** ** |
|------------------------------------|------------|----------------------|------------|----------------------|------------|
| ** **                         | ** ** | **Six Months Ended** | ** ** | **Six Months Ended** | ** ** |
| ** **                         | ** ** | **June 30,  2004**   | ** ** | **June 28,  2003**   | ** ** | **June 30,  2004** | ** ** | **June 28,  2003** | ** ** |
| Service cost                       |       | $                    | 439        |                 | $          | 352 |   | $ | 329 |   | $ | 354 |   |
| Interest cost                      |       | 1,585                |       | 1,118                |       | 634 |   | 585 |   |
| Expected return on plan assets     |       | (2,144               | )          | (1,108               | )          | (134 | ) | (125 | ) |
| Amortization of prior service cost |       | 326                  |       | 255                  |       | — |   | — |   |
| Amortization of net loss           |       | 140                  |       | 236                  |       | 38 |   | 32 |   |
| Net periodic benefit cost          |       | $                    | 346        |                 | $          | 853 |   | $ | 867 |   | $ | 846 |   |

 

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** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **June 30,  2004**     | ** ** | **June 28,  2003**   | ** ** | **June 30,  2004** | ** ** | **June 28,  2003** | ** ** |
| Service cost                          |       | $                      | 39         |                 | $          | 18 |   | $ | 58 |   | $ | 36 |   |
| Interest cost                         |       | 77                     |       | 35                   |       | 115 |   | 70 |   |
| Amortization of transition obligation |       | 25                     |       | 11                   |       | 38 |   | 22 |   |
| Amortization of net loss              |       | 9                      |       | 4                    |       | 14 |   | 8 |   |
| Net postretirement benefit cost       |       | $                      | 150        |                 | $          | 68 |   | $ | 225 |   | $ | 136 |   |

 

16

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We anticipatedomestic pension plan contributions of approximately $3.3 million for thecurrent year.  As of June 30, 2004 wehave contributed $1.5 million to these plans.

 

**(12)         Segment Information**

 

We have identified tworeportable segments: the piano segment and the band and orchestral instrumentsegment.  We consider these two segmentsreportable as they are managed separately and the operating results of eachsegment are separately reviewed and evaluated by our senior management on aregular basis.  Management and the chiefoperating decision maker use income from operations as a meaningful measurementof profit or loss for the segments. Income from operations for the reportable segments includes certaincorporate costs allocated to the segments based primarily on revenue, as wellas intercompany profit.  Amounts reportedas “Other & Elim” include those corporate costs that were not allocated tothe reportable segments and the remaining intercompany profit elimination.

 

The following tables presentinformation about our operating segments for the three-month and six-monthperiods ended June 30, 2004 and June 28, 2003:

 
| **Three months ended 2004**     | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** | **Other  & Elim** | ** ** | **Consol  Total** | ** ** |
|---------------------------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|-------------------|------------|
| **U.S.**                        | ** ** | **Germany**       | ** ** | **Other**        | ** ** | **Total**             | ** ** | **U.S.**          | ** ** | **Other** | ** ** | **Total** |
| Net sales to external customers |       | $                 | 26,219     |             | $          | 11,395                |       | $                 | 7,319      |   | $ | 44,933 |   | $ | 37,700 |   | $ | 1,055 |   | $ | 38,755 |   | $ | — |   | $ | 83,688 |   |
| Income (loss) from operations   |       | 2,324             |       | 1,865            |       | 519                   |       | 4,708             |       | 3,031 |   | 23 |   | 3,054 |   | (549 | ) | 7,213 |   |
|                                 |            |                   |            |                  |            |                       |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| **Three months ended 2003**     | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** | **Other  & Elim** | ** ** | **Consol  Total** | ** ** |
|---------------------------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|-------------------|------------|
| **U.S.**                        | ** ** | **Germany**       | ** ** | **Other**        | ** ** | **Total**             | ** ** | **U.S.**          | ** ** | **Other** | ** ** | **Total** |
| Net sales to external customers |       | $                 | 25,971     |             | $          | 10,026                |       | $                 | 5,313      |   | $ | 41,310 |   | $ | 35,782 |   | $ | 943 |   | $ | 36,725 |   | $ | — |   | $ | 78,035 |   |
| Income (loss) from operations   |       | 2,145             |       | 631              |       | 456                   |       | 3,232             |       | 3,053 |   | (16 | ) | 3,037 |   | (459 | ) | 5,810 |   |
|                                 |            |                   |            |                  |            |                       |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| **Six months ended 2004**       | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** | **Other  & Elim** | ** ** | **Consol  Total** | ** ** |
|---------------------------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|-------------------|------------|
| **U.S.**                        | ** ** | **Germany**       | ** ** | **Other**        | ** ** | **Total**             | ** ** | **U.S.**          | ** ** | **Other** | ** ** | **Total** |
| Net sales to external customers |       | $                 | 52,960     |             | $          | 21,783                |       | $                 | 15,907     |   | $ | 90,650 |   | $ | 80,881 |   | $ | 2,218 |   | $ | 83,099 |   | $ | — |   | $ | 173,749 |   |
| Income (loss) from operations   |       | 4,576             |       | 3,421            |       | 1,671                 |       | 9,668             |       | 6,820 |   | 58 |   | 6,878 |   | (1,235 | ) | 15,311 |   |
|                                 |            |                   |            |                  |            |                       |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| **Six months ended 2003**       | ** ** | **Piano Segment** | ** ** | **Band Segment** | ** ** | **Other  & Elim** | ** ** | **Consol  Total** | ** ** |
|---------------------------------|------------|-------------------|------------|------------------|------------|-----------------------|------------|-------------------|------------|
| **U.S.**                        | ** ** | **Germany**       | ** ** | **Other**        | ** ** | **Total**             | ** ** | **U.S.**          | ** ** | **Other** | ** ** | **Total** |
| Net sales to external customers |       | $                 | 46,385     |             | $          | 20,028                |       | $                 | 10,832     |   | $ | 77,245 |   | $ | 81,240 |   | $ | 2,059 |   | $ | 83,299 |   | $ | — |   | $ | 160,544 |   |
| Income (loss) from operations   |       | 2,418             |       | 1,962            |       | 1,250                 |       | 5,630             |       | 4,582 |   | 47 |   | 4,629 |   | (1,045 | ) | 9,214 |   |
|                                 |            |                   |            |                  |            |                       |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

17

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**(13)         Summary of Guarantees**

 

During 2001,we completed a $150.0 million 8.75% Senior Note offering.  At the end of 2002, we repurchased $4.7million of these Senior Notes at 99.25%. On February 4, 2004, we issued an additional $29.0 million of theseSenior Notes at 106.3%.

 

Our paymentobligations under the 8.75% Senior Notes are fully and unconditionallyguaranteed on a joint and several basis by Conn-Selmer, Steinway, and certainother of our direct and indirect wholly-owned subsidiaries, each a Guarantor(the “Guarantor Subsidiaries”).  Thesesubsidiaries represent all of our (the “Issuer”) operations conducted in theUnited States.  The remainingsubsidiaries, which do not guarantee the 8.75% Senior Notes, represent non-U.S.operations (the “Non Guarantor Subsidiaries”).

 

The followingcondensed consolidating supplementary data illustrates the financial position,results of operations, and cash flows of the Guarantor Subsidiaries and the NonGuarantor Subsidiaries.  Separatecomplete financial statements of the respective Guarantors would not provideadditional material information that would be useful in assessing the financialcomposition of the Guarantor Subsidiaries. No single Guarantor Subsidiary has any significant legal restrictions onthe ability of investors or creditors to obtain access to its assets in eventof default on the guarantee other than its subordination to seniorindebtedness.

 

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

 

18

----

 

**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATING STATEMENTS OF INCOME**

**THREE MONTHS ENDED JUNE 30, 2004**

**Unaudited**

**(In Thousands)**

 
| ** **                        | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net sales                         |       | $                    | —     |                        | $          | 66,499                           |       | $                          | 20,090     |             | $          | (2,901 | ) | $ | 83,688 |   |
| Cost of sales                     |       | —               |       | 49,574                      |       | 12,798                           |       | (3,087                     | )          | 59,285           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Gross profit                      |       | —               |       | 16,925                      |       | 7,292                            |       | 186                        |       | 24,403           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Operating expenses:               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Sales and marketing               |       | —               |       | 7,472                       |       | 3,067                            |       | —                     |       | 10,539           |       |
| General and administrative        |       | 1,465                |       | 3,423                       |       | 1,511                            |       | —                     |       | 6,399            |       |
| Amortization of intangible assets |       | 116                  |       | 138                         |       | 1                                |       | —                     |       | 255              |       |
| Other operating (income) expense  |       | (886                 | )          | 577                         |       | 306                              |       | —                     |       | (3               | )          |
| Total operating expenses          |       | 695                  |       | 11,610                      |       | 4,885                            |       | —                     |       | 17,190           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss) from operations     |       | (695                 | )          | 5,315                       |       | 2,407                            |       | 186                        |       | 7,213            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Other income, net                 |       | —               |       | (296                        | )          | (438                             | )          | —                     |       | (734             | )          |
| Interest income                   |       | (3,657               | )          | (5,568                      | )          | (69                              | )          | 8,703                      |       | (591             | )          |
| Interest expense                  |       | 3,852                |       | 8,803                       |       | 62                               |       | (8,703                     | )          | 4,014            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss) before income taxes |       | (890                 | )          | 2,376                       |       | 2,852                            |       | 186                        |       | 4,524            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income taxes                      |       | (347                 | )          | 958                         |       | 1,142                            |       | 57                         |       | 1,810            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income (loss)                 |       | $                    | (543       | )                           | $          | 1,418                            |       | $                          | 1,710      |             | $          | 129 |   | $ | 2,714 |   |

 

19

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**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATING STATEMENT OF INCOME**

**THREE MONTHS ENDED JUNE 28, 2003**

**Unaudited**

**(In Thousands)**

 
| ** **                        | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net sales                         |       | $                    | —     |                        | $          | 63,645                           |       | $                          | 17,160     |             | $          | (2,770 | ) | $ | 78,035 |   |
| Cost of sales                     |       | —               |       | 46,665                      |       | 11,362                           |       | (2,705                     | )          | 55,322           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Gross profit                      |       | —               |       | 16,980                      |       | 5,798                            |       | (65                        | )          | 22,713           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Operating expenses:               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Sales and marketing               |       | —               |       | 7,764                       |       | 3,216                            |       | (36                        | )          | 10,944           |       |
| General and administrative        |       | 1,083                |       | 3,141                       |       | 1,311                            |       | —                     |       | 5,535            |       |
| Amortization of intangible assets |       | 113                  |       | 174                         |       | 1                                |       | —                     |       | 288              |       |
| Other operating (income) expense  |       | (800                 | )          | 701                         |       | 199                              |       | 36                         |       | 136              |       |
| Total operating expenses          |       | 396                  |       | 11,780                      |       | 4,727                            |       | —                     |       | 16,903           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss) from operations     |       | (396                 | )          | 5,200                       |       | 1,071                            |       | (65                        | )          | 5,810            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Other income, net                 |       | —               |       | (662                        | )          | (50                              | )          | —                     |       | (712             | )          |
| Interest income                   |       | (3,657               | )          | (5,193                      | )          | (13                              | )          | 8,360                      |       | (503             | )          |
| Interest expense                  |       | 3,280                |       | 8,506                       |       | 84                               |       | (8,360                     | )          | 3,510            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss) before income taxes |       | (19                  | )          | 2,549                       |       | 1,050                            |       | (65                        | )          | 3,515            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income taxes                      |       | (7                   | )          | 1,822                       |       | (438                             | )          | (22                        | )          | 1,355            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income (loss)                 |       | $                    | (12        | )                           | $          | 727                              |       | $                          | 1,488      |             | $          | (43 | ) | $ | 2,160 |   |

 

20

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**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATING STATEMENTS OF INCOME**

**SIX MONTHS ENDED JUNE 30, 2004**

**Unaudited**

**(In Thousands)**

 
| ** **                        | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net sales                         |       | $                    | —     |                        | $          | 139,194                          |       | $                          | 41,146     |             | $          | (6,591 | ) | $ | 173,749 |   |
| Cost of sales                     |       | —               |       | 104,107                     |       | 26,190                           |       | (6,676                     | )          | 123,621          |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Gross profit                      |       | —               |       | 35,087                      |       | 14,956                           |       | 85                         |       | 50,128           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Operating expenses:               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Sales and marketing               |       | —               |       | 15,684                      |       | 6,131                            |       | 18                         |       | 21,833           |       |
| General and administrative        |       | 2,825                |       | 6,542                       |       | 3,046                            |       | —                     |       | 12,413           |       |
| Amortization of intangible assets |       | 232                  |       | 312                         |       | 2                                |       | —                     |       | 546              |       |
| Other operating (income) expense  |       | (1,781               | )          | 1,197                       |       | 627                              |       | (18                        | )          | 25               |       |
| Total operating expenses          |       | 1,276                |       | 23,735                      |       | 9,806                            |       | —                     |       | 34,817           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss) from operations     |       | (1,276               | )          | 11,352                      |       | 5,150                            |       | 85                         |       | 15,311           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Other income, net                 |       | —               |       | (653                        | )          | (693                             | )          | —                     |       | (1,346           | )          |
| Interest income                   |       | (7,314               | )          | (11,121                     | )          | (98                              | )          | 17,305                     |       | (1,228           | )          |
| Interest expense                  |       | 7,486                |       | 17,463                      |       | 148                              |       | (17,305                    | )          | 7,792            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss) before income taxes |       | (1,448               | )          | 5,663                       |       | 5,793                            |       | 85                         |       | 10,093           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income taxes                      |       | (564                 | )          | 2,288                       |       | 2,295                            |       | 16                         |       | 4,035            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income (loss)                 |       | $                    | (884       | )                           | $          | 3,375                            |       | $                          | 3,498      |             | $          | 69 |   | $ | 6,058 |   |

 

21

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**STEINWAYMUSICAL INSTRUMENTS, INC. AND SUBSIDIARIES**

**CONSOLIDATING STATEMENTS OF INCOME**

**SIX MONTHS ENDED JUNE 28, 2003**

**Unaudited**

**(In Thousands)**

 
| ** **                        | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|-----------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net sales                         |       | $                    | —     |                        | $          | 132,267                          |       | $                          | 34,223     |             | $          | (5,946 | ) | $ | 160,544 |   |
| Cost of sales                     |       | —               |       | 100,761                     |       | 22,071                           |       | (5,833                     | )          | 116,999          |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Gross profit                      |       | —               |       | 31,506                      |       | 12,152                           |       | (113                       | )          | 43,545           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Operating expenses:               |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Sales and marketing               |       | —               |       | 16,058                      |       | 5,947                            |       | (48                        | )          | 21,957           |       |
| General and administrative        |       | 2,287                |       | 6,683                       |       | 2,519                            |       | —                     |       | 11,489           |       |
| Amortization of intangible assets |       | 226                  |       | 349                         |       | 2                                |       | —                     |       | 577              |       |
| Other operating (income) expense  |       | (1,600               | )          | 1,435                       |       | 425                              |       | 48                         |       | 308              |       |
| Total operating expenses          |       | 913                  |       | 24,525                      |       | 8,893                            |       | —                     |       | 34,331           |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss) from operations     |       | (913                 | )          | 6,981                       |       | 3,259                            |       | (113                       | )          | 9,214            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Other income, net                 |       | —               |       | (1,197                      | )          | (136                             | )          | —                     |       | (1,333           | )          |
| Interest income                   |       | (7,314               | )          | (10,398                     | )          | (41                              | )          | 16,632                     |       | (1,121           | )          |
| Interest expense                  |       | 6,561                |       | 17,011                      |       | 160                              |       | (16,632                    | )          | 7,100            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income (loss) before income taxes |       | (160                 | )          | 1,565                       |       | 3,276                            |       | (113                       | )          | 4,568            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Income taxes                      |       | (56                  | )          | 1,371                       |       | 456                              |       | (46                        | )          | 1,725            |       |
|                              |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income (loss)                 |       | $                    | (104       | )                           | $          | 194                              |       | $                          | 2,820      |             | $          | (67 | ) | $ | 2,843 |   |

 

22

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATING BALANCE SHEETS**

**JUNE 30, 2004**

**Unaudited**

**(In Thousands)**

 
| ** **                                      | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
| ASSETS                                          |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Current assets:                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash                                            |       | $                    | —     |                        | $          | (351                             | )          | $                          | 6,438      |             | $          | 24,236 |   | $ | 30,323 |   |
| Accounts, notes and leases receivable, net      |       | —               |       | 74,896                      |       | 9,757                            |       | —                     |       | 84,653           |       |
| Inventories                                     |       | —               |       | 123,454                     |       | 36,976                           |       | (1,046                     | )          | 159,384          |       |
| Prepaid expenses and other current assets       |       | 401                  |       | 2,271                       |       | 2,015                            |       | —                     |       | 4,687            |       |
| Deferred tax assets                             |       | —               |       | 8,168                       |       | 4,806                            |       | —                     |       | 12,974           |       |
| Total current assets                            |       | 401                  |       | 208,438                     |       | 59,992                           |       | 23,190                     |       | 292,021          |       |
|                                            |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Property, plant and equipment, net              |       | 161                  |       | 80,386                      |       | 16,317                           |       | (952                       | )          | 95,912           |       |
| Investment in subsidiaries                      |       | 69,643               |       | 241,488                     |       | —                           |       | (311,131                   | )          | —           |       |
| Trademarks                                      |       | —               |       | 6,280                       |       | 3,915                            |       | —                     |       | 10,195           |       |
| Goodwill                                        |       | —               |       | 18,795                      |       | 12,480                           |       | —                     |       | 31,275           |       |
| Other intangibles, net                          |       | 3,170                |       | 2,166                       |       | 4                                |       | —                     |       | 5,340            |       |
| Other assets                                    |       | 3,061                |       | 8,434                       |       | 2,979                            |       | 952                        |       | 15,426           |       |
| TOTAL ASSETS                                    |       | $                    | 76,436     |                        | $          | 565,987                          |       | $                          | 95,687     |             | $          | (287,941 | ) | $ | 450,169 |   |
|                                            |       |                 |       |                        |       |                             |       |                       |       |             |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY       |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Current liabilities:                            |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Current portion of long-term debt               |       | $                    | —     |                        | $          | 6,568                            |       | $                          | 3,933      |             | $          | — |   | $ | 10,501 |   |
| Accounts payable                                |       | 456                  |       | 8,633                       |       | 3,169                            |       | —                     |       | 12,258           |       |
| Other current liabilities                       |       | (15,054              | )          | 38,690                      |       | 14,190                           |       | (286                       | )          | 37,540           |       |
| Total current liabilities                       |       | (14,598              | )          | 53,891                      |       | 21,292                           |       | (286                       | )          | 60,299           |       |
|                                            |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Long-term debt                                  |       | 176,071              |       | 13,005                      |       | —                           |       | 24,236                     |       | 213,312          |       |
| Intercompany                                    |       | (114,803             | )          | 118,361                     |       | (3,558                           | )          | —                     |       | —           |       |
| Deferred tax liabilities                        |       | —               |       | 16,264                      |       | 8,822                            |       | 39                         |       | 25,125           |       |
| Other non-current liabilities                   |       | 834                  |       | 1,629                       |       | 17,694                           |       | —                     |       | 20,157           |       |
| Total liabilities                               |       | 47,504               |       | 203,150                     |       | 44,250                           |       | 23,989                     |       | 318,893          |       |
|                                            |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Stockholders’ equity                       |       | 28,932               |       | 362,837                     |       | 51,437                           |       | (311,930                   | )          | 131,276          |       |
|                                            |       |                 |       |                        |       |                             |       |                       |       |             |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY |       | $                    | 76,436     |                        | $          | 565,987                          |       | $                          | 95,687     |             | $          | (287,941 | ) | $ | 450,169 |   |

 

23

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**STEINWAY MUSICAL INSTRUMENTS, INC. ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATING BALANCE SHEETS**

**DECEMBER 31, 2003**

**Unaudited**

**(In Thousands)**

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

 

24

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. ANDSUBSIDIARIES**

**CONSOLIDATING STATEMENTS OF CASH FLOWS**

**SIX MONTHS ENDED JUNE 30, 2004**

**Unaudited**

**(In Thousands)**

 
| ** **                                                                           | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
| Cash flows from operating activities:                                                |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income (loss)                                                                    |       | $                    | (884       | )                           | $          | 3,375                            |       | $                          | 3,498      |             | $          | 69 |   | $ | 6,058 |   |
| Adjustments to reconcile net income (loss)  to cash flows from operating activities: |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Depreciation and amortization                                                        |       | 262                  |       | 4,233                       |       | 843                              |       | —                     |       | 5,338            |       |
| Amortization of bond premium                                                         |       | (105                 | )          | —                      |       | —                           |       | —                     |       | (105             | )          |
| Deferred tax benefit                                                                 |       | —               |       | (131                        | )          | (87                              | )          | —                     |       | (218             | )          |
| Debt issuance costs                                                                  |       | (105                 | )          | —                      |       | —                           |       | —                     |       | (105             | )          |
| Other                                                                                |       | —               |       | (136                        | )          | 108                              |       | —                     |       | (28              | )          |
| Changes in operating assets and  liabilities:                                        |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Accounts, notes and leases receivable                                                |       | —               |       | (11,642                     | )          | 3,179                            |       | —                     |       | (8,463           | )          |
| Inventories                                                                          |       | —               |       | (6,140                      | )          | (3,006                           | )          | (85                        | )          | (9,231           | )          |
| Prepaid expenses and other assets                                                    |       | (1,298               | )          | 719                         |       | (3,356                           | )          | —                     |       | (3,935           | )          |
| Accounts payable                                                                     |       | 333                  |       | 752                         |       | (332                             | )          | —                     |       | 753              |       |
| Other liabilities                                                                    |       | (511                 | )          | (973                        | )          | 687                              |       | 16                         |       | (781             | )          |
| Cash flows from operating activities                                                 |       | (2,308               | )          | (9,943                      | )          | 1,534                            |       | —                     |       | (10,717          | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash flows from investing activities:                                                |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Capital expenditures                                                                 |       | (19                  | )          | (1,568                      | )          | (465                             | )          | —                     |       | (2,052           | )          |
| Proceeds from disposal of fixed assets                                               |       | —               |       | 76                          |       | —                           |       | —                     |       | 76               |       |
| Cash flows from investing activities                                                 |       | (19                  | )          | (1,492                      | )          | (465                             | )          | —                     |       | (1,976           | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash flows from financing activities:                                                |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Borrowings under lines of credit                                                     |       | —               |       | 3,583                       |       | 3,766                            |       | 3,000                      |       | 10,349           |       |
| Repayments under lines of credit                                                     |       | (7                   | )          | (6,576                      | )          | (3,908                           | )          | —                     |       | (10,491          | )          |
| Repayments of long-term debt                                                         |       | —               |       | (3,352                      | )          | —                           |       | —                     |       | (3,352           | )          |
| Proceeds from issuance of stock                                                      |       | 4,594                |       | —                      |       | —                           |       | —                     |       | 4,594            |       |
| Intercompany transactions                                                            |       | (2,260               | )          | 5,174                       |       | (2,914                           | )          | —                     |       | —           |       |
| Cash flows from financing activities                                                 |       | 2,327                |       | (1,171                      | )          | (3,056                           | )          | 3,000                      |       | 1,100            |       |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Effect of exchange rate changes on cash                                              |       | —               |       | —                      |       | (367                             | )          | —                     |       | (367             | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Increase (decrease) in cash                                                          |       | —               |       | (12,606                     | )          | (2,354                           | )          | 3,000                      |       | (11,960          | )          |
| Cash, beginning of period                                                            |       | —               |       | 12,255                      |       | 8,792                            |       | 21,236                     |       | 42,283           |       |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash, end of period                                                                  |       | $                    | —     |                        | $          | (351                             | )          | $                          | 6,438      |             | $          | 24,236 |   | $ | 30,323 |   |

 

25

----

 

**STEINWAY MUSICAL INSTRUMENTS, INC. ANDSUBSIDIARIES**

**CONSOLIDATING STATEMENTS OF CASH FLOWS**

**SIX MONTHS ENDED JUNE 28, 2003**

**Unaudited**

**(In Thousands)**

 
| ** **                                                                           | ** ** | **Issuer  of Notes** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non  Guarantor  Subsidiaries** | ** ** | **Reclass/  Eliminations** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------|------------|-----------------------------|------------|----------------------------------|------------|----------------------------|------------|------------------|------------|
| Cash flows from operating activities:                                                |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Net income (loss)                                                                    |       | $                    | (104       | )                           | $          | 194                              |       | $                          | 2,820      |             | $          | (67 | ) | $ | 2,843 |   |
| Adjustments to reconcile net income (loss)  to cash flows from operating activities: |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Depreciation and amortization                                                        |       | 255                  |       | 4,503                       |       | 788                              |       | —                     |       | 5,546            |       |
| Deferred tax benefit                                                                 |       | —               |       | (130                        | )          | (122                             | )          | —                     |       | (252             | )          |
| Other                                                                                |       | —               |       | 90                          |       | 89                               |       | —                     |       | 179              |       |
| Changes in operating assets and  liabilities:                                        |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Accounts, notes and leases receivable                                                |       | —               |       | (11,682                     | )          | 409                              |       | (120                       | )          | (11,393          | )          |
| Inventories                                                                          |       | —               |       | (550                        | )          | (3,026                           | )          | 113                        |       | (3,463           | )          |
| Prepaid expenses and other assets                                                    |       | 185                  |       | 1,538                       |       | (247                             | )          | —                     |       | 1,476            |       |
| Accounts payable                                                                     |       | 11                   |       | (2,189                      | )          | (282                             | )          | 78                         |       | (2,382           | )          |
| Other liabilities                                                                    |       | 353                  |       | (154                        | )          | 504                              |       | (46                        | )          | 657              |       |
| Cash flows from operating activities                                                 |       | 700                  |       | (8,380                      | )          | 933                              |       | (42                        | )          | (6,789           | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash flows from investing activities:                                                |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Capital expenditures                                                                 |       | (23                  | )          | (1,100                      | )          | (552                             | )          | —                     |       | (1,675           | )          |
| Capital contribution to subsidiary                                                   |       | —               |       | (513                        | )          | 513                              |       | —                     |       | —           |       |
| Proceeds from disposal of fixed assets                                               |       | —               |       | —                      |       | —                           |       | —                     |       | —           |       |
| Cash flows from investing activities                                                 |       | (23                  | )          | (1,613                      | )          | (39                              | )          | —                     |       | (1,675           | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash flows from financing activities:                                                |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Borrowings under lines of credit                                                     |       | —               |       | 5,119                       |       | 1,246                            |       | —                     |       | 6,365            |       |
| Repayments under lines of credit                                                     |       | (3                   | )          | (5,119                      | )          | (1,002                           | )          | 3                          |       | (6,121           | )          |
| Repayment of long-term debt                                                          |       | —               |       | (3,240                      | )          | —                           |       | —                     |       | (3,240           | )          |
| Intercompany transactions                                                            |       | (674                 | )          | 5,817                       |       | (5,185                           | )          | 42                         |       | —           |       |
| Cash flows from financing activities                                                 |       | (677                 | )          | 2,577                       |       | (4,941                           | )          | 45                         |       | (2,996           | )          |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Effect of exchange rate changes on cash                                              |       | —               |       | —                      |       | 88                               |       | —                     |       | 88               |       |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Increase (decrease) in cash                                                          |       | —               |       | (7,416                      | )          | (3,959                           | )          | 3                          |       | (11,372          | )          |
| Cash, beginning of period                                                            |       | —               |       | 1,166                       |       | 6,736                            |       | 11,197                     |       | 19,099           |       |
|                                                                                 |       |                 |       |                        |       |                             |       |                       |       |             |       |
| Cash, end of period                                                                  |       | $                    | —     |                        | $          | (6,250                           | )          | $                          | 2,777      |             | $          | 11,200 |   | $ | 7,727 |   |

 

26

----

 

**(13)****                          SubsequentEvents**

 

On July 22, 2004, we entered into anagreement to acquire substantially all of the assets of G. Leblanc Corporationof Wisconsin, a high-quality band instrument manufacturer, for approximately$36.0 million.  The transaction issubject to customary closing conditions and purchase price adjustments and isexpected to close in the third quarter. We will accommodate this purchase with cash, supplemented by ourexisting credit facilities.

27

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

**(Tabular Amounts in Thousands Except Shareand 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. Moreover, we are the largest domestic producer of band and orchestralinstruments and offer a complete line of brasswind, woodwind, percussion andstringed instruments and related accessories with well-known brand names suchas Bach, Selmer, C.G. Conn, King, and Ludwig. We sell our products through dealers and distributors worldwide. Ourpiano customer base consists of professional artists, amateur pianists, andinstitutions such as concert halls, universities, and music schools.  Our band and orchestral instrument customerbase consists primarily of middle school and high school students, but alsoincludes adult amateur and professional musicians.

 

**Critical Accounting Policies**

 

Thenature of our business - the production and sale of musical instruments - issuch that it rarely involves application of highly complex or subjectiveaccounting principles.  The accountingpolicies that are subject to significant management estimates are thosenormally found in traditional businesses and include inventory reserves,accounts receivable reserves, reserves on notes receivable, and warrantyreserves.  We have significant experienceand data on which to base these estimates. Historical information is adjusted for specific uncertainties, such asnew product introductions, and contemporaneous information, such as pricefluctuations.  Management regularlyperforms assessments of the underlying assumptions and believes that theyprovide a reasonable basis for the estimates contained in our financialstatements.

 

**Forward-Looking Statements**

 

Certain statements contained in this document are “forward-lookingstatements” within the meaning of Section 21E of the Securities andExchange Act 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, 2003, our Final Prospectus filed inAugust 1996, and Registration Statement No. 333-62790 filed inJune 2001, particularly in the sections entitled “Risk Factors.”  We encourage you to read those descriptionscarefully.  We caution investors not toplace undue reliance on the forward-looking statements contained in thisreport.  These statements, like allstatements contained in this report, speak only as of the date of this report(unless another date is indicated) and we undertake no obligation to update orrevise the statements except as required by law.

 

28

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**Resultsof Operations**

 

*Three Months Ended June 30, 2004 Compared to Three Months EndedJune 28, 2003*

 
| ** **                 | ** ** | **Quarter Ended**       | ** ** | ** ** | ** ** | **Change**              | ** ** |
|----------------------------|------------|-------------------------|------------|------------|------------|-------------------------|------------|
| ** **                 | ** ** | **June 30,  2004** | ** ** | ** ** | ** ** | **June 28,  2003** | ** ** | ** ** | ** ** | **$** | ** ** | **%** | ** ** |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Net sales                  |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Band                       |       | $                       | 38,755     |       |       |                    | $          | 36,725 |   |   |   | 2,030 |   | 5.5 |   |
| Piano                      |       | 44,933                  |       |       |       | 41,310                  |       |   |   | 3,623 |   | 8.8 |   |
| Total sales                |       | 83,688                  |       |       |       | 78,035                  |       |   |   | 5,653 |   | 7.2 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Cost of sales              |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Band                       |       | 29,844                  |       |       |       | 27,697                  |       |   |   | 2,147 |   | 7.8 |   |
| Piano                      |       | 29,441                  |       |       |       | 27,625                  |       |   |   | 1,816 |   | 6.6 |   |
| Total cost of sales        |       | 59,285                  |       |       |       | 55,322                  |       |   |   | 3,963 |   | 7.2 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Gross profit               |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Band                       |       | 8,911                   |       | 23.0%      |       | 9,028                   |       | 24.6% |   | (117 | ) | (1.3 | ) |
| Piano                      |       | 15,492                  |       | 34.5%      |       | 13,685                  |       | 33.1% |   | 1,807 |   | 13.2 |   |
| Total gross profit         |       | 24,403                  |       |       |       | 22,713                  |       |   |   | 1,690 |   | 7.4 |   |
|                       |       | 29.2%                   |       |       |       | 29.1%                   |       |   |   |   |   |   |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Operating expenses         |       | 17,190                  |       |       |       | 16,903                  |       |   |   | 287 |   | 1.7 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Income from operations     |       | 7,213                   |       |       |       | 5,810                   |       |   |   | 1,403 |   | 24.1 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Other income, net          |       | (734                    | )          |       |       | (712                    | )          |   |   | (22 | ) | 3.1 |   |
| Net interest expense       |       | 3,423                   |       |       |       | 3,007                   |       |   |   | 416 |   | 13.8 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Income before income taxes |       | 4,524                   |       |       |       | 3,515                   |       |   |   | 1,009 |   | 28.7 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Income taxes               |       | 1,810                   |       | 40.0%      |       | 1,355                   |       | 38.5% |   | 455 |   | 33.6 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Net income                 |       | $                       | 2,714      |       |       |                    | $          | 2,160 |   |   |   | 554 |   | 25.6 |   |

 

*Overview –*We are pleased with the results of our banddivision’s new product introduction and channel distribution strategies.  Also, our suppliers were better able to meetour order demands than in the first quarter. On April 1, we were able to substantially complete our facilityrationalization project, closing one of our woodwind manufacturing facilitiesand consolidating the production process into another facility.

 

29

----

 

The performance of our piano division alsoimproved over the year ago quarter.  OurAsian operations continued their strong performance through the second quarter,and our domestic and European operations’ results were consistent with theprior period.

 

*Net Sales –*The increase in net sales of $5.7 millionresulted in part from a 6% increase in Steinway grand unit shipments, themajority of which occurred internationally, as well as $1.4 million in benefitattributable to foreign exchange.  Anincrease in Boston product shipments of 12% also contributed to the salesimprovement of the piano division.  Ourband division sales increased 5.5% as we were able to reduce our backorderposition on sourced product with many of our suppliers.  An increase in demand for our percussioninstruments also contributed to the improvement.

 

*G**ross Profit –* Gross profit increased $1.7 million due to thehigher overall sales and improved margin performance for the pianodivision.  Piano margins increased from33.1% to 34.5% due to the favorable mix towards higher margin grand units soldby our international divisions. Domestically, the margin improvement resulting from the increasedproductivity at our New York factory was offset by unfavorable exchange rateson purchased product sold during the period. Band gross margins, which deteriorated from 24.6% to 23.0%, wereadversely impacted by increased freight costs attributable in part to higherfuel charges, and cash discounts offered to customers.  In this period we sold instruments which hadhigher costs resulting from our reduced production levels in 2003.  This also contributed to the margin decrease.

 

*Operating Expenses* –The increase in operating expenses of $0.3 million occurred principally as aresult of $0.3 million from foreign currency translation.  Excluding this impact, operating expenseswere consistent with the prior year.

 

*Interest Expense and Other Income, Net –*These other expenses increased $0.4 million to$2.7 million due to the additional interest expense resulting from our issuanceof an additional $29.0 million in 8.75% Senior Notes in February, 2004.

 

*Income Taxes**–*Our effective tax rate increased from38.5% to 40% primarily as a result of changes in tax legislation in certainstates in which we do business and the increase in the ratio of domestic incometo foreign source income, which negatively impacts our ability to effectivelyuse foreign tax credits.

 

30

----

 

*Six Months Ended June 30, 2004 Compared to Six Months EndedJune 28, 2003*

 
| ** **                 | ** ** | **Quarter Ended**       | ** ** | ** ** | ** ** | **Change**              | ** ** |
|----------------------------|------------|-------------------------|------------|------------|------------|-------------------------|------------|
| ** **                 | ** ** | **June 30,  2004** | ** ** | ** ** | ** ** | **June 28,  2003** | ** ** | ** ** | ** ** | **$** | ** ** | **%** | ** ** |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Net sales                  |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Band                       |       | $                       | 83,099     |       |       |                    | $          | 83,299 |   |   |   | (200 | ) | (0.2 | ) |
| Piano                      |       | 90,650                  |       |       |       | 77,245                  |       |   |   | 13,405 |   | 17.4 |   |
| Total sales                |       | 173,749                 |       |       |       | 160,544                 |       |   |   | 13,205 |   | 8.2 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Cost of sales              |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Band                       |       | 64,160                  |       |       |       | 65,279                  |       |   |   | (1,119 | ) | (1.7 | ) |
| Piano                      |       | 59,461                  |       |       |       | 51,720                  |       |   |   | 7,741 |   | 15.0 |   |
| Total cost of sales        |       | 123,621                 |       |       |       | 116,999                 |       |   |   | 6,622 |   | 5.7 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Gross profit               |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Band                       |       | 18,939                  |       | 22.8%      |       | 18,020                  |       | 21.6% |   | 919 |   | 5.1 |   |
| Piano                      |       | 31,189                  |       | 34.4%      |       | 25,525                  |       | 33.0% |   | 5,664 |   | 22.2 |   |
| Total gross profit         |       | 50,128                  |       |       |       | 43,545                  |       |   |   | 6,583 |   | 15.1 |   |
|                       |       | 28.9%                   |       |       |       | 27.1%                   |       |   |   |   |   |   |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Operating expenses         |       | 34,817                  |       |       |       | 34,331                  |       |   |   | 486 |   | 1.4 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Income from operations     |       | 15,311                  |       |       |       | 9,214                   |       |   |   | 6,097 |   | 66.2 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Other income, net          |       | (1,346                  | )          |       |       | (1,333                  | )          |   |   | (13 | ) | 1.0 |   |
| Net interest expense       |       | 6,564                   |       |       |       | 5,979                   |       |   |   | 585 |   | 9.8 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Income before income taxes |       | 10,093                  |       |       |       | 4,568                   |       |   |   | 5,525 |   | 121.0 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Income taxes               |       | 4,035                   |       | 40.0%      |       | 1,725                   |       | 37.8% |   | 2,310 |   | 133.9 |   |
|                       |       |                    |       |       |       |                    |       |   |   |   |   |   |   |
| Net income                 |       | $                       | 6,058      |       |       |                    | $          | 2,843 |   |   |   | 3,215 |   | 113.1 |   |

 

*Overview –*Although our band division performance was constrained by some of oursuppliers not being able to fully meet our short-term order demands in thebeginning of the period, this was rectified by the end of the secondquarter.  Our new product introductionand channel distribution strategies are being accepted by the marketplace, andmost of the costs associated with training personnel in our combined productionfacility are behind us.

 

Our piano division was able to significantlyimprove performance over the year ago period. Internationally, we were able to capitalize on recent improvements inthe Asian economy.  Domestically, bothour wholesale and our retail performance improved, as did the sales of ourdomestic mid-price piano lines.

 

31

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*Net Sales –*The increase in net sales of $13.2 millionresulted from a 13% increase in Steinway grand unit shipments, which wereattributable to domestic and Asian operations. A $3.9 million benefit attributable to foreign exchange and an increaseof 23% in our domestic Boston product shipments also contributed to theimprovement.  The sales results for theband division were flat for the period on a slight unit increase of 2%.  In the first half of the period, weexperienced lower order rates from school music dealers and were in a backorderposition on many imported products.  In thelatter half of the period, school music dealer orders leveled off, and thebacklog position on much of our sourced product was eliminated, enabling us tomake up the sales lost in the first part of the period.

 

*G**ross Profit –* Gross profit increased $6.6 million as boththe piano and band segments experienced improvements in gross margins.  Piano margins increased from 33.0% to 34.4%due primarily to the increase in domestic retail sales and improvedproductivity in our domestic factory.  Afavorable product mix sold by our European divisions also contributed to theincrease.  In 2003, band gross profit wasadversely impacted by $1.9 million in payments to employees in accordance withexpired labor contracts and $1.3 million from work stoppages at two of ourplants.  In 2004, gross profit wasnegatively impacted by $1.4 million in severance costs associated with theclosure of one of our woodwind manufacturing facilities.  The decrease in these atypical chargesresulted in the band division’s gross margin improvement from 21.6% to 22.8%for the period.  In addition, we soldinstruments which had higher costs resulting from our reduced production levelsin 2003, which negatively impacted our margins. However, this was mitigated in part by the increase in sales of highermargin imported products.

 

*Operating Expenses* –The increase in operating expenses of $0.5 million occurred principally as aresult of $0.8 million from foreign currency translation.  Excluding this impact, operating expensesdecreased slightly, reflecting band division savings resulting fromadministrative staff reductions and lower sales and marketing expenses.

 

*Interest Expense and Other Income, Net –*These other expenses increased $0.6million to $5.2 million due to the additional interest expense resulting fromour issuance of an additional $29.0 million in 8.75% Senior Notes in February,2004.

 

*Income Taxes**–*Our effective tax rate is significantlyimpacted by our ability to utilize foreign tax credits.  The amount of such credit utilization isbased on the ratio of foreign source to total income computed solely on a tax,as opposed to book, reporting basis.  Asa result of the strengthening of our domestic piano and band divisions andchanges in tax legislation in certain states in which we do business, oureffective tax rate has increased from 37.8% to 40.0% in the current 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 six months ended June 30, 2004 and June 28, 2003 aresummarized as follows:

 
| ** **                                                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **Change** | ** ** |
|------------------------------------------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
| Net income:                                                                  |       | $        | 6,058      |     | $          | 2,843      |       | $ | 3,215 |   |
| Changes in operating assets and liabilities                                  |       | (21,657  | )          | (15,105  | )          | (7,504     | )          |
| Other adjustments to reconcile net income  to cash from operating activities |       | 4,882    |       | 5,473    |       | (591       | )          |
| Cash flows from operating activities                                         |       | (10,717  | )          | (6,789   | )          | (4,880     | )          |
|                                                                         |       |     |       |     |       |       |       |
| Cash flows from investing activities                                         |       | (1,976   | )          | (1,675   | )          | 651        |       |
|                                                                         |       |     |       |     |       |       |       |
| Cash flows from financing activities                                         |       | 1,100    |       | (2,996   | )          | 4,096      |       |
|                                                                              |            |          |            |          |            |            |            |  |  |  |

 

Despitethe $3.2 million increase in net income, cash flows from operating activitiesdecreased $3.9 million.  This resultedfrom our use of an additional $5.8 million to normalized our inventory levels,which were comparatively low in the prior year due to strikes at our Eastlake,Ohio and La Grange, Illinois manufacturing facilities.  We also used $1.8 million to establishworker’s compensation trust accounts in order to eliminate the fees associatedwith the letter of credit previously used to meet this requirement.

 

Thedecrease in cash flows from investing activities of $0.3 million is primarilydue to increased capital expenditures. The increase in cash flows from financing activities of  $4.1 million resulted primarily from proceedsfrom stock option exercises of $4.6 million.

 

## **BorrowingAvailability 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 June 30, 2004, there were no revolving credit loansoutstanding and availability based on eligible accounts receivable andinventory balances, net of letter of credit deductions of $2.3 million, wasapproximately $82.7 million.  Openaccount loans with foreign banks also provide for borrowings by Steinway’sforeign subsidiaries of up to €17.1 million ($20.9 million at the June 30,2004 exchange rate).  A portion of theopen account loans can be converted into a maximum of £0.5 million ($0.9million at the June 30, 2004 exchange rate) for use by our UK branch and¥600 million ($5.5 million at the June 30, 2004 exchange rate) for use byour Japanese subsidiary.  We had $3.9million in foreign loans outstanding as of June 30, 2004.

 

OnFebruary 4, 2004 we purchased 1,271,450 shares of our Ordinary commonstock directly from our largest institutional shareholder.  In exchange, we issued $29.0 million inprincipal amount of our 8.75%

 

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Senior Notes due 2011under the existing indenture.  We issuedthese bonds at a premium of 106.3%.  Thistransaction resulted in an increase to our treasury stock of $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.  As a result of theFebruary 4th stock repurchase, we have approached the currentlimitation.  Although this limitationwill increase over time, we currently have no short-term plans to repurchaseadditional Ordinary common stock either directly from shareholders or on theopen market.

 

Ourlong-term financing consists primarily of $174.3 million of 8.75% Senior Notesand $43.8 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 June 30, 2004.

 

Ourfacility rationalization project, which was started in 2003, is substantiallycomplete, as we closed one of our Elkhart, Indiana woodwind manufacturingfacilities on April 1, 2004.  Wehave an additional annual interest requirement of $2.5 million as a result ofthe $29.0 million bond issuance described above. We do not expect any residualeffects from our facility rationalization project or our additional interestobligations to have a material impact on our liquidity.

 

OnJuly 22, 2004, we entered into an agreement to purchase substantially allof the assets of G. Leblanc Corporation, a manufacturer of high-quality bandinstruments, for approximately $36.0 million. The purchase is subject to customary closing conditions and purchaseprice adjustments.  Leblanc expects togenerate revenues of approximately $28.0 million for 2004.  We intend to fund this acquisition withapproximately $22.0 million in cash, supplemented by borrowings on our creditfacility.  We expect to pay off theborrowings associated with the acquisition by the end of 2004.  We are not aware of any other trends,demands, commitments, or costs of resources that are expected to materiallyimpact liquidity or capital resources. Therefore, we believe that cash on hand, together with cash flowsanticipated from operations and available borrowings under the Credit Facility,will be adequate to meet existing debt service requirements, fund continuingcapital requirements and satisfy working capital and general corporate needsfor the next twelve months.

 

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 untilthe options are exercised.

 

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**Contractual Obligations**

 

The followingtable provides a summary of our contractual obligations at June 30, 2004:

 
| ** **                      | ** ** | **Payments due by period** | ** ** |
|---------------------------------|------------|----------------------------|------------|
| **Contractual  Obligations**    | ** ** | **Total**                  | ** ** | **Less than  1 year** | ** ** | **1 - 3 years** | ** ** | **3 - 5 years** | ** ** | **More than  5 years** | ** ** |
|                            |       |                       |       |   |   |   |   |   |   |   |   |
| Long-term debt (1)              |       | $                          | 222,104    |   | $ | 10,501 |   | $ | 16,352 |   | $ | 20,906 |   | $ | 174,345 |   |
| Operating leases (2)            |       | 275,691                    |       | 5,306 |   | 8,872 |   | 7,398 |   | 254,115 |   |
| Purchase obligations (3)        |       | 11,486                     |       | 11,136 |   | 236 |   | 114 |   | — |   |
| Other long-term liabilities (4) |       | 18,529                     |       | 1,512 |   | 3,023 |   | 3,023 |   | 10,971 |   |
| Total                           |       | $                          | 527,810    |   | $ | 28,455 |   | $ | 28,483 |   | $ | 31,441 |   | $ | 439,431 |   |

 

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**Notesto Contractual Obligations:**

 

(1) The nature of our long-term debt obligations is described morefully in the “Borrowing Availability and Activities” section of “Liquidityand Capital Resources.”

(2) Approximately $258.6 million of our operating lease obligations areattributable to the ninety-nine year land lease associated with the purchase ofSteinway Hall; the remainder is attributable to the leasing of other facilitiesand equipment.

(3) Purchase obligations consist of firm purchase commitments for rawmaterials, imported products, and equipment.

(4) Other long-term liabilities consist primarily of pension obligations.

 

**NewAccounting Pronouncements**

 

InDecember 2003, the FASB revised SFAS No. 132, “Employers’ Disclosuresabout Pensions and Other Postretirement Benefits.”  SFAS No. 132 requires additional disclosureabout the assets, obligations, cash flows, and net periodic benefit cost ofdefined benefit pension plans and other defined benefit postretirementplans.  This statement also requiresdisclosure about the types of plan assets, investment strategy, measurementdates, plan obligations, and cash flows. SFAS No. 132 is effective for fiscal years ending afterDecember 15, 2003.  Disclosure ofinformation about foreign plans required by this statement is effective forfiscal years ending after June 15, 2004. Interim period disclosures for both domestic and foreign plans requiredby this statement are effective for periods beginning after December 15,2003, and are included in Note 11.

 

**ITEM 3**                                     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK

** **

**We are exposed to market riskassociated with changes in foreign currency exchange rates and interestrates.  We mitigate our foreign currencyexchange rate risk by maintaining foreign currency cash balances and holdingforward foreign currency contracts. These contracts are used as a hedge against foreign currencytransactions and are not used for trading or speculative purposes.  The fair value of the forward foreigncurrency exchange contracts is sensitive to changes in foreign currencyexchange rates.  The impact of an adversechange in foreign currency exchange rates would not be materially differentthan that disclosed in the our Annual Report on Form 10-K for the year endedDecember 31, 2003.**

 

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**Our revolving loans and term loansbear interest at rates that fluctuate with changes in LIBOR.  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 endedDecember 31, 2003.**

** **

**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 ourdetermination whether to retain, replace, or retire this debt.**

** **

**ITEM 4**                                     CONTROLS AND PROCEDURES

** **

As of the end of the period covered by this report, weevaluated the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-15(e) and15d-15(e)). Our disclosure controls and procedures are the controls and otherprocedures that we designed to ensure that we record, process, summarize andreport in a timely manner the information we must disclose in reports that wefile with or submit to the SEC. Our Chief Executive Officer and Chief FinancialOfficer reviewed and participated in this evaluation. Based on this evaluationthe Chief Executive Officer and Chief Financial Officer concluded that ourdisclosure controls were effective.  Indesigning the Company’s disclosure controls and procedures, the Company’smanagement recognizes that any controls, no matter how well designed andoperated, can only provide reasonable, not absolute, assurance of achieving thedesired control objectives.  During thefiscal quarter covered by this report, there have not been any significantchanges in our internal accounting controls or in other factors that couldsignificantly affect those controls.

 

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**PART II****                                OTHERINFORMATION**

 

#### **ITEM 4**                                     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

At the Company’s Annual Meeting ofShareholders held on May 19, 2004, the Board of Directors was re-elected in itsentirety.  The votes cast for eachnominee were as follows:

 
| ** **          | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|---------------------|------------|------------|------------|--------------|------------|
|                |       |       |       |         |       |
| Kyle Kirkland       |       | 51,926,862 |       | 1,402,800    |       |
| Dana D. Messina     |       | 51,946,831 |       | 1,382,831    |       |
| John M. Stoner, Jr. |       | 51,903,402 |       | 1,426,260    |       |
| Bruce A. Stevens    |       | 51,907,102 |       | 1,422,560    |       |
| A. Clinton Allen    |       | 52,958,361 |       | 371,301      |       |
| Rudolph K. Kluiber  |       | 52,982,011 |       | 347,651      |       |
| Peter McMillan      |       | 52,981,911 |       | 347,751      |       |

 

The proposal to ratify Deloitte & Toucheto serve as the Company’s independent auditors for the fiscal year endingDecember 31, 2004 was approved with 53,202,982 votes cast for, 103,163votes against, and 23,517 abstentions.

 

**ITEM 6****                                     EXHIBITSAND REPORTS ON FORM 8-K**

 
| (a)    |   | Exhibits                                                                                    |
|--------|--------|---------------------------------------------------------------------------------------------|
|   |   |                                                                                        |
|   |   | 4.1                                                                                         | Seventh  Amendment to the Second Amended and Restated Credit Agreement dated as of May  26, 2004 by and among Conn-Selmer, Inc. f/k/a The Selmer Company, Inc. and  the surviving corporation of the merger of United Musical Instruments USA,  Inc. and United Musical Instrument Holdings, Inc. with and into Conn-Selmer,  Inc., as borrowers; those signatories identified as guarantors, the lenders,  and GMAC Commercial Credit LLC, as administrative agent. |
|   |   |                                                                                        |
|   |   | 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 |
|   |   |                                                                                        |
| (b)    |   | Reports on Form 8-K                                                                         |
|   |   |                                                                                        |
|   |   | During the quarter ended June 30, 2004 we filed or furnished the  following reports on |
|   |   | Form 8-K:                                                                                   |

 

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On May 6, 2004, the Company filed a Current Report on Form 8-K thatincluded a press release issued on the same date announcing its earnings forthe quarter ended March 31, 2004.

 

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Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrants have 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: August 5, 2004 |                                            |
|                           |                                                 |  |  |

 

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