10-Q 1 a06-21563_110q.htm QUARTERLY REPORT PURSUANT TO SECTIONS 13 OR 15(D)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

x

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

 

 

 

 

For the quarterly period ended September 30, 2006

 

 

 

o

 

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

 

 

 

 

 

For the transition period from                                 to                                 

 

Commission File No. 000 – 22207

GUITAR CENTER, INC.

(Exact Name of Registrant as Specified in its Charter)

DELAWARE

 

95-4600862

(State or other jurisdiction of

 

(I.R.S. Employer

incorporation or organization)

 

Identification Number)

 

 

 

5795 LINDERO CANYON ROAD

 

 

WESTLAKE VILLAGE, CALIFORNIA

 

91362

(Address of principal executive offices)

 

(Zip Code)

 

(818) 735-8800

Registrant’s telephone number, including area code

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes   x     No   o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   x

Accelerated filer   o

Non-accelerated filer   o

 

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

 

Yes   o     No   x

 

As of November 3, 2006, there were 29,325,361 shares of our common stock, $.01 par value, outstanding.

 




GUITAR CENTER, INC. AND SUBSIDIARIES

INDEX

Part I.

Financial Information

 

 

 

 

 

 

Item 1. Consolidated Financial Statements (Unaudited)

 

 

 

 

 

 

Consolidated Balance Sheets – September 30, 2006 and December 31, 2005

 

 

 

 

 

 

Consolidated Statements of Income – Three months ended September 30, 2006 and 2005

 

 

 

 

 

 

Consolidated Statements of Income – Nine months ended September 30, 2006 and 2005

 

 

 

 

 

 

Consolidated Statements of Cash Flows – Nine months ended September 30, 2006 and 2005

 

 

 

 

 

 

Notes to 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 1.

Legal Proceedings

 

 

 

 

 

 

Item 1A.

Risk Factors

 

 

 

 

 

 

Item 6.

Exhibits

 

 




GUITAR CENTER, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands)

(Unaudited)

 

 

 

September 30,

 

December 31,

 

 

 

2006

 

2005

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

10,211

 

$

14,529

 

Accounts receivable, less allowance for doubtful accounts of $3,200 and $2,844, respectively

 

43,677

 

40,844

 

Merchandise inventories

 

558,463

 

445,771

 

Prepaid expenses and other current assets

 

21,402

 

15,533

 

Deferred income taxes

 

14,324

 

13,492

 

Total current assets

 

648,077

 

530,169

 

Property and equipment, net of accumulated depreciation and amortization of $147,944 and $125,440, respectively

 

186,978

 

149,209

 

Goodwill

 

96,627

 

85,929

 

Intangible assets, net

 

7,535

 

9,142

 

Other assets, net

 

4,014

 

5,741

 

Total assets

 

$

943,231

 

$

780,190

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

110,937

 

$

79,497

 

Accrued expenses and other current liabilities

 

67,653

 

106,181

 

Merchandise advances

 

20,138

 

25,127

 

Borrowings under revolving line of credit

 

147,440

 

32,266

 

Total current liabilities

 

346,168

 

243,071

 

Other long-term liabilities

 

15,039

 

11,995

 

Deferred income taxes

 

13,113

 

20,307

 

Long-term debt

 

 

100,000

 

Total liabilities

 

374,320

 

375,373

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, 5,000 authorized, none issued and outstanding

 

 

 

Common stock, $0.01 par value, authorized 100,000 shares at September 30, 2006 and 55,000 shares at December 31, 2005, issued and outstanding 29,307 at September 30, 2006 and 26,092 at December 31, 2005

 

293

 

261

 

Additional paid-in capital

 

450,360

 

326,755

 

Retained earnings

 

118,258

 

77,801

 

Total stockholders’ equity

 

568,911

 

404,817

 

Total liabilities and stockholders’ equity

 

$

943,231

 

$

780,190

 

 

See accompanying notes to consolidated financial statements.

1




GUITAR CENTER, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

 

 

 

Three months ended September 30,

 

 

 

2006

 

2005

 

Net sales

 

$

472,732

 

$

421,061

 

Cost of goods sold, buying and occupancy

 

339,465

 

297,243

 

Gross profit

 

133,267

 

123,818

 

Selling, general and administrative expenses

 

114,022

 

98,366

 

Operating income

 

19,245

 

25,452

 

Interest expense, net of interest income of $68 and $26, respectively

 

2,173

 

2,021

 

Gain on sale of property

 

2,115

 

 

Income before income taxes

 

19,187

 

23,431

 

Income taxes

 

7,866

 

9,022

 

Net income

 

$

11,321

 

$

14,409

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

Basic

 

$

0.39

 

$

0.55

 

Diluted

 

$

0.38

 

$

0.51

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

Basic

 

28,874

 

25,975

 

Diluted

 

29,924

 

29,946

 

 

See accompanying notes to consolidated financial statements.

2




GUITAR CENTER, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(In thousands, except per share data)

(Unaudited)

 

 

 

Nine months ended September 30,

 

 

 

2006

 

2005

 

Net sales

 

$

1,401,457

 

$

1,219,743

 

Cost of goods sold, buying and occupancy

 

1,000,327

 

869,413

 

Gross profit

 

401,130

 

350,330

 

Selling, general and administrative expenses

 

331,120

 

275,266

 

Operating income

 

70,010

 

75,064

 

Interest expense, net of interest income of $216 and $675, respectively

 

6,399

 

4,811

 

Gain on sale of property

 

2,115

 

 

Income before income taxes

 

65,726

 

70,253

 

Income taxes

 

25,269

 

27,049

 

Net income

 

$

40,457

 

$

43,204

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

Basic

 

$

1.49

 

$

1.67

 

Diluted

 

$

1.41

 

$

1.52

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

Basic

 

27,119

 

25,819

 

Diluted

 

29,911

 

29,836

 

 

See accompanying notes to consolidated financial statements.

3




GUITAR CENTER, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

 

 

 

Nine months ended September 30,

 

 

 

2006

 

2005

 

Operating activities:

 

 

 

 

 

Net income

 

$

40,457

 

$

43,204

 

Adjustments to reconcile net income to net cash (used in) provided by operating activities:

 

 

 

 

 

Depreciation and amortization

 

26,634

 

20,630

 

(Gain) loss on disposal of property and equipment

 

(2,115

)

1,849

 

Amortization of deferred financing fees

 

539

 

784

 

Stock-based compensation

 

14,941

 

 

Tax benefit from exercise of stock options

 

 

7,175

 

Deferred income taxes

 

(7,139

)

350

 

Changes in operating assets and liabilities, net of effect of acquisitions:

 

 

 

 

 

Accounts receivable

 

(2,250

)

5,653

 

Merchandise inventories

 

(104,185

)

(82,193

)

Prepaid expenses and other current assets

 

(5,869

)

(4,703

)

Other assets, net

 

(297

)

(725

)

Accounts payable

 

31,330

 

34,977

 

Accrued expenses and other current liabilities

 

(39,088

)

(18,271

)

Merchandise advances

 

(5,038

)

3,817

 

Other long-term liabilities

 

3,044

 

(8,289

)

Net cash (used in) provided by operating activities

 

(49,036

)

4,258

 

Investing activities:

 

 

 

 

 

Purchase of property and equipment

 

(61,542

)

(60,305

)

Proceeds from sale of property and equipment

 

2,565

 

 

Purchase of available-for-sale securities

 

 

(27,305

)

Proceeds from sale of available-for-sale securities

 

 

47,460

 

Acquisition of businesses, net of cash acquired

 

(20,815

)

(101,925

)

Net cash used in investing activities

 

(79,792

)

(142,075

)

Financing activities:

 

 

 

 

 

Net change in borrowings under revolving line of credit

 

115,174

 

74,004

 

Proceeds from exercise of stock options

 

6,086

 

10,175

 

Proceeds from stock issued under employee purchase plan

 

1,220

 

953

 

Excess tax benefit from exercise of stock options

 

2,033

 

 

Repayment of long-term debt

 

(3

)

 

Net cash provided by financing activities

 

124,510

 

85,132

 

Net decrease in cash and cash equivalents

 

(4,318

)

(52,685

)

Cash and cash equivalents at beginning of period

 

14,529

 

60,453

 

Cash and cash equivalents at end of period

 

$

10,211

 

$

7,768

 

 

See accompanying notes to consolidated financial statements.

4




GUITAR CENTER, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

 

 

Nine months ended September 30,

 

 

 

2006

 

2005

 

Non-cash investing and financing activities:

 

 

 

 

 

Acquisition of businesses, in which the fair value of assets and liabilities were as follows:

 

 

 

 

 

Accounts receivable

 

$

583

 

$

5,745

 

Merchandise inventories

 

8,507

 

59,424

 

Prepaid expenses and other current assets

 

 

677

 

Property and equipment

 

597

 

3,775

 

Goodwill

 

10,698

 

49,663

 

Intangible assets

 

1,107

 

 

Other assets

 

 

5,299

 

Total assets acquired

 

21,492

 

124,583

 

Current liabilities

 

(1,564

)

(19,779

)

Other long-term liabilities

 

 

(460

)

Deferred income taxes

 

887

 

(2,419

)

Total liabilities assumed

 

(677

)

(22,658

)

Net assets acquired

 

$

20,815

 

$

101,925

 

 

 

 

 

 

 

Conversion of debt to common stock

 

$

98,512

 

$

 

 

See accompanying notes to consolidated financial statements.

5




GUITAR CENTER, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. Nature of Business and Significant Accounting Policies

Nature of Business

Guitar Center, Inc. (the “Company”) is the leading United States retailer of guitars, amplifiers, percussion instruments, keyboards and pro-audio and recording equipment. As of September 30, 2006, our retail subsidiary operated 194 Guitar Center stores across the United States consisting of 132 primary format stores, 59 secondary format stores and 3 tertiary format stores. In addition, as of September 30, 2006, our Music & Arts Center division operated more than 90 stores specializing in band instruments for sale and rental, serving teachers, band directors, college professors and students. We are also the largest direct response retailer of musical instruments in the United States through our wholly owned subsidiary, Musician’s Friend, Inc., and its catalog and website, www.musiciansfriend.com.

Basis of Presentation

In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments necessary to present fairly the financial position of the Company as of September 30, 2006, the results of operations for the three and nine months ended September 30, 2006 and 2005, respectively, and its cash flows for the nine months ended September 30, 2006 and 2005. The accompanying consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2005.

The Company’s results of operations and cash flows for the interim periods may not be indicative of the results of operations and cash flows for the full year.

Use of Estimates in the Preparation of Financial Statements

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

Reclassifications

A reclassification has been made to the December 31, 2005 consolidated balance sheet to separately report intangible assets, net, which was previously included with other assets, net. This reclassification has no impact on the previously reported net income or stockholders’ equity.

2. Acquisition of Businesses

During the second quarter of 2006, our Guitar Center division acquired four retail locations in Texas and related net assets from Hermes Trading Company, Inc., a musical instruments retailer, for approximately $11.0 million.

During the nine months ended September 30, 2006, our Music & Arts Center division acquired a total of 13 stores and related net assets for an aggregate purchase price of approximately $9.8 million.

The aggregate purchase price for the acquisitions in the nine months ended September 30, 2006 (including purchase price adjustments of $0.4 million) totaled approximately $20.8 million, which was principally allocated to merchandise inventories of $8.5 million and goodwill of $10.7 million.

The acquisitions were accounted for under the purchase method of accounting in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations.” The results of operations of the acquisitions were not material to the current period consolidated financial statements and, as such, pro forma financial information is not presented for these acquisitions. The results of operations of the acquired businesses are included in the consolidated financial statements from the respective dates of acquisition.

6




On April 15, 2005, the Company completed the acquisition of Music & Arts Center, Inc., a Maryland-based musical instruments retailer with an emphasis on the beginning musician. At the time of the acquisition, Music & Arts Center, Inc. operated 61 retail locations, primarily located in the Northeast, Mid-Atlantic and Southern regions of the United States. The Company acquired Music & Arts Center, Inc. to expand our existing presence in the band and orchestra instrument business. The acquired business and our existing American Music Group business were combined into a new division under the Music & Arts Center name.

3. Goodwill and Intangible Assets

Goodwill represents the excess of the purchase price over the fair value of identifiable net assets acquired resulting from business acquisitions accounted for under the purchase method. The changes in the carrying amount of goodwill by reportable segment for the nine months ended September 30, 2006 were as follows (in thousands):

 

Guitar

 

Music &

 

Musician’s

 

 

 

 

 

Center

 

Arts

 

Friend

 

Total

 

Balance at December 31, 2005

 

$

5,382

 

$

77,106

 

$

3,441

 

$

85,929

 

Goodwill resulting from acquisitions

 

8,160

 

2,106

 

 

10,266

 

Goodwill adjustments

 

 

432

 

 

432

 

Balance at September 30, 2006

 

$

13,542

 

$

79,644

 

$

3,441

 

$

96,627

 

 

Intangible assets with definite useful lives are amortized over their respective estimated useful lives. The following is a summary of intangible assets as of September 30, 2006 and December 31, 2005 (dollars in thousands, life in years):

 

 

 

September 30, 2006

 

 

 

Weighted-

 

Gross

 

 

 

 

 

 

 

Average Useful

 

Carrying

 

Accumulated

 

 

 

 

 

Life

 

Amount

 

Amortization

 

Total

 

Unamortized trademark

 

 

$

5,367

 

$

 

$

5,367

 

Amortized

 

 

 

 

 

 

 

 

 

Customer contracts

 

1.4

 

4,003

 

(3,640

)

363

 

Covenants not to compete

 

3.9

 

2,674

 

(1,133

)

1,541

 

Other

 

2.6

 

852

 

(588

)

264

 

Intangible assets, net

 

 

 

$

12,896

 

$

(5,361

)

$

7,535

 

 

 

 

 

December 31, 2005

 

 

 

Weighted-

 

Gross

 

 

 

 

 

 

 

Average Useful

 

Carrying

 

Accumulated

 

 

 

 

 

Life

 

Amount

 

Amortization

 

Total

 

Unamortized trademark

 

 

$

5,325

 

$

 

$

5,325

 

Amortized

 

 

 

 

 

 

 

 

 

Customer contracts

 

1.4

 

3,430

 

(1,734

)

1,696

 

Covenants not to compete

 

3.7

 

2,200

 

(596

)

1,604

 

Other

 

2.6

 

834

 

(317

)

517

 

Intangible assets, net

 

 

 

$

11,789

 

$

(2,647

)

$

9,142

 

 

Amortization of intangible assets is included in selling, general and administrative expenses. The estimated amortization expense related to intangible assets for each of the five years and thereafter as of September 30, 2006 is as follows (in thousands):

7




 

Year ending December 31,

 

 

 

 

 

 

 

Remainder of 2006

 

$

387

 

2007

 

983

 

2008

 

409

 

2009

 

247

 

2010

 

97

 

2011

 

45

 

Thereafter

 

 

Total

 

$

2,168

 

 

4. Net Income Per Share

The following table summarizes the calculation of diluted weighted average shares and diluted net income per share for the periods presented below (in thousands, except per share data):

 

Three months ended

 

Nine months ended

 

 

 

September 30,

 

September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Net income, as reported

 

$

11,321

 

$

14,409

 

$

40,457

 

$

43,204

 

Add back interest, net of tax, on 4% Senior Convertible Notes (a)

 

118

 

727

 

1,722

 

2,181

 

Net income, excluding interest expense on 4% Senior Convertible Notes

 

$

11,439

 

$

15,136

 

$

42,179

 

$

45,385

 

 

 

 

 

 

 

 

 

 

 

Basic weighted average shares outstanding

 

28,874

 

25,975

 

27,119

 

25,819

 

Dilutive effect of stock options outstanding

 

650

 

1,079

 

740

 

1,125

 

Shares issuable on assumed conversion of 4% Senior Convertible Notes (b)

 

400

 

2,892

 

2,052

 

2,892

 

Diluted weighted average shares outstanding

 

29,924

 

29,946

 

29,911

 

29,836

 

 

 

 

 

 

 

 

 

 

 

Basic net income per share

 

$

0.39

 

$

0.55

 

$

1.49

 

$

1.67

 

Diluted net income per share

 

$

0.38

 

$

0.51

 

$

1.41

 

$

1.52

 

 


(a)   Represents the interest expense for the period the 4% Senior Convertible Notes (the “Notes”) were outstanding, including contingent interest and amortization of deferred financing costs, net of tax, using an effective tax rate of 41.0% and 37.7% for the three and nine months ended September 30, 2006 and 38.5% for the three and nine months ended September 30, 2005.

(b)   Represents the weighted-average number of common shares issuable upon the conversion of the Notes, up to the date of actual conversion.

For the three and nine months ended September 30, 2006 and 2005, the only potential additional shares of common stock that could become outstanding were shares issuable upon exercise of stock options and conversion of the Notes up to the date of actual conversion.

For the three and nine months ended September 30, 2006, options to acquire weighted-average shares of 1,059,000 and 869,000, respectively, were outstanding but were excluded from the computation of diluted net income per share because their effect was anti-dilutive. For the three and nine months ended September 30, 2005, options to acquire weighted-average shares of 77,000 and 177,000, respectively, were outstanding but were excluded from the computation of diluted net income per share because their effect was anti-dilutive.

For the three and nine months ended September 30, 2006, 0.4 million and 2.1 million shares, respectively, of common stock issuable upon conversion of the Notes issued in June 2003 (reflecting an effective conversion price of $34.58) were deemed to be potential common stock and were deemed to be outstanding for the purposes of calculating diluted net income per share under the “if-converted” method of accounting under which the after-tax interest expense, including

8




contingent interest and amortization of deferred financing costs, for the period is added back to net income. For the three and nine months ended September 30, 2005, the common stock issuable upon conversion of the Notes amounted to 2.9 million shares. The Notes were called for redemption by the Company on June 15, 2006 and substantially all of the outstanding Notes were converted into common stock prior to the July 15, 2006 redemption date. See Note 9 for further discussion of the Notes.

5. Segment Information

Our reportable business segments are Guitar Center stores, Music & Arts Center and Musician’s Friend direct response. Management evaluates segment performance based primarily on net sales, operating income (loss) and income (loss) before income taxes. Accounting policies of the segments are the same as the accounting policies for the consolidated company. There are no differences between the measurements of profits or losses or assets of the reportable segments and those of the Company on a consolidated basis.

The following table summarizes financial information for our operating segments as of September 30, 2006 and December 31, 2005 and for the three and nine months ended September 30, 2006 and 2005 (in thousands):

 

Three Months Ended September 30, 2006

 

Nine Months Ended September 30, 2006

 

 

 

Guitar

 

Music &

 

Musician’s

 

 

 

Guitar

 

Music &

 

Musician’s

 

 

 

 

 

Center

 

Arts

 

Friend

 

Total

 

Center

 

Arts

 

Friend

 

Total

 

Net Sales

 

$

352,470

 

$

34,190

 

$

86,072

 

$

472,732

 

$

1,031,601

 

$

99,180

 

$

270,676

 

$

1,401,457

 

Gross Profit

 

94,123

 

13,331

 

25,813

 

133,267

 

277,327

 

42,667

 

81,136

 

401,130

 

Depreciation and amortization

 

7,228

 

1,331

 

883

 

9,442

 

20,167

 

4,111

 

2,356

 

26,634

 

Selling, general and adiministrative expenses

 

75,616

 

17,411

 

20,995

 

114,022

 

219,731

 

46,884

 

64,505

 

331,120

 

Operating income (loss)

 

18,507

 

(4,080

)

4,818

 

19,245

 

57,596

 

(4,217

)

16,631

 

70,010

 

Income (loss) before income tax (benefit)

 

20,984

 

(7,062

)

5,265

 

19,187

 

60,495

 

(12,808

)

18,039

 

65,726

 

Capital expenditures

 

21,164

 

679

 

1,653

 

23,496

 

53,498

 

2,609

 

5,435

 

61,542

 

 

 

Three Months Ended September 30, 2005

 

Nine Months Ended September 30, 2005

 

 

 

Guitar

 

Music &

 

Musician’s

 

 

 

Guitar

 

Music &

 

Musician’s

 

 

 

 

 

Center

 

Arts

 

Friend

 

Total

 

Center

 

Arts (1)

 

Friend

 

Total

 

Net Sales

 

$

310,130

 

$

30,121

 

$

80,810

 

$

421,061

 

$

904,410

 

$

65,032

 

$

250,301

 

$

1,219,743

 

Gross Profit

 

87,014

 

13,299

 

23,505

 

123,818

 

247,139

 

27,413

 

75,778

 

350,330

 

Depreciation and amortization

 

5,388

 

1,295

 

630

 

7,313

 

15,902

 

3,017

 

1,711

 

20,630

 

Selling, general and adiministrative expenses

 

64,120

 

14,611

 

19,635

 

98,366

 

186,310

 

34,437

 

54,519

 

275,266

 

Operating income (loss)

 

22,894

 

(1,312

)

3,870

 

25,452

 

60,829

 

(7,024

)

21,259

 

75,064

 

Income (loss) before income tax (benefit)

 

22,867

 

(3,715

)

4,279

 

23,431

 

60,145

 

(12,264

)

22,372

 

70,253

 

Capital expenditures

 

21,335

 

315

 

826

 

22,476

 

56,016

 

810

 

3,479

 

60,305

 

 

 

Guitar

 

Music &

 

Musician’s

 

 

 

 

 

Center

 

Arts

 

Friend

 

Total

 

Total assets at September 30, 2006

 

$

628,913

 

$

230,686

 

$

83,632

 

$

943,231

 

Total assets at December 31, 2005

 

$

512,802

 

$

197,045

 

$

70,343

 

$

780,190

 

 


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

9




6. Stock-Based Compensation

Effective January 1, 2006, the Company adopted the provisions of, and accounts for stock-based compensation in accordance with, SFAS No. 123—revised 2004 (“SFAS No. 123(R)”), “Share–Based Payment,” which replaced SFAS No. 123, “Accounting for Stock–Based Compensation,” and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” Under the fair value recognition provisions of this statement, stockbased compensation cost for option awards is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the requisite service period of the award. For performance share awards, stock-based compensation expense is measured at the market price of the Company’s stock on the date the underlying plan receives compensation committee approval, or other form of a mutual understanding of the key terms and conditions of performance. The Company elected the modified prospective method, under which prior periods are not restated for comparative purposes. The valuation provisions of SFAS No. 123(R) apply to new grants subsequent to the effective date. Estimated compensation for unvested grants that were outstanding as of the effective date will be recognized over the remaining service period using the compensation cost estimated for the SFAS No. 123 pro forma disclosures.

Stock-based compensation expense for all stock award plans included in our consolidated statement of income for the three months ended September 30, 2006 was $3.0 million ($1.8 million, net of tax), or $0.06 per diluted share. Stock-based compensation expense for all stock award plans included in our consolidated statement of income for the nine months ended September 30, 2006 was $14.9 million ($9.2 million, net of tax), or $0.31 per diluted share. Stock-based compensation expense for all stock award plans included in our consolidated statement of income for the three and nine months ended September 30, 2005 was $1.4 million ($0.8 million, net of tax), or $0.03 per diluted share. As a result of adopting SFAS No. 123(R) on January 1, 2006, income before income taxes for the three and nine months ended September 30, 2006 was $2.8 million and $10.7 million lower, respectively, and net income for the three and nine months ended September 30, 2006 was $1.7 million and $6.6 million lower, respectively, than if we had continued to account for stock-based compensation under APB No. 25. If we had not adopted SFAS No. 123(R), our basic and diluted net income per share for the three months ended September 30, 2006 would have been increased by $0.06 and for the nine months ended September 30, 2006, basic and diluted income per share would have been increased by $0.25 and $0.22, respectively. Under the APB No. 25 intrinsic value method, the Company would not have recorded stock-based compensation expense in 2006 related to stock option awards, but would have recorded stock-based compensation expense related to awards of performance shares, restricted stock and deferred stock.

Prior to the adoption of SFAS No. 123(R), we presented all tax benefits for deductions resulting from the exercise of stock options as operating cash flows on our consolidated statement of cash flows. SFAS No. 123(R) requires the benefits of tax deductions in excess of recognized compensation expense to be reported as a financing cash flow, rather than as an operating cash flow. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. Total cash flow will remain unchanged from what would have been reported under prior accounting rules. For the nine months ended September 30, 2006, $2.0 million of excess tax benefits from the exercise of stock options reported in financing cash flows would have been reported as operating cash flows had SFAS No. 123(R) not been adopted.

The following table details the effect on net income and net income per share as if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based compensation during the three and nine months ended September 30, 2005 (in thousands, except per share data):

10




 

 

Three months ended

 

Nine months ended

 

 

 

September 30, 2005

 

September 30, 2005

 

Net income, as reported

 

$

14,409

 

$

43,204

 

Add: Total stock-based employee compensation expense, net of related tax effects

 

883

 

$

883

 

Deduct: Total stock-based employee compensation expense determined under fair value based methods for all awards, net of related tax effects

 

2,765

 

5,541

 

Pro forma net income

 

$

12,527

 

$

38,546

 

 

 

 

 

 

 

Net income per share:

 

 

 

 

 

Basic - as reported

 

$

0.55

 

$

1.67

 

Basic - pro forma

 

$

0.48

 

$

1.49

 

Diluted - as reported

 

$

0.51

 

$

1.52

 

Diluted - pro forma

 

$

0.44

 

$

1.37

 

 

Incentive Compensation Plans

Our 2004 Incentive Stock Award Plan (as amended, the “2004 Plan”) provides for the issuance of stock options, stock appreciation rights, restricted stock, deferred stock, dividend equivalents, performance awards and stock payments, or any combination thereof. Substantially all stock awards are currently issued under the 2004 Plan.

Prior to fiscal 2004, the Company had adopted various stock option plans (the “Prior Plans”). A small number of grants are expected to be made under the Prior Plans, and outstanding awards under the Prior Plans will continue to be in effect.

Under the 2004 Plan and the Prior Plans, an aggregate of 1.3 million shares of common stock were available for issuance as of September 30, 2006, which includes 0.7 million additional shares approved by our stockholders on April 28, 2006. The Company generally issues new shares for stock option exercises, performance share awards and restricted stock awards.

Stock Options

Option grants are issued at fair market value on the date of grant and generally vest over four years. Option grants generally expire ten years after the date of grant.

In the second quarter of 2005, we converted to a lattice-based binomial model from a Black-Scholes model. The conversion was implemented beginning with grants issued during the second quarter of 2005. The fair value of our grants issued prior to the second quarter of 2005 was determined using the Black-Scholes model.

Using the lattice-based binomial model, the fair value of each option award is estimated based on the assumptions noted in the following table. Because lattice-based binomial models incorporate ranges of assumptions for inputs, those ranges are disclosed. Expected volatilities are based on historical volatility of the Company’s stock and implied volatilities for open market exchange-traded options issued “near-the-money”. The Company uses historical data to estimate option exercise and employee departure behavior. Assumptions were developed separately for our senior management from the other participants of our stock plans, since senior management’s exercise behavior is expected to differ materially from the other participants. The expected term of share options granted is derived from the output of the option pricing model and represents the period of time that options granted are expected to be outstanding. The range in expected term results from the different post-vesting behaviors exhibited by senior management and the other participants. The risk free interest rate is based on US Treasury zero-coupon issues with remaining terms similar to the expected term of the options.

The assumptions used to value option grants under the lattice-based binomial model for the three months and nine months ended September 30, 2006 and 2005 are as follows:

11




 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Expected volatility range

 

40-43

%

32-52

%

35-49

%

32-52

%

Weighted-average expected volatility

 

41.3

%

42.0

%

41.6

%

42.0

%

Expected term (in years)

 

4.38

 

7.38

 

4.38-5.75

 

7.38

 

Risk-free interest rate

 

4.3-4.7

%

3.5-4.0

%

4.3-4.9

%

3.5-4.0

%

Expected dividends

 

 

 

 

 

 

Stock option activity for all plans during the nine months ended September 30, 2006 is as follows:

 

 

 

 

 

Weighted-

 

 

 

 

 

 

 

Weighted-

 

Average

 

 

 

 

 

 

 

Average

 

Remaining

 

Aggregate

 

 

 

 

 

Exercise

 

Contractual Term

 

Intrinsic Value

 

 

 

No. of Shares

 

Price

 

(in years)

 

(in thousands)

 

Outstanding at December 31, 2005

 

2,802,394

 

$

31.94

 

 

 

 

 

Granted

 

558,400

 

43.60

 

 

 

 

 

Exercised

 

(290,485

)

20.95

 

 

 

 

 

Forfeited

 

(92,647

)

49.82

 

 

 

 

 

Expired

 

 

 

 

 

 

 

Outstanding at September 30, 2006

 

2,977,662

 

$

34.63

 

6.85

 

$

38,404

 

 

 

 

 

 

 

 

 

 

 

Exercisable at September 30, 2006

 

1,736,811

 

$

26.11

 

5.43

 

$

34,302

 

 

The weighted-average grant-date fair value of options granted during the three and nine months ended September 30, 2006 was $18.07 and $18.85. The weighted-average grant-date fair value of options granted during the three and nine months ended September 30, 2005 was $32.91 and 27.09. The aggregate intrinsic value of options (the amount by which the stock price on the date of exercise exceeded the stock price of the option on the date of grant) exercised during the nine months ended September 30, 2006 and 2005 was $8.3 million and $25.6 million, respectively.

In February 2006, the Company entered into a transition agreement with its former Chief Financial Officer upon his retirement from the Company, which provided for the immediate acceleration of all of his outstanding options totaling 32,002 shares. Included in the stock-based compensation expense for the nine months ended September 30, 2006 is expense related to this acceleration of $0.8 million ($0.5 million net of tax).

Employee Stock Purchase Plan

Our Employee Stock Purchase Plan (the “ESPP”) is a tax-qualified employee stock purchase plan under which options are permitted to purchase our common stock at a price which is eighty-five percent of the stock’s fair market value on either the first or last day of the offering period, whichever price is lower. The options are then automatically exercised on the last business day of the offering periods, which end in June and December. The participants purchase the shares through payroll deductions.

The assumptions used to value the ESPP options under the lattice-based binomial model for the three months and nine months ended September 30, 2006 are as follows:

12




 

 

Three months ended

 

Nine months ended

 

 

 

September 30, 2006

 

September 30, 2006

 

Expected volatility range

 

34-40

%

32-40

%

Weighted-average expected volatility

 

36.9

%

36.5

%

Expected term

 

6 months

 

6 months

 

Risk-free interest rate

 

5.0

%

4.4-5.0

%

Weighted-average grant-date fair value

 

$

11.62

 

$

12.20

 

 

Total stock-based compensation expense recognized for ESPP options was $0.2 million and $0.6 million, respectively, for the three and nine months ending September 30, 2006.

Long Term Incentive Plan

In July 2005, the Company adopted the Long Term Incentive Plan (the “LTIP”), which provides equity incentives to senior management that include not only stock options or similar grants, but also a performance share program that measures performance on a multi-year basis. The performance period under the LTIP began on July 1, 2005 and ends on December 31, 2007. Awards under the LTIP are made under the 2004 Plan or any successor plan. It is expected that each participant will receive an annual grant of stock options under the 2004 Plan, pursuant to its terms. Performance shares in the form of common stock are earned by the participants based upon specified objective performance goals during the performance period of the LTIP. The number of shares issuable could change if we add or subtract executives to or from the plan. The compensation committee also has the discretion to make cash payments in lieu of performance shares. Any subsequent long-term incentive plans established during the performance period for inclusion of new participants are combined for reporting purposes with the LTIP.

The target number of performance shares potentially issuable under the LTIP is expected to be 250,912, with the actual number of shares ultimately issuable to be between zero and twice such amount, depending on actual performance and number of participants. Included in the target performance shares are 21,382 shares for two new executives added to the plan effective April 1, 2006. The performance period for these new participants began on April 1, 2006 and ends on December 31, 2007. The number of target shares was reduced in the third quarter of 2006 by 15,273 shares due to the departure of a participant. The previously recorded stock compensation expense related to this participant was reversed in the third quarter of 2006.

Stock-based compensation expense related to the LTIP is estimated based on forecasted performance during the performance period compared to plan targets. At the end of each reporting period, we reevaluate our assessment of performance under the plan and make adjustments to the expense as necessary based on the latest estimates available. The fair value of performance share awards is based on the market price of the Company’s stock on the date the underlying plan receives compensation committee approval, or other form of a mutual understanding of the key terms and conditions of performance.

For the three months ended September 30, 2006, the Company recorded a $0.1 million reduction to stock-based compensation expense related to the LTIP. For the nine months ended September 30, 2006, the Company recorded stock-based compensation expense related to the LTIP of $5.0 million ($3.1 million net of tax), or $0.10 per diluted share. Included in the $5.0 million expense is $1.8 million of stock-based compensation expense recorded in the first quarter of 2006 related to the LTIP that should have been recorded in the fourth quarter of 2005 under the variable plan accounting method established by APB No. 25. The Company does not believe that this misstatement is material to our current or previously issued consolidated financial statements.

Restricted Stock Awards/Deferred Stock Awards

Awards of restricted stock and deferred stock are generally made to the non-employee directors of the Company and are measured on the date of grant. These time-based awards vest over three to five years and are forfeitable under certain conditions.

A summary of the Company’s awards of performance shares, restricted stock, and deferred stock as of and for the nine months ended September 30, 2006 is presented below:

13




 

 

 

 

Weighted-Average

 

 

 

No. of Shares

 

Grant-Date Fair

 

 

 

(1)

 

Value

 

Nonvested balance at December 31, 2005

 

506,848

 

$

55.94

 

Granted

 

63,051

 

48.88

 

Vested

 

(2,014

)

49.93

 

Forfeited

 

(30,546

)

56.32

 

Nonvested balance at September 30, 2006

 

537,339

 

$

55.12

 

 


(1)           Represents the maximum number of shares that can be issued based on the achievement of certain performance criteria.

The total fair value of restricted stock and deferred stock vested during the nine months ended September 30, 2006 was immaterial. Based on our latest estimates, there was $6.7 million ($4.0 million net of tax) of total unrecognized compensation cost for nonvested shares, as of September 30, 2006, that is expected to be recognized over a weighted average period of 1.5 years.

7. Legal Proceedings

On November 29, 2005, a case was filed against the Company and other defendants, including our Chief Executive Officer, in the United States District Court for the Southern District of Florida. The amended complaint asserts, among other things, violations of the Federal Racketeering Influenced and Corrupt Organization Act (RICO) and a corresponding Florida statute, Sections 1 and 2 of the Sherman Antitrust Act, Section 2 of the Clayton Act (as amended by the Robinson-Patman Act), the Florida Antitrust Act of 1980, and the Florida Deceptive and Unfair Trade Practices Act, as well as tortious interference with business relationship under Florida law, various common law claims and civil conspiracy under Florida law by some or all of the identified defendants in connection with the claimed inability of Ace Pro Sound and Recording, L.L.C. to obtain vendor lines for its store. The complaint purports to be made as a class action on behalf of all current and former retail sellers of musical instruments and/or sound equipment and/or recording equipment with stores located in geographical regions in the United States wherein some or all of the defendants have carried on business, and seeks compensatory damages, treble damages, punitive damages, injunctive relief and attorneys’ fees.

The Company and the other defendants, under a joint defense agreement, have filed motions to dismiss all claims and the plaintiff has filed reply briefs.

While we believe this lawsuit is without merit and intend to defend it vigorously, it may, regardless of the outcome, result in substantial expenses and damages to us and may significantly divert the attention of our management. There can be no assurance that we will be able to achieve a favorable settlement of this lawsuit or obtain a favorable resolution of this lawsuit if it is not settled. An unfavorable resolution of this lawsuit could have a material adverse effect on our business, financial condition and results of operations. Regardless of the outcome, the costs and expenses incurred by us to defend this lawsuit could adversely impact our financial condition.

On October 13, 2004, a putative class action lawsuit entitled Carlos Rodriguez v. The Guitar Center, Inc. [sic], Case No. GC322958, was filed in the Superior Court of the State of California for the County of Los Angeles. The lawsuit was filed by an individual purporting to represent all hourly retail store employees employed by us within the State of California. On December 15, 2004, a putative class action lawsuit entitled James McClain et. al. v. Guitar Center Stores, Inc., Case No. BC326002, was filed in the Superior Court of the State of California for the County of Los Angeles. The lawsuit was filed by three individuals purporting to represent all hourly retail store employees employed by us within the State of California. Among other things, the lawsuits alleged that we improperly failed to document and enforce break-time and lunch-time periods for such employees and sought an unspecified amount of damages, penalties and attorneys’ fees. In July 2006, the court approved a final class action settlement. Pursuant to the settlement, the Company made payments to the class members in October 2006 of approximately $2.9 million to fully resolve claims by eligible class members.

In addition to the lawsuits described above, we are involved in various claims and legal actions arising in the ordinary course of our business and, while the results of those proceedings cannot be predicted with certainty, we believe that the final outcome of those matters will not have a material adverse effect on our business, financial condition and results of operations.

14




8. Common Stock

On April 28, 2006, the Company’s stockholders approved an amendment to the Restated Certificate of Incorporation to increase the number of authorized shares of common stock from 55 million to 100 million.

9. Conversion of Notes

On June 15, 2006, the Company called for redemption all of the outstanding Notes due 2013. The Notes were originally issued on June 13, 2003 in the aggregate principal amount of $100 million. Holders were able to convert the Notes into shares of common stock at an effective conversion price of approximately $34.58 per share, in lieu of accepting redemption. Prior to the redemption date of July 15, 2006, holders of substantially all of the remaining outstanding Notes elected to convert their Notes into shares of the Company’s common stock. As a result of these conversions, approximately 2.9 million shares of common stock were issued to the holders that elected to convert their Notes. In connection with the redemption of the unconverted Notes, the Company paid approximately $3,000 in cash, which includes the redemption and premium payments and cash paid in lieu of fractional shares. In conjunction with the redemption, the Company reclassified approximately $1.5 million of unamortized debt issuance costs from other assets to additional paid-in capital in the third quarter of 2006.

Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

Guitar Center, Inc. is the leading United States retailer of guitars, amplifiers, percussion instruments, keyboards and pro-audio and recording equipment.  As of September 30, 2006, our retail subsidiary operated 194 Guitar Center stores across the United States consisting of 132 primary format stores, 59 secondary format stores and 3 tertiary format stores. In addition, as of September 30, 2006, our Music & Arts Center division operated more than 90 stores specializing in band instruments for sale and rental, serving teachers, band directors, college professors and students. We are also the largest direct response retailer of musical instruments in the United States through our wholly owned subsidiary, Musician’s Friend, Inc., and its catalog and website, www.musiciansfriend.com.

During the third quarter, we opened a total of ten Guitar Center stores, including three primary format stores in Fairview Heights, Illinois, Fayetteville, Georgia and Lewisville, Texas, six secondary format stores in Allentown, Pennsylvania, Beaumont, Texas, Davenport, Iowa, Greensboro, North Carolina, Lubbock, Texas and Reno, Nevada and a tertiary format store in Sioux Falls, South Dakota . The new stores added 113,000 square feet of retail space and increased the retail space for Guitar Center stores to a total of 2.8 million square feet at the end of the third quarter of 2006.

As we enter new markets, we expect that we will initially incur higher administrative and promotional costs per store than is currently experienced in established markets. We expect competition to continue to increase as other music product retailers attempt to execute national growth strategies. Our business strategy will also emphasize opportunities to continue to grow each of our brands, including further acquisitions if attractive candidates can be located for reasonable prices.

Financial Reporting Change

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), Share–Based Payment (“SFAS No. 123(R)”), effective for a company’s first fiscal year beginning after June 15, 2005. SFAS No. 123(R) supersedes Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123(R) requires all share–based compensation to employees, including grants of employee stock options, to be recognized in the consolidated statements of income based on fair values rather than pro forma footnote disclosure.

15




Effective January 1, 2006, we adopted SFAS No. 123(R), and elected the modified prospective transition method. This method permits us to apply the new requirements on a prospective basis. For additional information on our adoption of SFAS No. 123(R), see Note 6, Stock–Based Compensation, of the Notes to Consolidated Financial Statements in this Quarterly Report on Form 10–Q.

Executive Summary

Consolidated net sales for the quarter ended September 30, 2006 increased 12.3%, or $51.7 million, to $472.7 million compared to $421.1 million in the third quarter of 2005. Consolidated net income for the quarter was $11.3 million, a decrease of 21.4% compared to the third quarter of 2005. Net income per diluted share decreased to $0.38 from $0.51 in the third quarter of 2005.

For the third quarter of 2006, our Guitar Center stores generated 2.9% comparable store sales growth and an increase of 13.7% in total net sales compared to the third quarter of 2005. Sales from new stores totaled $33.3 million and represented 78.8% of the overall increase in net sales. We opened ten new Guitar Center stores in the quarter. We continue to face a more challenging retail environment, which may impact sales and operating margins trends for the foreseeable future.

Musician’s Friend, our direct response unit, generated an increase in net sales for the third quarter of 6.5% to $86.1 million compared to $80.8 million in the third quarter of 2005. Gross profit margins increased by 0.9% of net sales compared to the third quarter of 2005, reflecting a higher selling margin offset somewhat by reduced shipping and handling revenue resulting from the competitive environment.

For the three months ended September 30, 2006, net sales for our Music & Arts Center segment increased 13.5% to $34.2 million from $30.1 million for the same period in 2005. The increase was generated primarily from newly acquired businesses. Comparable sales for the third quarter were down slightly by 0.2%. Gross profit margins declined by 5.2% of net sales compared to the third quarter of 2005. The decrease was primarily the result of lower selling margin, increased occupancy costs, and higher shrink expense.

Discussion of Critical Accounting Policies

In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of our financial statements in conformity with accounting principles generally accepted in the United States. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results and require management’s most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Additionally, the policy described below regarding credits and other vendor allowances is unique to our industry and deserves the attention of a reader of our financial statements.

Valuation of Inventory

We value our merchandise inventory at the lower of cost, using the weighted-average method, or market. Rental inventories are valued at the lower of cost or market using the specific identification method and are depreciated on a straight-line basis while out under a rental agreement for rent-to-own sales. We record adjustments to the value of inventory based upon obsolescence and changes in market value. Applicable costs associated with bringing inventory through our Guitar Center retail distribution center are capitalized to inventory. The amounts are expensed to cost of goods sold as the associated inventory is sold. Management has evaluated the current level of inventories considering future customer demand for our products, taking into account general economic conditions, growth prospects within the marketplace, competition, market acceptance of current and upcoming products, and management initiatives. Based on this evaluation, we have recorded impairment adjustments to inventory and to cost of goods sold for estimated decreases in net realizable value. These judgments are made in the context of our customers’ shifting needs, product and technological trends, and changes in the demographic mix of our customers. A misinterpretation or misunderstanding of these conditions and uncertainties in the future outlook of our industry or the economy, or other failure to estimate correctly, could result in inventory valuation changes as of any given balance sheet date.

Valuation of Long-Lived Assets

Long-lived assets such as property and equipment and identifiable intangibles with finite lives are reviewed for

16




impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Goodwill and other intangibles with indefinite lives that are not amortized are required to be reviewed for impairment on an annual basis, or more frequently when triggering events occur. Factors we consider important, which could trigger impairment, include, among other things:

·              Significant underperformance relative to historical or projected operating results;

·              Significant changes in the manner of our use of the acquired assets or the strategy of our overall business;

·              Significant negative industry or economic trends; and

·              Significant decline in stock value for a sustained period.

For long-lived assets other than goodwill and intangibles that are not amortized, the determination of whether impairment has occurred is based on an estimate of undiscounted future cash flows attributable to the assets, as compared to the carrying value of the assets. Assumptions used in these cash flows are consistent with internal forecasts and consider current and future expected sales volumes and related operating costs and any anticipated increases or declines based on expected market conditions and local business environment factors. If a potential impairment is identified, the amount of the impairment loss recognized would be determined by estimating the fair value of the assets and recording a loss if the fair value was less than the book value. Fair value will be determined based on appraisal values assessed by third parties, if deemed necessary, or a discounted future cash flows analysis. For goodwill and other intangibles that are not amortized, impairment to be recognized is measured as the amount by which the carrying amount of the assets exceeds the fair value of the related assets of the underlying reporting unit to which the goodwill relates.

Our assessment regarding the existence of impairment factors is based on market conditions and the operational performance of our business. Our review of factors present and the resulting appropriate carrying value of our goodwill, intangibles and other long-lived assets are subject to judgments and estimates that management is required to make.

Sales Returns

As part of our “satisfaction guaranteed” policy, we allow Guitar Center customers to return product generally within 30 days after the date of purchase, and we allow Musician’s Friend customers to return product within 45 days. Music & Arts Center customers have 30 business days from the date of purchase to return product. We regularly review and revise, when deemed necessary, our estimates of sales returns based upon historical trends. While our estimates during the past few years have approximated actual results, actual returns may differ significantly from estimate, either favorably or unfavorably, if factors such as economic conditions or the competitive environment differ from our expectations.

Credits and Other Vendor Allowances

We receive cooperative advertising allowances (i.e., an allowance from the manufacturer to subsidize qualifying advertising and similar promotional expenditures we make relating to the vendor’s products), price protection credits (i.e., credits from vendors with respect to in-stock inventory if the vendor subsequently lowers their wholesale price for such products) and vendor rebates (i.e., credits or rebates provided by vendors based on the purchase of specified products and paid at a later date). Cooperative advertising allowances are recognized as a reduction to selling, general, and administrative expense when we incur the advertising expense eligible for the credit. We recognized cooperative advertising allowances of $2.8 million and $2.6 million for the three months ended September 30, 2006 and 2005, respectively. For the nine months ended September 30, 2006 and 2005, we recognized $8.4 million and $6.5 million of cooperative advertising allowances. Price protection credits and vendor rebates are accounted for as a reduction of the cost of merchandise inventory and are recorded at the time the credit or rebate is earned. The effect of price protection credits and vendor rebates is recognized in the income statement at the time the related inventory is sold as a reduction in cost of goods sold. The reserves against cooperative advertising and rebate receivables are determined by specifically identifying uncollectible accounts through an aging review and an analysis of vendor relationships. We received payments for vendor rebates of $7.0 million and $6.1 million for the three months ended September 30, 2006 and 2005 and $24.6 million and $23.1 million for the nine months ended September 30, 2006 and 2005, respectively. We earned and recognized vendor rebates of $7.4 million and $7.7 million for the three months ended September 30, 2006 and 2005 and $23.4 million and $21.2 million for the nine months ended September 30, 2006 and 2005, respectively. None of these credits are recorded as revenue.

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Stock-based Compensation

Effective January 1, 2006, we adopted SFAS No. 123(R) to account for our stock-based compensation plans. We elected the modified prospective method of adoption, which permitted application of the new requirements on a prospective basis. Accordingly, prior period amounts have not been restated. Under this application, stock-based compensation is recorded for all awards granted on or after the date of adoption and for the portion of previously granted awards that remain unvested at the date of adoption. Currently, our stock-based compensation expense relates to stock options, our employee stock purchase program, performance share awards, restricted stock awards, and deferred stock awards.

Under SFAS No. 123(R), we determine the fair value of stock options, including options granted under our Employee Stock Purchase Plan (the “ESPP”), using a lattice-based binomial model. Assumptions used in the model were developed in consultation with an outside valuation specialist. The model requires the input of several assumptions including expected volatility, dividend yield, and risk-free rate of return, as well as certain assumptions regarding exercise behavior. Assumptions were developed separately for our senior management from the other participants of our stock plans, since senior management’s exercise behavior is expected to differ materially from the other participants. These assumptions reflect management’s best estimates, but they involve inherent uncertainties based on market conditions, generally outside of our control. As a result, if other assumptions were used, total stock-based compensation cost, as determined in accordance with SFAS No. 123(R) could have been materially impacted. Furthermore, if different assumptions are used for future grants, stock-based compensation could be materially impacted in future periods.

Also, under SFAS No. 123(R), stock-based compensation expense is recorded net of estimated forfeitures. The forfeiture rate assumption used in determining stock-based compensation expense is estimated based on historical data. The actual forfeiture rate could differ from these estimates.

Stock-based compensation expense related to performance share awards issued under our Long Term Incentive Plan (the “LTIP”) is estimated based on our forecasted performance compared to plan targets. At the end of each reporting period, we reevaluate our assessment of performance under the plan and make adjustments to the expense as necessary based on the latest estimates available. Under SFAS No. 123(R), the fair value of performance share awards is based on the market price of the Company’s stock on the date the underlying plan receives compensation committee approval, or other form of a mutual understanding of the key terms and conditions of performance.

Gift Cards

We sell gift cards to our customers in our Guitar Center retail stores. Revenue from gift card sales is recognized at redemption of the gift card. Our gift cards do not have expiration dates. Based on historical redemption rates, a certain percentage of gift cards will never be redeemed, which is referred to as “breakage.” Estimated breakage income is recognized as the remaining gift card values are redeemed and is recorded as a reduction of cost of goods sold.

Results of Operations

The following table presents our consolidated statements of income, as a percentage of sales, for the periods indicated:

 

 

 

Three months ended September 30,

 

Nine months ended September 30,

 

 

 

2006

 

2005

 

2006

 

2005

 

Net sales

 

100.0

%

100.0

%

100.0

%

100.0

%

Gross profit

 

28.2

 

29.4

 

28.6

 

28.7

 

Selling, general and administrative expenses

 

24.1

 

23.4

 

23.6

 

22.6

 

Operating income

 

4.1

 

6.0

 

5.0

 

6.1

 

Interest expense, net

 

0.5

 

0.5

 

0.5

 

0.4

 

Gain on sale of property

 

0.5

 

0.0

 

0.2

 

0.0

 

Income before income tax expense

 

4.1

 

5.5

 

4.7

 

5.7

 

Income taxes

 

1.7

 

2.1

 

1.8

 

2.2

 

Net income

 

2.4

%

3.4

%

2.9

%

3.5

%

 

Three Months Ended September 30, 2006 Compared to the Three Months Ended September 30, 2005

Consolidated net sales for the three months ended September 30, 2006 increased 12.3% to $472.7 million, compared

18




to $421.1 million for the same period in 2005.

Net sales from Guitar Center stores for the three months ended September 30, 2006 totaled $352.5 million, a 13.7% increase from $310.1 million for the same period in 2005. Sales from new stores were $33.3 million and represented 78.8% of the total increase in Guitar Center retail store sales. Comparable Guitar Center store sales for the third quarter increased 2.9%. Comparable store sales achieved this level despite experiencing a more challenging retail environment throughout the quarter. Comparable store sales are defined as sales for the comparable periods, excluding net sales attributable to stores not open for 14 months as of the end of the reporting period. We believe that comparable store sales are a more useful indicator of store performance than the change in total net sales, since comparable store sales exclude the effects of changes in the number of stores open. We continue to face a more challenging retail environment, which may impact sales and operating margin trends for the foreseeable future.

Net sales from the Music & Arts Center segment for the three months ended September 30, 2006 increased 13.5% to $34.2 million from $30.1 million for the same period in 2005. Substantially all of the sales growth for the third quarter of 2006 was generated from new locations, primarily acquired businesses and new affiliates. Comparable sales declined slightly by 0.2% in the third quarter of 2006.

Net sales from the Musician’s Friend channel totaled $86.1 million for the three months ended September 30, 2006, an increase of $5.3 million, or 6.5%, from the same period in 2005. The increase in sales primarily reflects the improved leveraging of an expanding buyer file and advertising strategies. We continue to face increased competition in the direct response channel, which we expect to impact that segment’s net sales and gross margin for the foreseeable future.

Consolidated gross profit for the three months ended September 30, 2006 compared to 2005 increased 7.6% to $133.3 million from $123.8 million. Gross profit as a percentage of net sales for the three months ended September 30, 2006 declined to 28.2% from 29.4% in the same period in 2005. As discussed below, we define selling margin as net sales less the cost of the associated merchandise charged by the vendor plus the associated inventory costs from fulfilling inventory through our distribution center. The cost of merchandise inventory is net of all associated vendor discounts and rebates. Freight is not included in selling margin.

Gross profit as a percentage of net sales for Guitar Center stores was 26.7% in the third quarter of 2006 compared with 28.1% in the third quarter of 2005. The decrease in gross margin was primarily due to higher occupancy costs of 0.8% and lower selling margin of 0.6%. The higher occupancy costs were primarily due to higher store rent and higher depreciation and amortization expense. The selling margin in the prior year period was impacted by the reduction in inventory reserves and benefits associated with unclaimed merchandise advances.

Gross profit for the Music & Arts Center segment was 39.0% for the three months ended September 30, 2006 compared to 44.2% for the same period in 2005. The decline in gross margin was primarily due to reduced selling margin of 3.1%, higher occupancy costs of 1.5% and higher shrink expense of 0.6%. The reduced selling margin was primarily due to adjustments in the prior year period to record higher vendor rebates of 1.7% and higher rental margins on the acquired contracts from the Music & Arts Center, Inc. acquisition of 1.0%. The higher occupancy costs were primarily due to higher rent expense. The higher shrink expense was impacted by higher instrument recoveries in the prior year period.

Gross profit for the Musician’s Friend segment was 30.0% for the three months ended September 30, 2006 compared to 29.1% in the third quarter of 2005. The increased gross margin was primarily due to higher selling margin of 1.2% partially offset by reduced shipping and handling revenue of 0.3%. Reduced shipping and handling revenue resulted from expanded free freight offers due to increased online competition.

Consolidated selling, general and administrative (SG&A) expenses for the three months ended September 30, 2006 increased 15.9% to $114.0 million from $98.4 million for the same period in 2005. As a percentage of net sales, SG&A expenses were 24.1% for the third quarter in 2006 compared to 23.4% in the third quarter of 2005. The increase was primarily due to higher stock-based compensation and increased promotional costs.

SG&A expenses for the Guitar Center division in the third quarter of 2006 were 21.5% as a percentage of net sales compared to 20.7% in the third quarter of 2005. The increase was primarily due to higher advertising costs of 0.6% and stock-based compensation expense of 0.2%. The higher advertising costs resulted primarily from increased promotional efforts to drive sales in the current quarter. The higher stock-based compensation consisted of expense for options and other stock awards of 0.5% offset by a decrease in expense under the LTIP of 0.3%.

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SG&A expenses for Music & Arts Center were 50.9% of net sales in the third quarter of 2006 compared to 48.5% in the third quarter of 2005. The increase was primarily due to higher salary expense of 2.0% and higher stock-based compensation expense of 0.8%. The salary expense was impacted by costs of expansion into Texas resulting from the closure of a competitor. The higher stock-based compensation consisted of expense for options and other stock awards of 0.5% and an increase in expense under the LTIP of 0.3%.

SG&A expenses for the Musician’s Friend division were 24.4% of sales in the third quarter of 2006 compared to 24.3% in the third quarter of 2005. The increase was primarily due to higher expenses for depreciation and amortization of 0.3%, computer maintenance of 0.2%, insurance of 0.2% and stock-based compensation of 0.3% offset by a reduction in advertising costs of 1.1%. The higher depreciation and amortization was primarily related to capital purchases for equipment and building improvements. The higher stock-based compensation consisted of expense for options and other stock awards of 1.3% offset by a decrease in expense under the LTIP of 1.0%. The lower advertising was primarily the result of reduced catalog circulation, offset somewhat by higher web-based marketing.

Consolidated operating income decreased 24.4% to $19.2 million for the three months ended September 30, 2006 from $25.5 million in the comparable 2005 period. As a percentage of net sales, consolidated operating income declined to 4.1% from 6.0% in the third quarter of 2005.

Interest expense, net for the three months ended September 30, 2006 increased to $2.2 million from $2.0 million in the third quarter of 2005. The increase was principally due to higher borrowings under the revolving credit facility used primarily to fund working capital requirements offset by reduced interest resulting from the conversion of the 4% senior notes in July 2006.

The gain on sale of property of $2.1 million in the third quarter of 2006 resulted from the disposition of real estate made available by the relocation of a Guitar Center store.

For the three months ended September 30, 2006, income tax expense was $7.9 million compared to $9.0 million for the same period in 2005. The effective tax rate in the third quarter increased to 41.0% compared to 38.5% in the prior year quarter. The rate increase was primarily due to the treatment of incentive stock options, or ISO’s, under SFAS 123(R). In addition, the rate was impacted by a partial reversal, amounting to $0.2 million, of the valuation allowance decrease recorded in the second quarter of 2006. The effective tax rate is subject to ongoing review and evaluation and may fluctuate in future quarters.

Consolidated net income for the three months ended September 30, 2006 decreased 21.4% to $11.3 million, compared to $14.4 million in the same period in 2005 as a result of the combinations of factors described above.

Nine Months Ended September 30, 2006 Compared to the Nine Months Ended September 30, 2005

Consolidated net sales for the nine months ended September 30, 2006 increased 14.9% to $1,401 million, compared to $1,220 million for the same period in 2005.

Net sales from Guitar Center stores for the nine months ended September 30, 2006 totaled $1,032 million, a 14.1% increase from $904.4 million for the same period in 2005. Sales from new stores were $84.5 million and represented 66.5% of the total increase in Guitar Center retail store sales. Comparable Guitar Center store sales increased 4.7% for the nine month period. We continue to face a more challenging retail environment, which may impact sales and operating margin trends for the foreseeable future.

On April 15, 2005, we completed our acquisition of Music & Arts Center, Inc., a Maryland-based musical instrument retailer with an emphasis on the beginning musician. The acquired business was combined with our former American Music business into a new division of our retail store subsidiary that operates under the Music & Arts Center name. Financial results for the period of January 1, 2005 through April 15, 2005 reflect only our former American Music stores and do not include results from the acquired business. However, comparable sales for the periods are computed using the combined comparable sales of Music & Arts Center, Inc. and American Music stores. Net sales from the Music & Arts Center division for the nine months ended September 30, 2006 totaled $99.2 million compared to $65.0 million for the same period in 2005. The increase in net sales is primarily due to the acquisition of Music & Arts Center, Inc. on April 15, 2005. Combined comparable sales increased 1.3% for the nine month period.

Net sales from the Musician’s Friend segment totaled $270.7 million for the nine months ended September 30, 2006, a $20.4 million, or 8.1%, increase from the same period in 2005. The increase in sales primarily reflects the improved

20




leveraging of an expanding buyer file and advertising strategies. We continue to face increased competition in the direct response channel, which we expect to impact that segment’s net sales and gross margin for the foreseeable future.

Consolidated gross profit for the nine months ended September 30, 2006 compared to 2005 increased 14.5% to $401.1 million from $350.3 million. Gross profit as a percentage of net sales for the nine months ended September 30, 2006 was 28.6% compared to 28.7% in the prior year period. As discussed below, we define selling margin as net sales less the cost of the associated merchandise charged by the vendor plus the associated inventory costs from fulfilling inventory through our distribution center. The cost of merchandise inventory is net of all associated vendor discounts and rebates. Freight is not included in selling margin.

Gross profit as a percentage of net sales for Guitar Center stores was 26.9% in the nine month period ended September 30, 2006 compared with 27.3% in the same period in 2005. The decline in gross profit was primarily due to higher occupancy costs of 0.5% partially offset by higher selling margin of 0.1%. The higher occupancy costs were primarily due to higher store rent and higher depreciation and amortization expense.

The gross profit margin for the Music & Arts Center division was 43.0% for the nine months ended September 30, 2006 compared to 42.2% for the same period in 2005. The margin improvement was primarily due to the write-down in the prior year period of $0.6 million, or 0.9% of sales, of inventory carried at American Music resulting from a change in product assortment. Excluding this prior year inventory write-down, the gross margin was 43.0% for both periods. In 2006, higher occupancy costs of 0.8% were offset by higher selling margin of 0.6% and lower shrink of 0.2%. The higher occupancy costs were primarily due to higher rent expense and higher telecommunications costs. The improved selling margin was driven by a change in product mix and better pricing under the Music & Arts business as compared to the American Music business in 2005. During 2005, we discontinued our low margin institutional business sales which are not part of our ongoing Music & Arts Center strategy. The lower shrink expense was due to higher instrument recoveries in the current period.

Gross profit margin for the Musician’s Friend division was 30.0% for the nine months ended September 30, 2006 compared to 30.3% in the same period in 2005. The decrease resulted primarily from reduced shipping and handling revenue of 1.3%, higher freight costs of 0.2% and increased purchasing costs of 0.1%, partially offset by higher selling margin of 1.3%. Reduced shipping and handling revenue resulted from expanded free freight offers due to increased online competition.

Consolidated SG&A expenses for the nine months ended September 30, 2006 increased 20.3% to $331.1 million from $275.3 million for the same period in 2005. As a percentage of net sales, SG&A expenses were 23.6% for the nine month period in 2006 compared to 22.6% in the same period in 2005. The increase was primarily due to the recognition of $14.9 million of stock-based compensation expenses in the current year consisting of expenses for stock options and other awards totaling $9.9 million, or 0.7% of sales, and expense under the LTIP totaling $5.0 million, or 0.4% of sales.  This was an increase in stock-based compensation expense of 0.9% of sales over the prior year period, which included $1.4 million of expense under the LTIP. The components of stock-based compensation for the nine months ended September 30, 2006 consisted of the following:

 

 

 

 

As a % of

 

 

 

Amount in

 

consolidated

 

 

 

millions

 

net sales

 

Stock-based compensation expense for the nine months ended September 30, 2006:

 

 

 

 

 

Stock options and other awards for the nine months ended September 30, 2006

 

$

9.1

 

0.6

%

Acceleration of stock option vesting related to the retirement of our former Chief Financial Officer in February 2006

 

0.8

 

0.1

%

Total expense from options and other awards

 

9.9

 

0.7

%

LTIP performance related to the fourth quarter of 2005

 

1.8

 

0.1

%

LTIP performance related to the nine months ended September 30, 2006

 

3.2

 

0.2

%

Total expense from LTIP

 

5.0

 

0.4

%

Total stock-based compensation expense

 

$

14.9

 

1.1

%

 

The stock-based compensation related to stock options, including the ESPP, and other awards was recorded as a

21




result of the adoption of SFAS No. 123(R) effective January 1, 2006. Upon the retirement of our former Chief Financial Officer announced in February 2006, all of his remaining unvested options totaling 32,002 shares immediately vested. Pursuant to SFAS No. 123(R), stock-based compensation expense in the amount of $0.8 million was recorded due to the vesting acceleration. A total of $5.0 million of stock-based compensation expense related to the LTIP was recorded in the nine months ended September 30, 2006. Included in this figure was $1.8 million of expense that should have been recorded in the consolidated financial statements in the fourth quarter of 2005. The error was discovered subsequent to the issuance of the 2005 consolidated financial statements. We do not believe that this misstatement is material to our current or previously issued consolidated financial statements. The remaining LTIP expense of $3.2 million relates to the initial adoption of SFAS No. 123(R) and recognition of performance under the LTIP provisions for the nine months ended September 30, 2006.

SG&A expenses for the Guitar Center division for the nine months ended September 30, 2006 were 21.3% as a percentage of net sales compared to 20.6% in same period in 2005. The increase was primarily due to higher expenses for stock-based compensation of 0.7%, advertising costs of 0.1%, store opening costs of 0.1% and credit card expenses of 0.1% offset by lower equipment rent costs of 0.2% and lower payroll and benefits of 0.2%.

SG&A expenses for Music & Arts Center were 47.3% of sales for the nine months ended September 30, 2006 compared to 53.0% in the same period in 2005. The reduction in expenses was primarily due to expenses totaling $2.8 million, or 4.3% of sales, recorded in the prior year period related to the acquisition of Music & Arts Center, Inc. consisting of the elimination of a redundant point of sales system, severance costs, and moving costs to relocate certain American Music employees to the Music & Arts corporate office in Maryland. Excluding the prior year acquisition-related expenses, the SG&A expenses decreased by 1.4% of sales compared to the prior year period, which is primarily due to improved leveraging on the higher revenue base of the combined businesses of Music & Arts Center, Inc. and American Music partially offset by stock-based compensation expenses of 1.4%.

SG&A expenses for the Musician’s Friend division were 23.8% of sales for the nine months ended September 30, 2006 compared to 21.8% for the same period in 2005. The increase was primarily due to higher expenses for stock-based compensation of 1.7%, payroll costs of 0.6%, insurance of 0.3% and depreciation and amortization of 0.2%, partially offset by lower advertising expense of 1.3%. Higher payroll costs were driven by higher office and warehouse salaries. The lower advertising was primarily the result of reduced catalog circulation, offset somewhat by higher web-based marketing.  Other smaller increases were experienced related to computer maintenance expense, bad debt expense and consulting expense.

Consolidated operating income decreased 6.7% to $70.0 million for the nine months ended September 30, 2006 from $75.1 million in the comparable 2005 period. As a percentage of net sales, consolidated operating income declined to 5.0% from 6.1% in the prior year period. This decline reflects the higher SG&A expenses resulting primarily from the recognition of stock-based compensation expenses in the current year period and a slight decrease in consolidated gross profit margin compared to the prior year period.

Interest expense, net for the nine months ended September 30, 2006 increased to $6.4 million from $4.8 million in the comparable 2005 period. The increase was due to higher borrowings under the revolving credit facility used primarily to fund the acquisition of Music & Arts Center, Inc. on April 15, 2005 and increased working capital requirements offset somewhat by reduced interest resulting from the conversion of the 4% senior notes in July 2006.

The gain on sale of property of $2.1 million recorded in the third quarter of 2006 resulted from the disposition of real estate made available by the relocation of a Guitar Center store.

For the nine months ended September 30, 2006, income tax expense was $25.3 million compared to $27.0 million for the same period in 2005. The effective tax rate for the nine months ended September 30, 2006 was 38.4%, compared to 38.5% in the prior year period. The slightly lower rate was the result of a $0.8 million, or $0.03 per diluted share, reduction in the current period of a valuation allowance related to a capital loss recorded in 2001. Substantially offsetting this was a rate increase associated with the treatment of incentive stock options, or ISO’s, under SFAS 123(R).

Consolidated net income for the nine months ended September 30, 2006 decreased 6.4% to $40.5 million, compared to $43.2 million in the same period in 2005 as a result of the combinations of factors described above.

Liquidity and Capital Resources

Our need for liquidity will arise primarily from the funding of capital expenditures, working capital requirements and payments on our indebtedness, as well as possible acquisitions. We have historically financed our operations primarily

22




through internally generated funds and borrowings under our credit facilities. Please see “Risk Factors” in our Annual Report on Form 10-K filed for the year ended December 31, 2005 for a discussion of factors which could reasonably likely result in a decrease in the amount of internally generated funds available to finance capital expenditures and working capital requirements. As of September 30, 2006, we had $147.4 million in borrowings outstanding under our credit facility and had available borrowings of $46.3 million (net of $6.2 million of outstanding letters of credit).

Our credit facility with a syndicate of banks led by Wells Fargo Retail Finance, as amended through April 26, 2006, permits borrowings up to $200 million (which may be increased to $250 million at our option), subject to borrowing base limitations. The actual amount available is tied to our inventory and receivable base, and our obligations under the credit facility are secured by liens on our principal assets. Borrowing options are prime rate plus applicable prime margin, or London Interbank Offered Rate (“LIBOR”), plus applicable LIBOR margin. The applicable prime and LIBOR margins are based upon levels of excess availability and adjusted quarterly. If excess availability is greater than $30 million, the applicable prime margin is -0.25% and applicable LIBOR margin is 0.75%. If excess availability is less than or equal to $30 million and greater than $15 million, the applicable prime margin is 0.00% and the applicable LIBOR margin is 1.00%. If excess availability is less than or equal to $15 million, the applicable prime margin is 0.00% and the applicable LIBOR margin is 1.25%. An unused fee of 0.25% is assessed on the unused portion of the credit facility. The agreement underlying the credit facility includes significant restrictive negative covenants. Among other things, these covenants restrict or prohibit our ability to incur debt and issue specified equity instruments, incur liens on our assets, make any significant changes in our corporate structure or the nature of our business, dispose of assets, make guaranties, prepay debt, engage in a change in control transaction, pay dividends, make investments or acquisitions, engage in transactions with affiliates and incur capital expenditures. The agreement also includes representations and warranties which must be true each time we borrow funds under the credit facility and affirmative covenants. The full text of the contractual requirements imposed by this financing is set forth in the Amended and Restated Loan and Security Agreement and related amendments which have been filed with the Securities and Exchange Commission (SEC). Subject to limited cure periods, the lenders under our credit facility may demand repayment of these borrowings prior to stated maturity upon the occurrence of specified events, including if we breach the terms of the agreement, suffer a material adverse change, engage in a change in control transaction, suffer a significant adverse legal judgment, default on other significant obligations, or in the event of specified events of insolvency. The credit agreement matures in December 2011.

During 2002 we entered into master operating lease agreements with General Electric Capital Corporation and US Bank to lease equipment and other property primarily to support the operations of the distribution center for our Guitar Center retail stores. Under these agreements, we leased a total of $10.5 million in equipment and other property.

The terms of our significant financing agreements, including those related to our credit facility and the equipment lease facilities described above, are not dependent on any change in our credit rating. We believe that the key company-specific factors affecting our ability to maintain our existing debt and lease financing relationships and to access such capital in the future are our present and expected levels of profitability and cash flow from operations, our working capital and fixed asset collateral bases, our expected level of capital expenditures, and the level of our equity capital relative to the level of debt obligations. In addition, as noted above, our existing agreements include significant restrictions on future financings, including among others, limits on the amount of indebtedness that we may incur and whether or not such indebtedness may be secured by any of our assets.

As is the case with most multi-unit retailers, substantially all of the real property used in our business is leased under operating lease agreements. Please see Item 2. Properties, “—Disclosures About Contractual Obligations and Commercial Commitments” and Note 8 to the Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2005. We anticipate making additional capital investments of $4.0 million to $5.0 million in the fourth quarter of 2006 in connection with the expansion of our Guitar Center distribution center and the new corporate office build out, and we expect to incur increased rent expense for the expanded distribution center starting during the fourth quarter of 2006. On March 30, 2006, our Musician’s Friend division executed a lease agreement for a new distribution center for our direct response business that will have a capacity significantly exceeding the capacity of the current distribution center that it will replace. This lease is treated as an operating lease for accounting purposes. Details of the lease agreement were included in the Current Report on Form 8-K we filed on March 30, 2006. In August 2006, we entered into a master operating lease agreement to lease equipment totaling approximately $13 million to support the operations of the distribution center for our Musician’s Friend division.

Net cash used in operating activities was $49.0 million for the nine months ended September 30, 2006 compared to net cash provided by operating activities of $4.3 million for the same period in 2005. The primary uses of cash during the nine months ended September 30, 2006 were an increase in merchandise inventories of $104.2 million and a decrease in accrued expenses and other current liabilities of $39.1 million. The increase in merchandise inventories was primarily due to

23




the 29 Guitar Center stores opened in the current period and an increase in business volumes across all segments.  The reduction of accrued expenses and other current liabilities was primarily due to payments of income taxes and sales taxes. The primary sources of cash were generated from the current period earnings and an increase in accounts payable of $31.3 million due mostly to higher business volumes and timing of vendor payments.

Cash used in investing activities was $79.8 million for the nine months ended September 30, 2006 compared to $142.1 million for the same period in 2005. The cash used in investing activities for the nine months ended September 30, 2006 included $61.5 million of capital expenditures, comprised primarily of $34.4 million on new stores and remodels, $11.0 million on computer equipment purchases and $7.4 million related to the expansion of our distribution center facilities. Also, our acquisition of businesses for the Music & Arts Center division totaled $9.8 million for the nine months ended September 30, 2006. During the second quarter of 2006, we also acquired four retail locations of Hermes Trading Company, Inc. for approximately $11.0 million.

Cash provided by financing activities totaled $124.5 million for the nine months ended September 30, 2006 compared to $85.1 million in the same period in 2005. The cash provided by financing activities in the nine months ended September 30, 2006 was due to increased borrowings under the revolving line of credit to support business acquisitions, capital expenditures and working capital requirements.  In addition, proceeds from the exercise of stock options provided $8.1 million (including $2.0 million in excess tax benefits that are reflected in cash flows from financing activities) and employee purchases of our common stock under the ESPP provided $1.2 million.

We believe that our current operating cash flows, working capital, cash on hand, borrowings available under our credit facility and other sources of liquidity will be sufficient to meet our obligations in the ordinary course of business over the next twelve months, including capital expenditures and new store openings. We anticipate our capital expenditures will be between $26.0 million and $30.0 million for the fourth quarter of fiscal 2006.

Our known capital resource and liquidity requirements for 2006 are expected to be primarily provided by net cash flow from operations and borrowings available under our credit facility. Traditionally, we have experienced the largest use of cash from operating activities in the latter part of the third quarter and in the fourth quarter due to the build up of inventory to support the holiday season, resulting in additional borrowings under our line of credit. We believe that our borrowing ability under our amended credit facility will be sufficient to provide the seasonal liquidity we believe will be required during the 2006 fiscal year.

Depending upon market conditions, we may also elect or be required to raise additional capital in the form of common or preferred equity, debt or convertible securities for the purpose of providing additional capital to fund working capital needs or continued growth of our existing business or to refinance existing obligations. Any such financing activity will be dependent upon many factors, including our liquidity needs, market conditions and prevailing market terms, and we cannot assure you that future external financing for us will be available on attractive terms or at all. If we require but are unable to obtain additional liquidity on favorable terms, we may be required to curtail our growth plans and our financial condition and results of operations would likely be materially adversely impacted.

In 2006, we are pursuing an aggressive growth strategy by opening additional stores in new and existing markets. During the nine months ended September 30, 2006, we opened a total of 29 new Guitar Center stores, consisting of 10 primary format stores, 17 secondary format stores and 2 tertiary format stores. We expect our cost of capital improvements for a primary format Guitar Center store to average approximately $1.2 million consisting of leasehold improvements, fixtures and equipment. A new primary format store is also expected to require approximately $2.0 to $2.5 million in gross inventory. We have developed secondary format Guitar Center stores to build in sites that we do not believe will support our primary format units. For our secondary market stores, we expect to require an average of approximately $0.9 million in capital improvements and approximately $1.7 to $2.0 million in gross inventory. Our first tertiary format store to serve smaller population centers was opened in late 2005 and we have opened two more stores in 2006. For our tertiary format stores, we expect to require an average of approximately $0.6 million in capital improvements and approximately $1.0 million in gross inventory. These capital expenditures reflect the increasing construction costs that we have been experiencing. We expect these increases to continue for the foreseeable future, and these costs may increase above our expectations.

We are also anticipating additional capital and strategic investments related to improving our fulfillment facilities and upgrading our technology and systems, including an enterprise data warehouse, retail point of sale system replacement, retail inventory management systems improvements, and enterprise systems replacement for our direct response division. We also continue to make significant investments in information technology across our businesses and to incur costs and make investments designed to expand the reach of our businesses on the Internet. The costs of these initiatives and other

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investments related to our businesses will continue to be significant.

Throughout our history, we have primarily grown organically. However, we also believe there may be attractive opportunities to expand by selectively acquiring existing music products retailers or other complimentary businesses, if attractive opportunities can be identified. We believe that our growth at Music & Arts Center will in large part be driven through many small acquisitions. While we cannot provide assurance that we will complete any further acquisition transactions, in the ordinary course of our business we investigate and engage in negotiations regarding such opportunities. Acquisitions will be financed with cash on hand, drawings under our existing credit facilities, expansion of our credit facilities, issuance of debt or equity securities, or a combination, depending upon transaction size and market conditions, among other things.

Recently Issued Accounting Pronouncements

In June 2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes.” FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” This Interpretation defines the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. FIN 48 is effective for fiscal years beginning after December 15, 2006. We are currently evaluating the effect that the adoption of FIN 48 will have on our financial position and results of operations.

In June 2006, the FASB ratified Emerging Issues Task Force issued Issue 06-3, “How Sales Taxes Collected From Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement” (EITF 06-3). EITF 06-3 requires a company to disclose its accounting policy (i.e., gross or net presentation) regarding the presentation of taxes within the scope of EITF 06-3. If taxes are significant, a company should disclose the amount of such taxes for each period for which an income statement is presented. The guidance is effective for periods beginning after December 15, 2006. We are currently evaluating the effect that the adoption of EITF 06-3 will have on our financial position and results of operations.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (SAB 108), to address diversity in practice in quantifying financial statement misstatements. SAB 108 requires that we quantify misstatements based on their impact on each of our financial statements and related disclosures. SAB 108 is effective as of the end of our 2006 fiscal year, allowing a one-time transitional cumulative effect adjustment to retained earnings as of January 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB 108. We are currently evaluating the impact, if any, adopting SAB 108 will have on our consolidated financial statements.

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements.” SFAS No. 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. SFAS No. 157 is effective for fiscal years beginning after November 15, 2007. We are currently evaluating the impact, if any, the adoption of SFAS No. 157 will have on our operating income or net income.

Seasonality

Our business follows a seasonal pattern, peaking during the holiday selling season in November and December. Sales in the fourth quarter are typically significantly higher on a per store basis and through the direct response unit than in any other quarter. In addition, band rental season for our Music & Arts Center business starts in August and carries through mid-October, but that seasonality does not have a significant impact on our consolidated results.

Inflation

We believe that the relatively moderate rates of inflation experienced in recent years have not had a significant impact on our net sales or profitability. However, in 2006, we have been experiencing rising steel, lumber, concrete, labor, fuel and freight costs related to opening, remodeling, operating and relocating our stores, expanding our distribution centers and operating our business.

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Forward-Looking Statements; Business Risks

This report contains forward-looking statements relating to, among other things, future results of operations, growth and investment plans, sales, trends in gross margin, growth in the Internet portion of our direct response business and other factors affecting growth in sales and earnings. Specific forward-looking statements are provided regarding our management’s current views regarding new store openings, capital expenditure levels and the dates new facilities and systems will become operational. Statements regarding new store openings are based largely on our current expectations and are necessarily subject to associated business risks related to, among other things, the identification of suitable sites or acquisition opportunities, the timely construction, staffing and merchandising of those stores and other matters, some of which are outside of our control. Statements regarding the dates new facilities and systems will become operational are dependent upon third parties and events beyond our control, such as the availability of third party consulting resources, construction delays, technology development delays and other events. Sales and earnings trends are also affected by many other factors including, among others, world and national political events, including general economic conditions, the effectiveness of our promotion and merchandising strategies, our ability to integrate and profitably operate acquired businesses, the efficient operation of our supply chain, including the continued support of our key vendors, our effective management of business risks, including litigation, and competitive factors applicable to our retail and direct response markets.

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

Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We do not have any assets or liabilities which, in our view, impose upon us significant market risk except for our credit facility which has a variable rate of interest generally consisting of stated premiums above LIBOR. At September 30, 2006, we had $147.4 million in outstanding borrowings under our credit facility. As short-term interest rates fluctuate, the interest expense we incur on our credit facility will change resulting in either a positive or negative effect on our financial position, results of operations and cash flows. At this borrowing level for our credit facility, a one percentage point increase in interest rates would have an unfavorable impact on pre-tax earnings of $1.5 million on an annual basis. The primary interest rate exposure on the credit facility is based on LIBOR. We do not use derivative financial instruments in our investment portfolio. Historically, we have not carried significant cash balances and any cash in excess of our daily operating needs has been used to reduce our borrowings. Excess cash is generally invested in short-term, high quality interest bearing investments.

Item 4. CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed pursuant to the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to provide reasonable assurance that information relating to us and our subsidiaries that we are required to disclose in the reports that we file or submit to the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Part II.  OTHER INFORMATION

Item 1. Legal Proceedings

For information on legal proceedings, see Note 7 of Notes to Consolidated Financial Statements “Legal Proceedings”, which is incorporated by reference in response to this Item 1.

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Item 1A. Risk Factors

Except for the risk factors set forth below, there have been no material changes to the risk factors disclosed in Item 1A of Part 1 in our Form 10-K for the year ended December 31, 2005. The risk factors set forth below were disclosed in our Form 10-K, but have been updated to provide additional information.

Our failure to maintain and expand our distribution centers could adversely impact our business.

We are in the process of significantly expanding our Guitar Center and direct response distribution centers to increase our capacity to support continued expansion. We have made, and expect to continue to make, significant capital investments in these facilities. We expect to incur increased rent starting during the fourth quarter of 2006 for our new Guitar Center distribution center. The lease for our direct response distribution center expires in the third quarter of 2007. We are in the process of constructing a larger replacement distribution center for our direct response business, and expect to complete that facility prior to the expiration of the lease on our existing facility. Our failure to complete our expansions and replacements on time and on budget may result in the need for us to expend additional capital and may impair the efficient operation of our distribution system, which could materially adversely impact our business, results of operations, financial condition and prospects.

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

Our success depends to a significant extent on the services of members of our senior management. The loss of one or more of these individuals or other key personnel could have a material adverse effect on our business, results of operations, liquidity and financial position. In particular, two members of senior management at our direct response business have left the company in 2006. The departure of these individuals has increased the strain on management capacity, and the departure of further senior management at our direct response business could further strain management capacity. The departures that have occurred in 2006, or future departures, may adversely impact the results of our direct response business.

Historically, we have promoted employees from within our organization to fill senior operations, sales and store management positions. In order to achieve our growth plans, we depend upon our ability to retain and promote existing personnel to senior management, and we must attract and retain new personnel with the skills and expertise to manage our business. If we cannot hire, retain and promote qualified personnel, our business, results of operations, financial condition and prospects could be adversely affected.

Item 6.  Exhibits

 

Exhibit
Number

 

Description

31.1

 

Certification of the Company’s Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2

 

Certification of the Company’s Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1

 

Certification of the Company’s Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2

 

Certification of the Company’s Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized as of the 7th day of November 2006.

 

Guitar Center, Inc.

 

 

 

/s/ ERICK MASON

 

 

 

 

Erick Mason, Executive Vice President and

 

Chief Financial Officer

 

 

 

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