2. Goodwill and Intangible Assets

We have goodwill at our Guitar Center reporting unit, which is also an operating segment. We also have intangible assets primarily related to trademarks, customer relationships and favorable leases.

Goodwill impairment

In performing the qualitative assessments of our Guitar Center reporting unit as of October 1, 2012 and 2011, we considered macroeconomic conditions, industry and market conditions such as competition and the regulatory environment and entity-specific events that can affect the estimated fair value of a reporting unit. We determined that facts and circumstances did not indicate that the goodwill of the reporting unit was more likely than not impaired. Accordingly, we did not perform the quantitative goodwill impairment test for the Guitar Center reporting unit in 2012 or 2011.

Our qualitative assessment of our direct response reporting unit as of October 1, 2011 initially indicated that its goodwill was not more likely than not impaired. Before concluding the goodwill impairment test, revenue and operating income began to fall significantly below management’s expectations during the critical holiday selling season in November and December. We therefore determined it was appropriate to update our revenue and net cash flow projections and proceed to the two step goodwill impairment test and include updated information based on our fourth quarter results.

In performing step 1 of the goodwill impairment test of the direct response reporting unit, we used a discounted cash flow analysis and a market multiple analysis, equally weighted, to determine the estimated fair value of the reporting unit. We used discount rates that ranged from 14.0% to 15.0% for the discounted cash flow analysis. In addition, we used the Gordon Growth Method, for which the terminal capitalization rates used ranged from 0.5% to 1.5%. In the market multiple analysis, we used multiples based on earnings before interest, taxes, depreciation and amortization that ranged from 3.5x to 4.5x. The results of the step 1 impairment test indicated that there was a potential impairment of goodwill, as the carrying amount of the reporting unit exceeded its estimated fair value.

Consequently, we performed step 2 of the goodwill impairment test for the direct response reporting unit. The step 2 analysis resulted in an impairment charge of $107.0 million, which represented the remaining goodwill carrying amount. The primary reason for the decrease in estimated fair value of the direct response reporting unit with respect to the market multiple analysis and discounted cash flow analyses was decreased cash flow projections for the reporting unit. We reduced our cash flow projections for the reporting unit due to revenue and operating income results that were significantly below management’s expectations during the 2011 holiday selling season and uncertainty about how effectively the direct response reporting unit will emerge from the restructuring activities of 2011, our ability to optimize its new web platform and the extent to which intensifying e-commerce competition will continue to affect its operating results in future periods.

In 2010, the results of the step 1 process did not indicate a potential impairment of goodwill in the Guitar Center reporting unit or the direct response reporting unit, as the estimated fair values of the reporting units exceeded their carrying amounts. As a result, we did not complete step 2 of the goodwill impairment test for either reporting unit. In performing the step 1 process in 2010, we used discount rates that ranged from 11.0% to 14.0% and Gordon Growth terminal capitalization rates that ranged from 3.0% to 5.0%.

Goodwill allocation

In the first quarter of 2011, we reorganized our operating segments to emphasize a brand reporting structure. As a result of this change, the Guitar Center segment includes the sales and operating expenses of our Guitar Center online operations together with the sales and operating expenses of Guitar Center stores. Similarly, the Music & Arts segment includes the sales and operating expenses of our Music & Arts online operations with those of Music & Arts stores. We had previously reported the results of our Guitar Center and Music & Arts online operations with the direct response segment.

We reallocated goodwill from the direct response segment to the Guitar Center segment based on the relative fair values of the www.guitarcenter.com and direct response components. We did not allocate any goodwill to the www.musicarts.com component, as its net sales and operating income were not material in relation to the direct response segment as a whole.

In determining the estimated fair values of the direct response and guitarcenter.com components, we used a market multiple and a discounted cash flow analysis, as used for the annual goodwill impairment test. We used discount rates of 12.5% to 14.0% for the discounted cash flow analysis as of January 1, 2011. In addition, we used the Gordon Growth Method, for which the terminal capitalization rates used ranged from 4.8% to 5.0%.

Based on the results of this analysis, we reallocated $61.8 million of goodwill from the direct response segment to the Guitar Center segment.

The following table presents an analysis of the changes in goodwill by segment (in thousands):

	Guitar			Direct
	Center			Response			Total
Balance at December 31, 2010
Goodwill	$	644,393		$	170,718		$	815,111
Accumulated impairment losses	(123,804		)	(1,903		)	(125,707		)
	520,589			168,815			689,404

Reasssignment of goodwill upon change in operating segments	61,789			(61,789		)	—

Goodwill impairment	—			(107,026		)	(107,026		)

Balance at December 31, 2011
Goodwill	706,182			108,929			815,111
Accumulated impairment losses	(123,804		)	(108,929		)	(232,733		)
	582,378			—			582,378

Balance at December 31, 2012
Goodwill	706,182			—			706,182
Accumulated impairment losses	(123,804		)	—			(123,804		)
	$	582,378		$	—		$	582,378

Goodwill impairment did not result in non-compliance under our debt covenants.

Other intangible assets

We recognized impairment charges of $32.5 million in 2011 related to our direct response indefinite-lived trademarks.

The decline in estimated fair value of our direct response trademarks in 2011 was due to changes in management’s expectations about future operating results for our direct response segment. We significantly reduced our revenue and operating income projections for these brands due to revenue and operating income results that were significantly below management’s expectations during the 2011 holiday selling season and uncertainty about the growth of these brands and the restructuring activities of 2011. The reduced projections prompted us to use a lower royalty rate in the discounted cash flow analysis. In addition, we used a higher discount rate, primarily in applying a size risk premium based on market observations for similarly-sized companies.

We recognized impairment charges of $13.5 million in 2011 related to our direct response customer relationship intangible asset. Management determined that the carrying amount of the asset was not recoverable, primarily based on reduced revenue and operating income projections for our direct response segment. Because the direct response segment experienced a downward trend in revenue due to increasing competition and fell significantly below management’s expectations during the holiday selling season in 2011, revenue and operating income projections for the segment were reduced accordingly.

See Note 11 for more information about fair value measurements for our other intangible assets.

The following tables present a summary of our intangible assets (dollars in thousands, life in years):

		December 31, 2012
	Weighted-	Gross
	Average Useful	Carrying		Accumulated			Intangible
	Life	Amount		Amortization			Assets, Net
Unamortized trademark	—	$	208,501	$	—		$	208,501
Amortized
Customer relationships	13.0	224,302		(148,042		)	76,260
Favorable lease terms	7.5	57,721		(51,323		)	6,398
Covenants not to compete and other	4.3	785		(675		)	110
		$	491,309	$	(200,040	)	$	291,269

		December 31, 2011
	Weighted-	Gross
	Average Useful	Carrying		Accumulated			Intangible
	Life	Amount		Amortization			Assets, Net
Unamortized trademark	—	$	208,501	$	—		$	208,501
Amortized
Customer relationships	13.0	224,302		(125,049		)	99,253
Favorable lease terms	7.5	57,721		(45,436		)	12,285
Covenants not to compete and other	4.5	875		(774		)	101
		$	491,399	$	(171,259	)	$	320,140

We include amortization of favorable leases in cost of goods sold, buying and occupancy. We include amortization of other intangible assets such as customer relationships and non-compete agreements in selling, general and administrative expenses.

Amortization expense included in the consolidated statements of comprehensive income or loss was as follows (in thousands):

	Year ended December 31,
	2012		2011
Cost of goods sold, buying and occupancy	$	5,887	$	7,486
Selling, general and administrative expenses	23,093		35,396

The estimated amortization expense related to intangible assets for each of the next five years and thereafter as of December 31, 2012 was as follows (in thousands):

Year
2013	$		22,227
2014	16,387
2015	12,442
2016	9,640
2017	7,620
Thereafter	14,452
Total	$	82,768