10-Q 1 a13-19260_110q.htm 10-Q

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x

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

 

For the quarterly period ended September 30, 2013

 

OR

 

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 Number 333-175270-07

 

GUITAR CENTER HOLDINGS, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

Delaware

 

26-0843262

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer Identification No.)

 

 

 

5795 Lindero Canyon Road

Westlake Village, California 91362

 

(818) 735-8800

(Address of Principal Executive Offices, including Zip Code)

 

(Registrant’s Telephone Number, Including Area Code)

 

Commission File Number 000-22207

 

GUITAR CENTER, INC.

(Exact Name of Registrant as Specified in Its Charter)

 

Delaware

 

95-4600862

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer Identification No.)

 

 

 

5795 Lindero Canyon Road

Westlake Village, California 91362

 

(818) 735-8800

(Address of Principal Executive Offices, including Zip Code)

 

(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.

 

Holdings*

 

 

 

YES o NO o

 

 

Guitar Center*

 

 

 

YES o NO o

 

 

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

Holdings

 

 

 

YES x NO o

 

 

Guitar Center

 

 

 

YES x NO o

 

 

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act:

 

Holdings

 

Large accelerated filer o

 

 

 

Accelerated filer o

Non-accelerated filer x

 

(Do not check if a smaller reporting company)

 

Smaller reporting company o

 

Guitar Center

 

Large accelerated filer o

 

 

 

Accelerated filer o

Non-accelerated filer x

 

(Do not check if a smaller reporting company)

 

Smaller reporting company o

 

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

 

Holdings

 

 

 

YES o NO x

 

 

Guitar Center

 

 

 

YES o NO x

 

 

 

As of November 8, 2013 there were 9,740,160 shares of common stock, $0.01 par value per share, of Holdings outstanding.

 

As of November 8, 2013, there were 100 shares of common stock, $0.01 par value per share, of Guitar Center outstanding, all of which are owned by Holdings.

 


*The registrants have filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934, but are not required to file such reports under such sections.

 

 

 



Table of Contents

 

Explanatory Note

 

This quarterly report on Form 10-Q is a combined quarterly report being filed by Guitar Center, Inc. (“Guitar Center”) and Guitar Center Holdings, Inc. (“Holdings”). Guitar Center is a direct, wholly-owned subsidiary of Holdings. Each of Guitar Center and Holdings is filing on its own behalf all of the information contained in this quarterly report that relates to such company. Where information or an explanation is provided that is substantially the same for each company, such information or explanation has been combined in this quarterly report. Where information or an explanation is not substantially the same for each company, separate information and explanation has been provided. In addition, separate condensed consolidated financial statements for each company are included in this quarterly report.

 



Table of Contents

 

 

PART I - FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements

1

 

 

 

 

Guitar Center Holdings, Inc. and Subsidiaries

1

 

 

 

 

Condensed Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012 (unaudited)

1

 

 

 

 

Condensed Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2013 and 2012 (unaudited)

2

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012 (unaudited)

3

 

 

 

 

Guitar Center, Inc. and Subsidiaries

4

 

 

 

 

Condensed Consolidated Balance Sheets as of September 30, 2013 and December 31, 2012 (unaudited)

4

 

 

 

 

Condensed Consolidated Statements of Comprehensive Loss for the three and nine months ended September 30, 2013 and 2012 (unaudited)

5

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2013 and 2012 (unaudited)

6

 

 

 

 

Guitar Center Holdings, Inc. and Subsidiaries and Guitar Center, Inc. and Subsidiaries

7

 

 

 

 

Combined Notes to Condensed Consolidated Financial Statements (unaudited)

7

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

25

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

38

 

 

 

Item 4.

Controls and Procedures

38

 

 

 

 

PART II - OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

39

 

 

 

Item 1A.

Risk Factors

39

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

39

 

 

 

Item 3.

Defaults Upon Senior Securities

39

 

 

 

Item 4.

Mine Safety Disclosures

39

 

 

 

Item 5.

Other Information

39

 

 

 

Item 6.

Exhibits

40

 

 

 

Signatures

 

41

 



Table of Contents

 

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except par values)

(unaudited)

 

 

 

September 30,
2013

 

December 31,
2012

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash

 

$

26,026

 

$

74,836

 

Accounts receivable, net of allowance for doubtful accounts of $2,829 and $2,849, respectively

 

43,041

 

44,015

 

Merchandise inventories

 

611,720

 

564,959

 

Prepaid expenses and other current assets

 

28,175

 

23,285

 

Deferred income taxes

 

3,164

 

3,165

 

Total current assets

 

712,126

 

710,260

 

Property and equipment, net of accumulated depreciation and amortization of $294,049 and $250,835, respectively

 

206,598

 

213,969

 

Goodwill

 

222,517

 

582,378

 

Intangible assets, net of accumulated amortization of $182,016 and $200,040, respectively

 

272,610

 

291,269

 

Other assets, net

 

18,963

 

18,682

 

Total assets

 

$

1,432,814

 

$

1,816,558

 

 

 

 

 

 

 

Liabilities and Stockholders’ Deficit

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

152,183

 

$

116,973

 

Accrued expenses and other current liabilities

 

138,420

 

132,119

 

Merchandise advances

 

30,239

 

34,901

 

Current portion of long-term debt

 

6,764

 

135,725

 

Total current liabilities

 

327,606

 

419,718

 

Other long-term liabilities

 

21,666

 

20,669

 

Deferred income taxes

 

79,066

 

79,537

 

Long-term debt

 

1,605,848

 

1,445,654

 

Total liabilities

 

2,034,186

 

1,965,578

 

Commitments and contingencies

 

 

 

 

 

Stockholders’ deficit:

 

 

 

 

 

Preferred stock, $0.01 par value, 5,000 shares authorized, none issued and outstanding

 

 

 

Common stock, $0.01 par value, 20,000 shares authorized,9,740 issued and outstanding

 

97

 

97

 

Additional paid-in capital

 

634,481

 

633,800

 

Accumulated deficit

 

(1,235,950

)

(782,917

)

Total stockholders’ deficit

 

(601,372

)

(149,020

)

Total liabilities and stockholders’ deficit

 

$

1,432,814

 

$

1,816,558

 

 

See accompanying notes to condensed consolidated financial statements

 

1



Table of Contents

 

GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)

(unaudited)

 

 

 

Three months
ended September 30,

 

Nine months
ended September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Net sales

 

$

520,683

 

$

496,231

 

$

1,557,354

 

$

1,510,980

 

Cost of goods sold, buying and occupancy

 

373,150

 

348,869

 

1,105,975

 

1,053,581

 

Gross profit

 

147,533

 

147,362

 

451,379

 

457,399

 

Selling, general and administrative expenses

 

146,370

 

131,378

 

423,617

 

402,998

 

Impairment of intangible assets

 

 

 

2,300

 

 

Impairment of goodwill

 

360,100

 

 

360,100

 

 

Operating income (loss)

 

(358,937

)

15,984

 

(334,638

)

54,401

 

Interest expense, net of interest income of $7, $3, $27 and $30, respectively

 

39,264

 

41,208

 

119,298

 

123,726

 

Loss before income taxes

 

(398,201

)

(25,224

)

(453,936

)

(69,325

)

Income tax expense (benefit)

 

466

 

434

 

(903

)

1,306

 

Net loss

 

(398,667

)

(25,658

)

(453,033

)

(70,631

)

Other comprehensive income, net of income tax

 

 

 

 

173

 

Comprehensive loss

 

$

(398,667

)

$

(25,658

)

$

(453,033

)

$

(70,458

)

 

See accompanying notes to condensed consolidated financial statements

 

2



Table of Contents

 

GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

 

Nine months
ended September 30,

 

 

 

2013

 

2012

 

Operating activities:

 

 

 

 

 

Net loss

 

$

(453,033

)

$

(70,631

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

65,197

 

67,404

 

Impairment of property and equipment

 

1,731

 

559

 

Impairment of intangible assets

 

2,300

 

 

Impairment of goodwill

 

360,100

 

 

Net gain on disposal of property and equipment

 

(38

)

(2

)

Amortization of deferred financing fees

 

2,664

 

2,388

 

Non-cash interest expense

 

 

18,637

 

Stock-based compensation

 

681

 

704

 

Deferred income taxes

 

(470

)

(103

)

Payment of deferred paid-in-kind interest

 

(129,784

)

 

Changes in operating assets and liabilities, net of acquisitions:

 

 

 

 

 

Accounts receivable

 

977

 

(1,381

)

Merchandise inventories

 

(46,072

)

(99,370

)

Prepaid expenses and other current assets

 

(4,882

)

(3,741

)

Other assets, net

 

(17

)

(100

)

Accounts payable

 

35,181

 

36,389

 

Accrued expenses and other current liabilities

 

7,880

 

1,869

 

Merchandise advances

 

(4,662

)

(2,874

)

Other long-term liabilities

 

997

 

1,340

 

Net cash used in operating activities

 

(161,250

)

(48,912

)

 

 

 

 

 

 

Investing activities:

 

 

 

 

 

Purchase of property and equipment

 

(44,080

)

(48,781

)

Net proceeds from disposal of property and equipment

 

44

 

2,909

 

Acquisition of businesses

 

(1,143

)

 

Net cash used in investing activities

 

(45,179

)

(45,872

)

 

 

 

 

 

 

Financing activities:

 

 

 

 

 

Borrowings on asset-based revolving credit facility

 

354,000

 

57,000

 

Repayment of asset-based revolving credit facility

 

(189,000

)

(57,000

)

Repayment of long-term debt

 

(4,453

)

(484

)

Repurchase of common stock

 

 

(39

)

Financing fees

 

(2,928

)

(742

)

Net cash provided by (used in) financing activities

 

157,619

 

(1,265

)

Net decrease in cash

 

(48,810

)

(96,049

)

Cash at beginning of period

 

74,836

 

106,036

 

Cash at end of period

 

$

26,026

 

$

9,987

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest, including payment of deferred paid-in-kind interest

 

$

223,706

 

$

90,264

 

Income taxes

 

921

 

2,189

 

Non-cash investing and financing activities:

 

 

 

 

 

Assets acquired under capital lease

 

$

470

 

$

 

 

See accompanying notes to condensed consolidated financial statements

 

3



Table of Contents

 

GUITAR CENTER, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

(unaudited)

 

 

 

September 30,
2013

 

December 31,
2012

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash

 

$

26,026

 

$

74,836

 

Accounts receivable, net of allowance for doubtful accounts of $2,829 and $2,849, respectively

 

43,041

 

44,015

 

Merchandise inventories

 

611,720

 

564,959

 

Prepaid expenses and other current assets

 

28,175

 

23,285

 

Deferred income taxes

 

9,802

 

34,614

 

Total current assets

 

718,764

 

741,709

 

Property and equipment, net of accumulated depreciation and amortization of $294,049 and $250,835, respectively

 

206,598

 

213,969

 

Goodwill

 

222,517

 

582,378

 

Intangible assets, net of accumulated amortization of $182,016 and $200,040, respectively

 

272,610

 

291,269

 

Other assets, net

 

17,073

 

16,484

 

Total assets

 

$

1,437,562

 

$

1,845,809

 

 

 

 

 

 

 

Liabilities and Stockholder’s Equity (Deficit)

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

152,183

 

$

116,973

 

Accrued expenses and other current liabilities

 

197,862

 

199,195

 

Merchandise advances

 

30,239

 

34,901

 

Current portion of long-term debt

 

6,764

 

5,941

 

Total current liabilities

 

387,048

 

357,010

 

Other long-term liabilities

 

21,666

 

20,669

 

Deferred income taxes

 

85,710

 

105,327

 

Long-term debt

 

1,170,959

 

1,010,765

 

Due to Guitar Center Holdings, Inc.

 

54,548

 

224,113

 

Total liabilities

 

1,719,931

 

1,717,884

 

Commitments and contingencies

 

 

 

 

 

Stockholder’s equity (deficit):

 

 

 

 

 

Common stock, $0.01 par value, 1,000 shares authorized, 100 shares issued and outstanding

 

 

 

Additional paid-in capital

 

620,871

 

620,190

 

Accumulated deficit

 

(903,240

)

(492,265

)

Total stockholder’s equity (deficit)

 

(282,369

)

127,925

 

Total liabilities and stockholder’s equity (deficit)

 

$

1,437,562

 

$

1,845,809

 

 

See accompanying notes to condensed consolidated financial statements

 

4



Table of Contents

 

GUITAR CENTER, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(in thousands)

(unaudited)

 

 

 

Three months
ended September 30,

 

Nine months
ended September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Net sales

 

$

520,683

 

$

496,231

 

$

1,557,354

 

$

1,510,980

 

Cost of goods sold, buying and occupancy

 

373,150

 

348,869

 

1,105,975

 

1,053,581

 

Gross profit

 

147,533

 

147,362

 

451,379

 

457,399

 

Selling, general and administrative expenses

 

146,370

 

131,378

 

423,617

 

402,998

 

Impairment of intangible assets

 

 

 

2,300

 

 

Impairment of goodwill

 

360,100

 

 

360,100

 

 

Operating income (loss)

 

(358,937

)

15,984

 

(334,638

)

54,401

 

Interest expense, net of interest income of $7, $3, $27 and $30, respectively

 

23,842

 

21,214

 

67,699

 

63,746

 

Loss before income taxes

 

(382,779

)

(5,230

)

(402,337

)

(9,345

)

Income tax expense (benefit)

 

16,410

 

(3,192

)

8,638

 

(5,037

)

Net loss

 

(399,189

)

(2,038

)

(410,975

)

(4,308

)

Other comprehensive income, net of income tax

 

 

 

 

173

 

Comprehensive loss

 

$

(399,189

)

$

(2,038

)

$

(410,975

)

$

(4,135

)

 

See accompanying notes to condensed consolidated financial statements

 

5



Table of Contents

 

GUITAR CENTER, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

 

Nine months
ended September 30,

 

 

 

2013

 

2012

 

Operating activities:

 

 

 

 

 

Net loss

 

$

(410,975

)

$

(4,308

)

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

 

 

 

 

 

Depreciation and amortization

 

65,197

 

67,404

 

Impairment of property and equipment

 

1,731

 

559

 

Impairment of intangible assets

 

2,300

 

 

Impairment of goodwill

 

360,100

 

 

Net gain on disposal of property and equipment

 

(38

)

(2

)

Amortization of deferred financing fees

 

2,356

 

2,079

 

Non-cash interest expense

 

 

404

 

Stock-based compensation

 

681

 

704

 

Deferred income taxes

 

5,195

 

(13,803

)

Changes in operating assets and liabilities, net of acquisitions:

 

 

 

 

 

Accounts receivable

 

977

 

(1,381

)

Merchandise inventories

 

(46,072

)

(99,370

)

Prepaid expenses and other current assets

 

(4,882

)

(4,632

)

Other assets, net

 

(17

)

(100

)

Accounts payable

 

35,181

 

36,389

 

Accrued expenses and other current liabilities

 

246

 

8,460

 

Merchandise advances

 

(4,662

)

(2,874

)

Other long-term liabilities

 

997

 

1,340

 

Net cash provided by (used in) operating activities

 

8,315

 

(9,131

)

 

 

 

 

 

 

Investing activities:

 

 

 

 

 

Purchase of property and equipment

 

(44,080

)

(48,781

)

Net proceeds from disposal of property and equipment

 

44

 

2,909

 

Acquisition of businesses

 

(1,143

)

 

Net cash used in investing activities

 

(45,179

)

(45,872

)

 

 

 

 

 

 

Financing activities:

 

 

 

 

 

Borrowings on asset-based revolving credit facility

 

354,000

 

57,000

 

Repayment of asset-based revolving credit facility

 

(189,000

)

(57,000

)

Repayment of long-term debt

 

(4,453

)

(484

)

Financing fees

 

(2,928

)

(742

)

Repayment to Guitar Center Holdings, Inc.

 

(169,565

)

(39,820

)

Net cash used in financing activities

 

(11,946

)

(41,046

)

Net decrease in cash

 

(48,810

)

(96,049

)

Cash at beginning of period

 

74,836

 

106,036

 

Cash at end of period

 

$

26,026

 

$

9,987

 

 

 

 

 

 

 

Supplemental disclosures of cash flow information:

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

54,140

 

$

50,483

 

Income taxes

 

921

 

2,189

 

Non-cash investing and financing activities:

 

 

 

 

 

Assets acquired under capital lease

 

$

470

 

$

 

 

See accompanying notes to condensed consolidated financial statements

 

6



Table of Contents

 

GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

1.              Nature of Business and Significant Accounting Policies

 

Nature of Business

 

Guitar Center Holdings, Inc. is the parent company of wholly-owned Guitar Center, Inc. and its wholly-owned subsidiaries. All of the company’s operating activities are conducted out of Guitar Center, Inc. and its subsidiaries. The parent company’s business activities consist solely of debt and equity financing related to its ownership of Guitar Center, Inc.

 

In these notes, we refer to the condensed consolidated financial statements of Guitar Center Holdings, Inc. and its subsidiaries as “Holdings,” except where the context requires otherwise when discussing the debt or equity of the Guitar Center Holdings, Inc. entity. We refer to the condensed consolidated financial statements of Guitar Center, Inc. and its subsidiaries as “Guitar Center.”  The terms “we,” “us,” “our” and “the company” refer to Holdings and Guitar Center collectively.

 

We are the leading retailer of music products in the United States based on revenue. We operate three businesses under our Guitar Center, direct response and Music & Arts brands.

 

Our Guitar Center business offers guitars, amplifiers, percussion instruments, keyboards and pro audio and recording equipment through retail stores and online, along with repair services and rehearsal and/or lesson space in many of our stores. As of September 30, 2013, Guitar Center operated 253 Guitar Center stores across the United States, with 151 primary format stores, 84 secondary format stores and 18 tertiary format stores.

 

Our direct response business is a leading direct response retailer of musical instruments in the United States, and its operations include the Musician’s Friend and other branded websites and catalogs.

 

Our Music & Arts business specializes in band and orchestra instruments for sale and rental, serving students, teachers, band directors and college professors. As of September 30, 2013, Music & Arts operated 117 stores in 22 states, along with the Music & Arts website. The operations of our Woodwind & Brasswind website and catalogs are also reported in the Music & Arts business segment.

 

Principles of Consolidation

 

The accompanying unaudited condensed consolidated financial statements of Holdings and Guitar Center include the accounts of the respective companies’ wholly-owned subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Unaudited Interim Financial Information

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or GAAP, for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission, or SEC, for reporting on Form 10-Q. Accordingly, these notes do not include all disclosures normally included in complete financial statements prepared in accordance with GAAP. We believe the disclosures made are adequate for an understanding of the changes in financial position and performance of the entity since the last annual reporting date.  These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in our annual report on Form 10-K for the year ended December 31, 2012.

 

The accompanying unaudited condensed consolidated financial statements are prepared on the same basis as our annual consolidated financial statements. We believe the condensed consolidated financial statements contain all adjustments necessary for a fair presentation as prescribed by GAAP. Interim period adjustments are normal and recurring in nature, except where indicated otherwise in these notes.

 

Our business follows a seasonal pattern, peaking during the holiday selling season in November and December. Fourth quarter sales at our Guitar Center and direct response segments are typically significantly higher than in any other quarter. Accordingly, interim results may not be indicative of results for the entire year. Seasonality for our Music & Arts business centers around band rental season, which starts in August and carries through mid-October, but that seasonality does not have a significant impact on our consolidated results.

 

Use of Estimates in the Preparation of Financial Statements

 

The preparation of financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. In particular, we make judgments in areas such as allowances for doubtful accounts, depreciation and amortization, inventory valuation, self-insurance reserves, impairment of long-lived assets, goodwill and other intangible assets, litigation, provision for sales returns, vendor allowances, stock-based compensation and income taxes. Actual results could differ from these estimates.

 

As a result of economic conditions in the United States, there is uncertainty about unemployment, consumer confidence and business and consumer spending. Over the last several years, these factors have reduced our visibility into long-term trends, dampened our expectations of future business performance and increased the degree of uncertainty in our estimates.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

2.              Goodwill and Intangible Assets

 

Goodwill

 

The following table presents an analysis of the changes in goodwill by segment for the nine months ended September 30, 2013 (in thousands):

 

 

 

Guitar

 

Music

 

 

 

 

 

Center

 

& Arts

 

Total

 

Balance at December 31, 2012

 

 

 

 

 

 

 

Goodwill

 

$

706,182

 

$

 

$

706,182

 

Accumulated impairment losses

 

(123,804

)

 

 

(123,804

)

 

 

582,378

 

 

582,378

 

 

 

 

 

 

 

 

 

Goodwill resulting from acquisitions

 

 

239

 

239

 

Goodwill impairment

 

(360,100

)

 

(360,100

)

 

 

 

 

 

 

 

 

Balance at September 30, 2013

 

 

 

 

 

 

 

Goodwill

 

706,182

 

239

 

706,421

 

Accumulated impairment losses

 

(483,904

)

 

(483,904

)

 

 

$

222,278

 

$

239

 

$

222,517

 

 

We perform a qualitative assessment annually on the first day of the fourth quarter to determine if facts and circumstances indicate that goodwill is more likely than not impaired. We also test goodwill for impairment upon the occurrence of events or substantive changes in circumstances that indicate that goodwill is more likely than not impaired.

 

During the second quarter of 2013, operating income decreased significantly at our Guitar Center segment, which is also a reporting unit for purposes of testing goodwill for impairment. We concluded that there were sufficient indicators that goodwill at our Guitar Center segment may be impaired.

 

We performed step 1 of the goodwill impairment test for our Guitar Center reporting unit as of June 30, 2013. We used a discounted cash flow analysis and a market multiple analysis, equally weighted, to estimate the fair value of our Guitar Center reporting unit. Based on the step 1 analysis as of June 30, 2013, no goodwill impairment was indicated and we did not proceed to step 2 of the goodwill impairment test.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

During the third quarter of 2013, operating income at our Guitar Center segment fell significantly below our expectations. Based on a forward projection of our recent operating performance, we determined that if current trends were to continue there would be uncertainty as to when or whether our Guitar Center business would be able to achieve historical operating results. Given these uncertainties, we determined it was appropriate to revise our projections of future cash flows from the segment. Management concluded that these changes in facts and circumstances represented a triggering event, requiring us to again test the reporting unit’s goodwill for impairment.

 

We performed step 1 of the goodwill impairment test as of September 30, 2013 and determined that the carrying amount of the Guitar Center reporting unit exceeded its estimated fair value.  Step 2 of the impairment test requires us to estimate the fair value of all of the reporting unit’s assets and liabilities, including identifiable intangible assets, and compare the implied fair value of goodwill to its carrying value. We are in the process of performing step 2 of the goodwill impairment test and we expect to complete our analysis during the fourth quarter of 2013.  We recorded an estimated goodwill impairment charge of $360.1 million in the third quarter of 2013. Given the complexity of the step 2 analyses, the calculation of the fair value of certain assets, primarily property and equipment, amortizable intangible assets and favorable leases, among others, is still preliminary. The estimated impairment charge will be revised, if necessary, after the step 2 analysis is completed during the fourth quarter of fiscal 2013.

 

We use a discounted cash flow analysis and a market multiple analysis to estimate the fair value of our Guitar Center reporting unit for step 1 of the goodwill impairment test. The discounted cash flow analysis included assumptions for, among others, forecasted revenues, gross profit margins, operating profit margins, working capital requirements, perpetual growth rates and long term discount rates, all of which require significant judgments by management.

 

We also use discounted cash flow analyses and market-based techniques to estimate the fair values of the reporting unit’s assets and liabilities in step 2 of the goodwill impairment test. Significant management judgment is required in forecasting the future operating results and cash flows that are used in these analyses.

 

The non-cash impairment charge has no impact on our compliance with debt covenants, our cash flows or available liquidity, however it does have a material impact on our consolidated financial statements.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Other intangible assets

 

Our other intangible assets are comprised of indefinite-lived trademarks and trade names and finite-lived intangible assets, primarily related to customer relationships and below-market leases.

 

We perform a qualitative assessment annually on the first day of the fourth quarter to determine if facts and circumstances indicate that our indefinite-lived intangible assets are more likely than not impaired. We also test indefinite-lived intangible assets for impairment whenever events and circumstances indicate that the fair value of the asset is more likely than not less than its carrying amount.

 

Because we tested Guitar Center goodwill for impairment, we also evaluated the indefinite-lived intangible assets and amortizable intangible asset group of our Guitar Center segment for impairment as of June 30 and September 30, 2013. There was no impairment of the Guitar Center segment’s indefinite-lived intangible assets, as their estimated fair values exceeded their carrying amounts. Similarly, there was no impairment of the Guitar Center segment’s finite-lived intangible assets, as the projected future undiscounted cash flows from the asset group exceeded its carrying amount.

 

In the second quarter of 2013, we evaluated our direct response indefinite-lived trademarks and trade names for impairment after continued decreases in net sales at our direct response segment. Because net sales are the primary driver of fair value for our indefinite-lived trademarks and trade names, we determined that the decrease in net sales indicated possible impairment of these assets. We revised our revenue projections for the direct response brands based on net sales achieved through the first half of 2013 and expectations about our initiatives to improve the brands’ performance. As a result of the impairment analysis, we recognized an impairment charge of $2.3 million in the second quarter of 2013 related to certain of our direct response indefinite-lived trademarks and trade names.

 

The direct response segment’s amortizing customer relationship intangible asset was not considered impaired in the second quarter, as the projected future undiscounted cash flows from the asset group significantly exceeded its carrying amount.

 

During the third quarter, we did not test the direct response segment’s indefinite-lived intangible assets for impairment. Facts and circumstances did not indicate further impairment of these assets, as the segment’s net sales were within our revised revenue projections included in the impairment analysis performed as of the end of the second quarter.

 

See Note 5 for more information about fair value measurements for our intangible assets.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

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

 

 

 

 

 

September 30, 2013

 

 

 

Weighted-

 

Gross

 

 

 

 

 

 

 

Average Useful

 

Carrying

 

Accumulated

 

Intangible

 

 

 

Life

 

Amount

 

Amortization

 

Assets, Net

 

Unamortized trademarks

 

 

$

206,201

 

$

 

$

206,201

 

Amortized

 

 

 

 

 

 

 

 

 

Customer relationships

 

13.1

 

221,538

 

(158,790

)

62,748

 

Favorable lease terms

 

7.6

 

25,941

 

(22,580

)

3,361

 

Covenants not to compete and other

 

4.6

 

946

 

(646

)

300

 

 

 

 

 

$

454,626

 

$

(182,016

)

$

272,610

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2012

 

 

 

Weighted-

 

Gross

 

 

 

 

 

 

 

Average Useful

 

Carrying

 

Accumulated

 

Intangible

 

 

 

Life

 

Amount

 

Amortization

 

Assets, Net

 

Unamortized trademarks

 

 

$

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

 

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

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 is classified in our condensed consolidated statements of comprehensive loss as follows (in thousands):

 

 

 

Three months
ended September 30,

 

Nine months
ended September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Cost of goods sold, buying and occupancy

 

$

936

 

$

1,423

 

$

3,118

 

$

4,563

 

Selling, general and administrative expenses

 

4,693

 

5,776

 

13,872

 

17,331

 

 

The future estimated amortization expense related to intangible assets as of September 30, 2013 was as follows (in thousands):

 

Year

 

 

 

Remainder of 2013

 

$

5,428

 

2014

 

16,549

 

2015

 

12,583

 

2016

 

9,717

 

2017

 

7,663

 

Thereafter

 

14,469

 

Total

 

$

66,409

 

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

3.              Long-Term Debt

 

Long-term debt consisted of the following (in thousands):

 

 

 

September 30,

 

December 31,

 

 

 

2013

 

2012

 

Guitar Center

 

 

 

 

 

Senior secured asset-based revolving facility

 

$

165,000

 

$

 

Senior secured term loan

 

617,500

 

621,762

 

Obligations under capital leases, payable in monthly installments through 2014 and 2013, respectively

 

333

 

54

 

Senior unsecured notes

 

394,890

 

394,890

 

 

 

1,177,723

 

1,016,706

 

Less current portion

 

6,764

 

5,941

 

Guitar Center long-term debt, net of current portion

 

1,170,959

 

1,010,765

 

 

 

 

 

 

 

Holdings

 

 

 

 

 

Senior unsecured PIK notes

 

434,889

 

564,673

 

Less current portion

 

 

129,784

 

Holdings long-term debt, net of current portion

 

434,889

 

434,889

 

 

 

 

 

 

 

Holdings consolidated long-term debt, net of current portion

 

$

1,605,848

 

$

1,445,654

 

 

Guitar Center long-term debt as of September 30, 2013 consisted of (1) a senior secured asset-based revolving facility, referred to as the asset-based facility, with a maximum availability of $373 million, of which $165 million was outstanding, (2) a senior secured term loan facility, referred to as the term loan, in an aggregate principal amount of $617.5 million and (3) senior unsecured notes, referred to as the senior notes, in an aggregate principal amount of $394.9 million.

 

Holdings long-term debt as of September 30, 2013 consisted of senior unsecured payment-in-kind notes, referred to as the senior PIK notes, in an aggregate principal amount of $434.9 million.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Asset-based facility

 

The maximum available borrowing amount for our asset-based facility is subject to a borrowing base, which is calculated monthly based on specified percentages of the value of eligible inventory, credit card receivables and trade receivables. As of September 30, 2013, the borrowing base was $322 million, which supported $165 million of outstanding borrowings, $9 million of outstanding letters of credit and $148 million of availability.

 

Our daily average borrowings on the asset-based facility were $84.1 million for the nine months ended September 30, 2013.

 

As of September 30, 2013, the weighted average interest rate for borrowings on the asset-based facility was 3.2%.

 

Term loan modification

 

In June 2013, we reached an agreement with our lenders to modify certain terms of the term loan credit agreement. The amendments included the following:

 

·                  with respect to the $611.2 million of outstanding principal, as of the modification date, that matures in April 2017, increased the pricing margin over LIBOR from 525 basis points to 600 basis points and increased the pricing margin over prime rate from 425 basis points to 500 basis points;

 

·                  amended the time period for a 1.0% prepayment premium to apply to a prepayment or re-pricing transaction occurring within one year of the modification date; and

 

·                  amended the maximum consolidated secured net leverage ratio covenant as follows:

 

4.35x from April 1, 2013 through September 30, 2013

 

4.0x from October 1, 2013 through December 31, 2014

 

3.75x from January 1, 2015 through September 30, 2015

 

3.0x from July 1, 2015 through maturity.

 

Additionally, we were not required to test the secured net leverage ratio as a maintenance covenant for the fiscal quarter ended June 30, 2013.

 

We paid the lenders an aggregate of $2.9 million in arrangement and consent fees as part of the transactions. Fees paid to lenders were capitalized as debt issuance costs and are included in other assets, net in our condensed consolidated balance sheets. We amortize debt issuance costs to interest expense over the term of the related debts, using the effective interest method. Fees and expenses paid to third parties, totaling $0.2 million, were expensed and are included in selling, general and administrative expenses in our condensed consolidated statements of comprehensive loss for the nine months ended September 30, 2013.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Guarantees and dividend restrictions

 

Guitar Center’s term loan, asset-based facility and senior notes are guaranteed by substantially all of its subsidiaries. The subsidiary guarantors are 100% owned, all of the guarantees are full and unconditional and joint and several and Guitar Center, Inc. has no assets or operations independent from its subsidiaries within the meaning of Regulation S-X, Rule 3-10. Any non-guarantor subsidiaries are minor.

 

For information about dividend restrictions among Holdings, Guitar Center and its guarantor subsidiaries, see Note 5 to the audited consolidated financial statements included in our annual report on Form 10-K for the year ended December 31, 2012.

 

Future maturities

 

Future maturities of long-term debt as of September 30, 2013 were as follows (in thousands):

 

 

 

Guitar Center

 

Holdings

 

Holdings
Consolidated

 

Remainder of 2013

 

$

23,138

 

$

 

$

23,138

 

2014

 

14,582

 

 

14,582

 

2015

 

6,500

 

 

6,500

 

2016

 

150,052

 

 

150,052

 

2017

 

983,451

 

 

983,451

 

2018

 

 

434,889

 

434,889

 

 

 

$

1,177,723

 

$

434,889

 

$

1,612,612

 

 

The asset-based facility matured in October 2013 with respect to $50 million of the maximum borrowing amount and matures in February 2016 with respect to $323 million of the maximum borrowing amount. Of the $165 million outstanding borrowings as of September 30, 2013, $21 million matured in October 2013 and $144 million matures in February 2016. We refinanced outstanding borrowings that matured in October 2013 with extended borrowing commitments maturing in February 2016. Accordingly, the entire outstanding balance on the asset-based facility is classified as long-term debt in our condensed consolidated balance sheets.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

4.                    Segment Information

 

We have three reportable segments: Guitar Center, direct response and Music & Arts.

 

The Guitar Center segment sells products and services through Guitar Center retail stores and online. For the Guitar Center segment, operating costs primarily consist of labor, advertising, depreciation and store occupancy costs.

 

The direct response segment sells products through direct mail catalogs and online. For the direct response segment, operating costs primarily consist of catalog costs, e-commerce advertising costs and order processing and fulfillment costs.

 

The Music & Arts segment specializes in band instruments for sale and rental, serving students, teachers, band directors and college professors. For the Music & Arts segment, operating costs primarily consist of labor, depreciation and store occupancy costs.

 

Corporate is a non-operating segment, consisting of centralized management, general and administrative functions and unallocated costs of our shared service operations. Interest expense, interest income and income tax expense or benefit are evaluated on a consolidated basis and are not considered in the evaluation of segment results.

 

Beginning in 2013, our Music & Arts segment includes the operations of our Woodwind & Brasswind branded website and catalogs, which were previously reported together with our direct response segment. Management determined it was appropriate to evaluate the Music & Arts and Woodwind & Brasswind brands together, given the similarity of product lines offered and target customers of these brands. In addition, management elected in 2013 to allocate the costs of certain shared corporate services to our Guitar Center and direct response segments to provide better visibility into usage at each segment. We have adjusted the 2012 segment disclosures to reflect these changes in the measures of segment performance that are provided to our chief operating decision makers.

 

Our chief operating decision makers include our chief executive officer and chief financial officer. Our chief operating decision makers evaluate segment performance based primarily on net sales, gross profit and adjusted EBITDA. Adjusted EBITDA is defined as earnings before interest, income taxes, depreciation and amortization, with adjustments for certain non-cash and non-recurring expenses and other adjustments permitted under our debt agreements. Management views adjusted EBITDA as an important measure of segment performance because it is considered an indicator of segment operating cash flows and facilitates comparison of operating performance on a consistent basis. Adjusted EBITDA is a measure which is also used in calculating financial ratios in material debt covenants in our asset-based facility and term loan.

 

Adjusted EBITDA is not a recognized measurement under GAAP and should not be used in isolation or as a substitute for GAAP measures when analyzing our operating performance. Adjusted EBITDA should be used in addition to, and not as an alternative for, net income or loss as determined in accordance with GAAP. Because not all companies use identical calculations, our presentation of adjusted EBITDA may not be comparable to similarly titled measures of other companies. Furthermore, adjusted EBITDA is not intended to be a measure of free cash flow for our management’s discretionary use, as it does not consider certain cash requirements such as income tax payments, capital expenditures, working capital and debt service payments.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

The following tables summarize financial information for Holdings’ and Guitar Center’s reportable segments (in thousands):

 

 

 

Three months ended September 30, 2013

 

 

 

Guitar
Center

 

Music & Arts

 

Direct
Response

 

Corporate

 

Total

 

Net sales

 

$

389,367

 

$

70,387

 

$

60,929

 

$

 

$

520,683

 

Gross profit

 

106,400

 

24,127

 

17,018

 

(12

)

147,533

 

Selling, general and administrative expenses

 

97,011

 

22,616

 

19,259

 

7,484

 

146,370

 

Impairment of intangible assets

 

 

 

 

 

 

Impairment of goodwill

 

360,100

 

 

 

 

360,100

 

Operating income (loss)

 

(350,711

)

1,511

 

(2,241

)

(7,496

)

(358,937

)

Depreciation and amortization

 

15,700

 

1,450

 

3,945

 

1,080

 

22,175

 

Adjusted EBITDA

 

28,103

 

3,090

 

1,834

 

(5,059

)

27,968

 

Capital expenditures

 

10,524

 

2,184

 

3,026

 

1,084

 

16,818

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three months ended September 30, 2012

 

 

 

Guitar
Center

 

Music & Arts

 

Direct
Response

 

Corporate

 

Total

 

Net sales

 

$

366,564

 

$

64,591

 

$

65,076

 

$

 

$

496,231

 

Gross profit

 

103,320

 

23,068

 

20,530

 

444

 

147,362

 

Selling, general and administrative expenses

 

84,751

 

21,539

 

17,766

 

7,322

 

131,378

 

Operating income (loss)

 

18,569

 

1,529

 

2,764

 

(6,878

)

15,984

 

Depreciation and amortization

 

16,728

 

1,261

 

3,659

 

1,019

 

22,667

 

Adjusted EBITDA

 

36,643

 

2,867

 

6,561

 

(3,492

)

42,579

 

Capital expenditures

 

9,736

 

1,425

 

1,885

 

3,270

 

16,316

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine months ended September 30, 2013

 

 

 

Guitar
Center

 

Music & Arts

 

Direct
Response

 

Corporate

 

Total

 

Net sales

 

$

1,169,000

 

$

189,466

 

$

198,888

 

$

 

$

1,557,354

 

Gross profit

 

322,310

 

75,028

 

54,053

 

(12

)

451,379

 

Selling, general and administrative expenses

 

279,097

 

63,503

 

60,527

 

20,490

 

423,617

 

Impairment of intangible assets

 

 

 

2,300

 

 

2,300

 

Impairment of goodwill

 

360,100

 

 

 

 

360,100

 

Operating income (loss)

 

(316,887

)

11,525

 

(8,774

)

(20,502

)

(334,638

)

Depreciation and amortization

 

46,072

 

3,870

 

11,971

 

3,284

 

65,197

 

Adjusted EBITDA

 

96,017

 

16,261

 

7,641

 

(10,875

)

109,044

 

Capital expenditures

 

26,558

 

5,678

 

5,123

 

6,721

 

44,080

 

Total assets

 

 

 

 

 

 

 

 

 

 

 

Holdings

 

1,050,983

 

139,900

 

155,196

 

86,735

 

1,432,814

 

Guitar Center

 

1,050,983

 

139,900

 

155,196

 

91,483

 

1,437,562

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Nine months ended September 30, 2012

 

 

 

Guitar
Center

 

Music & Arts

 

Direct
Response

 

Corporate

 

Total

 

Net sales

 

$

1,125,599

 

$

173,965

 

$

211,416

 

$

 

$

1,510,980

 

Gross profit

 

324,327

 

70,753

 

62,217

 

102

 

457,399

 

Selling, general and administrative expenses

 

261,458

 

61,025

 

61,943

 

18,572

 

402,998

 

Operating income (loss)

 

62,869

 

9,728

 

274

 

(18,470

)

54,401

 

Depreciation and amortization

 

49,467

 

3,691

 

11,486

 

2,760

 

67,404

 

Adjusted EBITDA

 

116,438

 

14,049

 

12,604

 

(8,212

)

134,879

 

Capital expenditures

 

28,487

 

4,319

 

6,022

 

9,953

 

48,781

 

Total assets

 

 

 

 

 

 

 

 

 

 

 

Holdings

 

1,461,716

 

123,439

 

184,192

 

76,755

 

1,846,102

 

Guitar Center

 

1,461,716

 

123,439

 

184,192

 

98,865

 

1,868,212

 

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

We record property and equipment at our segments based on direct capital expenditures made at each segment. Total assets of our direct response segment include the assets of our order fulfillment center and customer contact centers and certain other assets that also support the online operations of our Guitar Center and Music & Arts segments. We allocate depreciation and amortization expense to our segments based on actual usage for assets used exclusively at each segment, and based on estimated usage, primarily measured by gross sales, for shared assets.

 

Material unallocated assets at our corporate segment primarily consist of cash, shared information technology infrastructure assets, including our data centers, internally-developed software costs, corporate office facilities, deferred income taxes and capitalized financing fees.

 

The following tables present a reconciliation of adjusted EBITDA to consolidated loss before income taxes (in thousands):

 

Holdings

 

 

 

Three months
ended September 30,

 

Nine months
ended September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Adjusted EBITDA

 

 

 

 

 

 

 

 

 

Guitar Center

 

$

28,103

 

$

36,643

 

$

96,017

 

$

116,438

 

Music & Arts

 

3,090

 

2,867

 

16,261

 

14,049

 

Direct response

 

1,834

 

6,561

 

7,641

 

12,604

 

Corporate

 

(5,059

)

(3,492

)

(10,875

)

(8,212

)

 

 

27,968

 

42,579

 

109,044

 

134,879

 

 

 

 

 

 

 

 

 

 

 

Depreciation and amortization expense

 

22,175

 

22,667

 

65,197

 

67,404

 

Interest expense, net

 

39,264

 

41,208

 

119,298

 

123,726

 

Non-cash charges

 

2,002

 

525

 

2,255

 

2,215

 

Impairment charges

 

361,029

 

559

 

364,131

 

559

 

Other adjustments

 

1,699

 

2,844

 

12,099

 

10,300

 

 

 

 

 

 

 

 

 

 

 

Consolidated loss before income taxes

 

$

(398,201

)

$

(25,224

)

$

(453,936

)

$

(69,325

)

 

Guitar Center

 

 

 

Three months
ended September 30,

 

Nine months
ended September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Adjusted EBITDA

 

 

 

 

 

 

 

 

 

Guitar Center

 

$

28,103

 

$

36,643

 

$

96,017

 

$

116,438

 

Music & Arts

 

3,090

 

2,867

 

16,261

 

14,049

 

Direct response

 

1,834

 

6,561

 

7,641

 

12,604

 

Corporate

 

(5,059

)

(3,492

)

(10,875

)

(8,212

)

 

 

27,968

 

42,579

 

109,044

 

134,879

 

 

 

 

 

 

 

 

 

 

 

Depreciation and amortization expense

 

22,175

 

22,667

 

65,197

 

67,404

 

Interest expense, net

 

23,842

 

21,214

 

67,699

 

63,746

 

Non-cash charges

 

2,002

 

525

 

2,255

 

2,215

 

Impairment charges

 

361,029

 

559

 

364,131

 

559

 

Other adjustments

 

1,699

 

2,844

 

12,099

 

10,300

 

 

 

 

 

 

 

 

 

 

 

Consolidated loss before income taxes

 

$

(382,779

)

$

(5,230

)

$

(402,337

)

$

(9,345

)

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

Adjustments in the calculation of adjusted EBITDA include the following:

 

·                  Non-cash charges include stock-based compensation expense and the non-cash portion of rent expense.

 

·                  Impairment charges for the three and nine months ended September 30, 2103 include an estimated goodwill impairment charge of $360.1 million at our Guitar Center segment.

 

·                  Other adjustments include restructuring charges, severance payments, bonuses under our long-term management incentive plan, various debt and financing costs, gains and losses on disposal of assets, special charges and management fees paid to Bain Capital, LLC, an affiliate of the majority stockholders of Holdings.

 

Other adjustments for the nine months ended September 30, 2013 include a loss of $3.0 million related to payments we made to a third-party freight invoice processor that ceased operations. We plan to pursue the recovery of this amount, but we cannot be certain of what amount, if any, we will recover.

 

Other adjustments include restructuring charges of $0.2 million for the three months ended September 30, 2012 and $1.9 million for the nine months ended September 30, 2012.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

5.              Fair Value Measurements

 

The accounting standards related to fair value measurements define fair value and provide a consistent framework for measuring fair value under GAAP. Valuation techniques are based on observable and unobservable inputs. Observable inputs reflect readily obtainable market data, while unobservable inputs reflect assumptions for which market data are not available.

 

Valuation inputs are classified into the following hierarchy:

 

·                  Level 1 Inputs— Quoted prices for identical instruments in active markets.

·                  Level 2 Inputs— Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

·                  Level 3 Inputs— Instruments with significant unobservable value drivers.

 

Valuation policies and procedures for fair value measurements using level 3 inputs are established by finance management reporting to our chief financial officer. We corroborate level 3 inputs with historical and market information where possible and appropriate and we may engage third-party valuation firms to assist us in determining certain fair value measurements.

 

We do not have any material assets or liabilities measured at fair value on a recurring basis.

 

The fair values of cash, receivables, accounts payable, accrued expenses and other current liabilities approximate their carrying values because of their short-term nature.

 

Some assets are not measured at fair value on an ongoing basis but are subject to fair value adjustments only in certain circumstances. These assets can include long-lived and intangible assets that have been reduced to fair value when they are impaired and long-lived assets that are held for sale. Assets that are written down to fair value when impaired are not subsequently adjusted to fair value unless further impairment occurs.

 

The following table presents the fair value hierarchy for assets measured at fair value on a non-recurring basis during the nine months ended September 30, 2013 (in thousands):

 

 

 

Fair Value Measurements

 

 

 

 

 

Using Inputs Considered as

 

 

 

Total

 

 

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Losses

 

Goodwill at the Guitar Center segment

 

$

 

$

 

$

222,278

 

$

222,278

 

$

360,100

 

Trademarks and trade names at the direct response segment

 

 

 

7,400

 

7,400

 

2,300

 

 

We use a combination of income-based and market-based approaches to estimate the fair value of goodwill. These approaches use significant unobservable inputs, including forecasted revenues, gross profit margins, operating profit margins, working capital requirements, perpetual growth rates and long term discount rates.

 

We use an income-based approach to estimate the fair values of our indefinite-lived trademarks and trade names, specifically the relief-from-royalty method. This approach uses unobservable inputs, including projected revenue and our internal cost of capital. This approach also uses market observations about royalty rates.

 

Total losses represent impairment charges recognized to reduce the assets’ carrying values to their estimated fair values.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

The following table presents quantitative information about level 3 inputs used in our fair value measurements during the nine months ended September 30, 2013:

 

Fair Value Measurement

 

Fair Value at
measurement
date

(in thousands)

 

Valuation technique

 

Unobservable input

 

Range

 

Trademarks and trade names at the direct response segment

 

$

7,400

 

Discounted cash flow

 

Weighted-average cost of capital

 

16.6%

 

 

 

 

 

 

 

Long-term revenue growth rate

 

1.0%

 

 

 

 

 

 

 

Royalty rates

 

0.5% - 1.5%

 

 

The following table presents the difference between the carrying amount and estimated fair value of our long-term debt (in thousands):

 

 

 

September 30, 2013

 

December 31, 2012

 

 

 

Carrying
Amount

 

Estimated
Fair Value

 

Carrying
Amount

 

Estimated
Fair Value

 

Guitar Center

 

 

 

 

 

 

 

 

 

Asset-based revolving credit facility

 

$

165,000

 

$

165,000

 

$

 

$

 

Senior secured term loan

 

617,500

 

604,378

 

621,762

 

600,000

 

Senior unsecured notes

 

394,890

 

423,590

 

394,890

 

418,579

 

Capital lease obligations

 

333

 

333

 

54

 

54

 

Total Guitar Center

 

1,177,723

 

1,193,301

 

1,016,706

 

1,018,633

 

 

 

 

 

 

 

 

 

 

 

Holdings

 

 

 

 

 

 

 

 

 

Senior unsecured PIK notes

 

434,889

 

475,823

 

564,673

 

596,965

 

 

 

 

 

 

 

 

 

 

 

Holdings consolidated

 

$

1,612,612

 

$

1,669,124

 

$

1,581,379

 

$

1,615,598

 

 

We estimate the fair value of our long-term debt using observable inputs classified as level 2 in the fair value hierarchy. We use present value and market techniques that consider rates of return on similar credit facilities recently initiated by companies with like credit quality in similar industries, quoted prices for similar instruments and inquiries with certain investment communities.

 

The carrying amount of our asset-based facility approximates its estimated fair value due to its short-term nature (borrowings are typically done in increments of 90 days or less), variable interest rate and similar rates offered for debt of similar maturities and credit risk.

 

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GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

6.              Legal

 

On September 11, 2009, a putative class action was filed by an individual consumer named David Giambusso in the United States District Court for the Southern District of California. The complaint alleged that Guitar Center and other defendants, including a trade association and several musical instrument manufacturers, exchanged sensitive information and strategies for implementing minimum advertised pricing, attempted to restrict retail price competition and monopolize at trade association-organized meetings, all in violation of Sections 1 and 2 of the Sherman Antitrust Act and California’s Unfair Competition Law. Subsequently, numerous additional lawsuits were filed in several federal courts (and one state court) attempting to represent comparable classes of plaintiffs with parallel allegations. Some of these lawsuits have expanded the group of defendants to include other manufacturers and others have alleged additional legal theories under state laws.

 

In December 2009 and January 2010, the Judicial Panel on Multidistrict Litigation issued several orders which had the effect of consolidating all pending actions in federal court under the caption In Re Musical Instruments and Equipment Antitrust Litigation, Case No. MDL-2121 (“MDL 2121”), except one state action filed in Tennessee. However, on July 18, 2013, the Tennessee matter was joined with MDL 2121, which remains pending before the Ninth Circuit Court of Appeals. We are not currently able to estimate a probable outcome or range of loss in this matter.

 

On August 31, 2011, a putative class action was filed by a former employee in San Francisco Superior Court in an action entitled Carson Pellanda vs. Guitar Center, Inc. The complaint alleges that Guitar Center allegedly violated California wage and hour laws, including failure to provide required meal periods and rest breaks, unpaid work time and failure to provide accurate itemized wage statements. A mediation was held on May 17, 2012, but no settlement was reached.  A second mediation was held on October 4, 2013.  A Mediator’s Proposal was accepted on October 28, 2013.  The loss was not material to our consolidated financial statements.

 

On May 24, 2011, a putative class action was filed in Los Angeles Superior Court in an action entitled Jason George vs. Guitar Center, Inc. and Guitar Center Stores, Inc. The complaint alleges that Guitar Center violated the California Song-Beverly Credit Card Act by requesting that its customers provide personal identification information in connection with the use of their credit cards. The complaint seeks monetary damages including statutory civil penalties in amounts of up to $1,000 per violation. In December 2012, a motion for summary judgment was filed on behalf of Guitar Center. A tentative ruling was issued by the court granting Guitar Center’s motion for summary judgment.  The court ordered additional limited discovery. The motion for summary judgment will be heard by the court on November 8, 2013. We are not currently able to estimate a probable outcome or range of loss in this matter.

 

On March 18, 2013, a putative class action was filed in Los Angeles Superior Court in an action entitled Stewart vs. Guitar Center, Inc. and Guitar Center Stores, Inc.  The complaint alleges that Guitar Center allegedly violated California wage and hour laws, including failure to provide required meal periods, rest breaks, unpaid work time, and failure to provide accurate itemized wage statements.  Guitar Center has retained defense counsel.  Guitar Center has filed a Motion to Abate due to duplicative litigation in the pending Pellanda vs. Guitar Center action. We are not currently able to estimate a probable outcome or range of loss in this matter. This matter will be joined with the Pellanda settlement.

 

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Table of Contents

 

GUITAR CENTER HOLDINGS, INC. AND SUBSIDIARIES

GUITAR CENTER, INC. AND SUBSIDIARIES

COMBINED NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

 

In addition to the matters described above, we are involved in various claims and legal actions in the normal course of business. We expect to defend all unresolved actions vigorously. We cannot assure you that we will be able to achieve a favorable settlement of these lawsuits or obtain a favorable resolution if they are not settled. However, it is management’s opinion that, after consultation with counsel and a review of the facts, a material loss with respect to our financial position, results of operations and cash flows is not probable from such currently pending normal course of business litigation matters.

 

24



Table of Contents

 

Item 2.                        Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

This quarterly report on Form 10-Q contains forward-looking statements that reflect our plans, estimates and beliefs. Any statements (including, but not limited to, statements to the effect that we or our management “anticipate,” “plan,” “project,” “estimate,” “expect,” “believe,” “intend,” “may,” “will,” “should” and other similar expressions) that are not statements of historical fact should be considered forward-looking statements. Specific examples of forward-looking statements include, but are not limited to, statements regarding our forecasts of financial performance, capital expenditures, working capital requirements and future effective tax rates. All forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those that we expected, including the factors described in the section entitled “Risk Factors” in our annual report on Form 10-K for the year ended December 31, 2012.

 

Our actual results could differ materially from those discussed in these forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, world and national political events, general economic conditions, the effectiveness of our promotion and merchandising strategies, 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 following discussion and analysis should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in this quarterly report and management’s discussion and analysis of financial condition and results of operations and the consolidated financial statements and related notes included in our annual report on Form 10-K for the year ended December 31, 2012.

 

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 represent our views 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.

 

Amounts shown in tables are generally rounded. Therefore, discrepancies in the tables between totals and the sum of the amounts listed may occur. All amounts are unaudited.

 

Overview

 

We are the leading retailer of music products in the United States based on revenue. We operate three reportable business segments: Guitar Center, direct response and Music & Arts. Our Guitar Center segment offers guitars, amplifiers, percussion instruments, keyboards and pro audio and recording equipment through our retail stores and online, along with repair services and rehearsal and/or lesson space in many of our stores. Our direct response segment offers catalog and online sales of a broad selection of music products under several brand names, including Musician’s Friend and Music 123. Our Music & Arts segment offers band and orchestra instruments for rental and sale, music lessons and a limited selection of products of the type offered by our Guitar Center segment.

 

Beginning in 2013, our Music & Arts segment includes the operations of our Woodwind & Brasswind branded website and catalogs, which were previously reported together with our direct response segment. Management determined it was appropriate to evaluate the Music & Arts and Woodwind & Brasswind brands together, given the similarity of product lines offered and target customers of these brands. In addition, management elected in 2013 to allocate the costs of certain shared corporate services to our Guitar Center and direct response segments to provide better visibility into usage at each segment. We have adjusted 2012 segment results in the following management discussion and analysis to reflect these changes.

 

Our Guitar Center segment is operated primarily out of Guitar Center Stores, Inc., our retail store subsidiary. Our direct response segment is comprised primarily of the online operations of our Musician’s Friend, Inc. and Music 123, Inc. subsidiaries. Our Music & Arts segment is comprised of the retail and online businesses operated under the Music & Arts brand name, which is operated by Guitar Center Stores, Inc., and also includes the operations of our Woodwind & Brasswind, Inc. subsidiary. Our non-operating corporate segment consists primarily of Guitar Center, Inc., the parent company of our operating subsidiaries, and GTRC Services, Inc., which operates shared support services for our operating subsidiaries.

 

25



Table of Contents

 

As of November 8, 2013, our wholly-owned retail subsidiary operated 255 Guitar Center stores in 44 states and 118 Music & Arts stores in 22 states. Our Guitar Center stores consisted of 151 primary format stores, 85secondary format stores and 19 tertiary format stores. The store format is determined primarily by the size of the market in which it is located. Our primary format stores serve major metropolitan population centers and generally range in size from 13,000 to 30,000 square feet. Our secondary format stores serve mid-tier metropolitan areas and generally range in size from 8,000 to 15,000 square feet. Tertiary market stores serve smaller population centers and generally range in size from 5,000 to 8,000 square feet.

 

Our calculation of comparable retail store sales includes sales from stores that have been open for 14 months and does not include sales originated from our Guitar Center website. We do not exclude remodeled or relocated stores from the calculation of comparable store sales. All references to comparable store sales results in this quarterly report are based on this calculation methodology.

 

Results of operations

 

The following tables present the components of net loss, as a percentage of sales, for the periods indicated:

 

Holdings

 

 

 

Three months
ended September 30,

 

Nine months
ended September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Net sales

 

100.0

%

100.0

%

100.0

%

100.0

%

Gross profit

 

28.3

 

29.7

 

29.0

 

30.3

 

Selling, general and administrative expenses

 

28.1

 

26.5

 

27.2

 

26.7

 

Impairment of intangible assets

 

 

 

0.1

 

 

Impairment of goodwill

 

69.2

 

 

23.1

 

 

Operating income (loss)

 

(68.9

)

3.2

 

(21.5

)

3.6

 

Interest expense, net

 

7.5

 

8.3

 

7.7

 

8.2

 

Loss before income taxes

 

(76.5

)

(5.1

)

(29.1

)

(4.6

)

Income tax expense (benefit)

 

0.1

 

0.1

 

(0.1

)

0.1

 

Net loss

 

(76.6

)%

(5.2

)%

(29.1

)%

(4.7

)%

 

Guitar Center

 

 

 

Three months
ended September 30,

 

Nine months
ended September 30,

 

 

 

2013

 

2012

 

2013

 

2012

 

Net sales

 

100.0

%

100.0

%

100.0

%

100.0

%

Gross profit

 

28.3

 

29.7

 

29.0

 

30.3

 

Selling, general and administrative expenses

 

28.1

 

26.5

 

27.2

 

26.7

 

Impairment of intangible assets

 

 

 

0.1

 

 

Impairment of goodwill

 

69.2

 

 

23.1

 

 

Operating income (loss)

 

(68.9

)

3.2

 

(21.5

)

3.6

 

Interest expense, net

 

4.6

 

4.3

 

4.3

 

4.2

 

Loss before income taxes

 

(73.5

)

(1.1

)

(25.8

)

(0.6

)

Income tax expense (benefit)

 

3.2

 

(0.6

)

0.6

 

(0.3

)

Net loss

 

(76.7

)%

(0.4

)%

(26.4

)%

(0.3

)%

 

26



Table of Contents

 

Three Months Ended September 30, 2013 Compared to the Three Months Ended September 30, 2012

 

Net sales

 

Consolidated net sales for the third quarter of 2013 increased 4.9% to $520.7 million, compared to $496.2 million for the same period in 2012.

 

Net sales from our Guitar Center segment for the third quarter of 2013 increased 6.2% to $389.4 million, compared to $366.6 million for the same period in 2012. The increase was primarily driven by new stores and comparable store sales growth.  New stores open less than 14 months contributed $12.8 million in incremental net sales during the quarter and comparable retail store sales increased 2.8%, or $9.9 million. Net sales from our Guitar Center website were flat compared to the same period last year. Comparable store sales benefited from a 2.3% increase in the total number of transactions, resulting from our marketing and pricing strategies during the quarter.

 

Net sales from our direct response segment for the third quarter of 2013 decreased 6.4% to $60.9 million, compared to $65.1 million for the same period in 2012. The decrease was primarily due to lower average order size, resulting from a 4.8% decrease in average unit price and a 2.4% decrease in items sold per order. We believe these decreases were the result of promotional offers during the quarter, such as free shipping and special merchandise promotions that increased our total number of orders, but not sufficiently to offset the decrease in average order size. Our direct response segment continues to be affected by the increasingly competitive e-commerce landscape, which has made it more difficult to attract and retain customers. We plan to continue testing different pricing and marketing strategies in an effort to improve customer retention and optimize our promotional tactics; these tests may create volatility in the segment’s net sales and gross profit. We expect these factors to continue to affect this segment’s net sales and gross profit for the foreseeable future.

 

Net sales from our Music & Arts segment for the third quarter of 2013 increased 9.0% to $70.4 million, compared to $64.6 million for the same period in 2012. The increase was primarily due to retail store sales growth and our continued success at increasing high-volume bid sales to school districts.

 

Gross profit

 

Consolidated gross profit for the third quarter of 2013 was $147.5 million, compared to $147.4 million for the same period in 2012. Gross profit margin was 28.3% for the third quarter of 2013, compared to 29.7% for the same period in 2012.

 

Gross profit margin for our Guitar Center segment was 27.3% for the third quarter of 2013, compared to 28.2% for the same period in 2012. The decrease was primarily due to lower selling margin of 0.9%. Selling margin decreased due to adjustments in selling prices, in the form of merchandise markdowns for inventory moved to clearance status. We took additional merchandise markdowns during the third quarter of 2013, with the goal of reducing inventory levels and replenishing our stores with the latest product assortments.

 

Gross profit margin for our direct response segment was 27.9% for the third quarter of 2013, compared to 31.5% for the same period in 2012. The decrease was primarily due to lower selling margin