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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

(Mark One)

For the fiscal year ended December 31, 2001
or

For the transition period from                              to                             

Commission file number 000-22207

GUITAR CENTER, INC.

(Exact name of registrant as specified in charter)

Registrant's telephone number, including area code: (818) 735-8800

Securities registered pursuant to 12(b) of the Act:
None

Securities registered pursuant to 12(g) of the Act:
Common Stock, $.01 par value
(Title of Class)

        Check if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

        As of March 25, 2002, the aggregate market value of voting stock held by nonaffiliates of the Company was approximately $230,830,000 (based upon the last reported sales price of the Common Stock on such date as reported by the Nasdaq National Market). Shares of Common Stock held by each executive officer, director, holder of greater than 10% of the outstanding Common Stock of the Registrant and person or entity known to the Registrant to be affiliates of the foregoing have been excluded in that such persons may be deemed to be affiliates. This assumption regarding affiliate status is not necessarily a conclusive determination for other purposes.

        Check 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 at least the past 90 days. YES ý    NO o

        As of March 25, 2002 there were 22,342,340 shares of Common Stock, par value $.01 per share, outstanding.

        Portions of the Proxy Statement for the annual stockholders' meeting scheduled to be held on May 3, 2002 are incorporated by reference into Part III.

The Exhibit Index appears on page 36.

PART I

Item 1. BUSINESS

Company History

        Guitar Center, Inc. was founded in 1964 in Hollywood, California. Our flagship Hollywood store currently is one of the nation's largest and best-known retail stores of its kind with approximately 30,600 square feet of retail space. The Hollywood store features one of the largest used and vintage guitar collections in the United States, attracting buyers and collectors from around the world. In front of the Hollywood store is the Rock Walk which memorializes over 200 famous musicians and music pioneers. The Rock Walk attracts several tour buses daily and has helped to create international recognition of the Guitar Center name. In 1972, we opened our second store in San Francisco to capitalize on the emerging San Francisco rock 'n roll scene. By this time, our inventory had been expanded to include drums, keyboards, accessories, and pro-audio and recording equipment.

        Throughout the 1980s, we expanded by opening nine stores in five major markets, including Chicago, Dallas and Minneapolis. Since 1990, we have continued our new store expansion and have focused on building the infrastructure necessary to manage our strategically planned growth. Current executive officers and key managers have been with our company for an average of 9 years and two of such executive officers (Mr. Larry Thomas, our Chairman and Co-Chief Executive Officer, and Mr. Marty Albertson, our President and Co-Chief Executive Officer) effectively assumed full operating control in 1992. Since then, we have focused on developing and realizing our long-term goal of expanding our position as the leading music products retailer throughout the United States.

        In May of 1999, we merged with Musician's Friend, Inc. in a stock for stock transaction. Musician's Friend operates the largest direct response channel (catalog and e-commerce) in the musical instruments industry in the United States. Robert Eastman, Chief Executive Officer of Musician's Friend, has been with the company for 18 years. The merger was accounted for as a pooling of interests.

        In April of 2001, we acquired the assets of American Music Group, Ltd. and related companies, a leading musical instrument retailer specializing in the sale and rental of band instruments and accessories. American Music Group operates as a division of our retail business and serves the band instruments market through its twelve band instrument retail stores and two mail order catalogs. The American Music Group acquisition enables us to serve a broader segment of the musical instruments industry, while maintaining our current focus on the merchandise offering of our Guitar Center store format. The acquisition of American Music Group provides us with new opportunities to expand our customer base and product offerings to the band instruments market. David Fleming is the President and Chief Operating Officer of American Music Group and has been with the company for 26 years. The acquisition was accounted for using the purchase method.

        We are a Delaware corporation with our principal executive offices located at 5795 Lindero Canyon Road, Westlake Village, California 91362, and our telephone number is (818) 735-8800. We maintain several corporate websites, including www.guitarcenter.com, however none of the information contained on our websites is incorporated into this annual report. Whenever we refer to the "Company" or to "us," or use the terms "we" or "our" in this annual report, we are referring to Guitar Center, Inc. and its subsidiaries.

Industry Overview

        The United States retail market for music products in 2000 was estimated in a study by The Music Trades magazine to be approximately $7.1 billion in net sales, representing a five-year compound annual growth rate of 5.9%. Inclusive of the $7.1 billion in net sales is the band instrument market which is currently an estimated $1.0 billion in the United States and industry trends and positive demographic trends suggest that the school music market will continue to grow. School enrollments have risen in

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each of the past seven years and an increased in publicity linking music making and improved academic performance has unquestionably improved prevailing attitudes towards music and music education. The broadly defined music products market, according to the National Association of Music Merchants, or NAMM, includes retail sales of string and fretted instruments, sound reinforcement and recording equipment, drums, keyboards, print music, pianos, organs, and school band and orchestral instruments. Products currently offered by us include categories of products which account for approximately $5.2 billion of this market, representing a five-year compound annual growth rate of 7.3%. The music products market, as currently defined by NAMM, however, does not include the significant used and vintage product markets or the computer software and apparel markets in which we actively participate.

        The industry is highly fragmented with the nation's leading five music products retailers, as measured by the number of stores operated by such retailers (i.e., Guitar Center, Sam Ash Music Corp., MARS Inc., Brook Mays/H&H, and Hermes Music), accounting for approximately 22.8% of the industry's estimated total sales in 2000. Furthermore, approximately 90% of the industry's estimated 5,900 retailers operate only one or two stores. A typical music products store averages approximately 3,200 square feet and generates an average of approximately $1.0 million in annual net sales. In contrast, our standard prototype Guitar Center stores generally average between 12,000 and 20,000 square feet, and in 2001 these stores generated an average of approximately $8.7 million in annual net sales for stores open the full year.

        Over the past ten years, technological advances in the industry have resulted in dramatic changes to the nature of music-related products. Manufacturers have combined computers and microprocessor technologies with musical equipment to create a new generation of products capable of high grade sound processing and reproduction. Products featuring those technologies are available in a variety of forms and have broad application across most of our music product categories. Most importantly, rapid technological advances have resulted in the continued introduction of higher quality products offered at lower prices and this trend is continuing. Today an individual consumer can affordably create a home recording studio which interacts with personal computers and is capable of producing high-quality digital recordings. Until recently, this type of powerful sound processing capability was expensive and was typically purchased only by professional sound recording studios.

Business

        As of December 31, 2001, we operated 96 Guitar Center stores, consisting of 88 stores in 35 major U.S. markets, including, among others, areas in or near Los Angeles, San Francisco, Chicago, Miami, Houston, Dallas, Detroit, Boston, Minneapolis, Seattle, Phoenix, Atlanta, New York and Cleveland, and eight stores in secondary markets. We also operated 12 American Music stores. From 1997 to 2001, our net sales grew at an annual compound growth rate of 26.4%, principally due to comparable store sales growth averaging 9.5% per year, the opening of new stores, and a 28.4% increase in the direct response channel. We achieved comparable store sales growth of 6%, 7% and 10% for the fiscal years ended December 31, 2001, 2000 and 1999, respectively.

        For the fiscal years ended December 31, 2001, 2000 and 1999, we had net income of $17.0 million, $22.5 million and $18.3 million, respectively.

Retail

        At our Guitar Center stores, we offer a unique retail concept in the music products industry, combining an interactive, hands-on shopping experience with superior customer service and a broad selection of brand name, high-quality products at guaranteed low prices. We create an entertaining and exciting atmosphere in our stores with bold and dramatic merchandise presentations, highlighted by bright, multi-colored lighting, high ceilings, music and videos. We believe approximately 74% of our sales are to professional and aspiring musicians who generally view the purchase of music products as a

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career necessity. These sophisticated customers rely on our knowledgeable and highly trained salespeople to answer technical questions and to assist in product demonstrations.

        Our standard prototype large format Guitar Center store generally ranges in size from 12,000 to 20,000 square feet (as compared to a typical music products retail store which averages approximately 3,200 square feet) and is designed to encourage customers to hold and play instruments. In late 2000, we opened our first new store using a smaller format. Results from this unit are encouraging and as of December 31, 2001 we had opened a total of five smaller format stores. We plan to open additional stores using this format of approximately 8,000 to 10,000 square feet to serve secondary markets. Each large format store carries an average of 11,000 core SKUs and each small format stores carries an average of 5,000 core SKUs, which in each case our management believes is significantly greater than a typical music products retail store. Our stores are organized into five departments, each focused on one product category. These departments cater to a musician's specific product needs and are staffed by specialized salespeople, many of whom are practicing musicians. We believe this retail concept differentiates us from our competitors and encourages repeat business.

        The following summarizes certain key operating statistics of our Guitar Center stores and is based upon the stores operated by us for the full year ended December 31:

(1)

Store-level operating income includes individual store revenue and expenses plus allocated rebates, cash discounts and purchasing department salaries (based upon individual store sales).

        Our American Music division retails band and orchestral instruments, as well as related accessories, principally to the school band market. These instruments are sold through a number of arrangements including conventional retail sales, rentals and rent-to-own arrangements. As of December 31, 2001, American Music Group operated 12 stores located in New York, Maine, Florida, Massachusetts, Illinois, Arizona and Nevada. The average store size was approximately 4,000 square feet. This division also operates retail "satellite" stores on the premises of third party musical instrument dealers, as well as a mail order business and a distributor of accessories.

        Our retail growth strategy is to continue to increase our presence in our existing markets and to open new stores in strategically selected markets. We will continue to pursue our strategy of clustering stores in major markets to take advantage of operating and advertising efficiencies and to build awareness of our name in new markets.

        We opened a total of 13 Guitar Center stores in 2001, and presently expect to open approximately 12 to 14 additional Guitar Center stores in 2002. Some of these stores will be smaller format units designed for secondary markets. In 2003, our present plan is to open approximately 18 to 22 Guitar Center stores.

        The acquisition of American Music Group during the second quarter of 2001 provides us with new opportunities to expand our customer base and product offerings to the band instruments market. During 2002, we plan to open six to eight American Music stores. In 2003, our present plan is to open approximately 14 to 16 additional American Music stores. For the immediate future, our objective is that about half of these new American Music units will be new units and about half will be acquisitions of existing businesses. We believe there exists a number of acquisition opportunities in the relatively fragmented band instruments market that could be a good fit into our American Music platform.

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        During 2001, we began construction of a distribution center in the Indianapolis, Indiana area to support our Guitar Center retail store operations with a view towards the facility commencing operation in the second half of 2002. This initiative will require significant financial and managerial resources for the next several quarters.

Direct Response

        Our Musician's Friend unit is an integrated e-commerce and catalog business. Through Musician's Friend, we offer musicians a shopping experience that satisfies the need for technical product information, confirmation of needs by a live person, quick and efficient service, and a musician-based staff for after sale support. The catalog presents a fresh assortment of products and promotions throughout the year, mixing big name products with unique and practical offerings. Our website, www.musiciansfriend.com, offers all that is shown in the catalog and more, supported by the same service and staff.

        The Musician's Friend business is based in Medford, Oregon and is supported by a customer contact center located in Salt Lake City, Utah and a distribution facility located in Kansas City, Missouri.

        Our customer contact staff receives product and customer service training in the Salt Lake City call center facility. Extensive product information, including technical information, product features and benefits, and real-time stocking information is available to the staff on their desktop systems via our intranet and back-end information systems. A staff of over 280 associates is trained and ready to respond to questions to help ensure that customers can purchase confidently. Website visitors are treated to a constantly updated and evolving, information rich shopping experience that includes product availability and purchase recommendations generated through collaborative filtering processes. Questions regarding products can be submitted electronically, or the musician can call our support center directly.

        Orders, whether taken electronically or by an associate in our customer contact center, are processed by our automated transaction system and generally ship within 24 hours. In 2001, we merged our three distribution centers into the Kansas City, Missouri facility, closing our Medford, Oregon and Knoxville, Tennessee facilities. We have implemented sophisticated inventory planning systems to help ensure that products are in-stock with the goal of maintaining a high initial line item fill rate. The initial line item fill rate reflects the percentage of catalog items ordered by our customers that we are able to supply in the initial shipment to that consumer. Split shipments of a single order impose additional shipping, handling and materials costs on us when compared to being able to fulfill an entire order in a single shipment. The technology on our website also permits our customers to monitor their orders online by accessing the UPS and Fed Ex tracking services.

        The focus of the Musician's Friend business strategy is to increase market share in the non-bricks and mortar retail segment of our industry. Our mailing and e-mail lists give us a significant base from which to grow. Our catalog circulation, which is broader than any other direct-mail circulation in our industry, provides a unique advertising and marketing platform for e-commerce. In addition, Musician's Friend enjoys significant customer loyalty as evidenced by a high rate of repeat purchases by customers. Over one-third of Musician's Friend customers place a second order within six months of their first order.

        Our business plan is to continue to leverage our leading industry position and existing infrastructure, and to build on that base to support the rapid growth in e-commerce. We believe that our leadership position and established direct marketing model leverages both Internet and direct mail mechanics to provide a significant competitive advantage. We also believe that there may be opportunities to acquire complementary direct response businesses and regularly investigate such opportunities.

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Business Strategy

Retail

        The goal in the retail stores is to continue to expand our position as the leading music products retailer throughout the United States. The principal elements of our business strategy are as follows:

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Store Expansion Strategy.  Our expansion strategy is to continue to increase our market share in existing markets and to penetrate strategically selected new markets. We opened a total of 13 Guitar Center stores in 2001, 14 stores in 2000, and 13 stores in 1999, and currently anticipate opening approximately 12 to 14 Guitar Center stores in 2002 and approximately 18 to 22 stores in 2003. Some of these stores will be smaller format units designed for secondary markets. In addition, we plan to open six to eight American Music stores during 2002 and 14 to 16 additional stores in 2003, approximately half of which are planned to be new stores and half from acquisitions. In preparation for this expansion, we have dedicated a substantial amount of our resources over the past several years to building the infrastructure necessary to support a large national chain. In addition, we have developed a methodology for targeting prospective store sites which includes analyzing demographic and psychographic characteristics of a potential store location. We believe there may be attractive opportunities to expand by selectively acquiring existing music products retailers and regularly investigate acquisition opportunities. Most of these opportunities, however, involve single stores or small chains in light of the relatively fragmented nature of our industry.

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Extensive Selection of Merchandise.  We offer an extensive selection of brand name music products complemented by lesser known, hard to find items and unique, vintage equipment. The average 11,000 core SKUs offered through each of our large format Guitar Center stores, and the average 5,000 core SKUs for our small format Guitar Center stores, provide a breadth and depth of in-stock items which we believe is not available from traditional music products retailers.

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Brand Development Strategy.  Our plan is to continue to grow our Guitar Center business while also building a separate retail business in the band instruments market using the American Music platform we recently acquired. While the two brands have distinctly different customer bases that we intend to serve through separate retail concepts, we also believe that each retail brand will benefit from the other. For example, we intend to make a number of Guitar Center SKU's available for sale in the American Music channel. Further, in a number of the current and planned Guitar Center retail locations we intend to construct separate American Music units thereby better leveraging those facilities.

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Highly Interactive, Musician-Friendly Store Concept.  The purchase of musical instruments is a highly personal decision for musicians. We therefore believe that a large part of our success is attributable to our creative instrument presentations and colorful, interactive displays which encourage the customer to hold and play instruments as well as to participate in product demonstrations. Each store also provides private sound-controlled rooms to enhance a customer's listening experience while testing various instruments.

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Exceptional Customer Service.  Exceptional customer service is fundamental to our operating strategy. Accordingly, we conduct extensive training programs for our salespeople, who specialize in one of our five product categories. Many of our salespeople are also musicians. With the advances in technology and continuous new product introductions in the music products industry, customers increasingly rely on qualified salespeople to offer expert advice and assist in product demonstrations. We believe that our emphasis on training and customer service distinguishes us within the industry and is a critical part of our success.

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Innovative Promotional and Marketing Programs.  We sponsor innovative promotional and marketing events, which include in-store demonstrations, famous artist appearances and weekend

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themed sales events, designed to create significant store traffic and exposure. In addition, our special grand opening activities in new markets are designed to generate consumer awareness for each new store. We believe these events help us to build a loyal customer base and to encourage repeat business. Since our inception, we have compiled a unique, proprietary database containing information on more than six million customers. This database enables us to advertise to select target customers based on historical buying patterns. We believe the typical music products retailer does not have the resources to support large-scale promotional events or an extensive advertising program.

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Guaranteed Low Prices.  We endeavor to be the low price leader in each of our markets, as underscored by our 30-day low price guarantee. Our size permits us to take advantage of volume discounts for large orders and other vendor supported programs. Although prices are usually determined on a regional basis, store managers are trained and authorized to adjust prices in response to local market conditions.

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Experienced and Motivated Management Team.  Our executive officers and key managers have an average of nine years employment with Guitar Center, Musician's Friend and American Music Group.

Direct Response

        The goal of the e-commerce and catalog business unit is to capitalize and expand on our leadership position. Comprehensive direct marketing, analysis and leveraging of the extensive customer information available on our information systems are used to define effective marketing campaigns. The presentation of an extensive selection of products and maintenance of an effective degree of continual and informative contact with prospects and customers provide the attention grabbing content that generate results. In 2001, we circulated over 14 million catalogs and sent over 61.4 million e-mails to prospects and customers. This resulted in a 22% increase in orders as compared to 2000. The call center fielded over 2.1 million calls during 2001.

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Targeted Marketing.  We have experience at targeting appropriate prospect and customer segments with the right offers. Extensive segmentation of customer lists and continual analysis by our circulation department are designed to ensure that the right mix of catalog and e-commerce offers are presented to each segment of customers. Our utilization of techniques in demographic data overlay and statistical modeling help ensure that Musician's Friend retains a leadership position in music gear direct marketing.

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Extensive Product Selection.  Musician's Friend stocks a broad assortment of products representing most of the premier lines; in some cases we are the exclusive direct sales dealer for the manufacturer. With some manufacturers, the Musician's Friend business unit alone is their second largest dealer behind Guitar Center's retail operations. Each catalog presents 4,000 or more SKUs, selected from the 25,000 or more SKUs that we carry. The website presents a more complete selection of products than the catalog due to its significantly lower publishing cost.

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Continual Customer Contact.  Prospects and customers receive periodic mailings from Musician's Friend and American Music, depending on their particular attributes. Musicians can "opt-in" for weekly electronic newsletters featuring news, information and promotions. Our "Platinum Members" preferred credit card customers receive additional marketing contacts via monthly statement mailings. Our musician-staffed call center is available 24-hours-a-day, seven-days-a-week for questions, technical information and customer service. While browsing the website, customers are presented with customized product recommendations.

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Merchandising

        Our merchandising concept differentiates us from most of our competitors. Guitar Center offers merchandise at guaranteed low prices and utilizes aggressive marketing and advertising to attract new customers and maintain existing customer loyalty. The principal elements of our merchandising philosophy are as follows:

•

Extensive Selection of Merchandise.  We seek to maintain a broad customer appeal by offering high-quality merchandise at multiple price points to serve musicians ranging from the casual hobbyist to the serious professional performer. Our Guitar Center units offer products in five primary categories: guitars, amplifiers, percussion instruments, keyboards, and pro-audio and recording equipment, and our American Music Group units offer band and orchestral instruments as well as related accessories.

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Guitars. We believe that our electric, acoustic and bass guitar selections are among the deepest and broadest in the industry. Major manufacturers, including Fender, Gibson, Taylor, Martin, PRS, Yamaha, Ovation and Ibanez, are well represented in popular models and colors. We believe we have one of the largest selections of custom, one-of-a-kind and used/vintage guitars of any retailer. Prices range from $175 for entry-level guitars to over $50,000 for special vintage guitars. In addition, our line of stringed instruments includes banjos, mandolins and dobros, among others. We also offer an extensive selection of guitar sound processing units and products that allow the guitar to interface with a personal computer. These products serve crossover demand from the traditional guitarist into new computer-related sound products.

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Amplifiers. We offer an extensive selection of electric, acoustic and bass guitar amplifiers and, in addition, carry a broad selection of boutique and vintage amplifiers with prices ranging from $50 to $5,000. We represent most manufacturers, including Marshall, Fender, Crate, Ampeg, S.W.R. and Mesa Boogie.

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Percussion Instruments. We believe that we are one of the largest sellers of percussion products in the United States. Our offerings range from basic drum kits to freestanding African congos and bongos and other rhythmic and electronic percussion products with prices ranging from $10 to $10,000. We also have a large selection of vintage and used percussion instruments. Name brands include Drum Workshop, Remo, Sabian, Pearl, Yamaha, Premier, Tama and Zildjian. We carry an extensive selection of digital drum kits and hand held digital drum units. The digital units produce a variety of high quality life-like drum sounds and have broad appeal to musicians.

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Keyboards. We carry a wide selection of keyboard products and computer peripheral and software packages with prices ranging from $100 to $5,000. We offer an extensive selection of software for the professional, hobbyist, studio engineer and the post-production market enthusiast. The product line covers a broad range of manufacturers including Roland, Alesis, Korg, Kurzweil, Emu and Yamaha. We also maintain a broad selection of computer-related recording products, including sound cards, sound libraries and composition, sequence and recording software.

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Pro-Audio and Recording Equipment. Our pro-audio and recording equipment division offers products ranging in price from $100 to $25,000 for musicians at every level, from the casual hobbyist to the professional recording engineer. Our products range from recording tape to state-of-the-art digital recorders. We believe we also carry one of the largest assortments of professional stage audio, disc jockey and lighting equipment for small traveling bands, mobile disc jockeys, private clubs and large touring professional bands. Our major brand name manufacturers include Digidesign, JBL, Panasonic, Sony, Mackie, Tascam, Yamaha, Roland and Alesis.

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Band and Orchestral Instruments and Accessories. Through American Music Group we offer a full-range of brass and woodwind band instruments including trumpets, flutes, clarinets, trombones, saxophones, piccolos, French horns, flugelhorns, cornets, baritones, and related music accessories. We also offer a full range of stringed instruments, such as violins, violas, cellos, and string basses, and related accessories. Name brand manufacturers include Leblanc, Jupiter, Gemeinhardt, Selmer, Buffet, Schiller, Blessing, DEG, Yamaha and Rico.

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Broad Used Merchandise Selection.    In our retail stores, we offer an extensive selection of used merchandise, the majority of which derives from instruments traded in or sold to us by customers. Our trade-in policy provides musicians with an alternative form of payment and the convenience of selling an old instrument and purchasing a new one at a single location. Used products are bought and priced to sell by store managers who are well trained and knowledgeable in the used musical instrument market.

Retail Store Operations

        To facilitate our strategy of accelerated but controlled growth, we have centralized many key aspects of Guitar Center store operations, including the development of policies and procedures, accounting systems, training programs, store layouts, purchasing and replenishment, advertising and pricing. Such centralization effectively utilizes the experience and resources of our headquarters staff to establish a high level of consistency throughout all of our stores.

        Our Senior Vice President of Stores and 11 regional sales managers lead Guitar Center retail stores. Store management is normally comprised of a store manager, a sales manager, an operations manager, two assistant store managers and five department managers. Each store also has a warehouse manager and a sales staff that ranges from 20 to 40 employees. Retail store operations for American Music is led by our President and Chief Operating Officer. Store management is comprised of a store manager, educational representative and related sales and support staff.

        We ensure that store managers are well trained and experienced individuals who will maintain our store concept and philosophy. Each manager completes an extensive training program that instills the values of operating as a business owner, and only experienced store employees are promoted to the position of store manager. We seek to encourage responsiveness and entrepreneurship at each store by providing store managers with a relatively high degree of autonomy relating to operations, personnel and merchandising. Managers play an integral role in the selection and presentation of merchandise, as well as the promotion of our reputation.

        We view our employees as long-term members of our team. We encourage employee development by providing the sales force with extensive training and the opportunity to increase both compensation and responsibility level through increased product knowledge and performance. Our aggressive growth strategy provides employees with the ability to move into operations, sales and store management positions, an opportunity which management believes is not available at most other music retailers. As we open new stores, the qualified and experienced employees from existing stores primarily fill key in-store management positions. By adopting a "promotion from within" strategy, we maintain a well-trained, loyal and enthusiastic sales force that is motivated by our strong opportunities for advancement. Larry Thomas and Marty Albertson, our Chairman and Co-Chief Executive Officer and President and Co-Chief Executive Officer, respectively, each began their careers as salespersons at Guitar Center.

Marketing and Promotion

        We maintain three unique and proprietary databases (Guitar Center, Musician's Friend and American Music Group) containing information on over 6 million customers. We believe that these databases assist in generating repeat business by targeting customers based on their purchasing history and by permitting us to establish and maintain personal relationships with our customers.

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Retail

        For the Guitar Center retail stores, our advertising and promotion strategy is designed to enhance the Guitar Center name and increase consumer awareness and loyalty. The advertising and promotional campaigns are developed around "events" designed to attract significant store traffic and exposure. We regularly plan large promotional events including the Green Tag Sale in March, the Anniversary Sale in August, and the Guitar-a-thon in November. We believe that our special events have a broad reach as many of them have occurred annually during the past 20 years. These events are often coordinated with product demonstrations, interactive displays, clinics and in-store artist appearances.

        As we enter new markets, we initiate an advertising program, including mail and radio promotions, television and Internet campaigns, and other special grand opening activities, designed to accelerate sales volume for each new store. Radio advertising plays a significant part in our store-opening campaign to generate excitement and create customer awareness.

        For the American Music retail stores, our advertising efforts are focused primarily on schools. The advertising and promotional campaigns are developed around "rental nights" designed to display our orchestral and band instruments at elementary and high schools. These events attract band directors, music educators, parents and students. Our key promotional events are held primarily from August through October. In addition to "rental nights," we also have education representatives that travel around the country to promote and educate band directors on our instruments and our sales and rental programs. We maintain long-term relationships with educators in order to provide visibility to our products and obtain access to student musicians.

Direct Response

        For e-commerce and catalog customers, we maintain a stream of communication in electronic and print media, presenting consumers with an optimized and refreshed mix of offers. Extensive analysis of customer behavior and transactions along with the industry expertise of our merchandising staff provides our marketing staff with offers carefully targeted for optimal response. Cooperative marketing relations with key industry suppliers ensure that Musician's Friend customers are kept current with trends presented by the latest music gear.

        The same transactional databases that make accurate market targeting available for catalog and e-mail circulation are enhanced by the information archived from our website traffic. With the use of an analytical engine developed by Net Perceptions, and continued development of additional tools, our merchandising and marketing departments are able to present product and promotional offerings to prospects with an improved likelihood of triggering purchases.

        Our plans for Musician's Friend include the development of catalogs targeted towards particular segments of the musician market. In 2001, we introduced the Musician's Friend Drummer catalog that is oriented towards percussion instruments and the Musician's Friend DJ catalog oriented for DJ customers.

        We believe that there may be opportunities to acquire complimentary direct response businesses and are also examining opportunities to use the Internet to expand further the reach of our brands. These opportunities are being created by the rapid development of content and community sites oriented towards music and musicians.

Customer Service

Retail

        Exceptional customer service is fundamental to our operating strategy. With the rapid changes in technology and continuous new product introductions, customers depend on salespeople to offer expert advice and to assist with product demonstrations. We believe that our well-trained and highly

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knowledgeable sales force differentiates us from our competitors and is critical to maintaining customer confidence and loyalty. Our employees are typically musicians who are selected and trained to understand the needs of our customers. Guitar Center store salespeople specialize in one of our five product categories and begin training on their first day of employment. Guitar Center store sales and management training programs are implemented on an ongoing basis to maintain and continually improve the level of customer service and sales support in the stores. We believe that our employee testing program impresses upon our salespeople a sense of professionalism and reduces employee turnover by providing salespeople with the opportunity to increase their salaries by advancing through the certification program. We believe that due to our emphasis on training, we are able to attract and retain well-qualified, highly motivated salespeople committed to providing superior customer service. In addition, a technical advisory board certifies each salesperson in the keyboards and pro-audio and recording departments after satisfactory completion of an extensive training program.

        Our Guitar Center store customer base consists of the professional or aspiring musician who makes or hopes to make a living through music and the amateur musician or hobbyist who views music as recreation. Management estimates that professional and aspiring musicians, who generally view the purchase of musical products as a career necessity, represent approximately 68% of our customer base, and account for approximately 74% of our sales. These customers make frequent visits to a store and develop relationships with the sales force. We generate repeat business and are successful in utilizing our unique and proprietary database to market selectively to these customers based on past buying patterns. In addition, we service touring professionals, providing customized products for musical artists.

        The majority of our sales force at American Music is composed of music teachers and education representatives who are experienced band instructors. The customer base of American Music consists primarily of band directors, music educators, college professors who are involved in music education and students of music education programs.

Direct Response

        Musician's Friend maintains a staff of over 280 contact center and customer service associates, staffing the contact center 24-hours-a-day, seven-days-a-week. Customers can contact agents via phone, e-mail, live chat or fax for questions regarding products, technical information, and recommendation information on the status of their accounts to place orders. Most of the staff is comprised of musicians who are given extensive and ongoing product training. The Salt Lake City contact center houses an extensive product demonstration area and training facility. In-house technical staff as well as manufacturers' representatives conducts weekly product training.

        We maintain a database of product information for use by the agents in our contact center that is always available on our corporate intranet. The intranet also makes operational and instructional information available to agents, minimizing their downtime and maximizing their ability to service customer needs effectively. All of this information, along with customer account information, is available in real time, giving agents the ability to keep customers constantly up to date.

        The website is updated hourly with new product information so customers can work with the latest available data. As this is an area that is constantly evolving, customers are continually presented with new and more extensive information. In addition, the collaborative filtering process results in customized product recommendation to customers browsing the website. In 2001, we completed an extensive website upgrade to provide customer identification tracking and more flexible ordering functions to enhance our customer's web experience.

        To provide the customer with a high degree of satisfaction, we offer a 45-day satisfaction guaranteed return policy and 45-day lowest price guarantee. All information regarding transactions and customer accounts is stored in a database accessible by customer service representatives, ensuring that they can provide customers with timely and accurate information regarding their accounts.

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        For customers that have registered e-mail addresses with us, we offer automated order and shipment verification. This provides customers with UPS or Fed Ex order tracking information as soon as their shipment has been processed.

Order Fulfillment

        Musician's Friend orders are fulfilled out of the company-operated distribution center located in Kansas City, Missouri, which became fully operational in 2001. In the second quarter of 2001, we closed our existing distribution facilities in Medford, Oregon and Knoxville, Tennessee and consolidated all direct response fulfillment in the Kansas City facility.

        Credit card authorization and fraud management systems are automated, minimizing delays in processing. The distribution center processes orders taken before 5 p.m., Eastern time, for same-day shipping of in-stock items, minimizing delays in delivery to customers. Orders ship primarily by UPS and Fed Ex.

        All returns are routed to the Kansas City warehouse where repairs and quality evaluations are made. Returned and blemished products are sold through an outlet store located in the Kansas City facility and by offering such products at reduced prices on the musiciansfriend.com website.

        In addition, a small portion of the American Music business is conducted by mail order, with orders fulfilled out of a warehouse located in Liverpool, New York.

Purchasing, Distribution and Inventory Control

        Purchasing.    We believe that we have excellent relationships with our vendors and, in many instances, are the vendor's largest customer. Given our high volume, we are generally able to receive prompt order fulfillment and access to our vendors' premium products. We maintain a centralized buying group comprised of merchandise managers, buyers, planners and distributors. Merchandise managers and buyers are responsible for the selection and development of product assortments and the negotiation of prices and terms. The planners and distributors are responsible for maintaining inventory levels and allocating the merchandise to the stores and direct response distribution center. We use two merchandise replenishment systems (one for the Guitar Center retail stores and one for the direct response business) which automatically analyze and forecast sales trends for each stock keeping unit, or SKU, using various statistical models, supporting the buyers by predicting merchandise requirements. This has resulted in limited "out of stock" positions.

        Our business and expansion plans are dependent to a significant degree upon our vendors. As we believe is customary in the industry, we do not have any long-term supply contracts with our vendors. Please see "—Risks Related to the Business—We depend on suppliers who may not be able to or desire to supply our requirements."

        Distribution.    During 2001, we began construction of a central distribution center in the Indianapolis, Indiana area for our Guitar Center retail store operations with a view towards the facility commencing operation in the second half of 2002. At the present time, we do not have a central warehouse/distribution center and each of our vendors drop ship directly to each of our retail stores. Our Guitar Center retail operations have reached a sufficient size that we believe there is an opportunity to reduce chainwide inventory levels and therefore reduce working capital requirements by operating a central warehouse/distribution center to service the retail stores. We have hired an experienced logistics executive and retained additional key personnel with the skills necessary to manage the central distribution center. Migration from our present "drop-ship" model to a centralized distribution model is an important development in our operating strategy and will require significant financial and managerial resources for the next several quarters.

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        We are also evaluating additional capital and strategic requirements related to improving our fulfillment facilities and technology and pursuing new opportunities in the e-commerce activities of Guitar Center, Musician's Friend, American Music Group and related businesses.

        Inventory Control.    We have invested significant time and resources in our inventory control system at the Guitar Center retail stores and believe we have one of the most sophisticated systems in the music products retail industry. We believe the vast majority of music product retailers do not use a computerized inventory management system. We perform inventory cycle counts daily, both to measure shrinkage and to update the perpetual inventory on a store-by-store basis. As appropriate, we also stock balance inventory among stores to assure proper distribution of product and to control overall inventory levels. Our inventory shrinkage level has historically been low, which we attribute to our sophisticated system controls and strong corporate culture.

Retail Store Site Selection

        We believe we have developed unique and, what historically have been, highly effective selection criteria to identify prospective store sites for our Guitar Center units. In evaluating the suitability of a particular location, we concentrate on the demographics of our target customer as well as traffic patterns and specific site characteristics such as visibility, accessibility, traffic volume, shopping patterns and availability of adequate parking. Stores are typically located in free-standing locations to maximize their outside exposure and signage.

Management Information Systems

Retail

        We have invested significant resources in management information systems that provide real-time information for the Guitar Center division. The systems have been designed to integrate all major aspects of our business, including sales, gross margins, inventory levels, purchase order management, automated replenishment and merchandise planning. Our highly sophisticated management information systems provide us with the ability to monitor all critical aspects of activity on a real-time basis. Our system capabilities include inter-store transactions, vendor analysis, serial number tracking, inventory analysis and commission sales reporting. We believe that the system we have developed will enable us to continue to improve customer service and operational efficiency and support our needs for the immediately foreseeable future.

        We presently have underway a project to install new management information systems at American Music Group. This implementation is an important project to facilitate further integration of American Music with our other business and to provide a scaleable system backbone to facilitate the growth of this division.

Direct Response

        Musician's Friend maintains an extensive transaction processing system as well as systems supporting e-commerce, operations and marketing analysis, and internal support information. All transaction and inventory information is available real-time. The e-commerce website is updated during the day through a firewall, providing a high degree of security for our internal systems. We have completed phase one of a security and redundancy enhancement program for our web systems, relocating related hardware and software to Bellingham, Washington. Dedicated systems are used for inventory planning and for website analysis.

        The systems provide management with extensive marketing, merchandising and operational information, and provide call center and customer service staff with current inventory and customer

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account information. The choice of platforms and databases provides us with a strong foundation for ongoing development of systems.

Competition

        We are in direct competition with two other major retail chains within the music industry—Sam Ash of New York, New York and Music and Recording Superstores ("MARS") of Miami, Florida. In addition, we compete with various direct response companies such as American Music Supply, Sam Ash Music, and Sweetwater Sound. As of December 31, 2001, we were in direct competition with Sam Ash in 12 of our markets and with MARS in 19 of our markets. In recent years, Sam Ash and MARS have continued to open new stores, although that activity slowed in 2001 and MARS recently made a public announcement regarding several store closures. The competitive landscape remains dynamic and we cannot predict what level of national and local competition our retail store and direct response businesses will face in the future. Nonetheless, we continue to believe that there is room for further consolidation within the music products retailing industry as the top five retailers (including Guitar Center, Sam Ash and MARS) only account for an estimated 23% of the market in 2000 compared to an estimated 60% market share held by the top ten specialty retailers in the consumer electronics, home improvement and toy industries.

        We believe that the ability to compete successfully in our markets is determined by several factors, including breadth and quality of product selection, pricing, effective merchandise presentation, customer service, store location and proprietary database marketing programs. Customer satisfaction is paramount to our operating strategy and we believe that providing knowledgeable and friendly customer service gives us a competitive advantage. The store environment is designed to be an entertaining and exciting environment in which to shop. In an effort to exceed customer expectations, our stores provide a number of services not generally offered by most competitors, including the ability to hold and use merchandise, product demonstrations and extensive product selection. Salespeople are highly trained and specialize in one of our five product areas. Salespeople are certified by an outside technical advisory board, based on extensive training and product knowledge testing. We believe that this certification process has increased the professionalism of our employees while reducing turnover. Customers are encouraged to help themselves to the displayed instruments and to seek the assistance of the professional salespeople.

        Certain factors, however, could materially and adversely affect our ability to compete successfully in our markets, including, among others, the expansion by us into new markets in which our competitors are already established, competitors' expansion into markets in which we are currently operating, the adoption by competitors of innovative store formats and retail sales methods or the entry into our markets by competitors with substantial financial or other resources. See "—Risks Related to the Business—We may be unable to meet our growth strategy, which could result in financial performance below that planned for internally or expected by the investment community" and "—We face significant competition particularly from those retailers also trying to execute national expansion strategies."

Employees

        As of December 31, 2001, we employed 4,291 people, of whom 3,085 were hourly employees and 1,206 were salaried. None of our employees are covered by a collective bargaining agreement. We believe that we enjoy good employee relations.

Brand Names and Service Marks

        We operate our core retail stores under the "Guitar Center" brand and our core direct response business under the "Musician's Friend" brand.

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        We have registered the GUITAR CENTER, ROCK WALK, MUSICIAN'S FRIEND, ROGUE, AXMAN, PULSE PERCUSSION, PARADISE, GUITAR MAN, RAM, MIDI BY MAIL, ALUMINATOR, MITCHELL GUITARS, THE MUSICIAN'S CHOICE and AMERICAN MUSIC service marks with the United States Patent and Trademark Office. We believe that these service marks have become important components of our merchandising and marketing strategy. The loss of the GUITAR CENTER, MUSICIAN'S FRIEND or AMERICAN MUSIC service mark could have a material adverse effect on our business.

Risks Related to the Business

        An investment in our securities involves a high degree of risk. Described below are some of the risks and uncertainties facing our company. There may be additional risks that we do not presently know of or that we currently consider immaterial. Any of these risks could adversely affect our business, results of operations, liquidity and financial position.

We may be unable to meet our retail store growth strategy, which could result in financial performance below that planned for internally or expected by the investment community.

        Our retail store growth strategy includes opening new stores and increasing sales at existing locations. We intend to pursue an aggressive expansion strategy by opening additional stores in new and existing markets. We opened a total of 13 Guitar Center stores in 2001, and presently expect to open approximately 12 to 14 additional Guitar Center stores in 2002. Some of these stores will be smaller format units designed for secondary markets. In 2003, our present plan is to open approximately 18 to 22 Guitar Center stores. During 2002, we plan to open six to eight American Music stores. In 2003, our present plan is to open approximately 14 to 16 additional American Music stores. For the immediate future, our objective is that about half of these new American Music units will be new units and about half will be acquisitions of existing businesses. We believe there exists a number of acquisition opportunities in the relatively fragmented band instruments market that could be a good fit into our American Music platform. Our expansion plan depends on a number of factors, including:

•

identification of suitable retail sites and appropriate acquisition candidates;



•

negotiation of acceptable lease terms;



•

hiring, training and retention of skilled personnel;



•

availability of adequate capital;



•

sufficient management and financial resources to support the new locations; and



•

vendor support.

        We cannot assure that we will achieve our store expansion goals or that our new stores will achieve sales or profitability levels similar to our existing stores. Our expansion strategy includes clustering stores in existing markets. This has in the past and may in the future result in the transfer of sales to the new store and a reduction in the profitability of an existing store. In addition to the factors noted above, expansion to new markets may present unique competitive and merchandising challenges, including:

•

significant start-up costs, including promotion and advertising;



•

management of stores in distant locations;



•

availability of desirable product lines; and



•

our expansion may involve acquisitions, including acquisitions in business segments in which we have limited or no experience.

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        Historically, we have achieved significant sales growth in existing stores. Our quarterly comparable stores sales results have fluctuated significantly in the past. Sales growth for comparable periods, excluding net sales attributable to stores not open for 14 months, was as follows for our Guitar Center stores:

        A variety of factors affect our comparable store sales results, including:

•

competition;



•

economic conditions;



•

consumer and music trends;



•

changes in our merchandise mix;



•

product distribution;



•

transfer of sales to new locations (i.e., market clustering); and



•

timing of our promotional events.

        Our management is presently planning for annual comparable store sales growth of 4% to 6% for the immediate future, although fluctuations will undoubtedly take place from period to period. A shortfall in comparative sales growth in any period will likely cause a shortfall in earnings.

        Any shortfall in the growth plan for new stores or our existing stores would likely result in financial performance below that for which we have planned or the investment community expects.

Our growth plans could be accelerated by acquisitions although such transactions involve special risks.

        We believe that our expansion may be accelerated by the acquisition of existing music product retailers. For example, in April 2001 we acquired the business of American Music Group, a New York-based retailer of band instruments, a business in which we were not previously engaged. Further, our growth plans for the American Music Group business contemplate a significant number of relatively small acquisitions. We also regularly investigate acquisition opportunities complimentary to our Guitar Center and Musician's Friend businesses. Accordingly, in the ordinary course of our business, we regularly consider, evaluate and enter into negotiations related to potential acquisition opportunities. We may pay for these acquisitions in cash or securities, including equity securities, or a combination of both. We cannot assure you that attractive acquisition targets will be available at reasonable prices or that we will be successful in any such transaction. Acquisitions involve a number of special risks, including:

•

diversion of our management's attention;



•

integration of the acquired business with our business; and



•

unanticipated legal liabilities and other circumstances or events.

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We depend on suppliers who may not be able to or desire to supply our requirements.

        We depend significantly on our suppliers for both our existing stores and the direct response unit as well as our expansion goals for each of these units. We do not have any long-term contracts with our suppliers, which we believe is customary in our industry. If we failed to maintain our relationships with our key brand name vendors, we believe this could have a material adverse effect on our business. We believe we currently have adequate supply sources; however, we cannot assure you that sufficient quantities or the appropriate mix of products will be available in the future to supply our existing stores and expansion plans. This risk is especially prevalent in new markets where our vendors have existing agreements with other dealers and thereby may be unwilling or unable to meet our requirements. Also, our growth presents a challenge to some of our vendors as it requires significant production increases by them which at times results in extended lead times and shortages of desirable products.

We face significant competition particularly from those retailers also trying to execute national expansion strategies.

        Our industry is fragmented and highly competitive. We compete with many different types of music product retailers, including conventional retailers, as well as other catalog and e-commerce retailers, who sell many or most of the items we sell. We anticipate increased competition in our existing markets and planned new markets as other large format music product retailers, including Sam Ash Music and MARS, execute growth plans in their retail and e-commerce businesses. Additionally, our expansion to new markets will be inhibited by established competitors in those markets. If our competitors adopt a new, innovative store format or retail selling method, or if a new competitor with substantial financial or other resources enters the marketplace, then we may fail to achieve market position gains or may lose market share.

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 Larry Thomas, our Chairman and Co-CEO, Marty Albertson, our President, and Co-CEO, Robert Eastman, the CEO of our wholly-owned subsidiary, Musician's Friend, Inc., and David Flemming, President and Chief Operating Officer of American Music Group, as well as our ability to attract and retain additional key personnel with the skills necessary to manage our existing business and growth plans. 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. During 2001, we entered into a five-year employment contract with each of Mr. Thomas and Mr. Albertson. Additionally, we carry key man insurance on the lives of Mr. Thomas and Mr. Albertson in the amounts of $5.0 million and $3.5 million, respectively. 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 will 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.

We intend to implement a new distribution center for the Guitar Center retail stores, which presents operational risks and will require a significant investment.

        During 2001, we began construction of a central warehouse/distribution center in the Indianapolis, Indiana area for our Guitar Center retail store operations with a view towards the facility commencing operations in 2002. Migration from our present "drop-ship" model to a centralized distribution model is an important development in our operating strategy and will require significant financial and managerial resources for the next several quarters. This program involves financial and operating risks that could include the need to expend greater funds than presently budgeted or disruptions in retail

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store operations and the loss of sales if inventory is not timely provided in the required quantities. Further, one of the key underlying economic assumptions of our distribution center project is that this program will permit us to reduce overall inventory levels as a percentage of sales thereby resulting in significantly reduced working capital requirements. Any failure to reach our inventory reduction targets will adversely affect our future financial performance and capital needs, potentially in a material manner. Failure to execute on these requirements could result in a poor or no return on our investment and a distraction of the efforts of our management team.

Our retail operations are concentrated in California, which ties our financial performance to events in that state.

        As of December 31, 2001, our corporate headquarters as well as 21 of our 96 Guitar Center stores were located in California and stores located in that state generated 28.3% and 29.0% of our retail sales for 2001 and 2000, respectively. Although we have opened and acquired stores in other areas of the United States, a significant percentage of our net sales and results of operations will likely remain concentrated in California for the foreseeable future. As a result, our results of operations and financial condition are heavily dependent upon general consumer trends and other general economic conditions in California and are subject to other regional risks, including earthquakes. We do maintain certain earthquake insurance, but such policies carry significant deductibles and other restrictions.

Economic conditions or changing consumer preferences could also adversely impact us.

        Our business is sensitive to consumer spending patterns, which can be affected by prevailing economic conditions. A downturn in economic conditions in one or more of our markets could have a material adverse effect on our results of operations, financial condition, business and prospects. For example, our business has been adversely affected by recent weak economic conditions and the events of September 11, 2001. Although we attempt to stay informed of consumer preferences for musical products and accessories typically offered for sale in our stores, any sustained failure on our part to identify and respond to trends would have a material adverse effect on our results of operations, financial condition, business and prospects.

We must manage efficiently the expansion of our direct response business, including the musiciansfriend.com website, our systems that process orders in our direct response business, and our fulfillment resources in order to service our customers properly.

        Our direct response business, particularly our e-commerce business, will require significant investments to respond to anticipated growth and competitive pressures. If we fail to rapidly upgrade our website in order to accommodate increased traffic, we may lose customers, which would reduce our net sales. Furthermore, if we fail to expand the computer systems that we use to process and ship customer orders and process payment and the fulfillment facilities we use to manage and ship our inventory, we may not be able to successfully distribute customer orders. We experienced some delays of this sort in 2001 in connection with the consolidation of our fulfillment centers. As a result, we could incur excessive shipping costs due to the need to split delayed shipments, increased marketing costs in the form of special offers to affected customers or the loss of customers altogether. We may experience difficulty in improving and maintaining such systems if our employees or contractors that develop or maintain our key systems become unavailable to us. We have experienced periodic service disruptions and interruptions, which we believe will continue to occur, while enhancing and expanding these systems.

We must efficiently integrate the American Music Group and grow its band instrument business in order to earn an acceptable return on that investment.

        In April 2001, we completed our acquisition of American Music Group, a New York-based retailer of band instruments. We have not previously participated in the band instruments segment of the music

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products business and have no experience in this distribution channel. We have integrated this business into our retail stores division and intend to use the acquired American Music business as a platform to grow in the band instruments business. Thus, we face the normal challenges of any acquisition, such as integration of personnel and systems as well as the need to learn, understand and further develop this business. Further we presently have underway a project to install new management information systems at American Music. This implementation is an important project to facilitate further integrating of American Music with our other businesses and to provide a scaleable systems backbone to facilitate growth of this division. In addition, we have also begun to market through the American Music stores some Guitar Center products not previously marketed by it and to leverage some common infrastructure. Failure to execute on these requirements and initiatives described above could result in a poor or no return on our investment and a distraction of the efforts of our management team from the core Guitar Center and Musician's Friend brands.

Net sales of our e-commerce business could decrease if our online security measures fail.

        Our relationships with our e-commerce customers may be adversely affected if the security measures that we use to protect their personal information, such as credit card numbers, are ineffective. If, as a result, we lose customers, our net sales could decrease. We rely on security and authentication technology that we license from third parties. With this technology, we perform real-time credit card authorization and verification with our bank. We cannot predict whether events or developments will result in a compromise or breach of the technology we use to protect a customer's personal information. Furthermore, our servers may be vulnerable to computer viruses, physical or electronic break-ins and similar disruptions. We may need to expend significant additional capital and other resources to protect against a security breach or to alleviate problems caused by any breaches. We cannot assure that we can prevent all security breaches.

If we do not respond to rapid technological changes, our services could become obsolete and we could lose customers.

        If we face material delays in introducing new services, products and enhancements, our e-commerce customers may forego the use of our services and use those of our competitors. To remain competitive, we must continue to enhance and improve the functionality and features of our online store. The Internet and the online commerce industry are rapidly changing. If competitors introduce new products and services embodying new technologies, or if new industry standards and practices emerge, our existing website and proprietary technology and systems may become obsolete. To develop our website and other proprietary technology entails significant technical and business risks. We may use new technologies ineffectively or we may fail to adapt our website, our transaction processing systems and our computer network to meet customer requirements or emerging industry standards. In addition, the success of e-commerce may result in greater efficiency and lower prices, which could have an adverse effect on selling prices and margins in our retail store business and in our catalog business and generally constrain profitability in the specialty retail business.

Our hardware and software systems are vulnerable to damage that could harm our business

        Our success partially depends upon the efficient operation of our computer hardware and software systems. We use management information systems to track inventory information at the store level, communicate information to and from stores and aggregate daily sales information. These systems and our operations are vulnerable to damage or interruption from:

•

earthquake, fire, flood an other natural disasters; and



•

power loss, computer systems failure, internet and telecommunications or data network failure.

        Any failure that causes an interruption in our operations could result in reduced net sales.

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We may need to change the manner in which we conduct our business if government regulation increases which could impose additional costs and adversely affect our financial results.

        The adoption or modification of laws or regulations relating to the Internet could adversely affect the manner in which we currently conduct our e-commerce business. For example, laws related to the taxation of online commercial activity, including direct response sales, remain in flux. In addition, the growth and development of the market for online commerce may lead to more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on us. Laws and regulations directly applicable to communications or commerce over the Internet are becoming more prevalent. The law of the Internet, however, remains largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing intellectual property, consumer privacy, taxation of e-commerce transactions and the like are interpreted and enforced. Any adverse change in any of these laws or in the interpretation or scope of existing laws could have a material adverse effect on our results of operations, financial condition or prospects.

The results of operations of our Direct Response Division could be materially adversely affected should the distribution of catalogs and other direct mail become more costly or less effective.

        Our Direct Response Division, Musician's Friend, relies on the United States Postal Service to distribute its catalogs and other direct mail communications to consumers. The events of September 11, 2001 disrupted mail delivery. Further, should the United States Postal Service significantly tighten security guidelines or impose additional processes on mail to detect or respond to contamination, the expected result would be increased costs to shippers and lengthened delivery times, each of which will impose greater costs on us. There is also concern, not yet documented, that some consumers are disposing of direct mail pieces, such as catalogs, out of fear of contamination in the mail system. Any trend of this sort would reduce the number of catalogs in circulation, reduce response rates, raise costs and decrease margins.

We have a limited history of trading on the Nasdaq National Market, and our stock price could be volatile.

        We began trading on the Nasdaq National Market on March 14, 1997. The market price of our shares of common stock has been subject to significant fluctuations in response to our operating results and other factors, including announcements by our competitors, and those fluctuations will likely continue in the future. In addition, the stock market in recent years has experienced significant price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of particular companies. These fluctuations, as well as a shortfall in sales or earnings compared to public market analysts' expectations, changes in analysts' recommendations or projections, and general economic and market conditions, may adversely affect the market price of our common stock.

Forward-looking statements and associated risks.

        This annual report contains forward-looking statements, relating to, among other things, future results of operations, growth plans (including, without limitation, the number and timing of new store openings and the growth of our e-commerce business), sales, gross margin and expense trends, capital requirements and general industry and business conditions applicable to us. These statements are based largely on our current expectations and are subject to a number of risks and uncertainties. Our actual results could differ materially from these forward-looking statements. In addition to the other risks described elsewhere in this section, important factors to consider in evaluating these statements include changes in external competitive market factors, changes in our business strategy or an inability to execute our strategy due to unanticipated changes in the music products industry or the economy in general, the emergence of new or growing specialty retailers of music products and various other competitive factors that may prevent us from competing successfully in existing or future markets. In

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light of these risks and uncertainties, we can not assure you that the forward-looking statements contained in this annual report will in fact be realized. Further, we do not undertake any duty to update the forward-looking statements contained in this annual report, particularly those related to management's future estimates which are subject to revision due to changes in the business environment that we face.

Our actual operating results may differ significantly from our projections.

        From time to time, we release projections regarding our future performance that represent our management's estimates as of the date of release. These projections, which are forward looking-statements, are prepared by our management and are qualified by, and subject to, the assumptions and the other information contained in the release. Our projections are not prepared with a view toward compliance with published guidelines of the Securities and Exchange Commission, the American Institute of Certified Public Accountants, any regulatory or professional agency or body, or generally accepted accounting principles. In addition, neither our independent public accountants nor any other independent expert or outside party compiles or examines the projections and, accordingly, no such person expresses any opinion or any other form of assurance with respect thereto. Projections are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and are based upon specific assumptions with respect to future business decisions, some of which will change. We state possible outcomes as high and low ranges which are intended to provide a sensitivity analysis as variables are changed but are not intended to represent that actual results could not fall outside of the suggested ranges. The principal reason that we release this data is to provide a basis for our management to discuss our business outlook with analysts and investors. We do not accept any responsibility for any projections or reports published by any such persons. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions of the projections furnished by us will not materialize or will vary significantly from actual results. Accordingly, our projections are only an estimate of what management believes is realizable as of the date of release. Actual results will vary from the projections and the variations may be material. Investors should also recognize that the reliability of any forecasted financial data diminishes the farther in the future that the data is projected. In light of the foregoing, investors are urged to put the projections in context and not to place undue reliance on them.

        Any failure to successfully implement our operating strategy or the occurrence of any of the events or circumstances set forth in this report could result in the actual operating results being different than the projections, and such differences may be adverse and material.

Item 2. PROPERTIES

        We lease all but three of our stores and presently intend to lease all new locations. We lease both our direct response customer contact center facility in Salt Lake City, Utah with approximately 21,000 square feet and a central distribution center in Kansas City, Missouri with approximately 141,000 square feet. We have entered into a 10-year agreement to lease a 505,000 square feet central distribution center, which is expandable to 750,000 square feet, for our Guitar Center retail stores in Indianapolis, Indiana. The terms of the store leases are generally for 10 years and typically allow us to renew for two additional five-year terms. Most of the leases require us to pay property tax, utilities, normal repairs, common area maintenance and insurance expenses.

        We lease our corporate offices of approximately 69,600 square feet, which are located at 5795 Lindero Canyon Road, California 91362. Our direct response business is headquartered in a facility we own located at 931 Chevy Way, Medford, Oregon 97504 and the American Music Group business is headquartered in a facility we lease located at 7845 Maltlage Drive, Liverpool, New York 13090.

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Store Locations

        The table below sets forth certain information concerning our Guitar Center and American Music retail stores as of December 31, 2001:

Guitar Center Stores