GUITAR CENTER INC - 10-K Annual Report

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

Delaware (State or other jurisdiction of incorporation or organization)		95-4600862 (I.R.S. Employer Identification Number)
5795 Lindero Canyon Road Westlake Village, California		91362 (Zip Code)
(Address of principal executive offices)

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

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 194 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o

Indicate by check mark 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. ý

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes ý No o

As of March 6, 2003, the aggregate market value of voting stock held by nonaffiliates of the Company was approximately $358,289,000 (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 and each 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.

As of March 6, 2003 there were 22,791,134 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 April 30, 2003 are incorporated by reference into Part III.

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 10 years and our two Co-Chief 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, a separate business unit of our company, 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 19 years.

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 operates as a division of our retail business and serves the student and family market through its 20 band instrument retail stores. The American Music 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 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 and has been with the company for 27 years.

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. Our periodic and current reports are available, free of charge, on the website noted above at a reasonable time following the filing with the SEC. 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.

The United States retail market for music products in 2001 was estimated in a study by the National Association of Music Merchants, or NAMM, to be approximately $6.9 billion in net sales, representing a five-year compound annual growth rate of 2.8%. The broadly defined music products market, according to 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 the estimated $6.9 billion of this market's sales, representing a five-year compound annual growth rate of 4.6%. The music products market, as currently defined by NAMM, however, does not include the significant used and vintage product markets or apparel markets in which we actively participate.

Included in the $6.9 billion of estimated industry sales is the band instrument market estimated at $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 each of the past eight years and publicity linking music making and improved academic performance has unquestionably improved prevailing attitudes towards music and music education.

According to The Music Trades magazine, 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, Brook Mays/H&H, Sam Ash Music Corp., Hermes Music and Victor's House of Music), accounting for approximately 23.2% of the industry's estimated total sales in 2001. The list of leading retailers excludes Mars Music, which was liquidated in the fourth quarter of 2002. Furthermore, approximately 90% of the industry's estimated 6,000 to 6,200 retailers operate only one or two stores. A typical music products store averages approximately 5,500 square feet and generates an average of approximately $1.2 million in annual net sales. In contrast, our standard large format Guitar Center stores generally range in size from 12,000 to 20,000 square feet, and in 2002 these stores generated an average of approximately $9.0 million in annual net sales for stores open the full year.

Over the past decade, 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 primarily by professional sound recording studios.

As of December 31, 2002, we operated 108 Guitar Center stores, consisting of 96 stores in 40 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, Denver and Cleveland, and 12 stores in secondary markets. We also operated 20 American Music stores, including the five stores acquired from M&M Music in June 2002. From 1998 to 2002, our net sales grew at an annual compound growth rate of 22.5%, principally due to comparable store sales growth averaging 8.2% per year, the opening of new stores, and a 27.9% increase in the direct response channel. We achieved comparable store sales growth of 6%, 6%, and 7% for the fiscal years ended December 31, 2002, 2001 and 2000, respectively.

For the fiscal years ended December 31, 2002, 2001 and 2000, we had net income of $25.3 million, $17.0 million and $22.5 million, respectively.

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. Based on market research conducted by us, we believe approximately 73% of our sales are to professional and aspiring musicians who generally view the purchase of music products as a 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 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 5,500 square feet) and is designed to encourage customers to hold and play instruments. In late 2000, we opened our first smaller format store, and have since opened 9 additional small format stores. We plan to continue 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 12,000 core SKUs and each small format store carries an average of 7,000 core SKUs, which in each case our management believes is significantly greater than a typical music products retail store. Our core SKUs represent our consistent and established product lines which are considered staple products for our customers. 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 key operating statistics of our Guitar Center stores and is based upon the stores operated by us for the full year ended December 31:

	2002			2001
Number of stores operated for the full year		96			83
Average net sales per square foot	$	546		$	537
Average net sales per store	$	8,616,000		$	8,657,000
Average store-level operating income	$	941,000		$	871,000
Average store-level operating income margin		10.9	%		10.1	%

The above key operating statistics are based upon results of Guitar Center retail stores in operation for at least 12 months as of December 31, 2002 and 2001, respectively. Average net sales per square foot, which increased $9 in the current year, is a measure of sales efficiency based on square footage. Average net sales per store represents the average result of stores open more than 12 months, and is typically affected by the opening of small format stores which generate lower levels of sales. Although small format stores generate lower levels of sales, these stores cost less to build, stock and operate than our large format stores. Store-level operating income and margin includes individual store revenue and expenses plus allocated rebates, cash discounts and purchasing department salaries (based upon individual store sales).

Our American Music division operates family music stores, retailing band and orchestral instruments, introductory guitars, percussion and keyboards, as well as related accessories. These instruments are sold or rented principally to the school band market. As of December 31, 2002, American Music operated 20 stores located in New York, Maine, Florida, Massachusetts, Illinois, Arizona, Nevada and Georgia. AMG retail stores range from 1,300 to 10,000 square feet, with an average store size of approximately 4,500 square feet. This division also rents its instruments through third party musical instrument dealers referred to as "satellite stores."

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 12 Guitar Center stores in 2002, and presently expect to open approximately 16 to 18 additional Guitar Center stores in 2003. Some of these stores will be smaller format units designed for secondary markets.

The acquisition of American Music 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 opened three American Music stores and acquired five M&M Music stores. In 2003, our present plan is to open approximately six to eight additional American Music stores, with some of this expansion likely to come through the acquisition 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. During 2002, we added a significant number of guitar, percussion, pro audio, keyboard and accessory products to the American Music retail stores. Our objective is to position American Music as a family music store capable of fulfilling a wider array of consumer needs.

During 2001, we began construction of a distribution center in the Indianapolis, Indiana area to support our Guitar Center retail store operations. The facility commenced operations in July 2002. We have entered into a 10-year agreement to lease the facility and have entered into agreements to lease equipment to support its operations. We also have entered into numerous additional commitments necessary to further support the operations of the facility. As of December 31, 2002, most product was flowing through the distribution facility, with the exception of limited products which we continue to drop ship to our stores. Our plans in 2003 are for nearly all product to flow through this distribution facility with the exception of special orders which will continue, for the most part, to be drop shipped to our stores. Completion of the migration from our former "drop-ship" model to a centralized distribution model is an important development in our operating strategy and has required the allocation of significant financial and managerial resources. In accordance with generally accepted accounting principles, a portion of the costs of operating this facility are absorbed into our Guitar Center merchandise inventories and recognized as an element of cost of goods sold when the related inventory is sold. This could result in a slight decrease in reported gross margin depending on our success in defraying these additional costs, although we also hope to realize efficiencies involving other costs such as selling, general and administrative and interest expense.

Our Musician's Friend subsidiary, which we operate as a separate business 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 210 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. In 2002 we relocated our customer service telephone staff for returns to our Kansas City distribution center where they could be closer to the returns process while assisting our customers.

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. In 2002 our Kansas City distribution center was expanded by 100,000 square feet to its present 241,000 square feet. Initiatives were completed to improve inventory management and reduce outbound shipping costs. 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 FedEx 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.

Our business plan is to continue to leverage our leading industry position and existing infrastructure, and to build on that base to support the continued 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.

The goal in the retail stores business 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:

The goal of the e-commerce and catalog business unit is to capitalize and expand on our leadership position. Leveraging of our extensive customer database is used to design 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 2002, we circulated over 15.8 million catalogs and sent over 96.4 million e-mails to prospects and customers. The call center fielded over 2.2 million calls during 2002, and hosted over 40,000 live chat sessions.

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:

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 utilizes the experience and resources of our headquarters staff to establish a high level of consistency throughout all of our stores.

Our Executive Vice President of Stores and 11 district sales managers manage the 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 the President and Chief Operating Officer of that division. Store management is comprised of a store manager, assistant 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 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.

We maintain three unique and proprietary databases (Guitar Center, Musician's Friend and American Music) containing information on over 7 million customers, including approximately 2 million customer names which were purchased in early 2003 from Mars Music at an auction conducted in connection with that company's bankruptcy proceedings. We believe that these databases assist in identifying customer prospects and in generating repeat business by targeting consumers based on their purchasing history and by permitting us to establish and maintain personal relationships with our customers.

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. Cooperative advertising and in-store training from our major vendors ensures that our customers are kept current with trends presented by the latest music gear.

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.

We provide limited credit to corporate customers and similar house accounts on a current account basis. Generally, all credit made available to retail customers and all extended payment arrangements are provided by third party consumer credit companies which are non-recourse to us, meaning that the risk of non-payment is borne by the third party provider so long as we comply with its administrative and approval policies. These arrangements also give us the flexibility to offer attractive payment options to our customers on a promotional basis, such as no interest periods, reduced interest rates or deferred payment options. These programs are also non-recourse to us but we pay the credit provider a fee reflecting the below-market, promotional benefit of the particular program.

For the American Music retail stores, our advertising efforts are focused primarily on the school band market and community. For instrument rental 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.

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 advertising and on-going training with key industry suppliers ensures 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 relevant and personalized product and promotional offerings to prospects.

Musician's Friend also offers its customers private label credit card programs on non-recourse terms comparable to those offered by Guitar Center. These programs include the Platinum Card offered by Musician's Friend and the new Clef Card offered for customers of the Giardinelli band

instruments catalog. These credit cards permit us to offer carefully tailored competitive promotional opportunities to our customers.

Our plans for Musician's Friend include the development of catalogs targeted towards particular segments of the musician market. In 2002, Musician's Friend took over production of two small catalogs from the American Music division. The LMI Catalog is oriented toward young, school-aged children and the Giardinelli Catalog is targeted to band and orchestra buyers. 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. For example, in late 2002 we purchased the principal assets of Marsmusic.com, including the URL address and hardware. New opportunities are also being created by the rapid development of content and community sites oriented towards music and musicians.

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 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.

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 58% of our customer base, and account for approximately 73% 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. With the introduction of the family music store concept, we have added a limited retail sales force. The customer base of American Music has historically consisted of band directors, music educators, college professors who are involved in music education and students of music education programs.

Musician's Friend maintains a staff of over 210 contact center 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 or the status of their 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 conduct 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, customers may return items for a full refund within 45 days of purchase. Additionally, if customers find a lower advertised price within 45 days of purchase, we will match the competitor's advertised price.

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

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. In 2002, we expanded the facility to 241,000 square feet, adding another 100,000 square feet for bulk inventory storage.

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 FedEx.

All returns are routed to the Kansas City warehouse where repairs and quality evaluations are made. On site repair and customer service representatives assist our customers and reduce the costs associated with returns. 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.

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. Both Guitar Center and Musician's Friend maintain centralized buying groups. Our centralized buyers include merchandise managers, buyers, planners, replenishers, and allocators. Merchandise managers and buyers are responsible for the selection and development of product assortments and the negotiation of prices and terms. The planners, replenishers and allocators are responsible for maintaining inventory levels and allocating the merchandise to the retail distribution center, stores and direct response distribution center. We use merchandise replenishment systems 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 while maintaining minimal inventory levels.

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 a relatively small number of manufacturers and suppliers who may not be able to or desire to supply our requirements."

Distribution. During 2001, we began construction of a distribution center in the Indianapolis, Indiana area to support our Guitar Center retail store operations. The facility commenced operations in July 2002. We have entered into a 10-year agreement to lease the facility. As of December 31, 2002, nearly all product was flowing through the distribution facility, with the exception of special orders which will continue, for the most part, to be drop-shipped to our stores. Completion of the migration from our former "drop-ship" model to a centralized distribution model is an important development in our operating strategy and has required the allocation of significant financial and managerial resources. In accordance with generally accepted accounting principles, a portion of the costs of operating this facility are absorbed into our Guitar Center merchandise inventories and recognized as an element of cost of goods sold when the related inventory is sold. This could result in a slight decrease in reported gross margin depending on our success in defraying these additional costs, although we also hope to realize efficiencies involving other costs such as selling, general and administrative and interest expense.

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 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.

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.

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 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. This implementation is an important project to facilitate the American Music family music store concept and to provide a scaleable system backbone to facilitate the growth of this brand.

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. Our direct response business does not have redundant Internet or operating systems and would be vulnerable to catastrophic events. In the event of a disaster, our direct response business would most likely experience delays in processing and shipping orders until we executed our failure recovery plans. Dedicated systems are used for inventory planning and for website analysis. Initiatives were completed to improve inventory management and reduce outbound shipping costs. Many of the systems which run our distribution center operations function via wireless technology.

The systems provide management with extensive marketing, merchandising and operational information, and provide call center and customer service staff with current inventory and customer account information. The choice of platforms and databases provides us with a strong foundation for ongoing development of systems.

We are in direct competition with the other major multi-unit retail chain in the music products industry—Sam Ash Music based in New York, New York. In addition, we compete with various direct response companies such as American Music Supply (unrelated to our American Music division), Sam Ash Music, and Sweetwater Sound. As of December 31, 2002, we were in direct competition with Sam Ash in 14 of our markets. In recent years, Sam Ash has continued to open new or acquired stores, and various store openings are planned for 2003. One of our primary competitors, Mars Music, Inc., or Mars, filed for federal bankruptcy court protection on September 27, 2002 and has completed a liquidation resulting in the closure of all of its stores. We cannot predict the impact the closure of Mars will have on our business, including how many of the Mars customers will move their shopping to our businesses versus our competitors. Of the Mars Music stores closed, Sam Ash acquired four of the locations. 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, per The Music Trades magazine, (including Guitar Center and Sam Ash) only account for an estimated 23.2% of the market in 2001.

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 internal training team, 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.

Various 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 Guitar Center and American Music retail growth strategy, which could adversely affect our results of operations" and "—We face significant competition, and our efforts to increase our market share may be inhibited by existing or new competitors also trying to execute national expansion strategies."

As of December 31, 2002, we employed 5,003 people, of whom 4,197 were hourly employees and 806 were salaried. None of our employees are covered by a collective bargaining agreement. We believe that we enjoy good employee relations.

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

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.

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. A shortfall in comparative sales growth in any period will likely cause a shortfall in earnings, and result in financial performance below that for which we have planned or the investment community expects.

We may be unable to meet our Guitar Center and American Music retail store growth strategy, which could adversely affect our results of operations.

Our retail store growth strategy includes opening new stores in new and existing markets and increasing sales at existing locations. As of December 31, 2002, we operated 108 Guitar Center stores and 20 American Music stores. We opened a total of 12 Guitar Center stores in 2002, and currently expect to open approximately 16 to 18 additional Guitar Center stores in 2003. Some of these Guitar Center stores will be smaller format units designed for secondary markets.

We opened a total of eight American Music stores in 2002, five of which were acquired in connection with American Music's acquisition of M&M Music, a band instrument retailer. We currently expect to open approximately six to eight additional American Music stores in 2003. Some of these stores may be acquired in connection with the acquisition 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.

The success of our retail store expansion plans depend on many factors, including:

A number of these factors are, to a significant extent, beyond our control. As a result, we do not know whether we will be able to continue to open and/or acquire additional Guitar Center and American Music stores at the rates currently anticipated. If we are unable to achieve our retail store expansion goals, or the new stores underperform our expectations, our results of operations could be adversely affected.

We face unique competitive and merchandising challenges in connection with our plans to open additional Guitar Center and American Music retail stores in new markets.

As part of our retail growth strategy, we plan to open and/or acquire additional Guitar Center and American Music stores in new markets. This expansion into new markets will present unique competitive and merchandising challenges, including:

Any of these factors may lead to a shortfall in revenues or an increase in costs with respect to the operation of these stores. If we are not able to operate these stores profitably, our results of operations would be adversely affected.

Our retail store expansion strategy, including our strategy of clustering retail stores, may adversely impact our comparable store sales.

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 retail stores:

		2002		2001		2000
Quarter 1		5	%	7	%	8	%
Quarter 2		8	%	5	%	7	%
Quarter 3		5	%	3	%	6	%
Quarter 4		7	%	6	%	7	%
	Full Year	6	%	6	%	7	%

We do not know whether our new stores will achieve sales or profitability levels similar to our existing stores. Our expansion strategy includes clustering stores in existing markets. Clustering 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, a variety of factors affect our comparable store sales results, including:

Our management is presently planning for annual comparable store sales growth of 5% to 7% 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, and result in financial performance below that for which we have planned or the investment community expects.

Our growth plans depend on our completion of acquisitions, and these 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. Our growth plans for the American Music business contemplate a significant number of relatively small acquisitions. For example, in June 2002 American Music acquired M&M Music, a band instrument retailer. 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:

We depend on a relatively small number of manufacturers and suppliers who may not be able to or desire to supply our requirements.

Brand recognition is of significant importance in the retail music products business. As a result, we depend on a relatively small number of manufacturers and 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, and any failure to maintain our relationships with our key brand name vendors would have a material adverse effect on our business. A number of the manufacturers of the products we sell are limited in size and manufacturing capacity and have significant capital or other constraints. These manufacturers may not be able or willing to meet our increasing requirements for inventory, and 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. These capacity restraints could lead to extended lead times and shortages of desirable products. The risk is especially prevalent in new markets where our vendors have existing agreements with other dealers and thereby may be unwilling or unable for contractual or other reasons to meet our requirements. The efficient operation of our new distribution center for the Guitar Center stores is also highly dependent upon compliance by our vendors with precise requirements as to the timing, format and composition of shipments, which in many instances requires changes and upgrades to the operational procedures and logistics and supply chain management capabilities of vendors, all of which are outside of our control. Additionally, many of our vendors receive product from overseas and depend on common carriers to transport merchandise into the country. We also rely on common carriers to transport product from our vendors to our central distribution center in Indiana, and from the distribution facility to our Guitar Center stores. Any disruption in the services of common carriers due to employee strikes or other unforeseen events could impact our ability to maintain sufficient quantities of inventory in our retail locations.

We face significant competition, and our efforts to increase our market share may be inhibited by existing or new competitors also trying to execute national expansion strategies.

The retail music products 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 believe that large format music product retailers such as our company will seek to expand in part through the acquisition of small, independently owned stores or franchises, and we anticipate increased competition in our existing markets and planned new markets from these consolidating retailers. These retailers may identify target companies or execute their acquisition strategies more effectively than our company. In addition, these retailers may have greater financial resources or other competitive advantages as compared to our company. Our expansion to new markets will be inhibited by these and other established competitors. In addition, one or more of our competitors may adopt a new, innovative store format or retail selling method. If we are not able to compete effectively, we may fail to achieve market position gains or may lose market share.

Mars Music, Inc. filed for federal bankruptcy court protection on September 27, 2002 and closed all of its stores in 2002. We cannot predict the impact that the closure of Mars will have on our business, including how many of the Mars customers will move their shopping to our business versus our competitors.

We must efficiently integrate American Music 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 had not previously participated in the band instruments segment of the music products business and had no prior experience in this distribution channel. We intend to use the acquired American Music business as a platform to develop and grow a family music store concept that will emphasize band instruments and also sell selected guitar, percussion, pro audio, keyboard and accessory products sold by our Guitar Center stores. 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. We are installing new management information systems at American Music, which has proven to be a challenging project requiring more time and resources than originally anticipated. This implementation is an important project to facilitate further integrating of American Music with our other businesses and to provide a systems backbone to permit growth of this division. In addition, in 2002 we started marketing through the American Music stores some Guitar Center products not previously carried by American Music. This change in merchandising strategy from the historic focus of American Music on band instruments is in process and is an important element of our family music store concept for this brand. Failure to execute on these requirements and initiatives could result in a poor or no return on our investment, constitute a distraction of the efforts of our management team from the core Guitar Center and Musician's Friend brands and potentially require us to recognize an impairment in the significant amount of goodwill recorded in the acquisitions of American Music and M&M Music.

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 Fleming, President and Chief Operating Officer of American Music, 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.

The implementation of our new distribution center for the Guitar Center retail stores presents operational risks and represents a significant investment.

During 2001, we began construction of a distribution center in the Indianapolis, Indiana area to support our Guitar Center retail store operations. The conveyor systems, the warehouse management system, and all other technology systems and infrastructure commenced operations in July 2002. Migration from our former "drop-ship" model to a centralized distribution model is an important development in our operating strategy and will continue to require significant financial and managerial resources for the next several quarters. The efficient operation of the distribution center is also dependent upon the performance of third parties that we do not control, such as vendors who must

comply with new operating procedures and common carriers who must deliver product on time. This program involves financial and operating risks that could include the need to expend greater funds than presently budgeted or disruptions in retail 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, disruption of our retail store business 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, 2002, our corporate headquarters as well as 22 of our 108 Guitar Center stores were located in California and stores located in that state generated 27.5% and 28.3% of our retail sales for 2002 and 2001, 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 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, such as occurred after September 11, 2001, could have a material adverse effect on our results of operations, financial condition, business and prospects. Recent weak economic conditions have created uncertainty as to the future direction of the economy which is likely to continue to impact hobbyists and other general consumers who purchase from Musician's Friend and our American Music and Guitar Center stores. 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 may need to change the manner in which we conduct our business if government regulation or taxation imposes additional costs and adversely affects our financial results.

The adoption or modification of laws or regulations, or revised interpretations of existing laws, relating to the direct response industry could impose material liability on us and adversely affect the manner in which we currently conduct our catalog and e-commerce business. For example, laws related to the taxation of catalog, telephone, and online commercial activity, including the applicability of state sales and use taxes to direct response sales and direct response merchants such as Musician's Friend, 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, sales-based and other taxation of e-commerce transactions and the like are interpreted and enforced. Any adverse change in any of these laws or in the enforcement, interpretation or scope of existing laws

could result in material liability to us and have a material adverse effect on our results of operations, financial condition or 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 payments 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.

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 vital to the efficient operation of our retail stores and direct response business, and damage to these systems could harm our business.

We rely on our computer hardware and software systems for the efficient operation of our retail stores and direct response business. Our information systems provide our management with real-time inventory, sales and cost information that is essential to the operation of our business. Due to our number of stores, geographic diversity and other factors, we would be unable to generate this information in a timely and accurate manner in the event our hardware or software systems were unavailable. These systems are vulnerable to damage or interruption from a number of factors, including:

A significant information systems failure could reduce the quality or quantity of operating data available to our management. If this information were unavailable for any extended period of time, our management would be unable to efficiently run our business, which would result in a reduction in our net sales.

To attempt to mitigate these risks we have contracted services from third parties to provide backup systems for our Guitar Center retail stores in the event of a disaster. These services provide for our "mission critical" systems to be online within 48 hours following most disasters. Our direct response business does not have redundant Internet or operating systems and would be vulnerable to catastrophic events. In the event of a disaster, our direct response business would most likely experience delays in processing and shipping orders until we executed our failure recovery plans.

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

Our Direct Response business, Musician's Friend, relies on the United States Postal Service to distribute its catalogs and other direct mail communications to consumers. 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. We are also concerned that some consumers may dispose of direct mail pieces, such as catalogs, if fears of contamination in the mail system are heightened. Any trend of this sort would reduce the number of catalogs in circulation, reduce response rates, raise costs and decrease margins.

The market price of our 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' 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 contained in this annual report are subject to risks and other uncertainties.

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, comparable store sales growth 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 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.

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 American Institute of Certified Public Accountants, and 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 generally 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.

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 241,000 square feet, and our 505,000 square feet Guitar Center retail central distribution center near 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, Westlake Village, 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 division is headquartered in a facility we lease located at 7845 Maltage Drive, Liverpool, New York 13090.

The table below sets forth information concerning our Guitar Center and American Music retail stores as of December 31, 2002:

Store		Year Opened	Gross Square Feet	Status
Arizona
	Phoenix	1997	13,600	Lease
	Tempe	1997	12,100	Lease
	Tucson	2001	13,000	Lease
	Scottsdale (1)	2003	17,500	Lease
Arkansas