GUITAR CENTER INC - 10-K Annual Report

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, live-sound/DJ 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. As of December 31, 2004, we operated 136 Guitar Center stores. Among the 14 new stores we opened in 2004 were 5 large format stores and 9 small format stores. Current executive officers and key managers have been with our company for an average of 11 years, and our Chief Executive Officer, Mr. Marty Albertson and our Chairman Emeritus, Mr. Larry Thomas, 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. 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 21 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 retail business and serves the student and family market through its 19 band instrument retail stores.

On February 8, 2005, we entered into a definitive agreement to acquire privately held Music & Arts Center, a Maryland-based musical instruments retailer, which primarily addresses the beginning musician, with an emphasis on rentals, music lessons, and band and orchestra instrument sales. Music & Arts Center’s operations include approximately 60 retail locations and seven educational support centers. In the fiscal year ended January 31, 2005, Music & Arts’ sales were approximately $80 million. The Music & Arts stores are primarily located in the Northeast, Mid-Atlantic and Southern regions of the U.S. Under the terms of the agreement, we will acquire Music & Arts Center for approximately $90 million plus the assumption of an estimated $8 million in debt and other deferred obligations. The transaction will be funded through our available cash and recently amended credit facility. The acquisition is subject to customary terms and conditions, including the receipt of third party consents, and the closing is expected to occur in the second quarter of fiscal 2005. We intend to combine our American Music business and Music & Arts, with the combined business operating under the Music & Arts name.

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.

Industry Overview

The United States retail market for music products in 2003 was estimated in a study by the National Association of Music Merchants, or NAMM, to be approximately $7.0 billion in net sales, representing a five-year compound annual growth rate of 2.1%. 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 $5.8 billion of the estimated $7.0 billion of this market’s sales, representing a five-year compound annual growth rate of 6.2%. 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 $7.0 billion of estimated industry sales is the school music market estimated at $530 million in the United States. According to NAMM, despite the ongoing concerns of a national funding crisis in school music, all indications are that the industry’s sales woes had little if anything to do with the number of children participating in instrumental music programs. Rather, the cause seems to be a combination of falling unit prices and new competition. According to published reports, demographics in the school business remain favorable and the public’s appreciation of the value of music training continues to rise.

According to The Music Trades magazine, the industry is highly fragmented with the nation’s five leading music products retailers, as measured by the amount of sales generated by such retailers (i.e., Guitar Center, Inc., Sam Ash Music Corp., Brook Mays Music, Victor’s House of Music and Hermes), accounting for approximately 29.1% of the industry’s estimated total sales in 2003. According to Music USA 2004, there are approximately 8,400 retailers in the industry, and a typical music products store averages approximately 5,100 square feet and generates an average of approximately $1.1 million in annual net sales. In contrast, our standard large format Guitar Center stores generally range in size from 12,000 to 30,000 square feet, and in 2004 these stores generated an average of approximately $9.9 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. This trend accelerated in 2004 with the introduction of products such as Apple’s Garage Band.

Business

Of the 136 Guitar Center stores we operated at December 31, 2004, 113 were located in 46 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 23 stores were located in secondary markets. We also operated 19 American Music stores. From 2000 to

2004, our net sales grew at an annual compound growth rate of 17%, principally due to comparable store sales growth averaging 7% per year, the opening of new stores, and a 22% increase in the direct response channel. We achieved comparable Guitar Center store sales growth of 10%, 7%, and 6% for the fiscal years ended December 31, 2004, 2003 and 2002, respectively. Comparable store sales are defined as sales for the comparable periods, excluding net sales attributable to stores not open for 14 months as of the end of the reporting period.

For the fiscal years ended December 31, 2004, 2003 and 2002, we had net income of $63.4 million, $36.9 million and $25.3 million, respectively.

Guitar Center 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. Based on market research conducted by us, we believe that more than half of our Guitar Center store 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 30,000 square feet (as compared to a typical music products retail store which averages approximately 5,100 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 23 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 stock keeping units, or 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 (guitars, drums, keyboards, live-sound/DJ and recording, and accessories), 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.

We opened a total of 14 Guitar Center stores in 2004, and presently expect to open approximately 22 to 26 additional Guitar Center stores in 2005. This includes 8 to 10 large format stores and 14 to 16 small format stores. The small format stores are designed for secondary markets unable to support a large format unit..

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:

	2004			2003
Number of stores operated for the full year	122			108
Average net sales per square foot	$	585		$	560
Average net sales per store	$	9,184,000		$	8,720,000
Average store-level operating income	$	1,347,000		$	1,113,000
Average store-level operating income margin	14.7		%	12.8		%

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, 2004 and 2003, respectively. Average net sales per square foot,

which increased $25 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 Guitar Center 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.

Our distribution center in the Indianapolis, Indiana area supports our Guitar Center retail store operations. We have a 10-year agreement to lease the facility and we also have numerous additional commitments necessary to support the operations of the facility. Starting in 2003, nearly all products flow through the distribution facility, with the exception of special orders which will continue, for the most part, to be drop shipped to our stores. 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. 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.

American Music Retail

Our American Music division operates family music stores, retailing band and orchestral instruments, introductory guitars, percussion instruments and keyboards, as well as the related accessories. This division also rents its instruments on site and through “satellite stores” operated by third party musical instrument dealers. The principal market for American Music is the school band market. Some of our American Music division stores offer band and orchestral instruments for sale and rental as well as related accessories and a limited assortment of guitars, amplifiers, percussion instruments, keyboards, live-sound/DJ and recording equipment. As of December 31, 2004, American Music operated 19 stores located in New York, Maine, Florida, Massachusetts, Illinois, Arizona, Nevada and Georgia. During 2002, we opened three American Music stores, and acquired five M&M Music stores which were rebranded as American Music stores. In 2003, we opened one and closed two American Music stores. In 2004, we acquired one additional American Music store, Karnes Music, in the Chicago area and, following the acquisition, consolidated the operation of our Carol Stream location into the Karnes Music site in Itasca, resulting in the closure of the Carol Stream location. On February 8, 2005, we entered into a definitive agreement to acquire privately held Music & Arts Center, a Maryland-based musical instruments retailer, which primarily addresses the beginning musician, with an emphasis on rentals, music lessons, and band and orchestra instrument sales. We intend to combine our American Music business and Music & Arts, with the combined business operating under the Music & Arts name. We continue to believe there exists a number of additional acquisition opportunities in the relatively fragmented band instruments market that, like Karnes Music, could be a good fit into our American Music platform and continue to pursue acquisition opportunities. The existing American Music retail stores range from 1,400 to 25,800 square feet, with an average store size of approximately 6,400 square feet. Music & Arts Center’s operations include approximately 60 retail locations and 7 educational support centers.

Direct Response

Our Musician’s Friend subsidiary, which operates as a separate business unit, is an integrated e-commerce and catalog business. Musician’s Friend offers 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. Our catalogs present a fresh assortment of products and promotions throughout the year, mixing big name products with unique and practical offerings. The Musician’s Friend website, www.musiciansfriend.com, offers all that is shown in our catalogs 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 which also houses an outlet store for selling returns and blemished product.

Our customer contact staff receives product and customer service training in the Salt Lake City contact 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 intranet and back-end information systems. As of December 31, 2004, we had 131 full-time associates and 93 part-time associates 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 the support center directly. Our customer service telephone staff for returns is located in the Kansas City distribution center where they can be closer to the returns process while assisting 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 2002 our Kansas City distribution center was expanded by 100,000 square feet to its present 241,000 square feet. In 2003, 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 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.

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.

Business Strategy

Guitar Center Retail

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:

· 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 14 Guitar Center stores in each of 2004 and 2003 and 12 stores in 2002. We currently anticipate

opening approximately 22 to 26 additional Guitar Center stores in 2005. This includes 8 to 10 large format stores and 14 to 16 small format stores. 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 and continue to refine a methodology for targeting prospective store sites which includes analyzing demographic and psychographic characteristics of a potential store location.

· 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 12,000 core SKUs offered through each of our large format Guitar Center stores, and the average 7,000 core SKUs for our small format Guitar Center stores, provide a breadth and depth of in-stock items which we believe are not available from traditional music products retailers.

· Brand Development Strategy. Our plan is to continue to grow our Guitar Center business while also building a retail and rental business in the student and family market using the Music & Arts brand name. 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.

· 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. Most stores also provide private sound-controlled rooms to enhance a customer’s listening experience while testing various instruments.

· Exceptional Customer Service. Exceptional customer service is fundamental to our operating strategy. Accordingly, we conduct extensive training programs for our Guitar Center 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.

· Innovative Promotional and Marketing Programs. We sponsor innovative promotional and marketing events, which include in-store demonstrations, famous artist appearances and weekend 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 10 million customers. This database enables us to advertise to select target customers based on historical buying patterns. We added to our customer database in early 2003 by buying the customer database of Mars Music at an auction conducted in connection with that company’s bankruptcy proceedings. We believe the typical music products retailer does not have the resources to support large-scale promotional events or an extensive advertising program.

· Guaranteed Low Prices. We endeavor to be the low price leader in each of our markets, as underscored by our Guitar Center 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.

· Experienced and Motivated Management Team. Our executive officers and key managers have an average of 11 years employment with Guitar Center.

American Music Retail

· Store Expansion Strategy. We opened a total of eight American Music stores in 2002, five of which we obtained through the acquisition of M&M Music, a family music retailer. In 2003, we opened one and closed two American Music stores. In 2004, we acquired one additional American Music store, Karnes Music, in the Chicago area and, following the acquisition, consolidated the operation of our Carol Stream location to the Karnes Music site in Itasca, resulting in the closure of the Carol Stream location. On February 8, 2005, we entered into a definitive agreement to acquire privately held Music & Arts Center, a Maryland-based musical instruments retailer, which primarily addresses the beginning musician, with an emphasis on rentals, music lessons, and band and orchestra instrument sales. We intend to combine our American Music business and Music & Arts, with the combined business operating under the Music & Arts name. We continue to believe there exists additional attractive opportunities to expand by selectively acquiring existing music products retailers and regularly investigate acquisition opportunities. Most of these opportunities, however, are similar to Karnes Music and involve single stores or small chains in light of the relatively fragmented nature of our industry.

· Experienced and Motivated Management Team. Our executive officers and key managers have an average of 10 years employment with American Music. Effective March 31, 2005, Mr. David Fleming is retiring as President of American Music Group. Upon completion of the Music & Arts transaction, it is expected that the CEO of that business will be President of the combined division.

Direct Response

The goal of the e-commerce and catalog business unit is to capitalize and expand on our leadership position. Our extensive customer database is used to design effective marketing campaigns. The presentation of an extensive selection of products and continual and informative contact with prospects and customers provides attention grabbing content designed to generate results. In 2004 we circulated over 18 million catalogs under the Musician’s Friend, Giardinelli and LMI names and sent over 103 million e-mails to prospects and customers. The call center fielded over 2.1 million calls during 2004, and hosted over 64,000 live chat sessions.

Our key business strategies include the following:

· 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.

· 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. A typical Musician’s Friend catalog presents 4,500 or more SKUs, selected from the 35,000 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. During 2002 we added to our selection by assuming the operation of two small catalogs, Giardinelli and LMI, targeted to the band and educational market previously operated by American Music.

· Continual Customer Contact. Prospects and customers receive periodic mailings from Musician’s Friend, depending on their particular attributes. Musicians can “opt-in” for weekly electronic newsletters featuring news, information and promotions. Our preferred credit card customers (our

“Platinum” and “Clef Member” cards, all issued by a third party provider) receive additional marketing contacts via monthly statement mailings. Our musician-staffed contact 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.

· Experienced and Motivated Management Team. Our executive officers and key managers have an average of 10 years employment with Musician’s Friend.

Retail Merchandising

Guitar Center Retail

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 at Guitar Center. 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 and amplifiers, percussion instruments, keyboards and live sound/DJ and recording equipment, used and vintage, and accessories.

· Guitars and Amplifiers. We believe that our electric, acoustic, classic 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 $99 for entry-level guitars to over $100,000 for special vintage guitars. In addition, our line of stringed instruments includes banjos and mandolins, among others, although not all of these products are for sale at each of our retail locations. 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.

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, Vox, S.W.R. and Mesa Boogie.

· Percussion Instruments. We believe that we are the largest seller of percussion products in the United States. Our offerings range from basic drum kits to congas 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, Tama and Zildjian. We carry an extensive selection of electronic drum kits. These digital units produce a variety of high quality life-like drum sounds and have broad appeal to musicians.

· Keyboards, Live-sound/DJ and Recording Equipment. 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 markets. The product line covers a broad range of manufacturers including Roland, Casio, Korg and Yamaha. We also maintain a broad selection of computer-related recording products, including sound cards, sound libraries, and composition and recording software.

Our live-sound/DJ and recording equipment category 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 accessories to state-of-the-art digital recording systems. 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, Sony, Mackie, Shure, Tascam, Yamaha, Roland and Apple.

· Used and Vintage. We offer an extensive selection of used merchandise, the majority of which derives from instruments and technology products 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 trained and knowledgeable in the used musical instrument market.

· Accessories. Our accessory department offers a broad range of items considered consumables by our musician customers. These items range from guitar strings, picks, cables and straps, to performance microphones, cables and stands, to sophisticated signal processors that modify and enhance the sound of an instrument during performance or recording.

American Music Retail

American Music focuses on the family music market, particularly band instruments.

· Band and Orchestral Instruments and Accessories. Our American Music division offers band and orchestral instruments for sale and rental as well as related accessories and a limited assortment of guitars, amplifiers, percussion instruments, keyboards, live-sound/DJ and recording equipment. 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.

Retail Store Operations

Guitar Center Retail

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, four regional managers and 17 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.

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 our 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. Marty Albertson, our Chief Executive Officer, Mark Galster, our Executive Vice President of Stores and our four regional managers began their careers as a salespersons at Guitar Center.

American Music Retail

Retail store operations for American Music are led by the Vice President of Retail and the educational sales are led by the Vice President of Education. Store management is comprised of a store manager, assistant store manager, educational representative and related sales and support staff.

Marketing and Promotion

We maintain three unique and proprietary databases (Guitar Center, Musician’s Friend and American Music) containing information on over 10 million customers. 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.

Guitar Center 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/December. We believe that our special events have a broad reach as many of them have occurred annually during the past 22 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.

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.

American Music Retail

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. Our American Music stores also rent instruments over the counter.

Direct Response

Our direct response division maintains 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. Key industry suppliers provide on-going training and advertising to ensure our customers are kept current with trends and 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 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. We target specific customers with keyboard, percussion and DJ specialty catalogs.

We believe that there may be opportunities to acquire complementary direct response businesses and are also examining opportunities to use the Internet to expand further the reach of our brands. For example, in early 2003 we purchased the principal assets of Marsmusic.com, including the URL address and hardware. New opportunities are being created by the rapid development of auction, content and community sites oriented towards music and musicians.

Customer Service

Guitar Center 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 knowledgeable sales force differentiates us from our competitors and is critical to maintaining customer confidence and loyalty. Our employees are typically musicians trained to understand the needs of our customers. Guitar Center store salespeople specialize in one of our six 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. Our management estimates that professional and aspiring musicians, who generally view the purchase of musical products as a career necessity, represent approximately half of our customer base, and account for more than half 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.

American Music Retail

The majority of our educational representative sales force at American Music is composed of music teachers who are experienced band instructors. We also 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.

Direct Response

As of December 31, 2004, Musician’s Friend had a staff of 131 full-time and 93 part-time 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 regular 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 every 15 minutes 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. The website is continuously improved for customer ease and, in 2004, the Musician’s Friend web site received the Platinum Award from BizRate for customer service.

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.

Direct Response 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 2002, we expanded the facility to 241,000 square feet.

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 distribution center 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, 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. Both Guitar Center and Musician’s Friend maintain centralized buying groups. Our centralized buyers include merchandise managers, buyers, planners, forecasters, 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, forecasters, replenishers and allocators are responsible for maintaining inventory levels and allocating the merchandise to the retail distribution center, stores and direct response fulfillment 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 satisfactory 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, suppliers and common carriers who may not be able to or desire to supply our requirements.”

Distribution. Our distribution center in the Indianapolis, Indiana area supports our Guitar Center retail store operations. The facility commenced operations in July 2002. We have a 10-year agreement to lease the facility. Commencing in 2003, nearly all products flowed through the distribution facility, with the exception of special orders which will continue, for the most part, to be drop-shipped to our stores. 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.

We also continue to make significant investments in information technology across our businesses and to incur costs and make investments designed to expand the reach of our businesses on the Internet. The costs of these initiatives and other investments related to our businesses will continue to be significant.

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 at Guitar Center and Musician’s Friend, 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

Guitar Center 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 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.

American Music Retail

We continue to invest significant resources in the development and implementation of the basic information systems for American Music. The systems have been designed to operate and control fundamental business processes, including sales, rentals, store operations, inventory levels, purchase order management, and finance.

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. 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. In 2003, 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.

Competition

We are in direct competition with Sam Ash Music based in New York, New York, a major multi-unit retail chain in the music products industry. 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, 2004, we were in direct competition with Sam Ash in 38 of our markets. In recent years, Sam Ash has continued to open new or acquired stores. One of our primary competitors, Mars Music, Inc., filed for federal bankruptcy court protection on September 27, 2002, and completed a liquidation resulting in the closure of all of its stores. Of the Mars Music stores closed, Sam Ash acquired four of the locations from the bankruptcy court. 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 two retailers, per The Music Trades magazine (Guitar Center and Sam Ash), only accounted for an estimated 24.0% of the market in 2003.

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.”

Employees

As of December 31, 2004, we employed 6,434 people, of whom 5,442 were hourly employees and 992 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 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, RAM, MITCHELL GUITARS, THE MUSICIAN’S CHOICE, AMERICAN MUSIC, DIGITAL REFERENCE and MUSICIAN’S FRIEND.COM, FRETREST, GUITAR CENTER’S DRUMOFF, GUITAR CENTER’S SPINOFF, LIVEWIRE AND PROLINE 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 would likely 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. All 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, 2004, we operated 136 Guitar Center stores and 19 American Music stores. We opened a total of 14 Guitar Center stores in 2004, and currently expect to open approximately 22 to 26 additional Guitar Center stores in 2005. This includes 8 to 10 large format stores and 14 to 16 small format stores. Our planned store opening schedule may be affected by any acquisitions we may transact during a given period. If we complete any such transactions, our planned organic store openings may be reduced.

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. In 2003, we opened one American Music store and closed two. In 2004, we acquired one additional American Music store in the Chicago area and, following the acquisition, moved the operation of our Carol Stream location to the Karnes Music site in Itasca, resulting in the closure of the Carol Stream location. We believe there exists a number of acquisition opportunities, like Karnes Music, in the relatively fragmented band instruments market that could be a good fit into our American Music platform. On February 8, 2005, we entered into a definitive agreement to acquire privately held Music & Arts Center, a Maryland-based musical instruments retailer, which primarily addresses the beginning musician, with an emphasis on rentals, music lessons, and band and orchestra instrument sales. We intend to combine our American Music business and Music & Arts, with the combined business operating under the Music & Arts name. The American Music division incurred significant operating losses in 2003 and 2004, and absent the scale to be provided by the Music & Arts transaction, would likely incur operating losses in 2005.

The success of our retail store expansion plans depend on many 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;

· vendor support; and

· successful completion of our management information system and infrastructure build-out at American Music and integration of the Music & Arts business.

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 under perform 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, which could include international markets. This expansion into new markets will present unique competitive and merchandising challenges, including:

· significant start-up costs, including promotion and advertising;

· higher advertising and other administrative costs as a percentage of sales than is experienced in mature markets that are served by multiple stores, particularly in large urban markets where radio and other media costs are high;

· management of stores in distant locations or foreign countries;

· availability of desirable product lines; and

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

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 Guitar Center 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 Guitar Center 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 retail stores:

2004

2003

2002

(Mark One)
x	ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2004
or
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

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