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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


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

(Mark One)

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

For the fiscal year ended December 31, 2001
or

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

For the transition period from                              to                             

Commission file number 000-22207

GUITAR CENTER, INC.

(Exact name of registrant as specified in charter)

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)    

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

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

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

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

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

        Check whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days. YES ý    NO o

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

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

The Exhibit Index appears on page 36.





PART I

Item 1. BUSINESS

Company History

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

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

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

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

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

Industry Overview

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

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

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

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

Business

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

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

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

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

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

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

 
  2001
  2000
 
Number of stores operated for the full year     83     69  
Average net sales per square foot   $ 537   $ 535  
Average net sales per store     8,657,000     8,720,000  
Average store-level operating income (1)     871,000     945,000  
Average store-level operating income margin (1)     10.1 %   10.8 %

(1)
Store-level operating income includes individual store revenue and expenses plus allocated rebates, cash discounts and purchasing department salaries (based upon individual store sales).

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

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

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

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

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

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

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

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

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

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

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

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Business Strategy

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

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

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Merchandising

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

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Retail Store Operations

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

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

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

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

Marketing and Promotion

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

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

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

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

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

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

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

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

Customer Service

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

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

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

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

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

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

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

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

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

Order Fulfillment

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

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

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

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

Purchasing, Distribution and Inventory Control

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

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

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

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

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

Retail Store Site Selection

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

Management Information Systems

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

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

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

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

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

Competition

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

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

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

Employees

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

Brand Names and Service Marks

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

13



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

Risks Related to the Business

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

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

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

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

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

 
  2001
  2000
  1999
 
Quarter 1   7 % 8 % 10 %
Quarter 2   5 % 7 % 7 %
Quarter 3   3 % 6 % 11 %
Quarter 4   6 % 7 % 11 %
  Full Year   6 % 7 % 10 %

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

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

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

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

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

15


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

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

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

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

We depend on key personnel including our senior management who are important to the success of our business.

        Our success depends to a significant extent on the services of Larry Thomas, our Chairman and Co-CEO, Marty Albertson, our President, and Co-CEO, Robert Eastman, the CEO of our wholly-owned subsidiary, Musician's Friend, Inc., and David Flemming, President and Chief Operating Officer of American Music Group, as well as our ability to attract and retain additional key personnel with the skills necessary to manage our existing business and growth plans. The loss of one or more of these individuals or other key personnel could have a material adverse effect on our business, results of operations, liquidity and financial position. During 2001, we entered into a five-year employment contract with each of Mr. Thomas and Mr. Albertson. Additionally, we carry key man insurance on the lives of Mr. Thomas and Mr. Albertson in the amounts of $5.0 million and $3.5 million, respectively. Historically, we have promoted employees from within our organization to fill senior operations, sales and store management positions. In order to achieve our growth plans, we will depend upon our ability to retain and promote existing personnel to senior management, and we must attract and retain new personnel with the skills and expertise to manage our business. If we cannot hire, retain and promote qualified personnel, our business, results of operations, financial condition and prospects could be adversely affected.

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

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

16




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

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

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

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

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

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

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

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

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

17




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

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

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

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

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

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

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

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

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

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

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

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

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

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

Forward-looking statements and associated risks.

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

19




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

Our actual operating results may differ significantly from our projections.

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

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

Item 2. PROPERTIES

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

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

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Store Locations

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

Guitar Center Stores

Store

  Year
Opened

  Gross
Square
Feet

  Status

Arizona

 

 

 

 

 

 
  Phoenix   1997   13,600   Lease
  Tempe   1997   12,100   Lease
  Tucson   2001   10,100   Lease
Arkansas            
  Little Rock(1)   2002   8,700   Lease
Southern California            
  Hollywood   1964   30,600   Own
  San Diego(2)   1973   15,100   Lease
  Fountain Valley   1980   16,800   Lease
  Sherman Oaks   1982   18,700   Lease
  Covina   1985   15,400   Lease
  Southbay   1985   14,500   Lease
  San Bernardino   1993   15,000   Lease
  Brea   1995   14,900   Lease
  San Marcos   1996   14,900   Lease
  Rancho Cucamonga   1999   15,000   Lease
  El Toro   1999   16,300   Lease
  Oxnard   2000   14,000   Lease
  Bakersfield   2000   8,000   Lease
  Palmdale   2001   12,000   Lease
Northern California            
  San Francisco   1972   11,900   Lease
  San Jose   1978   14,200   Own
  El Cerrito(3)   1983   11,300   Lease
  Concord   1996   15,800   Lease
  Fresno   2000   15,500   Lease
  Sacramento   2000   15,800   Lease
  Modesto   2001   9,000   Lease
Colorado            
  Denver   1998   16,800   Lease
  Englewood   1998   16,800   Lease
  Arvada   1999   15,700   Lease
Connecticut            
  Manchester   1999   16,000   Lease
Florida            
  North Miami area   1996   20,900   Lease
  South Miami area   1996   14,700   Lease
  West Palm Beach   2001   15,200   Lease
Georgia            
  Atlanta   1997   23,600   Own
  Marietta   1997   22,800   Lease
Idaho            
  Boise   2001   10,800   Lease
Illinois            
  South Chicago   1979   13,800   Lease
  North Chicago   1981   11,000   Lease
  Central Chicago   1988   20,500   Lease
  Villa Park   1996   15,000   Lease
  Highland Park   2001   15,200   Lease
Indiana            
  Indianapolis   2001   15,600   Lease
Louisiana            
  New Orleans   1999   19,700   Lease
Maryland            
  Towson   1998   14,600   Lease
  Rockville(4)   2000   24,000   Lease
Massachusetts            
  Boston   1994   12,600   Lease
  Danvers   1996   14,600   Lease
  Natick   1997   15,100   Lease
  N. Attleboro   1998   16,800   Lease
Michigan            
  Detroit   1994   16,100   Lease
  Southfield   1996   18,800   Lease
  Canton   1998   16,800   Lease
  Grand Rapids(1)   2002   11,400   Lease
Minnesota            
  Twin Cities   1988   15,000   Lease
  Edina   1997   15,700   Lease
Missouri            
  N. St. Louis   1999   15,700   Lease
  Bridgeton   1999   15,000   Lease
Nevada            
  Las Vegas   1998   20,000   Lease
New Jersey            
  Springfield   1998   20,000   Lease
  E. Brunswick   1998   20,000   Lease
  Totowa   1999   15,600   Lease
  Paramus   1999   14,100   Lease
  Cherry Hill   2001   15,800   Lease
New York            
  Carle Place   1998   22,800   Lease
  Queens   1999   19,000   Lease
  Larchmont   1999   15,300   Lease
  Commack   2000   16,000   Lease
  Buffalo   2000   15,000   Lease
  Rochester   2001   15,300   Lease
North Carolina            
  Charlotte(1)   2002   15,200   Lease
  Raleigh(1)   2002   15,900   Lease
Ohio            
  Cleveland   1997   15,600   Lease
  Mayfield Heights   1998   15,400   Lease
  Cincinnati   1998   18,500   Lease
  Columbus(1)   2002   17,600   Lease
Oklahoma            
  Oklahoma City   2000   15,200   Lease
Oregon            
  Eugene   1996   7,700   Lease
  Medford   1987   11,900   Lease
  Clackamas   2000   15,600   Lease
  Beaverton   2000   15,300   Lease
Pennsylvania            
  Philadelphia   2000   15,200   Lease
  Plymouth Meeting   2001   14,900   Lease
  Monroeville   2001   14,000   Lease
Tennessee            
  Knoxville   1998   15,000   Lease
Texas            
  Dallas   1989   12,700   Lease
  Arlington   1991   19,200   Lease
  South Houston   1993   14,700   Lease
  North Houston   1994   14,700   Lease
  Central Dallas   1998   17,800   Lease
  Clearlake   1998   15,000   Lease
  Austin   2000   15,200   Lease
  Plano   2000   15,500   Lease
  Corpus Christi(1)   2002   10,500   Lease
Utah            
  Salt Lake City   1998   15,000   Lease
  Ogden(1)   2002   7,500   Lease

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Store

  Year
Opened

  Gross
Square
Feet

  Status
   
Virginia                
  Fairfax   1999   15,600   Lease    
  Seven Corners   1999   15,400   Lease    
  Virginia Beach   2000   16,000   Lease    
Washington                
  Tukwila   1997   18,000   Lease    
  Kirkland   1997   20,200   Lease    
  Seattle   1997   18,300   Lease    
  Lynnwood   1998   14,000   Lease    
  Tacoma   2001   15,600   Lease    
  Spokane   2001   12,800   Lease    

American Music Stores

 

 

 

 

 

 

 

 

Arizona

 

 

 

 

 

 

 

 
  Phoenix   1987   6,000   Lease    
  Mesa   1995   4,000   Lease    
Florida                
  Longwood   1986   4,500   Lease    
  Ft. Myers   1994   1,400   Lease    
  Jupiter   1995   2,280   Lease    
Illinois                
  Carol Stream   1980   8,500   Lease    
Maine                
  W. Falmouth   1973   4,700   Lease    
Massachusetts                
  Greenfield   1982   4,000   Lease    
Nevada                
  Las Vegas   1998   1,500   Lease    
New York                
  Syracuse   1970   6,000   Lease    
  Pittsford   1975   7,250   Lease    
  New York Mills   1999   1,250   Lease    

(1)
We have signed leases for these locations and presently expect each to open in 2002.

(2)
Represents stores relocated in 2001.

(3)
Excludes 10,000 square feet consisting of a basement warehouse space.

(4)
Excludes 24,000 square feet consisting of a basement warehouse space.

Item 3. LEGAL PROCEEDINGS

        We are not a party to any material legal proceedings. We are, however, involved in routine litigation arising in the ordinary course of our business and, while the results of the proceedings cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our consolidated financial position or results of operations.

Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        No matters were submitted to a vote of security holders during the fiscal quarter ended December 31, 2001.

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PART II

Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Market Information

        Our common stock is quoted on the Nasdaq National Market under the symbol "GTRC." The following table sets forth the high and low closing sale prices for the common stock for the calendar quarters indicated:

 
  2001
  2000
 
  High
  Low
  High
  Low
First Quarter   $ 18.25   $ 10.44   $ 11.44   $ 8.50
Second Quarter     21.13     16.56     14.81     10.00
Third Quarter     21.65     9.80     15.44     10.25
Fourth Quarter     15.10     10.74     14.44     10.13

        As of March 25, 2002, there were 229 stockholders of record, excluding the number of beneficial owners whose shares were held in street name. We believe that the number of beneficial holders is significantly in excess of such amount based on the security position listings we obtain from time to time for the purpose of facilitating mailings to our stockholders.

Dividend Policy

        We currently intend to retain any earnings to provide funds for the operation and expansion of our business and for the servicing and repayment of indebtedness, and do not intend to pay cash dividends on our common stock in the foreseeable future. Under the terms of the indenture governing our senior notes, we are not permitted to pay any dividends on the common stock unless certain financial tests and other conditions are satisfied. In addition, our bank facility with Wells Fargo Retail Finance, LLC contains certain covenants which, among other things, limit the payment of cash dividends on our capital stock. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources." Any determination to pay cash dividends on the common stock in the future will be at the sole discretion of our Board of Directors.

23


Item 6. SELECTED FINANCIAL DATA

        The selected financial data for the five years ended December 31, 2001 has been derived from our audited consolidated financial statements. The selected historical financial data should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations, our consolidated financial statements and the notes thereto included elsewhere in this annual report.

 
   
  Year Ended December 31,

   
 
 
  2001
  2000
  1999
  1998
  1997
 
 
  (in thousands, except per share and operating data)

 
INCOME STATEMENT DATA:                                
Net sales   $ 938,180   $ 785,671   $ 620,081   $ 485,714   $ 367,353  
Cost of goods sold     691,206     580,749     456,797     353,487     262,363  
   
 
 
 
 
 
Gross profit     246,974     204,922     163,284     132,227     104,990  
Selling, general and administrative expenses     200,748     156,698     128,416     108,449     74,587  
Transaction and other costs             4,674         755  
   
 
 
 
 
 
Operating income     46,226     48,224     30,194     23,778     29,648  
Other expense (income)     3,539             (324 )   (637 )
Interest expense, net     13,411     12,466     11,235     10,844     9,892  
   
 
 
 
 
 
Total other expense     16,950     12,466     11,235     10,520     9,255  
Income before income taxes (benefit), extraordinary loss and cumulative effect of change in accounting principle     29,276     35,758     18,959     13,258     20,393  
Income taxes (benefit)     12,243     13,304     (391 )   (3,155 )   (2,833 )
   
 
 
 
 
 
Income before extraordinary loss and cumulative effect of change in accounting principle     17,033     22,454     19,350     16,413     23,226  
   
 
 
 
 
 
Extraordinary loss on early extinguishment of debt, net of tax $1,679                     2,739  
Cumulative effect of change in accounting principle to write-off pre-opening costs, net of tax $578             1,074          
   
 
 
 
 
 
Net income   $ 17,033   $ 22,454   $ 18,276   $ 16,413   $ 20,487  
   
 
 
 
 
 
Net income per share (diluted)   $ 0.75   $ 1.01   $ 0.82   $ 0.72   $ 0.91  
   
 
 
 
 
 
Weighted average shares outstanding (1)     22,700     22,247     22,309     22,851     22,512  
   
 
 
 
 
 
OPERATING DATA:                                
Net sales per gross square foot (thousands) (2)   $ 537   $ 535   $ 555   $ 640   $ 699  
Net sales growth     19 %   27 %   28 %   32 %   41 %
Increase in comparable store sales (3)     6 %   7 %   10 %   13 %   13 %
Guitar Center stores open at end of period     96     83     69     56     40  
Ratio of earnings to fixed charges (4)     2.5x     3.0x     2.3x     2.0x     2.8x  
EBITDA (thousands) (5)   $ 61,232   $ 59,254   $ 43,041   $ 29,095   $ 33,734  
BALANCE SHEET AND OTHER DATA:                                
Net working capital   $ 90,113   $ 94,034   $ 80,536   $ 74,279   $ 68,591  
Property and equipment, net     81,056     68,658     58,174     42,410     26,134  
Total assets     404,684     325,569     266,851     208,058     161,031  
Total long-term and revolving debt (including current portion)     144,466     103,783     111,428     102,040     80,048  
Stockholders' equity     123,868     103,463     80,319     46,215     28,713  
Capital expenditures     24,697     17,862     19,768     21,678     12,648  
Net cash provided (used) by operating activities   $ 16,511   $ 34,367   $ 4,383   $ (8,549 ) $ (934 )

(1)
Weighted average shares represents shares calculated on a diluted basis.

(2)
Net sales per gross square foot is presented for Guitar Center retail stores only, excluding American Music retail stores, and does not include new stores opened during the reporting period.

(3)
Compares net sales for the comparable periods, excluding net sales attributable to stores not open for 14 months. All references in this annual report to comparable store sales results are based on this calculation methodology.

(4)
For the purpose of calculating the ratio of earnings to fixed charges, "earnings" represents income before provision for income taxes and fixed charges. "Fixed charges" consist of interest expense, amortization of debt financing costs, and one third of lease expense, which management believes is representative of the interest components of lease expense.

(5)
Represents net income before interest expense, income taxes, depreciation and amortization expense and certain other non-recurring, non-operating charges. The other charges added back to arrive at EBITDA are: (a) for 2001, $3,539,000, representing the after-tax charge recorded to write-off our investment in an unconsolidated entity; (b) for 2000, none; (c) for 1999, $5,748,000, consisting of (i) $4,674,000, representing transaction and severance costs incurred in connection with our merger with Musician's Friend, Inc. under the pooling of interests method and (ii) $1,074,000 representing the after-tax charge to record the cumulative effect of a change in accounting principle to write-off deferred pre-opening costs; (d) for 1998, none; and (e) for 1997, $2,739,000 representing the after-tax extraordinary charge recognized in connection with the early extinguishment of debt. We present EBITDA because many investors view this information as a useful measure of a company's ability to generate cash flow and service debt or capital obligations, however it should not be considered as a substitute for measures determined under generally accepted accounting principles, such as net income and cash flow from operations. Further, the calculation of EBITDA varies from company to company and thus the amount that we calculated using the methodology described above may not be comparable to the amount of EBITDA reported by other companies.

24


Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

General

        We operated 88 Guitar Center retail locations in 35 major markets and eight stores in secondary markets as of December 31, 2001. We also operate the largest direct response channel (Musician's Friend catalog and Internet) in the musical instruments industry in the United States. In addition, we acquired the assets of American Music Group and related companies in the second quarter of 2001. American Music Group, through its 12 band instrument retail stores, is a leading provider of band instruments and accessories, and primarily focuses on school band and orchestral instrument sales and rentals. We are operating the American Music business as a division of our Guitar Center retail business.

        From 1997 to 2001, our net sales grew at an annual compound growth rate of 26.4%, principally due to the comparable store sales growth of our Guitar Center stores averaging 10% per year, the opening of new stores, and a 28.4% per year increase in the direct response channel. We believe such volume increases are the result of the continued success of the implementation of our business strategy, continued growth in the music products industry and increasing consumer awareness of the Guitar Center, Musician's Friend and American Music brand names. We achieved comparable store sales growth of 6%, 7% and 10% for the fiscal years ended December 31, 2001, 2000 and 1999, respectively. We do not expect comparable store sales to continue to increase at historical rates.

        We opened a total of 13 Guitar Center stores in 2001 and currently anticipate opening approximately 12 to 14 Guitar Center stores in 2002 and approximately 18 to 22 stores in 2003. Some of these Guitar Center stores will be smaller format units designed for secondary markets. In addition, we plan to open six to eight American Music stores during 2002 and 14 to 16 in 2003. For the immediate future, our objective is that about half of these new American Music units will be new stores and about half will be acquisitions of existing businesses. 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 the Guitar Center and American Music Group brand names in new markets. In some markets this clustering strategy results in some transfer of sales from existing stores to new locations.

        As we enter new markets, we expect that we will initially incur higher administrative and promotional costs per store than is currently experienced in established markets. We expect competition to continue to increase as other music product retailers attempt to execute national growth strategies. Our business strategy will also emphasize opportunities to continue to grow each of our businesses, including through further acquisitions if attractive candidates can be located for reasonable prices.

Discussion of Critical Accounting Policies

        In the ordinary course of business, we have made a number of estimates and assumptions relating to the reporting of results of operations and financial condition in the preparation of its financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ significantly from those estimates under different assumptions and conditions. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results and require management's most difficult, subjective and complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.

25



        We value our Guitar Center inventories at the lower of cost or market using the first-in, first-out (FIFO) method. We record adjustments to the value of inventory based upon obsolescence and changes in market value. Management has evaluated the current level of inventories considering planned sales volume and other factors and, based on this evaluation, has recorded adjustments to cost of goods sold for estimated decreases in value. These adjustments are estimates, which could vary significantly, either favorably or unfavorably, from actual requirements if future economic conditions, consumer demand or competition differ from our expectations. Rental inventories are valued at the lower of cost or market using the specific identification method and are depreciated on a straight-line basis over the term of the rental agreement for rent-to-own sales, or over the estimated useful life of the rented instrument for rental only items.

        Long-lived assets and certain identifiable intangibles historically have been reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to future net cash flows estimated by us to be generated by said assets. If such assets are considered to be impaired, the impairment to be recognized is the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less selling costs. During the fourth quarter of 2001, in connection with our ongoing review of our long-lived assets, we determined that there were uncertainties regarding the ongoing business of a non-consolidated entity in which we hold an investment. Accordingly, we recorded a $3.5 million charge representing the write-off of this investment. At December 31, 2001, this was our only investment of this kind. There are no other events or changes in circumstances of which we are aware indicating that the carrying value of our long-lived assets may trigger an impairment consideration, however; we will periodically recognize impairments, if any. As described below under "New Accounting Pronouncements," the accounting treatment for goodwill and other intangible assets will change significantly effective January 1, 2002.

        We allow customers to return product when they meet certain established criteria. We regularly review and revise, when deemed necessary, our estimates of sales returns based primarily upon actual returns and historical trends. Actual returns may differ significantly, either favorably or unfavorably, from estimates if factors such as economic conditions or the competitive environment differ from our expectations.

26


Results of Operations

        The following table sets forth historical income statement data as a percentage of net sales:

 
  Fiscal Year Ended
December 31,

 
 
  2001
  2000
  1999
 
Net sales   100.0 % 100.0 % 100.0 %
Gross profit   26.3   26.1   26.3  
Selling, general and administrative expenses   21.4   19.9   20.7  
Transaction and other costs       0.8  
   
 
 
 
  Operating income   4.9   6.2   4.8  
Other expense:              
  Write-off of investment in non-consolidated entity   0.4      
  Interest expense, net   1.4   1.6   1.7  
  Interest expense to related parties       0.1  
   
 
 
 
  Total other expense   1.8   1.6   1.8  
Income before income taxes (benefit) and cumulative effect of change in accounting principle   3.1   4.6   3.0  
Income taxes (benefit)   1.3   1.7   (0.1 )
   
 
 
 
Income before cumulative effect of change in accounting principle   1.8 % 2.9 % 3.1 %
   
 
 
 

Fiscal 2001 Compared to Fiscal 2000

        Net sales for the year ended December 31, 2001 increased 19.4% to $938 million, compared with $786 million last year. Net sales from retail stores for fiscal 2001 totaled $781 million, a 19.8% increase from $652 million in fiscal 2000. Sales from new stores, including $24.0 million contributed by the newly acquired American Music stores, represent $93.8 million, or 73.1%, of the total increase in retail store sales. Comparable store sales for the full year increased 5.5%. Our management is presently anticipating comparable store sales growth of 4% to 6% for the immediate future, although fluctuations will undoubtedly take place from period to period. The foregoing statement is a forward-looking statement and is subject to the qualifications set forth below under "Forward-Looking Statements; Business Risks." Net sales from the direct response channel totaled $157 million in 2001, a $24 million increase from 2000. The growth in direct response sales has been driven by continued increases in Internet sales offset in part by declining catalog sales. Catalog sales decreased 0.1% to $88.4 million in 2001 from $88.5 million in 2000. Internet sales for the year increased 54.0% to $69.0 million from $44.8 million last year. The trend in favor of Internet sales over catalog sales is expected to continue. We believe that revenues in the direct response division were adversely affected by weak economic conditions that are affecting the hobbyist customer base of this unit. Total sales have been adversely affected by the recent slow down in the overall U.S. economy.

        Gross profit dollars for the year ended December 31, 2001 compared to 2000 increased 20.5% to $247 million from $205 million. Gross profit as a percentage of net sales for the year ended December 31, 2001 compared to 2000 increased to 26.3% from 26.1%. Gross profit margin percentage for the retail stores in 2001 after buying and occupancy costs was 25.7% compared to 25.3% in 2000. Retail gross margins improved due to higher gross margins for the American Music business compared to the Guitar Center business, as well as improvement in inventory shrinkage offset by higher occupancy costs. The gross profit margin for the direct response division was 29.7% for 2001 compared to 29.8% in 2000. The decrease is primarily due to a reduction in selling prices and an increase in promotional offers, offset by targeted marketing of identified slow moving products through new sales channels, including the Kansas City retail outlet.

27



        Selling, general and administrative expenses for fiscal 2001 increased 28.1% to $200.7 million from $156.7 million in fiscal 2000. As a percentage of net sales, selling, general and administrative expenses for fiscal 2001 increased to 21.4% from 19.9% in fiscal 2000. Selling, general and administrative expenses for the retail stores in 2001, inclusive of pre-opening costs and corporate general and administrative expenses, was 20.7% as a percentage of sales compared to 19.5% in fiscal 2000. The increase as a percentage of sales reflects the higher level of expense in the American Music business compared to the Guitar Center stores, an increase in payroll in our stores, higher insurance costs and higher operating lease expenses. Selling, general and administrative expenses for the direct response division were 24.7% of sales compared to 22.4% last year. The increase primarily reflects costs associated with the closing of our Medford and Knoxville fulfillment centers, consolidation of operations to Kansas City, negative leveraging from lower than expected sales, and additional freight and labor costs from split shipments.

        Operating income, for the reasons stated above, decreased 4.1% to $46.2 million from $48.2 million in fiscal 2000. As a percentage of sales, operating income was 4.9% and 6.1% in the years ended December 31, 2001 and 2000, respectively.

        In 2001, we recorded a $3.5 million, non-cash charge to reflect the write-off of our minority interest in a non-consolidated entity. This charge reflects our assessment of the likely future cash flows from the investment in light of the uncertainties regarding the ongoing business of this entity.

        Interest expense, net for fiscal 2001 increased to $13.4 million from $12.5 million in fiscal 2000. Interest expense consisted primarily of interest on our Senior Notes and borrowings under the line of credit primarily used to fund the acquisition of American Music, additions to inventory, and capital expenditures for our store expansions. Included in interest expense, net is a $592,000 charge in connection with the extension of our line of credit and the replacement of one of the former lenders in the syndicate. The overall increase in interest expense, net reflects increased borrowings under our credit facility, offset by a reduction in interest rates applicable to those borrowings.

        Income tax expense for the year ended 2001 was $12.2 million compared to $13.3 million for the same period last year. We did not recognize a tax benefit on the $3.5 million write-off of the minority investment in a non-consolidated entity because of the capital nature of the write-down and the uncertainty that we will have future capital gains to utilize the capital loss.

        Net income for fiscal 2001 decreased to $17.0 million from $22.5 million in fiscal 2000 as a result of the combinations of factors described above.

Fiscal 2000 Compared to Fiscal 1999

        Net sales for the year ended December 31, 2000 increased 26.7% to $786 million, compared with $620 million in the previous year. Net sales from retail stores for fiscal 2000 totaled $652 million, a 21.6% increase from $537 million in fiscal 1999. Sales from new stores contributed $79 million and represent 69% of the total increase in retail store sales. Comparable store sales for the full year increased 7%. The increase in comparable store sales was due to aggressive pricing on certain elements of inventory and good store sales performance due to the effect of successful promotions. Net sales from the direct response channel totaled $133 million in year 2000, a $50 million increase from 1999. Catalog sales increased 32% to $88 million in 2000 from $67 million in 1999. Internet sales for the year increased 170% to $45 million from $16 million from the previous year. Direct response results reflect the increase in average order size, sales facilitated by the third-party credit card introduced in the third quarter of 1999 and the impact of Net Perceptions selling software installed in the first quarter of 2000.

        Gross profit dollars for the year ended December 31, 2000 compared to 1999 increased 25.6% to $205 million from $163 million. Gross profit as a percentage of net sales for the year ended December 31, 2000 compared to 1999 decreased to 26.1% from 26.3%. Gross profit margin percentage

28



for the retail stores in 2000 after buying and occupancy costs was 25.3% compared to 26.0% in 1999. The reduction in gross profit margin relates to increased occupancy costs caused by the number of immature stores in the total store base, increased freight expense as a result of opening new stores farther from some of our key vendors and higher shrink losses. The gross profit margin for the direct response division was 29.8% for 2000 compared to 28.7% in 1999. The increase is principally due to improved selling margin.

        Selling, general and administrative expenses for fiscal 2000 increased 22.0% to $156.7 million from $128.4 million in fiscal 1999. As a percentage of net sales, selling, general and administrative expenses for fiscal 2000 decreased to 19.9% from 20.7% in fiscal 1999. Selling, general and administrative expenses for the retail stores in 2000 and in 1999, inclusive of pre-opening costs and corporate general and administrative expenses, were 19.5% of net sales. These results reflect the leveraging of corporate and administrative expenses offset by additional advertising and marketing expenses, and higher store level selling, general and administrative expenses due to the number of stores that are less than two years old. Selling, general and administrative expenses for the direct response division were 22.4% of sales for fiscal 2000 compared to 28.8% for fiscal 1999. The improvement largely reflects the leveraging of corporate overhead and marketing expenses as a result of the 59.8% increase in sales compared to 1999.

        Transaction and store conversion costs totaled $4.7 million, or 0.8% of sales, during the year ended December 31, 1999. No similar costs were incurred in 2000.

        Operating income for fiscal 2000 increased 59.7% to $48.2 million from $30.2 million in fiscal 1999. The increase is principally due to the increase in operating income from the direct response unit and the absence of transaction expenses compared to 1999. As a percentage of sales, operating income was 6.2% and 4.8% in the years ended December 31, 2000 and 1999, respectively.

        Interest expense, net for fiscal 2000 increased to $12.5 million from $11.2 million in fiscal 1999. Interest expense consisted primarily of interest on our Senior Notes and borrowings under the line of credit for additions to inventory and capital expenditures for our store expansions.

        In 2000, income taxes were recorded at normal income tax rates, whereas in 1999 an income tax benefit was recorded due to the reduction of the valuation reserve on the Company's deferred tax asset, net of current federal and state income taxes. We anticipate that in the future the income tax rate will be approximately 38%.

        In the first quarter of 1999, a charge to operations of $1.7 million, net of tax of $0.6 million, was incurred for the cumulative effect of a change in accounting principle to expense pre-opening costs. No similar charge was incurred in 2000.

        Net income for fiscal 2000 increased to $22.5 million from $18.3 million in fiscal 1999. The increase was principally due to an increase in operating income from the direct response unit, the absence of transaction expenses compared to prior year, and the cumulative effect of the change in accounting principle as discussed above.

29


Liquidity and Capital Resources

        Our need for liquidity will arise primarily from interest payable on indebtedness and the funding of capital expenditures and working capital requirements, as well as possible acquisitions. We have historically financed our operations through internally generated funds and borrowings under our credit facilities. Please see Item 1. Business—"Risks Related to the Business" herein for a discussion of factors which could reasonably likely result in a decrease in the amount of internally generated funds available to finance capital expenditures and working capital requirements. We have no mandatory payments of principal on the $66.7 million of Senior Notes outstanding prior to their final maturity in 2006. As of December 31, 2001, we had $76.9 million outstanding under the credit facility, excluding $1.1 million outstanding on letters of credit, and had available borrowings of $39.8 million.

        The credit facility permits borrowings up to $200 million, subject to borrowing base limitations ($117.8 million at December 31, 2001). Certain assets secure the credit facility and the actual amount available is tied to our inventory and receivable base. A fee of 0.375% is assessed on the unused portion of the credit facility. Borrowings bear interest at either the prime rate plus an applicable margin rate (5.25% at December 31, 2001), or at LIBOR plus an applicable margin rate (5.25% at December 31, 2001), at our option, with interest due monthly. The applicable margin rate is based upon a quarterly calculation of average daily availability at the end of each fiscal quarter. Borrowings are subject to minimum annual interest rate of 4%. The applicable interest rate at December 31, 2001 was LIBOR plus 2.00%. The agreement underlying the credit facility includes certain restrictive covenants. We were in compliance with such requirements as of December 31, 2001.

        For the year ended December 31, 2001, cash provided by operating activities was $16.5 million, most of which represented cash income from operations, net of additions to inventory. Cash used in investing activities totaled $53.3 million, which primarily consisted of capital expenditures for retail store expansions and computer equipment purchases ($24.7 million), and the acquisition of American Music Group ($28.5 million). Cash provided by financing activities totaled $41.3 million, which consisted principally of borrowings under our credit facilities.

        Inventory increased from $199 million to $250 million, or 25.3%. The increase in inventory was required principally to support existing sales growth and the opening of new retail locations. The increase also reflects the acquired balance of American Music's inventory of $18 million. Inventory per square foot at Guitar Center retail stores was $134 at December 31, 2001 compared to $130 in 2000. Inventory increased from $25.0 million to $29.5 million, or 18.1%, for the direct response division. The increase in inventory was required principally to support sales growth. Our ongoing objective is to improve inventory performance by refining our replenishment processes and systems, utilizing a distribution center for our Guitar Center stores, and through improved planning, presentation, and display of inventories in our retail stores.

        We intend to pursue an aggressive growth strategy by opening additional stores in new and existing markets. During 2001, we opened 13 new Guitar Center stores. Each new large format Guitar Center store typically has required approximately $1.6 to $1.8 million for gross inventory. Historically, our cost of capital improvements for a large format Guitar Center store has been approximately $850,000, consisting of leasehold improvements, fixtures and equipment. We incur higher costs in some geographic areas, particularly the Northeast. We have developed smaller Guitar Center stores to build in secondary markets or sites that we do not believe will support our large format units. The first of these units was opened in late 2000 and six more had been opened as of December 31, 2001. Our small format stores will incur approximately $400,000 to $450,000 in capital expenditures and require approximately $600,000 to $800,000 in inventory.

        We are also anticipating additional capital and strategic requirements related to improving our fulfillment facilities, upgrading our technology and systems, and pursuing new opportunities in the e-commerce activities of Guitar Center and Musician's Friend, and related businesses. In July 2000, we

30



leased a new distribution facility for Musician's Friend in Kansas City, and in July 2001 we closed our existing distribution facilities in Medford, Oregon and Knoxville, Tennessee and consolidated all direct response fulfillment in Kansas City.

        During 2001, we began construction of a central distribution center in the Indianapolis, Indiana area for our Guitar Center retail store operations with a view towards the facility commencing operation in the second half of 2002. We have entered into a 10-year agreement to lease the facility and we also plan to enter into numerous additional commitments necessary to support the operations of the facility. Migration from our present "drop-ship" model to a centralized distribution model is an important development in our operating strategy and will require significant financial and managerial resources for the next several quarters.

        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 Guitar Center and Musician's Friend on the Internet. The costs of these initiatives and other investments related to our businesses will continue to be significant.

        During 2002, we expect to incur approximately $20 million to $22 million in capital expenditures.

        Our expansion strategy is to continue to increase our market share in existing markets and to penetrate strategically selected new markets. We opened a total of 13 Guitar Center stores in 2001 and 14 stores in 2000, and currently anticipate opening approximately 12 to 14 Guitar Center stores in 2002. Some of these stores will be smaller format units designed for secondary markets. During 2002, we plan to open six to eight American Music stores. In 2003, our present plan is to open approximately 14 to 16 additional American Music stores. For the immediate future, our objective is that about half of these new American Music units will be new stores and about half will be acquisitions of existing businesses. We believe there exists a number of acquisition opportunities in the relatively fragmented band instruments market that could be a good fit into our American Music platform.

        We also believe there may be attractive opportunities to expand by selectively acquiring existing music products retailers or other complimentary businesses, if attractive opportunities can be identified. While we cannot provide assurance that we will complete any further acquisition transactions, in the ordinary course of our business we investigate and engage in negotiations regarding such opportunities. Acquisitions will be financed with drawings under our existing credit facilities, expansion of our credit facilities, issuance of debt or equity securities, or a combination, depending upon transaction size and market conditions, among other things.

        Our capital resources and liquidity for 2002 are presently expected to be provided by net cash flow from operations and additional borrowings under our credit facility and advances under operating leases. Depending upon market conditions, we may also elect or be required to raise additional capital in the form of common or preferred equity, debt or convertible securities for the purpose of providing additional capital to fund working capital needs or continued growth of our existing business, or to refinance existing obligations. Any such financing activity will be dependent upon many factors, including our liquidity needs, market conditions and prevailing market terms, and we can not assure you that future external financing for Guitar Center will be available on attractive terms or at all.

31



Disclosures about Contractual Obligations and Commercial Commitments

        The following tables aggregate all material contractual obligations and commercial commitments that affect our financial condition and liquidity as of December 31, 2001:

 
  Payments Due by Period
(In thousands)

Contractual Cash Obligations

  Total
  Less than
1 Year

  1-3 Years
  4-5 Years
  After 5 Years
Long-term debt(1)   $ 66,924   $ 257   $   $ 66,667   $
Operating lease commitments(2)     193,069     24,908     48,097     40,885     79,179
   
 
 
 
 
Total contractual cash obligations   $ 259,993   $ 25,165   $ 48,097   $ 107,552   $ 79,179
   
 
 
 
 
 
  Amounts of Commitment Expiration per Period
(In thousands)

Other Commercial Commitments

  Total
  Less than
1 Year

  1-3 Years
  4-5 Years
  After 5 Years
Revolving Line of credit(3)   $ 76,904   $   $   $ 76,904   $
Standby Letters of credit     1,148     1,148            
   
 
 
 
 
Total other commercial commitments   $ 78,052   $ 1,148   $   $ 76,904   $
   
 
 
 
 

(1)
Long-term debt consists principally of the unsecured Senior Notes bearing interest at 11% per annum, with interest due on a semi-annual basis. The Senior Notes mature on July 1, 2006.

(2)
Operating lease commitments consist principally of real property leases for our corporate offices, retail store facilities and distribution centers. These leases frequently include options which permit us to extend the terms beyond the initial fixed lease term. We also have acquired personal property through operating leases and based on current favorable market terms we plan to expand the use of this source of financing in 2002. Payments for these lease commitments are provided for by cash flows generated from operations.

(3)
The revolving line of credit provides for a maximum facility of $200,000,000, subject to certain borrowing base limitations and expires December 16, 2005. We plan to make additional borrowings or pay down the line of credit based on our cash flow requirements. We may need to renegotiate our credit facility prior to the expiration date depending on our future capital needs, our working capital base and alternative sources of financing available.

New Accounting Pronouncements

        On July 20, 2001, the Financial Accounting Standards Board issued Statement No. 141, "Business Combinations" (SFAS No. 141), and Statement No. 142, "Goodwill and Other Intangible Assets" (SFAS No. 142). These new pronouncements significantly change the permissible accounting methods for business combinations and the treatment of goodwill and other intangible assets. Prior to the adoption of these new standards, goodwill and similar intangible assets were generally amortized into income on a stated periodic basis. This treatment will be replaced by an alternative method, which will not require goodwill amortization on a stated basis but rather will require periodic testing of the goodwill for impairment, with no charge to income except to the extent of any such impairment. We adopted the new rules effective January 1, 2002, at which time we ceased to record periodic goodwill charges absent an impairment charge. As of December 31, 2001, goodwill was $21.0 million, the majority of which relates to the American Music Group acquisition. Amortization expense related to goodwill included in the consolidated statement of income was $827,000, $222,000 and $186,000 at December 31, 2001, 2000 and 1999, respectively.

32



        In August 2001, the Financial Accounting Standards Board issued Statement No. 143, "Accounting for Asset Retirement Obligations" (SFAS No. 143). This new pronouncement establishes financial accounting and reporting standards for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The provisions of SFAS No. 143 apply to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long-lived asset, except for certain obligations of lessees. The standard is effective for financial statements issued for fiscal years beginning after June 15, 2002 and we presently intend to adopt this standard effective January 1, 2003. We do not expect adoption of this standard to have a material effect on our consolidated financial statements.

        In October 2001, the Financial Accounting Standards Board issued Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS No. 144). This pronouncement provides new guidance on the recognition of impairment losses on long-lived assets to be held and used or to be disposed of and also broadens the definition of what constitutes a discontinued operation and how the results of a discontinued operation are to be measured and presented. The provisions of SFAS No. 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001. We adopted SFAS No. 144 effective January 1, 2002, and the adoption of this standard did not have a material effect on our consolidated financial statements.

Seasonality

        Our operating results are not highly seasonal, except for the effect of the holiday selling season in November and December. Sales in the fourth quarter are typically significantly higher on a per store basis and through the direct response unit than in any other quarter.

Inflation

        We believe that the relatively moderate rates of inflation experienced in recent years have not had a significant impact on our net sales or profitability.

Forward-Looking Statements; Business Risks

        This annual report contains forward-looking statements relating to, among other things, future results of operations, growth and investment plans, sales, trends in gross margin, growth in the Internet business and other factors affecting growth in sales and earnings. Specific forward-looking statements are provided regarding our management's current views regarding comparable store sales and new store openings. Statements regarding new store openings are based largely on our current expectations and are necessarily subject to associated business risks related to, among other things, the identification of suitable sites or acquisition opportunities, the timely construction, staffing and merchandising of those stores and other matters, some of which are outside of our control. Comparative store sales growth is highly dependent upon the effectiveness of our sales and promotion strategies and the effect of competition, including other national operators of music products stores attempting to implement national growth strategies. The American Music business was only recently acquired by us and may be subject to significant fluctuations as we integrate these activities with the other Guitar Center businesses.

        Sales and earnings trends are also affected by many other factors including, among others, world and national political events, general economic conditions, which recently have been weak, particularly in terms of consumer demand and general retail sales, the effectiveness of our promotion and merchandising strategies, changes in the music products industry, retail sales trends and the emergence of new or growing specialty retailers of music products. In light of these risks, there can be no assurance that the forward-looking statements contained in this report will in fact be realized. The statements made by us in this report represent our views as of the date of this report, and it should not

33



be assumed that the statements made herein remain accurate as of any future date. We do not presently intend to update these statements and undertake no duty to any person to affect any such update under any circumstances.

        For further discussion of risks associated with our business, please see the discussion under the caption Item 1. "Business—Risks Related to the Business."

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        We do not have any assets or liabilities which, in our view, impose upon us significant market risk except for our outstanding indebtedness represented by $66.7 million principal amount of Senior Notes due 2006 with a fixed interest rate of 11% and our credit facility which has a variable rate of interest generally consisting of stated premiums above the London Interbank Offered Rate, or LIBOR. At December 31, 2001, we had $76.9 million outstanding under our credit facility. To the extent prevailing short-term interest rates fluctuate the interest expense we incur on our credit facility will change with a resulting effect (positive or negative) on our financial position, results of operations and cash flows. However, based on the balances outstanding under our credit facility at year-end 2001, such a fluctuation would have to be relatively significant to have a material financial impact on us. We do not use derivative financial instruments in our investment portfolio. Presently, we do not carry significant cash balances as any cash in excess of our daily operating needs is used to reduce our borrowings.

Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

        See the index included at "Item 14. Exhibits, Financial Statement Schedules and Reports on Form 10-K."

Item 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

        Not Applicable


PART III

Item 10. DIRECTORS AND OFFICERS OF THE REGISTRANT

        The information required by this item is incorporated by reference to our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended, or Exchange Act, in connection with our annual meeting of stockholders.

Item 11. EXECUTIVE COMPENSATION

        The information required by this item is incorporated by reference to our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.

Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

        The information required by this item is incorporated by reference our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.

34



Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

        The information required by this item is incorporated by reference to our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.


PART IV

Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K

(a)
Documents filed as part of this Report:

 
   
   
   
    1.   The following financial statements for the Company are included as part of this Report:    
        Index to Financial Statements   Page 41
    2.   The following financial statement schedule for the Company is included as part of this Report:    
        Schedule II—Valuation and Qualifying Accounts   Page II-1
        All other schedules have been omitted since the required information is not present in amounts sufficient to require submission of the schedules, or because the information required is included in the financial statements.    
(b)
On November 15, 2001 Guitar Center furnished a Form 8-K including Item 9 information relating to earnings guidance provided to investors.

(c)
Those Exhibits, and the Index thereto, required to be filed by Item 601 of Regulation S-K are attached hereto. Certain management contracts and other compensation plans or arrangements required to be filed are identified on the attached Index with an asterisk (*).

35



INDEX TO EXHIBITS

Exhibit
Number

  Description
3.1   The Company's Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.5 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
3.2   The Company's Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.2 of the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended March 31, 2001).
3.3   Amendment to the Company's Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.3 of the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended September 30, 2001).
4.1   Indenture dated as of July 2, 1996 by and between the Company and U.S. Trust Company of California as trustee (Incorporated by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))
4.2   Form of Stock Certificate (Incorporated by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
4.3   Form of Indenture (Incorporated by reference to Exhibit 4.2 of the Company's Registration Statement on Form S-3 (Registration No. 333-65220)).
10.1   Registration Rights Agreement dated June 5, 1996 among the Company and the stockholders named therein (Incorporated by reference to Exhibit 10.2 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))
10.2*   The Company's Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.5 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
10.3*   Form of Indemnification Agreement between the Company and each of its directors and executive officers (Incorporated by reference to Exhibit 10.11 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
10.4*   Management Stock Option Agreement dated June 5, 1996 by and between the Company and Lawrence Thomas (Incorporated by reference to Exhibit 10.16 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))
10.5*   Management Stock Option Agreement dated June 5, 1996 by and between the Company and Marty Albertson (Incorporated by reference to Exhibit 10.17 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))
10.6*   Amended and Restated Memorandum of Understanding and Stock Option Agreement, dated as of December 30, 1996 (Incorporated by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-3 (Registration No. 333-62732)).
10.7*   Amendment No. 1 to Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.24 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
10.8*   Amended 1997 Equity Participation Plan (Incorporated by reference to Exhibit 10.22 of the Company's Annual Report on Form 10-K (Registration No. 000-22207) for the fiscal year ended December 31, 1998).
10.9*   Modification to Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.28 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
10.10*   Amendment No. 2 to the Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.30 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))

36


10.11*   Amendment No. 1 to Management Stock Option Agreement dated as of October 15, 1996 between the Company and Larry Thomas (Incorporated by reference to Exhibit 10.21 contained in Registration Statement on Form S-1 (File No. 333-10491))
10.12*   Amendment No. 1 to Management Stock Option Agreement dated as of October 15, 1996 between the Company and Marty Albertson (Incorporated by reference to Exhibit 10.22 contained in Registration Statement on Form S-1 (File No. 333-10491))
10.13*   Amendment No. 3 to Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.29 of the Company's Annual Report on Form 10-K (Registration No. 000-22207) for the fiscal year ended December 31, 1998).
10.14*   Amended and Restated Employment Agreement dated May 13, 1999 between Musician's Friend, Inc. and Robert Eastman (Incorporated by reference to Exhibit 10.31 of the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the period ending June 30, 1999).
10.15*   Agreement and Plan of Merger dated May 13, 1999 by and among the Company, EMIC Acquisition Corporation, Musician's Friend, Inc. and the Stockholders of Musician's Friend, Inc. (Incorporated by reference to Exhibit 2.1 of the Company's Current Report on Form 8-K dated May 28, 1999 (Registration No. 000-22207)).
10.16*   Amended and Restated Registration Rights Agreement dated May 13, 1999 by and among the Company, Chase Venture Capital Associates, L.P., Weston Presidio Capital II, L.P., Wells Fargo Small Business Investment Company, Inc., Larry Thomas, Marty Albertson, Amazing Grace Foundation, The Emmanuel Foundation, Midas Touch Investments Trust, Sterling Investments Trust, Syringa Investments Trust, Eiger Mountain Real Estate Trust, Promise Land Real Estate Development Trust and Musician's Friend Trust (Incorporated by reference to Exhibit 2.2 of the Company's Current Report on Form 8-K dated May 28, 1999 (Registration No. 000-22207)).
10.17*   Form of Amendment to the 1997 Equity Participation Plan of Guitar Center, Inc. approved by stockholders at the 2000 Annual Meeting of Stockholders. (Incorporated by reference to Exhibit 10.(35)(36) of the Company's Annual Report on Form 10-K (Registration No. 000-22207 for the fiscal year ended December 31, 1999)
10.18*   Form of Amendment to the Company's 1997 Equity Participation Plan approved by stockholders at the Annual Meeting of Stockholders held on April 26, 2001 (Incorporated by reference to Exhibit 10.37 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended March 31, 2001).
10.19*   Form of Employee Stock Purchase Plan as approved by stockholders at the Annual Meeting of Stockholders held on April 26, 2001 (Incorporated by reference to Exhibit 10.38 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended March 31, 2001).
10.20   Asset Purchase Agreement made as of March 20, 2001, by and among Guitar Center Stores, Inc., and American Music Group, Ltd., Eastern Musical Supply Co., Inc., Lyons Music, Inc., American Music, Inc., American Musical Instruments, Inc., Giardinelli Band Instruments Co., Central Music Supply, Inc., and GBI, Inc. (Incorporated by reference to Exhibit 10.40 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended June 30, 2001).
10.21*   Employment Agreement made as of March 20, 2001 between Guitar Center Stores, Inc. and David Fleming (Incorporated by reference to Exhibit 10.41 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended June 30, 2001).
10.22*   Amended and Restated Employment Agreement between the Company and Marty Albertson, effective as of June 6, 2001, with exhibits.
10.23*   Amended and Restated Employment Agreement between the Company and Larry Thomas, effective as of June 6, 2001, with exhibits.

37


10.24*   Amended and Restated Employment Agreement between the Company and Barry Soosman, effective as of July 1, 2001, with exhibit.
10.25*   Amended and Restated Employment Agreement between the Company and Bruce Ross, effective as of July 1, 2001, with exhibit.
10.26*   Amendment to the Company's 1997 Equity Participation Plan approved July 26, 2001 (Incorporated by reference to Exhibit 10.42 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended September 30, 2001).
10.27   Lease Agreement, dated as of August 15, 2001, by and between Guitar Center Stores, Inc. and Eaglepoint Partners Two, LLC.
10.28*   Second Amendment to Amended and Restated Memorandum of Understanding, effective as of September 5, 2001 (Incorporated by reference to Exhibit 10.44 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended September 30, 2001).
10.29*   Third Amendment to Amended and Restated Memorandum of Understanding, effective as of November 6, 2001.
10.30   Second Amended and Restated Loan and Security Agreement entered into as of December 21, 2001, between and among the Company, Guitar Center Stores, Inc., Musician's Friend, Inc. and the lenders identified therein.
12.1   Ratio of Earnings to Fixed Charges
21.1   Material subsidiaries of the Registrant as of December 31, 2001:
            Musician's Friend, Inc., a Delaware corporation.
            Guitar Center Stores, Inc., a Delaware corporation.
23.1   Consent of Independent Auditors (KPMG LLP)
24.1   Power of Attorney (included on page S-1)

*
Management contract or other compensation plan or arrangement.

38



SIGNATURES

        Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized as of this 27th day of March 2002.

    GUITAR CENTER, INC.

 

 

 

/S/  LARRY THOMAS
      
Larry Thomas
Chairman and Co-Chief Executive Officer

        KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Larry Thomas, Marty Albertson and Bruce Ross, as his attorneys-in-fact, each with the power of substitution, for him in any and all capacities, to sign any amendment to this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his substitute or substitutes may do or cause to be done by virtue hereof.

        Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.

Name
  Title
  Date

 

 

 

 

 
/s/  LARRY THOMAS      
Larry Thomas
  Chairman & Co-Chief Executive Officer and Director (Principal Executive Officer)   March 27, 2002

/s/  
MARTY ALBERTSON      
Marty Albertson

 

President & Co-Chief Executive Officer and Director

 

March 27, 2002

/s/  
BRUCE ROSS      
Bruce Ross

 

Executive Vice President, Chief Financial Officer and Secretary (Principal Financial Officer)

 

March 27, 2002

/s/  
ERICK MASON      
Erick Mason

 

Senior Vice President of Operations and Finance (Principal Accounting Officer)

 

March 27, 2002

/s/  
DAVID FERGUSON      
David Ferguson

 

Director

 

March 27, 2002

 

 

 

 

 

39



/s/  
HARVEY KIBEL      
Harvey Kibel

 

Director

 

March 27, 2002

/s/  
PETER STARRETT      
Peter Starrett

 

Director

 

March 27, 2002

/s/  
JEFFREY WALKER      
Jeffrey Walker

 

Director

 

March 27, 2002

/s/  
ROBERT EASTMAN      
Robert Eastman

 

Chief Executive Officer,
Musician's Friend, Inc.,
Director

 

March 27, 2002

/s/  
LARRY LIVINGSTON      
Larry Livingston

 

Director

 

March 27, 2002

40



INDEX TO FINANCIAL STATEMENTS

Report of Independent Auditors   42
Management's Responsibility for Financial Statements   43
Consolidated Balance Sheets as of December 31, 2001 and 2000   44
Consolidated Statements of Income for the years ended
December 31, 2001, 2000 and 1999
  45
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 2001, 2000 and 1999
  46
Consolidated Statements of Cash Flows for the years ended
December 31, 2001, 2000 and 1999
  47
Notes to Consolidated Financial Statements   48

 

 

Schedule
Financial Statement Schedule:    
  Valuation and Qualifying Accounts   II-1

41



REPORT OF INDEPENDENT AUDITORS

The Board of Directors and Stockholders
Guitar Center, Inc.:

        We have audited the accompanying consolidated balance sheets of Guitar Center, Inc. and subsidiaries as of December 31, 2001 and 2000 and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2001. In connection with our audits of the consolidated financial statements, we also have audited the consolidated financial statement schedule as listed in the accompanying index. These consolidated financial statements and the consolidated financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and the consolidated financial statement schedule based on our audits.

        We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Guitar Center, Inc. and subsidiaries as of December 31, 2001 and 2000 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related consolidated financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

Los Angeles, California
February 7, 2002

42



MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS

        We are responsible for the preparation of our consolidated financial statements and related information appearing in this Annual Report. We believe that the consolidated financial statements fairly reflect the form and substance of transactions and that the financial statements reasonably present our financial position and results of operations in conformity with generally accepted accounting principles. We also have included in our financial statements amounts that are based on estimates and judgments which we believe are reasonable under the circumstances.

        The independent accountants audit our consolidated financial statements in accordance with generally accepted auditing standards and provide an objective, independent review of the fairness of reported operating results and financial position.

        The Board of Directors of the Company has an Audit Committee composed of three non-management Directors. The Committee meets periodically with financial management and the independent accountants to review accounting, internal control, auditing and financial reporting matters.

    Larry Thomas
Chairman &
Co-Chief Executive Officer
  Bruce Ross
Executive Vice President &
Chief Financial Officer
         
Los Angeles, California
February 7, 2002
       

43



GUITAR CENTER, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)

 
  December 31,
2001

  December 31,
2000

 
ASSETS              
Current assets:              
  Cash and cash equivalents   $ 17,480   $ 12,934  
  Accounts receivable, less allowance for doubtful accounts $959 and $834, respectively     19,243     20,490  
  Merchandise inventories     249,685     199,287  
  Prepaid expenses and deposits     6,404     5,148  
  Deferred income taxes     4,744     5,931  
   
 
 
Total current assets     297,556     243,790  
Property and equipment, net     81,056     68,658  
Goodwill, net of accumulated amortization $1,710 and $884, respectively     21,032     5,367  
Deposits and other assets, net     5,040     7,754  
   
 
 
    $ 404,684   $ 325,569  
   
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY              
Current liabilities:              
  Accounts payable   $ 78,287   $ 72,301  
  Accrued expenses and other current liabilities     38,834     30,580  
  Merchandise advances     12,780     10,512  
  Revolving line of credit     76,904     35,868  
  Current portion of long-term debt     638     495  
   
 
 
Total current liabilities     207,443     149,756  
Other long-term liabilities     3,716     2,770  
Deferred income taxes     2,733     2,160  
Long-term debt     66,924     67,420  
   
 
 
Total liabilities     280,816     222,106  
Stockholders' equity:              
  Preferred Stock; authorized 5,000 shares at December 31, 2001 and 2000, none issued and outstanding          
  Common Stock, $0.01 par value per share, authorized 55,000 shares, issued and outstanding 22,315 at December 31, 2001 and 22,087 at December 31, 2000, respectively     223     221  
Additional paid in capital     248,063     244,693  
Accumulated deficit     (124,418 )   (141,451 )
   
 
 
  Total stockholders' equity     123,868     103,463  
   
 
 
    $ 404,684   $ 325,569  
   
 
 

See accompanying notes to consolidated financial statements.

44



GUITAR CENTER, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)

 
  Year ended December 31,
 
 
  2001
  2000
  1999
 
Net sales   $ 938,180   $ 785,671   $ 620,081  
Cost of goods sold, buying and occupancy     691,206     580,749     456,797  
   
 
 
 
  Gross profit     246,974     204,922     163,284  
Selling, general and administrative expenses     200,748     156,698     128,416  
Transaction and other costs             4,674  
   
 
 
 
  Operating income     46,226     48,224     30,194  
Other expense:                    
  Write-off of investment in non-consolidated entity     3,539          
Interest expense, net     13,411     12,466     10,734  
  Interest expense to related party             501  
   
 
 
 
  Total other expense     16,950     12,466     11,235  
Income before income taxes (benefit) and cumulative effect of change in accounting principle     29,276     35,758     18,959  
Income taxes (benefit)     12,243     13,304     (391 )
   
 
 
 
  Income before cumulative effect of change in accounting principle     17,033     22,454     19,350  
Cumulative effect of change in accounting principle to write-off pre-opening costs, net of tax of $578             1,074  
   
 
 
 
Net income   $ 17,033   $ 22,454   $ 18,276  
   
 
 
 
Net income per share                    
  Basic   $ 0.77   $ 1.02   $ 0.83  
   
 
 
 
  Diluted   $ 0.75   $ 1.01   $ 0.82  
   
 
 
 
Weighted average shares outstanding                    
  Basic     22,229     22,047     22,020  
   
 
 
 
  Diluted     22,700     22,247     22,309  
   
 
 
 

See accompanying notes to consolidated financial statements.

45



GUITAR CENTER, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In thousands)

 
  Number of
Shares

  Common
Stock

  Additional
Paid in
Capital

  Retained
Earnings
(Deficit)

  Total
Balance at December 31, 1998   20,093   $ 201   $ 228,195   $ (182,181 ) $ 46,215
  Exercise of employee stock options   19         208         208
  Issuance of stock for merger   1,911     20     (20 )      
  Contribution of land and building           1,750         1,750
  Conversion of related party debt to equity           13,870         13,870
  Net income               18,276     18,276
   
 
 
 
 
Balance at December 31, 1999   22,023     221     244,003     (163,905 )   80,319
  Exercise of employee stock options   64         690         690
  Net income               22,454     22,454
   
 
 
 
 
Balance at December 31, 2000   22,087     221     244,693     (141,451 )   103,463
  Exercise of employee stock options   113     1     1,279         1,280
  Issuance of stock for acquisition   115     1     2,091         2,092
  Net income               17,033     17,033
   
 
 
 
 
Balance at December 31, 2001   22,315   $ 223   $ 248,063   $ (124,418 ) $ 123,868
   
 
 
 
 

See accompanying notes to consolidated financial statements.

46



GUITAR CENTER, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)

 
  Year ended December 31,
 
 
  2001
  2000
  1999
 
OPERATING ACTIVITIES:                    
Net income   $ 17,033   $ 22,454   $ 18,276  
Adjustments to reconcile net income to net cash provided by operating activities:                    
  Depreciation and amortization     15,006     11,043     8,252  
  Loss on sale of property and equipment     16     13      
  Amortization of deferred financing fees     556     408     240  
  Write-down of deferred financing fees     592          
  Deferred income taxes     1,760     8,702     (2,041 )
  Write-off of investment in non-consolidated entity     3,539          
  Cumulative effect of change in accounting principle to write-off pre-opening costs             1,652  
Changes in operating assets and liabilities:                    
  Accounts receivable     3,204     (6,363 )   (513 )
  Merchandise inventories     (30,869 )   (37,457 )   (33,614 )
  Prepaid expenses and deposits     (910 )   (1,689 )   (601 )
  Other assets     (2,772 )   (1,409 )   (2,569 )
  Accounts payable     (1,445 )   31,168     5,981  
  Accrued expenses and other current liabilities     7,587     4,740     7,512  
  Other long-term liabilities     946     700     500  
  Merchandise advances     2,268     2,057     1,308  
   
 
 
 
Net cash provided by operating activities     16,511     34,367     4,383  
INVESTING ACTIVITIES:                    
  Purchase of property and equipment     (24,697 )   (17,862 )   (19,768 )
  Proceeds from sale of property and equipment     16          
  Investment in non-consolidated entity     (150 )   (3,389 )    
  Acquisition of business, net of cash acquired     (28,482 )        
   
 
 
 
Net cash used in investing activities     (53,313 )   (21,251 )   (19,768 )
FINANCING ACTIVITIES:                    
  Net change in revolving debt facility     41,036     (6,902 )   21,920  
  Proceeds from exercise of stock options     1,280     690     208  
  Payments under capital lease     (968 )   (743 )   (442 )
   
 
 
 
Net cash provided by (used in) financing activities     41,348     (6,955 )   21,686  
Net increase in cash and cash equivalents     4,546     6,161     6,301  
Cash and cash equivalents at beginning of year     12,934     6,773     472  
   
 
 
 
Cash and cash equivalents at end of period   $ 17,480   $ 12,934   $ 6,773  
   
 
 
 
NON-CASH INVESTING ACTIVITIES:                    
  Borrowings under capital leases   $ 473   $   $ 890  
  Contributions of land and building           $ 1,750  
  Related party debt converted to equity           $ 13,870  
Guitar Center purchased all of the assets of American Music                    
Group (2001) and Veneman Music Group (2000).                    
In conjunction with the acquisition, the fair value of assets and                    
liabilities were as follows:                    
  Fair value of assets acquired   $ 22,628   $ 1,256   $  
  Liabilities assumed     (8,511 )   (2,391 )    
  Goodwill     16,457     1,135      
  Common Stock issued     (2,092 )        
   
 
 
 
  Cash paid for acquisition     28,482          
  Cash acquired in acquisition     278          
   
 
 
 
  Net cash paid for acquisition   $ 28,760   $   $  
   
 
 
 
NON-CASH FINANCING ACTIVITIES:                    
Issuance of Common Stock in connection with the business acquisition   $ 2,092   $   $  
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:                    
  Cash paid during the year for:                    
    Interest   $ 12,068   $ 12,061   $ 11,001  
    Income taxes   $ 7,315   $ 2,603   $ 1,146  

See accompanying notes to consolidated financial statements.

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GUITAR CENTER, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

December 31, 2001

1. Nature of Business and Significant Accounting Policies

        Guitar Center, Inc. and subsidiaries (the "Company") operates a chain of retail stores and a direct response unit which sell musical instruments, primarily guitars, amplifiers, percussion instruments, keyboards, pro-audio, recording equipment, and band and orchestral instruments. At December 31, 2001, we operated 96 Guitar Center stores and 12 American Music stores in major cities throughout the United States, with 21 of the stores located in California.

        The consolidated financial statements include the financial statements of Guitar Center, Inc. and our wholly-owned subsidiaries. All significant intercompany balances and transactions have been eliminated in consolidation.

        We account for investments where we own less than 20% of the voting stock under the cost method of accounting.

        Certain reclassifications have been made to prior year amounts to conform with the current year's presentation.

        For the purposes of balance sheet classification and the statement of cash flows, we consider all highly liquid investments that are both readily convertible into cash and mature within 90 days of their date of purchase to be cash equivalents.

        Inventories, including used merchandise and vintage guitars, are valued at the lower of cost or market using the first-in, first-out (FIFO) method. Rental inventories are valued at the lower of cost or market using the specific identification method and are depreciated on a straight-line basis over the term of the rental agreement for rent-to-own sales, or over the estimated useful life of the rented instrument for rental only sales.

        Property and equipment are recorded at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets; generally five years for furniture and fixtures, computer equipment and vehicles, 15 years for buildings and 15 years or the life of the lease, whichever is less, for leasehold improvements. Maintenance and repair costs are expensed as they are incurred, while renewals and betterments are capitalized.

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        Goodwill represents the excess of the purchase price over the fair value of the net assets acquired resulting from business acquisitions and historically has been amortized over a 20 to 30 year period using the straight-line method.

        Long-lived assets and certain identifiable intangibles are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of the assets to future net cash flows expected to be generated by said assets. If such assets are considered to be impaired, the impairment to be recognized is the amount by which the carrying amount of the assets exceeds the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less selling costs. As described below under "New Accounting Pronouncements," the accounting treatment for goodwill and other intangible assets will change significantly effective January 1, 2002.

        Merchandise advances represent layaway deposits which are recorded as a liability pending consummation of the sale when the full purchase price is received from the customer, outstanding gift certificates which are recorded as a liability until redemption by the customer, and credit on account for customer returns and special orders.

        Retail sales are recognized at the time of sale, net of a provision for estimated returns. Band instrument rentals are recognized over the term of the rental agreement. The terms of the majority of our rental agreements do not exceed 30 months. Catalog and e-commerce sales are recognized when the related products are shipped to customers, net of a provision for estimated returns.

        We expense retail advertising as incurred. Mail order catalog costs are capitalized on a catalog by catalog basis and are amortized over the expected period of future benefits, not to exceed five months, under the provisions of AICPA Statement of Position 93-7, "Reporting of Advertising Costs."Advertising expense included in the consolidated statements of income for the years ended December 31, 2001, 2000 and 1999 is $34,781,000, $27,868,000 and $24,566,000, respectively.

        We lease certain store locations under operating leases that provide for annual payments that increase over the life of the leases. The aggregate of the minimum annual payments are expensed on a straight-line basis over the term of the related lease. The amount by which straight-line rent expense exceeds actual lease payment requirements in the early years of the leases is accrued as deferred

49


minimum rent and reduced in later years when the actual cash payment requirements exceed the straight-line expense.

        We account for income taxes under Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes" (SFAS No. 109). Under the asset and liability method of SFAS No. 109, deferred income tax assets and liabilities are recognized for the future tax consequences attributable to differences between financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under SFAS No. 109, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

        In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider the scheduled reversals of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment.

        Effective January 1, 1999, we adopted AICPA Statement of Position 98-5, "Reporting on the Costs of Start-up Activities," which requires all store pre-opening costs to be expensed as incurred. As a result of this adoption, we recorded a charge for the cumulative effect of this change in accounting principle of $1,074,000 (net of taxes of $578,000), or $0.05 per basic and diluted share, in the Statement of Income for the year ending December 31, 1999.

        We adopted SFAS No. 123, "Accounting for Stock-Based Compensation," which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to continue to apply the provisions of Accounting Principles Board ("APB") Opinion No. 25 "Accounting for Stock Issued to Compensation," and related interpretations and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method defined in SFAS No. 123 had been applied. We have elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123. As such, compensation expense for stock options issued to employees is recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.

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        The following table summarizes the reconciliations of Basic to Diluted Weighted Average Shares as required by SFAS No. 128 for the years ended December 31, 2001, 2000 and 1999:

 
  2001
  2000
  1999
 
  (in thousands)

Basic shares   22,229   22,047   22,020
Common stock equivalents—dilutive effect of options
outstanding
  471   200   289
   
 
 
Diluted shares   22,700   22,247   22,309
   
 
 

        Options to purchase 1.3 million shares of Common Stock at prices ranging from $15.94 to $28.56, options to purchase 1.4 million shares of Common Stock at prices ranging from $12.33 to $28.56 and options to purchase 1.4 million shares of Common Stock at prices ranging from $15.94 to $28.56 were outstanding during 2001, 2000 and 1999, respectively, but were not included in the computation of diluted earnings per share because the exercise price of these options was greater than the average market price of our common stock.

        Our deposits are with various high quality financial institutions. Customer purchases are transacted generally using cash or credit cards. In certain instances, we grant credit for larger purchases, generally to professional musicians, under normal trade terms. Trade accounts receivable were approximately $4,288,000 and $1,854,000 at December 31, 2001 and 2000, respectively. Credit losses have historically been within our expectations.

        The carrying amount of cash and cash equivalents approximates fair value due to the relatively short maturity of these instruments. The fair value of our revolving line of credit reflects the fair value based upon current rates available to us for similar debt. As of December 31, 2001 the fair value of our long-term debt was $66.0 million, based on quoted market prices. Our cost basis investment, as discussed at Note 7, was written-off at December 31, 2001, in consideration of the estimated future cash flows of the investment and the uncertainties regarding its ongoing business.

        The preparation of financial statements in conformity with generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from our estimates.

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        On July 20, 2001, the Financial Accounting Standards Board issued Statement No. 141, "Business Combinations" (SFAS No. 141), and Statement No. 142, "Goodwill and Other Intangible Assets" (SFAS No. 142). These new pronouncements significantly change the permissible accounting methods for business combinations and the treatment of goodwill and other intangible assets. Prior to the adoption of these new standards, goodwill and similar intangible assets were generally amortized into income on a stated periodic basis. This treatment will be replaced by an alternative method, which will not require goodwill amortization on a stated basis but rather will require periodic testing of the goodwill for impairment, with no charge to income except to the extent of any such impairment. We adopted the new rules effective January 1, 2002, at which time we ceased to record periodic goodwill charges absent an impairment charge. As of December 31, 2001, goodwill was $21.0 million, the majority of which relates to the American Music Group acquisition. Amortization expense related to goodwill included in the consolidated statements of income was $827,000, $222,000 and $186,000 at December 31, 2001, 2000 and 1999 respectively.

        In August 2001, the Financial Accounting Standards Board issued Statement No. 143, "Accounting for Asset Retirement Obligations" (SFAS No. 143). This new pronouncement establishes financial accounting and reporting standards for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The provisions of SFAS No. 143 apply to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long-lived asset, except for certain obligations of lessees. The standard is effective for financial statements issued for fiscal years beginning after June 15, 2002 and we presently intend to adopt this standard effective January 1, 2003. We do not expect adoption of this standard to have a material effect on our consolidated financial statements.

        In October 2001, the Financial Accounting Standards Board issued Statement No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" (SFAS No. 144). This pronouncement provides new guidance on the recognition of impairment losses on long-lived assets to be held and used or to be disposed of and also broadens the definition of what constitutes a discontinued operation and how the results of a discontinued operation are to be measured and presented. The provisions of SFAS No. 144 are effective for financial statements issued for fiscal years beginning after December 15, 2001. We adopted SFAS No. 144 effective January 1, 2002, and the adoption of this standard did not have a material effect on our consolidated financial statements.

2. Acquisitions

        On April 16, 2001, we acquired the assets of American Music Group, Ltd. and related companies, a New York-based musical instrument retailer specializing in the sale and rental of band instruments and accessories (the "American Music Group"). In consideration of the purchase, we paid $28.5 million in net cash and issued 115,358 shares of Guitar Center common stock amounting to $2.1 million. We also assumed or repaid liabilities of $8.5 million. As part of the terms of the purchase agreement, there is a $2.5 million hold-back on the transaction, pending the American Music Group business meeting certain operating objectives in 2001. The acquisition was accounted for using the purchase method. Subsequent to December 31, 2001, it was determined that some of the objectives subject to the holdback were satisfied and on February 21, 2002 we paid an additional $1.8 million in cash to the

52



previous owners of American Music Group in full satisfaction of our obligations under the hold-back arrangement. The amount was recorded as additional goodwill.

        The results of operations for American Music Group were not material to Guitar Center's previous presented consolidated financial statements and, as such, pro-forma financial information is not presented. The results of American Music Group are included in the Guitar Center's consolidated financial statements from the date of the acquisition.

        In May 2000, we acquired the stock of Veneman Music Company, Inc., a musical instrument retailer based in Rockville, Maryland. The acquisition was accounted for using the purchase method. All of the debt and other liabilities of Veneman's were either repaid or assumed by us in connection with the closing. The results of operations have been included in the consolidated financial statements from the date of acquisition.

        On May 28, 1999, we acquired all of the stock of Musician's Friend, Inc., pursuant to a merger agreement. Each share of Musician's Friend common stock was converted into approximately 10.02 shares of Guitar Center common stock. In total, 1.9 million shares of common stock were issued. Under the terms of the merger agreement, 30% of the total shares issued were placed in escrow for general indemnification purposes and for indemnification against damages related to specific tax issues. In the first quarter of 2000, the 10% general escrow was resolved whereby 50,002 shares of Common Stock were returned to Guitar Center and the balance released to the former Musician's Friend stockholders. The merger was accounted for under the pooling of interests method. Accordingly, our financial statements have been restated for all periods to include the results of Musician's Friend.

        Goodwill was recorded on the American Music Group and Veneman Music Company, Inc. acquisitions for any consideration paid in excess of fair value of the identifiable assets acquired. Through December 31, 2001, we amortized goodwill over twenty years. We adopted SFAS No. 142 effective January 1, 2002, at which time we ceased to record periodic goodwill charges absent an impairment charge. As of December 31, 2001, goodwill was $21.0 million, the majority of which relates to the American Music Group acquisition. Amortization expense related to goodwill included in the consolidated statements of income was $827,000 and $222,000 and $186,000 at December 31, 2001, 2000 and 1999, respectively.

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3. Merchandise Inventories

        The major classes of merchandise inventories are as follows:

 
  December 31,
 
  2001
  2000
 
  (in thousands)

Major goods   $ 162,039   $ 139,543
Band instruments     17,019    
Associated accessories     42,973     38,389
Vintage guitars     6,828     5,004
Used merchandise     14,063     10,139
General accessories     10,218     9,437
   
 
      253,140     202,512
Less inventory reserves     3,455     3,225
   
 
    $ 249,685   $ 199,287
   
 

        Major goods include stringed merchandise, percussion, keyboards, pro-audio and recording equipment. Band instruments include horns, flutes, brass and woodwind instruments. Associated accessories are comprised of accessories to major goods and band instruments. General accessories include other merchandise such as apparel, cables and books.

4. Property and Equipment

        Property and equipment consists of the following:

 
  December 31,
 
  2001
  2000
 
  (in thousands)

Land   $ 2,946   $ 2,996
Buildings     9,461     9,649
Furniture and fixtures     16,169     13,726
Computer equipment     33,483     24,941
Leasehold improvements     64,346     52,530
Construction in progress     5,000     307
   
 
      131,405     104,149
Less accumulated depreciation     50,349     35,491
   
 
    $ 81,056   $ 68,658
   
 

5. Debt

        At December 31, 2001, we had outstanding $66.7 million in principal amount of 11% Senior Notes due 2006. The Senior Notes are unsecured and pay interest at 11% on a semi-annual basis. The Senior Notes are not entitled to the benefit of a sinking fund. The Senior Notes may be redeemed, in whole or in part, at our option, at any time after July 1, 2001 at prices declining from 105.5% to 100.0% of the

54



principal amount redeemed, plus accrued and unpaid interest. The holders of the Senior Notes have the right to require us to repurchase their Senior Notes at 101% of the principal amount thereof, plus accrued and unpaid interest, upon the occurrence of a change of control, as defined. The Senior Notes mature on July 1, 2006.

        Our revolving line of credit, as amended in the fourth quarter of 2001, provides for a maximum facility amount of $200,000,000, subject to borrowing base limitations ($117.8 million at December 31, 2001), and expires December 16, 2005. A fee of 0.375% is assessed on the unused portion of the facility. Borrowings bear interest at either the prime rate plus an applicable margin rate (5.25% at December 31, 2001), or at LIBOR plus an applicable margin rate (5.25% at December 31, 2001), at our option, with interest due monthly. The applicable margin rate is based upon a quarterly calculation of average daily availability at the end of each fiscal quarter. The applicable interest rate at December 31, 2001 was LIBOR plus 2.00%. The agreement underlying the credit facility includes certain restrictive covenants. We were in compliance with such requirements as of December 31, 2001. At December 31, 2001, we had $76.9 million outstanding on the line of credit, $1.1 million outstanding on letters of credit, and $39.8 million in available borrowings.

        Certain assets of our Company secure the credit facility and the actual amount available to borrow is tied to our inventory and receivable base.

        At December 31, 2001, 2000 and 1999, $556,000, $408,000, and $240,000 amortization of deferred financing fees was included in interest expense. $1.4 million and $749,000 million of capitalized deferred financing fees was included in other assets, net of accumulated amortization of $3.0 million and $2.5 million, at December 31, 2001 and 2000, respectively.

6. Segment Information

        Our reportable business segments are retail (Guitar Center and American Music Group stores) and direct response (Musician's Friend's catalog and Internet). Management evaluates segment performance based primarily on net sales and income (loss) before income taxes and cumulative effect of change in accounting principle.

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        Net sales, depreciation and amortization, income (loss) before income taxes (benefit) and cumulative effect of change in accounting principle, capital expenditures, and total assets are summarized as follows for the twelve months ended December 31, 2001, 2000 and 1999 (in thousands):

 
  Retail
2001

  Direct Response
2001

  Total
  Retail
2000

  Direct Response
2000

  Total
Net sales   $ 780,763   $ 157,417   $ 938,180   $ 652,341   $ 133,330   $ 785,671
Depreciation and amortization     13,196     1,810     15,006     10,077     966     11,043
Income before income taxes     22,971     6,305     29,276     27,992     7,766     35,758
Capital expenditures     22,899     1,798     24,697     16,693     1,169     17,862
Total assets   $ 365,186   $ 39,498   $ 404,684   $ 290,972   $ 34,597   $ 325,569
 
  Retail
1999

  Direct Response
1999

  Total
Net sales   $ 536,650   $ 83,431   $ 620,081
Depreciation and amortization     7,450     802     8,252
Income (loss) before income taxes (benefit) and cumulative effect of change in accounting principle     22,551     (3,592 )   18,959
Capital expenditures     16,372     3,396     19,768
Total assets   $ 241,247   $ 25,604   $ 266,851

7. Investment in Non-Consolidated Entity

        At December 31, 2001 and 2000, we had an investment through a wholly-owned subsidiary, Musician's Choice, Inc., of approximately $3.5 and $3.3 million, respectively, in a non-consolidated entity, Musician.com Internet Network, Inc. ("Musician.com"). As of December 31, 2001 and 2000, we owned approximately 14% of the voting stock of Musician.com. As of these dates we also owned additional shares of non-voting common stock and non-voting preferred stock with a liquidation preference of $2.7 million. Musician.com operates community-based musician websites offering a wide range of services to empower amateur and professional musicians. We account for this investment under the cost method. During the fourth quarter of 2001, in consideration of the estimated future cash flows of Musician.com and the uncertainties regarding its ongoing business, we recorded a $3.5 million charge representing the write-off of our investment in this company.

8. Lease Commitments

        We lease offices, most of our retail store facilities, two of our distribution centers and various personal property used in our business under various operating leases which expire at varying dates through December 2018. Generally, the agreements contain provisions which require us to pay for normal repairs and maintenance, property taxes and insurance.

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        The total minimum lease commitment at December 31, 2001, under operating leases, is as follows:

Year ended December 31

  Amount
 
  (in thousands)

2002   $ 24,908
2003     25,253
2004     22,844
2005     21,284
2006     19,601
Thereafter     79,179
   
    $ 193,069
   

        Total rent expense included in the consolidated statements of income for the years ended December 31, 2001, 2000 and 1999 is $20,124,000, $15,587,000, and $11,749,000, respectively.

9. Employee Benefit Plans

        We have a defined contribution 401(k) plan with a 401(a) profit-sharing component (the "Plan") maintained for the exclusive benefit of eligible employees and their beneficiaries. Eligible employees can contribute from one to fifteen percent of their compensation. The Company, at its discretion, can make matching contributions to the Plan, which will be a uniform percentage of the eligible employees contributions. The Company may also, at its discretion, make profit-sharing contributions to the Plan. The profit-sharing contributions shall be allocated based on the relative compensation of all eligible employees. Our contributions to the Plan were $756,000, $414,000 and $274,000 for the years ended December 31, 2001, 2000 and 1999, respectively.

10. Stock Option and Purchase Plans

        In June 1996, we adopted the 1996 Performance Stock Option Plan (as amended, the "1996 Plan"), which provided for the granting of options to officers and key employees. The number of options granted were 1,503,323 with an exercise price equal to the fair market value ($10.89 per share) of the underlying stock at the date of grant and generally vested ratably over three years. No further options are available for grant under the 1996 Plan. At December 31, 2001, 447,099 options were outstanding under the 1996 Plan.

        In June 1996, we granted options to two officers to purchase 795,969 shares at an exercise price of $10.89 per share. Under the terms of the option agreements, the conditions for full accelerated vesting occurred during 1997. No additional options are available for grant under this plan. At December 31, 2001, all options granted were outstanding.

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        In January 1997, the 1997 Equity Participation Plan (as amended, the "1997 Plan") was adopted. Under the 1997 Plan, we may grant options to purchase up to 3,725,000 shares of common stock; provided, however, that grants to any one individual may not exceed 250,000 shares of Common Stock in any calendar year. Options granted under the 1997 Plan vest ratably over various terms. As of December 31, 2001, options to purchase 2,989,791 shares of common stock were outstanding under the 1997 Plan. At December 31, 2001, there were 1,096,903 shares exercisable with exercise prices ranging from $8.34 to $28.56 and a weighted average exercise price of $15.90.

        In connection with the merger with Musician's Friend, stock options to purchase 250,505 shares of Common Stock were assumed. The assumed stock options have exercise prices of $19.96 to $21.96 per share, with a weighted average exercise price of $20.31.

        In April 2001, the Employee Stock Purchase Plan (the "ESPP Plan") was adopted. The ESPP Plan is a tax-qualified employee stock purchase plan which authorizes 500,000 shares of our common stock, $0.01 par value, for issuance under the plan. Under the ESPP Plan, participants are granted options to purchase our common stock at a price which is eighty-five percent of the stock's fair market value on either the first or last day of the offering period, whichever price is lower. The options are then automatically exercised on the last business day of the offering period. The participants purchase the shares through payroll deductions. As of December 31, 2001, 24,926 shares had been purchased under the ESPP Plan at $11.59 per share.

        We apply APB Opinion No. 25 in accounting for our plans. Had we determined compensation cost based upon the fair value at the grant date for our stock options under SFAS No. 123 using the Black Scholes option pricing model, pro forma net income and pro forma net income per share, including the following weighted average assumptions used in these calculations, would have been as follows:

 
  2001
  December 31,
2000

  1999
 
 
  (in thousands, except per share
data-unaudited)

 
Pro forma net income   $ 16,383   $ 21,632   $ 14,359  
Pro forma net income per share (basic)   $ 0.74   $ 0.98   $ 0.65  
Pro forma net income per share (diluted)   $ 0.72   $ 0.97   $ 0.64  
Risk free interest rate     4.6 %   5.2 %   6.2 %
Expected lives     10.0     10.0     10.0  
Expected volatility     67.0 %   60.0 %   82.0 %
Expected dividends              

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        Stock option activity for all plans during the periods presented is as follows:

 
  No. of Shares
  Weighted Average
Exercise Price

Balance at December 31, 1998   2,438,557   $ 15.09
  Granted   495,319     17.51
  Exercised   (19,069 )   10.89
  Forfeited   (123,951 )   20.05
  Expired      
   
 
Balance at December 31, 1999   2,790,856     15.33
  Granted   915,008     11.10
  Exercised   (63,541 )   10.89
  Forfeited   (165,702 )   18.68
  Expired      
   
 
Balance at December 31, 2000   3,476,621     14.14
  Granted   994,744     15.35
  Exercised   (113,856 )   11.24
  Forfeited   (124,649 )   16.52
  Expired      
   
 
Balance at December 31, 2001   4,232,860   $ 14.43
   
 

        The following is a summary of stock options outstanding and exercisable at December 31, 2001:

 
  Outstanding
  Exercisable
Range of Exercise Prices

  Number of Options
  Weighted
Average Years
Remaining

  Weighted
Average Exercise
Price

  Number of Options
  Weighted
Average Exercise
Price

                           
$ 8.34 to $12.33   1,944,755   5.81   $ 10.78   1,424,150   $ 10.87
$ 13.44 to $16.65   1,235,849   9.18   $ 15.27   145,234   $ 15.24
$ 18.25 to $20.75   983,418   6.53   $ 19.88   701,750   $ 20.05
$ 21.96 to $28.56   68,838   6.20   $ 24.36   68,838   $ 24.36
     
 
 
 
 
$ 8.34 to $28.56   4,232,860   6.97   $ 14.43   2,339,972   $ 14.29
     
 
 
 
 

59


11. Income Taxes

        Total income taxes (benefit) before cumulative effect of change in accounting principle for the years ended December 31, 2001, 2000 and 1999 consists of:

2001

  Current
  Deferred
  Total
 
   
  (in thousands)

   
Federal   $ 9,022   $ 1,921   $ 10,943
State     1,461     (161 )   1,300
   
 
 
    $ 10,483   $ 1,760   $ 12,243
   
 
 
2000

  Current
  Deferred
  Total
 
   
  (in thousands)

   
Federal   $ 3,454   $ 8,332   $ 11,786
State     1,148     370     1,518
   
 
 
    $ 4,602   $ 8,702   $ 13,304
   
 
 
1999

  Current
  Deferred
  Total
 
 
   
  (in thousands)

   
 
Federal   $ 929   $ (1,710 ) $ (781 )
State     721     (331 )   390  
   
 
 
 
    $ 1,650   $ (2,041 ) $ (391 )
   
 
 
 

        Actual income taxes (benefit) for 2001, 2000 and 1999 differs from the statutory tax rate of 35% as applied to income before income taxes (benefit) and cumulative effect of change in accounting principle as follows:

 
  2001
  2000
  1999
 
 
  (in thousands)

 
Expected income tax expense   $ 10,245   $ 12,515   $ 6,636  
State income taxes, net of federal tax benefit     761     892     428  
Non deductible items     127     106     1,586  
Current use of NOL             (1,896 )
Change in valuation allowance     1,120         (7,145 )
Other     (10 )   (209 )    
   
 
 
 
Actual income tax expense (benefit)   $ 12,243   $ 13,304   $ (391 )
   
 
 
 

60


        The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities are presented below:

 
  2001
  2000
 
  (in thousands)

Deferred tax assets:            
  Federal net operating loss carryforwards   $ 743   $ 4,155
  State net operating loss carryforwards     181     177
  Accrued liabilities     2,438     2,457
  Merchandise inventories     3,158     3,582
  Alternative minimum tax carryforward         880
  Capital loss (Musician.com)     1,120    
   
 
Total gross deferred tax assets     7,640     11,251
   
 
Deferred tax liabilities            
  Depreciation     3,858     6,774
  Other     651     706
   
 
Total gross deferred liabilities:     4,509     7,480
   
 
Deferred tax assets, net of deferred tax liabilities     3,131     3,771
   
 
Less valuation allowance     (1,120 )  
   
 
Net deferred tax assets   $ 2,011   $ 3,771
   
 

        In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. We consider scheduled reversal of deferred tax liabilities, projected future taxable income and tax planning strategies in making this assessment. Based upon the level of historical taxable income and projections of future taxable income over the periods which the deferred tax assets are deductible, management believes it is more likely than not that we will realize the benefits of these deductible differences. The amount of the deferred tax assets considered realizable, however, could be reduced in the near term if estimates of future taxable income during the carryforward periods are reduced.

        For the year ended December 31, 2001, the deferred tax valuation allowance increased by $1,120,000 in connection with the write-down of the minority interest in the non-consolidated entity. Management believes it is more likely than not that the tax asset associated with the minority interest in the non-consolidated entity will not be realized because the related capital loss carryover may only be utilized to offset future capital gains.

61



12. Accrued Expenses and Other Current Liabilities

 
  December 31,
 
  2001
  2000
 
  (in thousands)

Wages, salaries and benefits   $ 10,957   $ 7,903
Sales tax payable     8,008     7,407
Accrued interest     4,150     3,860
Accrued income tax     6,391     249
Other     9,328     11,161
   
 
    $ 38,834   $ 30,580
   
 

13. Legal

        We are not a party to any material legal proceedings. We are, however, involved in routine litigation arising in the ordinary course of our business and, while the results of the proceedings cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our consolidated financial position or results of operations.

14. Quarterly Financial Data (unaudited)

 
  2001
 
  First
  Second
  Third
  Fourth
  Total
 
   
  (in thousands, except per share data)

   
Net sales   $ 213,152   $ 213,382   $ 225,264   $ 286,382   $ 938,180
Gross profit   $ 54,831   $ 56,095   $ 57,600   $ 78,448   $ 246,974
Net income   $ 4,965   $ 4,114   $ 1,373   $ 6,581   $ 17,033
Net income per share (diluted)   $ 0.22   $ 0.18   $ 0.06   $ 0.29   $ 0.75
 
  2000
 
  First
  Second
  Third
  Fourth
  Total
 
   
  (in thousands, except per share data)

   
Net sales   $ 175,846   $ 178,552   $ 191,001   $ 240,272   $ 785,671
Gross profit   $ 45,271   $ 46,032   $ 48,190   $ 65,429   $ 204,922
Net income   $ 4,114   $ 4,050   $ 4,275   $ 10,015   $ 22,454
Net income per share (diluted)   $ 0.19   $ 0.18   $ 0.19   $ 0.45   $ 1.01

62


SCHEDULE II


GUITAR CENTER, INC. AND SUBSIDIARY
VALUATION AND QUALIFYING ACCOUNTS
Years ended December 31, 2001 and 2000
(amounts in thousands)

 
  Balance at
beginning
of year

  Additions
charged to
operations

  Deductions
from
Allowance

  Other
  Balance
at end
of year

December 31, 2001                        
  Allowance for doubtful receivables   $ 834   125       $ 959
  Allowance for obsolescence & damaged goods   $ 3,225   230       $ 3,455

December 31, 2000

 

 

 

 

 

 

 

 

 

 

 

 
  Allowance for doubtful receivables   $ 1,143     309     $ 834
  Allowance for obsolescence & damaged goods   $ 2,060   1,165       $ 3,225

II-1



INDEX TO EXHIBITS

Exhibit
Number

  Description
3.1   The Company's Restated Certificate of Incorporation (Incorporated by reference to Exhibit 3.5 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
3.2   The Company's Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.2 of the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended March 31, 2001).
3.3   Amendment to the Company's Amended and Restated Bylaws (Incorporated by reference to Exhibit 3.3 of the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended September 30, 2001).
4.1   Indenture dated as of July 2, 1996 by and between the Company and U.S. Trust Company of California as trustee (Incorporated by reference to Exhibit 4.1 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))
4.2   Form of Stock Certificate (Incorporated by reference to Exhibit 4.4 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
4.3   Form of Indenture (Incorporated by reference to Exhibit 4.2 of the Company's Registration Statement on Form S-3 (Registration No. 333-65220)).
10.1   Registration Rights Agreement dated June 5, 1996 among the Company and the stockholders named therein (Incorporated by reference to Exhibit 10.2 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))
10.2*   The Company's Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.5 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
10.3*   Form of Indemnification Agreement between the Company and each of its directors and executive officers (Incorporated by reference to Exhibit 10.11 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
10.4*   Management Stock Option Agreement dated June 5, 1996 by and between the Company and Lawrence Thomas (Incorporated by reference to Exhibit 10.16 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))
10.5*   Management Stock Option Agreement dated June 5, 1996 by and between the Company and Marty Albertson (Incorporated by reference to Exhibit 10.17 of the Company's Registration Statement on Form S-1 (Registration No. 333-10491))
10.6*   Amended and Restated Memorandum of Understanding and Stock Option Agreement, dated as of December 30, 1996 (Incorporated by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-3 (Registration No. 333-62732)).
10.7*   Amendment No. 1 to Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.24 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
10.8*   Amended 1997 Equity Participation Plan (Incorporated by reference to Exhibit 10.22 of the Company's Annual Report on Form 10-K (Registration No. 000-22207) for the fiscal year ended December 31, 1998).
10.9*   Modification to Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.28 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))
10.10*   Amendment No. 2 to the Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.30 of the Company's Registration Statement on Form S-1 (Registration No. 333-20931))

II-2


10.11*   Amendment No. 1 to Management Stock Option Agreement dated as of October 15, 1996 between the Company and Larry Thomas (Incorporated by reference to Exhibit 10.21 contained in Registration Statement on Form S-1 (File No. 333-10491))
10.12*   Amendment No. 1 to Management Stock Option Agreement dated as of October 15, 1996 between the Company and Marty Albertson (Incorporated by reference to Exhibit 10.22 contained in Registration Statement on Form S-1 (File No. 333-10491))
10.13*   Amendment No. 3 to Amended and Restated 1996 Performance Stock Option Plan (Incorporated by reference to Exhibit 10.29 of the Company's Annual Report on Form 10-K (Registration No. 000-22207) for the fiscal year ended December 31, 1998).
10.14*   Amended and Restated Employment Agreement dated May 13, 1999 between Musician's Friend, Inc. and Robert Eastman (Incorporated by reference to Exhibit 10.31 of the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the period ending June 30, 1999).
10.15*   Agreement and Plan of Merger dated May 13, 1999 by and among the Company, EMIC Acquisition Corporation, Musician's Friend, Inc. and the Stockholders of Musician's Friend, Inc. (Incorporated by reference to Exhibit 2.1 of the Company's Current Report on Form 8-K dated May 28, 1999 (Registration No. 000-22207)).
10.16*   Amended and Restated Registration Rights Agreement dated May 13, 1999 by and among the Company, Chase Venture Capital Associates, L.P., Weston Presidio Capital II, L.P., Wells Fargo Small Business Investment Company, Inc., Larry Thomas, Marty Albertson, Amazing Grace Foundation, The Emmanuel Foundation, Midas Touch Investments Trust, Sterling Investments Trust, Syringa Investments Trust, Eiger Mountain Real Estate Trust, Promise Land Real Estate Development Trust and Musician's Friend Trust (Incorporated by reference to Exhibit 2.2 of the Company's Current Report on Form 8-K dated May 28, 1999 (Registration No. 000-22207)).
10.17*   Form of Amendment to the 1997 Equity Participation Plan of Guitar Center, Inc. approved by stockholders at the 2000 Annual Meeting of Stockholders. (Incorporated by reference to Exhibit 10.(35)(36) of the Company's Annual Report on Form 10-K (Registration No. 000-22207 for the fiscal year ended December 31, 1999)
10.18*   Form of Amendment to the Company's 1997 Equity Participation Plan approved by stockholders at the Annual Meeting of Stockholders held on April 26, 2001 (Incorporated by reference to Exhibit 10.37 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended March 31, 2001).
10.19*   Form of Employee Stock Purchase Plan as approved by stockholders at the Annual Meeting of Stockholders held on April 26, 2001 (Incorporated by reference to Exhibit 10.38 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended March 31, 2001).
10.20   Asset Purchase Agreement made as of March 20, 2001, by and among Guitar Center Stores, Inc., and American Music Group, Ltd., Eastern Musical Supply Co., Inc., Lyons Music, Inc., American Music, Inc., American Musical Instruments, Inc., Giardinelli Band Instruments Co., Central Music Supply, Inc., and GBI, Inc. (Incorporated by reference to Exhibit 10.40 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended June 30, 2001).
10.21*   Employment Agreement made as of March 20, 2001 between Guitar Center Stores, Inc. and David Fleming (Incorporated by reference to Exhibit 10.41 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended June 30, 2001).
10.22*   Amended and Restated Employment Agreement between the Company and Marty Albertson, effective as of June 6, 2001, with exhibits.
10.23*   Amended and Restated Employment Agreement between the Company and Larry Thomas, effective as of June 6, 2001, with exhibits.

II-3


10.24*   Amended and Restated Employment Agreement between the Company and Barry Soosman, effective as of July 1, 2001, with exhibit.
10.25*   Amended and Restated Employment Agreement between the Company and Bruce Ross, effective as of July 1, 2001, with exhibit.
10.26*   Amendment to the Company's 1997 Equity Participation Plan approved July 26, 2001 (Incorporated by reference to Exhibit 10.42 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended September 30, 2001).
10.27   Lease Agreement, dated as of August 15, 2001, by and between Guitar Center Stores, Inc. and Eaglepoint Partners Two, LLC.
10.28*   Second Amendment to Amended and Restated Memorandum of Understanding, effective as of September 5, 2001 (Incorporated by reference to Exhibit 10.44 to the Company's Quarterly Report on Form 10-Q (Registration No. 000-22207) for the quarterly period ended September 30, 2001).
10.29*   Third Amendment to Amended and Restated Memorandum of Understanding, effective as of November 6, 2001.
10.30   Second Amended and Restated Loan and Security Agreement entered into as of December 21, 2001, between and among the Company, Guitar Center Stores, Inc., Musician's Friend, Inc. and the lenders identified therein.
12.1   Ratio of Earnings to Fixed Charges
21.1   Material subsidiaries of the Registrant as of December 31, 2001:
            Musician's Friend, Inc., a Delaware corporation.
            Guitar Center Stores, Inc., a Delaware corporation.
23.1   Consent of Independent Auditors (KPMG LLP)
24.1   Power of Attorney (included on page S-1)

*
Management contract or other compensation plan or arrangement.

II-4




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PART I
PART II
PART III
PART IV
INDEX TO EXHIBITS
SIGNATURES
INDEX TO FINANCIAL STATEMENTS
REPORT OF INDEPENDENT AUDITORS
MANAGEMENT'S RESPONSIBILITY FOR FINANCIAL STATEMENTS
GUITAR CENTER, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (In thousands, except per share data)
GUITAR CENTER, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF INCOME (In thousands, except per share data)
GUITAR CENTER, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (In thousands)
GUITAR CENTER, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands)
GUITAR CENTER, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS December 31, 2001
GUITAR CENTER, INC. AND SUBSIDIARY VALUATION AND QUALIFYING ACCOUNTS Years ended December 31, 2001 and 2000 (amounts in thousands)
INDEX TO EXHIBITS


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Exhibit 10.22


AMENDED AND RESTATED EMPLOYMENT AGREEMENT

        This AMENDED AND RESTATED EMPLOYMENT AGREEMENT is made effective as of June 6, 2001 (the "Agreement"), between GUITAR CENTER, INC., a Delaware corporation, and successor in interest to Guitar Center Management Company, Inc. (collectively, the "Company"), and Marty Albertson (the "Executive").

        This Agreement amends and restates that certain Amended and Restated Employment Agreement, dated as of June 5, 1996 (the "Commencement Date"), between the Executive and the Company's predecessor, Guitar Center Management, Inc. (the "Original Agreement"). The Original Agreement was executed and delivered in connection with the closing of the Stock Purchase Agreement (the "Purchase Agreement") dated June 5, 1996, by and among the Company, Chase Venture Capital Associates, L.P., Wells Fargo Small Business Investment Company, Inc., Weston Presidio Capital II, L.P., and the security holder of the Company.

        In consideration of the mutual covenants contained herein and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto agree as follows:


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or such other address as the recipient party to whom notice is to be given may have furnished to the other party in writing in accordance herewith. Any such communication shall deemed to have been delivered and received (a) when delivered, if personally delivered, sent by telecopier or sent by overnight courier, and (b) on the fifth business day following the date posted, if sent by mail.

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        IN WITNESS WHEREOF, the parties hereto have executed this Amended and Restated Employment Agreement as of the date first written above.

    GUITAR CENTER, INC.

 

 

By:

 

/s/  
BRUCE ROSS      
Name: Bruce Ross
Title: Chief Financial Officer

 

 

By:

 

/s/  
MARTY ALBERTSON      
Marty Albertson

17



EXHIBIT A


TERRITORY

ARIZONA:
Phoenix metropolitan area

CALIFORNIA:
Los Angeles County metropolitan areas
Orange County metropolitan areas
San Diego County metropolitan areas
San Francisco/Alameda/Contra Costa/Marin/San Mateo County metropolitan areas
San Bernardino/Riverside County metropolitan area
Bakersfield metropolitan area
Fresno metropolitan area
Sacramento metropolitan area

COLORADO:
Denver metropolitan area

CONNECTICUT:
Hartford metropolitan area

DISTRICT OF COLUMBIA:
Washington, D.C. metropolitan area

FLORIDA:
Miami metropolitan area
Ft. Lauderdale/Hollywood metropolitan area

GEORGIA:
Atlanta metropolitan area

IDAHO:
Boise metropolitan area

ILLINOIS:
Chicago metropolitan area

INDIANA:
Indianapolis metropolitan area

LOUISIANA:
New Orleans metropolitan area

MARYLAND:
Baltimore metropolitan area

MASSACHUSETTS:
Boston metropolitan area

MICHIGAN:
Detroit metropolitan area

A-1



MINNESOTA:
Minneapolis/St. Paul metropolitan area

MISSOURI:
St. Louis metropolitan area

NEVADA:
Las Vegas metropolitan area

NEW JERSEY:
Camden metropolitan area
Newark metropolitan area

NEW YORK:
Buffalo metropolitan area
New York metropolitan area
Rochester metropolitan area

OHIO:
Cincinnati metropolitan area
Cleveland metropolitan area

OKLAHOMA:
Oklahoma City metropolitan area

OREGON:
Portland metropolitan area
Medford metropolitan area
Eugene metropolitan area

PENNSYLVANIA:
Philadelphia metropolitan area
Pittsburgh metropolitan area

TENNESSEE:
Knoxville metropolitan area

TEXAS:
Dallas/Ft. Worth metropolitan area
Houston metropolitan area
Austin metropolitan area

UTAH:
Salt Lake City metropolitan area

VIRGINIA:
Virginia Beach metropolitan area
Washington, D.C. metropolitan area

WASHINGTON:
Seattle metropolitan area.

A-2



EXHIBIT B


Policy of the Compensation Committee
of the Board of Directors of
Guitar Center, Inc.

Reimbursement of expenses incurred by the Chief Executive Officer
or any Co-Chief Executive Officer of Guitar Center, Inc.

Reimbursement of Business and other Bona Fide Expenses


        This Policy is adopted by the Compensation Committee (the "Committee") of the Board of Directors of Guitar Center, Inc. (the "Company") to be effective from and after June 6, 2001 unless and until amended, superceded, revoked or otherwise amended by subsequent action of the Committee or the Company's full Board of Directors. This Policy shall apply to the Chief Executive Officer of the Company or, for so long as there shall be Co-Chief Executive Officers, to each of them individually.

        1.    Accountable Plan Expenses.

        It is the intention of Guitar Center, Inc. (the "Company") to maintain an accountable plan as described in Regulation Section 1.62-2(c)(2). Accordingly, subject to the administrative review provided for in Paragraph 3 and the limitations provided for in Paragraph 4 of this Policy, the Company shall pay or reimburse a Chief Executive Officer for expenses that are allowable as deductions by Part VI (Sections 161 - 198) of the Internal Revenue Code that are paid or incurred by a Chief Executive Officer in connection with the performance of services as an employee of the Company. Pursuant to this Paragraph 1, the Company shall pay to or reimburse a Chief Executive Officer for business expenses involving the Chief Executive Officer that would not otherwise be eligible for reimbursement under the other general expense policies of the Company applicable to a Chief Executive Officer from time to time (including Section 3(c) of the Amended and Restated Employment Agreements to which each Co-Chief Executive Officer is presently a party), provided the expense is allowable as a deduction for federal income tax purposes as described above in this paragraph.

        2.    Nonaccountable Plan Expenses.

        In addition, the Company recognizes that a Chief Executive Officer may incur other bona fide expenses related to the Company's business that are not allowable as deductions by Part VI (Sections 161 - 198) of the Internal Revenue Code (e.g., country club membership dues and costs, tax preparation services, financial planning services and similar services and expenses, in each case to be provided by a vendor selected by the Chief Executive Officer). It is the intention of the Company to maintain a nonaccountable plan as described in Regulation Section 1.62-2(c)(3) with respect to such expenses. Accordingly, subject to the administrative review provided for in Paragraph 3 and the limitations provided for in Paragraph 4 of this Policy, the Company shall pay or reimburse a Chief Executive Officer for bona fide business expenses that are not allowable as deductions by Part VI (Sections 161 - 198) of the Internal Revenue Code that are paid or incurred by the Chief Executive Officer in connection with the performance of services as an employee of the Company. Pursuant to this Paragraph 2 and subject to Paragraph 3 and Paragraph 4, the Company shall also pay to or reimburse the Chief Executive Officer for travel and entertainment expenses involving the Chief Executive Officer and his spouse that would not otherwise be eligible for reimbursement under the other general expense policies of the Company applicable to a Chief Executive Officer from time to time (including Section 3(c) of the Amended and Restated Employment Agreements to which each Co-Chief Executive Officer is presently a party).

B-1



        3.    Administrative Review.

        In order to obtain payment or reimbursement pursuant to this Policy, the Chief Executive Officer shall present to the Chief Financial Officer reasonable documentary evidence regarding the expenditure and shall provide any supporting detail reasonably requested by him for the purpose of documenting the actual amount of the expenditure and providing an appropriate basis for the reporting of the expenditure in the Company's books and records, in its tax returns, and in its public reports to stockholders and regulatory agencies. The classification of the expenditure (i.e., as being taxable versus deductible/excludible and whether the expense should properly be accounted for under the other general expense reimbursement policies of the Company applicable to a Chief Executive Officer, Paragraph 1 of this Policy, or Paragraph 2 of this Policy) shall be made by the Chief Financial Officer. In the event of any dispute regarding such classification, the final determination shall be made by the Chairman of the Committee, unless it is solely a matter of the proper accounting or tax treatment, in which event the parties shall be bound by the determination of the Company's independent accounting firm that performs the annual audit.

        4.    Reimbursement Limitation.

        In no event, however, shall (i) the total amounts incurred by the Company pursuant to Paragraph 1 of this Policy, to the extent that such payments are not eligible for reimbursement under the Company's other general expense policies applicable to a Chief Executive Officer from time to time (including Section 3(c) of the Amended and Restated Employment Agreement to which each Co-Chief Executive Officer is presently a party), plus (ii) the total amounts incurred by the Company pursuant to Paragraph 2 of this Policy, exceed $100,000 in any 12-month period for each Co-Chief Executive Officer, with such determination to be made with respect to each 12-month period during the Employment Period commencing on July 1 and ending on the following June 30, subject to proration for any partial period. In order to avoid any doubt, it is acknowledged that each Co-Chief Executive Officer is as of the effective date of this Policy provided with a Company automobile pursuant to their respective employment agreements or predecessor provisions, and those expenses are not included within the $100,000 allowance provided for in this paragraph 4. The first period to which this Policy and this paragraph 4 shall apply will be the twelve months commencing July 1, 2001 and ending on June 30, 2002.

        5.    Tax Reporting.

        Each Chief Executive Officer shall be solely responsible for the payment of any federal, state or local income or other taxes (including without limitation withholding taxes), if any, applicable to any benefit or deemed benefit obtained by such Chief Executive Officer under this Policy and by accepting the benefits of this Policy shall be deemed to have agreed to pay all such taxes as due.

B-2





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AMENDED AND RESTATED EMPLOYMENT AGREEMENT
TERRITORY
Policy of the Compensation Committee of the Board of Directors of Guitar Center, Inc.


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Exhibit 10.23


AMENDED AND RESTATED EMPLOYMENT AGREEMENT

        This AMENDED AND RESTATED EMPLOYMENT AGREEMENT is made effective as of June 6, 2001 (the "Agreement"), between GUITAR CENTER, INC., a Delaware corporation, and successor in interest to Guitar Center Management Company, Inc. (collectively, the "Company"), and Larry Thomas (the "Executive").

        This Agreement amends and restates that certain Amended and Restated Employment Agreement, dated as of June 5, 1996 (the "Commencement Date"), between the Executive and the Company's predecessor, Guitar Center Management, Inc. (the "Original Agreement"). The Original Agreement was executed and delivered in connection with the closing of the Stock Purchase Agreement (the "Purchase Agreement") dated June 5, 1996, by and among the Company, Chase Venture Capital Associates, L.P., Wells Fargo Small Business Investment Company, Inc., Weston Presidio Capital II, L.P., and the security holder of the Company.

        In consideration of the mutual covenants contained herein and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto agree as follows:


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or such other address as the recipient party to whom notice is to be given may have furnished to the other party in writing in accordance herewith. Any such communication shall deemed to have been delivered and received (a) when delivered, if personally delivered, sent by telecopier or sent by overnight courier, and (b) on the fifth business day following the date posted, if sent by mail.

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        IN WITNESS WHEREOF, the parties hereto have executed this Amended and Restated Employment Agreement as of the date first written above.


 

GUITAR CENTER, INC.

 

By:

/s/  
BRUCE ROSS      
Name: Bruce Ross
Title: Chief Financial Officer

 

By:

/s/  
LARRY THOMAS      
Larry Thomas

16



EXHIBIT A


TERRITORY

ARIZONA:
Phoenix metropolitan area

CALIFORNIA:
Los Angeles County metropolitan areas
Orange County metropolitan areas
San Diego County metropolitan areas
San Francisco/Alameda/Contra Costa/Marin/San Mateo County metropolitan areas
San Bernardino/Riverside County metropolitan area
Bakersfield metropolitan area
Fresno metropolitan area
Sacramento metropolitan area

COLORADO:
Denver metropolitan area

CONNECTICUT:
Hartford metropolitan area

DISTRICT OF COLUMBIA:
Washington, D.C. metropolitan area

FLORIDA:
Miami metropolitan area
Ft. Lauderdale/Hollywood metropolitan area

GEORGIA:
Atlanta metropolitan area

IDAHO:
Boise metropolitan area

ILLINOIS:
Chicago metropolitan area

A-1


INDIANA:
Indianapolis metropolitan area

LOUISIANA:
New Orleans metropolitan area

MARYLAND:
Baltimore metropolitan area

MASSACHUSETTS:
Boston metropolitan area

MICHIGAN:
Detroit metropolitan area

MINNESOTA:
Minneapolis/St. Paul metropolitan area

MISSOURI:
St. Louis metropolitan area

NEVADA:
Las Vegas metropolitan area

NEW JERSEY:
Camden metropolitan area
Newark metropolitan area

NEW YORK:
Buffalo metropolitan area
New York metropolitan area
Rochester metropolitan area

OHIO:
Cincinnati metropolitan area
Cleveland metropolitan area

OKLAHOMA:
Oklahoma City metropolitan area

OREGON:
Portland metropolitan area
Medford metropolitan area
Eugene metropolitan area

PENNSYLVANIA:
Philadelphia metropolitan area
Pittsburgh metropolitan area

TENNESSEE:
Knoxville metropolitan area

TEXAS:
Dallas/Ft. Worth metropolitan area
Houston metropolitan area
Austin metropolitan area

UTAH:
Salt Lake City metropolitan area

A-2


VIRGINIA:
Virginia Beach metropolitan area
Washington, D.C. metropolitan area

WASHINGTON:
Seattle metropolitan area.

A-3



EXHIBIT B


Policy of the Compensation Committee
of the Board of Directors of
Guitar Center, Inc.

Reimbursement of expenses incurred by the Chief Executive Officer
or any Co-Chief Executive Officer of Guitar Center, Inc.

Reimbursement of Business and other Bona Fide Expenses


        This Policy is adopted by the Compensation Committee (the "Committee") of the Board of Directors of Guitar Center, Inc. (the "Company") to be effective from and after June 6, 2001 unless and until amended, superceded, revoked or otherwise amended by subsequent action of the Committee or the Company's full Board of Directors. This Policy shall apply to the Chief Executive Officer of the Company or, for so long as there shall be Co-Chief Executive Officers, to each of them individually.

        1.    Accountable Plan Expenses.

        It is the intention of Guitar Center, Inc. (the "Company") to maintain an accountable plan as described in Regulation Section 1.62-2(c)(2). Accordingly, subject to the administrative review provided for in Paragraph 3 and the limitations provided for in Paragraph 4 of this Policy, the Company shall pay or reimburse a Chief Executive Officer for expenses that are allowable as deductions by Part VI (Sections 161 - 198) of the Internal Revenue Code that are paid or incurred by a Chief Executive Officer in connection with the performance of services as an employee of the Company. Pursuant to this Paragraph 1, the Company shall pay to or reimburse a Chief Executive Officer for business expenses involving the Chief Executive Officer that would not otherwise be eligible for reimbursement under the other general expense policies of the Company applicable to a Chief Executive Officer from time to time (including Section 3(c) of the Amended and Restated Employment Agreements to which each Co-Chief Executive Officer is presently a party), provided the expense is allowable as a deduction for federal income tax purposes as described above in this paragraph.

        2.    Nonaccountable Plan Expenses.

        In addition, the Company recognizes that a Chief Executive Officer may incur other bona fide expenses related to the Company's business that are not allowable as deductions by Part VI (Sections 161 - 198) of the Internal Revenue Code (e.g., country club membership dues and costs, tax preparation services, financial planning services and similar services and expenses, in each case to be provided by a vendor selected by the Chief Executive Officer). It is the intention of the Company to maintain a nonaccountable plan as described in Regulation Section 1.62-2(c)(3) with respect to such expenses. Accordingly, subject to the administrative review provided for in Paragraph 3 and the limitations provided for in Paragraph 4 of this Policy, the Company shall pay or reimburse a Chief Executive Officer for bona fide business expenses that are not allowable as deductions by Part VI (Sections 161 - 198) of the Internal Revenue Code that are paid or incurred by the Chief Executive Officer in connection with the performance of services as an employee of the Company. Pursuant to this Paragraph 2 and subject to Paragraph 3 and Paragraph 4, the Company shall also pay to or reimburse the Chief Executive Officer for travel and entertainment expenses involving the Chief Executive Officer and his spouse that would not otherwise be eligible for reimbursement under the other general expense policies of the Company applicable to a Chief Executive Officer from time to time (including Section 3(c) of the Amended and Restated Employment Agreements to which each Co-Chief Executive Officer is presently a party).

B-1



        3.    Administrative Review.

        In order to obtain payment or reimbursement pursuant to this Policy, the Chief Executive Officer shall present to the Chief Financial Officer reasonable documentary evidence regarding the expenditure and shall provide any supporting detail reasonably requested by him for the purpose of documenting the actual amount of the expenditure and providing an appropriate basis for the reporting of the expenditure in the Company's books and records, in its tax returns, and in its public reports to stockholders and regulatory agencies. The classification of the expenditure (i.e., as being taxable versus deductible/excludible and whether the expense should properly be accounted for under the other general expense reimbursement policies of the Company applicable to a Chief Executive Officer, Paragraph 1 of this Policy, or Paragraph 2 of this Policy) shall be made by the Chief Financial Officer. In the event of any dispute regarding such classification, the final determination shall be made by the Chairman of the Committee, unless it is solely a matter of the proper accounting or tax treatment, in which event the parties shall be bound by the determination of the Company's independent accounting firm that performs the annual audit.

        4.    Reimbursement Limitation.

        In no event, however, shall (i) the total amounts incurred by the Company pursuant to Paragraph 1 of this Policy, to the extent that such payments are not eligible for reimbursement under the Company's other general expense policies applicable to a Chief Executive Officer from time to time (including Section 3(c) of the Amended and Restated Employment Agreement to which each Co-Chief Executive Officer is presently a party), plus (ii) the total amounts incurred by the Company pursuant to Paragraph 2 of this Policy, exceed $100,000 in any 12-month period for each Co-Chief Executive Officer, with such determination to be made with respect to each 12-month period during the Employment Period commencing on July 1 and ending on the following June 30, subject to proration for any partial period. In order to avoid any doubt, it is acknowledged that each Co-Chief Executive Officer is as of the effective date of this Policy provided with a Company automobile pursuant to their respective employment agreements or predecessor provisions, and those expenses are not included within the $100,000 allowance provided for in this paragraph 4. The first period to which this Policy and this paragraph 4 shall apply will be the twelve months commencing July 1, 2001 and ending on June 30, 2002.

        5.    Tax Reporting.

        Each Chief Executive Officer shall be solely responsible for the payment of any federal, state or local income or other taxes (including without limitation withholding taxes), if any, applicable to any benefit or deemed benefit obtained by such Chief Executive Officer under this Policy and by accepting the benefits of this Policy shall be deemed to have agreed to pay all such taxes as due.

B-2





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AMENDED AND RESTATED EMPLOYMENT AGREEMENT
TERRITORY
Policy of the Compensation Committee of the Board of Directors of Guitar Center, Inc.


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Exhibit 10.24


SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT

        This SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT is made effective as of July 1, 2001 (the "Agreement"), between GUITAR CENTER, INC., a Delaware corporation (the "Company"), and Barry Soosman (the "Executive").

        This Agreement amends and restates that certain Amended and Restated Employment Agreement, dated as of July 1, 1998, between the Executive and the Company, which agreement amended and restated that certain Employment Agreement, dated as of June 5, 1996, between the Executive and the Company's predecessor, Guitar Center Management, Inc., as amended by Amendment No. 1 dated October 15, 1996 and Amendment No. 2 dated as of January 30, 1997 (as so amended, the "Original Agreement"). The Original Agreement was executed and delivered in connection with the closing of the Stock Purchase Agreement (the "Purchase Agreement") dated June 5, 1996 (the "Commencement Date") by and among the Company, Chase Venture Capital Associates, L.P., Wells Fargo Small Business Investment Company, Inc., Weston Presidio Capital II, L.P., and the security holder of the Company.

        In consideration of the mutual covenants contained herein and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto agree as follows:


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or such other address as the recipient party to whom notice is to be given may have furnished to the other party in writing in accordance herewith. Any such communication shall deemed to have been delivered and received (a) when delivered, if personally delivered, sent by telecopier or sent by overnight courier, and (b) on the fifth business day following the date posted, if sent by mail.

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10


(Signature Page Follows)

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        IN WITNESS WHEREOF, the parties hereto have executed this Second Amended and Restated Employment Agreement as of the date first written above.

    GUITAR CENTER, INC.

 

 

By:

 

/s/  
LARRY THOMAS      
Name: Larry Thomas
Title: Chairman of the Board

 

 

 

 

/s/  
BARRY SOOSMAN      
Name: Barry Soosman

12



EXHIBIT A


TERRITORY

ARIZONA:
Phoenix metropolitan area

CALIFORNIA:
Los Angeles County metropolitan areas
Orange County metropolitan areas
San Diego County metropolitan areas
San Francisco/Alameda/Contra Costa/Marin/San Mateo
        County metropolitan areas
San Bernardino/Riverside County metropolitan area
Bakersfield metropolitan area
Fresno metropolitan area
Sacramento metropolitan area

COLORADO:
Denver metropolitan area

CONNECTICUT:
Hartford metropolitan area

DISTRICT OF COLUMBIA:
Washington, D.C. metropolitan area

FLORIDA:
Miami metropolitan area
Ft. Lauderdale/Hollywood metropolitan area

GEORGIA:
Atlanta metropolitan area

IDAHO:
Boise metropolitan area

ILLINOIS:
Chicago metropolitan area

INDIANA:
Indianapolis metropolitan area

LOUISIANA:
New Orleans metropolitan area

MARYLAND:
Baltimore metropolitan area

MASSACHUSETTS:
Boston metropolitan area

MICHIGAN:
Detroit metropolitan area

MINNESOTA:
Minneapolis/St. Paul metropolitan area

A-1



MISSOURI:
St. Louis metropolitan area

NEVADA:
Las Vegas metropolitan area

NEW JERSEY:
Camden metropolitan area
Newark metropolitan area

NEW YORK:
Buffalo metropolitan area
New York metropolitan area
Rochester metropolitan area

OHIO:
Cincinnati metropolitan area
Cleveland metropolitan area

OKLAHOMA:
Oklahoma City metropolitan area

OREGON:
Portland metropolitan area
Medford metropolitan area
Eugene metropolitan area

PENNSYLVANIA:
Philadelphia metropolitan area
Pittsburgh metropolitan area

TENNESSEE:
Knoxville metropolitan area

TEXAS:
Dallas/Ft. Worth metropolitan area
Houston metropolitan area
Austin metropolitan area

UTAH:
Salt Lake City metropolitan area

VIRGINIA:
Virginia Beach metropolitan area Washington, D.C. metropolitan area

WASHINGTON:
Seattle metropolitan area.

A-2





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SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT
TERRITORY


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Exhibit 10.25


SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT

        This SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT is made effective as of July 1, 2001 (the "Agreement"), between GUITAR CENTER, INC., a Delaware corporation (the "Company"), and Bruce Ross (the "Executive").

        This Agreement amends and restates that certain Amended and Restated Employment Agreement, dated as of July 1, 1998, between the Executive and the Company, which agreement amended and restated that certain Employment Agreement, dated as of June 5, 1996, between the Executive and the Company's predecessor, Guitar Center Management, Inc., as amended by Amendment No. 1 dated October 15, 1996 and Amendment No. 2 dated as of January 30, 1997 (as so amended, the "Original Agreement"). The Original Agreement was executed and delivered in connection with the closing of the Stock Purchase Agreement (the "Purchase Agreement") dated June 5, 1996 (the "Commencement Date") by and among the Company, Chase Venture Capital Associates, L.P., Wells Fargo Small Business Investment Company, Inc., Weston Presidio Capital II, L.P., and the security holder of the Company.

        In consideration of the mutual covenants contained herein and other good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the parties hereto agree as follows:


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or such other address as the recipient party to whom notice is to be given may have furnished to the other party in writing in accordance herewith. Any such communication shall deemed to have been delivered and received (a) when delivered, if personally delivered, sent by telecopier or sent by overnight courier, and (b) on the fifth business day following the date posted, if sent by mail.

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        (Signature Page Follows)

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        IN WITNESS WHEREOF, the parties hereto have executed this Second Amended and Restated Employment Agreement as of the date first written above.

    GUITAR CENTER, INC.

 

 

By:

 

/s/  
LARRY THOMAS      
Larry Thomas
Chairman of the Board

 

 

By:

 

/s/  
BRUCE L. ROSS      
Bruce L. Ross

12



EXHIBIT A


TERRITORY

ARIZONA:
Phoenix metropolitan area

CALIFORNIA:
Los Angeles County metropolitan areas
Orange County metropolitan areas
San Diego County metropolitan areas
San Francisco/Alameda/Contra Costa/Marin/San Mateo
    County metropolitan areas
San Bernardino/Riverside County metropolitan area
Bakersfield metropolitan area
Fresno metropolitan area
Sacramento metropolitan area

COLORADO:
Denver metropolitan area

CONNECTICUT:
Hartford metropolitan area

DISTRICT OF COLUMBIA:
Washington, D.C. metropolitan area

FLORIDA:
Miami metropolitan area
Ft. Lauderdale/Hollywood metropolitan area

GEORGIA:
Atlanta metropolitan area

IDAHO:
Boise metropolitan area

ILLINOIS:
Chicago metropolitan area

INDIANA:
Indianapolis metropolitan area

LOUISIANA:
New Orleans metropolitan area

MARYLAND:
Baltimore metropolitan area

MASSACHUSETTS:
Boston metropolitan area

MICHIGAN:
Detroit metropolitan area

MINNESOTA:
Minneapolis/St. Paul metropolitan area

A-1



MISSOURI:
St. Louis metropolitan area

NEVADA:
Las Vegas metropolitan area

NEW JERSEY:
Camden metropolitan area
Newark metropolitan area

NEW YORK:
Buffalo metropolitan area
New York metropolitan area
Rochester metropolitan area

OHIO:
Cincinnati metropolitan area
Cleveland metropolitan area

OKLAHOMA:
Oklahoma City metropolitan area

OREGON:
Portland metropolitan area
Medford metropolitan area
Eugene metropolitan area

PENNSYLVANIA:
Philadelphia metropolitan area
Pittsburgh metropolitan area

TENNESSEE:
Knoxville metropolitan area

TEXAS:
Dallas/Ft. Worth metropolitan area
Houston metropolitan area
Austin metropolitan area

UTAH:
Salt Lake City metropolitan area

VIRGINIA:
Virginia Beach metropolitan area
Washington, D.C. metropolitan area

WASHINGTON:
Seattle metropolitan area.

A-2





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SECOND AMENDED AND RESTATED EMPLOYMENT AGREEMENT
TERRITORY


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Exhibit 10.27

    EAGLEPOINT PARTNERS TWO, LLC
   
    as Landlord    

 

 

AND

 

 

 

 

GUITAR CENTER STORES, INC.


 

 
    as Tenant    


LEASE AGREEMENT

Dated as of August 15, 2001

        LEASE AGREEMENT dated as of August 15, 2001, between EAGLEPOINT PARTNERS TWO, LLC an Indiana limited liability company, as lessor (herein called "Landlord"), having an address at 9777 N. College Avenue, Indianapolis, IN 46280 and GUITAR CENTER STORES, INC., a(n) Delaware corporation, as lessee (herein called "Tenant"), having an address at 5795 Lindero Canyon Road, Westlake Village, CA 91362.

        WHEREAS, Landlord is the fee simple owner of the parcel of land described more particularly in Schedule A attached hereto and by reference made a part hereof; and

        WHEREAS, Landlord and Tenant desire to enter into a lease relating to said parcel of land and improvements intended to be constructed thereon.

        NOW, THEREFORE, Landlord and Tenant hereby agree as follows:

        1.    Demise.    For and in consideration of the rents and other amounts hereinafter stipulated to be paid and the provisions of this Lease hereinafter stipulated to be observed and performed by Tenant and Landlord, Landlord hereby demises and lets to Tenant, and Tenant hereby takes and leases from Landlord, for the term described in Section 4 and subject to the provisions hereinafter set forth, the parcel of land described in Exhibit A attached hereto and by reference made a part hereof (the "Land") (including the unhindered right to use, in common with others authorized to use them, such access roads, approaches, curbs, and driveways allowing ingress and egress to and from the Land and the improvements to be constructed thereon), and improvements to be constructed thereon consisting of an approximately 505,250 square foot building (the "Building") and other improvements which may be constructed thereon (the "Improvements"), the Building and Improvements all to be constructed pursuant to Exhibit D attached hereto and by reference made a part hereof, and all easements, rights and appurtenances thereto (the Land, Building and Improvements collectively herein called the "Premises"). Upon completion of the Improvements, Landlord shall provide Tenant with (i) a Certificate of Occupancy and (ii) architect and engineer certifications evidencing that the Premises have been built according to the plans and specifications contained herein. Landlord shall use its reasonable best efforts to inform Tenant of any required occupancy permits which may be required by the governing authorities.

        2.    Title; Condition; Mortgage.    

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        3.    Use.    Tenant shall have the right to occupy and use the Premises for the operation of Warehouse/Distribution Center, incidental office, and any other use incidental thereto (the "Permitted Use") and for no other purpose without the prior written consent of Landlord, which consent shall not be unreasonably withheld, conditioned or delayed. In no event shall Tenant use the Premise for a use which is prohibited by any applicable laws or ordinances, now or hereafter in effect.

        4.    Term.    Subject to the provisions of this Lease, Tenant shall have and hold the Premises for a term commencing June 14, 2002 (the "Commencement Date") and continuing for one hundred and twenty (120) consecutive months (such period herein called the "Term"). If the Commencement Date is other than the first day of a month, and therefore this Lease would expire on a day other than the last day of a month, the length of the Term shall be extended through the last day of that month. Prior to the Commencement Date and no later than February 14, 2002 (the "Fixturing Occupancy Date"), Tenant shall have access to the Premises for fixturing and the condition of the Premises shall be as described in Exhibit F. Tenant covenants and agrees that such fixturing period shall be deemed to be under the terms, covenants, conditions and provisions of this Lease, except as to the covenant to pay Basic Rent, Additional Rent or other amounts payable by Tenant hereunder. Thirty (30) days after the Fixturing Occupancy Date, Landlord shall deliver the Premises to Tenant for the completion of Tenant's fixturing and the beginning of operations and the condition of the Premises shall be as described in Exhibit F-1. Tenant covenants and agrees that such period prior to the Commencement Date shall be deemed to be under the terms, covenants, conditions and provisions of this Lease, except as to the covenant to pay Basic Rent. The Commencement Date shall extend one day for every day that the Premises are not available to Tenant as described in Exhibit F on the Fixturing Occupancy Date or as described in Exhibit F-1 thirty (30) days after the Fixturing Occupancy Date.

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        Excepting delays caused by Tenant and events of force majeure as defined in Section 31, Landlord shall provide to Tenant two (2) days of abatement (in addition to any other abatement provided hereunder) of Basic Rent, Additional Rent and other amounts payable by Tenant hereunder for every day past the Fixturing Occupancy Date that the Premises is not as described in Exhibit F or for every day past thirty (30) days past the Fixturing Occupancy Date that the Premises is not as described in Exhibit F-1.

        Excepting delays caused by Tenant and events of force majeure as defined in Section 31, if Landlord fails to deliver the Premises to Tenant as described in Exhibit F prior to May 15, 2002 or as described in Exhibit F-1 prior to June 14, 2002, Tenant shall have the right, but not the obligation, to terminate this Lease by delivering written notice to Landlord of Tenant's election to terminate.

        5.    Rent.    

        The security deposit has been intentionally deleted from this Lease.

        6.    Payment of Expenses.    Commencing thirty (30) days after the Fixturing Occupancy Date, and continuing throughout the term, Tenant shall be responsible for the payment of taxes, utilities and other charges (see Section 8 for further provisions), insurance as required by this Lease (see Section 15 for further provisions), and Tenant's repairs (see Section 12 for further provisions).

        7.    Net Lease; Nonterminability.    

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        8.    Taxes and Other Charges; Compliance With Law and Agreements.    

        9.    Liens.    Tenant will remove and discharge promptly, at its cost and expense, all liens, encumbrances and charges upon the Premises which arise for any reason whatsoever as a result of Tenant's, its employees', agents' or invitees' actions or inactions or in connection with any services performed or materials furnished by or at the request of Tenant, its employees, agents or invitees,

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including but not limited to all such liens, encumbrances and charges which arise out of the possession, use, occupancy, maintenance, repair, replacement or rebuilding of the Premises by Tenant or by reason of labor or materials furnished or claimed to have been furnished to Tenant, but excluding (i) the Permitted Exceptions and (ii) minor liens, encumbrances and charges which do not individually or in the aggregate materially adversely affect the value or use of the Premises for which it is to be used by Tenant hereunder provided that Landlord receives adequate surety against any loss. Notwithstanding the foregoing, Tenant shall have the right to bond any such lien, encumbrance or charge and contest it by appropriate proceeding prosecuted diligently and in good faith. Tenant shall have no obligation in connection with liens resulting from any act or omission of Landlord or Landlord's agents, representatives, contractors, employees or adjacent tenants.

        10.    Indemnification.    

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        11.    Landlord's Repairs.    During the term of the Lease and any extensions thereof, Landlord shall maintain, repair and replace, as necessary at its expense, the structural integrity of the roof, foundation (excluding the slab), exterior walls and all other structural components of the Building, excluding damages caused by Tenant, its agents, invitees and contractors. The term "exterior walls" as used in this Section shall not include windows, glass or plate glass, doors or overhead doors, special store fronts, dock bumpers, dock plates or levelers, or office entries. Tenant shall promptly give Landlord written notice of any repair required by Landlord pursuant to this Section, after which Landlord shall promptly repair.

        12.    Tenant's Repairs; Inspection.    Tenant, at its expense, shall repair, replace and maintain in good condition all portions of the Premises and all areas, improvements and systems exclusively serving the Premises including without limitation, dock and loading areas, truck doors, interior portions of plumbing, water and sewer lines up to points of common connection, fire sprinklers and fire protection systems, entries, doors, ceilings, windows, interior walls, and the interior surface of demising walls, and heating, ventilation and air conditioning systems reasonable wear and tear, damages caused by Landlord, its agents, invitees and contractors excluded. Such repair and replacements include capital expenditures and repairs whose benefit may extend beyond the Term. Heating, ventilation and air conditioning systems and other mechanical and building systems serving the Premises shall be maintained at Tenant's expense pursuant to maintenance service contracts entered into by Tenant. If Tenant fails to perform any repair or replacement for which it is responsible, Landlord may perform such work and be reimbursed by Tenant within thirty (30) days after demand therefor. Tenant shall bear the full cost of any repair or replacement to any part of the Premises that results from damage caused by Tenant, its agents, contractors, or invitees. Notwithstanding anything to the contrary set forth in this Section 12, or elsewhere in this Lease, if any capital additions, repairs or replacements in connection with any governmental requirement, code compliance, or other such capital additions, repairs or replacements are required by any law, ordinance, rule or regulation that the express terms of this don't require Landlord to make, and the useful life of such capital addition, repair or replacement will survive the expiration of the Lease, then the cost of such capital repair or replacement shall be prorated between Landlord and Tenant (i.e., Tenant shall be responsible for the cost of such capital repair or replacement, divided by its useful life, multiplied by the remaining term including any extension exercised under Section 32—Landlord shall be responsible for the rest of the cost of any such capital repair or replacement). Tenant shall consult with Landlord about the cost and method of making such additions, repairs or replacements. In no event shall Tenant be responsible for any maintenance, repairs or replacement required as a result of any act or omission of Landlord, Landlord's contractors, agents, representatives, employees, or invitees.

        Landlord, Mortgagee and their authorized representatives may upon twenty-four (24) hours prior notice to Tenant, or without notice in the case of an emergency (but in such case, Landlord shall be responsible for properly securing the Premises prior to leaving), during Tenant's regular business hours enter the Premises or any part thereof for the purpose of inspecting the same. Neither Landlord nor Mortgagee shall have any duty to make such inspection, nor shall they incur any liability or obligation for making or not making any such inspection.

        In the event of an emergency (any event that in Tenant's reasonable opinion poses a potential threat to life and/or property), and/or in the event that Landlord shall fail to perform any of Landlord's responsibilities within the applicable cure period, then Tenant shall have the right, but not the obligation to make the necessary and appropriate repairs, or to take the necessary appropriate action, on behalf of Landlord, and Landlord shall promptly reimburse Tenant the full cost of such repairs or action. If Landlord shall fail to full reimburse Tenant for such costs, Tenant may, but shall not be required to deduct such amounts from up to Ten Per Cent (10%) of the amount of any installment of Basic Rent owing from Tenant to Landlord.

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        13.    Alterations and Additions.    

        14.    Condemnation and Casualty.    

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        15.    Insurance.    

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        16.    Termination.    

        17.    Subletting; Assignment.    

        Tenant may neither sublet nor assign the Premises or any part thereof without the prior written consent of Landlord, which consent shall not be unreasonably withheld, conditioned or delayed. No sublease or assignment hereunder, whether or not consented to by Landlord shall affect or reduce any obligations of Tenant or rights of Landlord hereunder, and following any such assignment or subletting, all obligations of Tenant hereunder shall continue in full effect as the obligations of a principal and not of a guarantor or surety, as though no subletting or assignment had been made. Neither this Lease nor the term hereby demised shall be mortgaged by Tenant, nor shall Tenant mortgage or pledge the interest of Tenant in and to any sublease of the Premises or any portion thereof or the rentals payable thereunder. Any such mortgage or pledge, and any such sublease or assignment made otherwise than as permitted by this Section 17, shall be void. Tenant shall, within 10 days after the execution of any such sublease or assignment, deliver a conformed copy thereof to Landlord. Notwithstanding anything in this Lease contained to the contrary, Tenant may, at any time, and without obtaining Landlord's consent but with prior written notice to Landlord, assign its interest in this Lease or sublet the whole or any part of the Premises to any business organization affiliated with Tenant, or any business organization resulting from the consolidation or merger of Tenant with any other business organization or organizations, provided that the resulting company has a reputation and financial condition equal to or greater than Tenant and Tenant provides the financial and other information reasonably requested by Landlord regarding the assignee or sublessee.

        18.    Advances by Landlord; Permitted Contests.    

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        19.    Conditional Limitations—Events of Default and Remedies.    

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        20.    Notices.    All notices and other instruments or communications pursuant to this Lease (including, without limitation, all agreements, acceptances, undertakings, demands, waivers, requests, consents, approvals, offers, statements and certificates) shall be in writing and shall be validly given if mailed by prepaid United States certified mail, return receipt requested or sent by reputable overnight delivery service or sent by facsimile with a confirmation hard copy sent by a reputable overnight delivery service, addressed to the person entitled to receive the same. Landlord and Tenant, and any other person to whom any such writing is to be given hereunder, shall each have the right to specify, from time to time, as its address for purposes of this Lease, any address in the United States upon giving written notice thereof to each other person then entitled to receive notices or other instruments hereunder. The addresses and facsimile numbers of Landlord and Tenant for purposes of this Lease, until notice to the contrary has been given as above provided, shall be as follows:

    Landlord:   EAGLEPOINT PARTNERS TWO,
LLC c/o Lauth Property Group
9777 N. College Avenue
Indianapolis, IN 46280
Facsimile: (317) 848-6511

 

 

Tenant:

 

GUITAR CENTER STORES, INC.
Attn: Robert J. Stannard, Director of Real Estate
5795 Lindero Canyon Road
West Lake Village, CA 91362
Facsimile: (818) 735-7923

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Each such writing given by Tenant or Landlord pursuant to this Lease shall be signed by a duly authorized officer or employee of Tenant or Landlord (respectively) in the name and on behalf of Tenant or Landlord (respectively).

        21.    Estoppel Certificates.    

        22.    No Merger.    There shall be no merger of this Lease or of the leasehold estate hereby created with the fee estate or leasehold estate in the Premises or any portion thereof by reason of the fact that the same person may acquire or hold, directly or indirectly, all or part of such fee estate and this Lease or the leasehold estate hereby created or any interest in this Lease, and this Lease shall not be terminated for any cause except as expressly provided herein.

        23.    Surrender.    

16


        24.    Separability.    Each provision contained in this Lease shall for all purposes be construed to be separate and independent and the breach of any such provision by Landlord shall not discharge or relieve Tenant from Tenant's obligation to observe and perform each provision of this Lease to be observed or performed by Tenant. If any provision of this Lease or the application thereof to any person or circumstance shall to any extent be invalid and unenforceable, the remainder of this Lease, or the application of such provision to persons or circumstances other than those as to which it is invalid or unenforceable, shall not be affected thereby, and each provision of this Lease shall be valid and shall be enforceable to the extent permitted by law.

        25.    Binding Effect.    All provisions contained in this Lease shall be binding upon (subject to the provisions of Section 17(b)), inure to the benefit of and be enforceable by, the respective successors and permitted assigns of Landlord and Tenant to the same extent as if each such successor or assign were named as a part to this Lease. This Lease embodies the entire agreement between Landlord and Tenant relating to the subject matter hereof and supersedes all prior agreements and understanding relating to such subject matter. The provisions of this Lease may be amended, waived or terminated only by an instrument signed by Landlord and Tenant.

        26.    Miscellaneous.    The headings to the various Sections of this Lease have been inserted for convenience of reference only and shall not modify, define, limit or expand the expressed provisions of this Lease. This Lease shall be governed by and construed and enforced in accordance with the laws of the state in which the Premises are located.

        27.    Tax and Insurance Deposits.    In the event Landlord becomes obligated to the Mortgagee to make payments for taxes and insurance premiums in accordance with the terms of the Mortgage, upon notice thereof by Landlord, Tenant shall pay to Landlord as Additional Rent on the Payment Dates for Basic Rent, an amount equal to 1/12 of the annual real estate taxes and assessments, if any, levied or to be levied against the Premises and of the insurance premiums, if any, next becoming due (all hereinafter referred to as the "charges") all as estimated by Landlord, so that Landlord shall have sufficient funds to pay the charges on the first day of the month preceding the month in which they become due. If, from time to time, Landlord shall determine that the balance of the funds held by it to pay the charges is or will be insufficient to pay any of the charges when the same shall become due and payable, then Tenant shall pay to Landlord any amount necessary to remedy such deficiency within thirty (30) days of receipt of written notice from Landlord to Tenant. Landlord shall hold all such

17



amounts and pay the charges before the same become delinquent, with the right, however, to Landlord to apply, after an Event of Default, any sums so received as a credit against any Basic Rent or Additional Rent then remaining unpaid or to the payment of any of the charges.

        28.    No Broker.    The parties warrant and represent to each other that they have no knowledge that any brokers or other agents were involved in the consummation of this Lease, except for Lauth Property Group, Inc. and CB Richard Ellis Global Logistics Group whose commissions shall be paid by Landlord. Except for the foregoing, Landlord and Tenant shall indemnify and hold each other harmless from any claims, liabilities, damages or expense incurred as a result of any party claiming any fee or commission through the indemnifying party.

        29.    Subordination and Non-Disturbance.    At the option of Landlord, and subject to receipt by Tenant of a non-disturbance agreement in favor of Tenant, and reasonably acceptable in form and substance to Tenant, this Lease shall, at all times, be subject, subordinate and inferior to any mortgage that may be placed on the Premises. Tenant shall, within twenty (20) days after demand, execute any reasonable instrument reasonably necessary to effect the foregoing provision provided said instrument includes a non-disturbance provision to Tenant's benefit which provides that if Landlord's interest in the Premises is sold or conveyed upon the exercise of any remedy provided in any Mortgage or by deed in lieu thereof, or if the holder of the Mortgage takes possession of the Premises thereto, this Lease shall not be terminated, nor shall Tenant's possession of the Premises be disturbed, and Tenant shall be entitled the rights of quiet enjoyment so long as Tenant is not in default under the Lease beyond the applicable cure period. As a condition precedent to this Lease being subordinate to a Mortgage, Landlord shall promptly obtain from the holders of any Mortgage such a non-disturbance agreement in form and substance reasonably satisfactory to Tenant. During the Term and any extended Term, Tenant shall be entitled to the rights of quiet enjoyment pursuant to the terms of this Lease.

        30.    Financial Statements.    If Tenant ceases to be a publicly-traded company during the Lease Term and any extensions thereof, Tenant shall provide to Landlord on an annual basis, within ninety (90) days following the end of Tenant's fiscal year, a copy of Tenant's most recent certified and audited financial statements prepared as of the end of Tenant's fiscal year. Such financial statements shall be prepared in conformity with generally accepted accounting principles.

        31.    Force Majeure    Except for Tenant's payment of Basic Rent and Additional Rent, both Parties shall be excused for the period of any delay in the performance of any obligation hereunder when such delay is occasioned by causes beyond its control, including, but not limited to, war, invasion or hostility; work stoppages, boycotts, slowdowns or strikes; shortages of materials, equipment, labor or energy; man-made or natural casualties; unusual weather conditions; acts or omissions of governmental or political bodies; or civil disturbances or riots. Landlord will promptly give Tenant notice in the event Landlord becomes aware that, due to force majeure or any other cause, Landlord will be unable to deliver the Improvements on or before thirty (30) days following the Fixturing Occupancy Date.

        32.    Extension Option    Provided Landlord has not declared an event of default in this Lease that remains uncured, beyond the applicable cure period, and this Lease is then in full force and effect, Tenant shall have two (2) options to extend this Lease and the Lease Term for extended terms of five (5) years each (an "Extension Term") to be exercisable only by written notice given by Tenant to landlord at least twelve (12) months prior to the expiration of the Lease Term then in effect. If Tenant exercises such option in accordance with the provisions and limitations of this Section, this lease and the Lease Term shall be extended for five (5) years (unless sooner terminated pursuant to the terms of this Lease) commencing on the date following the last day of the Lease Term in effect prior to such option being exercised upon all of the then applicable terms, covenants and conditions contained in this Lease, except that the Rent for the entire Extension Term shall be at an annual rate determined as set forth below, it being understood that such Rent shall be payable in equally monthly installments, in advance, just as in the case of the Initial Term. The Rent for the Extension Term shall be at the greater

18



of (i) the Rent payable at the end of the Lease Term prior to the Extension Term; or (ii) the then fair market rent for the Premises for the Extension Term, to be determined as follows: At any time during the six (6) month period prior to the twelve (12) month written notice period (but in any event not less than sixty (60) days prior to Tenant's notice deadline), Landlord shall provide Tenant with Landlord's written designation of what it believes the fair market rent to be for the Extension Term. If Tenant disagrees with Landlord's designation and if the parties are otherwise unable to agree upon the fair market rent of the Premises for the Extension Term, then Tenant may initiate the following arbitration process to determine the fair market rent (the "Market Rent") by sending written notice thereof to Landlord within thirty (30) days after Landlord provides Tenant notice of Landlord's designation of Market Rent for the Extension Term. If Tenant fails to initiate this arbitration process as aforesaid, time being of the essence, then Landlord's designation of Market Rent (as set forth in Landlord's notice) shall be conclusive. In order to be effective, Tenant's notice to Landlord initiating the arbitration process shall specify the name and address of the person designated to act as an arbitrator on its behalf. Within ten (10) days after the designation of Tenant's arbitrator, Landlord shall give notice to Tenant specifying the name and address of the person designated to act as an arbitrator on Landlord's behalf. If Landlord fails to notify Tenant of the appointment of its arbitrator within the time above specified, then the appointment of the second arbitrator shall be made in the same manner as hereinafter provided for the appointment of a third arbitrator in a case where two arbitrators are appointed hereunder and the parties are unable to agree upon such appointment. The two arbitrators so chosen shall meet within then (10) days after the second arbitrator is appointed, and if, within ten (10) days after the second arbitrator is appointed, the two arbitrators shall not agree upon a determination of Market Rent, they shall together appoint a third arbitrator. In the event of their being unable to agree upon such appointment within ten (10) days after the appointment of the second arbitrator the third arbitrator shall be selected by the parties themselves if they can agree thereon within a further period of five (5) days. If the parties do not so agree, then either party, on behalf of both and on notice to the other, may request such appointment by the American Arbitration Association (or any organization successor thereto) in accordance with its rules then prevailing.

        Each party shall pay the fees and expenses of the one of the two original arbitrators appointed by or for such party, and the fees and expenses of the third arbitrator and all other expenses (not including the attorneys fees, witness fees and similar expenses of the parties which shall be borne separately by each of the parties) of the arbitration shall be borne by the parties equally.

        If a third arbitrator is chosen as provided above, then such three arbitrators shall collectively determine the Market Rent and render a written certified report of their determination to both Landlord and Tenant within ten (10) days after appointment of the third arbitrator if such third arbitrator is appointed pursuant to this Section.

        Each of the arbitrators selected as herein provided shall have at least ten (10) years experience in the leasing and renting of warehousing and distribution buildings in the Indianapolis area. In addition, the third arbitrator (if any) shall be an independent party not affiliated in any way with either Landlord or Tenant.

        Each of the three arbitrators shall indicate its view of the Market Rent for the Extension Term. The resulting average shall be deemed to be the Rent for the Extension Term for the purposes of this Section.

        Time is of the essence with respect to the exercise of the option contained herein. Tenant shall not have the right to give any notice exercising such option after the expiration of the applicable time limitation set forth herein (twelve months prior to the expiration of the Lease Term then in effect), and any notice given after such time limitation purporting to exercise such option shall be void and of no force or effect.

19



        After the final determination of Option Rent, as set forth above, Tenant shall have the option, but not the obligation, to rescind Tenant's notice to Landlord of Tenant's election to exercise an Option to extend this Lease.

        The Original Term and, the Extension Terms are referred to collectively in this Lease as the "Lease Term."

        33.    Expansion Option    Provided Tenant is not in default hereunder, beyond the applicable cure period and has not abandoned the Premises, Tenant shall have the right (the "Expansion Right"), upon written notice to Landlord, to require Landlord to construct an approximately two hundred forty-two thousand five hundred twenty (242,520) square foot expansion of the Improvements (the "Expansion") subject to the conditions herein stated. Within sixty (60) days after Tenant's exercise of the Expansion Right, Landlord and Tenant shall agree on preliminary concept plans and specifications and a construction schedule for the Expansion (collectively the "Expansion Preliminary Plans"). After the Expansion Preliminary Plans have been approved and signed by Landlord and Tenant, Landlord shall cause an architect approved by Landlord and Tenant to proceed, with final plans and specifications and a construction schedule for the Expansion (collectively the "Expansion Plans and Specifications"). Tenant shall supply to the architect sufficient information to allow for the completion of the Expansion Plans and Specifications on an as-needed basis as determined by the architect. The Expansion shall be substantially similar to the construction and finish of the Improvements as originally constructed (including the quality and type of base building systems and all interior finishes). Landlord and Tenant shall have the right to approve the Expansion Plans and Specifications, which approval shall not be unreasonably withheld, conditioned or delayed. The Expansion Preliminary Plans and the Expansion Plans and Specifications shall be prepared at Tenant's expense unless the Expansion is built in which case the cost thereof shall be Project Costs as provided below and paid by Landlord. After the Expansion Plans and Specifications have been approved, Landlord shall establish basic rent resulting from the Expansion, and the Basic Rent shall be increased in accordance with the following formula at the time of Substantial Completion of the Expansion:

20


        34.    Tax Abatement    It is a condition subsequent to this Lease that Landlord obtain on or before the Commencement Date a stepped real estate tax abatement for the 505,250 square foot Building to be constructed at the Premises for a period of ten (10) years. Upon obtaining the tax abatement, Landlord shall provide Tenant with detailed documentation from the taxing authorities setting forth the terms of the abatement.

        35.    ADA Compliance    At the Commencement Date, Landlord shall deliver the Premises to Tenant in compliance with the Americans with Disabilities Act of 1990 (the "ADA"). Tenant shall be responsible for compliance with the ADA during the Term of the Lease and any extensions thereof. Should Landlord or Tenant receive notice of any alleged violation of the ADA relating to any portion of the Premises; any claims made or threatened in writing regarding noncompliance with the ADA and relating to any portion of the Premises; or any governmental or regulatory actions or investigations instituted or threatened regarding noncompliance with the ADA and relating to any portion of the Premises, Landlord or Tenant shall advise the other party in writing within ten (10) days after receipt of such notice, and provide the other with copies of same (as applicable).

        36.    Hazardous Substances    The term "Hazardous Substances", as used in this Lease shall mean pollutants, contaminants, or toxic or hazardous wastes, or any other substances, the use and/or the removal of which is required or the use of which is restricted, prohibited or penalized by any "Environmental Law", which term shall mean any federal, state or local law, ordinance or other statute of a governmental or quasi-governmental authority relating to pollution or protection of the environment. Tenant hereby agrees that (A) no activity will be conducted on the Premises that will produce any Hazardous Substance, except for such activities that are part of the ordinary course of Tenant's business activities (the "Permitted Activities") provided said Permitted Activities are conducted in accordance with all Environmental Laws; Tenant shall be responsible for obtaining any required permits and paying any fees and providing any testing required by any governmental agency in connection with any use of Hazardous Substances in the Premises by Tenant; (B) the Premises will not be used in any manner for the storage of any Hazardous Substances except for the temporary storage

21



of such materials that are used in the ordinary course of Tenant's business (the "Permitted Materials") provided such Permitted Materials are properly stored in a manner and location meeting all Environmental Laws; Tenant shall be responsible for obtaining any required permits and paying any fees and providing any testing required by any governmental agency in connection with any use of Hazardous Substances in the Premises by Tenant; (C) no portion of the Premises will be used as a landfill or a dump; (D) Tenant will not install any underground tanks of any type; (E) Tenant will not allow any surface or subsurface conditions to exist or come into existence that constitute, or with the passage of time may constitute a public or private nuisance; (F) Tenant will not permit any Hazardous Substances to be brought onto the Premises, except for the Permitted Materials described above, and if so brought or found located thereon, the same shall be immediately removed, with proper disposal, and all required cleanup procedures shall be diligently undertaken pursuant to all Environmental Laws. Landlord or Landlord's representative shall have the right but not the obligation to enter the Premises for the purpose of inspecting the storage, use and disposal of Permitted Materials to ensure compliance with all Environmental Laws. Should it be reasonably determined, that said Permitted Materials are being improperly stored, used, or disposed of, then Tenant shall immediately take such corrective action as reasonably required. Should Tenant fail to take such corrective action within 24 hours, Landlord shall have the right to perform such work and Tenant shall promptly reimburse Landlord for any and all costs associated with said work. If at any time during or after the Lease Term, the Premises are found to be so contaminated or subject to said conditions due to any contamination of the Premises by Tenant, or Tenant's employees, contractors, or invitees, Tenant shall diligently institute proper and thoroughcleanup procedures at Tenant's sole cost, and Tenant agrees to indemnify, defend and hold harmless Landlord, its lenders, any managing agents and leasing agents of the Premises, and their respective agents, partners, officers, directors and employees, from all claims, demands, actions, liabilities, costs, expenses, damages (actual or punitive) and obligations of any nature arising from or as a result of the use of the Premises by Tenant. The foregoing indemnification and the responsibilities of Tenant shall survive the termination or expiration of this Lease. Landlord acknowledges that Tenant will use chemicals, supplies and equipment in connection with Tenant's use of the Premises, typical to comparable office/warehouse/distribution center uses, (such as, by way of example, but without limitation, industrial lubricants, batteries and battery chargers, cleaning agents, etc.), and, provided that Tenant follows all applicable laws, such use shall not be considered a violation of the terms of this Lease.

        During the Lease Term, both Parties shall promptly provide the other Party with copies of all summons, citations, directives, information inquiries or requests, notices of potential responsibility, notices of violation or deficiency, orders or decrees, claims, complaints, investigations, judgments, letters, notice of environmental liens, and other communications, written or oral, actual or threatened, from the United States Environmental Protection Agency, Occupational Safety and Health Administration, the State of Indiana Environmental Protection Agency or other federal, state, or local agency or authority, or any other entity or individual, concerning (i) any Hazardous Substance and the Premises; (ii) the imposition of any lien on the Leased Premises, or (iii) any alleged violation of or responsibility under any Environmental Law.

        Landlord shall provide to Tenant a copy of the Phase I Environmental Assessment dated                        and the associated Reliance Letter dated                        attached hereto and incorporated herein as Exhibit E. Within thirty (30) days after the expiration of the Lease Term, Tenant shall commission, at Tenant sole cost and expense, a new Phase I Environmental Assessment addressing the then current condition of the Premises, and within thirty (30) days thereafter Tenant shall provide to Landlord a copy of such new Phase I Environmental Assessment and any associated Reliance Letter (if applicable).

        To the best of Landlord's knowledge, neither Landlord nor any previous owner or Tenant, released or discharged on, under, in, or about the Premises, the Building, or any property adjacent thereto, or

22



transported any Hazardous Substance to or from the Premises and/or the Building, or any property adjacent thereto. Landlord shall not cause or knowingly permit the presence, use, generation, release, discharge, storage, or disposal of any Hazardous Substance on, under, in, or about, or in the transportation of any Hazardous Substance to or from the Premises and/or the Building, or any property adjacent thereto, in violation of any applicable laws. The Premises and/or the Building, or any property adjacent thereto, is not in violation of any Applicable Law. Tenant shall not be liable for the removal and/or disposal of any Hazardous Substance, including, without limitation, any Hazardous Substance used in the construction of the Premises and or the Building which, now or in the future, may violate Applicable Law (as hereinafter defined).

        37.    Signage    Tenant shall be permitted to place its corporate identification on the Premises and on a monument sign in front of the Premises (the "Signs"). The exact design, size, location, installation and specifications for such Signs are subject to local sign ordinances and Landlord's prior written approval, which approval shall not be unreasonably withheld, conditioned or delayed.

        38.    Space Availability Notification.    Landlord shall use its best efforts to notify Tenant of the availability of additional space in Eaglepoint Business Park, and Tenant shall use its best efforts to notify Landlord of its need for additional space in Eaglepoint Business Park.

        39.    Construction Warranty.    Notwithstanding anything contained herein to the contrary, Landlord covenants and agrees that Landlord's Work will be built in accordance with the plans and specifications in EXHIBIT D, D-1, and D-2 and the Scope of Work attached hereto, all applicable laws and regulations; that Landlord has no knowledge of a violation of an Environmental Law at the Premises; and that Landlord will repair at its sole cost and expense all defects in workmanship and materials in the Premises (excluding improvements made by Tenant) of which Landlord has been notified within one (1) year of the Commencement Date. On the Commencement Date, the building services systems will be in good electrical, mechanical and operating condition (including without limitation the HVAC systems, foundation, slab, and other structural components, the roof, roof membrane, roof drains, plumbing, walls, doors, windows, and electrical systems). Landlord also shall provide to Tenant the benefit of any and all warranties and guarantees of the contractor, subcontractors, installers, suppliers and manufacturers during said one (1) year warranty period and for the longer warranty periods applicable to other systems, subject in each case to any limitations and exclusions set forth therein. However, the foregoing shall not limit Landlord's responsibilities for maintenance, repair and replacement of those repair items set forth in Section 11 of this Lease, nor limit Landlord's obligations set forth in Section 2 of this Lease.

        40.    Memorandum of Lease.    If requested by Tenant, Landlord shall execute and deliver a memorandum of lease in a mutually acceptable form in order to give notice of this Lease; provided, however, the relations between Landlord and Tenant with respect to the Premises shall be governed solely by the provisions of this Lease and not by any such memorandum of lease. The cost of recording such memorandum of lease shall be paid by Tenant.

        41.    Without Utilities.    Notwithstanding anything to the contrary contained in the Lease in the event that Tenant is without any of its utility services at any time that is thirty (30) days after the Fixturing Occupancy Date due to any act or omission of Landlord, or Landlord's contractors, agents, representatives, employees or invitees at any time that is thirty (30) days after the Fixturing Occupancy Date, then Tenant shall be entitled to one day of abatement of Basic Rent and Additional Rent for each day on which such interruption of services occurs.

        42.    Legal Expenses.    In the event that either party institutes an action or proceeding against the other party with respect to the violation of any of the terms hereof, or with respect to a declaration of rights hereunder, or intervenes in any suit in which the other is a party to enforce or protect its interests or rights hereunder, the prevailing party shall be entitled to all costs and expenses, including, reasonable attorneys' fees, incurred in such actions or proceedings, and in any appeal in connection

23



therewith by such prevailing party and if such prevailing party shall recover judgment in any such action, proceeding, or appeal, such costs, expenses, and attorneys' fees shall be included in and as part of such judgment.

        Signature page to follow.

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        IN WITNESS WHEREOF, Landlord and Tenant hereto have each caused this Lease to be duly executed and delivered in their respective names and behalfs as of the day and year first above written.

    LANDLORD:
EAGLEPOINT PARTNERS TWO, LLC

an Indiana limited liability company

 

 

By:

/s/  
GREGORY C. GURNIK      
     
    Printed: Gregory C. Gurnik
    Title: Member

 

 

TENANT:
GUITAR CENTER STORES, INC.

a(n) Delaware corporation

 

 

By:

/s/  
BRUCE L. ROSS      
     
    Printed: Bruce L. Ross
     
    Title: President
     

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Exhibit 10.29


THIRD AMENDMENT TO
AMENDED AND RESTATED
MEMORANDUM OF UNDERSTANDING
AND STOCK OPTION AGREEMENT

Effective as of November 6, 2001

        1.    General.    Reference is made to that certain Amended and Restated Memorandum of Understanding and Stock Option Agreement dated as of December 30, 1996, as amended by the Amendment and Consent thereto effective as of November 9, 1998 and the Second Amendment thereto effective as of September 5, 2001 (as amended, the "Stock Option"). Capitalized but undefined terms shall have the meanings provided in the Stock Option. Section 15 of the Stock Option provides that it may be amended at any time by the written agreement and consent of each of the Funds and by the members of Management holding not less than 662/3% of the unexercised Options and each of such persons is identified on the signature pages to this agreement.

        2.    Amendment.    The final paragraph of Section 2 of the Stock Option is hereby restated in its entirety as follows:

        3.    Miscellaneous.    Except for the restatement of the final paragraph of Section 2 as provided herein, the Stock Option remains in full force and effect. The miscellaneous provisions contained in Section 16, 17, 19, 20 and 22 shall apply to this Third Amendment to Amended and Restated Memorandum of Understanding and Stock Option Agreement.

(Signature Page Follows)


        IN WITNESS WHEREOF, the undersigned have duly executed this Third Amendment to Amended and Restated Memorandum of Understanding and Stock Option Agreement as required by Section 15 of the Stock Option, effective as of the first date set forth above.

    /s/ Larry Thomas
Larry Thomas

 

 

/s/ Marty Albertson

Marty Albertson

 

 

J.P. MORGAN PARTNERS (SBIC), LLC

 

 

/s/ David L. Ferguson

By: David L. Ferguson
Its: Managing Director

 

 

WELLS FARGO SMALL BUSINESS INVESTMENT COMPANY, INC.

 

 

/s/ Steven W. Burge

By: Steven W. Burge
Its: Managing Director

 

 

WESTON PRESIDIO CAPITAL II, L.P.

 

 

By:

 

WESTON PRESIDIO CAPITAL
MANAGEMENT II, L.P.
    Its:   General Partner

 

 

/s/ Michael P. Lazarus

By: Michael P. Lazarus
Its: General Partner

S-1




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THIRD AMENDMENT TO AMENDED AND RESTATED MEMORANDUM OF UNDERSTANDING AND STOCK OPTION AGREEMENT


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Exhibit 10.30



SECOND AMENDED AND RESTATED

LOAN AND SECURITY AGREEMENT

by and among

GUITAR CENTER, INC.,

and

GUITAR CENTER STORES, INC.,

and

MUSICIAN'S FRIEND, INC.

and

THE LENDERS THAT ARE SIGNATORIES HERETO

as the Lenders,

and

WELLS FARGO RETAIL FINANCE, LLC

as Arranger and Administrative Agent,

and

FLEET RETAIL FINANCE, INC.

as Documentation Agent

Dated as of December 21, 2001





TABLE OF CONTENTS

1.   DEFINITIONS AND CONSTRUCTION   2
    1.1 Definitions   2
    1.2 Accounting Terms   23
    1.3 Code   24
    1.4 Construction   24
    1.5 Schedules and Exhibits   24

2.

 

LOAN AND TERMS OF PAYMENT

 

24
    2.1 Revolver Advances   24
    2.2 Reduction in Facility Amount and Commitments   25
    2.3 Borrowing Procedures and Settlements   26
    2.4 Payments   31
    2.5 Overadvances   32
    2.6 Interest and Letter of Credit Fees: Rates, Payments, and Calculations   32
    2.7 Cash Management   33
    2.8 Crediting Payments   35
    2.9 Designated Account   35
    2.10 Maintenance of Loan Account; Statements of Obligations   35
    2.11 Fees   36
    2.12 Letters of Credit   36
    2.13 LIBOR Option   38
    2.14 Capital Requirements   40
    2.15 Joint and Several Liability of the Obligors   41
    2.16 Prior Loan Agreement; First Amendment   43

3.

 

CONDITIONS; TERM OF AGREEMENT

 

43
    3.1 Conditions Precedent to the Initial Extension of Credit   43
    3.2 Conditions Subsequent to the Initial Extension of Credit   44
    3.3 Conditions Precedent to all Extensions of Credit   45
    3.4 Term   45
    3.5 Effect of Termination   46
    3.6 Early Termination by Borrowers   46

4.

 

CREATION OF SECURITY INTEREST

 

46
    4.1 Grant of Security Interest   46
    4.2 Negotiable Collateral   47
    4.3 Collection of Accounts, General Intangibles, and Negotiable Collateral   47
    4.4 Delivery of Additional Documentation Required   47
    4.5 Power of Attorney   47
    4.6 Right to Inspect   48
    4.7 Control Agreements   48

5.

 

REPRESENTATIONS AND WARRANTIES

 

48
    5.1 No Encumbrances   48
    5.2 Eligible Accounts   48
    5.3 Eligible Inventory   48
    5.4 Equipment   48
    5.5 Location of Inventory and Equipment   49
    5.6 Inventory Records   49
    5.7 Location of Chief Executive Office; FEIN; Organization I.D. Number   49

i


    5.8 Due Organization and Qualification; Subsidiaries   49
    5.9 Due Authorization; No Conflict   49
    5.10 Litigation   50
    5.11 No Material Adverse Change   50
    5.12 Fraudulent Transfer   50
    5.13 Employee Benefits   50
    5.14 Environmental Condition   51
    5.15 Brokerage Fees   51
    5.16 Intentionally Omitted   51
    5.17 Intellectual Property   51
    5.18 Leases   51
    5.19 DDAs   51
    5.20 Offsite Storage Locations   51

6.

 

AFFIRMATIVE COVENANTS

 

51
    6.1 Accounting System   51
    6.2 Collateral Reporting   51
    6.3 Financial Statements, Reports, Certificates   53