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 10 years and our two Co-Chief Executive Officers (Mr. Larry Thomas, our Chairman and Co-Chief Executive Officer, and Mr. Marty Albertson, our President and Co-Chief Executive Officer) effectively assumed full operating control in 1992. Since then, we have focused on developing and realizing our long-term goal of expanding our position as the leading music products retailer throughout the United States.
In May of 1999, we merged with Musician's Friend, Inc. in a stock for stock transaction. Musician's Friend, a separate business unit of our company, operates the largest direct response channel (catalog and e-commerce) in the musical instruments industry in the United States. Robert Eastman, Chief Executive Officer of Musician's Friend, has been with the company for 19 years.
In April of 2001, we acquired the assets of American Music Group, Ltd. and related companies, a leading musical instrument retailer specializing in the sale and rental of band instruments and accessories. American Music operates as a division of our retail business and serves the student and family market through its 20 band instrument retail stores. The American Music acquisition enables us to serve a broader segment of the musical instruments industry, while maintaining our current focus on the merchandise offering of our Guitar Center store format. The acquisition of American Music provides us with new opportunities to expand our customer base and product offerings to the band instruments market. David Fleming is the President and Chief Operating Officer of American Music and has been with the company for 27 years.
We are a Delaware corporation with our principal executive offices located at 5795 Lindero Canyon Road, Westlake Village, California 91362, and our telephone number is (818) 735-8800. We maintain several corporate websites, including www.guitarcenter.com, however none of the information contained on our websites is incorporated into this annual report. Our periodic and current reports are available, free of charge, on the website noted above at a reasonable time following the filing with the SEC. Whenever we refer to the "Company" or to "us," or use the terms "we" or "our" in this annual report, we are referring to Guitar Center, Inc. and its subsidiaries.
Industry Overview
The United States retail market for music products in 2001 was estimated in a study by the National Association of Music Merchants, or NAMM, to be approximately $6.9 billion in net sales, representing a five-year compound annual growth rate of 2.8%. The broadly defined music products market, according to NAMM, includes retail sales of string and fretted instruments, sound reinforcement and recording equipment, drums, keyboards, print music, pianos, organs, and school
band and orchestral instruments. Products currently offered by us include categories of products which account for approximately $5.2 billion of the estimated $6.9 billion of this market's sales, representing a five-year compound annual growth rate of 4.6%. The music products market, as currently defined by NAMM, however, does not include the significant used and vintage product markets or apparel markets in which we actively participate.
Included in the $6.9 billion of estimated industry sales is the band instrument market estimated at $1.0 billion in the United States and industry trends and positive demographic trends suggest that the school music market will continue to grow. School enrollments have risen in each of the past eight years and publicity linking music making and improved academic performance has unquestionably improved prevailing attitudes towards music and music education.
According to The Music Trades magazine, the industry is highly fragmented with the nation's leading five music products retailers, as measured by the number of stores operated by such retailers (i.e., Guitar Center, Brook Mays/H&H, Sam Ash Music Corp., Hermes Music and Victor's House of Music), accounting for approximately 23.2% of the industry's estimated total sales in 2001. The list of leading retailers excludes Mars Music, which was liquidated in the fourth quarter of 2002. Furthermore, approximately 90% of the industry's estimated 6,000 to 6,200 retailers operate only one or two stores. A typical music products store averages approximately 5,500 square feet and generates an average of approximately $1.2 million in annual net sales. In contrast, our standard large format Guitar Center stores generally range in size from 12,000 to 20,000 square feet, and in 2002 these stores generated an average of approximately $9.0 million in annual net sales for stores open the full year.
Over the past decade, technological advances in the industry have resulted in dramatic changes to the nature of music-related products. Manufacturers have combined computers and microprocessor technologies with musical equipment to create a new generation of products capable of high grade sound processing and reproduction. Products featuring those technologies are available in a variety of forms and have broad application across most of our music product categories. Most importantly, rapid technological advances have resulted in the continued introduction of higher quality products offered at lower prices and this trend is continuing. Today an individual consumer can affordably create a home recording studio which interacts with personal computers and is capable of producing high-quality digital recordings. Until recently, this type of powerful sound processing capability was expensive and was typically purchased primarily by professional sound recording studios.
Business
As of December 31, 2002, we operated 108 Guitar Center stores, consisting of 96 stores in 40 major U.S. markets, including, among others, areas in or near Los Angeles, San Francisco, Chicago, Miami, Houston, Dallas, Detroit, Boston, Minneapolis, Seattle, Phoenix, Atlanta, New York, Denver and Cleveland, and 12 stores in secondary markets. We also operated 20 American Music stores, including the five stores acquired from M&M Music in June 2002. From 1998 to 2002, our net sales grew at an annual compound growth rate of 22.5%, principally due to comparable store sales growth averaging 8.2% per year, the opening of new stores, and a 27.9% increase in the direct response channel. We achieved comparable store sales growth of 6%, 6%, and 7% for the fiscal years ended December 31, 2002, 2001 and 2000, respectively.
For the fiscal years ended December 31, 2002, 2001 and 2000, we had net income of $25.3 million, $17.0 million and $22.5 million, respectively.
Retail
At our Guitar Center stores, we offer a unique retail concept in the music products industry, combining an interactive, hands-on shopping experience with superior customer service and a broad selection of brand name, high-quality products at guaranteed low prices. We create an entertaining and
exciting atmosphere in our stores with bold and dramatic merchandise presentations, highlighted by bright, multi-colored lighting, high ceilings, music and videos. Based on market research conducted by us, we believe approximately 73% of our sales are to professional and aspiring musicians who generally view the purchase of music products as a career necessity. These sophisticated customers rely on our knowledgeable and highly trained salespeople to answer technical questions and to assist in product demonstrations.
Our standard large format Guitar Center store generally ranges in size from 12,000 to 20,000 square feet (as compared to a typical music products retail store which averages approximately 5,500 square feet) and is designed to encourage customers to hold and play instruments. In late 2000, we opened our first smaller format store, and have since opened 9 additional small format stores. We plan to continue to open additional stores using this format of approximately 8,000 to 10,000 square feet to serve secondary markets. Each large format store carries an average of 12,000 core SKUs and each small format store carries an average of 7,000 core SKUs, which in each case our management believes is significantly greater than a typical music products retail store. Our core SKUs represent our consistent and established product lines which are considered staple products for our customers. Our stores are organized into five departments, each focused on one product category. These departments cater to a musician's specific product needs and are staffed by specialized salespeople, many of whom are practicing musicians. We believe this retail concept differentiates us from our competitors and encourages repeat business.
The following summarizes key operating statistics of our Guitar Center stores and is based upon the stores operated by us for the full year ended December 31:
The above key operating statistics are based upon results of Guitar Center retail stores in operation for at least 12 months as of December 31, 2002 and 2001, respectively. Average net sales per square foot, which increased $9 in the current year, is a measure of sales efficiency based on square footage. Average net sales per store represents the average result of stores open more than 12 months, and is typically affected by the opening of small format stores which generate lower levels of sales. Although small format stores generate lower levels of sales, these stores cost less to build, stock and operate than our large format stores. Store-level operating income and margin includes individual store revenue and expenses plus allocated rebates, cash discounts and purchasing department salaries (based upon individual store sales).
Our American Music division operates family music stores, retailing band and orchestral instruments, introductory guitars, percussion and keyboards, as well as related accessories. These instruments are sold or rented principally to the school band market. As of December 31, 2002, American Music operated 20 stores located in New York, Maine, Florida, Massachusetts, Illinois, Arizona, Nevada and Georgia. AMG retail stores range from 1,300 to 10,000 square feet, with an average store size of approximately 4,500 square feet. This division also rents its instruments through third party musical instrument dealers referred to as "satellite stores."
Our retail growth strategy is to continue to increase our presence in our existing markets and to open new stores in strategically selected markets. We will continue to pursue our strategy of clustering stores in major markets to take advantage of operating and advertising efficiencies and to build awareness of our name in new markets.
We opened a total of 12 Guitar Center stores in 2002, and presently expect to open approximately 16 to 18 additional Guitar Center stores in 2003. Some of these stores will be smaller format units designed for secondary markets.
The acquisition of American Music during the second quarter of 2001 provides us with new opportunities to expand our customer base and product offerings to the band instruments market. During 2002, we opened three American Music stores and acquired five M&M Music stores. In 2003, our present plan is to open approximately six to eight additional American Music stores, with some of this expansion likely to come through the acquisition of existing businesses. We believe there exists a number of acquisition opportunities in the relatively fragmented band instruments market that could be a good fit into our American Music platform. During 2002, we added a significant number of guitar, percussion, pro audio, keyboard and accessory products to the American Music retail stores. Our objective is to position American Music as a family music store capable of fulfilling a wider array of consumer needs.
During 2001, we began construction of a distribution center in the Indianapolis, Indiana area to support our Guitar Center retail store operations. The facility commenced operations in July 2002. We have entered into a 10-year agreement to lease the facility and have entered into agreements to lease equipment to support its operations. We also have entered into numerous additional commitments necessary to further support the operations of the facility. As of December 31, 2002, most product was flowing through the distribution facility, with the exception of limited products which we continue to drop ship to our stores. Our plans in 2003 are for nearly all product to flow through this distribution facility with the exception of special orders which will continue, for the most part, to be drop shipped to our stores. Completion of the migration from our former "drop-ship" model to a centralized distribution model is an important development in our operating strategy and has required the allocation of significant financial and managerial resources. In accordance with generally accepted accounting principles, a portion of the costs of operating this facility are absorbed into our Guitar Center merchandise inventories and recognized as an element of cost of goods sold when the related inventory is sold. This could result in a slight decrease in reported gross margin depending on our success in defraying these additional costs, although we also hope to realize efficiencies involving other costs such as selling, general and administrative and interest expense.
Direct Response
Our Musician's Friend subsidiary, which we operate as a separate business unit, is an integrated e-commerce and catalog business. Through Musician's Friend, we offer musicians a shopping experience that satisfies the need for technical product information, confirmation of needs by a live person, quick and efficient service, and a musician-based staff for after sale support. The catalog presents a fresh assortment of products and promotions throughout the year, mixing big name products with unique and practical offerings. Our website, www.musiciansfriend.com, offers all that is shown in the catalog and more, supported by the same service and staff.
The Musician's Friend business is based in Medford, Oregon and is supported by a customer contact center located in Salt Lake City, Utah and a distribution facility located in Kansas City, Missouri.
Our customer contact staff receives product and customer service training in the Salt Lake City call center facility. Extensive product information, including technical information, product features and benefits, and real-time stocking information is available to the staff on their desktop systems via our intranet and back-end information systems. A staff of over 210 associates is trained and ready to respond to questions to help ensure that customers can purchase confidently. Website visitors are treated to a constantly updated and evolving, information rich shopping experience that includes product availability and purchase recommendations generated through collaborative filtering processes.
Questions regarding products can be submitted electronically, or the musician can call our support center directly. In 2002 we relocated our customer service telephone staff for returns to our Kansas City distribution center where they could be closer to the returns process while assisting our customers.
Orders, whether taken electronically or by an associate in our customer contact center, are processed by our automated transaction system and generally ship within 24 hours. In 2001, we merged our three distribution centers into the Kansas City, Missouri facility, closing our Medford, Oregon and Knoxville, Tennessee facilities. In 2002 our Kansas City distribution center was expanded by 100,000 square feet to its present 241,000 square feet. Initiatives were completed to improve inventory management and reduce outbound shipping costs. We have implemented sophisticated inventory planning systems to help ensure that products are in-stock with the goal of maintaining a high initial line item fill rate. The initial line item fill rate reflects the percentage of catalog items ordered by our customers that we are able to supply in the initial shipment to that consumer. Split shipments of a single order impose additional shipping, handling and materials costs on us when compared to being able to fulfill an entire order in a single shipment. The technology on our website also permits our customers to monitor their orders online by accessing the UPS and FedEx tracking services.
The focus of the Musician's Friend business strategy is to increase market share in the non-bricks and mortar retail segment of our industry. Our mailing and e-mail lists give us a significant base from which to grow. Our catalog circulation, which is broader than any other direct-mail circulation in our industry, provides a unique advertising and marketing platform for e-commerce. In addition, Musician's Friend enjoys significant customer loyalty as evidenced by a high rate of repeat purchases by customers.
Our business plan is to continue to leverage our leading industry position and existing infrastructure, and to build on that base to support the continued growth in e-commerce. We believe that our leadership position and established direct marketing model leverages both Internet and direct mail mechanics to provide a significant competitive advantage. We also believe that there may be opportunities to acquire complementary direct response businesses and regularly investigate such opportunities.
Business Strategy
Retail
The goal in the retail stores business is to continue to expand our position as the leading music products retailer throughout the United States. The principal elements of our business strategy are as follows:
•Store Expansion Strategy. Our expansion strategy is to continue to increase our market share in existing markets and to penetrate strategically selected new markets. We opened a total of 14 Guitar Center stores in 2000, 13 stores in 2001, and 12 stores in 2002, and currently anticipate opening approximately 16 to 18 Guitar Center stores in 2003. Some of these stores will be smaller format units designed for secondary markets. In preparation for this expansion, we have dedicated a substantial amount of our resources over the past several years to building the infrastructure necessary to support a large national chain. In addition, we have developed a methodology for targeting prospective store sites which includes analyzing demographic and psychographic characteristics of a potential store location.
We opened a total of eight American Music stores in 2002, five of which we obtained through the acquisition of M&M Music, a family music retailer. In addition, we plan to open six to eight American Music stores during 2003, some of which will likely come from acquisitions. We believe there may be attractive opportunities to expand by selectively acquiring existing music products retailers and regularly investigate acquisition opportunities. Most of these opportunities, however, involve single stores or small chains in light of the relatively fragmented nature of our
industry. During 2002, we added a significant number of guitar, percussion, pro audio, keyboard and accessory products to the American Music retail stores. Our objective is to position American Music as a family music store capable of fulfilling a wider array of consumer needs.
•Extensive Selection of Merchandise. We offer an extensive selection of brand name music products complemented by lesser known, hard to find items and unique, vintage equipment. The average 12,000 core SKUs offered through each of our large format Guitar Center stores, and the average 7,000 core SKUs for our small format Guitar Center stores, provide a breadth and depth of in-stock items which we believe is not available from traditional music products retailers.
•Brand Development Strategy. Our plan is to continue to grow our Guitar Center business while also building a retail business in the student and family market using the American Music platform we recently acquired. While the two brands have distinctly different customer bases that we intend to serve through separate retail concepts, we also believe that each retail brand will benefit from the other. For example, we have started to make a number of Guitar Center SKU's available for sale in the American Music channel.
•Highly Interactive, Musician-Friendly Store Concept. The purchase of musical instruments is a highly personal decision for musicians. We therefore believe that a large part of our success is attributable to our creative instrument presentations and colorful, interactive displays which encourage the customer to hold and play instruments as well as to participate in product demonstrations. Most stores also provide private sound-controlled rooms to enhance a customer's listening experience while testing various instruments.
•Exceptional Customer Service. Exceptional customer service is fundamental to our operating strategy. Accordingly, we conduct extensive training programs for our salespeople, who specialize in one of our five product categories. Many of our salespeople are also musicians. With the advances in technology and continuous new product introductions in the music products industry, customers increasingly rely on qualified salespeople to offer expert advice and assist in product demonstrations. We believe that our emphasis on training and customer service distinguishes us within the industry and is a critical part of our success.
•Innovative Promotional and Marketing Programs. We sponsor innovative promotional and marketing events, which include in-store demonstrations, famous artist appearances and weekend themed sales events, designed to create significant store traffic and exposure. In addition, our special grand opening activities in new markets are designed to generate consumer awareness for each new store. We believe these events help us to build a loyal customer base and to encourage repeat business. Since our inception, we have compiled a unique, proprietary database containing information on more than 7 million customers. This database enables us to advertise to select target customers based on historical buying patterns. We added to our customer database in early 2003 by buying the customer database of Mars Music at an auction conducted in connection with that company's bankruptcy proceedings. We believe the typical music products retailer does not have the resources to support large-scale promotional events or an extensive advertising program.
•Guaranteed Low Prices. We endeavor to be the low price leader in each of our markets, as underscored by our Guitar Center 30-day low price guarantee. Our size permits us to take advantage of volume discounts for large orders and other vendor-supported programs. Although prices are usually determined on a regional basis, store managers are trained and authorized to adjust prices in response to local market conditions.
•Experienced and Motivated Management Team. Our executive officers and key managers have an average of ten years employment with Guitar Center, Musician's Friend and American Music.
Direct Response
The goal of the e-commerce and catalog business unit is to capitalize and expand on our leadership position. Leveraging of our extensive customer database is used to design effective marketing campaigns. The presentation of an extensive selection of products and maintenance of an effective degree of continual and informative contact with prospects and customers provide the attention grabbing content that generate results. In 2002, we circulated over 15.8 million catalogs and sent over 96.4 million e-mails to prospects and customers. The call center fielded over 2.2 million calls during 2002, and hosted over 40,000 live chat sessions.
Our key business strategies include the following:
•Targeted Marketing. We have experience at targeting appropriate prospect and customer segments with the right offers. Extensive segmentation of customer lists and continual analysis by our circulation department are designed to ensure that the right mix of catalog and e-commerce offers are presented to each segment of customers. Our utilization of techniques in demographic data overlay and statistical modeling help ensure that Musician's Friend retains a leadership position in music gear direct marketing.
•Extensive Product Selection. Musician's Friend stocks a broad assortment of products representing most of the premier lines; in some cases we are the exclusive direct sales dealer for the manufacturer. With some manufacturers, the Musician's Friend business unit alone is their second largest dealer behind Guitar Center's retail operations. Each catalog presents 4,000 or more SKUs, selected from the 47,000 or more SKUs that we carry. The website presents a more complete selection of products than the catalog due to its significantly lower publishing cost. During 2002 we added to our selection by assuming the operation of two small catalogs targeted to the band and educational market previously operated by American Music.
•Continual Customer Contact. Prospects and customers receive periodic mailings from Musician's Friend, depending on their particular attributes. Musicians can "opt-in" for weekly electronic newsletters featuring news, information and promotions. Our preferred credit card customers ("Platinum" and our new "Clef Member" cards, all issued by a third party provider) receive additional marketing contacts via monthly statement mailings. Our musician-staffed call center is available 24-hours-a-day, seven-days-a-week for questions, technical information and customer service. While browsing the website, customers are presented with customized product recommendations.
Retail Merchandising
Our merchandising concept differentiates us from most of our competitors. Guitar Center offers merchandise at guaranteed low prices and utilizes aggressive marketing and advertising to attract new customers and maintain existing customer loyalty. The principal elements of our merchandising philosophy are as follows:
•Extensive Selection of Merchandise. We seek to maintain a broad customer appeal by offering high-quality merchandise at multiple price points to serve musicians ranging from the casual hobbyist to the serious professional performer. Our Guitar Center units offer products in five primary categories: guitars and amplifiers, percussion instruments, keyboards, pro-audio and recording equipment, used and vintage, and accessories. Our American Music division offers band and orchestral instruments for sale and rental as well as related accessories and a lesser assortment of guitars, amplifiers, percussion instruments, keyboards, and pro-audio and recording equipment than a Guitar Center store.
•Guitars and Amplifiers. We believe that our electric, acoustic, classic and bass guitar selections are among the deepest and broadest in the industry. Major manufacturers,
including Fender, Gibson, Taylor, Martin, PRS, Yamaha, Ovation and Ibanez, are well represented in popular models and colors. We believe we have one of the largest selections of custom, one-of-a-kind and used/vintage guitars of any retailer. Prices range from $99 for entry-level guitars to over $100,000 for special vintage guitars. In addition, our line of stringed instruments includes banjos, mandolins and dobros, among others. We also offer an extensive selection of guitar sound processing units and products that allow the guitar to interface with a personal computer. These products serve crossover demand from the traditional guitarist into new computer-related sound products.
We offer an extensive selection of electric, acoustic and bass guitar amplifiers and, in addition, carry a broad selection of boutique and vintage amplifiers with prices ranging from $50 to $5,000. We represent most manufacturers, including Marshall, Fender, Crate, Ampeg, Vox, S.W.R. and Mesa Boogie.
•Percussion Instruments. We believe that we are the largest seller of percussion products in the United States. Our offerings range from basic drum kits to congos and bongos and other rhythmic and electronic percussion products with prices ranging from $10 to $10,000. We also have a large selection of vintage and used percussion instruments. Name brands include Drum Workshop, Remo, Sabian, Pearl, Yamaha, Tama and Zildjian. We carry an extensive selection of electronic drum kits. These digital units produce a variety of high quality life-like drum sounds and have broad appeal to musicians.
•Keyboards, Pro-Audio and Recording Equipment. We carry a wide selection of keyboard products and computer peripheral and software packages with prices ranging from $100 to $5,000. We offer an extensive selection of software for the professional, hobbyist, studio engineer and the post-production market enthusiast. The product line covers a broad range of manufacturers including Roland, Alesis, Korg, Emu and Yamaha. We also maintain a broad selection of computer-related recording products, including sound cards, sound libraries and composition, sequence and recording software.
Our pro-audio and recording equipment category offers products ranging in price from $100 to $25,000 for musicians at every level, from the casual hobbyist to the professional recording engineer. Our products range from recording tape to state-of-the-art digital recorders. We believe we also carry one of the largest assortments of professional stage audio, disc jockey and lighting equipment for small traveling bands, mobile disc jockeys, private clubs and large touring professional bands. Our major brand name manufacturers include Digidesign, JBL, Sony, Mackie, Tascam, Yamaha, Roland and Alesis.
•Used and Vintage. We offer an extensive selection of used merchandise, the majority of which derives from instruments and technology products traded in or sold to us by customers. Our trade-in policy provides musicians with an alternative form of payment and the convenience of selling an old instrument and purchasing a new one at a single location. Used products are bought and priced to sell by store managers who are well trained and knowledgeable in the used musical instrument market.
•Accessories. Our accessory department offers a broad range of items considered 'consumables' by our musician customers. These items range from guitar strings, picks, cables and straps, to performance microphones, cables, stands and sophisticated signal processors that modify and enhance the sound of an instrument during performance or recording.
•Band and Orchestral Instruments and Accessories. Through the American Music division we offer a full range of brass and woodwind band instruments including trumpets, flutes,
clarinets, trombones, saxophones, piccolos, French horns, flugelhorns, cornets, baritones, and related music accessories. We also offer a full range of stringed instruments, such as violins, violas, cellos, and string basses, and related accessories. Name brand manufacturers include Leblanc, Jupiter, Gemeinhardt, Selmer, Buffet, Schiller, Blessing, DEG, Yamaha and Rico.
Retail Store Operations
To facilitate our strategy of accelerated but controlled growth, we have centralized many key aspects of Guitar Center store operations, including the development of policies and procedures, accounting systems, training programs, store layouts, purchasing and replenishment, advertising and pricing. Such centralization utilizes the experience and resources of our headquarters staff to establish a high level of consistency throughout all of our stores.
Our Executive Vice President of Stores and 11 district sales managers manage the Guitar Center retail stores. Store management is normally comprised of a store manager, a sales manager, an operations manager, two assistant store managers and five department managers. Each store also has a warehouse manager and a sales staff that ranges from 20 to 40 employees. Retail store operations for American Music is led by the President and Chief Operating Officer of that division. Store management is comprised of a store manager, assistant store manager, educational representative and related sales and support staff.
We ensure that store managers are well trained and experienced individuals who will maintain our store concept and philosophy. Each manager completes an extensive training program that instills the values of operating as a business owner, and only experienced store employees are promoted to the position of store manager. We seek to encourage responsiveness and entrepreneurship at each store by providing store managers with a relatively high degree of autonomy relating to operations, personnel and merchandising. Managers play an integral role in the presentation of merchandise, as well as the promotion of our reputation.
We view our employees as long-term members of our team. We encourage employee development by providing the sales force with extensive training and the opportunity to increase both compensation and responsibility level through increased product knowledge and performance. Our aggressive growth strategy provides employees with the ability to move into operations, sales and store management positions, an opportunity which management believes is not available at most other music retailers. As we open new stores, the qualified and experienced employees from existing stores primarily fill key in-store management positions. By adopting a "promotion from within" strategy, we maintain a well-trained, loyal and enthusiastic sales force that is motivated by our strong opportunities for advancement. Larry Thomas and Marty Albertson, our Chairman and Co-Chief Executive Officer and President and Co-Chief Executive Officer, respectively, each began their careers as salespersons at Guitar Center.
Marketing and Promotion
We maintain three unique and proprietary databases (Guitar Center, Musician's Friend and American Music) containing information on over 7 million customers, including approximately 2 million customer names which were purchased in early 2003 from Mars Music at an auction conducted in connection with that company's bankruptcy proceedings. We believe that these databases assist in identifying customer prospects and in generating repeat business by targeting consumers based on their purchasing history and by permitting us to establish and maintain personal relationships with our customers.
Retail
For the Guitar Center retail stores, our advertising and promotion strategy is designed to enhance the Guitar Center name and increase consumer awareness and loyalty. The advertising and promotional campaigns are developed around "events" designed to attract significant store traffic and exposure. We regularly plan large promotional events including the Green Tag Sale in March, the Anniversary Sale in August and the Guitar-a-thon in November. We believe that our special events have a broad reach as many of them have occurred annually during the past 20 years. These events are often coordinated with product demonstrations, interactive displays, clinics and in-store artist appearances. Cooperative advertising and in-store training from our major vendors ensures that our customers are kept current with trends presented by the latest music gear.
As we enter new markets, we initiate an advertising program, including mail and radio promotions, television and Internet campaigns, and other special grand opening activities, designed to accelerate sales volume for each new store. Radio advertising plays a significant part in our store-opening campaign to generate excitement and create customer awareness.
We provide limited credit to corporate customers and similar house accounts on a current account basis. Generally, all credit made available to retail customers and all extended payment arrangements are provided by third party consumer credit companies which are non-recourse to us, meaning that the risk of non-payment is borne by the third party provider so long as we comply with its administrative and approval policies. These arrangements also give us the flexibility to offer attractive payment options to our customers on a promotional basis, such as no interest periods, reduced interest rates or deferred payment options. These programs are also non-recourse to us but we pay the credit provider a fee reflecting the below-market, promotional benefit of the particular program.
For the American Music retail stores, our advertising efforts are focused primarily on the school band market and community. For instrument rental the advertising and promotional campaigns are developed around "rental nights" designed to display our orchestral and band instruments at elementary and high schools. These events attract band directors, music educators, parents and students. Our key promotional events are held primarily from August through October. In addition to "rental nights," we also have education representatives that travel around the country to promote and educate band directors on our instruments and our sales and rental programs. We maintain long-term relationships with educators in order to provide visibility to our products and obtain access to student musicians.
Direct Response
We maintain a stream of communication in electronic and print media, presenting consumers with an optimized and refreshed mix of offers. Extensive analysis of customer behavior and transactions along with the industry expertise of our merchandising staff provides our marketing staff with offers carefully targeted for optimal response. Cooperative advertising and on-going training with key industry suppliers ensures that Musician's Friend customers are kept current with trends presented by the latest music gear.
The same transactional databases that make accurate market targeting available for catalog and e-mail circulation are enhanced by the information archived from our website traffic. With the use of an analytical engine developed by Net Perceptions, and continued development of additional tools, our merchandising and marketing departments are able to present relevant and personalized product and promotional offerings to prospects.
Musician's Friend also offers its customers private label credit card programs on non-recourse terms comparable to those offered by Guitar Center. These programs include the Platinum Card offered by Musician's Friend and the new Clef Card offered for customers of the Giardinelli band
instruments catalog. These credit cards permit us to offer carefully tailored competitive promotional opportunities to our customers.
Our plans for Musician's Friend include the development of catalogs targeted towards particular segments of the musician market. In 2002, Musician's Friend took over production of two small catalogs from the American Music division. The LMI Catalog is oriented toward young, school-aged children and the Giardinelli Catalog is targeted to band and orchestra buyers. In 2001, we introduced the Musician's Friend Drummer catalog that is oriented towards percussion instruments and the Musician's Friend DJ catalog oriented for DJ customers.
We believe that there may be opportunities to acquire complimentary direct response businesses and are also examining opportunities to use the Internet to expand further the reach of our brands. For example, in late 2002 we purchased the principal assets of Marsmusic.com, including the URL address and hardware. New opportunities are also being created by the rapid development of content and community sites oriented towards music and musicians.
Customer Service
Retail
Exceptional customer service is fundamental to our operating strategy. With the rapid changes in technology and continuous new product introductions, customers depend on salespeople to offer expert advice and to assist with product demonstrations. We believe that our well-trained and knowledgeable sales force differentiates us from our competitors and is critical to maintaining customer confidence and loyalty. Our employees are typically musicians who are selected and trained to understand the needs of our customers. Guitar Center store salespeople specialize in one of our five product categories and begin training on their first day of employment. Guitar Center store sales and management training programs are implemented on an ongoing basis to maintain and continually improve the level of customer service and sales support in the stores. We believe that our employee testing program impresses upon our salespeople a sense of professionalism and reduces employee turnover by providing salespeople with the opportunity to increase their salaries by advancing through the certification program. We believe that due to our emphasis on training, we are able to attract and retain well-qualified, highly motivated salespeople committed to providing superior customer service.
Our Guitar Center store customer base consists of the professional or aspiring musician who makes or hopes to make a living through music and the amateur musician or hobbyist who views music as recreation. Management estimates that professional and aspiring musicians, who generally view the purchase of musical products as a career necessity, represent approximately 58% of our customer base, and account for approximately 73% of our sales. These customers make frequent visits to a store and develop relationships with the sales force. We generate repeat business and are successful in utilizing our unique and proprietary database to market selectively to these customers based on past buying patterns. In addition, we service touring professionals, providing customized products for musical artists.
The majority of our sales force at American Music is composed of music teachers and education representatives who are experienced band instructors. With the introduction of the family music store concept, we have added a limited retail sales force. The customer base of American Music has historically consisted of band directors, music educators, college professors who are involved in music education and students of music education programs.
Direct Response
Musician's Friend maintains a staff of over 210 contact center customer service associates, staffing the contact center 24-hours-a-day, seven-days-a-week. Customers can contact agents via phone, e-mail, live chat or fax for questions regarding products, technical information or the status of their orders.
Most of the staff is comprised of musicians who are given extensive and ongoing product training. The Salt Lake City contact center houses an extensive product demonstration area and training facility. In-house technical staff as well as manufacturers' representatives conduct weekly product training.
We maintain a database of product information for use by the agents in our contact center that is always available on our corporate intranet. The intranet also makes operational and instructional information available to agents, minimizing their downtime and maximizing their ability to service customer needs effectively. All of this information, along with customer account information, is available in real time, giving agents the ability to keep customers constantly up to date.
The website is updated hourly with new product information so customers can work with the latest available data. As this is an area that is constantly evolving, customers are continually presented with new and more extensive information. In addition, the collaborative filtering process results in customized product recommendation to customers browsing the website. In 2001, we completed an extensive website upgrade to provide customer identification tracking and more flexible ordering functions to enhance our customer's web experience.
To provide the customer with a high degree of satisfaction, customers may return items for a full refund within 45 days of purchase. Additionally, if customers find a lower advertised price within 45 days of purchase, we will match the competitor's advertised price.
For customers that have registered e-mail addresses with us, we offer automated order and shipment verification. This provides customers with UPS or FedEx order tracking information as soon as their shipment has been processed.
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. In 2002, we expanded the facility to 241,000 square feet, adding another 100,000 square feet for bulk inventory storage.
Credit card authorization and fraud management systems are automated, minimizing delays in processing. The distribution center processes orders taken before 5 p.m., Eastern Time, for same-day shipping of in-stock items, minimizing delays in delivery to customers. Orders ship primarily by UPS and FedEx.
All returns are routed to the Kansas City warehouse where repairs and quality evaluations are made. On site repair and customer service representatives assist our customers and reduce the costs associated with returns. Returned and blemished products are sold through an outlet store located in the Kansas City facility and by offering such products at reduced prices on the musiciansfriend.com website.
Purchasing, Distribution and Inventory Control
Purchasing. We believe that we have excellent relationships with our vendors and, in many instances, are the vendor's largest customer. Given our high volume, we are generally able to receive prompt order fulfillment and access to our vendors' premium products. Both Guitar Center and Musician's Friend maintain centralized buying groups. Our centralized buyers include merchandise managers, buyers, planners, replenishers, and allocators. Merchandise managers and buyers are responsible for the selection and development of product assortments and the negotiation of prices and terms. The planners, replenishers and allocators are responsible for maintaining inventory levels and allocating the merchandise to the retail distribution center, stores and direct response distribution center. We use merchandise replenishment systems which automatically analyze and forecast sales
trends for each stock keeping unit, or SKU, using various statistical models, supporting the buyers by predicting merchandise requirements. This has resulted in limited "out of stock" positions while maintaining minimal inventory levels.
Our business and expansion plans are dependent to a significant degree upon our vendors. As we believe is customary in the industry, we do not have any long-term supply contracts with our vendors. Please see "-Risks Related to the Business-We depend on a relatively small number of manufacturers and suppliers who may not be able to or desire to supply our requirements."
Distribution. During 2001, we began construction of a distribution center in the Indianapolis, Indiana area to support our Guitar Center retail store operations. The facility commenced operations in July 2002. We have entered into a 10-year agreement to lease the facility. As of December 31, 2002, nearly all product was flowing through the distribution facility, with the exception of special orders which will continue, for the most part, to be drop-shipped to our stores. Completion of the migration from our former "drop-ship" model to a centralized distribution model is an important development in our operating strategy and has required the allocation of significant financial and managerial resources. In accordance with generally accepted accounting principles, a portion of the costs of operating this facility are absorbed into our Guitar Center merchandise inventories and recognized as an element of cost of goods sold when the related inventory is sold. This could result in a slight decrease in reported gross margin depending on our success in defraying these additional costs, although we also hope to realize efficiencies involving other costs such as selling, general and administrative and interest expense.
We are also evaluating additional capital and strategic requirements related to improving our fulfillment facilities and technology and pursuing new opportunities in the e-commerce activities of Guitar Center, Musician's Friend, American Music and related businesses.
Inventory Control. We have invested significant time and resources in our inventory control system at the Guitar Center retail stores and believe we have one of the most sophisticated systems in the music products retail industry. We believe the vast majority of music product retailers do not use a computerized inventory management system. We perform inventory cycle counts daily, both to measure shrinkage and to update the perpetual inventory on a store-by-store basis. As appropriate, we also stock balance inventory among stores to assure proper distribution of product and to control overall inventory levels. Our inventory shrinkage level has historically been low, which we attribute to our sophisticated system controls and strong corporate culture.
Retail Store Site Selection
We believe we have developed unique and, what historically have been, highly effective selection criteria to identify prospective store sites for our Guitar Center units. In evaluating the suitability of a particular location, we concentrate on the demographics of our target customer as well as traffic patterns and specific site characteristics such as visibility, accessibility, traffic volume, shopping patterns and availability of adequate parking. Stores are typically located in free-standing locations to maximize their outside exposure and signage.
Management Information Systems
Retail
We have invested significant resources in management information systems that provide real-time information for the Guitar Center division. The systems have been designed to integrate all major aspects of our business, including sales, gross margins, inventory levels, purchase order management, automated replenishment and merchandise planning. Our sophisticated management information systems provide us with the ability to monitor all critical aspects of activity on a real-time basis. Our system capabilities include inter-store transactions, vendor analysis, serial number tracking, inventory analysis and commission sales reporting. We believe that the system we have developed will enable us to continue to improve customer service and operational efficiency and support our needs for the immediately foreseeable future.
We presently have underway a project to install new management information systems at American Music. This implementation is an important project to facilitate the American Music family music store concept and to provide a scaleable system backbone to facilitate the growth of this brand.
Direct Response
Musician's Friend maintains an extensive transaction processing system as well as systems supporting e-commerce, operations and marketing analysis, and internal support information. All transaction and inventory information is available real-time. The e-commerce website is updated during the day through a firewall, providing a high degree of security for our internal systems. Our direct response business does not have redundant Internet or operating systems and would be vulnerable to catastrophic events. In the event of a disaster, our direct response business would most likely experience delays in processing and shipping orders until we executed our failure recovery plans. Dedicated systems are used for inventory planning and for website analysis. Initiatives were completed to improve inventory management and reduce outbound shipping costs. Many of the systems which run our distribution center operations function via wireless technology.
The systems provide management with extensive marketing, merchandising and operational information, and provide call center and customer service staff with current inventory and customer account information. The choice of platforms and databases provides us with a strong foundation for ongoing development of systems.
Competition
We are in direct competition with the other major multi-unit retail chain in the music products industry-Sam Ash Music based in New York, New York. In addition, we compete with various direct response companies such as American Music Supply (unrelated to our American Music division), Sam Ash Music, and Sweetwater Sound. As of December 31, 2002, we were in direct competition with Sam Ash in 14 of our markets. In recent years, Sam Ash has continued to open new or acquired stores, and various store openings are planned for 2003. One of our primary competitors, Mars Music, Inc., or Mars, filed for federal bankruptcy court protection on September 27, 2002 and has completed a liquidation resulting in the closure of all of its stores. We cannot predict the impact the closure of Mars will have on our business, including how many of the Mars customers will move their shopping to our businesses versus our competitors. Of the Mars Music stores closed, Sam Ash acquired four of the locations. The competitive landscape remains dynamic and we cannot predict what level of national and local competition our retail store and direct response businesses will face in the future. Nonetheless, we continue to believe that there is room for further consolidation within the music products retailing industry as the top five retailers, per The Music Trades magazine, (including Guitar Center and Sam Ash) only account for an estimated 23.2% of the market in 2001.
We believe that the ability to compete successfully in our markets is determined by several factors, including breadth and quality of product selection, pricing, effective merchandise presentation, customer service, store location and proprietary database marketing programs. Customer satisfaction is paramount to our operating strategy and we believe that providing knowledgeable and friendly customer service gives us a competitive advantage. The store environment is designed to be an entertaining and exciting environment in which to shop. In an effort to exceed customer expectations, our stores provide a number of services not generally offered by most competitors, including the ability to hold and use merchandise, product demonstrations and extensive product selection. Salespeople are highly trained and specialize in one of our five product areas. Salespeople are certified by an internal training team, based on extensive training and product knowledge testing. We believe that this certification process has increased the professionalism of our employees while reducing turnover. Customers are encouraged to help themselves to the displayed instruments and to seek the assistance of the professional salespeople.
Various factors, however, could materially and adversely affect our ability to compete successfully in our markets, including, among others, the expansion by us into new markets in which our competitors are already established, competitors' expansion into markets in which we are currently operating, the adoption by competitors of innovative store formats and retail sales methods or the entry into our markets by competitors with substantial financial or other resources. See "-Risks Related to the Business-We may be unable to meet our Guitar Center and American Music retail growth strategy, which could adversely affect our results of operations" and "-We face significant competition, and our efforts to increase our market share may be inhibited by existing or new competitors also trying to execute national expansion strategies."
Employees
As of December 31, 2002, we employed 5,003 people, of whom 4,197 were hourly employees and 806 were salaried. None of our employees are covered by a collective bargaining agreement. We believe that we enjoy good employee relations.
Brand Names and Service Marks
We operate our retail stores under the "Guitar Center" and "American Music" brands and our direct response business under the "Musician's Friend" brand.
We have registered the GUITAR CENTER, ROCK WALK, MUSICIAN'S FRIEND, ROGUE, AXMAN, PULSE PERCUSSION, 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. A shortfall in comparative sales growth in any period will likely cause a shortfall in earnings, and result in financial performance below that for which we have planned or the investment community expects.
We may be unable to meet our Guitar Center and American Music retail store growth strategy, which could adversely affect our results of operations.
Our retail store growth strategy includes opening new stores in new and existing markets and increasing sales at existing locations. As of December 31, 2002, we operated 108 Guitar Center stores and 20 American Music stores. We opened a total of 12 Guitar Center stores in 2002, and currently expect to open approximately 16 to 18 additional Guitar Center stores in 2003. Some of these Guitar Center stores will be smaller format units designed for secondary markets.
We opened a total of eight American Music stores in 2002, five of which were acquired in connection with American Music's acquisition of M&M Music, a band instrument retailer. We currently expect to open approximately six to eight additional American Music stores in 2003. Some of these stores may be acquired in connection with the acquisition of existing businesses. We believe there exists a number of acquisition opportunities in the relatively fragmented band instruments market that could be a good fit into our American Music platform.
The success of our retail store expansion plans depend on many factors, including:
•identification of suitable retail sites and appropriate acquisition candidates;
•negotiation of acceptable lease terms;
•hiring, training and retention of skilled personnel;
•availability of adequate capital;
•sufficient management and financial resources to support the new locations;
•vendor support; and
•successful completion of our new management information system at American Music.
A number of these factors are, to a significant extent, beyond our control. As a result, we do not know whether we will be able to continue to open and/or acquire additional Guitar Center and American Music stores at the rates currently anticipated. If we are unable to achieve our retail store expansion goals, or the new stores underperform our expectations, our results of operations could be adversely affected.
We face unique competitive and merchandising challenges in connection with our plans to open additional Guitar Center and American Music retail stores in new markets.
As part of our retail growth strategy, we plan to open and/or acquire additional Guitar Center and American Music stores in new markets. This expansion into new markets will present unique competitive and merchandising challenges, including:
•significant start-up costs, including promotion and advertising;
•higher advertising and other administrative costs as a percentage of sales than is experienced in mature markets that are served by multiple stores, particularly in large urban markets where radio and other media costs are high;
•management of stores in distant locations;
•availability of desirable product lines; and
•our expansion may involve acquisitions, including acquisitions in business segments in which we have limited or no experience.
Any of these factors may lead to a shortfall in revenues or an increase in costs with respect to the operation of these stores. If we are not able to operate these stores profitably, our results of operations would be adversely affected.
Our retail store expansion strategy, including our strategy of clustering retail stores, may adversely impact our comparable store sales.
Historically, we have achieved significant sales growth in existing stores. Our quarterly comparable stores sales results have fluctuated significantly in the past. Sales growth for comparable periods, excluding net sales attributable to stores not open for 14 months, was as follows for our retail stores:
We do not know whether our new stores will achieve sales or profitability levels similar to our existing stores. Our expansion strategy includes clustering stores in existing markets. Clustering has in the past and may in the future result in the transfer of sales to the new store and a reduction in the profitability of an existing store. In addition, a variety of factors affect our comparable store sales results, including:
•competition;
•economic conditions, including in particular, discretionary consumer spending;
•consumer and music trends;
•changes in our merchandise mix;
•product distribution; and
•timing and effectiveness of our promotional events.
Our management is presently planning for annual comparable store sales growth of 5% to 7% for the immediate future, although fluctuations will undoubtedly take place from period to period. A shortfall in comparative sales growth in any period will likely cause a shortfall in earnings, and result in financial performance below that for which we have planned or the investment community expects.
Our growth plans depend on our completion of acquisitions, and these transactions involve special risks.
We believe that our expansion may be accelerated by the acquisition of existing music product retailers. For example, in April 2001 we acquired the business of American Music Group, a New York-based retailer of band instruments, a business in which we were not previously engaged. Our growth plans for the American Music business contemplate a significant number of relatively small acquisitions. For example, in June 2002 American Music acquired M&M Music, a band instrument retailer. We also regularly investigate acquisition opportunities complimentary to our Guitar Center and Musician's Friend businesses. Accordingly, in the ordinary course of our business, we regularly consider, evaluate and enter into negotiations related to potential acquisition opportunities. We may pay for these acquisitions in cash or securities, including equity securities, or a combination of both. We cannot assure you that attractive acquisition targets will be available at reasonable prices or that we will be successful in any such transaction. Acquisitions involve a number of special risks, including:
•diversion of our management's attention;
•integration of the acquired business with our business; and
•unanticipated legal liabilities and other circumstances or events.
We depend on a relatively small number of manufacturers and suppliers who may not be able to or desire to supply our requirements.
Brand recognition is of significant importance in the retail music products business. As a result, we depend on a relatively small number of manufacturers and suppliers for both our existing stores and the direct response unit as well as our expansion goals for each of these units. We do not have any long-term contracts with our suppliers, and any failure to maintain our relationships with our key brand name vendors would have a material adverse effect on our business. A number of the manufacturers of the products we sell are limited in size and manufacturing capacity and have significant capital or other constraints. These manufacturers may not be able or willing to meet our increasing requirements for inventory, and we cannot assure you that sufficient quantities or the appropriate mix of products will be available in the future to supply our existing stores and expansion plans. These capacity restraints could lead to extended lead times and shortages of desirable products. The risk is especially prevalent in new markets where our vendors have existing agreements with other dealers and thereby may be unwilling or unable for contractual or other reasons to meet our requirements. The efficient operation of our new distribution center for the Guitar Center stores is also highly dependent upon compliance by our vendors with precise requirements as to the timing, format and composition of shipments, which in many instances requires changes and upgrades to the operational procedures and logistics and supply chain management capabilities of vendors, all of which are outside of our control. Additionally, many of our vendors receive product from overseas and depend on common carriers to transport merchandise into the country. We also rely on common carriers to transport product from our vendors to our central distribution center in Indiana, and from the distribution facility to our Guitar Center stores. Any disruption in the services of common carriers due to employee strikes or other unforeseen events could impact our ability to maintain sufficient quantities of inventory in our retail locations.
We face significant competition, and our efforts to increase our market share may be inhibited by existing or new competitors also trying to execute national expansion strategies.
The retail music products industry is fragmented and highly competitive. We compete with many different types of music product retailers, including conventional retailers, as well as other catalog and e-commerce retailers, who sell many or most of the items we sell. We believe that large format music product retailers such as our company will seek to expand in part through the acquisition of small, independently owned stores or franchises, and we anticipate increased competition in our existing markets and planned new markets from these consolidating retailers. These retailers may identify target companies or execute their acquisition strategies more effectively than our company. In addition, these retailers may have greater financial resources or other competitive advantages as compared to our company. Our expansion to new markets will be inhibited by these and other established competitors. In addition, one or more of our competitors may adopt a new, innovative store format or retail selling method. If we are not able to compete effectively, we may fail to achieve market position gains or may lose market share.
Mars Music, Inc. filed for federal bankruptcy court protection on September 27, 2002 and closed all of its stores in 2002. We cannot predict the impact that the closure of Mars will have on our business, including how many of the Mars customers will move their shopping to our business versus our competitors.
We must efficiently integrate American Music and grow its band instrument business in order to earn an acceptable return on that investment.
In April 2001, we completed our acquisition of American Music Group, a New York-based retailer of band instruments. We had not previously participated in the band instruments segment of the music products business and had no prior experience in this distribution channel. We intend to use the acquired American Music business as a platform to develop and grow a family music store concept that will emphasize band instruments and also sell selected guitar, percussion, pro audio, keyboard and accessory products sold by our Guitar Center stores. Thus, we face the normal challenges of any acquisition, such as integration of personnel and systems as well as the need to learn, understand and further develop this business. We are installing new management information systems at American Music, which has proven to be a challenging project requiring more time and resources than originally anticipated. This implementation is an important project to facilitate further integrating of American Music with our other businesses and to provide a systems backbone to permit growth of this division. In addition, in 2002 we started marketing through the American Music stores some Guitar Center products not previously carried by American Music. This change in merchandising strategy from the historic focus of American Music on band instruments is in process and is an important element of our family music store concept for this brand. Failure to execute on these requirements and initiatives could result in a poor or no return on our investment, constitute a distraction of the efforts of our management team from the core Guitar Center and Musician's Friend brands and potentially require us to recognize an impairment in the significant amount of goodwill recorded in the acquisitions of American Music and M&M Music.
We depend on key personnel including our senior management who are important to the success of our business.
Our success depends to a significant extent on the services of Larry Thomas, our Chairman and Co-CEO, Marty Albertson, our President and Co-CEO, Robert Eastman, the CEO of our wholly-owned subsidiary, Musician's Friend, Inc., and David Fleming, President and Chief Operating Officer of American Music, as well as our ability to attract and retain additional key personnel with the skills necessary to manage our existing business and growth plans. The loss of one or more of these individuals or other key personnel could have a material adverse effect on our business, results of operations, liquidity and financial position. During 2001, we entered into a five-year employment contract with each of Mr. Thomas and Mr. Albertson. Additionally, we carry key man insurance on the lives of Mr. Thomas and Mr. Albertson in the amounts of $5.0 million and $3.5 million, respectively. Historically, we have promoted employees from within our organization to fill senior operations, sales and store management positions. In order to achieve our growth plans, we will depend upon our ability to retain and promote existing personnel to senior management, and we must attract and retain new personnel with the skills and expertise to manage our business. If we cannot hire, retain and promote qualified personnel, our business, results of operations, financial condition and prospects could be adversely affected.
The implementation of our new distribution center for the Guitar Center retail stores presents operational risks and represents a significant investment.
During 2001, we began construction of a distribution center in the Indianapolis, Indiana area to support our Guitar Center retail store operations. The conveyor systems, the warehouse management system, and all other technology systems and infrastructure commenced operations in July 2002. Migration from our former "drop-ship" model to a centralized distribution model is an important development in our operating strategy and will continue to require significant financial and managerial resources for the next several quarters. The efficient operation of the distribution center is also dependent upon the performance of third parties that we do not control, such as vendors who must
comply with new operating procedures and common carriers who must deliver product on time. This program involves financial and operating risks that could include the need to expend greater funds than presently budgeted or disruptions in retail store operations and the loss of sales if inventory is not timely provided in the required quantities. Further, one of the key underlying economic assumptions of our distribution center project is that this program will permit us to reduce overall inventory levels as a percentage of sales thereby resulting in significantly reduced working capital requirements. Any failure to reach our inventory reduction targets will adversely affect our future financial performance and capital needs, potentially in a material manner. Failure to execute on these requirements could result in a poor or no return on our investment, disruption of our retail store business and a distraction of the efforts of our management team.
Our retail operations are concentrated in California, which ties our financial performance to events in that state.
As of December 31, 2002, our corporate headquarters as well as 22 of our 108 Guitar Center stores were located in California and stores located in that state generated 27.5% and 28.3% of our retail sales for 2002 and 2001, respectively. Although we have opened and acquired stores in other areas of the United States, a significant percentage of our net sales and results of operations will likely remain concentrated in California for the foreseeable future. As a result, our results of operations and financial condition are heavily dependent upon general consumer trends and other general economic conditions in California and are subject to other regional risks, including earthquakes. We do maintain earthquake insurance, but such policies carry significant deductibles and other restrictions.
Economic conditions or changing consumer preferences could also adversely impact us.
Our business is sensitive to consumer spending patterns, which can be affected by prevailing economic conditions. A downturn in economic conditions in one or more of our markets, such as occurred after September 11, 2001, could have a material adverse effect on our results of operations, financial condition, business and prospects. Recent weak economic conditions have created uncertainty as to the future direction of the economy which is likely to continue to impact hobbyists and other general consumers who purchase from Musician's Friend and our American Music and Guitar Center stores. Although we attempt to stay informed of consumer preferences for musical products and accessories typically offered for sale in our stores, any sustained failure on our part to identify and respond to trends would have a material adverse effect on our results of operations, financial condition, business and prospects.
We may need to change the manner in which we conduct our business if government regulation or taxation imposes additional costs and adversely affects our financial results.
The adoption or modification of laws or regulations, or revised interpretations of existing laws, relating to the direct response industry could impose material liability on us and adversely affect the manner in which we currently conduct our catalog and e-commerce business. For example, laws related to the taxation of catalog, telephone, and online commercial activity, including the applicability of state sales and use taxes to direct response sales and direct response merchants such as Musician's Friend, remain in flux. In addition, the growth and development of the market for online commerce may lead to more stringent consumer protection laws, both in the United States and abroad, that may impose additional burdens on us. Laws and regulations directly applicable to communications or commerce over the Internet are becoming more prevalent. The law of the Internet, however, remains largely unsettled, even in areas where there has been some legislative action. It may take years to determine whether and how existing laws such as those governing intellectual property, consumer privacy, sales-based and other taxation of e-commerce transactions and the like are interpreted and enforced. Any adverse change in any of these laws or in the enforcement, interpretation or scope of existing laws
could result in material liability to us and have a material adverse effect on our results of operations, financial condition or prospects.
We must manage efficiently the expansion of our direct response business, including the musiciansfriend.com website, our systems that process orders in our direct response business, and our fulfillment resources in order to service our customers properly.
Our direct response business, particularly our e-commerce business, will require significant investments to respond to anticipated growth and competitive pressures. If we fail to rapidly upgrade our website in order to accommodate increased traffic, we may lose customers, which would reduce our net sales. Furthermore, if we fail to expand the computer systems that we use to process and ship customer orders and process payments and the fulfillment facilities we use to manage and ship our inventory, we may not be able to successfully distribute customer orders. We experienced some delays of this sort in 2001 in connection with the consolidation of our fulfillment centers. As a result, we could incur excessive shipping costs due to the need to split delayed shipments, increased marketing costs in the form of special offers to affected customers or the loss of customers altogether. We may experience difficulty in improving and maintaining such systems if our employees or contractors that develop or maintain our key systems become unavailable to us. We have experienced periodic service disruptions and interruptions, which we believe will continue to occur, while enhancing and expanding these systems.
Net sales of our e-commerce business could decrease if our online security measures fail.
Our relationships with our e-commerce customers may be adversely affected if the security measures that we use to protect their personal information, such as credit card numbers, are ineffective. If, as a result, we lose customers, our net sales could decrease. We rely on security and authentication technology that we license from third parties. With this technology, we perform real-time credit card authorization and verification with our bank. We cannot predict whether events or developments will result in a compromise or breach of the technology we use to protect a customer's personal information. Furthermore, our servers may be vulnerable to computer viruses, physical or electronic break-ins and similar disruptions. We may need to expend significant additional capital and other resources to protect against a security breach or to alleviate problems caused by any breaches. We cannot assure that we can prevent all security breaches.
If we do not respond to rapid technological changes, our services could become obsolete and we could lose customers.
If we face material delays in introducing new services, products and enhancements, our e-commerce customers may forego the use of our services and use those of our competitors. To remain competitive, we must continue to enhance and improve the functionality and features of our online store. The Internet and the online commerce industry are rapidly changing. If competitors introduce new products and services embodying new technologies, or if new industry standards and practices emerge, our existing website and proprietary technology and systems may become obsolete. To develop our website and other proprietary technology entails significant technical and business risks. We may use new technologies ineffectively or we may fail to adapt our website, our transaction processing systems and our computer network to meet customer requirements or emerging industry standards. In addition, the success of e-commerce may result in greater efficiency and lower prices, which could have an adverse effect on selling prices and margins in our retail store business and in our catalog business and generally constrain profitability in the specialty retail business.
Our hardware and software systems are vital to the efficient operation of our retail stores and direct response business, and damage to these systems could harm our business.
We rely on our computer hardware and software systems for the efficient operation of our retail stores and direct response business. Our information systems provide our management with real-time inventory, sales and cost information that is essential to the operation of our business. Due to our number of stores, geographic diversity and other factors, we would be unable to generate this information in a timely and accurate manner in the event our hardware or software systems were unavailable. These systems are vulnerable to damage or interruption from a number of factors, including:
•earthquake, fire, flood and other natural disasters; and
•power loss, computer systems failure, Internet and telecommunications or data network failure.
A significant information systems failure could reduce the quality or quantity of operating data available to our management. If this information were unavailable for any extended period of time, our management would be unable to efficiently run our business, which would result in a reduction in our net sales.
To attempt to mitigate these risks we have contracted services from third parties to provide backup systems for our Guitar Center retail stores in the event of a disaster. These services provide for our "mission critical" systems to be online within 48 hours following most disasters. Our direct response business does not have redundant Internet or operating systems and would be vulnerable to catastrophic events. In the event of a disaster, our direct response business would most likely experience delays in processing and shipping orders until we executed our failure recovery plans.
The results of operations of our Direct Response business could be materially adversely affected should the distribution of catalogs and other direct mail become more costly or less effective
Our Direct Response business, Musician's Friend, relies on the United States Postal Service to distribute its catalogs and other direct mail communications to consumers. Should the United States Postal Service significantly tighten security guidelines or impose additional processes on mail to detect or respond to contamination, the expected result would be increased costs to shippers and lengthened delivery times, each of which will impose greater costs on us. We are also concerned that some consumers may dispose of direct mail pieces, such as catalogs, if fears of contamination in the mail system are heightened. Any trend of this sort would reduce the number of catalogs in circulation, reduce response rates, raise costs and decrease margins.
Our stock price could be volatile.
The market price of our common stock has been subject to significant fluctuations in response to our operating results and other factors, including announcements by our competitors, and those fluctuations will likely continue in the future. In addition, the stock market in recent years has experienced significant price and volume fluctuations that often have been unrelated or disproportionate to the operating performance of particular companies. These fluctuations, as well as a shortfall in sales or earnings compared to public market analysts' expectations, changes in analysts' expectations, changes in analysts' recommendations or projections, and general economic and market conditions, may adversely affect the market price of our common stock.
Forward-looking statements contained in this annual report are subject to risks and other uncertainties.
This annual report contains forward-looking statements, relating to, among other things, future results of operations, growth plans (including, without limitation, the number and timing of new store openings, comparable store sales growth and the growth of our e-commerce business), sales, gross
margin and expense trends, capital requirements and general industry and business conditions applicable to us. These statements are based largely on our current expectations and are subject to a number of risks and uncertainties. Our actual results could differ materially from these forward-looking statements. In addition to the other risks described elsewhere in this section, important factors to consider in evaluating these statements include changes in external competitive market factors, changes in our business strategy or an inability to execute our strategy due to unanticipated changes in the music products industry or the economy in general, the emergence of new or growing specialty retailers of music products and various other competitive factors that may prevent us from competing successfully in existing or future markets. In light of these risks and uncertainties, we can not assure you that the forward-looking statements contained in this annual report will in fact be realized. Further, we do not undertake any duty to update the forward-looking statements contained in this annual report, particularly those related to management's future estimates which are subject to revision due to changes in the business environment that we face.
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 American Institute of Certified Public Accountants, and neither our independent public accountants nor any other independent expert or outside party compiles or examines the projections and, accordingly, no such person expresses any opinion or any other form of assurance with respect thereto.
Projections are based upon a number of assumptions and estimates that, while presented with numerical specificity, are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control and are based upon specific assumptions with respect to future business decisions, some of which will change. We generally state possible outcomes as high and low ranges which are intended to provide a sensitivity analysis as variables are changed but are not intended to represent that actual results could not fall outside of the suggested ranges. The principal reason that we release this data is to provide a basis for our management to discuss our business outlook with analysts and investors. We do not accept any responsibility for any projections or reports published by any such persons.
Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions of the projections furnished by us will not materialize or will vary significantly from actual results. Accordingly, our projections are only an estimate of what management believes is realizable as of the date of release. Actual results will vary from the projections and the variations may be material. Investors should also recognize that the reliability of any forecasted financial data diminishes the farther in the future that the data is projected. In light of the foregoing, investors are urged to put the projections in context and not to place undue reliance on them.
Any failure to successfully implement our operating strategy or the occurrence of any of the events or circumstances set forth in this report could result in the actual operating results being different than the projections, and such differences may be adverse and material.
Item 2.
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 241,000 square feet, and our 505,000 square feet Guitar Center retail central distribution center near Indianapolis, Indiana. The terms of the store leases are generally for 10 years and typically allow us to renew for two additional five-year terms. Most of the leases require us to pay property tax, utilities, normal repairs, common area maintenance and insurance expenses.
We lease our corporate offices of approximately 69,600 square feet, which are located at 5795 Lindero Canyon Road, Westlake Village, California 91362. Our direct response business is headquartered in a facility we own located at 931 Chevy Way, Medford, Oregon 97504 and the American Music division is headquartered in a facility we lease located at 7845 Maltage Drive, Liverpool, New York 13090.
Store Locations
The table below sets forth information concerning our Guitar Center and American Music retail stores as of December 31, 2002:
Guitar Center Stores
(1)We have signed leases for these locations and presently expect each to open in 2003. (2)Represents store relocated in 2002. (3)Excludes 10,000 square feet consisting of a basement warehouse space. (4)Excludes 24,000 square feet consisting of a basement warehouse space. (5)Represents stores acquired from M&M in 2002. Item 3.
Item 3. LEGAL PROCEEDINGS
We are involved in various claims and legal actions 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.
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, 2002.
PART II
Item 5.
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:
As of March 6, 2003, there were 462 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 specified financial tests and other conditions are satisfied. In addition, our bank facility with Wells Fargo Retail Finance, LLC and a syndicate of other lenders contains covenants which, among other things, prohibit 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.
Item 6.
Item 6. SELECTED FINANCIAL DATA
The selected data presented below under the captions "Income Statement Data" and "Balance Sheet and Other Data" for, and as of the end of, each of the years in the five-year periods ended December 31, 2002, are derived from the consolidated financial statements of Guitar Center, Inc. and subsidiaries, which financial statements have been audited by KPMG LLP, independent auditors. The consolidated financial statements as of December 31, 2002 and 2001, and for each of the years in the three-year period ended December 31, 2002, and the report thereon, are included elsewhere in this Annual Report. The information presented below under the caption "Operating Data" is unaudited. 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.
Footnotes appear on following page.
Footnotes to table on previous page.
(1)Weighted average shares represents shares calculated on a diluted basis.
(2)Net sales per gross square foot is a measure of sales efficiency based on square footage. This calculation 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 as of the end of the latter reporting period. 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, and depreciation and amortization expense. The reconciliation from reported net income to EBITDA is as follows:
EBITDA is not a measure of financial performance under generally accepted accounting principles. 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, and some of our debt instruments, including our Senior Notes, include covenants that use similar concepts. EBITDA should not, however, 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.
Item 7.
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
As of December 31, 2002, we operated 108 Guitar Center stores, with 96 stores in 40 major markets and 12 stores in secondary markets. 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, through its 20 family music retail stores, is a provider of band instruments and accessories, and primarily focuses on school band and orchestral instrument sales and rentals. The American Music business operates as a division of our retail business.
From 1998 to 2002, our net sales grew at an annual compound growth rate of 22.5%, principally due to the comparable store sales growth of our retail stores averaging 8% per year, the opening of new stores, and a 27.9% 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%, 6%, and 7% for the fiscal years ended December 31, 2002, 2001 and 2000, respectively. We do not expect total or comparable store sales to continue to increase at historical rates, as we already maintain operations in most major markets for our industry, and a higher percentage of our new stores opened will be in secondary markets. We expect that these secondary market stores will contribute lower sales per store than historically achieved from our stores operating in major markets
We opened a total of 12 Guitar Center stores in 2002 and currently anticipate opening approximately 16 to 18 Guitar Center stores in 2003. Some of these Guitar Center stores will be smaller format units designed for secondary markets. We opened a total of eight American Music stores in 2002, five of the eight by acquisition of M&M Music, a band instrument retailer. In addition, we plan to open six to eight American Music stores during 2003, some of which will likely be from 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 brands, 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 our 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. Additionally, the policy described below regarding credits and other vendor allowances is unique to our industry and deserves the attention of a reader of our financial statements.
Valuation of Inventory
We value our inventories 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 associated rental agreement for rent-to-own sales, or over the estimated useful life of the rented instrument for rental only items. We record adjustments to the value of inventory based upon obsolescence and changes in market value. Applicable costs associated with bringing inventory through our Guitar Center retail distribution center are capitalized to inventory. The amounts are expensed to cost of goods sold as the associated inventory is sold. Management has evaluated the current level of inventories considering future customer demand for our products, taking into account general economic conditions, growth prospects within the marketplace, competition, market acceptance of current and upcoming products, and management initiatives. Based on this evaluation, we have recorded adjustments to cost of goods sold for estimated decreases in value. These judgments are made in the context of our customers' shifting needs, social and technological trends, and changes in the demographic mix of our customers. A misinterpretation or misunderstanding of these conditions and uncertainties in the future outlook of our industry or the economy, or other failure to estimate correctly, could result in inventory valuation changes, either favorably or unfavorably, compared to the requirement determined to be appropriate as of the balance sheet date.
Valuation of Long-Lived Assets
Long-lived assets such as property and equipment, goodwill, cost method investments and identifiable intangibles, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Factors we consider important, which could trigger impairment include, among other things:
•Significant underperformance relative to historical or projected operating results;
•Significant changes in the manner of our use of the acquired assets or the strategy of our overall business;
•Significant negative industry or economic trends; and
•Significant decline in stock value for a sustained period.
The determination of whether impairment has occurred is based on an estimate of undiscounted cash flows attributable to the assets at the store level, as compared to the carrying value of the assets. Assumptions used in these cash flows are consistent with internal forecasts and consider current and future expected sales volumes and related operating costs and any anticipated increases or declines based on expected market conditions and local business environment factors. If a potential impairment is identified, the amount of the impairment loss recognized would be determined by estimating the fair value of the assets and recording a loss if the fair value was less than the book value. Fair value will be determined based on appraisal values assessed by third parties, if deemed necessary, or the undiscounted future cash flows as determined above. For cost method investments, we would record a loss when the decline in value is other than temporary. Assets to be disposed of are reported at the lower of the carrying amount or fair value less selling costs.
Our assessment regarding the existence of impairment factors is based on market conditions and the operational performance of our business. Our review of factors present and the resulting appropriate carrying value of our goodwill, intangibles and other long-lived assets are subject to judgments and estimates that management is required to make.
Sales Returns
As part of our "satisfaction guaranteed" policy, we allow Guitar Center customers to return product generally within 30 days after the date of purchase; we allow direct response customers to return product within 45 days. We regularly review and revise, when deemed necessary, our estimates of sales returns based upon historical trends. While our estimates during the past few years have closely approximated actual results, 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.
Credits and Other Vendor Allowances
We receive cooperative advertising allowances (i.e., an allowance from the manufacturer to subsidize qualifying advertising and similar promotional expenditures we make relating to the vendor's products), price protection credits (i.e., credits from vendors with respect to in-stock inventory if the vendor subsequently lowers their wholesale price for such products) and vendor rebates (i.e., credits or rebates provided by vendors based on the purchase of specified products and paid at a later date). Cooperative advertising allowances are recognized as a reduction to selling, general, and administrative expense when we incur the advertising expense eligible for the credit. We recognized cooperative advertising allowances of $4.9 million, $4.5 million and $5.1 million for the years ended December 31, 2002, 2001 and 2000, respectively, recorded as an offset to selling, general and administrative expense. Price protection credits and vendor rebates are accounted for as a reduction of the cost of merchandise inventory and are recorded at the time the credit or rebate is earned. The effect of price protection credits and vendor rebates is recognized in the income statement at the time the related inventory is sold, as a reduction in cost of goods sold. None of these credits are recorded as revenue.
Results of Operations
The following table sets forth current and historical income statement data as a percentage of net sales:
Fiscal 2002 Compared to Fiscal 2001
Net sales for the year ended December 31, 2002 increased 16.0% to $1.1 billion, compared with $949.3 million last year. Net sales from retail stores for fiscal 2002 totaled $892.1 million, a 14.3% increase from $780.8 million in fiscal 2001. Sales from new stores contributed $63.3 million and represent 57.0% of the total increase in retail store sales. Comparable store sales for the full year
increased 6%. The increase in comparable store sales was due to good response to our advertising and marketing for our Guitar Center stores and the closure of a competitor, Mars Music, which was in markets also served by us. Our management is presently anticipating comparable store sales growth of 5% to 7% 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 $208.7 million in 2002, a $40.2 million, or 23.9%, increase from 2001, due primarily to increased orders driven by higher circulation and promotional targeting (15.0%) and an increase in the average order (8.9%). Although catalogs are mailed to both Internet and catalog customers, we continue to see a shifting in customer preference towards placing orders via the Internet. Catalog sales, which consist of all orders placed through the contact center, increased 16.2% to $109.2 million in 2002 from $94.0 million in 2001. Internet sales for the year, which represents orders placed via the Internet, increased 33.5% to $99.5 million from $74.5 million last year.
One of our primary competitors, Mars Music, Inc., filed for federal bankruptcy court protection on September 27, 2002 and has completed a liquidation resulting in the closure of all of its stores. We cannot predict the impact the closure of Mars will have on our business, including how many of the Mars customers will move their shopping to our businesses versus our competitors.
During the second quarter of 2002, we adopted a new accounting policy to conform with EITF 00-10, Accounting for Shipping and Handling Fees and Costs. Prior to adopting EITF 00-10, shipping and handling fees paid by our customers to our direct response division were recognized as a reduction to cost of goods sold. To conform with EITF 00-10, we now treat such fees as revenue. As a result, $13.0 million and $11.1 million of shipping and handling fees were recognized as direct response division revenue in the years 2002 and 2001, respectively. The reclassification of these fees has no effect on operating income, net income or earnings per share for any period. We have made a conforming reclassification in all historical accounting periods to provide a comparable presentation. Please see our Current Report on Form 8-K dated July 25, 2002 for a schedule of the reclassification amounts applied to our historical financial statements in order to implement this accounting policy.
Gross profit dollars for the year ended December 31, 2002 compared to 2001 increased 17.6% to $290.4 million from $247.0 million. Gross profit as a percentage of net sales for the year ended December 31, 2002 compared to 2001 increased to 26.4% from 26.0%. Gross profit as a percentage of net sales for the retail stores in 2002 was 25.6% compared to 25.7% in 2001. The decrease in retail gross margins is primarily due to a change in product mix, which resulted in incrementally higher freight costs (0.2% of sales), increased occupancy costs (0.2% of sales), and planned distribution center costs (0.2% of sales), offset by improved selling margins at our retail stores (0.5%). The gross profit margin for the direct response division was 29.7% for 2002 compared to 27.7% in 2001. The improvement in margin is attributed to better pricing and favorable market conditions compared to the post-9/11 environment in 2001, as well as a shift towards Internet ordering which presents customers with a higher margin assortment of accessories and other low cost products not carried in the catalogs (1.0% of sales). Reduced shipping costs (1.0% of sales) are due to efficiency improvements at the distribution center, including the implementation of marry-up shipping techniques.
Selling, general and administrative expenses for fiscal 2002 increased 17.8% to $236.5 million from $200.7 million in fiscal 2001. As a percentage of net sales, selling, general and administrative expenses for fiscal 2002 increased to 21.5% from 21.1% in fiscal 2001. Selling, general and administrative expenses for the retail stores in 2002 was 21.2% as a percentage of sales compared to 20.7% in fiscal 2001. The increase reflects planned costs associated with the new Guitar Center distribution center near Indianapolis, Indiana (0.3% of sales), increased insurance costs (0.2% of sales), increased travel costs (0.1% of sales), and increased management payroll costs (0.3% of sales), offset by increased leveraging of advertising and payroll costs for the Guitar Center stores (collectively 0.4% of sales). Selling, general and administrative expenses for the direct response division were 22.6% of sales
compared to 23.1% last year. The decrease primarily reflects reduced postage costs related to catalog mailings (0.2% of sales) and improved performance at the warehouse with reduced packing supplies (0.3% of sales) due to the improvement in marry up fill rate and reduction of split shipments.
Operating income, for the reasons stated above, increased 16.6% to $53.9 million from $46.2 million in fiscal 2001. As a percentage of sales, operating income was 4.9% in both years ended December 31, 2002 and 2001, 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 reflected our assessment of the likely future cash flows from the investment in light of the uncertainties regarding the ongoing business of this entity. No similar cost was incurred in 2002.
Interest expense, net for fiscal 2002 decreased to $13.1 million from $13.4 million in fiscal 2001. The decrease is due to lower interest rates applicable to our line of credit borrowings and a $592,000 non-recurring charge in 2001 related to the extension of our line of credit and replacement of one of our former lenders, offset by additional borrowings.
Income tax expense for fiscal 2002 was $15.5 million compared to $12.2 million for the same period last year. In the prior 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. Excluding the effect of the write-off of the minority investment, our effective tax rates for each of the years ending December 31, 2002 and 2001 was 38%.
Net income for fiscal 2002 increased to $25.3 million from $17.0 million in fiscal 2001 as a result of the combinations of factors described above.
Fiscal 2001 Compared to Fiscal 2000
Net sales for the year ended December 31, 2001 increased 19.4% to $949.3 million, compared with $794.8 million in the previous year. Net sales from retail stores for fiscal 2001 totaled $780.8 million, a 19.7% increase from $652.3 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 6%. Net sales from the direct response channel totaled $168.5 million in 2001, a $26.1 million increase from 2000. The growth in direct response sales has been driven by continued increases in Internet sales offset in part by a slight decline in catalog sales. Catalog sales decreased 0.4% to $94.0 million in 2001 from $94.4 million in 2000. Internet sales for the year increased 55.2% to $74.5 million from $48.0 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 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.
During the second quarter of 2002, we adopted a new accounting policy to conform with EITF 00-10, Accounting for Shipping and Handling Fees and Costs. Prior to adopting EITF 00-10, shipping and handling fees paid by our customers to our direct response division were recognized as a reduction to cost of goods sold. To conform with EITF 00-10, we now treat such fees as revenue. As a result, $11.1 million and $9.1 million of shipping and handling fees were recognized as direct response division revenue in the years 2001 and 2000, respectively. The reclassification of these fees has no effect on operating income, net income or earnings per share for any period. We have made a conforming reclassification in all historical accounting periods to provide a comparable presentation. Please see our Current Report on Form 8-K dated July 25, 2002 for a schedule of the reclassification amounts applied to our historical financial statements in order to implement this accounting policy.
Gross profit dollars for the year ended December 31, 2001 compared to 2000 increased 20.5% to $247.0 million from $204.9 million. Gross profit as a percentage of net sales for the year ended December 31, 2001 compared to 2000 increased to 26.0% from 25.8%. 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 27.7% for 2001 compared to 27.9% 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.
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 21.1% from 19.7% 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 in 2001 were 23.1% of sales compared to 20.9% in fiscal 2000. 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 reflected 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 fiscal 2001 was $12.2 million compared to $13.3 million for the same period in fiscal 2000. 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.
Liquidity and Capital Resources
Our need for liquidity will arise primarily from the funding of capital expenditures, working capital requirements and payments on our indebtedness, as well as possible acquisitions. We have historically financed our operations primarily through internally generated funds and borrowings under our credit facilities. Please see Item 1. Business-"Risks Related to the Business" 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, 2002, we had $82.7 million outstanding under the credit facility, excluding $2.6 million outstanding on letters of credit, and had available borrowings of $77.0 million.
The credit facility permits borrowings up to $200 million, subject to borrowing base limitations ($162.3 million at December 31, 2002). The actual amount available is tied to our inventory and receivable base, and repayment obligations under the credit facility are secured by liens on our principal assets. 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 (4.75% at December 31, 2002), or at LIBOR plus an applicable margin rate (4.00% at December 31, 2002), 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 a minimum annual interest rate of 4.00%. The applicable interest rate at December 31, 2002 was LIBOR plus 2.00%. The agreement underlying the credit facility includes significant restrictive negative covenants. Among other things, these covenants restrict our ability to incur debt and issue specified equity instruments, incur liens on our assets, make any significant change in our corporate structure or the nature of our business, dispose of assets, make guaranties, prepay debt, engage in a change in control transaction, pay dividends, make investments or acquisitions, engage in transactions with affiliates and incur capital expenditures, and also require that we satisfy specified financial requirements including a tangible net worth test and a minimum availability test. Under the tangible net worth test, we are required to maintain, as of each quarter end, a minimum level of tangible net worth which, under the agreement, is defined as stockholders' equity, less goodwill, plus $3.5 million (or $132.4 million at December 31, 2002). The minimum amounts required by the agreement increase on a quarterly basis and are $112.0 million at December 31, 2002, $115.0 million at March 31, 2003, $118.0 million at June 30, 2003, $122.0 million at September 30, 2003, $134.0 million at December 31, 2003 and $155.0 million at March 31, 2004 and thereafter. The minimum availability test requires that we maintain $10.0 million of reserved availability under the agreement based on its borrowing base limitations. The amount we disclose in our public reports from time to time as available to borrow under the agreement ($77.0 million at December 31, 2002) is already reduced by this required reserve and thus represents a net amount available under the agreement. The agreement also includes representations and warranties which must be true each time we borrow funds under the credit facility and affirmative covenants. The full text of the contractual requirements imposed by this financing is set forth in the Amended and Restated Loan and Security Agreement which has been filed with the Securities and Exchange Commission. We were in compliance with such requirements as of December 31, 2002. Subject to limited cure periods, the lenders under our credit facility may demand repayment of these borrowings prior to stated maturity upon the occurrence of specified events, including if we breach the terms of the agreement, suffer a material adverse change, engage in a change in control transaction, suffer a significant adverse legal judgment, default on other significant obligations, or in the event of specified events of insolvency. The credit agreement matures in December 2005.
The Senior Notes, which are unsecured obligations, are governed by an indenture. The indenture requires that we pay interest at a rate of 11% per annum in semi-annual coupons due on each July 1 and January 1, with all outstanding principal due and payable in July 2006. We have the right to prepay some or all of the notes at any time for an amount equal to principal, accrued interest and a premium, subject to a notice requirement. The premium is presently 3.667% of the principal amount redeemed, but reduces to 1.833% on July 1, 2003 and to zero from and after July 1, 2004. In the event of a change in control transaction, the holders of the Senior Notes may require repayment of the principal and accrued interest plus a 1.0% premium. The indenture includes restrictive covenants. Among other things, these covenants restrict our ability to incur debt and issue specified equity instruments, incur liens on our assets, make any significant change in our corporate structure or the nature of our business, pay dividends, make investments, make guaranties, and dispose of assets. The full text of the
contractual requirements imposed by this financing is set forth in the indenture which has been filed with the Securities and Exchange Commission. We were in compliance with such requirements as of December 31, 2002. Subject to limited cure periods, the holders of the Senior Notes may demand repayment of these borrowings prior to stated maturity upon the occurrence of specified events, including if we breach the terms of the indenture, in the event of specified events of insolvency, if we suffer a significant adverse legal judgment or if other significant obligations are accelerated.
The terms of our significant financing agreements, including those related to our credit facility, the Senior Notes and the equipment lease facilities described below, are not dependent on any change in our credit rating. We believe that the key company-specific factors affecting our ability to maintain our existing debt and lease financing relationships and to access such capital in the future are our present and expected levels of profitability and cash flow from operations, our working capital and fixed asset collateral bases, our expected level of capital expenditures, and the level of equity capital of the company relative to the level of debt obligations. In addition, as noted above, our existing agreements include significant restrictions on future financings, including among others, limits on the amount of indebtedness that we may incur and whether or not such indebtedness may be secured by any of our assets.
During the first quarter of 2002, we entered into master operating lease agreements with General Electric Capital Corporation and US Bank to lease equipment and other property primarily to support the operations of the new central distribution center for our Guitar Center retail stores. Under these agreements, we leased a total of $10.5 million in equipment and other property. The agreement calls for monthly payments to General Electric Capital Corporation of $138,000 for a term of 36 months through September 1, 2005, and monthly payments to US Bank of $48,000 for a term of 12 months through December 28, 2003. The leases have options to extend through September 30, 2009 and December 28, 2005, respectively.
As is the case with most multi-unit retailers, substantially all of the real property used in our business is leased under operating lease agreements. Please see, Item 2. Properties, "-Disclosures About Contractual Obligations and Commercial Commitments" and Note 8 to our financial statements.
For the year ended December 31, 2002, cash provided by operating activities was $12.2 million, most of which represented cash income from operations, net of additions to inventory. Cash used in investing activities totaled $32.2 million, which primarily consisted of capital expenditures for retail store expansions and computer equipment purchases ($26.3 million), and acquisitions ($5.9 million). Cash provided by financing activities totaled $8.4 million, which consisted principally of borrowings under our credit facility.
Our principal working capital need is to provide for the inventory levels necessary to support our sales activities, particularly the Guitar Center retail stores. Inventory increased from $249.7 million to $292.1 million, or 17.0%. The increase in inventory was required principally to support existing sales growth, the opening of new retail locations and the opening of the new Guitar Center retail distribution center. Inventory per square foot at Guitar Center retail stores (Guitar Center store and distribution center inventories under GAAP divided by total store retail square footage on a given date) was $140 at December 31, 2002 compared to $134 in 2001. 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. Inventory increased from $29.5 million at December 31, 2001 to $30.2 million at December 31, 2002, or 2.1%, against increased sales of 23.9%, for the direct response division, reflecting increased inventory turns.
We provide limited credit to corporate customers and similar house accounts on a current account basis. We generally do not provide credit to our retail customers but instead offer programs provided by third party consumer credit companies which are non-recourse to us, meaning that the risk of
non-payment is borne by the third party provider so long as we comply with its administrative and approval policies. From time to time we participate in programs that provide our customers with below-market interest rates, deferred payments or similar benefits. These programs are also non-recourse to us but we pay the credit provider a fee which is recognized as a component of selling, general and administrative expense at the time of the sale to the consumer.
We intend to pursue an aggressive growth strategy by opening additional stores in new and existing markets. During 2002, we opened 12 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 9 more had been opened as of December 31, 2002. Our small format stores have typically incurred approximately $560,000 in capital expenditures and require approximately $1.1 million to $1.2 million 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 our retail and direct response divisions as well as related businesses. In July 2000, we 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 distribution center in the Indianapolis, Indiana area to support our Guitar Center retail store operations. The facility commenced operations in July 2002. We have entered into a 10-year agreement to lease the facility and we also have entered into numerous additional commitments necessary to support the operations of the facility. As of December 31, 2002, nearly all product was flowing through the distribution facility, with the exception of special orders which will continue, for the most part, to be drop shipped to our stores. Migration from our former "drop-ship" model to a centralized distribution model is an important development in our operating strategy and has required the allocation of significant financial and managerial resources. In accordance with generally accepted accounting principles, a portion of the costs of operating this facility are absorbed into our Guitar Center merchandise inventories and recognized as an element of cost of goods sold when the related inventory is sold. This could result in a slight decrease in reported gross margin depending on our success in defraying these additional costs, although we also expect to realize efficiencies involving other costs such as selling, general and administrative and interest expense.
We also continue to make significant investments in information technology across our businesses and to incur costs and make investments designed to expand the reach of our businesses on the Internet. The costs of these initiatives and other investments related to our businesses will continue to be significant.
During 2003, we expect to incur approximately $28 million to $30 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 12 Guitar Center stores in 2002 and 13 stores in 2001, and currently anticipate opening approximately 16 to 18 Guitar Center stores in 2003. Some of these stores will be smaller format units designed for secondary markets. We opened a total of eight American Music stores in 2002, five of the eight by acquisition of M&M Music, a band instrument and retail merchandise retailer. During 2003, we plan to open six to eight American Music stores, some which will likely 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 2003 are presently expected to be primarily provided by net cash flow from operations and additional borrowings under our credit facility. 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.
Disclosures about Contractual Obligations and Commercial Commitments
The following table aggregates all material contractual obligations and commercial commitments that affect our financial condition and liquidity as of December 31, 2002:
(1)Long-term debt consists principally of the unsecured Senior Notes and the revolving line of credit. The Senior Notes bear interest at 11% per annum, with interest due on a semi-annual basis, and mature on July 1, 2006. The revolving line of credit provides for a maximum facility of $200,000,000, subject to 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 and other sources of capital, if any. 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. (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 rented personal property through operating leases. Payments for these lease commitments are provided for by cash flows generated from operations. Please see Note 8 to the consolidated financial statements. (3)Other long-term liabilities consist of our outstanding standby letters of credit at December 31, 2002. New Accounting Pronouncements
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 obligations of lessees. The standard was effective for financial statements issued for fiscal years beginning after June 15, 2002. We adopted this standard effective January 1, 2003, and it did not have a material effect on our consolidated financial statements.
In July 2002, the FASB issued Statement No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This standard requires companies to recognize costs associated with exit or disposal plans. This statement is effective prospectively to exit or disposal activities initiated after December 31, 2002. Early adopting is permitted. We adopted SFAS No. 146 effective August 1, 2002, and the adoption of this standard did not have an impact on our consolidated financial statements.
In December 2002, the Financial Accounting Standards Board issued Statement No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123" (SFAS No. 148). SFAS No. 148 amends Statement No. 123, "Accounting for Stock-Based Compensation" (SFAS No. 123), to provide alternative methods of transition for enterprises that elect to change to the SFAS No. 123 fair value method of accounting for stock-based employee compensation. SFAS No. 148 permits two additional transition methods for entities that adopt the preferable SFAS No. 123 fair value method of accounting for stock-based employee compensation. Both of those methods avoid the ramp-up effect arising from prospective application of the fair value method under the existing transition provisions of SFAS No. 123. In addition, under the provisions of SFAS No. 148, the original Statement No. 123 prospective method of transition for changes to the fair value method is no longer permitted in fiscal periods beginning after December 15, 2003. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The disclosures to be provided in annual financial statements are required for fiscal years ended after December 15, 2002, and the disclosures to be provided in interim financial reports will be required for interim periods begun after December 15, 2002, with earlier application encouraged. We adopted SFAS No. 148 effective December 2002, which did not have a material effect on our consolidated financial statements.
In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46). This interpretation clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements" (ARB 51), and requires companies to evaluate variable interest entities for specific characteristics to determine whether additional consolidation and disclosure requirements apply. This interpretation is immediately applicable for variable interest entities created after January 31, 2003, and applies to fiscal periods beginning after June 15, 2003 for variable interest entities acquired prior to February 1, 2003. We do not expect that the adoption of this interpretation will have any impact on our financial position or results of operations.
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, new store openings, and capital expenditure levels. 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. Comparable 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, reformat their store model and build-out the information and management structure.
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 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.
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, 2002, we had $82.7 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 2002, 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.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the index included at "Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K."
Item 9.
Item 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not Applicable
PART III
Item 10.
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.
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.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this item is incorporated by reference into our definitive Proxy Statement to be filed pursuant to Regulation 14A under the Exchange Act in connection with our annual meeting of stockholders.
Item 13.
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.
Item 14.
Item 14. CONTROLS AND PROCEDURES
Within 90 days prior to the date of this report, our company carried out an evaluation, under the supervision and with the participation of our management, including our Co-Chief Executive Officers and Chief Financial Officer, of the effectiveness and design of our disclosure controls and procedures (as defined in Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934). Based on the foregoing, our Co-Chief Executive Officers and Chief Financial Officer concluded that such disclosure controls and procedures were effective. There have been no significant changes in internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
PART IV
Item 15.
Item 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K
(a)Documents filed as part of this Report:
(b)On November 14, 2002 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 (*).
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 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 for the quarterly period ended September 30, 2001).
3.4
Amendment to the Company's Amended and Restated Bylaws adopted February 25, 2003 (filed herewith)
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 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).
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; Registration 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; Registration 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 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 for the quarterly 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).
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).
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 10.36 of the Company's Annual Report Form 10-K 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 Aril 26, 2001 (Incorporated by reference to Exhibit 10.37 to the Company's Quarterly Report on Form 10-Q 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 Form 10-Q for the 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 for the quarterly period ending 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 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 (Incorporated by reference to Exhibit 10.22 to the Company's Annual Report on Form 10-K for the year ended December 31, 2001).
10.23*
Amended and Restated Employment Agreement between the Company and Larry Thomas, effective as of June 6, 2001, with exhibits (Incorporated by reference to Exhibit 10.23 to the Company's Annual Report on Form 10-K for the year ended December 31, 2001).
10.24*
Amended and Restated Employment Agreement between the Company and Barry Soosman, effective as of June 6, 2001, with exhibits (Incorporated by reference to Exhibit 10.24 to the Company's Annual Report on Form 10-K for the year ended December 31, 2001).
10.25*
Amended and Restated Employment Agreement between the Company and Bruce Ross, effective as of June 6, 2001, with exhibits (Incorporated by reference to Exhibit 10.25 to the Company's Annual Report on Form 10-K for the year ended December 31, 2001).
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 for the quarterly period ended September 30, 2201).
10.27
Lease Agreement, dated as of August 15, 2001, by and between Guitar Center Stores, Inc. and Eaglepoint Partners Two, LLC (Incorporated by reference to Exhibit 10.27 to the Company's Annual Report on Form 10-K for the year ended December 31, 2001).
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 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 (Incorporated by reference to Exhibit 10.29 to the Company's Annual Report on Form 10-K for the year ended December 31, 2001).
10.30
Second Amendment 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 (Incorporated by reference to Exhibit 10.30 to the Company's Annual Report on Form 10-K for the year ended December 31, 2001).
10.31
Master Lease Agreement, dated as of March 4, 2002, between Guitar Center, Inc. and General Electric Capital Corporation (Incorporated by reference to Exhibit 10.31 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2002).
10.32
Annex II to the Stock Purchase Agreement, dated June 14, 2002, by and among Guitar Center, Inc., Guitar Center Stores, Inc., M&M Music Ltd. And the stockholders of M&M Music Ltd. relating to the registration of Guitar Center, Inc. common stock under the Securities Act of 1933 (Incorporated by reference to Exhibit 10.32 to the Company's Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2002).
12.1
Ratio of Earnings to Fixed Charges
21.1
Material subsidiaries of the Registrant as of December 31, 2002:
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 47)
*Management contract or other compensation plan or arrangement.
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 14th day of March 2003.
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 14, 2003
/s/ MARTY ALBERTSON Marty Albertson
President & Co-Chief Executive Officer and Director
March 14, 2003
/s/ BRUCE ROSS Bruce Ross
Executive Vice President, Chief Financial Officer and Secretary (Principal Financial Officer)
March 14, 2003
/s/ ERICK MASON Erick Mason
Executive Vice President, Chief Administrative Officer (Principal Accounting Officer)
March 14, 2003
/s/ ROBERT EASTMAN Robert Eastman
Chief Executive Officer, Musician's Friend, Director
March 14, 2003
/s/ DAVID FERGUSON David Ferguson
Director
March 14, 2003
/s/ LARRY LIVINGSTON Larry Livingston
Director
March 14, 2003
/s/ GEORGE MRKONIC George Mrkonic
Director
March 14, 2003
/s/ PETER STARRETT Peter Starrett
Director
March 14, 2003
/s/ JEFFREY WALKER Jeffrey Walker
Director
March 14, 2003
CERTIFICATIONS
I, Larry Thomas, certify that:
1. I have reviewed this annual report on Form 10-K of Guitar Center, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 14, 2003
By /s/ LARRY THOMAS Larry Thomas
Co-Chief Executive Officer
CERTIFICATIONS
I, Martin Albertson, certify that:
1. I have reviewed this annual report on Form 10-K of Guitar Center, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 14, 2003
By /s/ MARTY ALBERTSON Marty Albertson
Co-Chief Executive Officer
CERTIFICATIONS
I, Bruce Ross, certify that:
1. I have reviewed this annual report on Form 10-K of Guitar Center, Inc.;
2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report;
3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent function):
a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and
6. The registrant's other certifying officers and I have indicated in this annual report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
Date: March 14, 2003
By /s/ BRUCE ROSS Bruce Ross
Chief Financial Officer
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, 2002 and 2001 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, 2002. 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, 2002 and 2001 and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002 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.
As discussed in Note 15 to the consolidated financial statements, effective January 1, 2002, the Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 142, "Goodwill and Other Intangible Assets."
KPMG LLP
Los Angeles, California
February 11, 2003
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 auditors 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 independent Directors. The Committee meets periodically with financial management and the independent auditors to review accounting, internal control, auditing and financial reporting matters.
Larry Thomas
Chairman &
Co-Chief Executive Officer
Marty Albertson
President &
Co-Chief Executive Officer
Bruce Ross
Executive Vice President &
Chief Financial Officer
Los Angeles, California
February 11, 2003
GUITAR CENTER, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
GUITAR CENTER, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share data)
See accompanying notes to consolidated financial statements.
GUITAR CENTER, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In thousands)
See accompanying notes to consolidated financial statements.
GUITAR CENTER, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
See accompanying notes to consolidated financial statements.
GUITAR CENTER, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002
1. Nature of Business and Significant Accounting Policies
Nature of Business
Guitar Center, Inc. and subsidiaries (the "company" or "we") operates a chain of retail stores and a direct response unit which sells musical instruments, primarily guitars, amplifiers, percussion instruments, keyboards, pro-audio, recording equipment, and band and orchestral instruments. At December 31, 2002, we operated 108 Guitar Center stores and 20 American Music stores in major cities throughout the United States, with 22 of the stores located in California.
Principles of Consolidation
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.
Reclassifications
Reclassifications have been made to prior year amounts to conform with the current year's presentation. During the second quarter of 2002, we adopted a new accounting policy to conform with EITF 00-10, "Accounting for Shipping and Handling Fees and Costs". Prior to adopting EITF 00-10, shipping and handling fees paid by our customers to our direct response division were recognized as a reduction to cost of goods sold. To conform with EITF 00-10, we now treat such fees as revenue. As a result, $13.0 million, $11.1 million and $9.1 million of shipping and handling fees were recognized as direct response revenue in the fiscal years 2002, 2001 and 2000, respectively. The reclassification of these fees has no effect on operating income, net income or earnings per share for any period.
Merchandise Inventories
Inventories, including used merchandise and vintage guitars, are valued at the lower of cost or market using the first-in, first-out (FIFO) method. Applicable costs associated with bringing inventory through our Guitar Center retail distribution center are capitalized to inventory. The amounts are expensed to cost of goods sold as the associated inventory is sold. 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. We receive price protection credits and vendor rebates from vendors, which are accounted for as a component of merchandise inventory and are recorded at the time the credit or rebate is earned. The effect of price protection credits and vendor rebates is recognized in the income statement as an effective reduction in cost of goods sold at the time the related item of inventory is sold. None of these credits are recorded as revenue.
Property and Equipment
Property and equipment is 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.
Goodwill
Goodwill represents the excess of the purchase price over the fair value of the net assets acquired resulting from business acquisitions and was historically amortized over a 20 to 30 year period using the straight-line method. In the current year we adopted SFAS No. 142 which no longer requires the periodic amortization of goodwill. As of December 31, 2002 we had unamortized goodwill in the amount of $26.0 million and unamortized identifiable intangible assets in the amount of $325,000. We have tested goodwill and intangible assets for impairment under the provisions of SFAS No. 142 and these tests indicated that there was no impairment. Net income for the years ended December 31, 2001 and 2000, had SFAS No. 142 been in effect, would have been $17.5 million and $22.6 million, respectively, compared to reported net income of $17.0 million and $22.5 million, respectively. Basic and fully diluted earnings per share for the year ended December 31, 2001, if SFAS No. 142 had been in effect, would have both improved by $0.02, and basic and fully diluted earnings per share for the year ended December 31, 2000 would have remained consistent and improved by $0.01, respectively.
Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of
Long-lived assets and 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. In 2002, no impairment was identified.
Merchandise Advances
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.
Self-Insurance Reserves
In 2002, we began to maintain a self-insurance program for workers' compensation. Estimated costs under this program, including incurred but not reported claims are recorded as expenses based upon actuarially determined historical experience and trends of paid and incurred claims. Self-insurance reserves amounted to $789,000 at December 31, 2002 and are included in accrued liabilities.
Revenue Recognition
Retail sales are recognized at the time of sale, net of a provision for estimated returns. Band instrument rentals are recognized on a straight-line basis over the term of the rental agreement. The
terms of the majority of our rental agreements do not exceed 30 months. Direct response sales are recognized when the products are shipped and title passes to customers, net of a provision for estimated returns. Direct response items sold to customers are made pursuant to a sales contract that provides for transfer of both title and risk of loss upon the Company's delivery to the carrier (commonly referred to as "F.O.B. Shipping Point"). Return allowances are estimated using historical experience.
Advertising Costs
We expense retail advertising as incurred. Advertising expense included in the consolidated statements of income for the years ended December 31, 2002, 2001 and 2000 is $35.0 million, $34.8 million, and $27.9 million, respectively. 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." Capitalized mail order catalog costs at December 31, 2002, 2001 and 2000 were $1.9 million, $1.7 million and $1.6 million, respectively. The realizability of the capitalized mail order catalog costs are evaluated at each balance sheet date by comparing the carrying amount of such assets on a cost-pool-by-cost-pool basis to the probable remaining future net revenues expected to result directly from such advertising. If the carrying amounts of such deferred mail order catalog costs exceed the remaining future net revenues that probably will be realized from such catalog, the excess capitalized amount is written down and expensed in the current period. There was no write-down of capitalized mail order catalog costs for the years ended December 31, 2002, 2001 and 2000.
We receive cooperative advertising allowances from manufacturers in order to subsidize qualifying advertising and similar promotional expenditures we make relating to the vendor's products. These advertising allowances are recognized as a reduction to selling, general and administrative expense when we incur the advertising expense eligible for the credit. We recognized cooperative advertising allowances of $4.9 million, $4.5 million and $5.1 million for the years ended December 31, 2002, 2001 and 2000, respectively.
Rent Expense
We lease the majority of our 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 minimum rent and reduced in later years when the actual cash payment requirements exceed the straight-line expense.
Income Taxes
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.
Store Pre-Opening Costs
The costs of start-up activities for new store openings are expensed as incurred.
Stock Option Plans
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. 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:
Earnings Per Share
The following table summarizes the reconciliation of Basic to Diluted Weighted Average Shares for the years ended December 31, 2002, 2001 and 2000:
Options to purchase 1.3 million shares of Common Stock at prices ranging from $16.23 to $28.56, options to purchase 1.3 million shares of Common Stock at prices ranging from $15.94 to $28.56, and options to purchase 1.4 million shares of Common Stock at prices ranging from $12.33 to $28.56 were outstanding during fiscal 2002, 2001 and 2000, 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.
Concentration of Credit Risk
Our deposits are with various high quality financial institutions. Customer purchases are transacted generally using cash or credit cards. In various instances, we grant credit for larger purchases, generally to professional musicians, under normal trade terms. Trade accounts receivable were approximately
$5.2 million and $4.3 million at December 31, 2002 and 2001, respectively. Credit losses have historically been within our expectations.
Fair Value of Financial 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, 2002 the fair value of our long-term debt was $69.1 million, based on quoted market prices. As discussed at Note 7, a cost-based investment 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.
Use of Estimates in the Preparation of Financial Statements
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.
New Accounting Pronouncements
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 various obligations of lessees. The standard is effective for financial statements issued for fiscal years beginning after June 15, 2002. We adopted this standard effective January 1, 2003, and it did not have a material effect on our consolidated financial statements.
In July 2002, the FASB issued Statement No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." This standard requires companies to recognize costs associated with exit or disposal plans. This statement is effective prospectively to exit or disposal activities initiated after December 31, 2002. Early adoption is permitted. We adopted SFAS No. 146 effective August 1, 2002, and the adoption of this standard did not have an impact on our consolidated financial statements.
In December 2002, the Financial Accounting Standards Board issued Statement No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosure-an amendment of FASB Statement No. 123" (SFAS No. 148). SFAS No. 148 amends Statement No. 123, "Accounting for Stock-Based Compensation" (SFAS No. 123), to provide alternative methods of transition for enterprises that elect to change to the SFAS No. 123 fair value method of accounting for stock-based employee compensation. SFAS No. 148 permits two additional transition methods for entities that adopt the preferable SFAS No. 123 fair value method of accounting for stock-based employee compensation. Both of those methods avoid the ramp-up effect arising from prospective application of the fair value method under the existing transition provisions of SFAS No. 123. In addition, under the provisions of SFAS No. 148, the original Statement 123 prospective method of transition for changes to the fair value method is no longer permitted in fiscal periods beginning after December 15, 2003. SFAS No. 148 also amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The disclosures to be provided in annual financial statements are required for fiscal years ended after December 15, 2002, and the disclosures to be provided in interim financial reports will be required for interim periods begun after December 15, 2002, with earlier application encouraged. We adopted SFAS No. 148 which did not have any impact on our consolidated financial statements.
In January 2003, the Financial Accounting Standards Board issued FASB Interpretation No. 46, "Consolidation of Variable Interest Entities" (FIN 46). This interpretation clarifies the application of Accounting Research Bulletin No. 51, "Consolidated Financial Statements" (ARB 51), and requires companies to evaluate variable interest entities for specific characteristics to determine whether additional consolidation and disclosure requirements apply. This interpretation is immediately applicable for variable interest entities created after January 31, 2003, and applies to fiscal periods beginning after June 15, 2003 for variable interest entities acquired prior to February 1, 2003. We do not expect that the adoption of this interpretation will have any impact on our financial position or results of operations.
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 ("American Music"). In consideration of the purchase, we paid $28.5 million in net cash and issued 115,358 shares of Guitar Center common stock for $2.1 million. We acquired assets of $22.6 million and assumed or repaid liabilities of $8.5 million. Goodwill of $16.5 million was recorded. The acquisition was accounted for using the purchase method. As part of the terms of the purchase agreement, there was a $2.5 million holdback on the transaction, pending the American Music business meeting operating objectives in 2001. During the first quarter of 2002, 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 previous owners of American Music in full satisfaction of our obligations under the holdback arrangement. The amount was recorded as additional goodwill.
In February 2002, we acquired the inventory and assumed the customer credit liabilities of Music Loft East, Inc., a single store located in Raleigh, North Carolina. In connection with the purchase we paid $488,000 in cash, acquired assets with a fair value of $369,000, and assumed liabilities of $146,000. Goodwill in the amount of $265,000 was recorded.
On June 14, 2002, we acquired M&M Music, a five-store band instrument retailer headquartered in Valdosta, Georgia. Under the terms of the agreement, we acquired the stock of M&M Music for total consideration of up to $6.0 million. We acquired assets with a fair value of $4.4 million and assumed liabilities and paid expenses of $1.3 million. Goodwill in the amount of $2.9 million was recorded. Under the terms of the purchase agreement, during the second quarter of 2002 we paid $3.6 million in cash and during the third quarter we issued 90,602 shares of Guitar Center stock, representing $1.5 million. As part of the terms of the purchase agreement, there was a $0.9 million holdback on the transaction, pending the M&M Music business meeting balance sheet requirements. During the fourth quarter of 2002, it was determined that the requirements subject to the holdback were satisfied and we issued an additional 54,360 in stock in consideration for the remaining $0.9 million of the purchase price.
The results of operations of American Music, the assets of the Raleigh store and M&M Music were not material to Guitar Center's previously presented consolidated financial statements and, as such, pro-forma financial information is not presented. The results of operations for each of these entities are included in Guitar Center's consolidated financial statements from the dates of the acquisition.
Goodwill was recorded on the American Music, Music Loft and M&M Music acquisitions in the amount of the total consideration paid in excess of the fair value of the identifiable assets acquired. Through December 31, 2001, we amortized goodwill over twenty years. Please see Note 1 for a description of significant changes in the accounting for goodwill implemented in 2002.
3. Merchandise Inventories
The major classes of merchandise inventories are as follows:
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:
5. Debt
At December 31, 2002, 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, as of December 31, 2002 through July 31, 2006, at prices declining from 103.7% to 100.0% of the 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 ($162.3 million at December 31, 2002), 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 (4.75% at December 31, 2002), or at LIBOR plus an applicable margin rate (4.00% at December 31, 2002), 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, 2002 was LIBOR plus 2.00%. At December 31, 2002, we had $82.7 million outstanding on the line of credit, $2.6 million outstanding on letters of credit, and $77.0 million in available borrowings.
Assets of our Company secure the credit facility and the actual amount available to borrow is tied to our inventory and receivable base.
The agreements underlying the credit facility and Senior Notes include restrictive covenants. We were in compliance with such requirements as of December 31, 2002.
For the years ended December 31, 2002, 2001 and 2000, $664,000, $556,000, and $408,000 of amortization of deferred financing fees was included in interest expense. $2.2 million and $2.5 million of capitalized deferred financing fees was included in other assets, net of accumulated amortization of $2.1 million and $1.4 million, at December 31, 2002 and 2001, respectively.
6. Segment Information
Our reportable business segments are retail (Guitar Center and American Music 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 (benefit). Accounting policies of the segments are the same as the accounting policies for the consolidated Company. There are no differences between the measurements of profits or losses or assets of the reportable segments and those of the Company on a consolidated basis.
Net sales, depreciation and amortization, income before income taxes, capital expenditures, and total assets are summarized as follows for the years ended December 31, 2002, 2001 and 2000 (in thousands):
7. Investment in Non-Consolidated Entity
At December 31, 2001, we had an investment through a wholly-owned subsidiary, Musician's Choice, Inc., of approximately $3.5 million, in a non-consolidated entity, Musician.com Internet Network, Inc. ("Musician.com"). As of December 31, 2001, we owned approximately 14% of the voting stock of Musician.com. As of this date 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 operated
community-based musician websites which went out of business in 2002. We accounted 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, our distribution centers and various personal property used in our business under operating leases which expire at varying dates through December 2017. Generally, the agreements contain provisions which require us to pay for normal repairs and maintenance, property taxes and insurance.
The total minimum lease commitment at December 31, 2002, under operating leases, is as follows:
Total rent expense included in the consolidated statements of income for the years ended December 31, 2002, 2001 and 2000 is $26.3 million, $20.1 million and $15.6 million, 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. At our discretion, we can make matching contributions to the Plan, which will be a uniform percentage of the eligible employees' contributions. We may also, at our discretion, make profit-sharing contributions to the Plan. The profit-sharing contributions shall be allocated based on the relative compensation of all eligible employees. Plan expense was $1.2 million, $712,000 and $433,000 for the years ended December 31, 2002, 2001 and 2000, respectively.
10. Stock Option and Purchase Plans
1996 Performance Stock Option Plan
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. Under the 1996 Plan, the number of options available for grant was 713,782, with a maximum term of ten years and an exercise price equal to the fair market value ($10.89 per share) of the underlying stock at the date of grant. The options generally vested ratably over three years. At December 31, 2002, options to purchase 377,984 shares of common stock were outstanding. No additional options are available for grant under the 1996 Plan.
Management Stock Option Agreements
In June 1996, we granted options to two officers to purchase 795,970 shares at an exercise price of $10.89 per share with a term of ten years. 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, 2002, all options granted were outstanding and exercisable.
1997 Equity Participation Plan
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 with a maximum life of ten years. As of December 31, 2002, options to purchase 3,224,009 shares of common stock were outstanding under the 1997 Plan, and 1,510,944 shares were exercisable with exercise prices ranging from $8.34 to $28.56 and a weighted average exercise price of $17.41.
Included in the options outstanding are options to purchase 88,489 shares of common stock that were assumed in connection with the merger with Musician's Friend.
Employee Stock Purchase Plan
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, 2002, 78,994 shares had been purchased under the ESPP Plan at a weighted-average price of $12.09 per share.
We apply APB Opinion No. 25 in accounting for our plans. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant.
Stock option activity for all plans during the periods presented is as follows:
The following is a summary of stock options outstanding and exercisable at December 31, 2002:
11. Income Taxes
Total income taxes (benefit) for the years ended December 31, 2002, 2001 and 2000 consist of:
Actual income taxes for 2002, 2001 and 2000 differ from the statutory tax rate of 35% as applied to income before income taxes as follows:
The tax effects of temporary differences that give rise to significant portions of deferred tax assets and liabilities are presented below:
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, 2002, the deferred tax valuation allowance increased by $19,000 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.
12. Accrued Expenses and Other Current Liabilities
13. Legal
We are involved in various claims and legal actions 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)
15. Goodwill and Other Intangible Assets
Amortization expense related to goodwill and other intangible assets was $827,000 and $219,000 for the years ended December 31, 2001 and 2000, respectively. The following table reconciles previously reported net income as if the provisions of SFAS No. 142 were in effect at 2001 and 2000:
Schedule II
GUITAR CENTER, INC. AND SUBSIDIARIES
VALUATION AND QUALIFYING ACCOUNTS
Years ended December 31, 2002 and 2001
(amounts in thousands)
II-1
PART II
PART III
PART IV
INDEX TO EXHIBITS
SIGNATURES
CERTIFICATIONS
CERTIFICATIONS
CERTIFICATIONS
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, 2002