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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from __________________ to ___________________
COMMISSION FILE NUMBER 000-22207
GUITAR CENTER, INC.
(Exact name of registrant as specified in charter)
DELAWARE 95-4600862
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
5155 CLARETON DRIVE 91301
AGOURA HILLS, CALIFORNIA (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (818) 735-8800
Securities registered pursuant to 12(b) of the Act:
NONE
Securities registered pursuant to 12(g) of the Act:
COMMON STOCK, $.01 PAR VALUE
(Title of Class)
Check if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
As of March 9, 1999, the aggregate market value of voting stock held by
nonaffiliates of the Company was approximately $205,200,000 (based upon the
last reported sales price of the Common Stock on such date as reported by the
Nasdaq National Market). Shares of Common Stock held by each executive officer,
director, holder of greater than 10% of the outstanding Common Stock of the
Registrant and person or entity known to the Registrant to be affiliates of the
foregoing have been excluded in that such persons may be deemed to be
affiliates. This assumption regarding affiliate status is not necessarily a
conclusive determination for other purposes.
Check whether the Registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
at least the past 90 days.
YES [X] NO [ ].
As of March 9, 1999 there were 20,111,658 shares of Common Stock,
par value $.01 per share, outstanding.
Portions of the Proxy Statement for the annual stockholders' meeting
scheduled to be held on April 26, 1999 are incorporated by reference into
Part III.
The Exhibit Index appears on page S-2.
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PART I
ITEM 1. BUSINESS
COMPANY HISTORY
Guitar Center, Inc. was founded in 1964 in Hollywood, California. 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.
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 70 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.
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 the Company for an average
of 14 years and two of such executive officers (Mr. Larry Thomas, the
Company's President and Chief Executive Officer, and Mr. Marty Albertson, the
Company's Executive Vice President and Chief Operating Officer) effectively
assumed full operating control in 1992. Since then, we have focused on
developing and realizing our long-term goal of expanding Guitar Center's
position as the leading music products retailer throughout the United States.
We are a Delaware corporation with our principal executive offices
located at 5155 Clareton Drive, Agoura Hills, California 91301, and our
telephone number is (818) 735-8800. 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.
BUSINESS
As of December 31, 1998, we operated 48 stores in 24 major U.S.
markets, including, among others, areas in or near Los Angeles, San
Francisco, Chicago, Miami, Houston, Dallas, Detroit, Boston, Minneapolis,
Seattle, Phoenix, Atlanta, New York and Cleveland. From fiscal 1994 through
fiscal 1998, our net sales and operating income before deferred compensation
expense grew at compound annual growth rates of 32.0% and 32.2% respectively.
This growth was principally the result of strong and consistent comparable
store sales growth, averaging 15.2% per year over such five-year period, and
the opening of 31 new stores. Comparable store sales (stores opened for at
least 14 months) for fiscal 1996, 1997 and 1998 were $187.7 million, $236.5
million and $332.7 million respectively.
We offer a unique retail concept in the music products industry,
combining an interactive, hands-on shopping experience with superior customer
service and a broad selection of brand name, high-quality products at
guaranteed low prices. We create an entertaining and exciting atmosphere in
our stores with bold and dramatic merchandise presentations, highlighted by
bright, multi-colored lighting, high ceilings, music and videos. We believe
approximately 68% 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 upon our knowledgeable and highly trained
salespeople to answer technical questions and to assist in product
demonstrations.
Our prototype store generally ranges in size from 12,000 to 20,000
square feet (as compared to a typical music products retail store which
averages approximately 3,200 square feet) and is designed to encourage
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customers to hold and play instruments. Each store carries an average of
7,000 core SKUs, which management believes is significantly greater than a
typical music products retail store, and is 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.
Our stores historically have generated strong and stable operating
results. Our stores, after being open for at least twelve months, have had
positive store-level operating income in each of the past five fiscal years.
The following summarizes certain key operating statistics of our store
and is based upon the 36 stores operated by us for the full year ended December
31, 1998:
Average 1998 net sales per square foot $ 638
Average 1998 net sales per store 9,888,000
Average 1998 store-level operating income (1) 1,404,000
Average 1998 store-level operating income margin (1) 14.2%
- ----------------------
(1) Store-level operating income includes individual store revenue and
expenses plus allocated rebates, cash discounts, advertising and
purchasing department salaries (based upon individual store sales).
Our 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 stores in 1998, and
presently expect to open approximately 12 stores in 1999 and approximately 16
stores in 2000. We have committed substantial resources to building a corporate
infrastructure and management information system that we believe can support our
needs, including our expansion plans, for the foreseeable future.
For the fiscal years ended December 31, 1996, 1997 and 1998, we had net
income (loss) of ($72.4) million, $16.3 million and $27.4 million, respectively.
INDUSTRY OVERVIEW
The United States retail market for music products in 1997 was
estimated in a study by MUSIC USA magazine to be approximately $6.1 billion
in net sales, representing a five year compound annual growth rate of 7.1%.
The broadly defined music products market, according to the National
Association of Music Merchants ("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 $4.3 billion of this market, representing a
five-year compound annual growth rate of 8.4%. The music products market, as
currently defined by NAMM, however, does not include the significant used and
vintage product markets, or the computer software or apparel market in which
we actively participate.
The industry is highly fragmented with the nation's leading five
music products retailers, as measured by the number of stores operated by
such retailers (I.E, Guitar Center, Sam Ash Music Corp, Brook Mays/C&S/H&H,
Schmitt Music Company and Musician's Friend, Inc.), accounting for
approximately 10.9% of the industry's estimated $6.1 billion in net sales in
1997. Furthermore, 90% of the industry's estimated 8,400 retailers operate
only one or two stores. A typical music products store averages approximately
3,200 square feet and generates an average of approximately $0.7 million in
annual net sales. In contrast, one of our stores generally averages between
12,000 and 20,000 square feet and in 1998 generated an average of
approximately $9.4 million in annual net sales for stores open the full year
(excluding our Hollywood store).
Over the past ten years, technological advances in the industry have
resulted in dramatic changes to the nature of music-related products.
Manufacturers have combined computers and microprocessor technologies with
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musical equipment to create a new generation of products capable of high
grade sound processing and reproduction. Products featuring this technology
are available in a variety of forms and have broad applications 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. For example, 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 prohibitively
expensive and was typically purchased only by professional sound recording
studios.
BUSINESS STRATEGY
Our goal 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:
- EXPANSION STRATEGY. Our expansion strategy is to continue to
increase our market share in existing markets and to penetrate
strategically selected markets. We opened a total of 12 stores in
1998 and 8 stores in 1997, and currently anticipate opening
approximately 12 stores in 1999 and approximately 16 stores in
2000. 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. See "-- Site Selection." We also believe there
may be attractive opportunities to expand by selectively
acquiring existing music products retailers. However, in the
music industry there are only a small number of companies that
would strategically and financially be a beneficial opportunity
for us to acquire. Our "average" store is 15,000 square feet,
carrying 7,000 SKUs and generating first year sales of
$6,000,000, whereas the "average" industry store is 3,200 square
feet, carrying 2,500 SKUs and generating sales of $720,000.
Within the industry there are other opportunities to expand,
such as through mail order catalogue and internet sales
businesses. We are presently investigating these avenues of
growth either by acquisition or development of our own
capability.
- 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 7,000 core SKUs offered through each of our stores
provide a breadth and depth of in-stock items which we believe is
not available from traditional music products retailers.
- HIGHLY INTERACTIVE, MUSICIAN-FRIENDLY STORE CONCEPT. The purchase
of musical instruments is a highly personal decision for
musicians. We therefore believe that a large part of our success
is attributable to our creative instrument presentations and
colorful, interactive displays which encourage the customer to
hold and play instruments as well as to participate in product
demonstrations. Each store also provides private sound-controlled
rooms to enhance a customer's listening experience while testing
various instruments.
- 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
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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 1.8 million customers. This
database enables us to advertise to select target customers based
on historical buying patterns. We believe the typical music
products retailer does not have the resources to support
large-scale promotional events or an extensive advertising
program.
- GUARANTEED LOW PRICES. We endeavor to be the low price leader in
each of our markets, as underscored by our 30-day low price
guarantee. Our size permits us to take advantage of volume
discounts for large orders and other vendor supported programs.
Although prices are usually determined on a regional basis, store
managers are trained and authorized to adjust prices in response
to local market conditions.
- EXPERIENCED AND MOTIVATED MANAGEMENT TEAM. Our executive officers
and key managers have an average of 14 years with the Company.
MERCHANDISING
Our merchandising concept differentiates us from most of our
competitors. We create an entertaining and exciting atmosphere in our stores
with bold and dramatic merchandise presentations, highlighted by bright,
multi-colored lighting, high ceilings, music and videos. We offer our
merchandise at guaranteed low prices and utilize 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. We offer products in five
primary categories: guitars, amplifiers, percussion instruments,
keyboards, and pro audio and recording equipment.
- GUITARS. We believe that our electric, acoustic and bass
guitar selections are among the deepest and broadest in the
industry. Each store features for sale 300 to 500 guitars on
the "guitar wall" and also displays many autographed
instruments from world-renowned musicians. Major
manufacturers, including Fender, Gibson, Taylor, Martin,
PRS, Yamaha, Ovation and Ibanez, are well represented in
popular models and colors. We believe we have one of the
largest selections of custom, one-of-a-kind and used/vintage
guitars of any retailer. Prices range from $175 for
entry-level guitars to over $50,000 for special vintage
guitars. In addition, our line of string instruments include
banjos, mandolins and dobros, among others. We also offer an
extensive selection of guitar sound processing units and
products which allow the guitar to interface with a personal
computer. These products serve crossover demand from the
traditional guitarist into new computer-related sound
products.
- AMPLIFIERS. We offer an extensive selection of electric
acoustic and bass guitar amplifiers and in addition carry a
broad selection of boutique and vintage amplifiers with
prices ranging from $50 to $5,000. We represent most
manufacturers, including Marshall, Fender, Crate, Ampeg,
S.W.R. and Mesa Boogie.
- PERCUSSION INSTRUMENTS. We believe that we are one of the
largest retailers of percussion products in the United
States. Our offerings range from basic drum kits to free
standing African congos and bongos and other rhythmic and
electronic percussion products with prices ranging from $10
to $10,000. We also have a large selection of vintage and
used percussion instruments. Name brands include Drum
Workshop, Remo, Sabian, Pearl, Yamaha, Premier, Tama and
Zildjian. We carry an extensive selection of digital drum
kits and hand held digital drum units. The digital units
produce a variety of high quality life-like drum sounds and
have
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broad appeal to musicians.
- KEYBOARDS. We carry a wide selection of keyboard products
and computer peripheral and software packages with prices
ranging from $100 to $5,000. We offer an extensive selection
of software for the professional, hobbyist, studio engineer
and the post production market enthusiast. The product line
covers a broad range of manufacturers including Roland,
Alesis, Korg, Kurzweil, Emu, Yamaha and Ensoniq. We also
maintain a broad selection of computer related recording
products, including sound cards, sound libraries and
composition, sequence and recording software.
- PRO AUDIO AND RECORDING EQUIPMENT. Our pro audio and
recording equipment division offers products ranging in
price from $100 to $25,000 for musicians at every level,
from the casual hobbyist to the professional recording
engineer. Our products range from recording tape to
state-of-the-art digital recorders. We believe we also carry
one of the largest assortments of professional stage audio,
disc jockey and lighting equipment for small traveling
bands, mobile disc jockeys, private clubs and large touring
professional bands. Our major brand name manufacturers
include JBL, Panasonic, Sony, Mackie, Tascam, Yamaha, Roland
and Alesis.
- BROAD USED MERCHANDISE SELECTION. We offer an extensive selection
of used merchandise, the majority of which derives from
instruments traded in or sold to us by customers. Our trade-in
policy provides musicians with an alternative form of payment and
the convenience of selling an old instrument and purchasing a new
one at a single location. Used products are bought and priced to
sell by store managers who are well trained and knowledgeable in
the used musical instrument market.
- GUARANTEED LOW PRICES. We endeavor to be the price leader in each
of the markets we serve. We are one of the leading retailers in
each of our product categories and our size permits us to take
advantage of volume discounts for large orders and other vendor
supported programs. To maintain this strategy of guaranteed low
prices, we routinely monitor prices in each of our markets to
assure that our prices remain competitive. Although prices are
typically determined on a regional basis, store managers are
trained and authorized to adjust prices in response to local
market conditions. We underscore our low price guarantee by
providing a cash refund of the price difference if an identical
item is advertised by a competitor at a lower price within thirty
days of the customer's purchase.
- DIRECT MARKETING, ADVERTISING AND PROMOTION. 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 twenty
years. These events are often coordinated with product
demonstrations, interactive displays, clinics and in-store artist
appearances.
As we enter new markets, we initiate an advertising program, including
mail and radio promotions 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 maintain a unique and proprietary database containing information on
over 1.8 million customers. We believe that this database assists in generating
repeat business by targeting customers based on their purchasing history and by
permitting us to establish and maintain personal relationships with our
customers.
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CUSTOMER SERVICE
Exceptional customer service is fundamental to our operating
strategy. With the rapid changes in technology and continuous new product
introductions, customers depend on salespeople to offer expert advice and to
assist with product demonstrations. We believe that our well trained and
highly 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. Salespeople specialize in one of our five product categories
and begin training on their first day of employment. 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. Based on examination results, an employee is given a rating which
determines his or her salary and level of responsibility. 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 salary by advancing through the
certification program. We believe that due to our emphasis on training, we
are able to attract and retain well-qualified, highly motivated salespeople
committed to providing superior customer service. In addition, each
salesperson in the keyboards and pro audio and recording departments is
certified by a technical advisory board after satisfactory completion of an
extensive training program.
Our customer base consists of (i) the professional or aspiring
musician who makes or hopes to make a living through music and (ii) the
amateur musician or hobbyist who views music as recreation. Management
estimates that professional and aspiring musicians, who view the purchase of
musical products as a career necessity, represent approximately 68% of our
customer base, and account for approximately 75% 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.
STORE OPERATIONS
To facilitate our strategy of accelerated but controlled growth, we
have centralized many key aspects of our operations, including the
development of policies and procedures, accounting systems, training
programs, store layouts, purchasing and replenishment, advertising and
pricing. Such centralization effectively utilizes the experience and
resources of our headquarters staff to establish a high level of consistency
throughout all of our stores.
Our store operations are led by our Chief Operating Officer and
seven regional store managers with each regional manager responsible for
approximately five to eight stores. Store management is comprised of a store
manager, a sales manager, an operations manager, two assistant store managers
and five department managers. Each store also has a warehouse manager and a
sales staff that ranges from 20 to 40 employees.
We ensure that store managers are well-trained and experienced
individuals who will maintain our store concept and philosophy. Each manager
completes an extensive training program which instills the values of
operating as a business owner, and only experienced store employees are
promoted to the position of store manager. As a result of this strategy, the
average tenure of the store managers is approximately three years. We seek to
encourage responsiveness and entrepreneurship at each store by providing
store managers with a relatively high degree of autonomy relating to
operations, personnel and merchandising. Managers play an integral role in
the selection and presentation of merchandise, as well as the promotion of
our reputation.
We view our employees as long-term members of the Guitar Center team.
We encourage employee development by providing the salesforce 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 opportunity to move into operations, sales
and store management positions, which management believes is not available at
most other music retailers. As we open new stores, key in-store management
positions are primarily filled by the qualified and experienced employees from
existing stores. By
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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. Both Larry Thomas and Marty Albertson, our
Chief Executive Officer and Chief Operating Officer, respectively, began
their careers as salespersons at Guitar Center.
PURCHASING, DISTRIBUTION AND INVENTORY CONTROL
- PURCHASING. We believe we have excellent relationships with our
vendors and, as one of the industry's largest volume purchasers,
are able to receive prompt order fulfillment and access to our
vendors' premium products. We maintain a centralized buying group
comprised of merchandise managers, buyers, planners and
distributors. Merchandise managers and buyers are responsible for
the selection and development of product assortments and the
negotiation of prices and terms. The planners and distributors
are responsible for maintaining inventory levels and allocating
the merchandise to the stores. We use a proprietary merchandise
replenishment system which automatically analyzes and forecasts
sales trends for each SKU using various statistical models,
supporting the buyers by predicting each store's merchandise
requirements. This has resulted in limited "out of stock"
positions. We also utilize a software system, Arthur, for
inventory budgeting purposes for all product groups at the store
level.
Our business and our 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. See "-- Risks Related to
the Business -- We Depend on Suppliers."
- DISTRIBUTION. We are currently evaluating the benefits and
detriments to our operating income of having a central
warehouse/distribution center. At the present time we do not have
a central warehouse/distribution center and each of our vendors
drop ship directly to each of our stores. To date we have been
able to successfully execute our expansion strategy without a
central warehouse/distribution facility. However, we believe
there is an opportunity to reduce chainwide inventory levels
and therefore reduce working capital requirements if we had a
central warehouse/distribution center or used the services of
a third party provider. We are presently conducting a study
with the help of outside consultants to determine the financial
implications and logistics of utilizing a central
warehouse/distribution center.
- INVENTORY CONTROL. Management has invested significant time and
resources in our inventory control systems and believe we have
one of the most sophisticated systems in the music products
retail industry. Management believes the vast majority of music
product retailers do not use a computerized inventory management
system. We perform cycle inventory 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 shrinkage level has
historically been very low which management attributes to our
highly sophisticated system controls and strong corporate
culture.
SITE SELECTION
We believe we have developed a unique and, what historically have been,
a highly effective selection criteria to identify prospective store sites. 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. Due to
the fact that our vendors drop ship merchandise directly to the stores, our
expansion plans have been dependent more on the characteristics of the
individual store site than any logistical constraints that would be imposed by a
central distribution facility. See "-- Store Locations."
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MANAGEMENT INFORMATION SYSTEMS
We have invested significant resources in management information
systems that provide real-time information both by store and by SKU. The
systems have been designed to integrate all major aspects of our business
including sales, gross margins, inventory levels, purchase order management,
automated replenishment and merchandise planning. Our highly sophisticated
management information system provides us with the ability to monitor all
critical aspects of store 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.
COMPETITION
We are in direct competition with two other major chains within the
music industry -- Sam Ash of New York, New York and Music and Recording
Superstores of Miami, Florida. As of December 31, 1998 we are in direct
competition with Sam Ash in 7 of our markets and with MARS in 6 of our
markets. Sam Ash and MARS have also been expanding their store base and,
based on published reports, will continue to do so in 1999, and we expect
that there will be additional competitive overlap in new and existing Guitar
Center markets. There is, however, room for consolidation within the music
industry as the top ten retailers (including Guitar Center, Sam Ash and MARS)
only account for approximately 15% of the market compared to a 60% market
share held by the top ten retailers in the consumer electronics industry and
the toy industry.
We believe that the ability to compete successfully in our markets
is determined by several factors, including breadth and quality of product
selection, pricing, effective merchandise presentation, customer service,
store location and proprietary database marketing programs. Customer
satisfaction is paramount to our operating strategy and we believe that
providing knowledgeable and friendly customer service gives us a competitive
advantage. The store environment is designed to be an entertaining and
exciting environment in which to shop. In an effort to exceed customer
expectations, our stores provide a number of services not generally offered
by most competitors, including the ability to hold and use merchandise,
product demonstrations and extensive product selection. Salespeople are
highly trained and specialize in one of our five product areas. Salespeople
are certified by an outside technical advisory board, based on extensive
training and product knowledge testing. We believe that this certification
process has increased the professionalism of our employees while reducing
turnover. Customers are encouraged to help themselves to the displayed
instruments or to seek the assistance of the professional salespeople.
Certain factors, however, could materially and adversely affect our
ability to compete successfully in our markets, including, among others, the
expansion by us into new markets in which our competitors are already
established, competitors' expansion into markets in which we are currently
operating, the adoption by competitors of innovative store formats and retail
sales methods or the entry into our market by competitors with substantial
financial or other resources. See "-- Risks Related to the Business -- We May Be
Unable to Meet Our Growth Strategy"; and "We Have Competitors."
EMPLOYEES
As of December 31, 1998, we employed approximately 1,727 people, of
whom approximately 937 were hourly employees and approximately 790 were
salaried. To date, we have been able to recruit qualified personnel to manage or
staff our stores. None of our employees are covered by a collective bargaining
agreement. We believe that we enjoy good employee relations.
SERVICE MARKS
We have registered the GUITAR CENTER and ROCK WALK service marks with
the United States Patent and Trademark Office. We believe that these service
marks have become important components in our
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merchandising and marketing strategy. The loss of the GUITAR CENTER service
mark could have a material adverse effect on our business.
RISKS RELATED TO THE BUSINESS
Described below are some of the risks and uncertainties facing our
company. There may be additional risks that we do not presently know of or that
we currently consider immaterial. All of these risks could adversely affect our
business, results of operations, liquidity and financial position.
WE MAY BE UNABLE TO MEET OUR GROWTH STRATEGY
Our growth strategy includes opening new stores and increasing sales at
existing locations. We intend to pursue an aggressive expansion strategy by
opening additional stores in new and existing markets. As of December 31, 1998,
we operated 48 stores. We opened 12 stores in 1998 and 8 stores in 1997, and
plan to open approximately 12 stores in 1999 and approximately 16 stores in
2000. Our expansion plan depends on a number of factors, including:
- Identification of suitable retail sites;
- Negotiation of acceptable lease terms;
- Hiring, training and retention of skilled personnel;
- Sufficient management and financial resources to support the new
locations; and
- Vendor support
We cannot assure that we will achieve our store expansion goals. We
cannot assure that our new stores will achieve sales or profitability levels
like our existing stores. Our expansion strategy includes clustering stores in
existing markets. This may result in the transfer of sales to the new store and
a reduction in the profitability of an existing store. In addition to the
factors noted above, expansion to new markets may present unique competitive and
merchandising challenges, including:
- Significant start-up costs, including promotion and advertising;
- Management of stores in distant locations; and
- Warehousing future retail locations (we do not currently
warehouse our new locations but may if a unique situation
becomes available)
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:
- -------------------------------------------------------------------------------
1998 1997 1996
Quarter 1 17.5% 13.6% 14.5%
Quarter 2 14.0% 12.5% 9.3%
Quarter 3 10.3% 13.6% 7.6%
Quarter 4 10.8% 10.7% 10.1%
FullYear 12.8% 12.4% 10.2%
- -------------------------------------------------------------------------------
A variety of factors affect our comparable store sales results,
including:
- Competition;
- Economic conditions;
- Consumer and music trends;
- Changes in our merchandise mix;
- Product distribution;
11
- Transfer of sales to new locations (i.e. market clustering); and
- Timing of our promotional events
We do not anticipate that we will continue to achieve comparable store
sales increases at these levels.
We also believe that our expansion may be accelerated by the
acquisition of existing music product retailers (or possibly by the
development or acquisition of catalogue and internet businesses). 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 each. We cannot assure 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 acquisition with our business; and
- Unanticipated legal liabilities and other circumstances or
events.
As of the filing date of this annual report, we had no agreements or
commitments to enter into any acquisitions.
WE DEPEND ON SUPPLIERS
We depend significantly on our suppliers for both our existing stores
and our expansion goals. We do not have any long term contracts with our
suppliers, which we believe is customary in our industry. If we failed to
maintain our relationship with our key brand name vendors, we believe this could
have a material adverse effect on our business. We believe we currently have
adequate supply sources; however, we cannot assure sufficient quantities or the
appropriate mix of products will be available in the future to supply our
existing stores and expansion plans. This risk is especially prevalent in new
markets where our vendors have existing agreements with other dealers and
thereby may be unwilling or unable to meet our requirements.
WE HAVE COMPETITORS
Our industry is fragmented and highly competitive. We compete with many
different types of retailers, including conventional retailers, as well as
catalogue and electronic commerce retailers, who sell many or most of the items
sold in our stores. We anticipate increased competition in our existing markets
and planned new markets as other large format music product retailers execute
their announced growth plans. Additionally, our expansion to new markets will be
inhibited by established competitors in those markets. If our competitors adopt
a new, innovative store format or retail selling method, or if a new competitor
with substantial financial or other resources enters the market place, then we
may fail to achieve market position gains or may lose market share.
WE DEPEND ON KEY PERSONNEL
Our success depends to a significant extent on the services of Larry
Thomas, our President, and Marty Albertson, our Executive Vice President and
Chief Operating Officer, 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. In June 1996, we
entered into a five-year employment contract with both Mr. Thomas and Mr.
Albertson. Additionally, we carry key man insurance on the lives of Mr.
Thomas and Mr. Albertson in the amount of $5.0 million and $3.5 million,
respectively. Historically, we have promoted from within our organization to
fill senior operation, sales, and store management positions. In order to
achieve our growth plans, we will depend upon our ability to promote existing
personnel to senior management and to retain such employees, 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.
12
OUR OPERATIONS ARE CONCENTRATED IN CALIFORNIA
As of December 31, 1998, 13 of our 48 stores were located in
California and generated 37.4% and 43.8% of our net sales for 1998 and 1997,
respectively. Although we have opened 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 not maintain earthquake insurance.
ECONOMIC CONDITIONS COULD ADVERSELY IMPACT INDUSTRY RESULTS; CHANGING CONSUMER
PREFERENCES COULD ALSO ADVERSELY IMPACT US
Our business is sensitive to consumer spending patterns, which in turn,
can be affected by prevailing economic conditions. A downturn in economic
conditions in one or more of our markets could have a material adverse effect on
our results of operations, financial condition, business and prospects. 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 HAVE A LIMITED HISTORY OF TRADING ON THE NASDAQ NATIONAL MARKET; OUR STOCK
PRICE COULD BE VOLATIVE
We began trading on the Nasdaq National Market on March 14, 1997. The
market price of our shares of common stock has been subject to significant
fluctuations in response to our operating results and other factors, including
announcements by our competitors, and those fluctuations will likely continue in
the future. In addition, the stock market in recent years has experienced
significant price and volume fluctuations that often have been unrelated or
disproportionate to the operating performance of particular companies. These
fluctuations, as well as a shortfall in sales or earnings compared to public
market analysts' expectations, changes in analysts' recommendations or
projections, and general economic and market conditions, may adversely effect
the market price of our common stock.
SIGNIFICANT UNCERTAINTY EXISTS REGARDING THE ABILITY OF SOFTWARE TO RECOGNIZE
YEAR 2000 DATES
Many older computer systems and software products currently in use
are coded to accept only two digit entries in the date code field. These date
code fields will need to accept four digit entries to distinguish 21st
century dates from 20th century dates. Significant uncertainty exists in the
software industry concerning the potential effects associated with such
compliance. Any failure by us to ensure that such software complies with Year
2000 requirement could have a material adverse effect on our business,
financial condition and results of operations. Furthermore, while we
developed a plan to identify programs used by our computer systems that may
require modification, and have initiated programs to rectify any such
problems, there can be no assurance that such plans and programs will be
effective in making such programs Year 2000 compliant or will be completed
prior to December 31, 1999. We utilize third-party equipment and licenses
software from third parties that may not be Year 2000 compliant. Failure of
our software or internal computer systems or of third-party equipment or
software utilized by us to be Year 2000 compliant could result in a material
adverse effect on our business, financial condition and results of operations.
FORWARD LOOKING STATEMENTS AND ASSOCIATED RISKS
This annual report contains certain 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),
sales, gross margin and expense trends, Year 2000 conversion, 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.
13
ITEM 2. PROPERTIES
We lease all but four of our stores and presently intend to lease all
new locations. 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 20,000 square feet,
which are located at 5155 Clareton Drive, Agoura Hills, California 91301. Due to
our expansion, which has included the hiring of new corporate and administrative
personnel, we leased additional space in a nearby location, with approximately
7,800 square feet.
14
STORE LOCATIONS
The table below sets forth certain information concerning our stores as
of December 31, 1998:
Gross Gross
Year Square Year Square
Store Opened Feet Status Store Opened Feet Status
- ----------------------------------------------------------- ------------------------------------------------------
ARIZONA MASSACHUSETTS
Phoenix 1997 13,600 Lease Boston 1994 12,600 Lease
Tempe 1997 12,100 Lease Danvers 1996 14,600 Lease
SOUTHERN CALIFORNIA Natick 1997 15,100 Lease
Hollywood 1964 30,600 Own N. Attleboro 1998 16,800 Lease
San Diego 1973 13,500 Own MICHIGAN
Fountain Valley 1980 16,800 Lease Detroit 1994 10,100 Lease
Sherman Oaks 1982 18,700 Lease Southfield 1996 13,600 Lease
Covina 1985 15,400 Lease Canton 1998 17,200 Lease
Southbay 1985 14,500 Lease MINNESOTA
San Bernardino 1993 9,500 Lease Twin Cities 1988 9,500 Lease
Brea 1995 14,900 Lease Edina 1997 15,300 Lease
San Marcos 1996 14,900 Lease MISSOURI
Rancho Cucamonga (2) 1999 15,000 Lease N. St. Louis (2) 1999 15,000 Lease
NORTHERN CALIFORNIA NEW JERSEY
San Francisco 1972 11,900 Lease Springfield 1998 20,000 Lease
San Jose 1978 14,200 Own E. Brunswick 1998 20,000 Lease
El Cerrito (1) 1983 21,300 Lease NEW YORK
Concord (3) 1996 15,800 Lease Carle Place 1998 22,800 Lease
COLORADO Commack (2) 1998 16,000 Lease
Denver 1998 16,400 Lease Queens (2) 1999 19,000 Lease
Westminster (2) 1999 15,000 Lease OHIO
CONNECTICUT Cleveland 1997 15,600 Lease
Manchester (2) 1999 16,000 Lease Mayfield Heights 1998 14,600 Lease
FLORIDA Cincinnati 1998 16,000 Lease
North Miami area 1996 22,300 Lease TEXAS
South Miami area 1996 14,700 Lease Dallas 1989 12,700 Lease
GEORGIA Arlington 1991 9,700 Lease
Atlanta 1997 23,600 Own South Houston 1993 14,700 Lease
Marietta (3) 1997 22,800 Lease North Houston 1994 14,700 Lease
ILLINOIS Central Dallas 1998 18,000 Lease
South Chicago 1979 13,800 Lease Clearlake 1998 15,000 Lease
North Chicago 1981 10,300 Lease VIRGINIA
Central Chicago (3) 1988 20,500 Lease Fairfax (2) 1999 15,600 Lease
Villa Park 1996 15,000 Lease WASHINGTON
MARYLAND Seattle 1997 21,300 Lease
Towson 1998 14,600 Lease Lynnwood 1998 14,000 Lease
- -------------------------
(1) Of the 21,300 square feet, approximately 10,000 square feet consists of a
basement and warehouse space.
(2) We have signed leases for these locations and presently expect each to
open in 1999.
(3) Represents stores which we relocated in 1998.
15
ITEM 3. LEGAL PROCEEDINGS
We are not a party to any material legal proceedings and are not aware
of any pending or threatened litigation that, if decided adversely to the
Company, would reasonably be expected to have a material adverse effect on our
financial condition.
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, 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
We effected our initial public offering on March 14, 1997 at a price of
$15.00 per share. 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:
1998 HIGH LOW
- -------------- ------- -------
First Quarter $ 23.625 $ 19.380
Second Quarter 31.313 23.625
Third Quarter 32.750 18.438
Fourth Quarter 26.313 13.625
As of March 9, 1999, there were 118 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.
DIVIDEND POLICY
We currently intend to retain any earnings to provide funds for the
operation and expansion of our business and for the servicing and repayment of
indebtedness and do not intend to pay cash dividends on our Common Stock in the
foreseeable future. Under the terms of the indenture governing our senior notes,
we are not permitted to pay any dividends on the Common Stock unless certain
financial ratio tests and other conditions are satisfied. In addition, our bank
facility with Wells Fargo Bank, N.A. contains certain covenants which, among
other things, limit the payment of cash dividends on the capital stock of the
Company. 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.
16
ITEM 6. SELECTED FINANCIAL DATA
The selected financial data for the fiscal years ended December 31,
1994, 1995, 1996, 1997 and 1998 has been derived from the audited financial
statements of the Company. The selected historical financial data should be read
in conjunction with "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations", and the financial statements of the
Company and the notes thereto included elsewhere in this annual report.
FISCAL YEAR ENDED DECEMBER 31,
-------------------------------
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
(in thousands, except per share and store and inventory operating data)
INCOME STATEMENT DATA:
Net sales $ 129,039 $ 170,671 $ 213,294 $ 296,655 $ 391,665
Cost of goods sold (1) 92,275 123,415 153,222 214,345 282,023
--------- --------- --------- --------- ---------
Gross profit 36,764 47,256 60,072 82,310 109,642
Selling, general and administrative 26,143 32,664 41,345 56,915 77,182
expenses
Deferred compensation expense (2) 1,259 3,087 71,760 -- --
--------- --------- --------- --------- ---------
Operating income (loss) $ 9,362 $ 11,505 $ (53,033) $ 25,395 $ 32,460
--------- --------- --------- --------- ---------
Other (expense) income
Interest expense, net (252) (368) (12,169) (8,928) (8,509)
Transaction expense and other 45 65 (7,068) (220) 324
--------- --------- --------- --------- ---------
$ (207) $ (303) $ (19,237) $ (9,148) $ (8,185)
--------- --------- --------- --------- ---------
Income (loss) before provision for
income taxes and extraordinary loss 9,155 11,202 (72,270) 16,247 24,275
Provision for income taxes (benefit) 326 345 139 (2,833) (3,158)
--------- --------- --------- --------- ---------
Income (loss) before extraordinary loss $ 8,829 $ 10,857 $ (72,409) $ 19,080 $ 27,433
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
Extraordinary loss on early extinguishment
of debt, net of tax $1,679 -- -- -- (2,739) --
--------- ---------
Net income -- -- -- $ 16,341 $ 27,433
--------- ---------
--------- ---------
Net income per share (diluted) -- -- -- $ 0.79 $ 1.31
--------- ---------
--------- ---------
Weighted average shares outstanding (3) -- -- -- 20,602 20,923
--------- ---------
--------- ---------
OPERATING DATA:
Net sales per gross square foot (4) $ 546 $ 661 $ 707 $ 649 $ 638
Net sales growth 32.6% 32.3% 25.0% 39.1% 32.0%
Increase in comparable store sales (5) 17.3% 23.4% 10.2% 12.4% 12.8%
Stores open at end of period 20 21 28 36 48
Inventory turns 3.4x 3.7x 3.4x 3.0x 2.8x
Ratio of Earnings to Fixed Charges (6) 11.6x 11.7x -- 2.6x 3.3x
Capital expenditures $ 3,277 $ 3,432 $ 6,133 $ 9,650 $ 17,101
BALANCE SHEET DATA:
Net working capital $ 11,468 $ 6,002 $ 27,436 $ 61,611 $ 72,452
Property, plant and equipment, net 11,642 13,276 14,966 22,809 34,754
Total assets 46,900 49,618 74,849 132,624 171,594
Total long term and revolving debt 825 -- 103,536 66,667 74,414
(including current portion)
Senior preferred stock -- -- 15,186 -- --
Junior preferred stock -- -- 138,610 -- --
Stockholders' equity (deficit) 23,424 19,763 (68,815) 28,776 57,398
FOOTNOTES APPEAR ON FOLLOWING PAGE.
17
FOOTNOTES TO TABLE ON PREVIOUS PAGE.
- -----------------------
(1) Cost of goods sold includes buying and occupancy costs.
(2) For the fiscal year 1996, we recorded a non-recurring deferred compensation
expense of $71.8 million, of which $69.9 million related to the
cancellation and exchange of management stock options pursuant to our 1996
recapitalization and $1.9 million related to a non-cash charge resulting
from the grant of stock options to management by certain investors. See
Note 1 to the Consolidated Financial Statements.
(3) Weighted average shares represents shares calculated on a diluted basis.
(4) Net sales per gross square foot does not include new stores opened during
the reporting period.
(5) Compares net sales for the comparable periods, excluding net sales
attributable to stores not open for 14 months.
(6) 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. Earnings
were insufficient to cover fixed charges by $72.3 million for the year
ended December 31, 1996.
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
GENERAL
As of December 31, 1998, the Company had 48 stores operating in 24
major markets. From 1994 to 1998, Guitar Center's net sales and operating income
before deferred compensation expense grew at compound annual growth rates of
32.0% and 32.2%, respectively, principally due to comparable store sales growth
averaging 15.2% per year and the opening of new stores. Guitar Center achieved
comparable store net sales growth of 10.2%, 12.4%, 12.8% and for the fiscal
years ended December 31, 1996, 1997 and 1998, respectively. These increases were
primarily attributable to increases in unit sales rather than increases in
prices or changes in product mix. Management believes such volume increases are
the result of the continued success of the Company's implementation of its
business strategy, continued strong growth in the music products industry and
increasing consumer awareness of the Guitar Center name. The Company does not
expect comparable store sales to continue to increase at historical rates.
The Company opened 12 stores in 1998 and 8 stores in 1997 and presently
expects to open approximately 12 stores in 1999 and 16 stores in 2000. In
preparation for these additional stores, management has dedicated a substantial
amount of resources over the past several years to building the infrastructure
necessary to support a large, national chain. For example, the Company spent
$4.4 million from January 1, 1993 to December 31, 1998 on system upgrades to
support the storewide integration of a state-of-the-art management information
system. The Company has also established centralized operating and financial
controls and has implemented an extensive training program to ensure a high
level of customer service in its stores. Management believes that the
infrastructure is in place to support its needs for the immediately foreseeable
future, including its present expansion plans as described herein.
Guitar Center's expansion strategy includes opening additional stores
in certain of its existing markets and entering new markets. As part of its
store expansion strategy, the Company opened five stores during a 14-month
period from October 1993 through November 1994. Additionally, the Company opened
7 stores in 1996, 8 stores in 1997 and 12 stores in 1998. The Company will
continue to pursue its strategy of clustering stores in major markets to take
advantage of operating and advertising efficiencies and to build awareness of
the Guitar Center name in new markets. In some markets where the Company has
pursued its clustering strategy, there has been some transfer of sales from
certain existing stores to new locations. Generally, however, mature stores have
demonstrated net sales growth rates consistent with the Company average. As the
Company enters new markets, management expects that it will initially incur
higher occupancy, administrative and advertising costs per store than it
currently experiences in established markets.
The following table sets forth certain historical income statement data
as a percentage of net sales:
FISCAL YEAR ENDED
DECEMBER 31,
----------------------------------------
1996 1997 1998
---- ---- ----
Net sales 100.0% 100.0% 100%
Gross profit 28.2 27.7 28.0
Selling, general and administrative expenses 19.4 19.2 19.7
----- ----- ----
Operating income before deferred compensation expense 8.8 8.5 8.3
Deferred compensation expense 33.7 -- --
----- ----- ----
Operating income (loss) (24.9) 8.5 8.3
Interest expense, net 5.7 3.0 2.2
Transaction expenses and other 3.3 0.1 (0.1)
----- ----- ----
Income (loss) before income taxes (33.9) 5.4 6.2
Income taxes (benefit) -- (1.0) (0.8)
----- ----- ----
Income (loss) before extraordinary loss (33.9)% 6.4% 7.0%
----- ----- ----
19
FISCAL 1998 COMPARED TO FISCAL 1997
Net sales for the year ended December 31, 1998 increased 32.0% to
$391.7 million from $296.7 million in fiscal 1997. This growth was attributable
to an increase of $57.3 million in new store net sales, accounting for 60.3% of
such increase. In addition, comparable store net sales increased 12.8% or $37.7
million, accounting for 39.7% of such increase. The increase in comparable net
store sales was primarily attributable to increases in unit sales rather than
increases in prices or changes in the mix of sales between the product
categories. Such volume increases were primarily the result of the continued
success of the Company's implementation of its business strategy, continued
strong growth in the music products industry and increasing consumer awareness
of the Guitar Center name.
Gross profit for fiscal 1998 compared to fiscal 1997 increased 33.2% to
$109.6 million from $82.3 million in fiscal 1997. Gross profit as a percentage
of net sales ("gross margin") for fiscal 1998 increased to 28.0% from 27.7% in
fiscal 1997. The increase in gross margin in 1998 over 1997 was due to an
increase in margin before occupancy and buying costs partially offset by an
increase in occupancy costs due to the fact that 27 of the 48 stores at December
31, 1998 were less than three years old. In addition, we have made opportunity
buys in merchandise and improved margins in the pro audio and keyboard segments
of the business.
Selling, general and administrative expenses for fiscal 1998 increased
35.6% to $77.2 million from $56.9 million in fiscal 1997. As a percentage of net
sales, selling, general and administrative expenses for fiscal 1998 increased to
19.7% from 19.2% in fiscal 1997. During fiscal 1998, 12 new stores commenced
operation and were open an average of nine months. In total, this increase was
attributable primarily to the number of stores open less than three years. In
1998, the Company operated 27 stores open less than three years (as compared to
15 stores in 1997). Typically, these stores experience higher operating costs as
a percentage of sales than a mature store.
The operating income for fiscal 1998 increased 27.8% to $32.5 million
from $25.4 million in fiscal 1997. As a percentage of net sales, operating
income decreased to 8.3% from 8.6% in the prior year, primarily due to the
increase in selling, general and administrative expenses, partially offset by
the increase in gross margin.
Interest expense, net for fiscal 1998 decreased to $8.5 million from
$8.9 million in fiscal 1997. Interest expense consisted principally of interest
on its senior notes and borrowings under the Company's line of credit. In 1997,
the Company redeemed, at a premium, $33.3 million principal amount of the Senior
Notes.
Income tax benefit in 1998 was recorded due to the reduction of the
valuation reserve on the Company's deferred tax asset, net of certain
alternative minimum tax and state taxes.
Net income for fiscal 1998 increased to $27.4 million from $16.3
million in fiscal 1997.
FISCAL 1997 COMPARED TO FISCAL 1996
Net sales for the year ended December 31, 1997 increased 39.1% to
$296.7 million from $213.3 million in fiscal 1996. This growth was attributable
to an increase of $57.3 million in new store net sales, accounting for 68.7% of
such increase. In addition, comparable store net sales increased 12.4% or $26.1
million, accounting for 31.3% of such increase. The increase in comparable net
store sales was primarily attributable to increases in unit sales rather than
increases in prices or changes in the mix of sales between the product
categories. Such volume increases were primarily the result of the continued
success of the Company's implementation of its business strategy, continued
strong growth in the music products industry and increasing consumer awareness
of Guitar Center stores.
Gross profit for fiscal 1997 compared to fiscal 1996 increased 37.0%
to $82.3 million from $60.1 million in fiscal 1996. Gross profit as a
percentage of net sales ("gross margin") for fiscal 1997 decreased to 27.7%
from 28.2% in fiscal 1996. The decrease in gross profit percentage reflects
the impact of operating fifteen stores
20
opened since January 1, 1996 (out of the total store base of 36 stores),
which typically experience lower gross profits than mature stores due to the
leveraging of occupancy costs. Comparatively, 1996 included the results of
eight stores opened since January 1, 1995 (out of the total store base of 28
stores). In addition, there was an increase in the mix of sales of high
technology products, which historically produce lower margins than low
technology products.
Selling, general and administrative expenses for fiscal 1997 increased
37.7% to $56.9 million from $41.3 million in fiscal 1996. As a percentage of net
sales, selling, general and administrative expenses for fiscal 1997 decreased to
19.2% from 19.4% in fiscal 1996. During fiscal 1997, eight new stores commenced
operation and were open an average of eight months.
In 1997, the Company had no deferred compensation expense, as such
programs were terminated during 1996. In 1996, the deferred compensation expense
resulted from a $69.9 million charge related to the purchase and exchange of
management stock options and the cancellation of the Company's prior stock
option program and a $1.9 million non-cash charge related to stock options
granted by certain investors to certain members of management.
The operating income for fiscal 1997 was $25.4 million compared to an
operating loss of $53.0 million in fiscal 1996. Operating income before deferred
compensation expense increased 35.6% to $25.4 million from $18.7 million over
the comparable period. As a percentage of net sales, operating income before
deferred compensation expense for fiscal 1997 decreased to 8.5% from 8.8% in the
prior year, primarily due to the reduction in gross profit discussed above.
Interest expense, net for fiscal 1997 decreased to $8.9 million from
$12.2 million in fiscal 1996. In 1997, the interest expense consisted
principally of interest on the Senior Notes. In 1997, the Company redeemed, at a
premium, $33.3 million principal amount of the Senior Notes. The interest
expense in 1996 was attributable to the write-off of financing fees of $4.7
million and interest of $7.5 million on outstanding borrowings during the seven
months following the Recapitalization.
In the second quarter of 1997, an extraordinary charge to operations of
$4.4 million, net of tax benefit of $1.7 million, was incurred equal to the
premium paid on the Notes plus the write-off of one-third of the unamortized
deferred financing fees.
Nonrecurring transaction expenses of $0.8 million related to the
Recapitalization were expensed in fiscal 1997.
Income tax benefit in 1997 was recorded due to the reduction of the
valuation reserve on the Company's deferred tax asset, net of certain
alternative minimum tax and state taxes. In 1996, no income taxes were recorded
due to the loss incurred.
Net income (loss) for fiscal 1997 increased to $16.3 million from
($72.4) million in fiscal 1996.
LIQUIDITY AND CAPITAL RESOURCES
Guitar Center's need for liquidity will arise primarily from
interest payable on its indebtedness and the funding of the Company's capital
expenditure and working capital requirements. The Company has historically
financed its operations through internally generated funds and borrowings
under its credit facilities. The Company has no mandatory payments of
principal on the Senior Notes prior to their final maturity in 2006. As of
December 31, 1998, the Company had $7.7 million outstanding under its 1997
Credit Facility and $170,000 outstanding on standby letters of credit. The
Company had available borrowings of approximately $32.1 million at December
31, 1998. The interest rate under the 1997 Credit Facility as of the filing
date of this annual report was 7.75% on prime rate based borrowings. The
agreement underlying the 1997 Credit Facility expires July 1, 2004 and
includes certain restrictive covenants which, among other things, require the
Company to maintain certain
21
financial ratios. The Company was in compliance with all such requirements as
of December 31, 1998.
The increase in inventories was required to support existing store
sales growth and the opening of new locations. Inventory per square foot was
$136.42 in 1998 as compared to $144.18 in 1997. The purchase of inventory was
principally funded by the Company's cash flow from operations and the 1997
Credit Facility. The Company's ongoing objective is to improve inventory
performance by refining its replenishment processes and systems, and through
improved planning, presentation, and display of inventories in its retail
stores.
For fiscal 1998 and 1997, cash provided by operating activities was
$1.2 million and cash used was $2.4 million, respectively. Cash used in
investing activities during fiscal 1998 totaled $17.3 million, relating
principally to the construction costs of opening new stores. In 1997, capital
expenditures totaled $19.1 million relating principally to the acquisition of
two musical instruments stores in Atlanta, Georgia ($10.3 million) and the
construction costs of opening new stores. Cash provided by financing activities
in fiscal 1998 totaled $8.5 million relating principally to borrowings under the
Company's line of credit.
The Company presently expects to spend approximately $16.0 million in
capital expenditures in 1999.
The Company intends to pursue an aggressive growth strategy by opening
additional stores in new and existing markets. The Company operated 48 stores as
of December 31, 1998, twelve of which were opened during 1998, eight of which
were opened during fiscal 1997, and seven of which were opened during fiscal
1996, and presently expects to open approximately twelve and sixteen stores in
each of fiscal 1999 and 2000, respectively.
The Company believes that there may be attractive opportunities to
expand by selectively acquiring existing music product retailers or by
developing or acquiring mail order catalogue and internet sales businesses.
In the ordinary course of business, the Company regularly considers,
evaluates and enters into negotiations related to potential acquisition
opportunities. Any such transactions may involve the payment by the Company
of cash or securities (including equity securities), or a combination of the
foregoing. As of the filing date of this annual report, the Company had no
agreements or commitments to enter into any acquisitions. There can be no
assurance that the Company will be able to identify suitable acquisition
candidates available for sale at reasonable prices or consummate any
acquisition or that any current negotiations will result in an acquisition.
See "Item 1. Business -- Risks Related to the Business -- We May Be Unable to
Meet our Growth Strategy."
Management believes that the Company has adequate capital resources
and liquidity to meet its borrowing obligations, fund all required capital
expenditures and pursue its business strategy for at least the next twelve
months, including its present plans for expansion as described elsewhere
herein. The Company's capital resources and liquidity are expected to be
provided by the Company's cash flow from operations and borrowings under the
1997 Credit Facility. Depending on market conditions, the Company may also
incur additional indebtedness or issue equity securities. There can no
assurance that such additional capital, if and when required, will be
available on terms acceptable to the Company, if at all.
INCOME TAXES
The Company operated as an "S" corporation for all reported periods
prior to the closing of its 1996 recapitalization on June 5, 1996. Accordingly,
federal taxes were paid at the stockholder level and the Company paid minimal
state income taxes. Upon consummation of the Recapitalization, the Company
eliminated its "S" corporation status and, accordingly, became subject to
federal, state and local corporate income taxes.
As a result of the $72.4 million loss incurred in fiscal 1996, the
Company has a tax net operating loss carryforward for federal income tax
purposes aggregating $41.8 million, which will expire if unused in 2011. As of
December 31, 1998, the Company had reserved $6.5 of the related deferred tax
asset of $17.0 million.
22
Upon finalization of the Company's 1998 tax returns, substantially
all of the Company's state income tax net operating loss will be utilized.
Consequently, state income taxes in 1999 will have to be funded through cash
payments. Additionally, due to certain changes in the Company's ownership
structure, it is anticipated that the timing of the use of the Company's
federal net operating loss may be limited during 1999. This limitation
affects the timing of realization of the tax benefit associated with our NOL,
not the amount of the ultimate benefit. It is currently anticipated that cash
payments for income taxes will be necessary in the fourth quarter of 1999.
See footnote 8 to the Consolidated Financial Statements.
SEASONALITY
The Company's results are not highly seasonal, although, as with most
retailers, sales in the fourth quarter are typically higher than in other
quarters.
YEAR 2000
The Year 2000 issue is primarily the result of computer programs using
a two-digit format, as opposed to four digits, to indicate the year. Computer
programs that are date dependent are found in the software that operates many IT
systems as well as in the computer based devices which control many types of
electronic equipment. Computer programs that are not Year 2000 compliant will be
unable to interpret dates beyond the year 1999, which could cause a system
failure or other computer errors, leading to a disruption in the operation of
the related IT systems or electronic equipment.
In 1997, the Company established a project plan to investigate the
Year 2000 compliance of its internal and third party computer system
applications and hardware. The objective was to verify third party compliance
and complete internal compliance prior to year end 1999. All work has been
substantially completed with the exception of a major software project
related to the Company's inventory management system due to be implemented in
April of 1999. As of the date of this annual report, the Company believes
that all of its significant IT systems will be Year 2000 compliant by the end
of 1999. The Company currently does not have a contingency plan with regard
to the Year 2000. During 1999, the Company will continue to evaluate whether
and to what extent contingency arrangements should be implemented.
The Company has also endeavored to assess the Year 2000 compliance
of the outside parties upon which it is most dependent, including large
vendors of the products resold in the Guitar Center stores. While the Company
is not aware of any material compliance difficulties expected by any such
supplier, its ability to obtain accurate information is necessarily limited.
A number of the Company's vendors manufacture their products overseas, also
making accurate information difficult to obtain. Those vendors, as well as
the Company, are also dependent upon the continued normal functioning of
surface and air transportation, electric utility and voice and data
transmission infrastructure, and the electronic payments systems and other
activities of large financial institutions. Many of these companies have very
significant Year 2000 compliance programs underway because they tend to be
dependent on large, proprietary "legacy" computing systems that are
particularly susceptible to Year 2000 problems. The success of these
compliance programs will prove important to the Company and those with which
it does business.
Based on the assessment efforts to date, however, the Company does not
believe that the Year 2000 issue will have a material adverse effect on its
financial condition or results of operations. The Company's beliefs and
expectations, however, are based on certain assumptions and expectations that
ultimately may prove to be inaccurate. The Company believes that by the end of
1999, it will be able to fully determine its most reasonably likely worst case
scenarios. Potential sources of risk include (a) the inability of principal
suppliers to be Year 2000 ready, which could result in delays in product
deliveries from such suppliers, (b) disruption of the distribution channel,
including ports, and transportation vendors, as a result of a general failure of
systems and necessary infrastructure such as electric power supply, voice and
data communications and financial payment systems, and (c) unexpected failures
of systems or devices that are misidentified as being Year 2000 compliant or
which prove unexpectedly to contain non-compliant, date-dependent computer code.
As of the date of this annual report, the Company does not expect the
future costs associated with its Year 2000 efforts to be substantial. To date,
the Company has spent minimal resources on the Year 2000 issue, as
23
such, primarily due to an already established, long term plan to upgrade and
modernize all systems which it has been implementing since 1995. The Year
2000 issues have been addressed as part of the overall global system
strategies. The Company's statements concerning future costs do not include
time and costs that may be incurred by the Company as a result of the failure
of any third parties, including suppliers, to become Year 2000 compliant, or
costs to implement any contingency plans.
The information above contains forward-looking statements which reflect
the current views of the Company with respect to Year 2000 compliance and the
related costs and possible impact on its financial performance. As indicated
above, these assessments may prove to be inaccurate. The Year 2000 problem is
novel. Neither the Company nor any of its suppliers is experienced at
identifying and remediating a problem of this sort which represents a systemic
defect that, if not corrected, will cause the failure of computer systems and
computer-controlled devices that are pervasive in the infrastructure of business
and government.
INFLATION
The Company believes that the relatively moderate rates of inflation
experienced in recent years have not had a significant impact on its nets sales
or profitability.
IMPACT OF RECENTLY ISSUED PRONOUNCEMENTS
In April 1998, the AICPA issued Statement of Position 98-5, "REPORTING
ON THE COSTS OF START-UP ACTIVITIES" (SOP 98-5). SOP 98-5 requires that costs
incurred during start-up activities, including organization costs and
pre-opening costs for new stores, be expenses as incurred. SOP 98-5 is effective
for financial statements for fiscal years beginning after December 15, 1998.
Initial application of SOP 98-5 should be as of the beginning of the fiscal year
in which SOP 98-5 is first adopted and should be reported as a cumulative effect
of a change in accounting principle.
The Company will adopt SOP 98-5 in the first quarter of 1999. In the
first quarter of 1999, the Company will record a cumulative effect of a change
in accounting principle of approximately $1,652,000 in the consolidated
statement of operations for the period ending March 31, 1999 relative to the
adoption of SOP 98-5.
FORWARD-LOOKING STATEMENTS
This annual report contains certain 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), sales, gross
margin and expense trends, Year 2000 conversion, capital requirements and
general industry and business conditions applicable to the Company. These
forward-looking statements are based largely on the Company's current
expectations and are subject to a number of risks and uncertainties. Actual
results could differ materially from these forward-looking statements. Important
factors to consider in evaluating such forward-looking statements include
changes in external competitive market factors, change in the Company's business
strategy or an inability to execute its 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 competitive factors
that may prevent the Company from competing successfully in existing or future
markets. In light of these risks and uncertainties, many of which are described
in greater detail in "Item 1. Business -- Risks Related to the Business," there
can be no assurance that the forward-looking statements contained in this Report
will in fact be realized.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
See the index included at "Item 14. Exhibits, Financial Statement Schedules
and Reports on Form 10-K."
24
PART III
ITEM 9. DIRECTORS AND OFFICERS OF THE REGISTRANT
The information required by this item is incorporated by reference to
the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), in
connection with the Company's annual meeting of stockholders.
ITEM 10. EXECUTIVE COMPENSATION
The information required by this item is incorporated by reference to
the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
under the Exchange Act in connection with the Company's annual meeting of
stockholders.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is incorporated by reference to
the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
under the Exchange Act in connection with the Company's annual meeting of
stockholders.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is incorporated by reference to
the Company's definitive Proxy Statement to be filed pursuant to Regulation 14A
under the Exchange Act in connection with the Company's annual meeting of
stockholders.
PART IV
ITEM 13. EXHIBITS, FINANCIAL STATEMENT SCHEDULE, AND REPORTS ON FORM 8-K
(a) Documents filed as part of this Report:
1. The following financial statements for the Company are included as
part of this Report:
Index to Financial Statements Page F-1
2. The following financial statement schedule for the Company is
included as part of this Report:
Schedule II -- Valuation and Qualifying Accounts Page II-1
All other schedules have been omitted since the required
information is not present in amounts sufficient to require
submission of the schedules, or because the information
required is included in the financial statements.
(b) No reports on Form 8-K were filed during the quarter ended December 31,
1998.
(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 (*).
25
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 3.7 of the Company's Registration Statement on Form S-1
(Registration No. 333-20931))
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 Restricted Stock Agreements dated as of May 1, 1996 between the
Company and certain members of management (Incorporated by reference to
Exhibit 4.2 of the Company's Registration Statement on Form S-1
(Registration No. 333-10491))
4.3 Warrants (1-4) dated June 5, 1996 for the purchase of shares of Common
Stock and Junior Preferred Stock issued to certain investors
(Incorporated by reference to Exhibit 4.3 of the Company's Registration
Statement on Form S-1 (Registration No. 333-10491))
4.4 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))
10.1 Recapitalization Agreement dated May 1, 1996 by and among the Company
and the stockholders named therein (Incorporated by reference to
Exhibit 10.1 of the Company's Registration Statement on Form S-1
(Registration No. 333-10491)
10.2 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))
10.3 Tax Indemnification Agreement dated as of May 1, 1996 by and among the
Company, Ray Scherr, and the individuals identified on the signature
pages thereto (Incorporated by reference to Exhibit 10.3 of the
Company's Registration Statement on Form S-1 (Registration No.
333-10491)
10.4* Employment Agreement dated June 5, 1996 between the Company and
Lawrence Thomas (Incorporated by reference to Exhibit 10.5 of the
Company's Registration Statement on Form S-1 (Registration No.
333-10491))
10.5* 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))
10.6* Employment Agreement dated June 5, 1996 between the Company and Marty
Albertson (Incorporated by reference to Exhibit 10.6 of the Company's
Registration Statement on Form S-1 (Registration No. 333-10491))
10.7* Employment Agreement dated June 5, 1996 between the Company and Bruce
Ross, as amended (Incorporated by reference to Exhibit 10.7 of the
Company's Registration Statement on Form S-1 (Registration No.
333-20931))
10.8* Employment Agreement dated June 5, 1996 between the Company and Raymond
Scherr (Incorporated by reference to Exhibit 10.8 of the Company's
Registration Statement on Form S-1 (Registration No. 333-10491))
10.9* Employment Agreement dated June 5, 1996 between the Company and Barry
Soosman, as amended (Incorporated by reference to Exhibit 10.9 of the
Company's Registration Statement
26
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
on Form S-1 (Registration No. 333-20931))
10.10 Securities Purchase Agreement dated June 5, 1996 by and among the
Company and the parties named therein (Incorporated by reference to
Exhibit 10.10 of the Company's Registration Statement on Form S-1
(Registration No. 333-10491))
10.11* 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))
10.12 Credit Agreement dated August 14, 1997 between the Company and Wells
Fargo Bank, N.A. (Incorporated by reference to Exhibit 10.36 of the
Company's Quarterly Report on Form 10-Q for the quarter ended September
30, 1997
10.15 Registration Rights Agreement dated July 2, 1996 by and among the
Company, Chase Securities Inc. and Donaldson, Lufkin & Jenrette
Securities Corporation (Incorporated by reference to Exhibit 10.15 of
the Company's Registration Statement on Form S-1 (Registration No.
333-10491))
10.16* 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))
10.17* 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))
10.18 Registration Agreement dated June 5, 1996 among the Company and the
parties named therein (Incorporated by reference to Exhibit 10.11
contained in Registration Statement on Form S-1 (File No. 333-10491))
10.19 Stockholders Agreement dated June 5, 1996 among the Company, and the
investors listed therein (Incorporated by reference to Exhibit 10.19 of
the Company's Registration Statement on Form S-1 (Registration No.
333-10491))
10.20* 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))
10.21* Form of Employee Stock Purchase Plan Agreement (Incorporated by
reference to Exhibit 10.25 of the Company's Registration Statement on
Form S-1 (Registration No. 333-20931))
10.22* Amended 1997 Equity Participation Plan
10.23 Stockholders Consent dated as of January 24, 1997 by and among the
Company and certain of its stockholders (Incorporated by reference to
Exhibit 10.27 of the Company's Registration Statement on Form S-1
(Registration No. 333-20931))
10.24* 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))
10.25* Management Stock Repurchase Agreement (Incorporated by reference to
Exhibit 10.29 of the Company's Registration Statement on Form S-1
(Registration No. 333-20931))
10.26* 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))
27
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
10.27* Amendment No. 1 to Management Stock Option Agreement dated as of
October 15, 1996 between the Company and Larry Thomas (Incorporated by
reference to Exhibit 10.21 contained in Registration Statement on Form
S-1 (File No. 333-10491))
10.28* Amendment No. 1 to Management Stock Option Agreement dated as of
October 15, 1996 between the Company and Marty Albertson (Incorporated
by reference to Exhibit 10.22 contained in Registration Statement on
Form S-1 (File No. 333-10491))
10.29* Amendment No. 3 to Amended and Restated 1996 Performance Stock Option
Plan
11.1 Calculation of Earnings (loss) per Common Stockholders
12.1 Ratio of Earnings to Fixed Charges
23.1 Independent Auditors' Consent
24.1 Power of Attorney (included on page S-1)
27.1 Financial Data Schedule
- ---------------------------
*Management contract or other compensation plan or arrangement.
28
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
5th day of March, 1999.
GUITAR CENTER, INC.
/s/ Larry Thomas
----------------------------------------
Larry Thomas
President and 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 President, Chief Executive Officer and
- -------------------------- Director (Principal Executive Officer) 3/5/99
Larry Thomas
/s/ Bruce Ross Executive Vice President, Chief Financial
- -------------------------- Officer and Secretary (Principal Financial 3/5/99
Bruce Ross and Accounting Officer)
/s/ Marty Albertson Executive Vice President, Chief Operating
- -------------------------- Officer and Director 3/5/99
Marty Albertson
/s/ Steven Burge
- -------------------------- Director 3/5/99
Steven Burge
/s/ David Ferguson
- -------------------------- Director 3/5/99
David Ferguson
/s/ Harvey Kibel
- -------------------------- Director 3/5/99
Harvey Kibel
/s/ Michael Lazarus
- -------------------------- Director 3/5/99
Michael Lazarus
/s/ Peter Starrett
- -------------------------- Director 3/5/99
Peter Starrett
/s/ Jeffrey Walker
- -------------------------- Director 3/5/99
Jeffrey Walker
GUITAR CENTER, INC.
29
INDEX TO FINANCIAL STATEMENTS
Report of Independent Auditors (KPMG LLP) F-2
Consolidated Balance Sheets as of December 31, 1997 and 1998 F-3
Consolidated Statements of Operations for the years ended
December 31, 1996, 1997 and 1998 F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the
years ended December 31, 1996, 1997 and 1998 F-5
Consolidated Statements of Cash Flows for the years ended
December 31, 1996, 1997 and 1998 F-6
Notes to Consolidated Financial Statements F-7
SCHEDULE
--------
Financial Statement Schedule:
Valuation and Qualifying Accounts II-1
30
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Guitar Center, Inc. and Subsidiary:
We have audited the accompanying consolidated balance sheets of
Guitar Center, Inc. and subsidiary as of December 31, 1998 and 1997 and the
related consolidated statements of operations, stockholders' equity (deficit)
and cash flows for each of the years in the three year period ended December
31, 1998. 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 generally accepted auditing
standards. 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 subsidiary as of December 31, 1998 and 1997 and the
results of their operations and their cash flows for each of the years in the
three year period ended December 31, 1998 in conformity with generally
accepted accounting principles. Also, in our opinion, the related
consolidated financial statement schedule, when considered in relation to the
basic consolidated financial statements taken as a whole, present fairly, in
all material respects, the information set forth therein.
KPMG LLP
Los Angeles, California
February 9, 1999
MANAGEMENT RESPONSIBILITY FOR FINANCIAL STATEMENTS
Management is responsible for the preparation of the Company's
consolidated financial statements and related informaiton appearing in this
annual report. Management believes that the consolidated financial statements
fairly reflect the form and substance of transactions and that the financial
statements reasonably present the Company's financial position and results of
operations in conformity with generally accepted accounting principles.
Management also has included in the Company's financial statements amounts
that are based on estimates and judgments which it believes are reasonable
under the circumstances.
The independent accountants audit the Company's consolidated
financial statements in accordance with generally accepted auditing
statements 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 Review Committee
composed of three non-management Directors. The Committee meets periodically
with financial management and the independent accountants to review
accounting, control, auditing and financial reporting matters.
Larry Thomas Bruce Ross
PRESIDENT & CEO EXECUTIVE VICE PRESIDENT & CFO
Los Angeles, California
February 9, 1999
31
GUITAR CENTER, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
DECEMBER 31,
1997 1998
---------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 7,755 $ 113
Accounts receivable, less allowance for doubtful accounts
of $150 (1997) and $198 (1998) 7,896 10,575
Merchandise inventories 78,898 102,853
Prepaid expenses and other current assets 3,118 4,990
Employee notes 108 --
--------------------------
Total current assets 97,775 118,531
Property and equipment, net 22,809 34,754
Deferred income taxes 5,000 10,431
Goodwill, net of accumulated amortization of $279 (1997) and $479 (1998) 4,094 4,618
Other assets 2,946 3,260
--------------------------
$ 132,624 $ 171,594
--------------------------
--------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 16,863 $ 18,790
Accrued expenses 15,731 14,648
Merchandise advances 3,570 4,918
Revolving line of credit -- 7,723
--------------------------
Total current liabilities 36,164 46,079
Other long-term liabilities 1,017 1,426
Long-term debt 66,667 66,691
Stockholders' equity:
Preferred Stock; authorized 5,000,000 shares at December 31, 1998
and December 31, 1997, none issued and outstanding -- --
Common stock, $0.01 par value, authorized 55,000,000 shares; issued
and outstanding 19,338,073 at December 31, 1997 and
20,092,943 at December 31, 1998 respectively 193 201
Warrants 6,500 --
Additional paid in capital 220,514 228,195
Accumulated deficit (198,431) (170,998)
--------------------------
Total stockholders' equity 28,776 57,398
--------------------------
$ 132,624 $ 171,594
--------------------------
--------------------------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
32
GUITAR CENTER, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
YEAR ENDED DECEMBER 31,
1996 1997 1998
----------------------------------------------------
Net sales $ 213,294 $ 296,655 $ 391,665
Cost of goods sold, buying and occupancy 153,222 214,345 282,023
--------- --------- ---------
Gross profit 60,072 82,310 109,642
Selling, general and administrative expenses 41,345 56,915 77,182
Deferred compensation expense 71,760 -- --
--------- --------- ---------
Operating income (loss) (53,033) 25,395 32,460
Interest expense, net (12,169) (8,928) (8,509)
Transaction expenses (6,942) (755) --
Other income (expenses) (126) 535 324
--------- --------- ---------
Income (loss) before income taxes and extraordinary loss (72,270) 16,247 24,275
Income taxes (benefit) 139 (2,833) (3,158)
--------- --------- ---------
Income (loss) before extraordinary loss (72,409) 19,080 27,433
Extraordinary loss on early extinguishment of debt, net of
tax benefit of $1,679 -- (2,739) --
--------- --------- ---------
Net income (loss) $ (72,409) $ 16,341 $ 27,433
Income (loss) available to common stockholders (1996
data is unaudited pro forma data):
Income (loss) before taxes $ (72,270) -- --
Pro forma income taxes -- -- --
--------- --------- ---------
Net income (loss) (72,270) -- --
Senior and junior preferred stock dividends 7,951 7,747 --
--------- --------- ---------
Net income (loss) available to common stockholders $ (80,221) $ 8,594 $ 27,433
--------- --------- ---------
--------- --------- ---------
Net income (loss) per common share
Basic $ (4.15) $ 0.44 $ 1.39
--------- --------- ---------
--------- --------- ---------
Diluted $ (3.93) $ 0.42 $ 1.31
--------- --------- ---------
--------- --------- ---------
Weighted average shares outstanding
Basic 19,329 19,331 19,766
--------- --------- ---------
--------- --------- ---------
Diluted 20,420 20,602 20,923
--------- --------- ---------
--------- --------- ---------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.
33
GUITAR CENTER, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS)
ADDITIONAL RETAINED
PREFERRED COMMON PAID IN EARNINGS
STOCK STOCK WARRANTS CAPITAL (DEFICIT) TOTAL
--------------------------------------------------------------------------------
(IN THOUSANDS)
Balance at December 31, 1995 $ -- $ 4,987 $ -- $ -- $ 4,776 $ 19,763
S Corporation cash distributions -- -- -- -- (28,057) (28,057)
S Corporation non-cash distributions -- -- -- -- (1,753) (1,753)
Redemption of prior sole stockholder
interest 19,800 (4,787) -- -- (128,115) (113,102)
Reclassification of prior
S Corporation deficit -- -- -- (10,249) 10,249 --
Issuance of equity to management 49,500 500 -- -- -- 50,000
Issuance of equity to new investors 69,300 700 -- -- -- 70,000
Issuance of warrants -- -- 6,500 -- -- 6,500
Options granted to management by
investor group -- -- -- 1,918 -- 1,918
Reclassification of excess of par
value -- (1,364) -- 1,364 -- --
Sale of equity to management 10 -- -- 1 -- 11
Net loss -- -- -- -- (72,409) (72,409)
Undeclared dividend on senior
preferred stock -- -- -- -- (1,602) (1,602)
Accretion of senior preferred stock -- -- -- -- (84) (84)
-------- ------- ------- --------- --------- --------
Balance at December 31, 1996 138,610 36 6,500 (6,966) (206,995) (68,815)
Sale of equity to management 307 -- -- 3 -- 310
Conversion of junior preferred stock (138,917) 93 -- 138,824 -- --
Offering of common stock -- 77 -- 106,959 -- 107,036
Repurchase of management common
stock -- (13) -- (18,404) -- (18,417)
Senior preferred dividends paid -- -- -- -- (7,747) (7,747)
Accretion of senior preferred stock -- -- -- -- (30) (30)
Exercise of employee stock options -- -- -- 98 -- 98
Net income -- -- -- -- 16,341 16,341
-------- ------- ------- --------- --------- --------
Balance at December 31, 1997 -- 193 6,500 220,514 (198,431) 28,776
Purchase of warrants/cost of
underwriting -- 8 (6,500) 6,394 -- (98)
Exercise of employee stock options -- -- -- 860 -- 860
Tax benefit from exercise of
employee stock options -- -- -- 427 -- 427
Net income -- -- -- -- 27,433 27,433
-------- ------- ------- --------- --------- --------
Balance at December 31, 1998 $ -- $ 201 $ -- $ 228,195 $(170,998) $ 57,398
-------- ------- ------- --------- --------- --------
-------- ------- ------- --------- --------- --------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
34
GUITAR CENTER, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
YEAR ENDED DECEMBER 31,
1996 1997 1998
------------------------------------------------
OPERATING ACTIVITIES
Net income (loss) $ (72,409) $ 16,341 $ 27,433
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization 2,161 3,148 4,747
Deferred compensation--repurchase of options 49,510 -- --
Investor options to management 1,918 -- --
Change in deferred tax asset -- (5,000) (5,431)
Tax benefit from exercise of stock options -- -- 427
(Gain) loss on sale of fixed assets 112 (535) (324)
Amortization of deferred financing fees 215 1,363 240
Changes in operating assets and liabilities:
Accounts receivable (1,859) (3,834) (2,679)
Merchandise inventories (18,424) (23,093) (23,955)
Prepaid expenses (698) (1,840) (1,872)
Other assets (511) (178) (1,078)
Accounts payable 1,392 2,858 1,927
Accrued liabilities 830 6,840 2,583
Deferred compensation (7,908) -- --
Merchandise advances 391 1,169 1,348
Other long-term liabilities 382 372 (2,175)
-------- --------- ---------
Net cash provided by (used in) operating activities (44,898) (2,389) 1,191
INVESTING ACTIVITIES
Acquisition of Rhythm City, net of cash acquired -- (10,300) (1,058)
Proceeds from sale of assets 433 893 733
Purchases of property and equipment (6,133) (9,650) (17,101)
Employee notes 15 (41) 108
-------- --------- ---------
Net cash used in investing activities (5,685) (19,098) (17,318)
FINANCING ACTIVITIES
Proceeds from issuance of long-term debt 100,000 -- --
Net change in revolving debt facility 3,536 (3,536) 7,723
Distribution of prior shareholder interest (113,102) -- --
Deferred financing fees paid (3,585) -- --
Issuance of common stock 1,200 -- --
Issuance of junior preferred stock 69,300 -- --
Issuance of senior preferred stock 13,500 -- --
Issuance of warrants 6,500 -- --
Distributions to prior sole shareholder (28,057) -- --
Redemption of Senior Notes -- (33,333) --
Proceeds from sale of stock to management -- 310 --
Proceeds from initial public offering -- 107,036 --
Proceeds from exercise of stock options -- 98 860
Redemption of senior preferred stock -- (22,963) --
Cost of warrant underwriting -- -- (98)
Redemption of management stock -- (18,417) --
-------- --------- ---------
Net cash provided by financing activities 49,292 29,195 8,485
-------- --------- ---------
Net increase (decrease) in cash and cash equivalents (1,291) 7,708 (7,642)
Cash and cash equivalents at beginning of year 1,338 47 7,755
-------- --------- ---------
Cash and cash equivalents at end of year $ 47 $ 7,755 $ 113
-------- --------- ---------
-------- --------- ---------
35
GUITAR CENTER, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(IN THOUSANDS)
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Cash paid during the year for:
Interest $11,890 $ 8,319 $ 12,175
-------- --------- ---------
-------- --------- ---------
Income taxes $ 139 $ 514 $ 626
-------- --------- ---------
-------- --------- ---------
SEE ACCOMPANYING NOTES TO CONSOLIDATED FINANCIAL STATEMENT
36
GUITAR CENTER, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1998
1. NATURE OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
NATURE OF BUSINESS
Guitar Center, Inc. and subsidiary ("Guitar Center" or the
"Company") operates a chain of retail stores which sell high quality musical
instruments primarily guitars, keyboard, percussion and pro-audio equipment.
At December 31, 1998, the Company operated 48 stores in major cities
throughout the United States with 13 of the stores located in California.
The financial statements give effect to the reincorporation of the
Company from a California to a Delaware corporation on October 11, 1996 and a
2.582-to-1 stock split effectuated on January 15, 1997.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the financial statements
of Guitar Center, Inc. and its wholly-owned subsidiary. All significant
intercompany balances and transactions have been eliminated in consolidation.
RECLASSIFICATIONS
Certain reclassifications have been made to prior year amounts in order
to conform to the 1998 presentation.
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.
PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost. Depreciation is computed
using the straight-line method over the estimated useful lives of the assets;
generally five years for furniture and fixtures, computer equipment and
vehicles, 15 years for buildings and 15 years or the life of the lease,
whichever is less, for leasehold improvements. Maintenance and repair costs are
expensed as they are incurred, while renewals and betterments are capitalized.
STORE PRE-OPENING COSTS
Effective January 1, 1996, the Company elected to capitalize certain
pre-opening costs and amortize the balance over 12 months. Effective January
1, 1999, the Company will expense pre-opening costs as required by AICPA
Statement of Position 98-5, "Reporting on the Costs of Start-up Activities"
(SOP 98-5). In the first quarter of 1999, the Company will record a charge
for the cumulative effect of a change in accounting principle of
approximately $1,652,000 in the consolidated statement of operations for the
period ending March 31, 1999 relative to the adoption of SOP 98-5.
ADVERTISING COSTS
The Company expenses the costs of advertising as incurred. Advertising
expense included in the statements of operations for the years ended December
31, 1996, 1997 and 1998, is $5,717,000, $7,527,000, and $10,230,000
respectively.
37
MERCHANDISE ADVANCES
Merchandise advances represent primarily layaway deposits which are
recorded as a liability pending consummation of the sale when the full purchase
price is received from the customer and outstanding gift certificates which are
recorded as a liability until redemption by the customer.
REVENUE RECOGNITION
Revenue is recognized at the time of sale, net of a provision for
estimated returns.
INCOME TAXES
In connection with the Recapitalization, the Company terminated its S
Corporation election and converted to a C Corporation for income tax purposes.
The Company accounts for income taxes under Statement of Financial Accounting
Standards No. 109, "Accounting for Income Taxes" ("SFAS 109"). Under the asset
and liability method of SFAS 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 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, 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. Management
considers the scheduled reversals of deferred tax liabilities, projected future
taxable income, and tax planning strategies in making this assessment.
Prior to the Recapitalization, the Company had elected to be taxed as
an S corporation. This election generally requires the individual stockholder
rather than the Company to pay federal income taxes on the Company's earnings.
GOODWILL
Goodwill represents the excess of the purchase price over the fair
value of the net assets acquired resulting from business combinations are being
amortized on a straight-line basis over 30 years.
RENT EXPENSE
The Company leases certain store locations under operating leases that
provide for annual payments that increase over the life of the leases. The
aggregate of the minimum annual payments are expensed on a straight-line basis
over the term of the related lease. The amount by which straight-line rent
expense exceeds actual lease payment requirements in the early years of the
leases is accrued as deferred minimum rent and reduced in later years when the
actual cash payment requirements exceed the straight-line expense.
CONCENTRATION OF CREDIT RISK
The Company's deposits are with various high quality financial
institutions. Customer purchases are transacted generally using cash or credit
cards. In certain instances, the Company grants credit for larger purchases,
generally to professional musicians, under normal trade terms. Trade accounts
receivable were approximately $677,000 and $668,000 at December 31, 1997 and
1998, respectively. Credit losses have historically been within management's
expectations.
38
USE OF ESTIMATES IN THE PREPARATION OF FINANCIAL STATEMENTS
The preparation of financial statements in conformity with generally
accepted accounting principles requires management 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 those estimates.
CASH AND CASH EQUIVALENTS
For the purposes of balance sheet classification and the statement of
cash flows, the Company considers all highly liquid investments that are both
readily convertible into cash and mature within 90 days of their date of
purchase to be cash equivalents.
IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF
The Company adopted the provisions of SFAS No. 121, ACCOUNTING FOR THE
IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, on
January 1, 1996. This Statement requires that long-lived assets and certain
identifiable intangibles be 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 an asset to future net cash flows expected
to be generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceed the fair value of the assets. Assets to be disposed
of are reported at the lower of the carrying amount or fair value less costs to
sell.
STOCK OPTION PLANS
Prior to January 1, 1996, the Company accounted for its stock option
plan in accordance with the provisions of Accounting Principles Board ("APB")
Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and related
interpretations. As such, compensation expense would be recorded on the date of
grant only if the current market price of the underlying stock exceeded the
exercise price. On January 1, 1996, the Company 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 APB Opinion No. 25 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. The Company has elected to continue to apply the provisions of APB
Opinion No. 25 and provide the pro forma disclosure provisions of SFAS No. 123.
EARNINGS PER SHARE
The following table summarizes the reconciliations of Basic to Diluted
Weighted Average Shares EPS calculation as required by SFAS No. 128 for the
years ended January 31, 1996, 1997 and 1998:
1996 1997 1998
-------------------------------------
(IN THOUSANDS)
Basic shares 19,329 19,331 19,766
Common stock equivalents 1,091 1,271 1,157
------- ------ ------
Diluted shares 20,420 20,602 20,923
------- ------ ------
------- ------ ------
Net income (loss) available to common stockholders is the same for
diluted and basic per share data. Per share data for 1996 includes the impact of
options issued within one year of the initial public offering in accordance with
the rules of the Securities and Exchange Commission.
39
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amount of the Company's financial instruments, which
principally include cash, accounts receivable, accounts payable and accrued
expenses, approximates fair value due to the relatively short maturity of such
instruments.
The fair value of the Company's short-term instruments reflects the
fair value based upon current rates available to the Company for similar debt.
As of December 31, 1998 the fair value of the Company's long term debt
instrument is $70.7 million, based on quoted market prices.
YEAR 2000
The Year 2000 problem is the result of computer programs being written
using two digits rather than four to define the applicable year. In January
1997, the Company developed a plan to resolve the Year 2000 problem to make its
system Year 2000 compliant. The plan includes modifying, upgrading, or replacing
its internal computer software applications and information systems. The Company
does not expect that the cost of its year 2000 compliance program will be
material to its business, results of operations or financial condition. Although
the impact on the Company caused by the failure of the Company's significant
suppliers to achieve year 2000 compliance in a timely manner or effective matter
is uncertain, the Company's business and results of operations could be
materially adversely affected by such a failure.
2. INVENTORIES
The major classes of inventories are as follows:
DECEMBER 31,
1997 1998
-------------------------
(IN THOUSANDS)
Major goods $ 52,820 $ 69,115
Associated accessories 14,361 18,487
Vintage guitars 3,667 4,567
Used merchandise 3,450 4,837
General accessories 4,600 5,847
-------- --------
$ 78,898 $102,853
-------- --------
-------- --------
Major goods includes the major product lines including stringed
merchandise, percussion, keyboards and pro-audio equipment. Associated
accessories are comprised of accessories to major goods. General accessories
includes other merchandise such as apparel, cables and books.
40
3. PROPERTY AND EQUIPMENT
Property and equipment consists of the following:
DECEMBER 31,
1997 1998
-----------------------
(IN THOUSANDS)
Land $ 2,590 $ 2,459
Buildings 8,793 8,156
Transportation equipment 481 740
Furniture and fixtures 11,206 16,270
Leasehold improvements 10,360 20,967
Construction in progress 2,062 2,611
------- -------
35,492 51,203
Less accumulated depreciation 12,683 16,449
------- -------
$22,809 $34,754
------- -------
------- -------
4. DEBT
In connection with the Recapitalization (on June 5, 1996, Guitar Center
consummated a series of transactions to effect the recapitalization of the
Company), the Company borrowed $100 million under the Bridge Facility. Financing
fees of $4.7 million were paid and charged to the statement of operations during
June 1996. On July 2, 1996, the Bridge Facility was repaid with the proceeds
from the sale of Senior Notes and cash on hand. The Senior Notes are unsecured
and pay interest at 11% on a semi-annual basis.
Immediately following the initial public offering, the Company called
for redemption, at a premium of 10%, an aggregate of $33.3 million principal
amount of the Senior Notes. On April 19, 1997, the Company used $37.9 million of
the net proceeds from the initial public offering to redeem such Senior Notes
(the "Senior Note Redemption"), including payment of all accrued and unpaid
interest with respect to the Senior Notes called for redemption. Accordingly, an
extraordinary charge to operations of $4.4 million, net of tax of $1.7 million
(or $0.14 and $0.13 per basic and diluted share, respectively), was incurred in
the second quarter of 1997 equal to the premium paid on the Senior Notes plus
the write off of one-third of the unamortized deferred financing fees.
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 the option of the Company,
at any time after July 1, 2001 at prices declining from 105.5% to 100.0% of the
principal amount redeemed, plus accrued and unpaid interest. The holders of the
Senior Notes have the right to require the Company 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
in 2006.
In the third quarter of 1997, the Company terminated its prior
credit facility (the "1996 Facility) and entered into a new $40 million
secured revolving line of credit (the "1997 Credit Facility") which is
available through July 1, 2004. The 1997 Credit Facility provides for
revolving credit or term loan borrowings up to $40 million in the aggregate.
The Facility is secured by inventory and receivables, as defined. A fee of
0.25% is assessed on the unused portion of the facility. Borrowings under the
1997 Credit Facility bear interest at either the prime rate or at LIBOR plus
1.5%, at the Company's option, with interest due monthly. At December 31,
1998 borrowings under the 1997 Credit Facility bear interest at 7.75%. At
December 31, 1998, the Company had $7.7 million outstanding under the 1997
Credit Facility and $170,000 outstanding on standby letters of credit. The
Company had available borrowings under the line of credit of approximately
$32.1 million at December 31, 1998.
Under the terms of the 1997 Credit Facility and the Senior Notes, the
Company is subject to various financial and other covenants. The Company was in
compliance with such covenants at December 31, 1997 and 1998.
41
5. LEASE COMMITMENTS AND RELATED PARTY TRANSACTIONS
The Company leases its office and most of its retail store facilities
under various operating leases which expire at varying dates through December
2014. Generally, the agreements contain provisions which require the Company to
pay for normal repairs and maintenance, property taxes and insurance.
The total minimum rental commitment at December 31, 1998, under
operating leases, is as follows:
YEAR ENDED DECEMBER 31 AMOUNT
- ------------------------ -----------------
(in thousands)
1999 $ 8,840
2000 9,594
2001 9,649
2002 9,678
2003 9,712
Thereafter 44,758
The total rental expense included in the statements of operations for
the years ended December 31, 1996, 1997 and 1998 is $2,856,000, $4,269,000, and
$6,267,000 respectively.
6. PROFIT SHARING PLAN
The Company has a Profit Sharing Plan (the "Plan") which covers
substantially all employees who meet a minimum employment requirement. The
Company's board of directors can elect to contribute up to 15% of the
participants' compensation for any plan year, subject to a maximum of $30,000
per participant. During the Plan years ended October 31, 1996, 1997 and 1998 the
Company declared total contributions of $654,000, $894,000 and $1,182,000
respectively, which is included in accrued liabilities. In 1997 and 1998,
$193,000 and $182,000 of Plan assets, which had been forfeited by terminated
employees, were reallocated to participants.
7. STOCK OPTION PLANS
1996 PERFORMANCE STOCK OPTION PLAN
In June 1996, the Company adopted the 1996 Performance Stock Option
Plan (as amended, the "1996 Plan"), which provides for the granting of options
to officers and key employees. The options were granted with an exercise price
equal to the fair market value ($10.89 per share) of the underlying stock at the
date of grant and generally vest ratably over three years. Upon the consummation
of the Offering, no further options are available for grant under the 1996 Plan.
MANAGEMENT STOCK OPTION AGREEMENTS
In June 1996, the Company granted options to certain officers to
purchase 795,969 shares at an exercise price of $10.89 per share. Under the term
of the option agreements, the conditions for full accelerated vesting occurred
during 1997. No additional options are available for grant under this plan.
1997 EQUITY PARTICIPATION PLAN
In January 1997, the Company and its stockholders adopted the 1997
Equity Participation Plan (the "1997 Plan"). Under the 1997 Plan, the Company
may grant options to purchase up to 1,375,000 shares of Common Stock, $.01 par
value ("Common Stock"); PROVIDED, HOWEVER, that grants to any one individual may
not exceed 150,000 shares of Common Stock in any calendar year. Options granted
under the 1997 Plan must have an exercise price equal to the fair market value
of the underlying Common Stock at the date of grant and vest ratably over
42
various terms. As of December 31, 1998, 781,282 options had been granted
under the 1997 Plan.
OTHER OPTION ARRANGEMENTS
In December 1996, the Company's institutional investors granted options
to certain officers and key managers of the Company to purchase shares held by
such investors at a purchase price of $4.33 per share. The Company is not a
party to this agreement and has not, and will not, incur any obligation in
connection with such options. Under generally accepted accounting principles,
the Company recorded a charge in fiscal 1996 to the statement of operations in
the amount of $1.9 million, with a corresponding increase to additional paid in
capital.
The Company applies APB Opinion No. 25 in accounting for its plans. Had
the Company determined compensation cost based upon the fair value at the grant
date for its stock options under SFAS No. 123 using the Black Scholes option
pricing model, net income per share after deduction for preferred stock
dividends of $7,747,000 in 1997 including the following weighted average
assumptions used in these calculations, would have been as follows:
DECEMBER 31,
-----------------------
1997 1998
-------- -------
($ IN THOUSANDS)
Pro forma net income $14,695 $25,114
Pro forma net income per share (basic) $ 0.36 $ 1.27
Pro forma net income per share (diluted) $ 0.34 $ 1.20
Risk free interest rate 6.2% 5.1%
Expected lives 10.0 10.0
Expected volatility 28.0% 70.0%
Expected dividends -- --
Pro forma net income reflects only options granted in 1996, 1997 and
1998. Therefore, the full impact of calculating compensation cost for stock
options under SFAS No. 123 is not reflected in the pro forma net income amounts
presented above because compensation cost is reflected over the options' vesting
period of 3 to 10 years and compensation cost for options granted prior to
January 1, 1996 is not considered.
Stock option activity during the periods indicated is as follows:
WEIGHTED AVERAGE
NO. OF SHARES EXERCISE PRICE
-----------------------------------
Balance at December 31, 1995 -- $ --
Granted 1,509,807 10.89
Exercised -- --
Forfeited -- --
Expired -- --
--------- ---------
Balance at December 31, 1996 1,509,807 10.89
Granted 30,000 18.50
Exercised (8,994) 10.89
Forfeited (7,096) 10.89
Expired -- --
--------- ---------
Balance at December 31, 1997 1,523,717 11.04
Granted 781,282 21.05
Exercised (78,545) 10.89
Forfeited (34,574) 16.84
Expired -- --
--------- ---------
Balance at December 31, 1998 2,191,880 $ 14.50
--------- ---------
--------- ---------
43
At December 31, 1998, the outstanding stock options had an exercise
price ranging from $10.89 to $28.56 per share and a remaining contractual
life of 8-10 years.
At December 31, 1998, the number of stock options exercisable was
1,157,811 and had a weighted average exercise price of $10.96.
TERMINATED PLAN
Prior to the Recapitalization, the Company had granted to certain
members of management options to purchase 81,407,400 shares of common stock
of the Company at prices ranging from $.0005 to $0.11 per share. Upon
consummation of the Recapitalization, these options were exchanged for cash
and securities with management and canceled. For financial statement
purposes, the Company recorded a charge of approximately $69.9 million (net
of the $7.9 million previously accrued as deferred compensation) in the
statement of operations.
8. INCOME TAXES
Total income tax (benefit) for the years ended December 31, 1997 and
1998 consist of:
1997
-------------
Income before extraordinary item $ (2,833)
Extraordinary item (1,679)
--------
$ (4,512)
--------
--------
1997 CURRENT DEFERRED TOTAL
--------------------------------------------
Federal $ 280 $(4,320) $(4,040)
State 208 (680) (472)
------- ------- -------
$ 488 $(5,000) $(4,512)
------- ------- -------
------- ------- -------
1998 CURRENT DEFERRED TOTAL
--------------------------------------------
Federal $ 1,634 $(5,431) $(3,797)
State 639 -- 639
------- ------- -------
$ 2,273 $(5,431) $(3,158)
------- ------- -------
------- ------- -------
The pro forma unaudited income tax adjustments presented represent
income taxes which would have been reported had the Company been subject to
Federal and State income taxes as a C Corporation. The historical pro forma
provisions for income taxes were as follows:
1996
------------
(IN THOUSANDS)
Historical income taxes $ 139
-----
Pro forma adjustments (unaudited):
Federal --
State (139)
Total pro forma adjustments (139)
-----
Total pro forma provision for income taxes $ --
-----
-----
44
Pro forma income tax expense for 1996 and actual income tax benefit
for 1997 differs from the statutory tax rate of 35% as applied to earnings
before income taxes and extraordinary item, as follows:
1996 1997 1998
---- ---- ----
(IN THOUSANDS)
Expected income tax expense (benefit) $(25,295) $ 5,686 $ 8,498
State income taxes, net of federal benefit (3,650) 651 1,226
Non deductible transaction costs 3,281 -- --
Change in valuation allowance -- (5,000) (5,431)
Utilization of net carryforward -- (4,373) (7,859)
Benefit not recorded due to net carryforward position 25,379 -- --
Other 285 203 408
-------- -------- --------
$ -- $ (2,833) $ (3,158)
-------- -------- --------
-------- -------- --------
The tax effects of temporary differences that give rise to significant
portions of deferred tax assets and liabilities are presented below:
1997 1998
---- ----
(IN THOUSANDS)
Deferred tax assets:
Federal net operating loss carryforward $21,635 $15,092
State net operating loss carryforwards 618 --
Deferred compensation -- 848
Accrued liabilities 1,477 841
Inventory reserves 1,946 2,037
------- -------
Total gross deferred tax assets 25,677 18,818
------- -------
Deferred tax liabilities
Depreciation 521 1,518
Other 321 325
------- -------
Total gross deferred liabilities 842 1,842
------- -------
Deferred tax assets net of deferred tax liabilities 24,835 16,976
------- -------
Less valuation allowance 19,835 6,545
------- -------
Net deferred tax assets $ 5,000 $10,431
------- -------
------- -------
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. Management
considers 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 the Company will realize the benefits
of these deductible differences, net of the existing valuation allowance at
December 31, 1998. The amount of the deferred tax asset considered realizable,
however, could be reduced in the near term if estimates of future taxable income
during the carryforward period are reduced. In order to fully realize the
deferred tax asset, the Company will need to generate future taxable income of
approximately $41.8 million prior to the expiration of the net operating loss
carry forwards in 2011.
In connection with the Recapitalization, the Company entered into a tax
indemnification agreement with its former sole stockholder pursuant to which the
Company has agreed to indemnify such stockholder for any loss, damage, or
liability and all expenses incurred, suffered, sustained or required to be paid
by such stockholder in the event that certain specified aspects of the
Recapitalization are not treated for tax purposes in the manner contemplated by
the Recapitalization and related transactions.
45
9. ACCRUED EXPENSES
DECEMBER 31,
--------------------
1997 1998
---- ----
(IN THOUSANDS)
Wages, salaries and benefits $ 3,693 $ 4,216
Sales tax payable 3,124 3,319
Accrued interest 3,691 25
Other 5,223 7,088
------- -------
$15,731 $14,648
------- -------
------- -------
10. PREFERRED STOCK
REDEEMABLE SENIOR PREFERRED STOCK AND WARRANTS
In 1996 in connection with the Recapitalization, the Company issued
800,000 shares of Senior Preferred Stock with an initial aggregate liquidation
value of $20.0 million.
In 1997, approximately $23.0 million of the net proceeds from the
Offering were used to redeem, at a premium of 3%, all of the outstanding shares
of the Senior Preferred Stock. As a result, the Company incurred a charge to
dividends in the first quarter of 1997 of $7.7 million for the difference
between the financial statement value of the Senior Preferred Stock and the face
amount thereof, plus premium.
Dividends on the Senior Preferred Stock accrued at a rate of 14%. Such
dividends were payable quarterly on each of March 15, June 15, September 15 and
December 15, beginning June 15, 1996. The Senior Preferred stock was mandatorily
redeemable on June 15, 2008 at a redemption price equal to the aggregate
liquidation value plus all accrued and unpaid cash dividends.
In connection with the issuance of the Senior Preferred Stock the
holders received detachable warrants (in addition to the Senior Preferred Stock)
for the aggregate $20.0 million paid. The warrants were exchangeable for 676,325
shares of Common Stock and expired on June 5, 2006. The market value of the
warrants at issuance was deemed to be $6.5 million with the Senior Preferred
Stock valued at $13.5 million. The Warrants were exercisable at a price of $0.01
per share. On June 3, 1998, the warrants were exercised and converted into
shares of common stock on a cashless exercise basis. The effect to the Company's
total stockholder's equity was immaterial.
The Senior Preferred stock accreted to its redemption value ($20.0
million) using the effective interest method through its mandatory redemption
date of June 15, 2008.
JUNIOR PREFERRED STOCK
In connection with the Recapitalization in 1996, 1,386,000 shares of
Junior Preferred Stock were issued. Each outstanding share of Junior Preferred
Stock had a liquidation preference of $100.00. Dividends accrued at a rate of 8%
per annum on the sum of the liquidation preference plus accumulated but unpaid
dividends thereon.
Upon consummation of the Offering, all of the outstanding shares of the
Junior Preferred Stock were automatically converted into shares of Common Stock
at a ratio of 6.667 shares of Common Stock for each share of Junior Preferred
Stock. No accrued and unpaid dividends were paid on any shares of Junior
Preferred Stock.
11. LEGAL
The Company is not a party to any material legal proceedings and is not
aware of any pending or threatened litigation that, if decided adversely to the
Company, would reasonably be expected to have a material adverse effect on the
Company's financial condition or results of operations.
46
12. QUARTERLY FINANCIAL DATA (UNAUDITED)
FISCAL 1998
(in thousands, except per share data)
FIRST SECOND THIRD FOURTH TOTAL
----- ------ ----- ------ -----
Net sales $ 85,216 $ 91,260 $ 96,195 $118,994 $391,665
Gross profit $ 23,530 $ 25,831 $ 26,985 $ 33,296 $109,642
Net income $ 4,220 $ 4,856 $ 4,717 $ 13,640 $ 27,433
Net income per share (diluted)
$ 0.20 $ 0.23 $ 0.22 $ 0.66 $ 1.31
FISCAL 1997
(in thousands, except per share data)
FIRST SECOND THIRD FOURTH TOTAL
----- ------ ----- ------ -----
Net sales $ 59,809 $ 69,627 $ 75,948 $ 91,271 $296,655
Gross profit $ 16,224 $ 19,010 $ 20,797 $ 26,279 $ 82,310
Net income (loss) $ (6,821) $ (531) $ 3,289 $ 12,657 $ 8,594
Net income (loss) per share
(diluted) $ (0.05) $ (0.03) $ 0.16 $ 0.61 $ 0.42
47
SCHEDULE II
GUITAR CENTER, INC. AND SUBSIDIARY
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 1997 AND 1998
(AMOUNTS IN THOUSANDS)
BALANCE AT ADDITIONS DEDUCTIONS BALANCE
BEGINNING CHARGED TO FROM AT END
OF YEAR OPERATIONS ALLOWANCE OTHER OF YEAR
---------- ---------- ---------- ----- -------
December 31, 1997
Allowance for doubtful receivables $150 -- -- -- $150
Allowance for obsolescence & damaged goods $600 -- -- -- $600
December 31, 1998
Allowance for doubtful receivables $150 $ 48 -- -- $198
Allowance for obsolescence & damaged goods $600 $165 $385 -- $380
48