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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
___________

FORM 10-K

OR

Commission file number 1-11908

DEPARTMENT 56, INC.
(Exact name of registrant as specified in its charter)

(952) 944-5600
(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 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 the past 90 days. Yes Q No q

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes Q No q

The aggregate market value of the voting stock held by non-affiliates of the registrant as of March 8, 2004 was $197,006,080 (based on the closing price of consolidated trading in the Common Stock on July 3, 2003, being the last trading day of the registrant’s most recently completed second fiscal quarter). For purposes of this computation, shares held by affiliates and by directors and officers of the registrant have been excluded. Such exclusion of shares held by directors and officers is not intended, nor shall it be deemed, to be an admission that such persons are affiliates of the registrant.

Number of Shares of Common Stock, par value $.01 per share, outstanding as of March 8, 2004: 13,181,186.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Company’s definitive Proxy Statement for the 2004 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year covered by this Form 10-K (the “2004 Proxy Statement”) are incorporated by reference in Parts II and III.

FORM 10-K TABLE OF CONTENTS

PART I

ITEM 1.   BUSINESS

General:

Department 56, Inc. (including its direct and indirect subsidiaries, “Department 56” or “the Company”) is a leading designer, distributor, wholesaler and retailer of fine quality collectibles and other giftware products sold through gift, home accessory and specialty retailers, department stores, general merchandise chains and “Big-Box” specialty chains, as well as through its own stores and consumer-direct home show sales business. The Company is best known for its Village Series of collectible, handcrafted, lighted ceramic and porcelain houses, buildings and related accessories in The Original Snow Village^® Collection and other Village series as well as its extensive line of holiday, special occasion and home decorative products, including its Snowbabies™ collectible porcelain figurines.

The Company was incorporated in Delaware in 1992 to hold the equity of a Minnesota corporation formed in 1984 under the name “Department 56, Inc.,” which has since changed its name to “D 56, Inc.” and has continued as the Company’s principal operating subsidiary.

The Company seeks to grow and acquire businesses that reinforce synergies, allowing it to complement its internal product development and accelerating its penetration into new markets and new channels. In the second quarter of fiscal year 2002, the Company commenced its Time to Celebrate™ initiative, a direct selling business that reaches consumers by using a network of independent sales consultants to sell giftware and home decorative products through the home show sales method. Also in 2002, the Company launched its Simple Traditions by Department 56™ line of Village products, developed and distributed for the unique needs of select general merchandise chains and Big-Box specialty retailers. The Company tailors its products, designs, packaging and prices to satisfy the varying demands of customers and consumers within each distribution channel. This focused, multi-faceted strategy is intended to position Department 56 as the premier giftware and collectibles company for the future.

The Company has two reportable segments – wholesale and retail. Although the product produced and sold for each segment is similar, the type of customer for the product and the method used to distribute the product are different. The segmentation of these operations also reflects how the Company’s chief executive officer currently reviews the results of these operations. See Note 11 within the Notes to Consolidated Financial Statements beginning on page F-6.

The Company is organized under the laws of Delaware. The Company’s principal executive offices are located at One Village Place, 6436 City West Parkway, Eden Prairie, MN, 55344, and telephone (952) 944-5600.

The Company files annual, quarterly and current reports and other information with the Securities and Exchange Commission (the “Commission”). You may read and copy any of the information on file with the Commission at the Commission’s Public Reference Room, at 450 Fifth Street, N.W., Room 1024, Washington, DC 20549. Please call the Commission at 1-800-SEC-0330 for further information on the public reference room. In addition, the Commission maintains an Internet site at www.sec.gov that contains reports, proxy and information statements and other information regarding issuers that file, as the Company does, electronically with the Commission.

The Company makes available, free of charge through a direct link to the SEC on the Company’s website www.department56.com its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as is reasonably practicable after such material is electronically filed with or furnished to the Commission. In addition, each of the key standing committees of the Board of Directors has a charter that sets forth the committee’s role and responsibilities. All of those charters are available on the Company’s website. The Board has also adopted its Governance Principles, a copy of which is also available on the Company’s website. The information on the Company’s website is not incorporated by reference into this annual report.

This Annual Report on Form 10-K includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). See “Item 7. — Management’s Discussion and Analysis of Results of Operations and Financial Condition — Forward-Looking Statements and Factors Affecting Future Earnings” herein.

Planned Disposition of Geppeddo Seasonal Kiosk Operations:

During 2001, the Company acquired the net assets of Axis Corporation, a privately held designer, importer and specialty retailer based in Salt Lake City, Utah. The acquired business sold dolls and doll accessories under the brand name of Geppeddo at kiosks located in major shopping centers throughout the United States during the peak holiday shopping season. The original strategy behind the Geppeddo acquisition was to give the Company additional differentiated and branded products and access to a new channel of distribution. However, since the acquisition, the demand for porcelain

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dolls has declined substantially. This softening combined with significantly reduced traffic at the kiosks resulted in a business model that the Company does not believe can be profitable going forward. As a result, in December 2003, the Company committed to a plan to cease operations of Geppeddo.

In accordance with Statement of Financial Accounting Standards (SFAS) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company will record Geppeddo’s results in continuing operations in 2003 and 2004 until the run-off of operations is complete, which is expected to be in the second quarter of 2004. When the run-off is complete, the Geppeddo results will be reclassified into discontinued operations for all periods presented. Additional information regarding the plan to cease operations is included in Management’s Discussion and Analysis of Results of Operations and Financial Condition beginning on page 10 and Note 2 within the Notes to Consolidated Financial Statements beginning on page F-6.

Unless otherwise noted, the following discussion relates to operations excluding the Geppeddo seasonal kiosk operations.

Wholesale Operations:

The Company sells its products to retailers through its wholesale operations, the principal facilities of which consist of eight corporate showrooms and two independently operated wholesale showrooms covering the major giftware market areas and trade shows in the U.S. In addition, the Company from time to time attends and solicits orders at giftware trade shows in select other markets throughout the U.S. and Canada.

The Company’s domestic wholesale operations serve an extensive base of retailers, primarily consisting of approximately 13,000 independent gift retailers across the U.S. and Canada who account for approximately 85% of its wholesale sales (the Company refers to this portion of its customer base as its “Gift and Specialty” channel). Approximately 4,660 of the Company’s principal wholesale customers receive the Company’s Village Series and/or Snowbabies products (which the Company sometimes refers to as its “collectible” products and/or lines). These retailers include approximately 1,410 independently owned Club 56^SM, Gold Key^SM and Showcase^SM Dealers, who receive special recognition and qualify for improved sales terms by satisfying certain volume, merchandising and/or promotional requirements. Approximately 15% of the Company’s wholesale sales are made to department stores, select general merchandise chains, and mail order houses. No single account represented more than 3% of the Company’s wholesale sales in fiscal 2003. The Company provides volume discounts to its customers on most of its products. The Company has generally had only limited sales outside the United States. International wholesale sales, which are made primarily in Canada, were approximately 3% of the Company’s wholesale sales in fiscal 2003.

Over the past four years, the Company’s principal wholesale customers have decreased in number by approximately 4,400, or 25%. Similarly, customers who sell the Company’s Village Series and/or Snowbabies products have decreased over the same period by approximately 1,670, or 26%. The Company believes the decrease in customers and related decrease in sales since 1999 is due to several factors including: the problems experienced during the implementation of the Company’s enterprise-wide computer system, an overall weakness in the economy which has forced some of the Company’s customers to go out of business or reduce their demand, and the typical characteristic of new customer order volume to be lower than order volume of exiting customers. The Company has enacted programs to curb the decline in customers and wholesale sales experienced over the past four years including implementing new customer ordering and shipping programs, strengthening its sales organization, refining its product development process, broadening the seasonal coverage of its product lines, and pursuing alternative channels of retail distribution. Management believes that some customer attrition is likely to continue within the base of customers carrying the Company’s collectible products. The Company plans to continue to seek complementary retailers and to offer its Simple Traditions and giftware lines for select general merchandise retail chains in order to augment revenue and to introduce more new consumers to the Company’s products.

Certain of the Company’s limited edition and year of production lighted Village Series and Snowbabies products are sold on allocation. Under its allocation practice, the Company specifies certain items among its Village Series and Snowbabies product lines which it does not allow customers to purchase in unlimited quantities. The Company periodically evaluates and adjusts its distribution network and reviews its policies with a view of optimizing both the Company’s distribution strategy and the store-level operations of its independent retailers.

The Company continues to market and advertise its products to retailers principally through giftware trade shows, brochures and trade journals. The Company provides merchandising and product information to its customers distributing Village and Giftware products through its business-to-business Internet site (“WIN”^SM or Web Information Network^SM). WIN also provides ordering, order status information and other transaction processing capabilities to its subscribers.

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The Company continues to expand the use of WIN in order to help its retailers with merchandising ideas and to obtain greater operational efficiencies for its customers and the Company.

The Company markets and advertises to existing and potentially new consumers through seasonal advertisements in magazines and newspapers, brochures and point-of-sale information. In addition, the Company publishes and sells Celebrations™, a quarterly consumer magazine, which contains product-related articles and descriptions of its product lines, and maintains an interactive consumer information center on its Internet web site (www.department56.com). Department 56 maintains a toll-free telephone line for collector and consumer questions and participates in collector conventions. The Company also extends its consumer advertising through the use of cooperative advertising with certain of its dealers using various media formats.

Retail Operations:

The Company sells its products to consumers through its retail operations, which in 2003 included five retail stores located in tourist destinations at Mall of America^®, outside Minneapolis, Minnesota; Aladdin Hotel and Casino^® in Las Vegas, Nevada; Downtown Disney^® in Anaheim, California; Water Tower Place^® in Chicago, Illinois; and Florida Mall^® in Orlando, Florida. The Company recently entered into a lease agreement for a retail store in the Pier 39^® shopping complex in San Francisco, California. The Company anticipates that this store will open during the second quarter of 2004.

In the second quarter of 2002, the Company commenced its Time to Celebrate direct selling business. Independent Time to Celebrate sales consultants, who are not agents or employees of the Company, market and distribute giftware and home decorative products to their customers principally through the home show method of direct sales. A consultant contacts consumers, selling primarily at home-based shows using seasonal brochures and product samples. The consultant collects payment from the consumer at the time the consumer’s order is submitted. A web-based consultant care tool has been created, allowing consultants to preview products, policies and procedures and to place and make payment against their orders. A consultant can place an order 24 hours a day, seven days a week. The order is processed and the products then delivered to the home show host. The host then handles delivery of the merchandise to the consumer. The consultants are the customers of Time to Celebrate and the Company generally has no transaction or arrangement with any end user of its product beyond the consultant. Consultants are responsible for payment to the Company upon or prior to shipment, whether or not the products are delivered to an end user.

Typical characteristics of companies engaged in direct sales include a high rate of turnover among sales consultants, and a positive correlation between the number of sales consultants and revenue. For these reasons, the recruiting and training of new Time to Celebrate sales consultants is expected to be continually necessary. Recruitment of people who are themselves experienced with the home show sales format and personal contacts resulting from home show activity constitute the primary means of obtaining new consultants. All consultants earn margin on their own sales and are eligible to receive bonuses from sales by consultants they have recruited. This rewards program and development of sales leadership is an essential part of Time to Celebrate’s long-term growth strategy. At the end of 2003, there were approximately 500 Time to Celebrate independent sales consultants located in 47 states. The Company does not expect the Time to Celebrate business to have a material financial impact on the Company’s retail operations until at least the end of 2004.

Products:

Village Series Products – Department 56 is best known for its Village Series, which includes several different series of collectible, handcrafted, lighted ceramic and porcelain houses, buildings and related accessories that depict nostalgic scenes. The Company introduces new pieces, limited edition pieces, figurines and other accessories each year to complement and provide continuity to the collections. To allow for these new introductions and to keep each series appropriately balanced, the Company has traditionally retired a number of its existing pieces from production each year. Retirement decisions are based on management’s judgment as to, among other things, expected consumer demand, whether a piece continues to fit the evolving design characteristics of a series, manufacturing considerations and, importantly, injecting an element of surprise. The Company also introduces new lighted pieces and accessories for a variety of holidays and special days, including Halloween, St. Patrick’s Day, Easter, Valentine’s Day and Fourth of July. The Company will continue to consider the introduction of new lighted pieces and accessories for other holidays and special day themes.

Giftware –The Company offers a wide range of other decorative giftware and home accessory items including the Company’s Snowbabies and Snowbunnies^®figurines; holiday and seasonal decorative items; as well as tableware. Giftware product lines are product lines developed around either a seasonal or unique design theme. The Company

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generally introduces new products and refines its product offerings twice a year. The Company currently maintains an aggregate of approximately 4,650 stock keeping units, of which approximately 3,900 are Giftware products.

Design and Production:

Each year, the Company introduces new products in its existing product lines and also develops entirely new design and product concepts. The design and manufacture of the Company’s products are complex processes. The path from initial conception of the design idea to market introduction generally takes approximately six to 12 months, although the Company continues to investigate processes intended to reduce this time. The Company’s Village Series and Simple Traditions products are principally composed of ceramic and porcelain clays, and the Company’s other products are designed in a variety of media, including paper maché, acrylic and resin.

The Company continues to add licensed trademarks and characters to its Village and Snowbabies lines. Since 1995, the Company has entered into license agreements with the owners of a variety of well-known American icons which are featured with Village buildings and as character “guests” of the Snowbabies. Adding licensed names and icons has allowed the Company to market to consumers who are enthusiasts of the licensed icons.

Department 56 believes that its relationships with its manufacturers, and the quality of their craftsmanship, provide a competitive advantage and are a significant contributor to the Company’s success. The Company imports most of its products from the Pacific Rim, primarily the People’s Republic of China and the Philippines. The Company also imports a small percentage of its products from India and Europe. During fiscal 2003, the Company imported products from approximately 150 independent manufacturing sources, some of which are represented by independent trading companies. The Company’s single largest manufacturing source represented approximately 25% of the Company’s imports in fiscal 2003. The Company’s emphasis on high-quality craftsmanship at affordable prices limits the sources from which the Company chooses to obtain products. The Company has long-standing relationships with the majority of its manufacturers (several for 20 years or more) and may purchase, typically on a year-to-year basis, a substantial portion of a manufacturer’s entire annual output. As a result of these relationships, the Company has experienced a low turnover of its manufacturing sources.

Distribution and Systems:

The products sold by the Company to its retail customers in the U.S. are generally shipped by ocean freight from abroad and then by rail to the Company’s distribution center located in the Minneapolis/St. Paul metropolitan area. Shipments from the Company to its wholesale customers and Time to Celebrate sales consultants are handled primarily by United Parcel Service or commercial trucking lines.

The Company’s systems maintain order processing from the time a product enters the Company’s system through shipping and ultimate payment collection from its wholesale customers and Time to Celebrate sales consultants. The Company also uses handheld optical scanners and bar coded labels in accepting orders at wholesale showrooms and in the field throughout the U.S. In addition, computer and communication software systems allow on-line information access between the Company’s headquarters and its showrooms, and those systems generally provide direct linkage with the Company’s field sales force. These systems also provide a range of order and product information and ordering capabilities to customers subscribing to its WIN business-to-business site and to Time to Celebrate sales consultants.

The Company’s retail systems also monitor and transmit to the Company on a daily basis the POS (point of sales) data for the Company’s owned retail stores.

Backlog and Seasonality:

The Company receives products, pays its suppliers and ships products throughout the year, although historically the majority of shipments have occurred in the second and third quarters of each year as retailers stock merchandise in anticipation of the winter holiday season. The Company continues to ship wholesale merchandise until mid-December each year. Accordingly, the Company’s wholesale backlog typically is lowest at the beginning of January. As of January 3, 2004, Department 56 had unfilled wholesale orders of approximately $3.5 million compared to $5.0 million at December 28, 2002. The entire backlog is scheduled to be shipped to customers during the 2004 fiscal year. Approximately 7% to 8% of the Company’s total annual wholesale customer orders have been cancelled in each of the last three years for a number of reasons, primarily customer credit considerations and inventory stock-outs.

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Historically, due to the timing of wholesale trade shows early in the calendar year, the Company has received the majority of its total annual wholesale customer orders during the first quarter of each year. During the first quarter of each of the past three years, the Company has received approximately 62% to 64% of its annual wholesale orders for such year. The Company can experience fluctuations in quarterly sales due to the timing of receipt of product from suppliers and subsequent shipment of product from the Company to customers, as well as the timing of orders placed by customers. As a result of the Company’s sales pattern, the Company has historically recorded a substantial portion of its wholesale revenues in its second and third quarters, and the majority of its store-based retail sales occur in the fourth quarter during the peak holiday shopping season.

The extended payment terms that the Company provides to many of its wholesale customers create a significant seasonal pattern in its working capital requirements. Due to the seasonal pattern of shipping and accounts receivable collection, the Company generally has greater working capital needs in its second and third quarters and experiences greater cash availability in its first and fourth quarters. The cash from the Company’s retail operations is also generated predominantly in the fourth quarter. The Company typically finances its operations through cash and marketable securities balances, internally generated cash flow and short-term seasonal borrowings.

Trademarks and Other Proprietary Rights:

The Company owns 40 U.S. trademark registrations and has pending U.S. trademark applications with respect to certain of its logos and brand names. In addition, the Company maintains selected trademarks in certain foreign countries.

Department 56 regards its trademarks and other proprietary rights as valuable assets and intends to maintain its trademarks and their registrations and vigorously defend against infringement. The U.S. registrations for the Company’s trademarks are currently scheduled to be cancelled at various times between 2004 and 2013 but can be maintained and renewed provided that the marks are still in use for the goods and services covered by such registrations. The Company has historically renewed its registered trademarks and expects to continue to renew them as business needs dictate.

Competition:

Department 56 competes generally for the discretionary income of consumers with other producers of collectibles, specialty giftware and home decorative accessory products. The collectibles area, in particular, is affected by changing consumer tastes and interests. The giftware industry is highly competitive, with a large number of both large and small participants. The Company’s competitors distribute their products through independent gift retailers, department stores, mass market and specialty chain stores, televised home shopping networks, Internet commerce and mail order houses, and through the home show sales method or other direct response marketing methods. The Company believes that the principal elements of competition in the specialty giftware industry are brand loyalty, design, quality, display and price. The Company believes that its competitive position is enhanced by a variety of factors, including the uniqueness, quality and enduring themes of the Company’s products, its reputation among retailers and consumers, its in-house design expertise, its sourcing and marketing capabilities, and the pricing of its products.

Imports:

The Company does not own or operate any manufacturing facilities and imports most of its products from manufacturers in the Pacific Rim, primarily the People’s Republic of China (“China”) and the Philippines. The Company also imports a small percentage of its products from sources in India and Europe.

The Company’s ability to import products and thereby satisfy customer orders is affected by the availability of, and demand for, quality production capacity abroad. The Company competes with other importers of specialty giftware products for the limited number of foreign manufacturing sources that can produce detailed, high-quality products at affordable prices. Foreign manufacturing and procurement of imports is subject to the following inherent risks: labor, economic and political instability; cost and capacity fluctuations and delays in transportation, dockage and materials handling; restrictive actions by governments; nationalizations; the laws and policies of the U.S. affecting importation of goods (including duties, quota and taxes); international political/military/terrorist developments; and foreign trade and tax laws. Moreover, the Company cannot predict what relevant political, legal or regulatory changes may occur, or the type or amount of any financial impact on the Company such changes may have in the future.

Fluctuations in currency exchange also present risk inherent in the Company’s method for inventory procurement. The Company’s costs could be adversely affected if the currencies of other countries in which the Company sources product

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appreciate significantly relative to the U.S. dollar; this could result, for example, from a decision by China to allow its currency to float instead of being pegged to the U.S. dollar at a fixed rate.

The Company’s products are subject to customs duties and regulations pertaining to the importation of goods, including requirements for the marking of certain information regarding the country of origin on the Company’s products. In its ordinary course of business, the Company may be involved in disputes with the U.S. Bureau of Customs and Border Protection (“U.S. Customs”) regarding the amount of duty to be paid, the value of merchandise to be reported or other customs regulations relating to certain of the Company’s imports, which may result in the payment of additional duties and/or penalties, or which may result in the refund of duties to the Company. Since the terrorist attacks of September 11, 2001, U.S. Customs has enacted various security protocols affecting the importation of goods. Such protocols could adversely affect the speed or cost involved in the Company’s receipt of inventory from its overseas vendors.

In fiscal 2003, approximately 88% of the Company’s imports were manufactured in China, and the Company anticipates that such percentage will hold constant or increase for the foreseeable future. China has joined the World Trade Organization and been accorded permanent “Normal Trade Relations” status by the U.S. government. However, various commercial and legal practices widespread in China, including the handling of intellectual properties and certain labor practices, as well as certain political and military actions taken or suggested by China, are under review by the U.S. government. China, moreover, has been designated a Country of Particular Concern (“CPC”) pursuant to the International Religious Freedom Act of 1998 (“IRFA”). The IRFA enumerates several specific retaliatory actions that may be taken by the U.S. government, none of which the Company believes would have a material impact on its business. The IRFA, however, also accords the President broad discretion in fashioning other or additional actions and, due to the breadth of the presidential powers under the IRFA, the Company is unable to predict what, if any, action the President could take in the future.

Accordingly, the ability to continue to conduct business with vendors located in China is subject to political uncertainties, the financial impact of which the Company is unable to estimate. To the extent China may have its exports or transaction of business with U.S. persons subject to political retaliation, the cost of Chinese imports could increase significantly and/or the ability to import goods from China may be materially impaired. In such an event, there could be an adverse effect on the Company until alternative arrangements for the manufacture of its products were obtained on economic, production and operational terms at least as favorable as those currently in effect.

Employees:

As of February 18, 2004, the Company had 293 full-time employees in the U.S., three in Canada and one in Taiwan. Of the total workforce, approximately 57 are engaged in wholesale sales representation throughout North America and 83 are associated with the Company’s retail operations. Local Union No. 638 of the Teamsters Union represents 61 of the Company’s U.S.-based warehouse, shipping and receiving personnel under a contract that expires on December 31, 2004. The Company believes that its labor relations are good and has never experienced a work stoppage.

Environmental Matters:

The Company is subject to various federal, state and local laws and regulations governing the use, discharge and disposal of hazardous materials. Compliance with current laws and regulations has not had and is not expected to have a material adverse effect on the Company’s financial condition. It is possible, however, that environmental issues may arise in the future that the Company cannot currently predict.

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ITEM 2.   PROPERTIES

The Company owns or leases buildings that contain approximately 541,000 square feet of floor space, as identified in the following table. The Company’s primary corporate showroom, executive offices and creative center are located in Eden Prairie, Minnesota. The office building in Eden Prairie, Minnesota is owned by the Company and the rest of the Company’s facilities are leased.

ITEM 3.   LEGAL PROCEEDINGS

In the ordinary course of its business, the Company is involved in various legal proceedings, claims and governmental audits. In the opinion of management, the ultimate disposition of these proceedings, claims and audits will not have a material adverse effect on the results of operations, financial position or cash flows of the Company.

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

No matters were submitted to a vote of the Company’s security holders during the last quarter of the year ended January 3, 2004.

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PART II

ITEM 5.   MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Department 56‘s common stock trades on the New York Stock Exchange (NYSE) under the symbol “DFS.” The table below sets forth the high and low sales prices as reported by the NYSE.

The Company has not declared or paid dividends on its Common Stock. The Company’s strategy includes the pursuit of a significant acquisition that aligns with and complements its existing business. As a result, the Company intends to accumulate cash. In the event the Company is not able to identify any acceptable acquisition by mid-2005, the Company intends to return cash to its shareholders at that time. As a holding company, the ability of the Company to pay cash dividends will depend upon the receipt of dividends or other payments from its subsidiaries. See “Item 7. – Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources” below with respect to restrictions under the Company’s credit agreement pertaining to its right to pay dividends.

As of March 8, 2004, the number of holders of record of the Company’s Common Stock was 817.

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ITEM 6.   SELECTED FINANCIAL DATA

FIVE-YEAR SUMMARY (In thousands, except per share amounts)
YEARS ENDED JANUARY 3, 2004, DECEMBER 28, 2002, DECEMBER 29, 2001,
DECEMBER 30, 2000, AND JANUARY 1, 2000

The following selected consolidated financial data should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the Consolidated Financial Statements and related Notes thereto, included elsewhere herein.

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ITEM 7.   MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
                 AND RESULTS OF OPERATIONS

(in millions, except per share amounts)

STRATEGIC OVERVIEW

The Company’s financial results for 2003 as well as for the prior two years were significantly impacted by fundamental changes occurring in our core Gift and Specialty account base; results for 2003 and 2002 were also impacted by a decline in demand for Geppeddo’s products in its channel of distribution.

We continued to see substantial attrition last year in the Gift and Specialty channel, which accounted for over 85% of the Company’s wholesale sales. This channel remained under stress during this past year, which resulted in accounts representing 7% of the Company’s 2002 Village product sales to cease doing business during 2003. Because the Company’s average Village customer represents higher average revenue to the Company than an average Giftware customer, losing Village accounts is a more difficult problem to overcome than losing Giftware accounts. The Company typically must open several new Village accounts to offset the revenue impact of losing one long-time Village account as the new accounts need time to build up their own consumer bases and demand within their stores. We have also found that our ongoing Village accounts continue to be more cautious in investing in inventory since the onset of tough economic conditions in 2001 and with their increased confidence in the Company’s ability to replenish Village product. Largely due to a decline in sales to this channel, the Company’s Village product sales declined 19% during 2003.

In addition to the impact of attrition in the Gift and Specialty channel, the Company’s Geppeddo division suffered further significant deterioration in its business during 2003. As the Company stated last year, our focus was to return Geppeddo to its historic level of profitability, but with conditions only worsening the decision was made to exit the business at the end of 2003. The financial implications of this decision are discussed in detail below.

In response to the changing nature of the Gift and Specialty channel, in particular as it has impacted the Company’s core Village business, the Company has continued to develop and implement a number of growth strategies designed to offset the impact of the decline in the Gift and Specialty channel and to grow both revenue and earnings in the long-term. A summary of these strategies and the progress made during 2003 follows:

Developing Year-Round Celebratory Products:

The Company is in the process of repositioning itself from a strong Christmas collectibles business to a company providing premier home decorative products to celebrate life’s extraordinary moments. The Company has expanded its Village lines to incorporate celebrations of all major holidays, special moments and seasons. This re-positioning strategy has also led to a strengthening, broadening and increased focus on the Company’s Giftware line with the goal of developing cohesive, multi-season product lines that will attract consumers year-round. While further progress needs to be made, the Company’s Giftware sales demonstrated early positive results during 2003 posting a 10% increase in sales.

Expand Multi-Channels of Distribution:

The continued difficulties with its core Gift and Specialty channel has led the Company to participate in more wholesale and direct channels of distribution in an effort to reach a broader base of consumers and take advantage of how and where consumers shop today. The Company has three strategic initiatives which it is pursuing:

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Leverage and Grow Our Core Consumer Base:

The Company is fortunate to have long enjoyed a strong consumer following for its core brands. It is our intention to forge closer links with this group and augment it with the consumers shopping at Department 56 Retail and Time to Celebrate as well as those consumers who visit us at www.department56.com. We will use a variety of direct marketing and consumer relationship marketing techniques to expand our relationships with our consumers.

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SUMMARY OF 2003 RESULTS OF OPERATIONS

•         Net income decreased by 48% from $31.8 million in 2002 (before the cumulative effect of adopting SFAS No. 142) to $16.4 million in 2003. Certain items affected the comparability of the Company’s earnings during 2003 with those of 2002, as shown in the following table:

Items Impacting Earnings Comparability
(In thousands)

•          After adjusting for the above items, net income (before the cumulative effect of adopting SFAS No. 142) decreased by 9% in 2003 principally due to a 7% decrease in wholesale sales and a decrease in the gross profit rate from 57% in 2002 to 54% in 2003. The 7% decrease in wholesale sales was driven by a 19% decrease in Village product sales, partially offset by a 10% increase in Giftware sales. The decrease in the gross profit rate was driven by a change in product mix from higher margin Village product to lower margin Giftware product.

•         In December 2003, the Company committed to a plan to cease operations of its Geppeddo seasonal kiosk business. In connection with this decision, the Company recorded total non-cash, pre-tax charges of $9.7 million noted in the table above. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company will record Geppeddo’s results in continuing operations in 2003 and 2004 until the run-off of operations is complete (expected to be in the second quarter of 2004). When the run-off is complete, the Geppeddo results will be reclassified into discontinued operations for all periods presented.

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CONSOLIDATED RESULTS

The following discussion of the results of operations and financial condition should be read in conjunction with the selected financial data in Item 6 and the Company’s Consolidated Financial Statements and related notes thereto, included elsewhere herein.

COMPARISON OF RESULTS OF OPERATIONS 2003 TO 2002

Net Sales

Net sales decreased $16.9 million, or 8%, from $208.6 million in 2002 to $191.7 million in 2003. The decrease in net sales was principally due to a decrease in net sales to wholesale customers.

Wholesale sales decreased $13.5 million, or 7%, from $180.4 million in 2002 to $166.9 million in 2003. Wholesale sales of the Company’s Village Series products decreased $20.5 million, or 19%, while sales of Giftware products increased $7.0 million, or 10% between the two periods. Village Series products represented 52% of the Company’s wholesale sales during 2003 versus 59% during 2002. Village sales continued to be negatively impacted by both the cautious buying patterns of Village dealers and the continued attrition in the number of these dealers, which is a trend that may continue. See five-year Village sales trend at “Item 6. Selected Financial Data – Five-Year Summary.”

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Retail sales decreased $3.5 million, or 12%, from $28.3 million in 2002 to $24.8 million in 2003. The decrease in retail sales was due to a decrease in Geppeddo sales and the fact that the Company did not operate its seasonal stores beyond January 2003. The decrease in sales was partially offset by an increase in sales at the Company’s retail stores as a result of opening two new stores in 2003 and an increase in Time to Celebrate sales. Comparable sales in the Company’s three stores that were open for a full year in both years decreased 1%.

Gross Profit

Gross profit as a percentage of net sales was 57% and 54% in 2002 and 2003, respectively. The decrease in the gross profit rate was principally due to a change in the mix of wholesale product shipments from higher margin Village product to lower margin Giftware product, a decrease in gross profit margins on Geppeddo sales due to higher markdowns and a $0.6 million charge to write-down inventory to its net realizable value, along with a decrease in seasonal store retail sales described above (which carry higher gross profit margins than the wholesale business).

Selling, General and Administrative Expenses

Selling, general and administrative expenses decreased $10.1 million, or 13%, between 2002 and 2003. Selling, general and administrative expenses as a percentage of net sales were 37% in 2002 and 35% in 2003. The decrease was principally due to lower seasonal store, kiosk and incentive compensation expenses in 2003. Seasonal store expenses were lower as the Company did not operate seasonal stores beyond January 2003. Kiosk expenses were lower as the Company operated 346 kiosks during the 2003 selling season compared to 417 kiosks during the 2002 selling season.

Impairment of Geppeddo Assets

In December 2003, the Company committed to a plan to cease operations of its Geppeddo seasonal kiosk business. In connection with this decision, the Company recorded a $9.1 million impairment charge related to Geppeddo’s assets. The impairment charge was comprised of $8.2 million for the write-off of goodwill, trademarks and other intangible assets, and $0.9 million for the impairment of long-lived assets.

Interest Expense

Interest expense decreased $1.5 million, or 43%, between 2002 and 2003. The decrease in interest expense resulted from a lower interest rate environment, as well as a decrease in the amount of debt outstanding. The Company paid off its remaining long term debt of $54 million during 2003.

Provision for Income Taxes

The effective income tax rate was 27% and 36% during 2002 and 2003, respectively. The lower effective income tax rate in 2002 was due to a $3.5 million reversal of prior year tax accruals that were no longer needed. Excluding this, the effective income tax rate was 36% in 2002. Management anticipates that the income tax provision rate for 2004 will be approximately 36%.

COMPARISON OF RESULTS OF OPERATIONS 2002 TO 2001

Net Sales

Net sales increased $8.2 million, or 4%, from $200.4 million in 2001 to $208.6 million in 2002. The increase in sales was principally due to an increase in retail sales, partially offset by a decrease in sales to wholesale customers.

Wholesale sales decreased $0.7 million, or 0.4%, from $181.1 million in 2001 to $180.4 million in 2002. Wholesale sales of the Company’s Village Series products decreased $3.2 million, or 3%, while sales of

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Giftware products increased $2.5 million, or 4% between the two periods. Village Series products represented 59% of the Company’s sales during 2002 versus 61% during 2001. The decrease in wholesale Village sales was principally due to a decrease in the number of Gift and Specialty customers carrying the Company’s Village product as a result of the continued contraction of the Gift and Specialty channel.

Retail sales increased $8.9 million from $19.4 million in 2001 to $28.3 million in 2002. The increase in retail revenues for the year was primarily attributable to the inclusion of January 2002 results from the seasonal stores and kiosks opened for the first time during 2001 as well as the increase in the number of seasonal stores and kiosks operated in 2002. The Company operated 20 seasonal stores and 417 seasonal kiosks during 2002 compared to 10 seasonal stores and 359 seasonal kiosks operated in 2001. Comparable sales in the Company’s two stores that were open for a full year in both years increased 2%.

Gross Profit

Gross profit as a percentage of net sales was 55% and 57% in 2001 and 2002, respectively. The increase in the gross profit rate for the year was principally due to the increase in retail sales (which carry higher gross profit than wholesale sales) and a decreased provision for excess and slow moving inventory. The gross profit rate increase was partially offset by a shift in the mix of wholesale product shipments from higher margin Village product to lower margin Giftware product. Retail sales represented 14% of sales in fiscal 2002 compared to 10% in 2001.

Selling, General and Administrative Expenses

Selling, general and administrative expenses increased $8.2 million, or 12%, between 2001 and 2002. Selling, general and administrative expenses as a percentage of net sales were approximately 34% in 2001 and 37% in 2002. The increase in selling, general and administrative expenses for fiscal 2002 was principally due to the increase in retail operations (which have higher selling, general and administrative expenses as a percentage of sales than the wholesale business) partially offset by non-recurring expenses related to the Company’s 25^th Anniversary Celebration in 2001, wholesale cost control initiatives and decreased depreciation expense as a result of the $5.6 million reduction in net depreciable assets from the litigation settlement described below.

Interest Expense

Interest expense decreased $3.6 million, or 51%, between 2001 and 2002. The decrease in interest expense resulted from a lower interest rate environment, as well as a decrease in the amount of term debt outstanding. The Company pre-paid $30 million of its term debt in May of 2002.

Litigation Settlement

On March 1, 2002, the Company received net proceeds (before income taxes) of $11.0 million in settlement of the Company’s litigation against Arthur Andersen LLP and Andersen Worldwide Société Coopérative concerning implementation of its information systems. This recovery resulted in other income of $5.4 million and a $5.6 million reduction in net depreciable assets.

Provision for Income Taxes

The effective income tax rate was 41% and 27% during 2001 and 2002, respectively. The change in income tax rates is due to several factors. First, the Company recorded adjustments to its income tax provision of $1.0 million and $3.5 million in 2001 and 2002, respectively, for the reversal of prior year tax accruals that were no longer needed. Secondly, 2001 reflects the recognition of a deferred tax valuation allowance of $1.5 million to reserve against the future deductibility of the capital losses recognized from its minority investment in 2-Day Designs, Inc. Finally, the Company’s decreased income tax provision rate for 2002 reflected the change in accounting for goodwill and other intangible assets previously reported.

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Cumulative Effect of Change in Accounting Principle

The Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, effective December 30, 2001. Under SFAS No. 142, goodwill and indefinite-lived intangible assets are no longer amortized, but are reviewed for impairment annually, or more frequently if certain indicators arise. With the adoption of this statement, the Company ceased amortization of its goodwill and indefinite-lived trademarks as of December 30, 2001 and recorded a $93.7 million charge to write-down its goodwill related to the leveraged buy-out of the Company in 1992. See Note 4 to the Consolidated Financial Statements.

PLANNED DISPOSITION OF GEPPEDDO SEASONAL KIOSK BUSINESS

In December 2003, the Company committed to a plan to cease operations of its Geppeddo seasonal kiosk business. The Company plans to wind-down operations in 2004 and anticipates that operations will cease in the second quarter of 2004. The original strategy behind the Geppeddo acquisition was to give the Company additional differentiated and branded products and access to a new channel of distribution. However, since the acquisition, the demand for porcelain dolls has decreased. This softening combined with reduced traffic at the kiosks has resulted in a business model that the Company does not believe can be profitable going forward.

In accordance with SFAS No. 144, the Company will present Geppeddo’s results in continuing operations in 2003 and 2004 until the run-off of operations is complete (expected to be in the second quarter of 2004). When the run-off is complete, the Geppeddo results will be reclassified into discontinued operations for all periods presented.

The results from Geppeddo’s operations are as follows:

SEASONALITY

Historically, due to the timing of wholesale trade shows early in the calendar year, the Company has received the majority of its total annual wholesale customer orders during the first quarter of each year. The Company entered 63% and 64% of its total net annual wholesale customer orders during the first quarter of 2003 and 2002, respectively. Cancellations of total annual wholesale customer orders were approximately 7% in both 2003 and 2002. Orders not shipped in a particular year, net of cancellations, are carried into backlog for the following year and have historically been orders for Spring and Easter products. The Company’s backlog of wholesale customer orders was $3.5 million and $5.0 million at January 3, 2004 and December 28, 2002, respectively.

The Company receives products, pays its suppliers and ships products throughout the year, although historically the majority of wholesale shipments occur in the second and third quarters as retailers stock merchandise in anticipation of the holiday season. As a result of this seasonal pattern, the Company generally records its highest wholesale sales during the second and third quarters of each year. However, the Company can experience fluctuations in quarterly sales and related net income compared with the prior year due to the timing of receipt

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of product from suppliers and subsequent shipment of product from the Company to customers, as well as the timing of orders placed by customers. In addition, the Company recognizes the majority of its retail sales in the fourth quarter during the peak holiday shopping season. The Company is not managed to maximize quarter-to-quarter results, but rather to achieve annual objectives designed to achieve long-term growth consistent with the Company’s business strategy.

LIQUIDITY AND CAPITAL RESOURCES

Cash Flows from Operations

Net cash provided by operating activities increased $15.4 million, or 75%, from $20.6 million in 2002 to $35.9 million in 2003. The increase was principally due to higher cash collections, partially offset by lower income from operations (excluding the $9.1 million Geppeddo non-cash impairment charge). Cash collections were higher in 2003 principally due to five additional days of cash collections in 2003 as a result of the 2003 fiscal year ending on January 3, 2004 compared to the 2002 fiscal year ending on December 28, 2002. Cash collections were also lower in 2002 due to an increase in the amount of sales qualifying for extended dating terms.

Accounts receivable, net of reserves, which principally consists of wholesale trade receivables, decreased by 36%, from $32.6 million at December 28, 2002 to $21.0 million at January 3, 2004. The decrease in accounts receivable was principally due to the additional five days of cash collections in fiscal 2003 as a result of the year ending on January 3, 2004 (compared to December 28, 2002 in fiscal 2002). Management believes there is adequate provision for any doubtful accounts receivable and product claims that may arise.

Because the Company’s wholesale business is not capital intensive, the Company has historically not incurred significant capital expenditures. Capital expenditures for the retail business were $1.9 million, $0.7 million, and $1.5 million in 2003, 2002 and 2001 respectively. Other capital expenditures were $0.6 million, $1.2 million and $1.4 million in 2003, 2002 and 2001, respectively. Capital expenditures for the retail business are anticipated to be approximately $0.9 million for each retail store opened during the year. Management anticipates other 2004 capital expenditures to approximate 1% of annual revenues. The Company has signed a lease to open its sixth retail store during the second quarter of 2004 at the Pier 39 shopping complex in San Francisco, California, and plans to open a seventh store during the second half of 2004.

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Sources of Liquidity

The Company’s primary source of cash is the funds generated from operations. Additionally, the Company has a revolving credit facility available for working capital and investment needs as described below. Based on current levels of operations, the Company believes its funds generated from operations, its available cash, and its revolving credit facility will be sufficient to finance any capital expenditures, contractual obligations or strategic initiatives in the foreseeable future.

The Company’s strategy includes the pursuit of a significant acquisition that aligns with and complements its existing business. As a result, the Company intends to accumulate cash over the next year to help finance a potential acquisition. The Company also has the ability to use its revolving credit facility to finance an acquisition. However, depending on the size of the acquisition, the Company may have to find additional financing to complete an acquisition. In the event the Company is not able to identify an acceptable acquisition by mid-2005, the Company intends to return cash to its shareholders at that time.

Consistent with customary practice in the giftware industry, the Company offers extended accounts receivable terms to many of its wholesale customers. This practice has typically created significant working capital requirements in the second and third quarters that the Company has generally financed with seasonal borrowings under its revolving credit facility. The Company’s cash and cash equivalents balances peak early in the first quarter of the subsequent year, following the collection of wholesale customer accounts receivable with extended payment terms and cash receipts from the Company’s retail operations.

In November 2003, the Company entered into a new three-year credit agreement. In connection therewith, the Company recorded $0.2 million in deferred financing fees, which are being amortized over the life of the credit agreement. The Company used the new credit facility to refinance the remaining term and revolving loans under its former credit agreement. As of January 3, 2004, no revolving loans were outstanding under the new credit agreement.

The revolving credit facility provides for borrowings of up to $75 million, which may be in the form of letters of credit and revolving credit loans. The letters of credit are issued primarily in connection with inventory purchases. The revolving credit facility includes an annual clean-down provision whereby the Company’s outstanding revolving credit loans and letters of credit may not exceed an aggregate of $30 million during any one 30-consecutive-day period beginning November 1 and ending March 31 of the following year. Borrowings under the credit agreement are subject to certain borrowing base limitations (as defined in the agreement). The Company’s borrowing capacity under the revolving credit facility as of January 3, 2004 was $75 million and will fluctuate during 2004 based on accounts receivable and inventory levels. The revolving line of credit provides for commitment fees of 0.20% to 0.375% per annum on the daily average of the unused commitment.

The credit agreement allows the Company to choose between two interest rate options in connection with its revolving credit loans. The interest rate options are the Floating Rate (as defined in the agreement) or the Eurodollar Rate (as defined in the agreement) plus an applicable margin. The applicable margin ranges from 0% to 0.375% for Floating Rate loans and from 0.875% to 1.25% for Eurodollar Rate loans. The credit agreement expires November 26, 2006.

The credit agreement includes restrictions as to, among other things, the amount of additional indebtedness, liens, contingent obligations, investments and dividends. Under the most restrictive of these covenants, approximately $251 million of retained earnings were restricted at January 3, 2004. The credit agreement also requires maintenance of minimum levels of interest coverage, net worth and maximum levels of leverage, in each case at the end of each fiscal quarter. None of these restrictions are expected to have a material adverse effect on the Company’s ability to operate in the future.

The Company has pledged the common stock of certain of its subsidiaries, direct and indirect, as collateral under the credit agreement, and certain of its subsidiaries, direct and indirect, have guaranteed repayment of amounts borrowed under the credit agreement.

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OFF-BALANCE SHEET ARRANGEMENTS

The Company does not have off-balance sheet arrangements.

CONTRACTUAL OBLIGATIONS

As of January 3, 2004, the Company is obligated to make cash payments in connection with its operating leases and purchase obligations in the amounts listed below. The Company does not have any long-term debt or capital lease obligations. The Company has no off-balance sheet debt or other unrecorded obligations other than the items noted in the following table:

See Note 7 to the Consolidated Financial Statements for a discussion of the Company’s other long-term liabilities.

WHOLESALE CREDIT AND RETURN POLICIES

The Company has credit policies that establish specific criteria related to creditworthiness that its customers must meet prior to the shipment of product to the customer. The Company periodically makes limited and selective exceptions to its policy of not shipping to customers with overdue balances when the particular customer has met specific criteria, which are indicative of a wherewithal and willingness to pay their past due and future balances.

The Company does not accept returns from wholesale customers without its prior authorization. Returns are typically accepted only for damaged or defective goods, or shipping discrepancies. The Company reserves the right to refuse authorization of any returns and to discard any unauthorized returns. If the Company accepts an unauthorized return or if a return is the result of a customer error, the wholesale customer may be subject to a 20% handling charge. The Company reserves the right to cancel open orders or backorders for those wholesale customers who abuse or excessively use return privileges.

CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements are prepared in accordance with generally accepted accounting principles of the United States. In connection with the preparation of the financial statements, we are required to make assumptions, make estimates and apply judgment that affect the reported amounts of assets, liabilities, revenue, expenses and related disclosures. The Company bases its assumptions, estimates and judgments on historical experience, current trends and other factors that management believes to be relevant at the time the consolidated financial statements are prepared. On a regular basis, management reviews the accounting policies, assumptions, estimates and judgments to ensure that our financial statements are presented fairly and in accordance with generally accepted accounting principles. However, because future events and their effects cannot be determined with certainty, actual results could differ from our assumptions and estimates, and such differences could be material.

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The following accounting policies are the accounting policies that management believes require the most difficult, subjective or complex judgments about matters that are inherently uncertain:

Sales Returns and Credits – An allowance is established for credits related to possible returned or damaged product, pricing and shipping discrepancies. The amount of the allowance is based on historical ratios of credits to sales, the historical average length of time between the sale and the credit, and other factors. Changes in customers’ behavior versus historical experience, changes in product damage or defect rates, or changes in the Company’s return policies are among the factors that would result in materially different amounts for this item. Based on 2003 sales returns and credits, a 10% increase or decrease in sales returns and credits would have had an impact of approximately $0.5 million.

Inventory Valuation – Inventory is valued at the lower of cost or net realizable value. The amount is determined by analyzing historical and projected sales information, plans for discontinued products and other factors. The Company procures product based on forecasted sales volume. If actual sales were significantly lower than forecasted sales due to unexpected economic or competitive conditions, it could result in materially higher surplus and discontinued inventories. Based on 2003 inventory write-downs, a 10% increase or decrease in inventory write-downs would have had an impact of less than $0.5 million.

Allowance for Doubtful Accounts – An allowance is established for estimated uncollectible accounts receivable. The required allowance is determined by reviewing customer accounts and making estimates of amounts that may be uncollectible. Factors considered in determining the amount of the reserve include the age of the receivable, the financial condition of the customer, general business, economic and political conditions, and other relevant facts and circumstances. Additionally, since the majority of the Company’s wholesale sales have dating terms which come due in November and December, the Company does not have visibility into overdue balances for most of its wholesale customers until the fourth quarter of its fiscal year. Due to the seasonality of the Company’s business, the extended dating terms provided to customers and the relative size of accounts receivable balances at year end, it is not uncommon for the Company to experience fluctuations in the provision for bad debt expense from quarter to quarter as the Company refines its estimate. Unexpected changes in the aforementioned factors would result in materially different amounts for this item. In addition, results could be materially different if economic conditions worsened for the Company’s customers. Based on 2003 bad debt write-offs, a 10% increase or decrease in bad debt write-offs would have had an impact of less than $0.5 million.

Tax Contingencies – The Company is periodically contacted or audited by federal and state tax authorities. These contacts or audits include questions regarding the timing and amount of deductions and the allocation of income among various tax jurisdictions. In evaluating the exposure associated with various filing positions, the Company records a reserve for estimated probable exposures. The estimate of this reserve contains uncertainty because management must use judgment to estimate the exposure associated with its various filing positions. To the extent the Company does not have to pay taxes for which reserves have been established or is required to pay amounts in excess of its reserves, the Company’s tax rate in a given financial period could be materially impacted.

RECENT ACCOUNTING PRONOUNCEMENTS

See Note 1 to the Consolidated Financial Statements regarding discussion of new accounting standards.

FOREIGN EXCHANGE

Approximately 97% of the Company’s sales in 2003 were denominated in United States dollars and, as a result, were not subject to changes in exchange rates. Approximately 3% of the Company’s sales were denominated in foreign currencies that were subject to changes in exchange rates. At this time, the Company does not use derivative instruments to manage the exchange rate risk.

The Company imports its product from manufacturers located in the Pacific Rim, principally China. Although the Company generally pays for its product in United States dollars, the cost of such product may fluctuate with the value of the Chinese currency because the purchase price paid to the Company’s vendors in United States dollars would be worth more or less in the Chinese currency. As a result, the Company’s costs could be adversely affected if the Chinese currency appreciates significantly relative to the United States dollar; this could result from a decision by the People’s Republic of China to allow its currency to float instead of being

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pegged to the U.S. dollar at a fixed rate. Conversely, its costs would be favorably affected if the Chinese currency depreciates significantly relative to the United States dollar. In addition, less than 1% of the Company’s product purchases in 2003 were denominated in foreign currencies that were subject to changes in exchange rates. During 2003, the Company did not use derivative instruments to manage the exchange rate risk.

See also “Item 1. Business – Restrictions on Imports.”

EFFECT OF INFLATION

The Company continually attempts to minimize any effect of inflation on earnings by controlling its operating costs and selling prices. During the past few years, the rate of inflation has been low and has not had a material impact on the Company’s results of operations.

FORWARD-LOOKING STATEMENTS AND FACTORS AFFECTING FUTURE EARNINGS

Certain statements made in this Annual Report on Form 10-K and the documents incorporated by reference in this Annual Report on Form 10-K include forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. All statements regarding the Company’s expected future financial position, results of operations, cash flows, financing plans, business strategy, budgets, tax rates, capital expenditures, competitive positions, growth opportunities, plans and objectives of management, as well as statements containing the words such as “anticipate,” “approximate,” “believe,” “plan,” “estimate,” “expect,” “project,” “could,” “should,” “will,” “intend,” “may” and other similar expressions, are forward-looking statements. Forward-looking statements do not relate strictly to historical or current facts.

Such forward-looking statements are inherently uncertain, and you must recognize that actual results may differ materially from forward-looking statements as a result of a variety of factors, including, without limitation, those discussed below. Such forward-looking statements are based on management’s current expectations and include known and unknown risks, uncertainties and other factors, many of which the Company is unable to predict or control, that may cause the Company’s actual results or performance to differ materially from any future results or performance expressed or implied by such forward-looking statements. These statements involve risks, uncertainties and other factors discussed below or described from time to time in the Company’s filings with the Commission.

Such factors include, among other things, the following: consumer acceptance of new products; changing public and consumer taste; product development efforts; identification and retention of sculpting and other talent; shift in product mix; completion of third-party product manufacturing; customer reorders and order cancellations; the volume, number, mix and timing of customer orders, reseller inventory policies, and the Company’s ability to forecast and fulfill changes in anticipated product demand; control of operating expenses; collection of accounts receivable; management of inventory; changes in the cost and availability of cargo transportation, dockage and materials handling with respect to both the importation of inventory and the shipment of product to the Company’s customers; the effect of regulations and operating protocols affecting the importation of goods into the U.S., including security measures adopted by U.S. Customs in light of heightened terrorism; changes in foreign exchange rates; corporate cash flow application, including share repurchases; cost of debt capital; functionality of information, operating and distribution systems; identification, completion and results of acquisitions, investments, Company-owned retail expansion, and other strategic business initiatives; capital expenditures and depreciation, and the timing thereof; grants of stock options or other equity equivalents; actual or deemed exercises of stock options; industry, general economic, regulatory, transportation, labor, and international trade and monetary conditions; adverse weather conditions, natural disasters (such as hurricanes and epidemics), terrorist activities and international political/military developments which may, among other things, impair performance at the retail stores of the Company and its customers; and actions of competitors. Actual results may vary materially from forward-looking statements and the assumptions on which they are based. The Company undertakes no obligation to update or publish in the future any forward-looking statements.

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ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The following discussion of the Company’s exposure to market risk contains “forward-looking statements” that involve risks and uncertainties. The information presented has been prepared utilizing certain assumptions considered reasonable in light of information currently available to management. Given the unpredictability of interest rates as well as other factors, actual results could differ materially from those projected in such forward-looking information.

The Company’s market risks relate primarily to changes in interest rates and currency exchange rates. The first component of the Company’s interest rate risk relates to its debt outstanding. The Company’s credit facility bears interest at variable rates. Because this facility carries a variable interest rate, the Company’s results of operations and cash flows will be exposed to changes in interest rates. Based on average borrowings in 2003, a 1% increase or decrease in current market interest rates would have an impact of approximately $0.5 million.

The second component of the Company’s interest rate risk involves the short-term investment of excess cash. Excess cash flow is typically invested in high-quality fixed income securities issued by banks, corporations and the U.S. government; municipal securities; and overnight repurchase agreements backed by U.S. government securities. These securities are classified as cash equivalents on the Company’s balance sheet. At January 3, 2004, the Company’s cash balance was approximately $22.5 million. Earnings from cash equivalents were approximately $0.2 million for the fifty-three weeks ended January 3, 2004. Based on the January 3, 2004 cash balance, a 1% increase or decrease in current market interest rates would have an impact of approximately $0.2 million.

Approximately 3% of the Company’s sales and less than 1% of the Company’s product purchases in fiscal year 2003 were denominated in a foreign currency. Based on these sales and product purchases, a 10% increase or decrease in the foreign currency exchange rates would have an impact of less than $1 million.

ITEM 8.   FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

See Consolidated Financial Statements on page F-1 herein.

ITEM 9.   CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
                 AND FINANCIAL DISCLOSURE

Not applicable.

ITEM 9A.   CONTROLS AND PROCEDURES

As of the end of the period covered by this report, an evaluation was carried out under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934). Any control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. The design of a control system inherently has limitations, including that the benefits of controls must be considered relative to their costs. Additionally, controls can be circumvented by the individual acts of some persons, or by collusion of two or more people. Therefore, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objective. Based upon and as of the date of that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that those disclosure controls and procedures are effective to provide reasonable assurance that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms.

There have been no changes in the Company’s internal control over financial reporting (as defined in Rules 13a-15 and 15d-15 of the Exchange Act) during the Company’s most recently completed fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART III

ITEM 10.   DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

Information required by this Item will be included in the 2004 Proxy Statement in the sections captioned “Item 1 — Election of Directors — Nominees for Terms Ending at the 2005 Annual Meeting of Stockholders,” “Information About the Board and Corporate Governance,” “Biographical Information Regarding Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting Compliance,” and such information is incorporated herein by reference.

ITEM 11.   EXECUTIVE COMPENSATION

Information required by this Item will be included in the 2004 Proxy Statement in the sections captioned “Information About the Board and Corporate Governance — Director Compensation,” and “Compensation of Executive Officers,” and such information is incorporated herein by reference.

ITEM 12.   SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
                   AND RELATED STOCKHOLDER MATTERS

Information required by this Item will be included in the 2004 Proxy Statement in the section captioned “Equity Compensation Plan Information,” and “Security Ownership of Certain Beneficial Owners and Management,” and such information is incorporated herein by reference.

ITEM 13.   CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Not applicable.

ITEM 14.   PRINCIPAL ACCOUNTANT FEES AND SERVICES

Information required by this Item will be included in the 2004 Proxy Statement in the section captioned “Audit Committee Report,” and such information is incorporated herein by reference.

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PART IV

ITEM 15.   EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

The Exhibits, and other documents filed as part of this Annual Report on Form 10-K, including those exhibits which are incorporated by reference herein, are:

Exhibits required in connection with this Annual Report on Form 10-K are listed below.

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†  Management contract or compensatory plan.
*  Filed herewith.

(b)   Reports on Form 8-K

     The Company filed the following Current Reports on Form 8-K during the fourth quarter of 2003:
          •   Form 8-K dated October 30, 2003.
          •   Form 8-K dated December 1, 2003.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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

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INDEPENDENT AUDITORS’ REPORT

To  the Board of Directors and Stockholders of
    Department 56, Inc.:

We have audited the consolidated balance sheets of Department 56, Inc. and subsidiaries (the Company) as of January 3, 2004 and December 28, 2002 and the related consolidated statements of income, cash flows, and stockholders’ equity for the years ended January 3, 2004, December 28, 2002, and December 29, 2001. Our audit also included the financial statement schedule listed in the Index at Item 15. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated 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, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of January 3, 2004 and December 28, 2002 and the results of its operations and its cash flows for the years ended January 3, 2004, December 28, 2002, and December 29, 2001 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

As discussed in Note 1 to the consolidated financial statements, in 2002 the Company changed its method of accounting for goodwill and other intangible assets to conform to Statement of Financial Accounting Standards No. 142.

Deloitte & Touche LLP

Minneapolis, Minnesota
March 1, 2004

F-1

DEPARTMENT 56, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
AS OF JANUARY 3, 2004 AND DECEMBER 28, 2002

See notes to consolidated financial statements.

F-2

DEPARTMENT 56, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME
(In thousands, except per share amounts)
YEARS ENDED JANUARY 3, 2004, DECEMBER 28, 2002, AND DECEMBER 29, 2001