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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
 
FORM 10-K
Annual Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
 
For the fiscal year ended FEBRUARY 2, 2002
 
Commission file number 000-24261
 
RESTORATION HARDWARE, INC.
(Exact name of registrant as specified in its charter)

DELAWARE		68-0140361
(State or other jurisdiction of incorporation of organization)		(I.R.S. Employer Identification No.)

15 KOCH ROAD, SUITE J CORTE MADERA, CALIFORNIA		94925
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code (415) 924-1005
 
Securities registered pursuant to section 12(b) of the Act: None

Title of each class		Name of each exchange on which registered
NONE		NONE

Securities registered pursuant to section 12(g) of the Act:
 
COMMON STOCK, $.0001 PAR VALUE
 
(Title of class)

     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. [X] Yes [   ] No

     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 the registrant’s knowledge, in definitive proxy or information statements incorporated by reference to Part III of this Form 10-K or any amendment to this Form 10-K. [   ]

     The aggregate market value of common stock held by non-affiliates of the registrant was approximately $171,499,690 as of April 23, 2002 based upon the closing price of the registrant’s common stock on The Nasdaq National Market reported for April 23, 2002. Shares of common stock held by each executive officer and director and by each person who on that date beneficially owned more than 5% of the outstanding common stock have been excluded in that such persons may under certain circumstances be deemed to be affiliates. This determination of affiliate status is not necessarily a conclusive determination of affiliate status for any other purpose.

     29,709,356 shares of the registrant’s $.0001 par value common stock were outstanding on April 23, 2002.

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TABLE OF CONTENTS

PART I
Item 1.		Business		3
Item 2.		Properties		14
Item 3.		Legal Proceedings		14
Item 4.		Submission of Matters to a Vote of Security Holders		14
PART II
Item 5.		Market for Registrant’s Common Equity and Related Stockholder Matters		15
Item 6.		Selected Financial Data		16
Item 7.		Management’s Discussion and Analysis of Financial Condition and Results of Operations		17
Item 7A		Quantitative and Qualitative Disclosures About Market Risk		26
Item 8.		Financial Statements and Supplementary Data		26
Item 9.		Changes in and Disagreements with Accountants on Accounting and Financial Disclosure		47
PART III
Item 10.		Directors and Executive Officers of the Registrant Executive Compensation		47
Item 11.		Executive Compensation and Other Information		48
Item 12.		Security Ownership of Certain Beneficial Owners and Management		48
Item 13.		Certain Relationships and Related Transactions		48
PART IV
Item 14.		Exhibits, Financial Statement Schedules, and Reports on Form 8-K		48

This annual report on Form 10-K contains forward-looking statements that are based on the beliefs of, and estimates made by and information currently available to, our management. The words “expect,” “anticipate,” “intend,” “plan” and similar expressions identify forward-looking statements. These statements are subject to risks and uncertainties. Actual results could differ materially from those discussed here. Factors that could cause or contribute to such differences include, but are not limited to, those discussed below in “Factors That May Affect Our Future Operating Results” and elsewhere in this annual report on Form 10-K. We assume no obligation to update this information.

Documents incorporated by reference: portions of the registrant’s proxy statement for its 2002 annual meeting of stockholders are incorporated by reference.

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PART I

ITEM 1. BUSINESS

GENERAL

     Our company, Restoration Hardware, Inc., together with our subsidiaries, is a specialty retailer of home furnishings, functional and decorative hardware and related merchandise that reflects our classic and authentic American point of view. We market our merchandise through retail locations, mail order catalogs and on the worldwide web at www.restorationhardware.com. Our merchandise strategy and our stores’ architectural style create a unique and attractive selling environment designed to appeal to an affluent, well educated 35 to 60 year old customer. We operated 104 stores in 31 states, the District of Columbia and in Canada at February 2, 2002. We operate on a 52 — 53 week fiscal year ending on the Saturday closest to January 31. The 2001 fiscal year was a 52-week year and ended on February 2, 2002.

     In addition to our retail stores, we operate a direct-to-customer sales channel which includes both catalog and Internet, and a wholly-owned furniture manufacturer.

     We commenced business more than 20 years ago as a purveyor of fittings and fixtures for older homes. Since then, we have evolved into a unique home furnishings retailer offering consumers an array of distinctive, high quality and often hard-to-find merchandise. We display our broad assortment of merchandise in an architecturally inviting setting. We believe that we create an attractive and entertaining environment in our stores by virtue of our eclectic product mix, which includes classic, high-quality furniture, lighting, home furnishings, premium-positioned home textiles and functional and decorative hardware. Integral to the shopping experience, most product displays are complemented by our unique in-store signage program, which provides historical, anecdotal and sometimes nostalgic descriptions of products.

     In 2001 we developed and initiated a repositioning plan for the company. The central component of this plan was the launch of a new merchandising strategy targeted for April 2002, which included the introduction of a number of new merchandise offerings, adjustment of overall product mix, and remodeling of our stores in order to best present the new merchandise. Other key elements of the plan included strengthening our balance sheet, upgrading the management team, eliminating under-performing products and reducing the overall number of items in the merchandise assortment, closing under-performing stores, and growing our direct-to-customer business. Over the course of 2001 substantial progress was made in each of these areas.

     In the first quarter of 2002 we have introduced premium-positioned home textiles and new bath hardware collections, as well as completed the remodeling of our stores. Also in connection with our repositioning plan, in April 2002 we redesigned our catalog and website to enhance the overall customer experience.

RETAIL STORES

Merchandising Mix

     We offer a broad but carefully edited selection of merchandise that provides a consistent point of view throughout our stores. Our collection of merchandise, not traditionally found in a single store environment, includes classic American-styled furniture, home furnishings, lighting, functional and decorative hardware, premium-positioned home textiles and discovery items. Our merchandise mix also includes proprietary products and hard-to-find products selected from non-traditional distribution channels that appear unique to our customers.

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     The percentage of total revenue contributed by major merchandising categories is as follows:

Product Selection, Purchasing and Sourcing

     We make merchandise purchases from over 460 vendors. These vendors include major domestic manufacturers, specialty niche manufacturers and importers. We maintain agents in China, England, France, Japan, India, Portugal and Eastern Europe, and our merchandising team travels to Asia and Europe in search of new products. By sourcing products offshore, we seek to achieve increased buying effectiveness and ensure exclusivity for a portion of our product line. In many instances, we also work closely with our vendors to develop products which are unique to us.

DIRECT-TO-CUSTOMER — CATALOG AND INTERNET

     Our catalog business complements our retail business by building customer awareness of a concept, increasing customer traffic in our stores, enhancing brand image and acting as an effective advertising vehicle. In addition, we maintain a website, www.restorationhardware.com, designed to sell our products, promote consumer awareness of Restoration Hardware and generate store traffic.

     In fiscal 2001, we distributed approximately 20.5 million catalogs as compared to approximately 12 million catalogs in fiscal 2000. We mail catalogs to persons with demographic profiles similar to those of our retail customers and who also possess previous mail order purchase histories. In fiscal 2001, approximately 65% of catalogs were circulated to past customers, and the remaining catalogs were mailed to prospects. These prospects were obtained primarily from customer lists of other high-end mail order companies sharing similar customer demographics. We out-source the fulfillment aspects of the business, including telemarketing, customer service and distribution, to a third party located in Portland, Tennessee.

     We believe our catalog is a key resource to further market our brand to both retail customers and customers outside of the retail trade areas.

THE MICHAELS FURNITURE COMPANY, INC.

     Purchased by Restoration Hardware in 1998, Michaels offers a line of furniture for the home and office. Specific product lines include living room, bedroom, dining room, home office and accessory items. Inter-company sales to Restoration Hardware represented virtually all of Michaels’ total sales during the fiscal year ended February 2, 2002 and this trend is expected to continue. Michaels is located in Sacramento, California.

MANAGEMENT INFORMATION SYSTEMS

     Our retail management information systems include fully integrated store, merchandising, distribution and financial systems. We utilize STS Systems for our point-of-sale, merchandise management and warehouse management systems, and rely on STS for software support. Recently we implemented a new e-commerce application and upgraded our merchandise analysis tool.

COMPETITION

     The retail market is highly competitive. We compete against a diverse group of retailers ranging from specialty stores to traditional furniture stores and department stores. Our product offerings also compete with a variety of national, regional and local retailers. We also compete with these and other retailers for customers, suitable retail locations, suppliers and qualified employees and management personnel. Many of our competitors have significantly greater financial, marketing and other resources. Moreover, increased competition may result, and has resulted, in potential or actual litigation between us and our competitors relating

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to such activities as competitive sales and hiring practices, exclusive relationships with key suppliers and manufacturers and other matters. As a result, increased competition may adversely affect our financial performance, and we cannot assure you that we will be able to compete successfully in the future.

     We believe that our ability to compete successfully is determined by several factors, including, among other things, the breadth and quality of our product selection, effective merchandise presentation, customer service, pricing and store location. Although we believe that we are able to compete favorably on the basis of these factors, we may not ultimately succeed in competing with other retailers in our market.

TRADEMARKS

     We have registered our trademark “Restoration Hardware” in the United States, Mexico and Canada.

EMPLOYEES

     At February 2, 2002, we had approximately 1,500 full-time employees and 1,700 part-time employees. We consider our employee relations to be good. None of our employees are represented by a collective bargaining agreement, nor have we ever experienced any work stoppage.

Factors that may affect our future operating results

We may not be able to successfully anticipate changes in consumer trends and our failure to do so may lead to loss of sales revenues and the closing of under-performing stores.

Our success depends on our ability to anticipate and respond to changing merchandise trends and consumer demands in a timely manner. Moreover, our new management team has adopted a repositioning strategy for the company which includes redefining and redirecting the focus of our stores, remodeling our stores, increasing our direct-to-customer business, and implementing a new merchandising strategy which involves introducing a variety of new merchandise offerings, as well as adjusting the overall mix of our product offerings. We have incurred and continue to incur, substantial costs in implementing this repositioning strategy. This repositioning strategy may create a number of significant challenges for us. If, for example, we misjudge market trends, we may significantly overstock unpopular products and be forced to take significant inventory markdowns, which would have a negative impact on our operating results. Conversely, shortages of popular items could result in loss of sales revenues and have a material adverse effect on our operating results. Moreover, the substantial costs we have incurred in implementing our repositioning strategy may not generate a corresponding increase in profits to our business.

We believe there is a lifestyle trend toward increased interest in home renovation and interior decorating, and we further believe we are benefiting from such a trend. The failure of this trend to materialize or a decline in such a trend could adversely affect consumer interest in our major product lines. Moreover, our products must appeal to a broad range of consumers whose preferences cannot always be predicted with certainty and may change between sales seasons. If we misjudge either the market for our merchandise or our customers’ purchasing habits, we may experience a material decline in sales or be required to sell inventory at reduced margins. We could also suffer a loss of customer goodwill if we do not adhere to our quality control or service procedures or otherwise fail to ensure satisfactory quality of our products. These outcomes may have a material adverse effect on our business, operating results and financial condition.

In fiscal year 2001, we closed three underperforming stores. We anticipate closing an additional six to eight underperforming stores through 2004. A material decline in sales and other adverse conditions resulting from our failure to accurately anticipate changes in merchandise trends and consumer demands may require us to close additional under-performing stores. The closure of such stores would subject us to additional costs including, but not limited to, employee severance costs, charges in connection with the impairment of assets and costs associated with the disposition of outstanding lease obligations.

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Our success is highly dependent on improvements to our planning and control processes and our supply chain.

An important part of our efforts to achieve efficiencies, cost reductions and sales growth is the identification and implementation of improvements to our planning, logistical and distribution infrastructure and our supply chain, including merchandise ordering, transportation and receipt processing. An inability to improve our planning and control processes or to take full advantage of supply chain opportunities could have a material adverse effect on our operating results.

In addition, we have recently incurred significant costs to implement a new e-commerce application and upgrade our merchandise analysis tools. However, we cannot assure you that these changes and the substantial costs we incurred to effect these changes will generate a corresponding financial return for our business.

Because our revenues are subject to seasonal fluctuations, significant deviations from projected demand for products in our inventory during a selling season could have a material adverse effect on our financial condition and results of operations.

Our business is highly seasonal. We make decisions regarding merchandise well in advance of the season in which it will be sold, particularly for the holiday selling season. The general pattern associated with the retail industry is one of peak sales and earnings during the holiday season. Due to the importance of the holiday selling season, the fourth quarter of each year has historically contributed, and we expect it will continue to contribute, a disproportionate percentage of our net sales and most of our net income for the entire year. In anticipation of increased sales activity during the fourth quarter, we incur significant additional expenses both prior to and during the fourth quarter. These expenses may include acquisition of additional inventory, catalog preparation and mailing, advertising, in-store promotions, seasonal staffing needs and other similar items. If, for any reason, our sales were to fall below our expectations in November and December, our business, financial condition and annual operating results may be materially adversely affected.

Increased advertising expenditure without increased revenues may have a negative impact on our operating results.

We expend a large amount of our available funds on advertising in advance of a particular season. Moreover, our advertising costs for the past three fiscal years have increased from approximately $11.2 million per year to approximately $16.1 million per year, and we expect to continue to increase our advertising expenditures in fiscal 2002. As a result, if we misjudge the directions or trends in our market, we may expend large amounts of our cash on advertising that generates little return on investment, which would have a negative effect on our operating results. During the last three fiscal years, our advertising costs have increased while our overall revenues have declined. Accordingly, we have spent increasing cash on advertising without achieving overall revenue increases and, if this trend were to continue, it would have a negative impact on our operating results.

Our quarterly results fluctuate due to a variety of factors and are not a meaningful indicator of future performance.

Our quarterly results have fluctuated in the past and may fluctuate significantly in the future, depending upon a variety of factors, including, among other things, the mix of products sold, the timing and level of markdowns, promotional events, store openings, closings, remodels or relocations, shifts in the timing of holidays, timing of catalog releases or sales, competitive factors and general economic conditions. Accordingly, our profits or losses may fluctuate. Moreover, in response to competitive pressures, we may take certain pricing or marketing actions that could have a material adverse effect on our business, financial condition and results of operations. Therefore, we believe that period-to-period comparisons of our operating results are not necessarily meaningful and cannot be relied upon as indicators of future performance. If our operating results in any future period fall below the expectations of securities analysts and investors, the market price of our securities would likely decline.

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Fluctuations in comparable store sales may cause our revenues and operating results from period to period to vary.

A variety of factors affect our comparable store sales including, among other things, the general retail sales environment, our ability to efficiently source and distribute products, changes in our merchandise mix, promotional events, the impact of competition and our ability to execute our business strategy efficiently. Our comparable store sales results have fluctuated significantly in the past, and we believe that such fluctuations may continue. Our comparable store sales decreased 4.6% in fiscal 2001, decreased 1% in fiscal 2000, and increased 0.8% in fiscal 1999. Past comparable store sales results may not be indicative of future results. As a result, the unpredictability of our comparable store sales may cause our revenues and operating results to vary quarter to quarter, and an unanticipated decline in revenues may cause our stock price to fluctuate.

We depend on a number of key vendors to supply our merchandise and provide critical services, and the loss of any one of our key vendors may result in a loss of sales revenues and significantly harm our operating results.

We make merchandise purchases from over 460 vendors. Our performance depends on our ability to purchase our merchandise in sufficient quantities at competitive prices. Although we have many sources of merchandise, two of our vendors, Mitchell Gold, a manufacturer of upholstered furniture, and Robert Abbey Inc., a manufacturer of table and floor lamps, together accounted for approximately 19% of our aggregate merchandise purchases in the fiscal year ended February 2, 2002. In addition, our smaller vendors generally have limited resources, production capacities and operating histories, and some of our vendors have limited the distribution of their merchandise in the past. We have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products, and any vendor or distributor could discontinue selling to us at any time. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future, or be able to develop relationships with new vendors to expand our options or replace discontinued vendors. Our inability to acquire suitable merchandise in the future or the loss of one or more key vendors and our failure to replace any one or more of them may have a material adverse effect on our business, results of operations and financial condition.

In addition, a single vendor supports the majority of our management information systems, and we have historically employed a single general contractor to oversee the construction of our new stores. A failure by the vendor to support our management information systems or by the contractor to provide its services adequately upon request in the future could have a material adverse effect on our business, results of operations and financial condition.

A disruption in any of our three distribution centers’ operations would materially affect our operating results.

The distribution functions for our stores are currently handled from our facilities in Hayward and Tracy, California and Baltimore, Maryland. Any significant interruption in the operation of any of these facilities may delay shipment of merchandise to our stores and customers, damage our reputation or otherwise have a material adverse effect on our financial condition and results of operations. Moreover, a failure to successfully coordinate the operations of these facilities also could have a material adverse effect on our financial condition and results of operations.

We are dependent on external funding sources which may not make available to us sufficient funds when we need them.

We, like other emerging-growth retailers, rely significantly on external funding sources to finance our operations and growth. Any reduction in cash flow from operations could increase our external funding requirements to levels above those currently available to us. While we currently have in place an $80.0 million credit facility, the amount available under this facility is typically much less than the

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$80.0 million stated maximum limit of the facility because the availability of eligible collateral for purposes of the borrowing base limitations in the credit facility usually reduces the overall credit amount otherwise available at any given time. We currently believe that the combination of the March 2001 preferred stock financing, the May and November 2001 common stock financings, our cash flow from operations and funds available under our credit facility will satisfy our capital requirements for at least the next 12 months. However, continued weakening of, or other adverse developments concerning, our sales performance or adverse developments concerning the availability of credit under our credit facility due to covenant limitations or other factors could limit the overall availability of funds to us.

In particular, we may experience cash flow shortfalls in the future and we may require additional external funding. However, we cannot assure you that we will be able to raise funds on favorable terms, if at all, or that future financing requirements would not be dilutive to holders of our capital stock. In the event that we are unable to obtain additional funds on acceptable terms or otherwise, we may be unable or determine not to take advantage of new opportunities or take other actions that otherwise may be important to our operations. Additionally, we may need to raise additional funds in order to take advantage of unanticipated opportunities. We also may need to raise additional funds to respond to changing business conditions or unanticipated competitive pressures. If we fail to raise sufficient funds, we may be required to delay or abandon some of our planned future expenditures or aspects of our current operations.

Because our business requires a substantial level of liquidity, we are dependent upon a credit facility with numerous restrictive covenants that limit our flexibility.

Our business requires substantial liquidity in order to finance inventory purchases, the employment of sales personnel for the peak holiday period, publicity for the holiday buying season and other similar advance expenses. In addition, other activities such as expenses of our direct-to-customer business may require additional capital expenditures. We currently have in place a credit facility with a syndicate of lenders, which includes, among others, Fleet Capital Corporation. The facility provides for an overall commitment of $80.0 million, of which $20.0 million is available for letters of credit. Over the past several years, we have entered into numerous modifications of this credit facility, primarily to address changes in the covenant requirements to which we are subject.

Covenants in the credit facility include, among others, ones that limit our ability to incur additional debt, make liens, make investments, consolidate, merge or acquire other businesses and sell assets, pay dividends and other distributions, and enter into transactions with affiliates. These covenants restrict numerous aspects of our business. Moreover, financial performance covenants require us, among other things, not to exceed particular capital expenditure limits. The credit facility also includes a borrowing base formula to address the availability of credit under the facility at any given time based upon numerous factors, including eligible inventory and eligible accounts receivable (subject to the overall maximum cap on total borrowings). Consequently, the availability of eligible collateral for purposes of the borrowing base formula may limit our ability to borrow under the credit facility.

As of February 2, 2002, we had no debt outstanding under our credit facility. However, we expect to draw upon the credit facility in the future. If we do, failure to comply with the terms of the credit facility would entitle the secured lenders to foreclose on our assets, including our accounts receivable, inventory, general intangibles, equipment, goods, fixtures and chattel paper. The secured lenders would be repaid from the proceeds of the liquidation of those assets before the assets would be available for distribution to other creditors and, lastly, to the holders of our capital stock. Our ability to satisfy the financial and other restrictive covenants may be affected by events beyond our control.

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Future increases in interest and other expense may impact our future operations.

High levels of interest and other expense have had and could have negative effects on our future operations. Interest expense decreased $1.1 million to $4.8 million in the fiscal year ended February 2, 2002, from $5.9 million the fiscal year ended February 3, 2001. This decrease resulted from reduced debt levels, partially offset by an increase in the average interest rate. In the fiscal year ended February 3, 2001, interest expense increased $4.5 million to $5.9 million from the prior year. In the fiscal year ended January 29, 2000, interest expense increased $0.5 million to $1.4 million. The increased interest expense in these fiscal years resulted primarily from an increase in the average borrowings outstanding. In the fiscal year ended February 2, 2002, cash raised in various equity financings together with cash generated from operations allowed the Company to reduce during the course of the year the outstanding balances under its credit facility and to end the year with no outstanding balance under the facility. In addition, while our credit facility was amended in March 2001 and September 2001 to provide us with more favorable interest rates and changes to some financial covenants, a substantial portion of our cash flow from operations was used to pay our interest expense and will not be available for other business purposes.

Our ability to continue to meet our future debt and other obligations and to minimize our average debt level depends on our future operating performance and on economic, financial, competitive and other factors. In addition, we may need to incur additional indebtedness in the future. Many of these factors are beyond our control. We cannot assure you that our business will generate sufficient cash flow or that future financings will be available to provide sufficient proceeds to meet our obligations or to service our total debt.

we are subject to trade restrictions and other risks associated with our dependence on foreign imports for our merchandise.

For the fiscal year ended February 2, 2002, we purchased approximately 32% of our merchandise directly from vendors located abroad and expect that such purchases will increase as a percentage of total merchandise purchases for the fiscal year ending on February 1, 2003. As an importer, our future success will depend in large measure upon our ability to maintain our existing foreign supplier relationships and to develop new ones. While we rely on our long-term relationships with our foreign vendors, we have no long-term contracts with them. Additionally, many of our imported products are subject to existing duties, tariffs and quotas that may limit the quantity of some types of goods which we may import into the United States. Our dependence on foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, changes in import duties, tariffs and quotas, loss of “most favored nation” trading status by the United States in relation to a particular foreign country, work stoppages, delays in shipments, freight cost increases, economic uncertainties, including inflation, foreign government regulations, and political unrest and trade restrictions, including the United States retaliating against protectionist foreign trade practices. If any of these or other factors were to render the conduct of business in particular countries undesirable or impractical, our financial condition and results of operations could be materially adversely affected.

While we believe that we could find alternative sources of supply, an interruption or delay in supply from our foreign sources, or the imposition of additional duties, taxes or other charges on these imports, could have a material adverse effect on our business, financial condition and results of operations unless and until alternative supply arrangements are secured. Moreover, products from alternative sources may be of lesser quality and/or more expensive than those we currently purchase, resulting in a loss of sales revenues to us.

As an importer we are subject to the effects of currency fluctuations related to our purchases of foreign merchandise.

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While most of our purchases outside of the United States currently are settled in U.S. dollars, it is possible that a growing number of them in the future may be made in currencies other than the U.S. dollar. Historically, we have not hedged our currency risk and do not currently anticipate doing so in the future. However, because our financial results are reported in U.S. dollars, fluctuations in the rates of exchange between the U.S. dollar and other currencies may decrease our sales margins or otherwise have a material adverse effect on our financial condition and results of operations in the future.

Increased investments related to our direct-to-customer business may not generate a corresponding increase in profits to our business.

We have invested additional resources in the expansion of our direct-to-customer business which could increase the risks associated with aspects of this business. In fiscal year 2001, sales through our direct-to-customer channel grew by 49 percent. Increased activity in our direct-to-customer business could result in material changes in our operating costs, including increased merchandise inventory costs and costs for paper and postage associated with the distribution and shipping of catalogs and product. Although we intend to attempt to mitigate the impact of these increases by improving efficiencies, we cannot assure you that we will succeed in mitigating expenses with increased efficiency or that cost increases associated with our direct-to-customer business will not have an adverse effect on the profitability of our business. Additionally, while we out-source the fulfillment of our direct-to-customer division, including telemarketing, customer service and distribution, to a third party, the third party may not have the capacity to accommodate our growth. This lack of capacity may result in delayed customer orders and deficiencies in customer service, both of which may adversely affect our reputation and cause us to lose sales revenue.

Our success is highly dependent on new manufacturers and suppliers with whom we do not have a long history working together.

In connection with our repositioning strategy, we are implementing a new merchandising strategy which will entail changing the nature and types of the many products that we sell. We anticipate changes in some of the manufacturers and suppliers of our products. Many of these manufacturers and suppliers will be new to us, and many of them will be located abroad. We cannot assure you that they will be reliable sources of our products. Moreover, these manufacturers and suppliers may be small and undercapitalized firms which produce limited numbers of items. Given their limited resources, these firms might be susceptible to production difficulties, quality control issues and problems in delivering agreed-upon quantities on schedule. We cannot assure you that we would be able, if necessary, to return products to these suppliers and obtain refunds of our purchase price or obtain reimbursement or indemnification from them if their products prove defective. These suppliers and manufacturers also may be unable to withstand the current downturn in the U.S. or worldwide economy. Significant failures on the part of these new suppliers or manufacturers could have a material adverse effect on our operating results.

In addition, many of these suppliers and manufacturers will require extensive advance notice of our requirements in order to produce products in the quantities we desire. This long lead time requires us to place orders far in advance of the time when certain products will be offered for sale, thereby exposing us to risks relating to shifts in customer demands and trends, and any downturn in the U.S. economy.

We depend on key personnel and could be affected by the loss of their services because of the limited number of qualified people in our industry.

The success of our business will continue to depend upon our key personnel, including our President and Chief Executive Officer, Mr. Gary G. Friedman. During the last year, we have experienced significant turnover in our executive staff, including the departure of our Chief Operating Officer and Chief Financial Officer. We have hired a new Chief Financial Officer, a new Chief Operating Officer and a number of other new executive personnel. Eight out of our twelve vice presidents are new. Although we believe that the hiring of such personnel will offer an opportunity to expand our management team with persons that can assist in implementing our new direction, turnover in personnel and the recruitment and retention of a

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new executive staff created a number of significant challenges for us. For instance, the responsibilities of the Chief Financial Officer include budgeting, financial forecasting and related areas of financial management. We have experienced transitional difficulties in administration in these areas in connection with the departure of our former Chief Financial Officer. However, the retention of our new Chief Financial Officer has allowed us to move rapidly to address these transitional issues. In so doing, we have discovered related and unrelated problems which we have been obligated to address and resolve and in certain cases, which we continue to work through. In particular, we are continuing to evaluate the various procedures used in our accounting systems and as a part of this evaluation we will implement such changes as necessary.

Additionally, competition for qualified employees and personnel in the retail industry is intense. The process of locating personnel with the combination of skills and attributes required to carry out our goals is often lengthy. Our success depends to a significant degree upon our ability to attract, retain and motivate qualified management, marketing and sales personnel, in particular store managers, and upon the continued contributions of these people. We cannot assure you that we will be successful in attracting and retaining qualified executives and personnel. In addition, our employees may voluntarily terminate their employment with us at any time. We also do not maintain any key man life insurance. The loss of the services of key personnel or our failure to attract additional qualified personnel could have a material adverse effect on our business, financial condition and results of operations.

Rapid growth of our company coupled with change in general economic conditions has impacted our profitability.

In fiscal years 1999 and 2000, we experienced rapid growth and, as a result, our costs and expenditures outpaced our revenues. Following this growth, the economy in the United States of America began to weaken. The combination of these two factors affected our profitability. As a result of these factors in fiscal years 1999, 2000 and 2001, we were not profitable. If similar factors continue to operate unmitigated, there will be a material adverse effect on our business, operating results and financial condition.

Changes in general economic conditions affect consumer spending and may significantly harm our revenues and results of operations.

We believe that general trends in the economy have adversely affected retail sales, and that we may continue to be hurt by such trends. In particular, a weakening environment for retail sales could adversely affect consumer interest in our major product lines. Our comparable store sales decreased 4.6% for the fiscal year ended February 2, 2002. Additionally, in fiscal years 2001, 2000 and 1999, we were not profitable. The success of our business depends to a significant extent upon the level of consumer spending. A number of economic conditions affect the level of consumer spending on merchandise that we offer, including, among other things, the general state of the economy, general business conditions, the level of consumer debt, interest rates, taxation and consumer confidence in future economic conditions. More generally, reduced consumer confidence and spending may result in reduced demand for our products and limitations on our ability to increase prices, and may also require increased levels of selling and promotional expenses. Adverse economic conditions and any related decrease in consumer demand for discretionary items such as those offered by us could have a material adverse effect on our business, results of operations and financial condition.

We face an extremely competitive specialty retail business market.

The retail market is highly competitive. We compete against a diverse group of retailers ranging from specialty stores to traditional furniture stores and department stores. Our product offerings also compete with a variety of national, regional and local retailers. We also compete with these and other retailers for customers, suitable retail locations, suppliers and qualified employees and management personnel. Many of our competitors have significantly greater financial, marketing and other resources. Moreover, increased competition may result in potential or actual litigation between us and our competitors relating to such activities as competitive sales and hiring practices, exclusive relationships with key suppliers and manufacturers and other matters. As a result, increased competition may adversely affect our future

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financial performance, and we cannot assure you that we will be able to compete successfully in the future.

Terrorist attacks and threats or actual war may negatively impact all aspects of our operations, revenues, costs and stock price.

Recent terrorist attacks in the United States, as well as future events occurring in response or connection to them, including, without limitation, future terrorist attacks or threats against United States targets, rumors or threats of war, actual conflicts involving the United States or its allies or military or trade disruptions affecting our domestic or foreign suppliers of merchandise, may impact our operations. The potential impact to our operations includes, among other things, delays or losses in the delivery of merchandise to us and decreased sales of the products we carry. Additionally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the U.S. and worldwide financial markets and economy. They also could result in economic recession in the U.S. or abroad. Any of these occurrences could have a significant impact on our operating results, revenues and costs and may result in the volatility of the market price for our common stock and on the future price of our common stock.

Our common stock price may be volatile.

The market price of our common stock has fluctuated significantly in the past, and is likely to continue to be highly volatile. In addition, the trading volume in our common stock has fluctuated, and significant price variations can occur as a result. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. In addition, the U.S. equity markets have from time to time experienced significant price and volume fluctuations that have particularly affected the market prices for the stocks of emerging-growth companies. These broad market fluctuations may materially adversely affect the market price of our common stock in the future. Such variations may be the result of changes in the trading characteristics that prevail in the market for our common stock, including low trading volumes, trading volume fluctuations and other similar factors that are particularly common among highly volatile securities of emerging-growth companies. Variations also may be the result of changes in our business, operations or prospects, announcements or activities by our competitors, entering into new contractual relationships with key suppliers or manufacturers by us or our competitors, proposed acquisitions by us or our competitors, financial results that fail to meet public market analysts’ expectations, changes in stock market analysts’ recommendations regarding us, other retail companies or the retail industry in general, and domestic and international market and economic conditions.

Future sales of our common stock in the public market could adversely affect our stock price and our ability to raise funds in new equity offerings.

We cannot predict the effect, if any, that future sales of shares of our common stock or the availability for future sale of shares of our common stock or securities convertible into or exercisable for our common stock will have on the market price of our common stock prevailing from time to time. For example, in connection with our May 2001 common stock financing, we filed a registration statement on Form S-3 with the Securities and Exchange Commission on June 1, 2001 to register approximately 4.5 million shares of our common stock acquired by the investors in the financing. The registration statement became effective on July 6, 2001. Additionally, in connection with our March 2001 preferred stock financing, we filed a registration statement on Form S-3 with the Securities and Exchange Commission to register up to 6.8 million shares of our common stock issued, or to be issued upon the conversion of our Series A preferred stock, to the investors in the financing. And, in connection with our November 2001 common stock financing, we filed a registration statement on Form S-3 with the Securities and Exchange Commission to register approximately 4.5 million shares of our common stock issued to the investors in the financing. Sale, or the availability for sale, of substantial amounts of common stock by our existing stockholders pursuant to an effective registration statement or under Rule 144, through the exercise of registration rights or the issuance of shares of common stock upon the exercise of stock options, or the conversion of our preferred stock, or the perception that such sales or issuances could occur, could adversely affect prevailing market prices for our common stock and could materially impair our future ability to raise capital through an offering of equity securities.

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We are subject to anti-takeover provisions and the terms and conditions of our preferred stock financing that could delay or prevent an acquisition and could adversely affect the price of our common stock.

Our Second Amended and Restated Certificate of Incorporation, as amended and Amended and Restated Bylaws, certain provisions of Delaware law and the certificate of designation governing the rights, preferences and privileges of our preferred stock may make it difficult in some respects to cause a change in control of our company and replace incumbent management. For example, our Second Amended and Restated Certificate of Incorporation, as amended and Amended and Restated Bylaws provide for a classified board of directors. With a classified board of directors, at least two annual meetings of stockholders, instead of one, will generally be required to effect a change in the majority of the board. As a result, a provision relating to a classified board may discourage proxy contests for the election of directors or purchases of a substantial block of our common stock because its provisions could operate to prevent obtaining control of the board in a relatively short period of time.

Separately, the holders of our preferred stock have the right to designate two members of our board of directors, and they also have a number of voting rights pursuant to the terms of the certificate of designation which could potentially delay, defer or prevent a change of control. In particular, the holders of our Series A preferred stock have the right to approve a number of actions by us, including mergers, consolidations, acquisitions and similar transactions in which the holders of Series A preferred stock and common stock do not receive at least three times the then existing conversion price per share of the Series A preferred stock. This right may create a potentially discouraging effect on, among other things, any third party’s interest in completing these types of transactions with us. Consequently, the terms and conditions under which we issued our preferred stock, coupled with the existence of other anti-takeover provisions, may collectively have a negative impact on the price of our common stock, may discourage third-party bidders from making a bid for our company or may reduce any premiums paid to our stockholders for their common stock.

In addition, our board of directors has the authority to fix the rights and preferences of, and to issue shares of, our preferred stock, which may have the effect of delaying or preventing a change in control of our company without action by holders of our common stock.

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ITEM 2. PROPERTIES

     We currently lease three properties located in Corte Madera, California, which are used as our headquarters. The first property in Corte Madera consists of approximately 3,600 square feet of office space and approximately 11,000 square feet of warehouse space. The lease expires on December 31, 2003. The second and third properties in Corte Madera consist of approximately 30,000 square feet of office space in total and the leases expire on May 15, 2003.

     We lease approximately 160,000 square feet of warehouse space in Hayward, California, for use as our west coast distribution center. This lease expires on July 31, 2004, with an option to extend for one additional five-year term. We lease an additional 191,000 square feet of warehouse space in Tracy, California, also for use as a distribution center. This lease expires on September 1, 2003. We lease approximately 276,000 square feet of warehouse space in Baltimore, Maryland, for use as our east coast distribution center. The lease expires on September 30, 2006, with options to extend for two additional three-year terms.

     As of February 2, 2002, we leased approximately 1,187,000 gross square feet for our 104 retail stores. Our retail stores’ lease terms range from 10 to 15 years. Most leases for our retail stores provide for a minimum rent, typically including escalating rent increases, plus a percentage rent based upon sales after certain minimum thresholds are achieved. The leases generally require us to pay insurance, utilities, real estate taxes, and repair and maintenance expenses.

     Michaels leases two properties used for the manufacturing and storage of furniture, in Sacramento, California. The main property consists of approximately 100,000 square feet of manufacturing space and 7,000 square feet of office space. The lease expires on February 28, 2008, with options to extend the lease for two additional 5-year terms. The second property consists of approximately 46,000 square feet of warehouse space which is used to house finished upholstered goods. This lease expires on July 31, 2006.

ITEM 3. LEGAL PROCEEDINGS

     There are no material pending legal proceedings against us. We are, however, involved in routine litigation arising in the ordinary course of our business. We believe that the final outcome of such proceedings should not have a material adverse effect on our consolidated financial condition or results of operations. However, we cannot assure you that the result of any proceeding will be in our favor.

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

     No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this annual report.

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PART II

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

MARKET INFORMATION

     Our common stock is listed on The Nasdaq National Market under the symbol “RSTO.” The closing price of our common stock on Nasdaq was $11.76 on April 23, 2002.

STOCKHOLDERS

     The number of our common stockholders of record as of April 23, 2002 was 206. This number excludes stockholders whose stock is held in nominee or street name by brokers.

DIVIDEND POLICY

     No dividends have been declared on our common stock since our 1998 initial public offering and it is not anticipated that we will pay any dividends in the foreseeable future on our common stock.

STOCK PRICE INFORMATION

     Set forth below are the high and low closing sale prices for shares of our common stock for each quarter during the fiscal years ended February 2, 2002 and February 3, 2001 as reported by The Nasdaq National Market.

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ITEM 6. SELECTED FINANCIAL DATA

     The following table sets forth selected, consolidated financial information for operations for the years indicated. This information is qualified by reference to and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” the consolidated financial statements, related notes thereto and other financial data included elsewhere in this annual report. The following results may not be indicative of our future operating results.

		Fiscal				Fiscal				Fiscal				Fiscal				Fiscal
		2001				2000 (2)				1999				1998 (1)				1997
Results of Operations (Dollars in thousands except per share amounts):
Net sales		$	366,473			$	366,236			$	298,902			$	211,347			$	98,655
Earnings (loss) before income taxes			(43,615	)			(5,977	)			(4,773	)			8,247				3,056
Net earnings (loss)			(33,867	)			(4,560	)			(3,040	)			4,866				1,748
Net earnings (loss) available to common shareholders			(36,684	)			(4,560	)			(3,040	)			3,867				(5,285	)
Basic EPS			(1.57	)			(0.27	)			(0.18	)			0.33				(1.20	)
Diluted EPS			(1.57	)			(0.27	)			(0.18	)			0.23				(1.20	)
Financial Position:
Working capital			49,979				36,196				48,373				34,417				8,188
Total assets			206,744				233,871				221,715				164,245				87,233
Long-term debt and other liabilities			3,236	(4)			39,470				37,145				470				10,678
Redeemable convertible preferred stock			14,106				—				—				—				43,033
Stockholders’ equity			88,144				78,875				82,882				83,755				(11,748	)
Retail Stores:
Store count			104				106				93				65				41
Comparable store sales growth (3)			(4.6	%)			(1.0	%)			0.8	%			12.3	%			11.1	%
Store selling sq. ft. at year-end			682,936				701,628				614,343				418,025				250,622

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RESULTS OF OPERATIONS

Net Sales

     Net sales consist of the following components:

     Net sales for the 52 weeks ended February 2, 2002 (“fiscal 2001”), increased $0.2 million or 0.1% over net sales for the 53 weeks ended February 3, 2001 (“fiscal 2000”). Net sales for fiscal 2000 increased $67.3 million, or 22.5%, over net sales for the 52 weeks ended January 29, 2000 (“fiscal 1999”). The furniture manufacturing sales include only those sales to third parties. Total net sales include shipping fees of $7.1 million, $5.7 million and $4.0 million for fiscal 2001, fiscal 2000, and fiscal 1999, respectively. As of February 2, 2002, we operated 104 stores in 31 states, the District of Columbia and Canada.

Retail Sales

     Retail sales decreased 2.9% in fiscal 2001 as compared to the prior year, primarily due to a 4.6% decrease in comparable store sales and the closure of three underperforming stores. As further discussed in “Liquidity and Capital Resources,” below, in the first and second quarters of fiscal 2001, we received cash proceeds from a third party to cancel leases and close three of our underperforming stores. The cash proceeds received of $5.3 million approximated the net book value of the assets that were written off as a part of the store closures.

     Over the second half of fiscal 2001, as part of our repositioning strategy, we reduced the number of items in our merchandise assortment by 30%, from approximately 7,000 to approximately 5,000 items. In connection with this process, under-performing products were eliminated and new products were introduced, resulting in the introduction of approximately 60% new product in the first quarter of fiscal 2002.

     Retail sales in fiscal 2000 increased 22.7% as compared to the prior year, primarily due to new store openings.

     Comparable store sales are defined as sales from stores whose gross square feet did not change by more than 20% in the previous 12 months and which have been open at least 12 full months. Stores generally become comparable in their 14th full month of operation. In any given period, the set of stores comprising comparable stores may be different from the set of the comparable stores in the previous period, depending on when stores were opened.

Direct-to-customer

     Direct-to-customer sales consist of catalog and Internet sales. Net direct-to-customer sales in fiscal 2001 increased $11.1 million or 49.2% as compared to fiscal 2000. Total catalogs mailed in fiscal 2001 increased to 20.5 million, as compared to approximately 12 million catalogs in fiscal 2000.

     Of the total catalogs mailed in fiscal 2001, 12.2 million were mailed into our retail trade areas, versus 4.9 million in the prior year. We believe that the strategy of mailing catalogs into retail trade areas increases customer traffic in

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our stores and enhances the overall brand image. In April 2002, in connection with our repositioning strategy, we redesigned our catalog and launched a new website to enhance the overall customer experience.

     Net direct-to-customer sales in fiscal 2000 increased $9.8 million as compared to fiscal 1999. Approximately half of the increase was from sales from our website, which was launched in August 1999. Total catalogs mailed in fiscal 2000 increased to 12.2 million, from 7.2 million in fiscal 1999.

Furniture Manufacturing

     We own a wholly-owned furniture manufacturing company located in Sacramento, California, The Michaels Furniture Company (Michaels). The large majority of furniture produced at Michaels is sold through the Company’s sales channels. Additionally, since we acquired Michaels, there have been sales of Michaels furniture to third party customers. Over the past 3 years, we have significantly reduced these sales to third parties in order to increase production capacity for inter-segment sales. Inter-segment sales to Restoration Hardware represented virtually all of Michaels’ total sales during fiscal 2001, and this trend is expected to continue.

COST OF SALES AND OCCUPANCY

     In fiscal 2001, cost of sales and occupancy expenses expressed as a percentage of net sales increased 9.4% to 78.7% from 69.3% in fiscal 2000.

     In the fourth quarter of fiscal 2001 we had charges due to special items totaling $17.5 million which accounted for 4.8% of the 9.4% increase in the cost of sales expressed as a percentage of net sales. These charges included: a $5.3 million charge to reduce certain inventory being eliminated in our repositioning strategy to its net realizable value, a $2.0 million accelerated depreciation charge related to reduced lives of certain long-lived assets being replaced in our Spring 2002 store remodel program, and a $10.2 million charge related to the write-down of long-lived assets in eight under-performing stores. These charges are further discussed below in the section “Special Items.”

     Merchandise markdown and clearance activity associated with our repositioning strategy resulted in a 5.2% deterioration in merchandise margins. Partially offsetting these negative factors, the cost of sales component which pertains to buying and distribution costs expressed as a percent of sales improved 0.6% in fiscal 2001 as compared to fiscal 2000, primarily as a result of lower freight expense to our stores, and lower payroll in our distribution centers.

     In fiscal 2000, cost of sales and occupancy expressed as a percentage of sales remained unchanged at 69.3% compared to the fiscal 1999. Merchandise margin improvements in fiscal 2000 as a result of better sourcing and product flow were offset by higher occupancy costs.

SELLING, GENERAL AND ADMINISTRATIVE

     Selling, general and administrative expenses expressed as a percentage of net sales increased 0.5% to 31.3% in fiscal 2001 from 30.8% in fiscal 2000. The increase is largely due to increased marketing and fulfillment charges in the direct-to-customer division, increased professional fees associated with our repositioning strategy and increased health and benefit costs for our employees. Selling, general and administrative expenses expressed as a percentage of net sales decreased 1.0% to 30.8% in fiscal 2000 from 31.8% in fiscal 1999. The decrease was primarily attributable to improvements store payroll and other store controllable expenses.

INTEREST EXPENSE AND INTEREST INCOME

     Interest expense includes interest related to the amortization of debt issuance costs and interest on borrowings under our line of credit facility. In fiscal 2001, such interest expense was $4.8 million as compared to $5.9 million in fiscal 2000. After eliminating non-cash interest charges related to amortization of debt issuance costs for both fiscal years, interest expense was $3.1 million for fiscal 2001 as compared to $5.1 million for fiscal 2000, a decrease of $2.0 million.

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     The decrease resulted from the amendments of our credit facility to provide for more favorable interest rates and a reduction in debt made possible by the $56.0 million (net of fees) raised in our preferred and common stock financings in fiscal 2001, as discussed below.

     We completed three financing transactions in fiscal 2001. In March 2001, we completed a preferred stock financing, appointed a new Chief Executive Officer, and amended our credit facility. In May and November, we completed two common stock financings. Combined net proceeds from our preferred stock and common stock transactions of $56.0 million (net of fees) were used to pay down our revolving line of credit and for other general corporate purposes. As a result, average borrowings in fiscal 2001 decreased to $23.6 million from $48.4 million in fiscal 2000. The average interest rate during the same period increased from 11.2% to 12.6%, primarily as a result of two high-interest term loans that were part of the amendment of the credit facility in September 2000. Until the anniversary of the amendment in September of fiscal 2001, the existence of these term loans negatively impacted our average interest rate in fiscal 2001 as compared to the prior year. The two term loans were paid off in the second and fourth quarters of fiscal 2001.

     In fiscal 2000, interest expense was $5.9 million as compared to $1.4 million in fiscal 1999, an increase of $4.5 million. During fiscal 2000 our average borrowings outstanding increased to $48.4 million from $20.8 million in fiscal 1999. Interest expense in fiscal 2000 included $0.7 million of amortization of debt issuance costs.

     Interest income, which consists of income from our short-term investments and notes receivable, increased $0.2 million in fiscal 2001 as compared to fiscal 2000. The majority of the increase was due to interest on a $2.05 million loan we provided to Mr. Friedman in connection with his purchase of common stock and preferred stock in March 2001. Interest income in fiscal 2000 increased $0.1 million as compared to fiscal 1999.

INCOME TAXES

     The fiscal 2001 income tax benefit included a valuation allowance charge of $7 million, as more further discussed in “Critical Accounting Policies” below. After adjusting for this charge, our effective tax benefit rate was 22.4% in fiscal 2001, as compared to a tax benefit rate of 37.4% in fiscal 2000 and a tax provision rate of 36.3% in fiscal 1999. These rates reflect the effect of aggregate state tax rates based on a mix of retail sales and direct-to-customer sales in the various states in which we have sales revenue or conduct business.

SPECIAL ITEMS

     Fiscal 2001 included special item charges of approximately $24.5 million. A discussion of these charges follows.

     Inventory lower of cost or market reserve — In connection with the elimination of approximately 30% of the items from our merchandise assortment, we recorded a charge of $5.3 million to write down discontinued merchandise at year-end to its estimated net realizable value.

     Accelerated depreciation — At the beginning of the fourth quarter 2001, concurrent with our November, 2001 private placement of common stock, we finalized our decision to remodel our stores in the first quarter of fiscal 2002. As a result, we recorded an accelerated depreciation charge of $2.0 million in order to reflect the shortened useful life of store fixtures and leasehold assets which were scheduled to be replaced.

     Asset impairment charge — In the course of performing our periodic cash flow analysis of our mature stores, we determined that an asset impairment charge of $10.2 million was required for eight underperforming locations. The impairment charge was calculated as the difference between the net book value of the store’s long-lived assets and the present value of the store’s estimated future cash flows over the remaining life of the lease.

     Tax Valuation Allowance — In the course of analyzing our projected taxable income, we determined that a valuation allowance of $7.0 million against our deferred tax assets was appropriate. The valuation allowance reduced our deferred tax assets to an amount that is more likely than not to be realized.

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LIQUIDITY AND CAPITAL RESOURCES

Operating Cash Flows:

     In fiscal 2001, net cash provided by operating activities decreased $15.1 million to $4.3 million, from $19.4 million in fiscal 2000. Cash decreased largely because of the following factors: the increased net losses resulting from a deterioration in merchandise margins due to increased cost of sales associated with our repositioning strategy; increased cash use in reducing accounts payable and other accrued expenses; and a reduction in cash provided from deferred lease incentives. These factors were partially offset by a reduction in the investment in inventory as a result of lower inventory balances, and a reduction in accounts receivable.

     In fiscal 2000, net cash provided by operating activities increased $15.1 million, to $19.4 million from $4.3 million in fiscal 1999. Cash increased largely because of a reduction during fiscal 2000 in the use of cash for building merchandise inventories, and improved operating margins before depreciation expense resulting from expense reductions. These factors were partially offset by reductions in cash provided from deferred lease incentives, and an increased use of cash in reducing accounts payable and other accrued expenses.

Investing Cash Flows:

     Net cash from investing activities increased $25.1 million, to a source of cash of $1.5 million in fiscal 2001, from a use of cash of $23.6 million in fiscal 2000. The majority of the change is due to a reduction in capital expenditures as a result of opening only one store in fiscal 2001 as compared to 13 in fiscal 2000. Additionally, in fiscal 2001, we entered into agreements with a third party to cancel leases and close three of our under-performing locations, for which we received $5.3 million.

     Net cash used in investing activities decreased $23.6 million, to $23.6 million in fiscal 2000 from $47.2 million in fiscal 1999, primarily due to a decrease in the number of new stores. In fiscal 2000, 13 new stores were added as compared to 28 stores in fiscal 1999.

     In connection with our repositioning strategy, in the first quarter of 2002 we remodeled our stores and launched a new website. Capital expenditures for these projects are expected to total approximately $15 million.

Financing Cash Flows:

     Net cash provided by financing activities increased $11.6 million, to $13.8 million in fiscal 2001 from $2.2 million in fiscal 2000. In March of 2001, we completed a preferred stock financing, appointed a new Chief Executive Officer and amended our credit facility. In May and November of 2001, we completed two common stock financings with various institutional investors. Combined net proceeds from our preferred stock financing and common stock transactions were $56.0 million and were used primarily to pay down our line of credit and for other general corporate purposes.

     In fiscal 2000, net cash provided by financing activities decreased $37.1 million to $2.2 million from $39.3 million in fiscal 1999, principally due to reduced borrowings under our line of credit.

     On March 21, 2001, we amended our existing credit facility. The amendment reduced the overall commitment under the line of credit from $111 million to $89 million, increased the amounts available for letters of credit from $10 million to $20 million and eliminated the minimum earnings before interest, taxes, depreciation and amortization (“EBITDA”) requirement. Additionally, the borrowing base calculation was modified to provide us with more available borrowings due to the pledge of additional collateral, and the interest rate was reduced by 0.25%, with possible additional reductions based on achievement of future EBITDA. The amended credit facility contains minimum availability requirements based on seasonality.

     The amended credit facility included two high-interest term loans. The first of these term loans was paid off in the second quarter of fiscal 2001. In September

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2001, the credit facility was further amended to provide for more favorable interest rates on the remaining term loan. This loan was paid off in January 2002.

     As a result of the paydowns of the term loans, as of February 2, 2002 the maximum availability under the facility was $80.0 million, with amounts available for letters of credit up to $20 million. Availability under the credit facility is limited by reference to a borrowing base calculation, based upon eligible inventory and accounts receivable. The amount available under the credit facility is typically much less than the $80.0 million stated maximum limit of the facility (as of February 2, 2002 the total borrowing base available was approximately $30 million). The agreement contains restrictive covenants including annual capital expenditure limits, minimum inventory levels, limitations on store openings and closings, and prohibitions on dividends. As of February 2, 2002, we had no loans outstanding, and $13.3 million in outstanding letters of credit. Interest is paid monthly at the bank’s reference rate or LIBOR plus a margin. The agreement expires on June 30, 2003.

     In connection with an amendment to our line of credit in September 2000, we issued putable warrants for the purchase of 550,000 shares of our common stock, subject to anti-dilution protections at $3.75 per share. In connection with the amendment of the credit facility in March 2001, 200,000 of the 550,000 warrants were repriced to $2.00 per share. The fair value of the warrants is calculated each quarter using the Black-Scholes model. The following assumptions were used in our calculation as of February 2, 2002: expected life of 20 months, stock volatility considered to be 50%, risk free interest rate of 2.28%, and no dividends during the expected term. For fiscal 2001, the mark-to-market revaluation of the warrants resulted in a charge of approximately $2.7 million against earnings. The warrants expire on September 27, 2005. As of February 2, 2002 warrants for the purchase of approximately 405,000 shares of common stock remained outstanding. During the first quarter of fiscal 2002, all of the remaining warrants were exercised.

While we currently believe that our cash flow from operations, proceeds received from our various equity financings in fiscal 2001 and funds available under our credit facility will satisfy our capital requirements for at least the next 12 months, adverse developments concerning our sales performance or the availability of credit under our credit facility due to covenant limitations or other factors could limit the overall availability of funds to us. Moreover, we may not have successfully anticipated our future capital needs and, should the need arise, additional sources of financing may not be available or, if available, may not be on terms favorable to us or our stockholders. For more information, please see the section “Factors That May Affect Our Future Operating Results,” above, in particular the sections “We are dependent on external funding sources which may not make available to us sufficient funds when we need them,” “Because our business requires a substantial level of liquidity, we are dependent upon a credit facility with numerous restrictive covenants that limit our flexibility” and “We may be unable to raise additional funds that we will need to remain competitive.”

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Contractual Commitments:

The following table summarizes significant contractual obligations of the Company as of February 2, 2002:

Revolving Credit Facility: As of February 2, 2002, the Company had no amounts outstanding under its revolving credit facility

CRITICAL ACCOUNTING POLICIES

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to product returns, bad debts, inventories, goodwill, taxes on income, financing operations, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

     Our management believes the following critical accounting policies affect their more significant judgments and estimates used in the preparation of our consolidated financial statements:

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	Inventory — Our merchandise inventory is carried at the lower of cost or market with cost determined on a weighted average cost method. In connection with our merchandise repositioning, we recorded a charge of $5.3 million to write down discontinued merchandise at year-end to its estimated net realizable value, bringing our total lower of cost or market reserve to $6.5 million. If actual market conditions are less favorable than those projected by our management, or if liquidation of the inventory is more difficult than anticipated, additional inventory write-downs may be required.
	Long-lived Asset Impairment — We record a long-lived asset impairment charge when events or changes in circumstances indicate that the carrying amount of a long-lived asset may not be recoverable based on estimated future cash flows. In the course of performing this analysis, we determined that a long-lived asset impairment charge of $10.2 million was required for eight under-performing stores. The impairment charge was calculated as the difference between the net book value of the store’s long-lived assets and the projected present value of store’s cash flows over the remaining life of the lease. Should actual results differ materially from projected results for these or other locations, additional impairment charges may be required in the future.
	Goodwill — We had goodwill in the amount of $4.6 million at February 2, 2002. As required by generally accepted accounting principles, we performed an impairment test of goodwill which resulted in no impairment being identified. However, the process of evaluating goodwill involves making certain judgements and estimates in regards to company strategies and future cash flows. To the extent additional information arises or our strategies change, it is possible that our conclusion regarding goodwill impairment could change and result in an impairment charge.
	Self-insurance costs — We record estimated liabilities for certain self-insured workers’ compensation programs. Should a greater amount of claims occur compared to what was estimated or the costs of the medical profession increase beyond what were anticipated, reserves recorded may not be sufficient and additional charges may be required.
	Income Taxes — We account for income taxes under Statement of Financial Standards No. 109 (“SFAS 109”) Accounting for Income Taxes. Accordingly, we record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. An analysis of projected taxable income and the corresponding utilization of these tax assets indicated that a valuation allowance of $7.0 million was appropriate. While future taxable income and ongoing prudent and feasible tax planning were considered in determining the amount of the valuation allowance, this allowance is subject to adjustment in the future. Specifically, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amounts, an adjustment to the deferred tax assets would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made. Additionally, SFAS 109 does not allow us to contemplate changes in tax laws or rates in our analysis of the utilization of our deferred tax assets. We believe that the economic stimulus bill that was enacted on March 9, 2002 may have a positive impact on our analysis of our deferred tax assets, resulting in additional deferred tax assets becoming more likely than not to be realized in the first quarter of fiscal 2002.

     The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management’s judgement in their application. There are also areas in which management’s judgement in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto which begin on page 31 of this annual report, which contain accounting policies and other disclosures required by generally accepted accounting principles.

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RECENT ACCOUNTING DEVELOPMENTS:

     Effective February 4, 2001, we adopted Statement of Financial Accounting Standards No. 133 (“SFAS No. 133”), Accounting for Derivative Instruments and Hedging Activities, as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities. SFAS No. 133, as amended, requires the recognition of all derivative instruments as either assets or liabilities in the statement of financial position measured at fair value. The adoption of this standard had no material effect on our financial condition or results of operations.

     In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 141 (“SFAS No.141”), Business Combinations (effective July 1, 2001) and Statement of Financial Accounting Standards No. 142 (“SFAS No. 142”), Goodwill and Other Intangible Assets (effective for the Company on February 3, 2002). SFAS No. 141 prohibits pooling-of-interests accounting for acquisitions. SFAS No. 142 specifies that goodwill and certain intangible assets will no longer be amortized but instead will be subject to periodic impairment testing. In accordance with the adoption of SFAS No. 142, as of February 3, 2002, we stopped amortizing goodwill. Goodwill was $4.6 million and $4.8 million as of February 2, 2002 and February 3, 2001, respectively. Goodwill amortization was $0.2 million in each of fiscal years 2001, 2000 and 1999. In accordance with SFAS 142, we will test goodwill for impairment under the new fair value approach.

     In October 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 144, (“SFAS No. 144”), Accounting for the Impairment or Disposal of Long-Lived Assets. This statement supercedes Statement of Financial Accounting Standards No. 121 (“SFAS No. 121”), Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, for the disposal of a segment of a business. SFAS No. 144 became effective for the Company on February 3, 2002. The adoption of this standard is not expected to have a material effect on our financial condition or results of operations.

RELATED PARTY TRANSACTIONS

     Stephen Gordon is Chairman of our Board of Directors. We lease our store in Eureka, California, from Mr. and Mrs. Gordon and a partnership of which Mr. Gordon is a partner. Pursuant to the written lease, we pay rent annually to Mr. and Mrs. Gordon and the partnership for use of the store. The aggregate lease payments paid to Mr. and Mrs. Gordon and the partnership were $65,657, 65,657 and 64,222 for the fiscal years ended February 2, 2002, February 3, 2001 and January 29, 2000. The lease term expires on May 31, 2004 and there are no renewal options. We believe that the lease arrangement with Mr. and Mrs. Gordon and a partnership of which Mr. Gordon is a partner was made on terms no less favorable to us than could have been obtained from unaffiliated third parties.

     In connection with the Series A and B preferred stock financing completed in March 2001, Mr. Gary Friedman, our Chief Executive Officer, purchased 455 shares of the Series A preferred stock and 545 shares of the Series B preferred stock for an aggregate purchase price of $1 million. In addition, as part of Mr. Friedman’s compensation package, we sold Mr. Friedman 571,429 shares of common stock at $1.75 per share and Mr. Friedman exercised his option to purchase 1.2 million shares of common stock at $1.75 per share for an aggregate sales price of approximately $3.1 million. In connection with this sale of preferred and common stock to Mr. Friedman, we also made a loan to Mr. Friedman in the amount of $2.05 million. All of the loan proceeds were used by Mr. Friedman to purchase a portion of this stock. The loan is a full recourse loan and is secured by shares of the common stock and preferred stock purchased by Mr. Friedman. This loan is evidenced by a note, dated

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March 22, 2001. Pursuant to the terms of the note, the interest rate on the outstanding principal amount of the loan is 8.5% per annum, payable on the first, second and third anniversaries of the date of the note. The principal is due on March 22, 2004 but the due date may be accelerated due to a number of factors, including, failure to make payments due under the note, expiration of the six-months period following the date Mr. Friedman ceases to be an employee of our company as a result of termination by us for cause, or 90 days after the closing of an acquisition of our company.

     All transactions with officers, directors and principal stockholders and their affiliates, including the loan arrangement with Mr. Friedman, were approved, and all future such transactions will continue to be, approved by a majority of our board of directors, including a majority of the independent and disinterested directors of our board, and will be on terms no less favorable to us than could be obtained from unaffiliated third parties.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

     This annual report on Form 10-K contains “forward-looking statements,” within the meaning of the Private Securities Litigation Reform Act of 1995, that involve known and unknown risks. Such forward-looking statements include statements as to the results of strategic initiatives, our working capital and capital expenditure needs, the impact of competition and other statements containing words such as “believes,” “anticipates,” “estimates,” “expects,” “may,” “intends,” and words of similar import or statements of our management’s opinion. These forward-looking statements and assumptions involve known and unknown risks, uncertainties and other factors that may cause our actual results, market performance or achievements to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Important factors that could cause such differences include, but are not limited to, changes in economic or business conditions in general, changes in product supply, fluctuations in comparable store sales, limitations resulting from restrictive covenants in our credit facility, failure of our management to anticipate changes in consumer trends, loss of key vendors, changes in the competitive environment in which we operate, changes in our management information needs, changes in management, failure to raise additional funds when required, changes in customer needs and expectations, governmental actions and consequences stemming from terrorist activities in or related to the United States. We undertake no obligation to update any forward-looking statements in order to reflect events or circumstances that may arise after the date of this annual report.

QUARTERLY RESULTS OF OPERATIONS

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ITEM 7A.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     We are exposed to market risks, which include changes in interest rates and, to a lesser extent, foreign exchange rates. We do not engage in financial transactions for trading or speculative purposes.

     The interest payable on our credit facility is based on variable interest rates and is, therefore, affected by changes in market interest rates. If interest rates on existing variable rate debt rose no more than 10% from the bank’s reference rate, our results of operations and cash flows would not be materially affected. In addition, we have fixed and variable income investments consisting of cash equivalents and short-term investments, which are also affected by changes in market interest rates.

     We do enter into a significant amount of purchase obligations outside of the United States which, to date, have been settled mostly in U.S. dollars and, therefore, we have only minimal exposure at present to foreign currency exchange risks. Historically, we have not hedged our currency risk and do not currently anticipate doing so in the future. However, it is possible that in the future a growing number of our purchases outside of the United States will be made in currencies other than the U.S. dollar. Consequently, fluctuations in the rates of exchange between the U.S. dollar and other currencies may subject us to foreign currency exchange risks in the future.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

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INDEPENDENT AUDITORS’ REPORT

To the Board of Directors and Stockholders
Restoration Hardware, Inc.
Corte Madera, California

     We have audited the accompanying consolidated balance sheets of Restoration Hardware, Inc. and its subsidiaries as of February 2, 2002 and February 3, 2001, and the related consolidated statements of operations, redeemable convertible preferred stock and stockholders’ equity and cash flows for each of the three fiscal years in the period ended February 2, 2002. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

     In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Restoration Hardware, Inc. and its subsidiaries as of February 2, 2002 and February 3, 2001, and the results of their operations and their cash flows for each of the three fiscal years in the period ended February 2, 2002 in conformity with accounting principles generally accepted in the United States of America.

/s/ DELOITTE & TOUCHE LLP
San Francisco, California
April 23, 2002

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RESTORATION HARDWARE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)

The accompanying notes are an integral part of these consolidated financial statements.

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RESTORATION HARDWARE, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands, except per share amounts)

The accompanying notes are an integral part of these consolidated financial statements.

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RESTORATION HARDWARE, INC.
 
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE
PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
(DOLLARS IN THOUSANDS)