RESTORATION HARDWARE INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(MARK ONE)


[X]		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended November 2, 2002

[ ]		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .

Commission File Number: 000-24261

RESTORATION HARDWARE, INC.
(Exact Name of Registrant as Specified in Its Charter)


DELAWARE		68-0140361
(State or Other Jurisdiction of		(IRS Employer
Incorporation or Organization)		Identification No.)

15 KOCH ROAD, SUITE J, CORTE MADERA, CA 94925
(Address of Principal Executive Offices) (Zip Code)

(415) 924-1005
(Registrant’s Telephone Number, Including Area Code)

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 requirement for the past 90 days.

Yes [X] No [ ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act)

Yes [X] No [ ]

As of December 6, 2002, 30,046,739 shares of the registrant’s common stock, $0.0001 par value per share, were outstanding.

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED NOVEMBER 2, 2002 AND NOVEMBER 3, 2001
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
	Item 4. Controls and Procedures
PART II. OTHER INFORMATION
	Item 1. Legal Proceedings.
	Item 3. Defaults Upon Senior Securities.
	Item 5. Other Information
	Item 6. Exhibits and Reports on Form 8-K
SIGNATURES
EXHIBIT INDEX
Form 10-Q
Exhibit 10.1
Exhibit 10.2
Exhibit 99.1

FORM 10-Q

FOR THE QUARTER ENDED NOVEMBER 2, 2002

TABLE OF CONTENTS


		PAGE
PART I	FINANCIAL INFORMATION
Item 1.	Financial Statements
	Condensed Consolidated Balance Sheets (Unaudited) as of November 2, 2002, February, 2, 2002 (restated) and November 3, 2001 (restated)	3
	Condensed Consolidated Statements of Operations (Unaudited) for the three and nine months ended November 2, 2002 and November 3, 2001 (restated)	4
	Condensed Consolidated Statements of Cash Flows (Unaudited) for the nine months ended November 2, 2002 and November 3, 2001 (restated)	5
	Notes to Condensed Consolidated Financial Statements (Unaudited)	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	9
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	22
Item 4.	Controls and Procedures	22
PART II	OTHER INFORMATION
Item 1.	Legal Proceedings	23
Item 3.	Defaults Upon Senior Securities	23
Item 5.	Other Information	23
Item 6.	Exhibits and Reports on Form 8-K	23
SIGNATURES		24
EXHIBIT INDEX		27

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

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


						February 2,
			November 2,			2002			November 3,
			2002			(Note 1)			2001

						(As Restated,			(As Restated,
						see Note 9)			see Note 9)

ASSETS
Current assets:
	Cash and cash equivalents		$	2,037		$	22,285		$	2,293
	Accounts receivable			4,931			3,278			4,740
	Merchandise inventories			127,964			62,609			105,917
	Prepaid expense			16,046			13,800			12,150

		Total current assets		150,978			101,972			125,100
	Property and equipment, net			93,432			87,934			101,849
	Goodwill			4,560			4,560			4,614
	Deferred tax asset			20,232			11,347			19,506
	Other long-term assets			812			929			796

		Total assets	$	270,014		$	206,742		$	251,865

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable and accrued expenses		$	55,775		$	34,065		$	54,526
	Current portion of deferred lease incentives			4,740			4,507			4,518
	Deferred revenue			4,168			2,855			3,619
	Other current liabilities			9,678			9,183			7,324

		Total current liabilities		74,361			50,610			69,987
	Long-term line of credit, net of debt issuance costs			49,157			—			33,489
	Long-term portion of deferred lease incentives			35,373			37,101			38,231
	Deferred rent			13,848			12,703			12,273
	Other long-term obligations			45			3,236			811

		Total liabilities		172,784			103,650			154,791
Series A redeemable convertible preferred stock, $.0001 par value, 28,037 shares designated on March 21, 2001, 13,470, 14,320, and 15,000 shares issued and outstanding, at November 2, 2002, February 2, 2002 and November 3, 2001, respectively, aggregate liquidation preference and redemption value of $15,426 at November 2, 2002				13,529			14,106			14,545
Common stock, $.0001 par value; 60,000,000 shares authorized: 29,985,802, 28,827,883 and 23,867,804 issued and outstanding, at November 2, 2002, February 2, 2002 and November 3, 2001, respectively				149,571			144,162			124,987
Stockholder loan				—			(2,050	)		(2,050	)
Unearned compensation				(659	)		(1,103	)		(423)
Accumulated other comprehensive loss				(100	)		(159	)		(149	)
Accumulated deficit				(65,111	)		(51,864	)		(39,836	)

		Total stockholders’ equity		83,701			88,986			82,529

		Total liabilities, redeemable convertible preferred stock and stockholders’ equity	$	270,014		$	206,742		$	251,865

See Notes to Condensed Consolidated Financial Statements.

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


				Three Months Ended						Nine Months Ended

				November 2,			November 3,			November 2,			November 3,
				2002			2001			2002			2001

							(As Restated, see Note 9)						(As Restated, see Note 9)
Net sales				$	90,774		$	75,504		$	245,170		$	222,075
Cost of sales and occupancy					63,669			61,632			184,264			179,836

			Gross profit		27,105			13,872			60,906			42,239
Selling, general and administrative expenses					30,024			26,181			84,875			71,785

		Loss from operations			(2,919	)		(12,309	)		(23,969	)		(29,546	)
Interest expense					(840	)		(1,056	)		(2,227	)		(3,744	)
Change in fair value of warrants					—			516			(278	)		(257	)
Interest income					6			49			129			123

		Loss before income taxes			(3,753	)		(12,800	)		(26,345	)		(33,424	)
Income tax benefit					1,351			4,600			13,484			12,019

		Net loss			(2,402	)		(8,200	)		(12,861	)		(21,405	)
Preferred shareholder return:
	Dividends				—			(375	)		(358	)		(1,035	)
	Beneficial conversion charge				—			—			—			(1,406	)

		Net loss available to common stockholders		$	(2,402	)	$	(8,575	)	$	(13,219	)	$	(23,846	)

Net loss per common share:
	Basic and diluted loss per share			$	(0.08	)	$	(0.36	)	$	(0.45	)	$	(1.10	)

	Weighted average shares basic and diluted				29,926			23,844			29,660			21,735

See Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(Unaudited)


				Nine Months Ended

				November 2, 2002			November 3, 2001

							(As Restated, see Note 9)
Cash flows from operating activities:
	Net loss				(12,861	)		(21,405	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Depreciation and amortization			14,336			13,391
		Change in fair value of warrants			278			257
		Deferred income taxes			(9,509	)		(12,095	)
		Other			—			88
		Changes in assets and liabilities:
			Accounts receivable		(1,649	)		3,329
			Merchandise inventories		(65,333	)		(21,986	)
			Prepaid expenses		(3,645	)		(4,194	)
			Accounts payable and accrued expenses		21,614			11,209
			Deferred revenue		1,312			(2,779	)
			Other current liabilities		494			(1,356	)
			Deferred rent		1,142			1,757
			Deferred lease incentives		(1,506	)		(2,861	)

		Net cash used in operating activities			(55,327	)		(36,645	)
Cash flows from investing activities:
	Proceeds from store closing agreements				—			5,325
	Capital expenditures				(18,232	)		(1,457	)

		Net cash (used in) provided by investing activities			(18,232	)		3,868
Cash flows from financing activities:
	Net proceeds from private placement of preferred stock				—			13,511
	Net proceeds from private placement of common stock				—			24,357
	Borrowings under revolving line of credit, net				50,164			683
	Repayments on long-term debt				—			(6,000	)
	Repayment of stockholder loan				2,050			—
	Debt issuance costs				(350	)		(1,406	)
	Other long-term obligations				(151	)		(58	)
	Issuance of common stock				1,518			1,499

		Net cash provided by financing activities			53,231			32,586
Effects of foreign currency exchange rate translation on cash					80			(126	)

Net decrease in cash and cash equivalents					(20,248	)		(317	)
Cash and cash equivalents:
	Beginning of period				22,285			2,610

	End of period			$	2,037		$	2,293

Additional cash flow information:
	Cash paid during the year for interest (net of amount capitalized)			$	854		$	2,208
	Cash (received) paid during the year for taxes				(4,096	)		36
Non-cash transactions:
	Conversion of Series A preferred stock to common stock			$	935		$	—
	Exercise of warrants				2,956			—
	Stockholder loan				—			2,050
	Beneficial conversion feature – preferred stock				—			1,406
	Beneficial conversion charge – preferred stock				—			(1,406	)
	Dividends attributable to preferred stock				358			(1,035	)

See Notes to Condensed Consolidated Financial Statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS FOR THE THREE AND NINE MONTHS ENDED NOVEMBER 2, 2002 AND NOVEMBER 3, 2001

1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business

Restoration Hardware, Inc., a Delaware corporation, together with its subsidiaries, is a specialty retailer of high-quality home furnishings, decorative accessories and hardware. These products are sold through retail locations, catalogs and the Internet. As of November 2, 2002, we operated 105 retail stores in 31 states, the District of Columbia and Canada.

Basis of Presentation

The accompanying interim condensed consolidated financial statements have been prepared from our records without audit and, in management’s opinion, include all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position at November 2, 2002 and November 3, 2001; results of operations for the three and nine months ended November 2, 2002 and November 3, 2001; and changes in cash flows for the nine months ended November 2, 2002 and November 3, 2001. The balance sheet at February 2, 2002, as presented, has been derived from our audited financial statements for the fiscal year then ended. Certain reclassifications have been made to the presentation of information for the fiscal year ended February 2, 2002 (sometimes referred to herein as fiscal 2001) to conform to the presentation of information for the fiscal year ending February 1, 2003 (sometimes referred to herein as fiscal 2002), including the reclassification of distribution-center-to-store freight and third party warehousing costs from selling, general and administrative expenses to cost of sales and occupancy.

Our accounting policies are described in Note 1 to the audited consolidated financial statements included in our annual report on Form 10-K/A for the fiscal year ended February 2, 2002. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted for purposes of the interim condensed consolidated financial statements. You should read the interim condensed consolidated financial statements in conjunction with the audited consolidated financial statements, including the notes, for the fiscal year ended February 2, 2002.

The results of operations for the three and nine months presented in this Form 10-Q are not necessarily indicative of the results to be expected for the full year.

Comprehensive income (loss) for the three months ended November 2, 2002 and November 3, 2001 were ($2,387,000) and ($8,358,000), respectively. Comprehensive income (loss) for the nine months ended November 2, 2002 and November 3, 2001 were ($12,802,000) and ($21,550,000), respectively.

2. RECENTLY ISSUED ACCOUNTING STANDARDS

In June 2002, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses accounting for restructuring and similar costs. SFAS No. 146 supersedes previous accounting guidance included in the Emerging Issues Task Force’s Issue No. 94-3. We will adopt the provisions of SFAS No. 146 for restructuring activities, if any, initiated after December 31, 2002. SFAS No. 146 requires that the liability for costs associated with an exit or disposal activity be recognized when the liability is incurred. Under Issue 94-3, a liability for an exit cost was recognized at the date of our commitment to an exit plan. SFAS No. 146 also establishes that the liability should initially be measured and recorded at fair value. Accordingly, our adoption of SFAS No. 146 may affect the timing of recognizing future restructuring costs as well as the amounts recognized.

3. GOODWILL

Upon the adoption of SFAS No 142, “Goodwill and Other Intangible Assets,” at the beginning of fiscal 2002, we discontinued the amortization of goodwill with a carrying value of $4.6 million. Had the non-amortization provisions of SFAS No. 142 been applied for the three and nine months ended November 3, 2001, our net loss available to common stockholders and loss per common share would have been as follows (in thousands, except per share amounts):


		Third Quarter						Year-to-Date

		2002			2001			2002			2001

Net loss available to common stockholders:
	Reported net loss available to common stockholders	$	(2,402	)	$	(8,575	)	$	(13,219	)	$	(23,846	)
	Goodwill amortization, net of tax effect		—			35			—			104

Adjusted net loss available to common stockholders		$	(2,402	)	$	(8,540	)	$	(13,219	)	$	(23,742	)

Basic and diluted loss per common share:
	Reported loss per share	$	(0.08	)	$	(0.36	)	$	(0.45	)	$	(1.10	)
	Goodwill amortization, net of tax effect		—			—			—			.01

Adjusted loss per common share		$	(0.08	)	$	(0.36	)	$	(0.45	)	$	(1.09	)

4. REVOLVING LINE OF CREDIT AND DEBT

At November 2, 2002, we had in place a credit facility with an overall commitment of $72.0 million, of which $25.0 million was available for letters of credit. As of November 2, 2002, we had $50.6 million outstanding under the line of credit (before unamortized debt issuance costs of $1.4 million), and $11.6 million in outstanding letters of credit. Interest is paid monthly at the bank’s reference rate or LIBOR plus a margin. As of November 2, 2002, the bank’s reference rate was 6.25% and the LIBOR plus margin rate was 4.49%. The availability of credit at any given time under the credit facility is limited by reference to a borrowing base formula based upon numerous factors, including eligible inventory and eligible accounts receivable. The amount available under the credit facility may be less than the stated maximum limit of the facility. As of November 2, 2002, in addition to outstanding borrowings and letter of credit obligations totaling $62.2 million, we had availability to borrow up to $5.5 million. The credit facility contains various restrictive covenants, including limitations on our annual capital expenditures, ability to incur additional debt, acquisition of other businesses and payment of dividends and other distributions.

On August 30, 2002, the credit facility was amended, primarily to: 1) reduce the overall commitment from $80 million to $72 million; 2) at our election, to provide for an additional $5 million of availability for any continuous 60-day period between August 1st and October 31st of any year (not to exceed the $72 million overall commitment); and 3) to extend the expiration date by twelve months to June 30, 2004. In November 2002, the credit facility was further amended and restated to reflect a number of minor revisions and updates to the then-existing credit facility documentation.

In connection with a September 2000 amendment of the credit facility, we issued warrants to purchase common stock to some of the lenders under the facility. As of February 2, 2002, approximately 405,000 of warrants at exercise prices of $3.75 and $2.00 per share remained outstanding. During the first quarter of fiscal 2002, all of these remaining warrants were net exercised on a cashless basis. The fair value of the warrants as of the exercise date was calculated using the Black-Scholes model, with the following assumptions: expected life of 1.7 years, stock volatility considered to be 50%, risk free interest rate of 2.3%, and no dividends during the expected term. As of November 2, 2002, the valuation of the warrants from the end of the prior fiscal year to their exercise dates resulted in additional expense of $278,000 during the nine months ended November 2, 2002.

5. PREFERRED STOCK

Pursuant to a Letter Agreement, dated as of August 2, 2002, holders of our Series A preferred stock agreed to waive their dividend participation right in the event we were to declare a dividend on our common stock. In the same agreement, we agreed that we will not declare any dividends payable to our common stock holders unless and until we first obtain the approval of the holders of at least seventy percent of the then outstanding shares of Series A preferred stock. We have never declared or paid any dividends on our capital stock and have no obligation to do so. As a result of the Letter Agreement, beginning with the second quarter of fiscal 2002, we no longer incur dividend charges related to our outstanding Series A preferred stock. Such charges totaled $0.4 million for the third quarter of fiscal 2001.

6. INCOME TAXES

SFAS No. 109, “Accounting for Income Taxes,” requires income taxes to be accounted for under an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, we generally take into account all expected future events except for changes in tax laws or rates, which are not permitted to be considered. Additionally, SFAS No. 109 allows deferred tax assets to be recognized only to the extent such deferred tax assets are more likely than not to be realized. During the first quarter of fiscal 2002, the Job Creation and Worker Assistance Act of 2002 was enacted into law. Among other things, this law provided for an extended carryback period from two years to five years for losses generated in fiscal years 2001 and 2002. As a result of this extended carryback period, we will be able to carryback and realize $4.0 million in net operating losses. As a result of the change in the law, we re-evaluated our deferred tax assets as of our fiscal quarter end on May 4, 2002 and, consequently, we reduced our valuation allowance at May 4, 2002 from $7.0 million to $3.0 million, reflective of a change of $4.0 million.

7. EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock and dilutive common stock equivalents (stock options, convertible preferred stock and warrants) outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if options or warrants to issue common stock were exercised, or convertible preferred stock was converted into common stock. The following table reflects the potentially dilutive securities that were excluded from the diluted earnings

per share calculation because their inclusion in net loss periods would be anti-dilutive to earnings per share:


	Third Quarter				Year-to-Date

	2002		2001		2002		2001

Common stock issuable upon conversion of the Series A preferred stock		6,760,692		7,500,000		6,760,692		7,500,000
Common stock subject to outstanding stock options		406,886		245,376		994,145		338,401
Common stock subject to outstanding warrants		—		550,000		—		550,000

The above stock options represent only those stock options whose exercise prices are less than the average market price of the stock for the quarter. Had we been in a net income position, there would have been 2,812,550 and 2,882,067 stock options for the three months ended November 2, 2002 and November 3, 2001, and 1,175,042 and 2,439,889 stock options for the nine months ended November 2, 2002 and November 3, 2001 that would have been excluded from the diluted earnings per share calculation because the option exercise price for those options exceeded the average stock price for those periods.

8. SEGMENT REPORTING

We classify our business interests into three identifiable segments: retail; direct-to-customer; and furniture manufacturing. The retail segment includes revenue and expense associated with our 105 retail locations. The direct-to-customer segment includes all revenue and expense associated with catalog and Internet sales. The furniture manufacturing segment includes all revenue and expense associated with our wholly-owned furniture manufacturer, The Michaels Furniture Company, Inc. We evaluate performance and allocate resources based on income from operations, which excludes unallocated corporate general and administrative costs. Certain segment information, including segment assets, asset expenditures and related depreciation expense, is not presented as all of our assets are commingled and are not available by segment.

Financial information for our business segments is as follows (dollars in thousands):


		Third Quarter						Year-to-Date

		2002			2001			2002			2001

Net Sales:
	Retail	$	79,869		$	68,951		$	218,060		$	202,371
	Direct-to-Customer		10,901			6,551			27,088			19,664
	Furniture manufacturing		5,180			3,176			13,317			12,820
	Intersegment furniture sales		(5,176	)		(3,174	)		(13,295	)		(12,780	)

Total net sales		$	90,774		$	75,504		$	245,170		$	222,075


		Third Quarter						Year-to-Date

		2002			2001			2002			2001

Income (loss) from operations:
	Retail	$	6,744		$	(1,194	)	$	7,129		$	2,130
	Direct-to-Customer		689			(637	)		1,980			(460	)
	Furniture manufacturing		107			(647	)		(194	)		(605	)
	Unallocated		(10,521	)		(9,973	)		(32,691	)		(29,784	)
	Intersegment loss from operations		62			142			(193	)		(827	)

Total loss from operations		$	(2,919	)	$	(12,309	)	$	(23,969	)	$	(29,546	)

9. RESTATEMENT

Subsequent to the issuance of our fiscal 2001 consolidated financial statements, we identified accounting errors concerning our accounts payable and inventory balances. The errors, which resulted from the incorrect processing of certain specific transactions, were primarily related to the duplicate recording of payables to vendors and to unrecorded amounts related to inventory freight costs. As a result, the accompanying condensed consolidated balance sheet as of November 3, 2001 and the related condensed consolidated statements of operations and cash flows for the periods ended November 3, 2001 have been restated from the amounts previously reported for the correction of these accounting errors. A summary of the significant effects of the restatement is as follows:


	For the period ended November 3, 2001
(in thousands, except per share amounts)	Three months						Nine months

	As previously reported			As restated			As previously reported			As restated

Gross profit		13,678			13,872			42,045			42,239
Loss from operations		(12,503	)		(12,309	)		(29,740	)		(29,546	)
Net loss		(8,318	)		(8,200	)		(21,523	)		(21,405	)
Loss per common share — basic and diluted		(0.36	)		(0.36	)		(1.10	)		(1.10	)


	As of November 3, 2001
(in thousands);	As previously reported			As restated

Accounts payable and accrued expenses		54,720			54,526
Accumulated deficit		(39,954	)		(39,836	)
Total stockholders’ equity		82,411			82,529

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following management's discussion and analysis of financial condition and results of operations gives effect to the restatement discussed in Note 9 to the condensed consolidated financial statements.

OVERVIEW

Our company, Restoration Hardware, Inc. (Nasdaq: RSTO), 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 environment designed to appeal to an affluent, well educated 35 to 60 year old customer. We operate on a 52 – 53 week fiscal year ending on the Saturday closest to January 31st.

As of November 2, 2002, we operated 105 stores in 31 states, the District of Columbia and Canada. 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 components of this plan were the launch of a new merchandising strategy in April 2002, adjustment of our overall product mix, and the remodeling of our stores in order to best present the new merchandise. Other key elements of the plan included strengthening our balance sheet, upgrading our 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. We have completed the initial phase of our new merchandising strategy and the remodeling of our stores and have completed or made substantial progress in all other key elements of the repositioning plan.

For the third quarter ended November 2, 2002, net sales were $90.8 million, a 20% increase versus net sales of $75.5 million for the third quarter ended November 3, 2001. Comparable stores sales for the third quarter ended November 2, 2002 increased 14.9%. Direct-to-customer sales, which include catalog and Internet sales, increased 66% to $10.9 million in the third quarter ended November 2, 2002. Net loss to common stockholders was $0.08 per share, or $2.4 million, for the third quarter ended November 2, 2002, a 72% improvement versus net loss to common stockholders of $0.36 per share, or $8.7 million, for the third quarter ended November 3, 2001.

For the nine months ended November 2, 2002, net sales were $245.2 million, a 10% increase from $222.1 million for the nine months ended November 3, 2001. Comparable store sales for the nine months ended November 2, 2002 increased 8.3%. Direct-to-customer sales increased 38% to $27.1 million for the nine months ended November 2, 2002. For the nine months ended November 2, 2002, net loss to common stockholders was $13.2 million, or $0.45 per share, versus a net loss to common stockholders of $23.8 million, or $1.10 per share, reported for the nine months ended November 3, 2001.

RESULTS OF OPERATIONS

NET SALES

Net sales consist of the following components:


(dollars in thousands)		Third Quarter 2002					Third Quarter 2001					Year-to-date 2002					Year-to-date 2001

		Dollars		% Total			Dollars		% Total			Dollars		% Total			Dollars		% Total

Retail		$	79,869		88	%	$	68,951		91	%	$	218,060		89	%	$	202,371		91	%
Direct-to-customer			10,901		12	%		6,551		9	%		27,088		11	%		19,664		9	%
Furniture manufacturing			4		0	%		2		0	%		22		0	%		40		0	%

	Total net sales	$	90,774		100	%	$	75,504		100	%	$	245,170		100	%	$	222,075		100	%

Net sales for the third quarter of fiscal 2002 increased $15.3 million or 20% from net sales for the third quarter of fiscal 2001. Net sales amounts include shipping fees of $2.0 million for the third quarter of fiscal 2002 and $1.5 million for the third quarter of fiscal

2001. The furniture manufacturing sales are reported in the sales channel through which they are sold. The furniture manufacturing net sales above include only such sales made to employees of The Michaels Furniture Company, Inc. and third party resellers. The increase in net sales in the third quarter of fiscal 2002 as compared to the third quarter of fiscal 2001 is principally due to a 14.9% increase in comparable store sales growth and increased sales in our direct-to-customer division.

Retail Sales


			Third Quarter						Year-to-Date

(dollars in thousands)			2002			2001			2002			2001

Retail sales			$	79,143		$	68,306		$	215,991		$	200,548
Shipping fees				726			645			2,069			1,823

		Net retail sales	$	79,869		$	68,951		$	218,060		$	202,371

Net retail sales growth (decline) percentage				15.8	%		(9.5	%)		7.8	%		(3.0	%)
Comparable stores sales increase (decrease)				14.9	%		(10.8	%)		8.3	%		(9.3	%)
Number of stores at period beginning				105			104			104			106
	Store openings			—			—			1			1
	Store closings			—			—			—			(3	)

Number of stores at period end				105			104			105			104

Store selling sq. ft. at period end				688,634			682,936			688,634			682,936

Net retail sales in the third quarter of fiscal 2002 increased 15.8% as compared to the same period of the prior year. The sales increase was primarily attributable to comparable store sales growth of 14.9%. Comparable store sales are defined as sales from stores whose gross square footage 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.

The third quarter of fiscal 2002 was our second full quarter operating under our new merchandising strategy. In April 2002, we remodeled substantially all of our stores and introduced a line of premium-positioned textiles and bath hardware and accessories.

For the nine months ended November 2, 2002, net retail sales increased 7.8% as compared to the same period of the prior year. The increase is primarily attributable to an 8.3% increase in comparable store sales offset by the reduction in sales resulting from the closure of three stores.

Direct-to-Customer


		Third Quarter						Year-to-date

(dollars in thousands)		2002			2001			2002			2001

Catalog sales		$	6,623		$	3,735		$	16,032		$	11,036
Internet sales			3,044			1,959			7,815			6,003

	Total direct-to-customer sales		9,667			5,694			23,847			17,039
Shipping fees			1,234			857			3,241			2,625

	Net direct-to-customer sales	$	10,901		$	6,551		$	27,088		$	19,664

Percent growth in direct-to-customer net sales			66	%		31	%		38	%		52	%
Percent growth in number of catalogs mailed			38	%		132	%		50	%		162	%

Direct-to-customer sales consist of catalog and Internet sales. Net direct-to-customer sales in the third quarter of fiscal 2002 increased 66% as compared to the third quarter of fiscal 2001, primarily as a result of increased catalog circulation. For the nine months ended November 2, 2002, net direct-to-customer sales increased 38% as compared to the same period of the prior year, primarily as a result of increased catalog circulation.

Furniture Manufacturing

The Michaels Furniture Company, Inc. is our wholly-owned furniture manufacturing company. It is located in Sacramento, California. Furniture produced at The Michaels Furniture Company, Inc. is sold through our sales channels, employees or third party resellers.

EXPENSES

The following table sets forth for the periods indicated the percentage of net sales represented by certain line items in our Condensed Consolidated Statements of Operations.


		Third Quarter						Year-to-Date

		2002			2001			2002			2001

Net sales			100	%		100	%		100	%		100	%
Cost of sales and occupancy			70	%		82	%		75	%		81	%

	Gross profit		30	%		18	%		25	%		19	%
Selling, general and administrative expenses			33	%		34	%		35	%		32	%

	Loss from operations		(3	%)		(16	%)		(10	%)		(13	%)
Interest expense, change in fair value of warrants and interest income			(1	%)		(1	%)		(1	%)		(2	%)

	Loss before income taxes		(4	%)		(17	%)		(11	%)		(15	%)
Provision for income taxes			1	%		6	%		6	%		5	%

	Net loss		(3	%)		(11	%)		(5	%)		(10	%)

COST OF SALES AND OCCUPANCY

Cost of sales and occupancy expenses expressed as a percentage of net sales decreased 12%, to 70% in the third quarter of fiscal 2002 from 82% in the third quarter of fiscal 2001. The majority of the decrease was due to improved merchandise margins as a result of significantly less clearance activity and improved sourcing, partially offset by reduced margins resulting from strong acceptance of our private label credit card, which was marketed with a ten percent off first purchase offer. Other factors that contributed to the decrease include lower occupancy and buying and distribution expense rates as a result of leveraging our costs relative to the comparable store sales increase.

Cost of sales and occupancy expenses expressed as a percentage of net sales decreased 6%, to 75% for the nine months ended November 2, 2002 from 81% for the same period of the prior year, principally as a result of the strength of the second and third quarter merchandise margins. In the first quarter of fiscal 2002, merchandise margins decreased as compared to the same period of the prior year, due to markdowns incurred in connection with the final clearance of merchandise replaced or eliminated as a result of our repositioning strategy.

SELLING, GENERAL AND ADMINISTRATIVE

Selling, general and administrative expenses expressed as a percentage of net sales decreased 1%, to 33% in the third quarter of fiscal 2002 from 34% in the third quarter of fiscal 2001, as a result of leveraging across all categories of selling, general and administrative expense.

Selling, general and administrative expenses expressed as a percentage of net sales for the nine months ended November 2, 2002 increased 3%, to 35% from 32% for the comparable period of the prior year. The increase resulted from several factors, including the following: marketing, advertising, training and store labor expenses associated with the launch of our repositioning strategy in the April to May period; corporate staffing additions and upgrades; and professional fees incurred in connection with implementing our revised revenue recognition policy for sales of furniture delivered to customers.

INTEREST EXPENSE, CHANGE IN FAIR VALUE OF WARRANTS AND INTEREST INCOME

Interest Expense

Interest expense includes interest on borrowings under our line of credit facility and amortization of debt issuance costs. Interest expense decreased $0.3 million, to $0.8 million in the third quarter of fiscal 2002, from $1.1 million in the third quarter of fiscal 2001. The decrease in interest expense is principally a result of a reduction in the average interest rate during these periods. As a result of the pay-down of high interest term loans in the second and fourth quarters of fiscal 2001, the average interest rate in the third quarter of fiscal 2002 decreased to 5.6% from 9.6% in the same period of fiscal 2001. Average borrowings outstanding in the third quarter of fiscal 2002 increased to $34.7 million from $24.6 million for the third quarter of fiscal 2001. Amortization of deferred financing costs in the third quarter of fiscal 2002 decreased to $0.3 million, from $0.4 million in the third quarter of fiscal 2001.

Interest expense for the nine months ended November 2, 2002 decreased $1.5 million, to $2.2 million from $3.7 million for the nine months ended November 2, 2002, primarily as a result of a reduction in average borrowings outstanding and a reduction in the average interest rate. For these periods, average borrowings outstanding decreased $9.1 million, to $19.3 million in fiscal 2002 from $28.4

million in fiscal 2001, and the average interest rate decreased to 6.8% from 11.2%.

Warrants

The Company originally issued warrants in connection with the September 2000 amendment of our credit facility. Such warrants have been exercised into common stock over time and all warrants had been exercised by the end of the first quarter in fiscal 2002. As such, there are no longer changes in fair value reflected in our statement of operations beginning in the second quarter of fiscal 2002.

For the nine months ended November 2, 2002, expense from the change in the fair value of the warrants remained constant at $0.3 million compared to the same period in the prior year.

Interest Income

Interest income, which consists of income from our short-term investments and notes receivable, decreased $43,000, to $6,000 in the third quarter of fiscal 2002 as compared to $49,000 in the third quarter of fiscal 2001. The decrease is principally due to the repayment of a shareholder note by our President and Chief Executive Officer, Gary G. Friedman, during the third quarter for fiscal 2002.

For the nine months ended November 2, 2002, interest income increased $6,000, to $129,000 from $123,000 for the third quarter of fiscal 2001 principally due to the increase of short-term investment income.

INCOME TAX BENEFIT

Our effective tax benefit rate was 36.0% for the third quarter of fiscal 2002 and fiscal 2001. This rate reflects 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.

Our income tax benefit for the first nine months of fiscal 2002 includes a partial reversal of a deferred tax valuation allowance established at the end of fiscal 2001. As a result of the Job Creation and Worker Assistance Act of 2002, enacted on March 9, 2002, $4.0 million of deferred tax assets became more likely than not to be realized, and was recognized as an additional tax benefit in the first quarter of fiscal 2002. As of November 2, 2002, a $3.0 million valuation allowance against deferred tax assets remained. Excluding the impact of the additional tax benefit, our effective tax benefit rate for the first nine months of fiscal 2002 and fiscal 2001 was 36.0%.

LIQUIDITY AND CAPITAL RESOURCES

Operating cash flows

Net cash used in operating activities for the nine months ended November 2, 2002 increased $18.7 million, to $55.3 million from $36.6 million for the comparable period of the prior year. The increase resulted primarily from increased payments for merchandise inventories, partially offset by a reduced net loss and the increase in accounts payable and accrued expenses related to the timing of cash payments.

Investing cash flows

Net cash from investing activities for the nine months ended November 2, 2002 changed $22.1 million, to a $18.2 million use of cash from a $3.9 million source of cash for the same period of the prior year. During this nine month period of fiscal 2002, we remodeled substantially all of our retail locations, opened one new retail store in Durham, North Carolina, and redesigned our website, all of which was paid for from our short-term investments combined with borrowings under our credit facility. In contrast, during the same period of fiscal 2001, we signed agreements with a third party to cancel leases and close three of our under-performing stores, for which we received cash compensation of $5.3 million. The total cash proceeds received approximated the net book value of the assets that were written off as part of the store closures.

Financing cash flows

Net cash provided by financing activities for the nine months ended November 2, 2002 increased $20.6 million, to $53.2 million from $32.6 million for the nine months ended November 3, 2001. Substantially all of the cash provided by financing activities for the first nine months of fiscal 2002 resulted from borrowings under our credit facility. In contrast, cash provided by financing activities for the same period of fiscal 2001 resulted primarily from the March and May preferred and common stock financings, which provided approximately $37.9 million in net proceeds. The net proceeds from these transactions were partially offset by a $6 million pay-down of long-term, high-interest debt, and approximately $1.4 million in debt issuance costs.

There are no additional store openings planned in fiscal 2002.

We currently believe that the combination of the 2001 preferred and common stock financings, our cash flow from operations and funds available under our credit facility will satisfy our expected working capital and capital expenditure requirements, including our contractual commitments described below, for at least the next 12 months. However, the 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. 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 below entitled “Factors that May Affect our Future Operating Results,” in particular the subsections “We are dependent on external funding sources which may not make available to us sufficient funds when we need them” and “Because our business requires a substantial level of liquidity, we are dependent upon a credit facility with numerous restrictive covenants that limit our flexibility.”

Contractual Commitments

The following table summarizes our significant contractual obligations as of November 2, 2002 (dollars in thousands):


				Amount of Commitment Expiration Period

				Less Than		1 - 3		4 - 5		After
		Total		1 Year		Years		Years		5 years

Contractual obligations:
	Operating leases	$	322,317	$	36,608	$	70,083	$	67,506	$	148,120
	Capital leases		1,216		764		420		32		—

Total contractual cash obligations		$	323,533	$	37,372	$	70,503	$	67,538	$	148,120


				Amount of Commitment Expiration Period

				Less Than		1 - 3		4 - 5		After
		Total		1 Year		Years		Years		5 years

Other commercial commitments:
	Revolving credit facility	$	60,419	$	—	$	60,419	$	—	$	—
	Standby letters of credit		2,019		2,019		—		—		—
	Trade letters of credit		9,562		9,562		—		—		—

Total commercial commitments		$	72,000	$	11,581	$	60,419	$	—	$	—

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements in our Form 10-K/A for the fiscal year ended February 2, 2002, which were prepared in accordance with accounting principles generally accepted in the United States. The preparation of our consolidated 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 ongoing 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:

Inventory

Our retail inventory is carried at the lower of cost or market with cost determined on a weighted average cost method. Manufacturing inventories are carried at the lower of cost or market with cost determined on a first-in, first-out method. Cost includes certain buying and distribution costs, including merchant payroll and other costs related to the purchase of inventory, as well as payroll and other costs to process inventory at our distribution centers. A provision, when necessary, has been made to reduce excess or obsolete inventory to its net realizable value.

Catalog Expenses

Prepaid catalog expenses consist of the cost to prepare, print and distribute catalogs. Such costs are amortized over the expected sales volume of each catalog.

Property and Equipment

Property and equipment are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful life of the asset, typically ranging from three to five years for all property and equipment except for leasehold improvements and lease acquisition costs. The cost of leasehold improvements and lease acquisitions is amortized over the useful life of the asset or applicable lease term, whichever is less.

Capitalization of Interest

The interest-carrying costs of capital assets under development or construction are capitalized based on our weighted average borrowing rate.

Goodwill

Goodwill, as it relates to our acquisition of The Michaels Furniture Company, Inc. represents the excess of the purchase price over the fair value of the net assets acquired in the transaction.

Capitalized Leases

Noncancellable leases which meet the criteria of capital leases are capitalized as assets and amortized over the lease term, using the interest method.

Impairment of Long-lived Assets

Our policy is to review long-lived assets and certain identifiable intangibles, including goodwill, for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable based on estimated future cash flows calculated on a store-by-store basis.

Self-insurance

We are self-insured for workers’ compensation. The self-insurance liability is determined based on an independent third party actuarial report. The liability is based on claims filed and an estimate of claims incurred but not yet reported.

Deferred Rent and Deferred Lease Incentives

Some of our operating leases contain predetermined fixed escalations of the minimum rent during the original term of the lease. For these leases, we recognize the related rental expense on a straight-line basis over the life of the lease and record the difference between the amount charged to operations and amounts paid as deferred rent. As part of our lease agreements, we receive certain lease incentives in certain circumstances. Allowances for these incentives have been deferred and are amortized on a straight-line basis over the life of the lease as reductions of rent expense.

Revenue Recognition

Retail stores sales: Revenue is recognized at the point of sales for all purchases which are taken from the store by the customer at the time of purchase.

Furniture sales: Furniture sales are recorded as either direct-to-customer sales or retail sales depending upon where the sales transaction originated. The majority of furniture sales involve the shipment of furniture to the customer. Revenue for these sales is recognized upon delivery of the furniture to the customer.

Non-furniture – direct-to-customer (Catalog and Internet) sales: Revenue is recognized upon shipment to the customer.

Shipping and handling: We record shipping and handling fees as net revenue in the sales channel segment (retail sales or direct-to-customer sales) that originated the sales transaction. Costs of shipping and handling are included in cost of sales and occupancy.

Returns: We provide an allowance for sales returns based on historical return rates.

Freight Relief

Cost of goods sold includes an estimate for inbound freight, which is based on historical ratios of inbound freight to inventory purchases.

Income Taxes

SFAS 109, “Accounting for Income Taxes,” requires income taxes to be accounted for under an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, we generally consider all expected future events other than changes in the tax law or rates.

Stock-based Compensation

We account for stock-based awards to employees using the intrinsic value method in accordance with APB No. 25, “Accounting for Stock Issued to Employees.”

Earnings per Share

Basic earnings per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock and dilutive common stock equivalents (stock options, convertible preferred stock and warrants) outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if options or warrants to issue common stock were exercised, or preferred stock was converted into common stock.

Contingencies and Litigation

We are involved from time to time in legal proceedings, including litigation arising in the ordinary course of our business. Due to the uncertainties inherent in any legal proceeding, we cannot accurately predict the ultimate outcome of any proceeding and may incur substantial costs to defend the proceeding, irrespective of the merits. Unfavorable outcome of any legal proceeding could have an adverse impact on our business, financial condition, and results of operations. As appropriate, we assess the likelihood of any adverse outcomes and the potential range of probable losses. The amount of loss accrual, if any, is subject to adjustment if and when warranted by new developments or revised strategies.

Other Considerations

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 judgment in their application. There are also areas in which management’s judgment in selecting any available alternative would not produce a materially different result. See our audited consolidated financial statements and notes thereto to our Annual Report on Form 10-K/A for the fiscal year ended February 2, 2002 which contain accounting policies and other disclosures required by generally accepted accounting principles.

RESTATEMENT

In the course of our continuing efforts to upgrade accounting systems and personnel, we identified accounting errors concerning our accounts payable and inventory balances as of February 2, 2002. The errors, which resulted from the incorrect processing of certain specific transactions, were primarily related to the recording of duplicate payments to vendors and also to unrecorded amounts related to inventory freight costs. As a result of correcting these identified accounting errors as of February 2, 2002, accounts payable and accrued liabilities as of November 3, 2001 decreased, from the originally reported amount of $54.7 million, to $54.5 million. There was no change to merchandise inventories for the same period. However, the correction for accounts payable and accrued liabilities resulted in reducing the reported net loss available to common stockholders as of November 3, 2001 from $8.7 million to $8.6 million, although the net loss per share remained the same at $0.36. Note 9 to the condensed consolidated financial statements in Item 1 of this Part I summarizes the significant effects of our restatement of the condensed consolidated financial statements as of and for the fiscal quarter ended November 3, 2001 to reflect the correction for these identified accounting errors.

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 management team adopted a repositioning strategy for the company that 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. To date, we completed the initial phase of our new merchandising strategy and the remodeling of our stores and have completed or made substantial progress in all other key elements of our repositioning plan. We have incurred, and continue to incur, substantial costs in implementing our 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.

During the fiscal year ended February 2, 2002, we closed three under-performing stores. We anticipate closing an additional six to eight under-performing 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 cause 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.

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 in implementing a new e-commerce application and upgrading 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 during the fiscal year ending February 1, 2003. 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 amounts of 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, remodelings 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.

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 the fiscal year ended February 2, 2002, decreased 1.0% in the fiscal year ended February 3, 2001, and increased 0.8% in the fiscal year ended January 29, 2000. Comparable store sales increased 14.9% in the third quarter ended November 2, 2002, as compared to the third quarter ended November 3, 2001. 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.

As of February 2, 2002, we made 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 $72.0 million credit facility, the amount available under this facility may be less than the $72.0 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 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, the 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, catalog production 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 $72.0 million, of which $25.0 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. Additionally, in August 2002, we further amended the credit facility, primarily to: 1) reduce the overall commitment from $80 million to $72 million; 2) at our election, to provide for an additional $5 million of availability for any continuous 60-day period between August 1st and October 31st for any year (not to exceed the $72 million overall commitment); and 3) to extend the expiration date of the credit facility by twelve months to June 30, 2004. Finally, in November 2002, we amended and restated the credit facility to reflect a number of minor revisions and updates to the then-existing credit facility documentation.

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.

We have drawn upon the credit facility in the past and we expect to draw upon it in the future. As a result, any 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, and fixtures. 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.

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. While our credit facility was amended at various times in 2001 and 2002 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. 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 fiscal year. The increased interest expense in these fiscal years resulted primarily from an increase in the average borrowings outstanding. Interest expense for the third quarter ended November 2, 2002 was $0.8 million.

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.

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 that could increase the risks associated with aspects of this segment of our business. In the fiscal year ended February 2, 2002, sales through our direct-to-customer channel grew by 49%. Net direct-to-customer sales in the third quarter ended November 2, 2002 increased 66% as compared to the third quarter ended November 3, 2001. 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 products. 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 have implemented a new merchandising strategy that entails changing the nature and types of the many products that we sell. Consequently, 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 a limited number 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 will 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, Gary G. Friedman. 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 changes in general economic conditions have impacted our profitability.

In the fiscal years ended January 29, 2000 and February 3, 2001, we experienced rapid growth and, as a result, our costs and expenditures outpaced our revenues. Following this growth, the economy in the United States began to weaken. The combination of these two factors affected our profitability. As a result of these factors in the fiscal years ended January 29, 2000, February 3, 2001 and February 2, 2002, 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, although our comparable store sales increased 14.9% in the third quarter ended November 2, 2002 and increased 8.3% for the nine months ended as of the same date. Additionally, in the fiscal years ended January 29, 2000, February 3, 2001 and February 2, 2002, 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, and has resulted, 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 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.

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

Terrorist attacks in the United States, as well as events occurring in response to or connection with 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 United States and worldwide financial markets and economy. Also, any of these events could result in economic recession in the United States 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. Variations in the market price of our common stock 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 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 approximately 6.4 million shares of our common stock issued, or to be issued, upon the conversion of our Series A preferred stock to some of our stockholders. 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. These latter two registration statements were declared effective by the Securities and Exchange Commission on October 31, 2002. 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.

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 presently 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 in control. In particular, the holders of our Series A preferred stock have the right to approve a number of actions by our company, 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.

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This quarterly report on Form 10-Q contains “forward-looking statements,” within the meaning of the Private Securities Litigation Reform Act of 1995, that involve known and unknown risks. The safe harbor provisions of the Securities Exchange Act of 1934, as amended, and the Securities Act of 1933, as amended, apply to the forward-looking statements we make. Such forward-looking statements can be identified by the use of forward-looking terminology 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, including those risks, uncertainties and other factors identified in the section of this report entitled “Factors that May Affect our Future Operating Results” and those risks, uncertainties and other factors identified elsewhere in this report. Such risks, uncertainties and other factors are based on current expectations. These risks, uncertainties and other factors 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. In preparing this report, we have made a number of assumptions and projections about the future of our business. These assumptions and projections could be inaccurate for several reasons, including, but not limited to, the factors described in the section of this report entitled “Factors that May Affect our Future Operating Results.” 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 report.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our market risk disclosures set forth in Item 7A of our Annual Report on Form 10-K/A for the year ended February 2, 2002 have not changed materially.

Item 4. Controls and Procedures

Quarterly Evaluation of the Company’s Disclosure Controls and Internal Controls. Within the 90 days prior to the date of this Quarterly Report on Form 10-Q, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures and internal controls. This evaluation (the “Controls Evaluation”) was done under the supervision and with the participation of management, including our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).

Controls Evaluation. In the course of the Controls Evaluation, we sought to identify data errors, controls problems or acts of fraud and to confirm that appropriate corrective action, including process improvements, were being undertaken. Our internal controls are also evaluated on an ongoing basis by our finance department and by our independent auditors in connection with their audit and review activities. Our intent is that the disclosure controls and procedures and the internal controls will be maintained as dynamic systems that change (including with improvements and corrections) as conditions warrant.

The company’s management, including the CEO and CFO, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. Inherent limitations in all control systems include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met.

In accord with SEC requirements, the CEO and CFO note that, since the date of the Controls Evaluation to the date of this Form 10-Q, we have been continuing our efforts to upgrade accounting systems and personnel and, as a result, we identified accounting errors concerning our accounts payable and inventory balances as of February 2, 2002. The errors, which resulted from the incorrect processing of certain specific transactions, were primarily related to the recording of duplicate payments to vendors and also to unrecorded amounts related to inventory freight costs. To specifically address these errors, we have implemented additional controls including but not limited to more refined exception reporting and more frequent reconciliations. Moreover, we have put in place other controls and procedures to prevent similar accounting errors from occurring in the future, including the hiring of a new Corporate Controller, performing a risk assessment to establish an internal audit function, and establishing a disclosure controls committee made up of several of our senior management, including the CFO and our Chief Operating Officer. We also recently retained a third party to conduct our internal audit function. We issued a press release on December 18, 2002, included as an exhibit to our Form 8-K filed with the SEC on December 19, 2002, relating to our intention to restate our annual financial statements for fiscal year 2001 and the first two quarters of fiscal year 2002. On December 23, 2002, we filed with the SEC an amended annual report on Form 10-K/A (Amendment No. 2) for the fiscal year ended February 2, 2002 and amended quarterly reports on Form 10-Q/A for each of the fiscal quarters ended May 4, 2002 and August 3, 2002.

Conclusions. Based on our Controls Evaluation, our CEO and CFO concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report. With regard to our internal controls, to date, we have not found irregularities other than those previously disclosed. This lack of additional indications of irregularities is a principal factor in our belief that for the quarter and up to the present date, our internal controls, with the additional controls to correct our accounting systems noted above, are adequate to permit the preparation of our financial statements in conformity with generally accepted accounting principles. However, we intend to continue to assess our internal controls and improve upon them. We intend to expand the documentation of our internal controls as our resources permit. Our controls evaluation will be ongoing as we institute these new systems.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

There are no material pending legal proceedings against us. We are, however, involved from time to time in legal proceedings, including litigation arising in the ordinary course of our business. At the present time, we believe no legal proceedings will have a material adverse effect on our business, financial condition or results of operations. However, we cannot assure you that the results of any proceeding will be in our favor. Moreover, due to the uncertainties inherent in any legal proceeding, we cannot accurately predict the ultimate outcome of any proceeding and may incur substantial costs to defend the proceeding, irrespective of the merits. Unfavorable outcome of any legal proceeding could have an adverse impact on our business, financial condition, and results of operations.

Item 3. Defaults Upon Senior Securities.

We will seek from the lenders under our Seventh Amended and Restated Loan and Security Agreement, dated as of November 26, 2002, a waiver of any default to the extent such a waiver is required as a result of our restatement of our financial results for the fiscal year ended February 2, 2002 and the fiscal quarters ended May 4, 2002 and August 3, 2002.

Item 5. Other Information

Effective October 9, 2002, our board of directors amended and restated our 1998 Stock Incentive Plan in order (i) to increase the number of initial options granted to non-employee directors under the Automatic Option Grant Program of the plan from options exercisable for 7,500 shares of common stock to options exercisable for 15,000 shares of common stock, (ii) to increase the number of annual options granted to non-employee directors under the Automatic Option Grant Program of the plan from options exercisable for 3,500 shares of common stock to options exercisable for 7,500 shares of common stock, (iii) to revise the effects of a change in control on options granted under each of the Salary Investment Option Grant Program and the Director Fee Option Grant Program of the plan and (iv) to make certain other minor additional revisions and corrections to the plan. Given the nature of the amendments to the plan, no stockholder approval is required to be obtained with regard to the amended and restated plan.

In order to reflect a number of minor revisions and updates to our existing credit facility documentation, we entered into a Seventh Amended and Restated Loan and Security Agreement, dated as of November 26, 2002, with a syndicate of lenders, including, among others, Fleet Capital Corporation.

Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits.

See attached exhibit index.

(b) Reports on Form 8-K.

On August 9, 2002, we filed with the Securities and Exchange Commission a current report on Form 8-K, which included reports under items 5 and 7 thereto and attached a press release issued on August 8, 2002 announcing our sales results for the second quarter of fiscal 2002.

On August 22, 2002, we filed with the Securities and Exchange Commission a current report on Form 8-K, which included reports under items 5 and 7 thereto and attached a press release issued on August 21, 2002 announcing our financial results for the second quarter of fiscal 2002.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.


		Restoration Hardware, Inc.

Date:	December 23, 2002	By:	/s/ GARY G. FRIEDMAN
			Gary G. Friedman
			President and Chief Executive Officer

Date:	December 23, 2002	By:	/s/ KEVIN W. SHAHAN
			Kevin W. Shahan
			Vice President and Chief Financial Officer
			(Principal Financial Officer)

RESTORATION HARDWARE, INC.

CERTIFICATION

I, Gary G. Friedman, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Restoration Hardware, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

b) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.



Date:	December 23, 2002

		By:
			/s/ GARY G. FRIEDMAN

			Gary G. Friedman
			Chief Executive Officer

RESTORATION HARDWARE, INC.

CERTIFICATION

I, Kevin W. Shahan, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Restoration Hardware, Inc.;

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report.

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

d) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

e) evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

f) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

c) all significant deficiencies in the design of operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

d) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and



Date:	December 23, 2002

		By:	/s/ KEVIN W. SHAHAN
			Kevin W. Shahan
			Chief Financial Officer

EXHIBIT INDEX


EXHIBIT NUMBER		DOCUMENT DESCRIPTIONS

3.1		Second Amended and Restated Certificate of Incorporation, as amended (1)
3.2		Amended and Restated Bylaws (2)
10.1		1998 Stock Incentive Plan Amended and Restated on October 9, 2002
10.2		Employment Agreement for Elizabeth Salamone
99.1		Seventh Amended and Restated Loan and Security Agreement, dated as of November 26, 2002, by and among Restoration Hardware, Inc., The Michaels Furniture Company, Inc., Fleet Capital Corporation, and The CIT Group/Business Credit, Inc.

(1)		Incorporated by reference to Exhibit 3.1 to the current report on Form 8-K for Restoration Hardware Inc. filed with the Securities and Exchange Commission on October 24, 2001.

(2)		Incorporated by reference to Exhibit 3.2 to the quarterly report on Form 10-Q for Restoration Hardware, Inc. for the quarterly period ended October 31, 1998, filed with the Securities and Exchange Commission on December 15, 1998.

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1.		I have reviewed this quarterly report on Form 10-Q of Restoration Hardware, Inc.;

2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and

	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and