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FORM 10-K

Commission file number 001-14077

WILLIAMS-SONOMA, INC.

Registrant’s telephone number, including area code (415) 421-7900

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

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

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

As of August 4, 2002, the approximate aggregate market value of voting stock held by non-affiliates of the registrant was $1,892,878,584 using the closing sales price on the previous business day of $20.45. It is assumed for purposes of this computation an affiliate includes all persons listed as executive officers and directors with the Securities and Exchange Commission, as well as the registrant’s Associate Stock Incentive Plan.

As of March 31, 2003, 115,116,133 shares of the registrant’s Common Stock were outstanding.

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DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s Proxy Statement for the 2003 Annual Meeting (the “Proxy Statement”) have been incorporated in Part III hereof.

FORWARD-LOOKING STATEMENTS

This document contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause the business and results of operations of Williams-Sonoma, Inc. (“we”, “us” or “our”) to differ materially from those expressed or implied by such forward-looking statements. Such forward-looking statements include, without limitation, any projections of earnings, revenues or financial items, any statements of the plans, strategies and objectives of management for future operations, any statements concerning proposed new products or retail concepts, any statements regarding future economic conditions or performance, any statements relating to our plans to increase retail leased square footage, any statements relating to our plans to open new retail stores, any statements relating to our projected capital expenditures, any statements relating to our plans to open additional Canadian stores, and statements of belief and any statements of assumptions underlying the foregoing.

The risks, uncertainties and assumptions referred to above include, but are not limited to, those discussed under the heading “Risk Factors” in Item 7 hereto and the risks discussed from time to time in our other public filings. All forward-looking statements included in this document are based on information available to us as of the date hereof, and we assume no obligation to update these forward-looking statements.

We have not undertaken, nor is it required, to publicly update or revise any of our forward-looking statements, even if experience or future events make it clear that the results set forth in such statements will not be realized.

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WILLIAMS-SONOMA, INC.

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PART I

ITEM 1. BUSINESS

We are a specialty retailer of products for the home. The retail segment of our business sells our products through our four retail store concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids and Hold Everything). The direct-to-customer segment of our business sells similar products through our seven direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed + Bath, Hold Everything, West Elm and Chambers) and four e-commerce websites (wsweddings.com, williams-sonoma.com, potterybarn.com and potterybarnkids.com). Based on net revenues in fiscal 2002, retail accounted for 60.3% of our business and direct-to-customer accounted for 39.7%. Based on their contribution to our net revenues in fiscal 2002, the principal concepts in both retail and direct-to-customer are: Williams-Sonoma, which sells cookware essentials; Pottery Barn, which sells contemporary tableware and home furnishings; and Pottery Barn Kids, which sells stylish children’s furnishings.

We were founded in 1956 with the opening of our first store in Sonoma, California by Charles E. Williams, currently Vice Chairman and a Director. Today, the Williams-Sonoma stores offer a wide selection of culinary and serving equipment, including cookware, cookbooks, cutlery, informal dinnerware, glassware, table linens, specialty foods and cooking ingredients. Our direct-to-customer business began in 1972 when we introduced our flagship catalog, “A Catalog for Cooks,” which marketed the Williams-Sonoma brand.

In 1983, we internally developed the Hold Everything catalog to offer innovative solutions for household storage needs by providing efficient organization solutions for every room in the house. The first Hold Everything store opened in 1985.

In 1986, we acquired Pottery Barn, a retailer and direct-to-customer merchandiser featuring a large assortment of items in casual home furnishings, flatware and table accessories that we design internally and source from around the world, to create a dynamic look in the home.

In 1989, we developed Chambers, a mail order merchandiser of high quality linens, towels, robes, soaps and accessories for the bed and bath.

In 1999, we launched both our Williams-Sonoma Internet wedding and gift registry website and our Williams-Sonoma e-commerce site. In addition, we launched the Pottery Barn Kids catalog, which offers stylish children’s furnishings.

In 2000, we opened our first Pottery Barn Kids stores across the United States. In addition, we also introduced our Pottery Barn website and created Pottery Barn Bed + Bath, a catalog dedicated to bed and bath products.

In 2001, we launched our Pottery Barn Kids website, Pottery Barn online gift and bridal registry, and Pottery Barn Kids online gift registry. Additionally, in 2001, we opened five new retail stores (two Williams-Sonoma, two Pottery Barn and one Pottery Barn Kids retail stores) in Toronto, Canada, our first stores outside the United States.

During fiscal 2001 and 2002, the Hold Everything brand developed and implemented a brand repositioning strategy in both the retail and direct-to-customer channels. As part of this repositioning strategy, sales expectations for the brand were modified to reflect reduced catalog pages and circulation, lowered store counts, and a change in merchandise mix. As of the end of fiscal 2002, we finalized our repositioning strategy and will be launching the new Hold Everything brand in fiscal 2003.

In 2002, we launched our new West Elm catalog. The new brand targets young, design conscious consumers looking to furnish and accessorize their apartments, lofts or first homes with quality products at accessible price points. West Elm product categories include furniture, decorative accessories, tabletop items and an extensive textile collection.

In April 2003, we will launch our newest catalog, PBteen, which will be the first home retail concept to focus exclusively on the teenage market. PBteen will offer exclusively designed lifestyle collections for bedrooms, study, and lounge areas that include products in five key merchandise categories: furniture, rugs, lighting,

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RETAIL STORES

The retail segment has four merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids and Hold Everything). As of February 2, 2003, we operated 478 retail stores, located in 42 states, Washington, D.C. and Toronto, Canada. This represents 236 Williams-Sonoma, 159 Pottery Barn, 56 Pottery Barn Kids, 13 Hold Everything, and 14 Outlet stores (our Outlet stores carry merchandise from all merchandising concepts). In fiscal 2003, we plan to increase retail leased square footage by approximately 9% to 11%. The average leased square footage for new and expanded stores in fiscal 2003 will be approximately 10,500 leased square feet for Pottery Barn, 7,700 leased square feet for Pottery Barn Kids and 7,300 leased square feet (including two flagship stores) for Williams-Sonoma.

DIRECT-TO-CUSTOMER OPERATIONS

The direct-to-customer segment has six merchandising concepts and sells products through our seven direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed + Bath, Hold Everything, West Elm and Chambers) and four e-commerce websites (wsweddings.com, williams-sonoma.com, potterybarn.com and potterybarnkids.com). Of these six merchandising concepts, the Pottery Barn brand and its extensions have been the major source of sales growth in the direct-to-customer segment for the last several years. We believe that the success of the Pottery Barn brand and its extensions reflect our continuing investment in product design and quality and the consumer recognition achieved through our Pottery Barn and Pottery Barn Kids catalogs, websites and stores.

The shift in percent of total revenue between the retail and direct-to-customer channels over the past several years is largely attributable to the introduction of the e-commerce websites and the Pottery Barn Kids brand. Launched as a catalog-only vehicle in fiscal 1999, it added significant volume to the direct-to-customer channel during its first two years. Launched in store format in late fiscal 2000, the brand has also generated significant new volume to the retail channel during the past two years.

Although the amount of e-commerce sales that are incremental to our direct-to-customer channel cannot be identified precisely, we estimate that approximately 40% to 50% of aggregate non-bridal e-commerce sales are incremental to the direct-to-customer channels and approximately 50% to 60% are from catalog customers who would have potentially placed an order via the catalog call center.

We send our catalogs to addresses from our proprietary customer list, as well as to names from lists from other mail order merchandisers, magazines and companies which we receive in exchange for either payment or new addresses, consistent with our published privacy policies. In accordance with prevailing industry practice, we rent our list to select merchandisers. Our customer list is continually updated to include new prospects and eliminate non-responders.

The direct-to-customer business complements the retail business by building customer awareness of a brand and acting as an effective advertising vehicle. In addition, we believe that the mail order catalogs and the Internet act as a cost efficient means of testing market acceptance of new products.

SUPPLIERS

We purchase our merchandise from numerous foreign and domestic manufacturers and importers, the largest of which individually accounted for approximately 4% of purchases during fiscal 2002. Approximately 58% of our merchandise purchases in fiscal 2002 were foreign sourced, primarily from Asia and Europe. Substantially all of our foreign purchases of merchandise are negotiated and paid for in U.S. dollars.

COMPETITION AND SEASONALITY

The specialty retail business is highly competitive. Our specialty retail stores, mail order catalogs and Internet websites compete with other retail stores, including large department stores, discount stores, other specialty

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Our business is subject to substantial seasonal variations in demand. Historically, a significant portion of our revenues and net earnings have been realized during the period from October through December, and levels of net revenues and net earnings have generally been significantly lower during the period from January through September. We believe this is the general pattern associated with the direct-to-customer and retail industries. In anticipation of our peak season, we hire a substantial number of additional employees in our retail stores and direct-to-customer processing and distribution areas, and incur significant fixed catalog production and mailing costs.

PATENTS, TRADEMARKS, COPYRIGHTS AND DOMAIN NAMES

We own and/or have applied to register over one hundred trademarks and service marks in the United States, Canada and in approximately 35 additional countries throughout the world. Exclusive rights to the trademarks and service marks are held by Williams-Sonoma, Inc. and are used by our subsidiaries under license. These marks include brand names for products as well as house marks for the subsidiaries and their signature publications and web sites. The house marks in particular, including “Williams-Sonoma,” the Williams-Sonoma Grande Cuisine logo, “Pottery Barn,” “Hold Everything,” “Chambers,” “Pottery Barn Kids,” and “west elm,” are of material importance to us. Trademarks are generally valid as long as they are in use and/or their registrations are properly maintained, and they have not been found to have become generic. Trademark registrations can generally be renewed indefinitely so long as the marks are in use. We own numerous copyrights and trade dress rights for our products, product packaging, catalogs, books, house publications and web site designs, among other things, which are also used by our subsidiaries under license. We hold patents on certain product functions and product designs. In addition, we have registered and maintain numerous Internet domain names, including “wsweddings.com,” “williams-sonoma.com,” “potterybarn.com,” and “potterybarnkids.com.” Collectively, the copyrights, trade dress rights, patents and domain names that we hold are of material importance to us.

EMPLOYEES

As of February 2, 2003, we employed approximately 32,000 persons, approximately 6,000 of whom were full-time employees. During the fiscal 2002 peak season, we hired approximately 15,000 temporary employees in our stores and in our direct-to-customer processing and distribution centers.

AVAILABLE INFORMATION

We file annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and proxy and information statements and amendments to reports filed or furnished pursuant to Sections 13(a) and 15(d) of the Securities Exchange Act of 1934, as amended. The public may read and copy these materials at the Securities and Exchange Commission’s (“SEC”) Public Reference Room at 450 Fifth Street, NW, Washington, D.C. 20549. The public may obtain information on the operation of the public reference room by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website (http://www.sec.gov) that contains reports, proxy and information statements and other information regarding Williams-Sonoma, Inc. and other companies that file materials with the SEC electronically. You may also obtain copies of our Forms 10-K and Forms 10-Q filed with the SEC, free of charge, on our website at www.williams-sonomainc.com.

ITEM 2. PROPERTIES

Our gross leased store space, as of February 2, 2003, totaled approximately 3,725,000 square feet for 478 stores compared to approximately 3,179,000 square feet for 415 stores at February 3, 2002. All of the existing stores are leased by us with original terms ranging generally from 3 to 23 years. Certain leases contain renewal

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We lease distribution facilities in the following locations:

Two of our distribution facilities in Memphis, Tennessee are leased from two partnerships whose partners include two of our directors, one of which is also an officer, both of whom are significant shareholders of ours. (See Note F to our Consolidated Financial Statements.)

We lease call centers in the following locations:

Our corporate facilities are located in San Francisco, California. Our primary headquarters, consisting of 122,000 square feet, was purchased in 1993. In February 2000, we purchased a 204,000 square foot facility in San Francisco, California for the purpose of consolidating certain headquarters staff and to provide for future growth.

We also lease office, warehouse, design/photo studio and data center space in the following locations:

During fiscal 2002, we leased to a third party approximately 33,000 square feet of our owned properties through April 2002 and we subleased to a third party approximately 38,000 square feet of our San Francisco leased properties through May 2002. As of February 2, 2003, we are occupying all of this 71,000 square feet of previously leased and subleased space.

ITEM 3. LEGAL PROCEEDINGS

As of the date hereof, there are no material legal proceedings pending against us. From time to time, we may become a party to and subject to claims incident to the ordinary course of our business. Although the results of the proceedings and claims cannot be predicted with certainty, we believe that the ultimate resolution of such matters will not have a material adverse effect on our business, results of operations or financial condition.

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

There were no matters submitted to a vote of security holders during the fourth quarter of the 2002 fiscal year.

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PART II

MARKET INFORMATION

Our common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol WSM. The following table sets forth the high and low closing prices on the NYSE for the periods indicated as adjusted for our two-for-one stock split on May 9, 2002.

The closing sales price of our common stock on the NYSE on March 31, 2003 was $21.80.

SHAREHOLDERS

The number of shareholders of record as of March 31, 2003 was approximately 525. This number excludes shareholders whose stock is held in nominee or street name by brokers.

DIVIDEND POLICY

We have never declared nor paid, and do not currently intend to pay, a cash dividend on our common stock.

STOCK SPLIT

On April 15, 2002, our Board of Directors declared a two-for-one stock split of our common stock. The stock split was effected by issuing one additional share of common stock for each outstanding share of common stock. The additional shares were distributed on May 9, 2002 to shareholders of record on April 29, 2002. All share and per share amounts have been restated to give effect to this stock split.

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ITEM 6. SELECTED FINANCIAL DATA

Five-Year Selected Financial Data

The information set forth above is not necessarily indicative of future operations, and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the consolidated financial statements and notes thereto in this Annual Report on Form 10-K.

1	The fiscal year ended February 3, 2002 included 53 weeks.
2	Per share amounts have been restated to reflect the 2-for-1 stock splits in May 1998 and May 2002.
3	Operating margin is defined as earnings before interest and income taxes (and before gain on sale of Gardeners Eden in fiscal 1999).
4	Pre-tax operating margin is defined as earnings before income taxes.

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BUSINESS

We are a specialty retailer of products for the home. The retail segment of our business sells our products through our four retail store concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids and Hold Everything). The direct-to-customer segment of our business sells similar products through our seven direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed + Bath, Hold Everything, West Elm and Chambers) and four e-commerce websites (wsweddings.com, williams-sonoma.com, potterybarn.com and potterybarnkids.com). Based on net revenues in fiscal 2002, retail accounted for 60.3% of our business and direct-to-customer accounted for 39.7%. Based on their contribution to our net revenues in fiscal 2002, the principal concepts in both retail and direct-to-customer are: Williams-Sonoma, which sells cookware essentials; Pottery Barn, which sells contemporary tableware and home furnishings; and Pottery Barn Kids, which sells stylish children’s furnishings. The following discussion and analysis of financial condition, results of operations, liquidity and capital resources should be read in conjunction with our audited consolidated financial statements and the notes thereto.

Results of Operations

NET REVENUES

Net revenues consist of retail sales, direct-to-customer sales and shipping fees. Retail sales include sales of merchandise to customers at our retail stores, direct-to-customer sales include sales of merchandise to customers through catalogs and the Internet, and shipping fees consist of revenue received from customers for delivery of merchandise.

The following table summarizes our net revenues for the 52 weeks ended February 2, 2003 (“fiscal 2002”), the 53 weeks ended February 3, 2002 (“fiscal 2001”) and the 52 weeks ended January 28, 2001 (“fiscal 2000”).

Net revenues for fiscal 2002 increased by $274,168,000 or 13.1% over fiscal 2001 and net revenues for fiscal 2001 increased by $257,179,000 or 14.1% over fiscal 2000. The increase in both years was primarily due to the opening of 63 net new stores in fiscal 2002 and 33 net new stores in fiscal 2001 and the growth of the Williams-Sonoma, Pottery Barn and Pottery Barn Kids concepts.

During fiscal 2001 and 2002, the Hold Everything brand developed and implemented a brand repositioning strategy in both the retail and direct-to-customer channels. As part of this repositioning strategy, sales expectations for the brand were modified to reflect reduced catalog pages and circulation, lowered store counts, and a change in merchandise mix.

During August 2002, we launched a private label credit card program in the Pottery Barn and Pottery Barn Kids brands. A third party credit provider administers the program and we bear no credit risk. The program launch included a 10% first-purchase discount and a loyalty rewards program to incentivize our customers to accept the card. As of February 2, 2003 (24 weeks after the initial launch of the program), approximately 319,000 cards had been issued with charges totaling over $164,000,000 in fiscal 2002. The promotional expense associated with the first-purchase discount and loyalty rewards program is accounted for as a reduction to revenue and totaled $15,700,000 in fiscal 2002.

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RETAIL REVENUES AND OTHER DATA

Retail revenues for fiscal 2002 increased by $187,182,000 or 15.1% over fiscal 2001 primarily due to a net increase of 63 stores and a 2.7% increase in comparable store sales. As of February 2, 2003, we operated 478 stores in 42 states, Washington, D.C. and Toronto, Canada. During fiscal 2002, we opened 78 stores (30 Williams-Sonoma, 18 Pottery Barn, 29 Pottery Barn Kids and 1 Outlet) and closed 15 stores (8 Williams-Sonoma, 4 Pottery Barn, 2 Hold Everything and 1 Outlet). Pottery Barn and Pottery Barn Kids accounted for 71.4% of the growth in retail revenues from fiscal 2001 to fiscal 2002.

As part of the Hold Everything brand repositioning strategy, eleven Hold Everything stores were closed during fiscal 2001 and two stores were closed in fiscal 2002. Most of these closures were smaller stores in non-strategic locations at or near their lease termination date.

In fiscal 2001, we opened our first stores outside the United States. A total of five stores were opened in the Toronto, Canada market — two Williams-Sonoma stores, two Pottery Barn stores, and one Pottery Barn Kids store. In fiscal 2002, we opened an additional three retail stores in Toronto — one in each brand. We anticipate opening three more Canadian stores in fiscal 2003 — one Pottery Barn store and one Williams-Sonoma store in Toronto, Ontario and one Pottery Barn store in Vancouver, B.C.

Retail revenues in fiscal 2001 increased by $191,214,000 or 18.3% over fiscal 2000, principally due to a net increase of 33 stores and a 1.7% increase in comparable store sales. Pottery Barn and Pottery Barn Kids accounted for 62.7% of the growth in retail revenues from fiscal 2000 to fiscal 2001.

Comparable Store Sales

Comparable stores are defined as those stores whose gross square feet did not change by more than 20% in the previous 12 months and which have been open for at least 12 consecutive fiscal months without closure for seven or more consecutive days. Comparable store sales are computed based on aggregate sales of comparable stores for the reporting period. By measuring the year-over-year sales of merchandise in the stores that have a

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Comparable store sales in the Pottery Barn Kids concept have fluctuated and are expected to continue to fluctuate in fiscal 2002 and fiscal 2001. This fluctuation is primarily due to (1) the rapid growth of the retail store base; (2) the initial impact of new store openings on existing comparable stores; (3) strong first year sales in new stores due to grand opening events; and (4) inventory management challenges that resulted from aggressive store opening calendars and better than expected merchandise successes in this recently launched retail concept. Based upon these factors and our experience during the early years of the Pottery Barn rollout of its Design Studio stores in the mid-1990’s, we expect continued volatility in the Pottery Barn Kids comparable store sales results during fiscal 2003. In fiscal 2002, Pottery Barn Kids operated 56 retail stores versus 27 stores in fiscal 2001. For the comparable store sales base calculation, 27 stores were included in fiscal 2002 and only 8 stores were included in fiscal 2001.

Our current business plan for fiscal 2003 is to increase retail leased square footage by approximately 9% to 11% or a net increase of approximately 34 new retail stores consisting of 20 Pottery Barn Kids stores, 11 net Pottery Barn stores, and 6 net Williams-Sonoma stores, less the closing of 3 Hold Everything stores in the terminal year of their leases.

DIRECT-TO-CUSTOMER REVENUES

Direct-to-customer revenues in fiscal 2002 increased by $86,986,000 or 10.2% over fiscal 2001. This increase was primarily due to increased catalog circulation, expanded use of e-commerce partnerships, and improved productivity of electronic direct marketing techniques in the Pottery Barn, Pottery Barn Kids and Williams-Sonoma brands. Additionally, the launch of the West Elm concept in April 2002 provided incremental sales to the direct-to-customer channel. Hold Everything sales declined during fiscal 2002 as a result of our brand repositioning activities, which include fewer pages per catalog, lower product density per page, and fewer catalog mailings.

In fiscal 2001, we unveiled our Pottery Barn Kids e-commerce website, launched our Pottery Barn online gift and bridal registry, and introduced our Pottery Barn Kids online gift registry. In fiscal 2000, we launched our Pottery Barn e-commerce website. Combined revenues (includes shipping fees) from the four websites were $235,956,000 in fiscal 2002, an increase of $82,067,000 or 53.3% from $153,889,000 in fiscal 2001. Although the amount of e-commerce sales that are incremental to our direct-to-customer channel cannot be identified

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Direct-to-customer revenues in fiscal 2001 increased by $65,965,000 or 8.4% over fiscal 2000 primarily due to strong growth in the Pottery Barn, Pottery Barn Kids and Williams-Sonoma concepts which was partially offset by lower sales in Hold Everything due to a planned reduction in catalog circulation during the development and implementation of our repositioning strategy for Hold Everything.

COST OF GOODS SOLD

Cost of goods and occupancy expenses increased by $113,583,000 in fiscal 2002 over fiscal 2001. Cost of goods and occupancy expenses expressed as a percentage of net revenues for fiscal 2002 decreased 170 basis points from fiscal 2001. The percentage decrease was primarily driven by several operational improvements including (1) an increase in shipping fees for merchandise delivered to customers; (2) a decrease in cost of merchandise due to improved sourcing efforts; (3) an increase in full-price merchandise sales and fewer markdowns; (4) a decrease in customer returns and associated costs; (5) a decrease in inventory shrinkage due to reduced inventory levels and improved accountability through the supply chain; and (6) lower freight costs from the distribution center to the stores.

Cost of goods and occupancy expenses increased by $141,349,000 in fiscal 2001 over fiscal 2000. Cost of goods and occupancy expenses expressed as a percentage of net revenues for fiscal 2001 decreased 10 basis points from fiscal 2000, principally due to fewer promotional markdowns, aggressive inventory management, increased initial markups and lower freight costs in the retail channels, partially offset by increased occupancy costs. The increase in occupancy costs was driven primarily by increased depreciation, an increase in the percentage mix of net revenues generated through the retail channel, and increased rent and utility costs.

Shipping costs consist of third-party delivery services and shipping materials. Shipping costs increased in fiscal 2002 and fiscal 2001 due to more shipments of products to customers as direct-to-customer sales increased, and a higher mix of furniture sales. As a percentage of shipping fees, shipping costs have continued to decline from 104.0% in fiscal 2000 to 102.9% in fiscal 2001, and to 87.4% in fiscal 2002 due to the negotiation of improved shipping rates that reduced costs per shipment. In addition, shipping fees increased due to an increase in rates that we charge our customers for shipping and handling.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses increased by $83,284,000 to $749,299,000 in fiscal 2002 from $666,015,000 in fiscal 2001, and as a percent of net revenues, decreased by 20 basis points to 31.7% in fiscal 2002 from 31.9% in fiscal 2001. This percentage decrease was primarily due to a reduction in other general expenses and lower catalog advertising costs, partially offset by higher employment costs. The reduced catalog advertising costs as a percentage of net revenues was primarily due to an overall reduction in the percentage of total net revenues being generated by the direct-to-customer channel, higher catalog productivity and lower catalog production costs. The employment cost increase as a percentage of net revenues was primarily due to increased incentive compensation based on the achievement of corporate profitability targets, an approximate $4,000,000 expense associated with the departure of our former Chief Executive Officer due in large part to the acceleration of vesting on stock options and restricted stock grants, and higher employment costs to support information technology initiatives.

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Selling, general and administrative expenses increased by $71,903,000 to $666,015,000 in fiscal 2001 from $594,112,000 in fiscal 2000, and as a percent of net revenues, decreased 60 basis points to 31.9% in fiscal 2001 from 32.5% in fiscal 2000. This percentage decrease was primarily due to reduced catalog advertising costs as a percentage of net revenues due to stronger consumer demand and higher catalog productivity, as well as an improvement in other general expenses, partially offset by higher employment costs. The fiscal 2001 employment cost increase, as a percentage of net revenues, was substantially driven by fiscal 2001 performance bonuses and non-cash stock-based compensation charges. In fiscal 2000, no performance bonuses or non-cash stock-based compensation charges were incurred.

INTEREST EXPENSE — NET

Net interest expense decreased by $5,848,000 to $20,000 in fiscal 2002, primarily due to the absence of any borrowings under our revolving line of credit facility in fiscal 2002 and an increase in short-term investment income. Net interest expense in fiscal 2001 decreased by $1,319,000 from $7,187,000 in fiscal 2000 to $5,868,000 in fiscal 2001, principally due to the decreased balance under our line of credit facility due to continued asset management initiatives (including aggressive inventory management programs) as well as lower interest rates on our borrowings, offset by a decrease in capitalized interest costs for projects under construction.

INCOME TAXES

Our effective tax rate was 38.5% for fiscal 2002, fiscal 2001 and fiscal 2000.

LIQUIDITY AND CAPITAL RESOURCES

In fiscal 2002, net cash provided by operating activities increased by $105,154,000 to $310,160,000 from $205,006,000 in fiscal 2001. This increase in operating cash is primarily attributable to higher net earnings and a significant increase in accounts payable and accrued liabilities primarily related to growth in merchandise inventories and higher freight payables. This increase was partially offset by increased merchandise inventory. Merchandise inventory growth of approximately 28.9% during fiscal 2002 is primarily a result of a 17.1% increase in selling square footage and a management initiative to improve order fulfillment and customer satisfaction.

For fiscal 2001, net cash provided by operating activities increased by $23,697,000 to $205,006,000 from $181,309,000 in fiscal 2000. The fiscal 2001 increase in operating cash was primarily attributable to higher net earnings, reductions in merchandise inventories and improved cash flow from accounts receivable offset by cash used to reduce accounts payable. The decrease in accounts payable was primarily due to substantially lower inventories and lower deferred catalog expenses. The decrease in merchandise inventories was primarily due to aggressive inventory management and improved inventory turns.

Net cash used in investing activities was $155,450,000 for fiscal 2002 as compared to $155,314,000 in fiscal 2001. Fiscal 2002 purchases of property and equipment were $156,181,000, which includes $107,214,000 for stores, $44,677,000 for systems development projects (including the Internet), and $4,290,000 for distribution and facility infrastructure projects.

Net cash used in investing activities decreased $78,046,000 in fiscal 2001 to $155,314,000 from $233,360,000 in fiscal 2000. Fiscal 2001 purchases of property and equipment were $155,987,000, which included $91,636,000 for stores, $47,440,000 for systems development projects (including the Internet), and $16,911,000 for distribution and facility infrastructure projects.

For fiscal 2002, cash used in financing activities was $36,737,000, comprised primarily of $48,361,000 for the repurchase of common stock and $7,378,000 for the repayment of long-term obligations, including capital leases and long-term debt, partially offset by $19,551,000 proceeds from the exercise of stock options.

For fiscal 2001, cash provided by financing activities was $6,182,000, comprised of $18,689,000 in proceeds from the exercise of stock options, partially offset by the repayment of long-term obligations of $12,507,000 including the repayment of a mortgage obligation and certain long-term debt obligations.

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Contractual Obligations

The following table provides summary information concerning our future contractual obligations as of February 2, 2003.

Long-Term Debt

Capital Leases

Commercial Commitments

The following table provides summary information concerning our outstanding commercial commitments as of February 2, 2003.

Line of Credit

Letters of Credit

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Standby Letters of Credit

OFF-BALANCE SHEET ARRANGEMENTS

Operating Leases

We have an operating lease for a 1,002,000 square foot retail distribution facility located in Olive Branch, Mississippi. The lease has an initial term of 22.5 years, expiring January 2022, with two optional five-year renewals. The lessor, an unrelated party, is a limited liability company with operations separate from the leasing of this distribution facility. The lessor financed the construction of the distribution facility and expansion through the sale of $39,200,000 Taxable Industrial Development Revenue Bonds, Series 1998 and 1999, issued by the Mississippi Business Finance Corporation. The bonds are collateralized by the distribution facility. As of February 2, 2003, approximately $33,811,000 was outstanding on the bonds. We are required to make annual rental payments of approximately $3,719,000, plus applicable taxes, insurance and maintenance expenses.

We have an operating lease for an additional 1,103,000 square foot retail distribution facility located in Olive Branch, Mississippi. The lease has an initial term of 22.5 years, expiring January 2023, with two optional five-year renewals. The lessor, an unrelated party, is a limited liability company. The lessor financed the construction of the distribution facility through the sale of $42,500,000 Taxable Industrial Development Revenue Bonds, Series 1999, issued by the Mississippi Business Finance Corporation. The bonds are collateralized by the distribution facility. As of February 2, 2003, approximately $36,703,000 was outstanding on the bonds. We are required to make annual rental payments of approximately $4,179,000, plus applicable taxes, insurance and maintenance expenses.

Related Party Lease Commitments

Partnership 1 financed the construction of this distribution facility through the sale of a total of $9,200,000 of Industrial Development Bonds in 1983 and 1985. Annual principal payments and monthly interest payments are required through maturity in December 2010. The Partnership 1 Industrial Development Bonds are collateralized by the distribution facility and the individual partners guarantee the bond repayments. As of February 2, 2003, $3,214,000 was outstanding under the Partnership 1 Industrial Development Bonds.

The operating lease for this distribution facility requires us to pay annual rent of $618,000 plus interest on the bonds calculated at a variable rate determined monthly (2.5% in February 2003), applicable taxes, insurance and maintenance expenses. Although the current term of the lease expires in August 2004, we are obligated to renew the operating lease until these bonds are fully repaid.

We have an operating lease entered into in August 1990 for another distribution facility that is adjoined to the Partnership 1 facility in Memphis, Tennessee. The lessor is a general partnership (“Partnership 2”) comprised

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Partnership 2 financed the construction of this distribution facility and related addition through the sale of a total of $24,000,000 of Industrial Development Bonds in 1990 and 1994. Quarterly interest and annual principal payments are required through maturity in August 2015. The Partnership 2 Industrial Development Bonds are collateralized by the distribution facility and require us to maintain certain financial covenants. As of February 2, 2003, $16,157,000 was outstanding under the Partnership 2 Industrial Development Bonds.

The operating lease for this distribution facility requires us to pay annual rent of approximately $2,700,000, plus applicable taxes, insurance and maintenance expenses. This operating lease has a term of 15 years expiring in August 2006, with three optional five-year renewal periods. We are, however, obligated to renew the lease until the bonds are fully repaid.

On March 4, 2002, our Board of Directors authorized management to obtain information, conduct negotiations, and enter into appropriate agreements with the intent to pursue potential acquisitions of the distribution facilities currently leased from Partnerships 1 and 2 prior to the end of fiscal 2002. In January 2003, management concluded that the acquisition of such distribution facilities would not be beneficial to us from both an operational and financial standpoint. Therefore, the distribution facilities were not acquired.

In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation (“FIN”) No. 46, “Consolidation of Variable Interest Entities.” FIN No. 46 explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity. FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. FIN No. 46 is effective immediately for variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. FIN No. 46 applies in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003.

Management determined that the partnerships (Partnerships 1 and 2) from which we leased our Memphis distribution facilities, qualify as a “variable interest entity” under FIN No. 46 due to their related party relationship with us. Therefore, we will be required to consolidate Partnerships 1 and 2 as of August 4, 2003, the beginning of the third quarter of fiscal 2003. We currently estimate that the consolidation will result in increases of approximately $16,000,000 in assets (primarily buildings) and $18,000,000 in liabilities (primarily long-term debt) to our consolidated balance sheet and a cumulative effect charge of approximately $2,000,000 after taxes to our statement of earnings as of August 4, 2003. The bonds issued in connection with Partnerships 1 and 2 have no recourse to us, and we do not anticipate incurring any loss from our obligations under these leases.

IMPACT OF INFLATION

The impact of inflation on results of operations has not been significant.

STOCK REPURCHASE PROGRAM

From time to time, we have repurchased our common stock on the open market and retired those shares we purchased. In January 2003, the Board of Directors authorized a stock repurchase program to acquire up to four million shares of our common stock in the open market. During the fourth quarter of fiscal 2002, we repurchased and retired two million shares of our common stock at a total cost of approximately $48,361,000, a weighted average cost of $24.18 per share. As of February 2, 2003, the remaining authorized amount of stock eligible for repurchase is two million shares. The total value of common stock we can repurchase is limited by the debt covenant associated with our credit facilities. Future purchases under this program will be made through open market transactions at times and amounts that management deems appropriate. The timing and actual number of shares to be purchased in the future will depend on a variety of factors such as price,

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CRITICAL ACCOUNTING POLICIES

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. The estimates and assumptions are evaluated on an on-going basis and are based on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ significantly from these estimates.

We believe the following critical accounting policies affect the significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

Sales Return Reserve

Depreciation and Amortization

Stock-Based Compensation

During fiscal 2001, we entered into employment agreements with certain executive officers under which we recognized stock-based compensation expense ratably over the vesting period.

Inventory Reserves

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Catalog Amortization

Self-Insured Liabilities

RISK FACTORS

The following information describes certain significant risks inherent in our business. You should carefully consider such risks, together with the other information contained in this Annual Report on Form 10-K and in our other public filings. If any of such risks and uncertainties actually occurs, our business, financial condition or operating results could differ materially from the plans, projections and other forward-looking statements included in Management’s Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report and in our other public filings. In addition, if any of the following risks and uncertainties, or if any other disclosed risks and uncertainties, actually occurs, our business, financial condition or operating results could be harmed substantially, which, in turn, could cause the market price of our stock to decline, perhaps significantly.

We must successfully anticipate changing consumer preferences and buying trends, and manage our inventory commensurate with customer demand.

Our success depends upon our ability to anticipate and respond to changing merchandise trends and customer demands in a timely manner. Consumer preferences cannot be predicted with certainty and may change between sales seasons. If we misjudge either the market for our merchandise or our customers’ purchasing habits, our sales may decline significantly and we may be required to mark down certain products to sell the resulting excess inventory or sell such inventory through our outlet stores at prices which are significantly lower than our retail prices, each of which would harm our business and operating results.

In addition, we must manage our inventory effectively and commensurate with customer demand. Much of our inventory is sourced from vendors located outside the United States. Thus, we usually must order merchandise, and enter into contracts for the purchase and manufacture of such merchandise, well in advance of the applicable selling season and frequently before trends are known. The extended lead times for many of our purchases may make it difficult for us to respond rapidly to new or changing trends. In addition, the seasonal nature of the specialty home products business requires us to carry a significant amount of inventory prior to peak selling season. As a result, we are vulnerable to demand and pricing shifts and to misjudgments in the selection and timing of merchandise purchases. If we do not accurately predict our customers’ preferences and acceptance levels of our products, our inventory levels will not be appropriate and our business and operating results may be negatively impacted.

Our business depends, in part, on factors affecting consumer spending that are out of our control.

Our business depends on consumer demand for our products and, consequently, is sensitive to a number of factors that influence consumer spending, including general economic conditions, disposable consumer

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The growth of our sales and profits depends, in large part, on our ability to successfully open new stores.

In each of the past three fiscal years, our retail stores have generated approximately 60% of our net revenues. We plan a net increase of approximately 34 new retail stores in fiscal 2003 as part of our growth strategy. There is no assurance that this strategy will be successful. Our ability to open additional stores successfully will depend upon a number of factors, including:

•	our identification and availability of suitable store locations;
•	our success in negotiating leases on acceptable terms;
•	our ability to secure required governmental permits and approvals;
•	our hiring and training of skilled store operating personnel, especially management;
•	our timely development of new stores, including the availability of construction materials and labor and the absence of significant construction and other delays in store openings;
•	the availability of financing on acceptable terms (if at all); and
•	general economic conditions.

Many of these factors are beyond our control. For example, for the purpose of identifying suitable store locations, we rely, in part, on demographics surveys regarding location of consumers in our target market segments. While we believe that the surveys and other relevant information are helpful indicators of suitable store locations, we recognize that the information sources cannot predict future consumer preferences and buying trends with complete accuracy. In addition, time frames for lease negotiations and store development vary from location to location and can be subject to unforeseen delays. Construction and other delays in store openings could have a negative impact on our business and operating results. There can be no assurance that we will be able to open new stores or that, if opened, those stores will be operated profitably.

We face intense competition from companies with brands or products similar to ours.

The specialty retail and direct-to-customer business is highly competitive. Our specialty retail stores, mail order catalogs and Internet websites compete with other retail stores, other mail order catalogs and other e-commerce websites that market lines of merchandise similar to ours. We compete with national, regional and local businesses utilizing a similar retail store strategy, as well as traditional furniture stores, department stores and specialty stores. The substantial sales growth in the direct-to-customer industry within the last decade has encouraged the entry of many new competitors and an increase in competition from established companies.

The competitive challenges facing us include, without limitation:

•	anticipating and quickly responding to changing consumer demands better than our competitors;
•	maintaining favorable brand recognition and achieving customer perception of value;
•	effectively marketing and competitively pricing our products to consumers in several diverse market segments; and
•	developing innovative, high-quality products in colors and styles that appeal to consumers of varying age groups and tastes, and in ways that favorably distinguish us from our competitors.

In light of the many competitive challenges facing us, there can be no assurance that we will be able to compete successfully. Increased competition could adversely affect our sales, operating results and business.

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We depend on key domestic and foreign vendors for timely and effective sourcing of our merchandise, and we are subject to various risks and uncertainties that might affect our vendors’ ability to produce quality merchandise.

Our performance depends on our ability to purchase our merchandise in sufficient quantities at competitive prices. We purchase our merchandise from numerous foreign and domestic manufacturers and importers. We have no contractual assurances of continued supply, pricing or access to new products, and any vendor could discontinue selling to us at any time. There can be no assurance that we will be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future. Any inability to acquire suitable merchandise or the loss of one or more key vendors could have a negative effect on our business and operating results because we would be missing products that we felt were important to our assortment, unless and until alternative supply arrangements are secured. We may not be able to develop relationships with new vendors, and products from alternative sources, if any, may be of a lesser quality and/or more expensive than those we currently purchase.

In addition, we are subject to certain risks, including availability of raw materials, labor disputes, union organizing activity, inclement weather, natural disasters, and general economic and political conditions, that might limit our vendors’ ability to provide us with quality merchandise on a timely basis. For these or other reasons, one or more of our vendors might not adhere to our quality control standards, and we might not identify the deficiency before merchandise ships to our stores or customers. Our vendors’ failure to manufacture or import quality merchandise in a timely and effective manner could damage our reputation and brands, and could lead to an increase in customer litigation against us and attendant increase in our routine litigation costs.

Our dependence on foreign vendors subjects us to a variety of risks and uncertainties.

We source our products from manufacturers in over 34 countries. Specifically, in fiscal 2002, approximately 58% of our merchandise purchases were foreign sourced, primarily from Asia and Europe.

Our dependence on foreign vendors means, in part, that we may be affected by declines in the relative value of the U.S. dollar to other foreign currencies. Although substantially all of our foreign purchases of merchandise are negotiated and paid for in U.S. dollars, declines in foreign currencies and currency exchange rates might negatively affect the profitability and business prospects of one or more of our foreign vendors. This, in turn, might cause such foreign vendors to demand higher prices for merchandise, hold up merchandise shipments to us, or discontinue selling to us, any of which could ultimately reduce our sales or increase our costs.

We are also subject to other risks and uncertainties associated with changing economic and political conditions in foreign countries. These risks and uncertainties include import duties and quotas, work stoppages, economic uncertainties (including inflation), foreign government regulations, wars and fears of war, political unrest and trade restrictions. We cannot predict whether any of the countries in which our products are currently manufactured or may be manufactured in the future will be subject to trade restrictions imposed by the U.S. or foreign governments or the likelihood, type or effect of any such restrictions. Any event causing a disruption or delay of imports from foreign vendors, including the imposition of additional import restrictions, restrictions on the transfer of funds and/or increased tariffs or quotas, or both, against home-centered items could increase the cost or reduce the supply of merchandise available to us and adversely affect our business, financial condition and operating results. Furthermore, some or all of our foreign vendors’ operations may be adversely affected by political and financial instability resulting in the disruption of trade from exporting countries, restrictions on the transfer of funds and/or other trade disruptions.

In addition, although we are in the process of developing and implementing an enhanced global compliance program, there remains a risk that one or more of our foreign vendors will not adhere to our global compliance standards (including, e.g., fair labor standards and the prohibition on child labor). If this happens, we could lose customer goodwill and favorable brand recognition, which could negatively affect our business and operating results.

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We must timely and effectively deliver merchandise to our stores and customers.

We cannot control all of the various factors that might affect our fulfillment rates in direct-to-customer sales and/or timely and effective merchandise delivery to our stores. We rely upon third party carriers for our merchandise shipments, including shipments to our customers and to and from all of our stores. Accordingly, we are subject to the risks, including labor disputes (e.g., west coast port strike of 2002), union organizing activity, inclement weather, natural disasters, and possible acts of terrorism associated with such carriers’ ability to provide delivery services to meet our shipping needs. Failure to deliver merchandise in a timely and effective manner could damage our reputation and brands. In addition, we are seeing fuel costs increase substantially and airline companies struggle to operate profitably, which could lead to increased fulfillment expenses and negatively affect our business and operating results by increasing costs and negatively affecting the efficiency of our shipments.

Our failure to successfully manage our order-taking and fulfillment operations might have a negative impact on our business.

The operation of our direct-to-customer business depends on our ability to maintain the efficient and uninterrupted operation of our order-taking and fulfillment operations and our e-commerce websites. Disruptions or slowdowns in these areas could result from disruptions in telephone service or power outages, inadequate system capacity, human error, natural disasters or adverse weather conditions. These problems could result in a reduction in sales as well as increased selling, general and administrative expenses.

In addition, we face the risk that we cannot hire enough qualified employees, especially during our peak season, to support our direct-to-customer operations, due to war or other circumstances that reduce the relevant workforce. The need to operate with fewer employees could negatively impact our customer service levels and our operations.

We experience fluctuations in our comparable store sales.

Our success depends, in part, upon our ability to increase sales at our existing stores. Various factors affect comparable store sales, including the number of stores we open, close and expand in any period, the general retail sales environment, changes in sales mix between distribution channels, our ability to efficiently source and distribute products, changes in our merchandise mix, competition, current economic conditions, the timing of release of new merchandise and promotional events, the success of marketing programs, and cannibalization of existing store sales by new stores. Among other things, weather conditions can affect comparable store sales, because inclement weather can require us to close certain stores temporarily and thus reduce store traffic. Even if stores are not closed, many customers may decide to avoid going to stores in bad weather. These factors may cause our comparable store sales results to differ materially from prior periods and from earnings guidance we have provided. Our comparable store sales have fluctuated significantly in the past on an annual, quarterly and monthly basis, and we expect that comparable store sales will continue to fluctuate in the future. Our comparable store sales increases for fiscal years 2002, 2001 and 2000 were 2.7%, 1.7% and 5.5%, respectively. Past comparable store sales are no indication of future results, and there can be no assurance that our comparable store sales will not decrease in the future. Our ability to maintain and improve our comparable store sales results depends in large part on maintaining and improving our forecasting of customer demand and buying trends, selecting effective marketing techniques, providing an appropriate mix of merchandise for our broad and diverse customer base and using more effective pricing strategies. Any failure to meet the comparable store sales expectations of investors and security analysts in one or more future periods could significantly reduce the market price of our common stock.

Our failure to successfully manage the costs and performance of our catalog mailings might have a negative impact on our business.

Postal rate increases and paper and printing costs affect the cost of our catalog mailings. We rely on discounts from the basic postal rate structure, such as discounts for bulk mailings and sorting by zip code and carrier routes. Our cost of paper has fluctuated significantly during the past three fiscal years, and our paper costs may

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We have historically experienced fluctuations in customer response to our catalogs. Customer response to our catalogs is substantially dependent on merchandise assortment, merchandise availability and creative presentation, as well as the sizing and timing of delivery of the catalogs. The failure to effectively produce or distribute the catalogs could affect the timing of catalog delivery, which could cause customers to forego or defer purchases.

We must successfully manage our Internet business.

The success of our e-commerce business depends, in part, on factors over which we have limited control. In addition to changing consumer preferences and buying trends relating to Internet usage, we are vulnerable to certain additional risks and uncertainties associated with the Internet, including changes in required technology interfaces, website downtime and other technical failures, changes in applicable federal and state regulation, security breaches, and consumer privacy concerns. Our failure to successfully respond to these risks and uncertainties might adversely affect the sales through our e-commerce business, as well as damage our reputation and brands.

We must successfully manage the complexities associated with a multi-channel and multi-brand business.

During the past few years, with the launch and expansion of our e-commerce business, new brands and brand expansions, our overall business has become substantially more complex. The changes in our business have forced us to develop new expertise and face new challenges, risks and uncertainties. For example, we face the risk that our e-commerce business might cannibalize a significant portion of our retail and catalog businesses. While we recognize that our e-commerce sales cannot be entirely incremental to sales through our retail and catalog channels, we seek to attract as many new customers as possible to our websites. We continually analyze the business results of our three channels and the relationships among the channels, in an effort to find opportunities to build incremental sales. However, we cannot ensure that, as our e-commerce business grows, it will not cannibalize a portion of our retail and catalog businesses.

We have recently introduced a new brand, West Elm, and may introduce additional new brands and brand extensions in the future. Our introduction of new brands and brand extensions poses another set of risks. If we devote time and resources to new brands and brand extensions, and those businesses are not as successful as we planned, then we risk damaging our overall business results. Alternatively, if our new brands and brand extensions prove to be very successful, we risk hurting our existing brands through the migration of customers to the new businesses. There can be no assurance that we can and will introduce new brands and brand extensions that improve our overall business and operating results.

Our inability to obtain commercial insurance at acceptable prices might have a negative impact on our business.

During fiscal 2002, there was a substantial increase in the costs of insurance, partly in response to the terrorist attacks of September 11, 2001, and financial irregularities and other fraud at publicly-traded companies. We believe that extensive commercial insurance coverage is prudent for risk management and anticipate that our insurance costs will increase substantially. In addition, for certain types or levels of risk (e.g., risks associated with earthquakes or terrorist attacks), we might determine that we cannot obtain commercial insurance at acceptable prices. Therefore, we might choose to forego or limit our purchase of relevant commercial insurance, choosing instead to self-insure one or more types or levels of risks. If we suffer a substantial loss that is not covered by commercial insurance, the loss and attendant expenses could have a material adverse effect on our business and operating results.

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Our inability or failure to protect our intellectual property would have a negative impact on our business.

Our trademarks, service marks, copyrights, patents, trade dress rights, trade secrets, domain names and other intellectual property are valuable assets that are critical to our success. The unauthorized reproduction or other misappropriation of our intellectual property could diminish the value of our brands or goodwill and cause a decline in our sales. There can be no assurance that we will be able to adequately protect our intellectual property or that the costs of defending our intellectual property will not adversely affect our operating results.

We have been sued and may be named in additional lawsuits in a growing number of industry-wide patent litigation cases relating to the Internet.

There appears to be a growing number of patent infringement lawsuits instituted against companies such as ours that have an e-commerce business. The plaintiff in each case claims to hold a patent that covers web technology, which is allegedly infringed by the operation of the defendants’ websites. We are currently a defendant in certain such patent infringement cases and anticipate being named in others in the future, as part of an industry-wide trend. Even in cases where a plaintiff’s claim lacks merit, the defense costs in a patent infringement case are very high. There can be no assurance that additional patent infringement claims will not be brought against us, or that the cost of defending such claims or the ultimate resolution of such claims will not negatively impact our business and operating results.

We are planning certain systems changes that might disrupt our supply chain operations.

Our success depends on our ability to source merchandise efficiently through appropriate systems and procedures. We are in the process of substantially modifying our information technology systems supporting the product pipeline, including design, sourcing, merchandise planning, forecasting and purchase order, inventory, distribution, transportation and price management. Modifications will involve updating or replacing legacy systems with successor systems during the course of several years. There are inherent risks associated with replacing our core systems, including supply chain disruptions that affect our ability to get products into our stores and delivered to customers. There can be no assurance that we will successfully launch these new systems or that the launch will occur without supply chain disruptions. Any resulting supply chain disruptions could have a material adverse effect on our business and operating results.

We need to manage our employment, occupancy and other operating costs.

To be successful, we need to manage our operating costs while we continue to look for opportunities to reduce costs. We recognize that we may need to increase the number of our employees, especially in peak sales seasons, and incur other expenses to support new brands and brand extensions, as well as the opening of new stores and direct-to-customer growth of our existing brands. In addition, although we strive to secure long-term contracts with our service providers and other vendors and otherwise limit our financial commitment to them, there can be no assurance that we will avoid unexpected operating cost increases in the future. Lower than expected sales, coupled with higher than expected costs, would negatively impact our business and operating results.

We depend on external funding sources for operating funds.

We regularly review and evaluate our liquidity and capital needs. We currently believe that our available cash, cash equivalents, cash flow from operations and cash available under our existing credit facilities will be sufficient to finance our operations and expected capital requirements for at least the next twelve months. However, as we continue to grow, we might experience peak periods for our cash needs during the course of our fiscal year, and we might need additional external funding to support our operations. Although we believe we would have access to additional debt and/or capital market funding if needed, there can be no assurance that such funds will be available to us on acceptable terms. If the cost of such funds is greater than expected, it could adversely affect our expenses and our operating results.

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Our operating and financial performance in any given period might not meet the extensive guidance that we have provided to the public.

We provide extensive public guidance on our expected operating and financial results for future periods. Although we believe that this guidance fosters confidence among investors and analysts, and is useful to our shareholders and potential shareholders, such guidance is comprised of forward-looking statements subject to the risks and uncertainties described in this report and in our other public filings and public statements. We cannot ensure that our guidance will always be accurate. If in the future our operating or financial results for a particular period do not meet our guidance or the expectations of investment analysts, the market price of our common stock could decline.

Our quarterly results of operations might fluctuate due to a variety of factors including seasonality.

Our quarterly results have fluctuated in the past and may fluctuate in the future, depending upon a variety of factors, including, but not limited to shifts in the timing of holiday selling seasons, including Valentine’s Day, Easter, Halloween, Thanksgiving and Christmas, and the strategic importance of fourth quarter results. A significant portion of our revenues and net earnings have been realized during the period from October through December. In anticipation of increased holiday sales activity, we incur certain significant incremental expenses, including the hiring of a substantial number of temporary employees to supplement our existing workforce. If, for any reason, we were to realize significantly lower-than-expected revenues or net earnings during the October through December selling season, our business and results of operations would be materially adversely affected.

Our failure to successfully anticipate merchandise returns might have a negative impact on our business.

We record a reserve for merchandise returns based on historical return trends together with current product sales performance in each reporting period. If actual returns are greater than those projected by management, additional sales returns might be recorded in the future. There can be no assurance that actual merchandise returns will not exceed our reserves. In addition, there can be no assurance that the introduction of new merchandise, changes in merchandise mix, changes in consumer confidence, or other competitive and general economic conditions will not cause actual returns to exceed merchandise return reserves. Any significant increase in merchandise returns that exceed our reserves could materially affect our business and results of operations.

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

Interest Rate Risk

The interest payable on our bank line of credit and on two of our operating leases is based on variable interest rates and therefore affected by changes in market interest rates. If interest rates on existing variable rate debt and operating leases rose 23 basis points (an approximately 10% increase in the associated variable rates as of February 2, 2003), our results from operations and cash flows would not be materially affected.

For one of the operating leases with a variable interest rate, we have an interest rate cap contract at 5.88% with a notional amount of $13,083,000 which extends through February 2005. The contract has not been designated as a hedge and is accounted for by adjusting the carrying amount of the contract to market. A loss of approximately $93,000 and $30,000 was recorded in selling, general and administrative expenses in fiscal 2002 and fiscal 2001, respectively.

In addition, we have fixed and variable income investments consisting of cash equivalents and short-term investments, which are also affected by changes in market interest rates. An increase in interest rates of 10% would have an immaterial effect on the value of these investments. Declines in interest rates would, however, decrease the income derived from these investments.

Foreign Currency Risks

We purchase a significant amount of inventory from vendors outside of the U.S. in transactions that are primarily U.S. dollar transactions. A small percentage of our international purchase transactions are in currencies other than the U.S. dollar. Any currency risks related to these transactions are immaterial to the company. A decline in the relative value of the U.S. dollar to other foreign currencies could, however, lead to increased purchasing costs.

As of February 2, 2003, we have eight retail stores in Toronto, Canada and expect to open three additional Canadian stores in fiscal 2003, which expose us to market risk associated with foreign currency exchange rate fluctuations. Due to our operations in Canada and the volatility of the Canadian dollar, we entered into 30-day forward contracts in order to limit the currency exposure associated with intercompany asset and liability accounts of our Canadian subsidiary. We recorded a loss of approximately $137,000 and $61,000 in selling, general and administrative expenses in fiscal 2002 and fiscal 2001, respectively.

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Williams-Sonoma, Inc.

See Notes to Consolidated Financial Statements.

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Williams-Sonoma, Inc.

            See Notes to Consolidated Financial Statements.

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Williams-Sonoma, Inc.