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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 3, 2003, the approximate aggregate market value of the registrant’s common stock held by non-affiliates was $2,648,318,228. It is assumed for purposes of this computation that an affiliate includes all persons as of August 3, 2003 listed as executive officers and directors with the Securities and Exchange Commission. This aggregate market value includes all shares held in the registrant’s Williams-Sonoma, Inc. Stock Fund.

As of March 29, 2004, 115,927,858 shares of the registrant’s Common Stock were outstanding.

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DOCUMENTS INCORPORATED BY REFERENCE

Portions of our definitive Proxy Statement for the 2004 Annual Meeting of Shareholders, also referred to in this Annual Report on Form 10-K as our Proxy Statement, which was filed with the Security and Exchange Commission, or SEC, on April 15, 2004, have been incorporated in Part III hereof.

FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they do not fully 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 the future performance of our brands, any statements relating to our plans to open new retail stores or close existing stores, any statements relating to our projected capital expenditures, any statements relating to our plans to open additional Canadian stores, any statements of belief and any statements of assumptions underlying the foregoing.

The risks, uncertainties and assumptions referred to above that could cause our results to differ materially from the results expressed or implied by such forward-looking statements include, but are not limited to, those discussed under the heading “Risk Factors” in Item 7 hereto and the risks, uncertainties and assumptions discussed from time to time in our other public filings and public announcements. 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.

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WILLIAMS-SONOMA, INC.

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PART I

ITEM 1. BUSINESS

OVERVIEW

We are a specialty retailer of products for the home. The retail segment of our business sells our products through our five retail store concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Hold Everything, and West Elm). The direct-to-customer segment of our business sells similar products through our eight direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed + Bath, PBteen, Hold Everything, West Elm and Chambers) and five e-commerce websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com and westelm.com). Based on net revenues in fiscal 2003, retail net revenues accounted for 58.9% of our business and direct-to-customer net revenues accounted for 41.1% of our business. Based on their contribution to our net revenues in fiscal 2003, the core brands in both retail and direct-to-customer are: Pottery Barn, which sells contemporary tableware and home furnishings; Williams-Sonoma, which sells cookware essentials; and Pottery Barn Kids, which sells stylish children’s furnishings.

We were founded in 1956 by Charles E. Williams, currently a Director Emeritus, with the opening of our first store in Sonoma, California. 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 wedding and gift registry e-commerce website and our Williams-Sonoma e-commerce website. 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 U.S. In addition, we introduced our Pottery Barn e-commerce website and created Pottery Barn Bed + Bath, a catalog dedicated to bed and bath products.

In 2001, we launched our Pottery Barn Kids e-commerce website, Pottery Barn gift and bridal registry, and Pottery Barn Kids 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 operated by us outside of the U.S.

In 2002, we launched our West Elm catalog. The 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 2003, we launched our West Elm e-commerce website and opened our first West Elm retail store.

In addition, during 2003, we launched our newest extension of the Pottery Barn brand, PBteen, with the introduction of the PBteen catalog. PBteen offers exclusive collections of home furnishings and decorative accessories that are specifically designed to reflect the personalities of the teenage market. In late 2003, we launched our PBteen e-commerce website.

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RETAIL STORES

The retail segment has five merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Hold Everything, and West Elm). As of February 1, 2004, we operated 512 retail stores, located in 42 states, Washington, D.C. and Canada. This represents 237 Williams-Sonoma, 174 Pottery Barn, 78 Pottery Barn Kids, 8 Hold Everything, 1 West Elm, and 14 Outlet stores (our Outlet stores carry merchandise from all merchandising concepts).

In fiscal 2004, we expect to increase retail leased square footage by approximately 8% to 9%. The average leased square footage for new and expanded stores in fiscal 2004 will be approximately 12,600 leased square feet for Pottery Barn, 12,100 leased square feet for West Elm, 7,800 leased square feet for Pottery Barn Kids, 6,900 leased square feet for Williams-Sonoma and 6,000 leased square feet for Hold Everything. Detailed financial information about the retail segment is found in Note L to our financial statements.

DIRECT-TO-CUSTOMER OPERATIONS

The direct-to-customer segment has seven merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, PBteen, Hold Everything, Chambers, and West Elm) and sells products through our eight direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed + Bath, PBteen, Hold Everything, West Elm and Chambers) and five e-commerce websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com, and westelm.com). Of these seven 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, e-commerce websites and stores.

The direct-to-customer channel over the past several years has been strengthened by the continued success of the Pottery Barn Kids brand, the introduction of e-commerce websites in all of our core brands, and the launching of our newest brands, West Elm and PBteen. Although the amount of e-commerce sales that are incremental to our direct-to-customer channel cannot be identified precisely, we estimate that approximately 50% to 60% of our non-bridal e-commerce sales are incremental to the direct-to-customer channels and approximately 40% to 50% are from mail order customers who recently received a catalog.

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 that 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 to eliminate non-responders.

The direct-to-customer business complements the retail business by building brand awareness 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 and new brands. Detailed financial information about the direct-to-customer segment is found in Note L to our financial statements.

SUPPLIERS

We purchase our merchandise from numerous foreign and domestic manufacturers and importers, the largest of which individually accounted for approximately 3% of purchases during fiscal 2003. Approximately 61% of our merchandise purchases in fiscal 2003 were foreign sourced from manufacturers in 41 countries, primarily from Asia and Europe. Substantially all of our foreign purchases of merchandise are negotiated and paid for in U.S. dollars.

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COMPETITION AND SEASONALITY

The specialty retail business is highly competitive. Our specialty retail stores, mail order catalogs and e-commerce websites compete with other retail stores, including large department stores, discount stores, other specialty retailers offering home centered assortments, other mail order catalogs and other e-commerce websites. 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. We compete on the basis of our brand authority, the quality of our merchandise, service to our customers and our proprietary customer list, as well as location and appearance of our stores. We believe that we compare favorably with many of our current competitors with respect to some or all of these factors.

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 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. We own and/or have applied to register our marks in the U.S., Canada and in approximately 20 additional countries. 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 our subsidiaries and their signature publications and websites. The house marks in particular, including “Williams-Sonoma,” the Williams-Sonoma Grande Cuisine logo, “Pottery Barn,” “hold everything,” “Chambers,” “pottery barn kids,” “PBteen,” 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 website 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,” “potterybarnkids.com,” “pbteen.com,” “westelm.com,” “holdeverything.com,” and “williamssonomahome.com.” Collectively, the copyrights, trade dress rights, patents and domain names that we hold are of material importance to us.

EMPLOYEES

As of February 1, 2004, we had approximately 36,049 employees, approximately 6,783 of whom were full-time employees. During the fiscal 2003 peak season, we hired approximately 15,777 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, proxy and information statements and amendments to reports filed or furnished pursuant to Sections 13(a), 14 and 15(d) of the Securities Exchange Act of 1934, as amended. The public may read and copy these materials at the SEC’s 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 at 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 Annual

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ITEM 2. PROPERTIES

Our gross leased store space, as of February 1, 2004, totaled approximately 4,163,000 square feet for 512 stores compared to approximately 3,725,000 square feet for 478 stores, as of February 2, 2003. All of the existing stores are leased by us with original terms ranging generally from 3 to 23 years. Certain leases contain renewal options for periods of up to 20 years. Store leases typically provide for minimum rental payments and additional rent based upon a percentage of store sales if a specified store sales target is exceeded. Such contingent rental expense is accrued each reporting period if achievement of a store sales target is considered probable. See Note E to our Consolidated Financial Statements for more information.

We lease distribution facilities in the following locations:

One of our Olive Branch distribution center agreements contains an option to lease an additional 333,000 square feet of distribution space. As of February 1, 2004, we had not exercised our rights under this option. In addition, subsequent to year-end, we entered into a lease agreement to lease an additional 781,000 square feet of distribution space in Cranbury, New Jersey. This agreement requires us to lease an additional 219,000 square feet of the facility in the event the current tenant vacates the premises.

Two of our distribution facilities in Memphis, Tennessee are leased from two partnerships whose partners include a Director and a Director Emeritus, both of whom are significant shareholders. See Note F to our Consolidated Financial Statements for more information.

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 believe that our facilities are adequate for our current needs and that suitable additional or substitute space will be available in the future to replace our existing facilities, if necessary, or to accommodate expansion of our operations.

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

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ITEM 3. LEGAL PROCEEDINGS

We are involved in lawsuits, claims and proceedings incident to the ordinary course of our business. These disputes, which are not currently material, are increasing in number as our business expands and our company grows larger. Litigation is inherently unpredictable. Any claims against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. The results of these lawsuits, claims and proceedings cannot be predicted with certainty. However, we believe that the ultimate resolution of these matters will not have a material adverse effect on our consolidated financial statements taken as a whole.

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 fiscal 2003.

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PART II

MARKET INFORMATION

Our common stock is traded on the New York Stock Exchange, or the NYSE, under the symbol WSM. The following table sets forth the high and low closing prices of our common stock 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 29, 2004 was $33.95. See Quarterly Financial Information contained in our Consolidated Financial Statements in this Annual Report on Form 10-K for the quarter-end closing sales price of our common stock for each quarter above.

SHAREHOLDERS

The number of shareholders of record of our common stock as of March 29, 2004 was approximately 522. This number excludes shareholders whose stock is held in nominee or street name by brokers.

DIVIDEND POLICY

We have never declared or paid, and do not currently intend to pay, a cash dividend on our common stock.

Additional information required by Item 5 is contained in Note H: Common Stock and Note I: Stock Options in the Consolidated Financial Statements in this Annual Report on Form 10-K.

EQUITY COMPENSATION PLAN INFORMATION

The information required by this Item regarding equity compensation plans is incorporated by reference to the information set forth in Item 12 of this Annual Report on Form 10-K.

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STOCK REPURCHASE PROGRAM

In January 2003, the Board of Directors authorized a stock repurchase program to acquire up to 4,000,000 shares of our outstanding common stock in the open market. During the fourth quarter of fiscal 2002, we repurchased and retired 2,000,000 shares of our common stock at a total cost of approximately $48,361,000, a weighted average cost of $24.18 per share. In the fourth quarter of fiscal 2003, we repurchased and retired an additional 1,785,000 shares of our common stock at a total cost of approximately $59,695,000, a weighted average cost of $33.44 per share. The 215,000 shares of our common stock remaining under the program were repurchased and retired during the first four weeks of fiscal 2004 at a total cost of approximately $6,840,000, a weighted average cost of $31.82 per share. The following table summarizes our repurchases of shares of our common stock during fiscal 2003 and fiscal 2002:

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ITEM 6. SELECTED FINANCIAL DATA

Five-Year Selected Financial Data

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OVERVIEW

In fiscal 2003, we delivered the highest pre-tax operating margin and diluted earnings per share in our history, increased our return on assets and repurchased approximately 1.8 million shares of our common stock. Our net revenues for fiscal 2003 increased 16.7% to $2.75 billion and diluted earnings per share increased by 26.9% to $1.32.

Operationally in fiscal 2003, we deepened our commitment to multi-channel retailing by launching our newest concept, PBteen, in both the catalog and e-commerce website channels (generating approximately $50.0 million in revenues in ten months of operations), and by expanding our West Elm concept into both the retail and e-commerce website channels. We improved our supply chain cost structure and continued to invest in the infrastructure and systems necessary to drive future operational efficiencies. To support the growth in our core brands and to prepare for the expected growth in our new and emerging brands (PBteen, Hold Everything, West Elm, and Williams-Sonoma Home), we increased our distribution square footage by approximately 35% and upgraded our distribution operating systems.

In fiscal 2004, we will continue to engineer our businesses around the three key strategic initiatives that have driven our financial performance over the last several years — increasing profitable top-line sales growth; increasing our pre-tax operating margin as a percentage of sales; and delivering consistent and predictable earnings to our shareholders.

To drive profitable top-line sales growth in our core brands, we expect to increase our store leased square footage by approximately 8% to 9% (driven by the opening of 36 new stores, the remodeling of 19 stores, and the closure of 25 permanent or remodeled stores), increase catalog circulation, expand customer contacts through electronic direct marketing, and intensify the marketing support behind our bridal and gift registry businesses. On the operational side of the business, we expect to increase our order fulfillment rates in the direct-to-customer channel and reduce customer return rates.

In our emerging brands (PBteen, Hold Everything, West Elm, and Williams-Sonoma Home), we are focused on enhancing brand awareness and customer access to the brands. To achieve these initiatives we plan to identify new customers, increase catalog circulation, including the launch of our newest catalog, Williams-Sonoma Home, expand the use of electronic direct marketing, launch a Hold Everything e-commerce website, and add three new retail locations in the second half of the year (two in West Elm and one in Hold Everything). The Williams-Sonoma Home catalog is expected to be introduced in the third quarter of fiscal 2004 (replacing our existing Chambers catalog), and the Hold Everything e-commerce website is expected to be launched in the fourth quarter of fiscal 2004.

To support all of these brand-building initiatives, we will be continuing to invest in our long-term infrastructure, including increasing distribution capacity and implementing new information technology. Although these investments are being made in advance of the revenue stream, their impact on earnings is more than offset by our continued ability to drive greater efficiencies in our existing supply chain operations and overhead cost structure.

Although we are committed to our key strategic initiatives, there are inherent risks associated with our business and the retail industry as a whole that may present challenges for us in the future. We have outlined these risks within the “Risk Factors” section of the “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Annual Report on Form 10-K.

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.

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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 our 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 1, 2004 (“fiscal 2003”), the 52 weeks ended February 2, 2003 (“fiscal 2002”) and the 53 weeks ended February 3, 2002 (“fiscal 2001”).

Net revenues for fiscal 2003 increased by $393,538,000, or 16.7%, over fiscal 2002 and net revenues for fiscal 2002 increased by $274,168,000, or 13.1%, over fiscal 2001. The increase in both years was primarily due to the increase in store leased square footage of 11.8% and 17.2%, driven by 46 and 69 new store openings, 19 and 9 remodeled stores, and comparable stores sales growth of 4.0% and 2.7% in fiscal 2003 and fiscal 2002, respectively. The increase was further aided by growth in the number of catalogs circulated during both fiscal 2003 and fiscal 2002 by 17.4% and 14.1%, respectively, as well as the growth of the Pottery Barn, Pottery Barn Kids and Williams-Sonoma concepts. This increase was partially offset by the temporary closure of 21 and 9 stores and the permanent closure of 10 and 6 stores in fiscal 2003 and fiscal 2002, respectively.

RETAIL REVENUES AND OTHER DATA

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Retail revenues in fiscal 2003 increased by $198,390,000, or 13.9%, over fiscal 2002 primarily due to an increase in store leased square footage of 11.8%, driven by 46 new store openings and 19 remodeled stores, and a 4.0% increase in comparable store sales. This increase was partially offset by the temporary closure of 21 stores and the permanent closure of 10 stores during fiscal 2003. Pottery Barn and Pottery Barn Kids accounted for 64.0% of the growth in retail revenues from fiscal 2002 to fiscal 2003.

Retail revenues in fiscal 2002 increased by $187,182,000, or 15.1%, over fiscal 2001 primarily due to an increase in store leased square footage of 17.2%, driven by 69 new store openings and 9 remodeled stores and a 2.7% increase in comparable store sales. This increase was partially offset by the temporary closure of 9 stores and the permanent closure of 6 stores during fiscal 2002. 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, two stores were closed during fiscal 2002 and five stores were closed during fiscal 2003. 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 U.S. 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. In fiscal 2003, we opened an additional three retail stores in the Canadian market — one Williams-Sonoma and one Pottery Barn store in Toronto, and one Pottery Barn store in Vancouver, British Columbia.

Comparable Store Sales

Comparable stores are defined as those stores in which gross square footage did not change by more than 20% in the previous 12 months and which have been open for at least 12 consecutive months without closure for seven or more consecutive days. By measuring the year-over-year sales of merchandise in the stores that have a history of being open for a full comparable 12 months or more, we can better gauge how the core store base is performing since it excludes store expansions and closings. Percentages represent changes in comparable store sales versus the same period in the prior year.

Comparable store sales increases in 2003 for Williams-Sonoma were driven by the reinstatement to historical levels of inventory per retail square foot early in the year, a strong merchandise offering

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The lower Pottery Barn comparable store sales growth rate in fiscal 2003 versus fiscal 2002 was primarily due to a difficult year-over-year comparison in addition to a challenging in-stock position on certain core inventories during early fiscal 2003 and a soft consumer response to the first and second quarter merchandise assortments.

Comparable store sales in the Pottery Barn Kids concept continued to fluctuate during fiscal 2003. In fiscal 2003 we opened 22 new stores and expanded into 12 new markets. At the end of fiscal 2003 we operated 78 stores versus 56 stores in fiscal 2002. For the comparable store sales base calculation, 56 stores were included in fiscal 2003 and only 27 stores were included in fiscal 2002. The comparable store sales increase in Pottery Barn Kids was primarily driven by a strong performance in single store markets, higher in-stock positions in retail inventory levels, successful in-store marketing programs, and new merchandise assortments. We expect comparable store sales for Pottery Barn Kids stores in multi-store markets to remain volatile during the growth phase of the concept, consistent with our experience in the early years of the Pottery Barn store rollout.

The comparable store sales increases in the Outlets were primarily due to an increase in merchandise available for liquidation through the Outlets, versus the prior year.

DIRECT-TO-CUSTOMER REVENUES

Direct-to-customer revenues in fiscal 2003 increased by $195,148,000, or 20.8%, over fiscal 2002. This increase was primarily driven by net sales generated in the Pottery Barn and Pottery Barn Kids brands in addition to incremental sales from PBteen and West Elm. Net sales in the Pottery Barn brand were driven primarily by an increase in the number of catalogs circulated and the momentum in our Internet business where traffic on the website increased substantially over fiscal 2002 and where conversion rates (the percentage of visitors to our website who make a purchase) continued to exceed the industry norm. The net sales increase in the Pottery Barn Kids brand over fiscal 2002 was primarily driven by an increase in the number of catalogs circulated and increased productivity in on-line advertising, as well as the growth in our baby and gift registry sales.

In fiscal 2003, we launched our PBteen and West Elm e-commerce websites. In total, Internet sales increased $132,448,000, or 66.1%, to $332,850,000 in fiscal 2003, from $200,402,000 in fiscal 2002, primarily driven by the Pottery Barn and Pottery Barn Kids brands. Although the amount of Internet sales that are incremental to our direct-to-customer channel cannot be identified precisely, we estimate that approximately 50% to 60% of our non-bridal e-commerce sales are incremental to the direct-to-customer channels and approximately 40% to 50% are from mail order customers who recently received a catalog.

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 on-line advertising, 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. This increase was partially offset by lower sales in

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COST OF GOODS SOLD

Cost of goods and occupancy expenses, which consist primarily of our cost of merchandise, rent and rent related expenses (including common area maintenance and utilities), and depreciation expense, increased by $218,989,000 in fiscal 2003 over fiscal 2002. Cost of goods and occupancy expenses expressed as a percentage of net revenues for fiscal 2003 increased 20 basis points from fiscal 2002. This percentage increase was primarily driven by increased inventory shrinkage and other inventory related costs due to an overall increase in inventory levels in addition to the negative impact of the strengthened euro. This increase was partially offset by a substantial rate reduction in occupancy expenses. The rate reduction in occupancy expenses was attributable to a greater percentage of our total company net revenues being generated in the direct-to-customer channel, which does not incur store occupancy expenses.

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, principally due to 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.

Shipping costs consist of third-party delivery services and shipping materials. Shipping costs increased in fiscal 2003 and fiscal 2002 due to a higher number of direct-to-customer shipments associated with the increase in direct-to-customer sales as well as a shift in the mix of product being shipped, with furniture accounting for a greater portion of the overall mix. This increase was substantially offset by a lower cost per shipment due to the consolidation of freight providers and the successful renegotiation of freight-to-customer contracts. As a result of these efficiencies, shipping costs, as a percentage of shipping fees, have continued to decline to 82.7% in fiscal 2003 from 87.4% in fiscal 2002 and 102.9% in fiscal 2001.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses increased by $106,491,000 to $855,790,000 in fiscal 2003 from $749,299,000 in fiscal 2002, and as a percent of net revenues, decreased by 60 basis points to 31.1% in fiscal 2003 from 31.7% in fiscal 2002. The improvement in selling, general and administrative expenses as a percentage of net revenues was attributable to lower year-over-year employment expense, partially offset by an increase in catalog advertising expense. The employment cost decrease was primarily driven by a year-over-year reduction in incentive compensation and employee separation costs associated with the departure of our former Chief Executive Officer during fiscal 2002. The increase in catalog advertising expense as a percentage of net revenues was primarily driven by a greater percentage of total company net revenues in fiscal 2003 being generated by the direct-to-customer channel, which incurs substantially higher catalog advertising costs than the retail channel. In addition, significantly higher advertising costs as a percentage of net revenues were incurred in the new and emerging catalog concepts, PBteen and West Elm.

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

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INTEREST INCOME AND EXPENSE

Interest income, comprised primarily of income from short-term investments, was $873,000 in fiscal 2003, $1,421,000 in fiscal 2002, and $331,000 in fiscal 2001.

Interest expense, net of capitalized interest, decreased by $1,419,000 to $22,000 in fiscal 2003, primarily due to a higher level of capitalized interest on long-term capital projects in fiscal 2003 and lower interest expense on our senior notes and capital leases. Interest expense, net of capitalized interest, decreased by $4,758,000 to $1,441,000 in fiscal 2002, primarily due to the absence of any borrowings under our revolving line of credit facility in fiscal 2002. Interest expense, net of capitalized interest was $6,199,000 in fiscal 2001.

INCOME TAXES

Our effective tax rate was 38.5% for fiscal 2003, fiscal 2002 and fiscal 2001. We currently expect the fiscal 2004 effective tax rate to be 38.3%.

LIQUIDITY AND CAPITAL RESOURCES

As of February 1, 2004, we held $163,910,000 in cash and cash equivalent funds. As is consistent with our industry, our cash balances are seasonal in nature, with the fourth quarter representing a significantly higher level of cash than other periods. Throughout the fiscal year we utilize our cash balances to build our inventory levels in preparation for our fourth quarter holiday sales. In fiscal 2004, we plan to utilize our cash resources to fund our inventory and inventory related purchases, catalog advertising and marketing initiatives, and to support current store development and infrastructure strategies. In addition to the current cash balances on-hand, we have a $200,000,000 credit facility available as of February 1, 2004. This facility, however, was not borrowed against by us in either fiscal 2003 or fiscal 2002. We believe our cash on-hand, in addition to our available credit facilities, will provide adequate liquidity for our business operations and growth opportunities during fiscal 2004.

In fiscal 2003, net cash provided by operating activities was $209,351,000 as compared to net cash provided by operating activities of $310,160,000 in fiscal 2002. The cash provided by operating activities in fiscal 2003 was primarily attributable to net earnings, an increase in our deferred rent and lease incentives due to an increase in retail store openings, and an increase in our accrued salary, benefits, customer deposits and other expenses due to an increase in unredeemed gift certificates, offset primarily by an increase in merchandise inventories. Our merchandise inventories increased in fiscal 2003 due to an increase in our leased and selling square footage of 11.8% and 11.4%, respectively, and our decision to increase our in-stock position on core merchandise inventories.

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 was 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 was primarily a result of a 17.1% increase in selling square footage and a management initiative to improve order fulfillment and customer satisfaction.

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Net cash used in investing activities was $211,979,000 for fiscal 2003 as compared to $155,450,000 in fiscal 2002. Fiscal 2003 purchases of property and equipment were $211,979,000, comprised of $109,145,000 for 46 new and 19 remodeled stores, $56,083,000 for systems development projects (including e-commerce websites) and $46,751,000 for distribution and facility infrastructure projects (including the purchase of a corporate aircraft for approximately $36,980,000). We invested in the corporate aircraft in response to the increasing complexity of our global sourcing program (representing 61% of annual inventory purchases from 41 foreign countries), the continued expansion of our retail stores and distribution centers and the increasing difficulty and risks associated with worldwide travel.

In fiscal 2004, we anticipate investing $180,000,000 to $190,000,000 in the purchase of property and equipment, primarily for the construction of 36 new stores and 19 remodeled stores, systems development projects (including e-commerce websites), and distribution and facility infrastructure projects.

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, comprised of $107,214,000 for 69 new and 9 remodeled or expanded stores, $44,677,000 for systems development projects (including e-commerce websites) and $4,290,000 for distribution and facility infrastructure projects.

For fiscal 2003, cash used in financing activities was $28,226,000, comprised primarily of $59,695,000 for the repurchase of common stock and $7,610,000 for the repayment of long-term obligations, including capital leases and long-term debt, partially offset by $39,120,000 in proceeds from the exercise of stock options.

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 in proceeds from the exercise of stock options.

Stock Repurchase Program

In January 2003, the Board of Directors authorized a stock repurchase program to acquire up to 4,000,000 shares of our outstanding common stock in the open market. During the fourth quarter of fiscal 2002, we repurchased and retired 2,000,000 shares of our common stock at a total cost of approximately $48,361,000, a weighted average cost of $24.18 per share. In the fourth quarter of fiscal 2003, we repurchased and retired an additional 1,785,000 shares of our common stock at a total cost of approximately $59,695,000, a weighted average cost of $33.44 per share. The 215,000 shares of our common stock remaining under the program were repurchased and retired during the first four weeks of fiscal 2004 at a total cost of approximately $6,840,000, a weighted average cost of $31.82 per share.

Contractual Obligations

The following table provides summary information concerning our future contractual obligations as of February 1, 2004.

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Long-Term Debt

Capital Leases

Other Contractual Obligations

Commercial Commitments

The following table provides summary information concerning our outstanding commercial commitments as of February 1, 2004.

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 1, 2004, approximately $33,098,000 was outstanding on the bonds. We are required to make annual rental payments of approximately $3,674,000, 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 1, 2004, approximately $36,003,000 was outstanding on the bonds. We are required to make annual rental payments of approximately $4,178,000, plus applicable taxes, insurance and maintenance expenses.

In December 2003, we entered into an agreement to lease an additional 780,000 square foot distribution facility located in Olive Branch, Mississippi. The lease has an initial term of six years, with two optional, two-year renewals. The agreement includes an option to lease an additional 333,000 square feet of the same distribution center. As of February 1, 2004, we had not exercised this option. We are required to make annual rental payments of approximately $1,927,000, plus applicable taxes, insurance and maintenance expenses.

Subsequent to our fiscal year-end, we entered into an agreement to lease 781,000 square feet of a distribution center located in Cranbury, New Jersey. The lease has an initial term of seven years, with three optional five-year renewals. The agreement requires us to lease an additional 219,000 square feet of the facility in the event the current tenant vacates the premises. Rent expense on the facility will be approximately $4.35 per square foot, plus applicable taxes, insurance and maintenance expenses.

In November 2002, the FASB issued FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which requires certain guarantees to be recorded at fair value. The interpretation also requires a guarantor to make new disclosures, even when the likelihood of making any payments under the guarantee is remote. In general, the interpretation applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying obligation that is related to an asset,

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In addition to the aircraft lease, we are party to a variety of contractual agreements under which we may be obligated to indemnify the other party for certain matters. These contracts primarily relate to our commercial contracts, operating leases, trademarks, intellectual property, financial agreements and various other agreements. Under these contracts, we may provide certain routine indemnifications relating to representations and warranties or personal injury matters. The terms of these indemnifications range in duration and may not be explicitly defined. Historically, we have not made significant payments for these indemnifications. We believe that if we were to incur a loss in any of these matters, the loss would not have a material effect on our financial condition or results of operations.

CONSOLIDATION OF MEMPHIS-BASED DISTRIBUTION FACILITIES

Our Memphis-based distribution facilities include an operating lease entered into in July 1983 for a distribution facility in Memphis, Tennessee. The lessor is a general partnership (“Partnership 1”) comprised of W. Howard Lester, Chairman of the Board of Directors and a significant shareholder of ours, and James A. McMahan, a Director Emeritus and a significant shareholder of ours. Partnership 1 does not have operations separate from the leasing of this distribution facility to us and does not have lease agreements with any unrelated third parties.

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 1, 2004, $2,785,000 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 (2.1% in February 2004), 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.

Our other Memphis-based distribution facility includes 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 of W. Howard Lester, James A. McMahan and two unrelated parties. Partnership 2 does not have operations separate from the leasing of this distribution facility to us and does not have lease agreements with any unrelated third parties.

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 1, 2004, $15,438,000 was outstanding under the Partnership 2 Industrial Development Bonds.

The operating lease for this distribution facility requires us to pay annual rent of approximately $2,600,000, 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.

As of February 1, 2004, the Company adopted FIN 46R. FIN 46R requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively

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IMPACT OF INFLATION

The impact of inflation on our results of operations for the past three fiscal years has not been significant.

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 we believe 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

Property and Equipment

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We review the carrying value of all long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we review for impairment all stores for which current cash flows from operations are negative or the construction costs are significantly in excess of the amount originally expected. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease. Our estimate of undiscounted future cash flows is based upon our experience, historical operations of the stores, estimates of future store profitability and economic conditions. The amount recorded for impairment is equal to the difference between the carrying value and the asset’s fair value. The fair value is estimated based upon future cash flows discounted at our weighted-average cost of capital. See Note A to the Consolidated Financial Statements for additional information regarding property and equipment.

Stock-Based Compensation

Inventory Reserves

Catalog Amortization

Self-Insured Liabilities

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Income Taxes

RISK FACTORS

The following information describes certain significant risks and uncertainties inherent in our business. You should carefully consider such risks and uncertainties, 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 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, or other liquidation channels, 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 U.S. 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 income, recession and fears of recession, war and fears of war, inclement weather, consumer debt, interest rates, sales tax rates and rate increases, consumer confidence in future economic conditions and political conditions, and consumer perceptions of personal well-being and security generally. Adverse changes in factors affecting discretionary consumer spending could reduce consumer demand for our products, thus reducing our sales and harming our business and operating results.

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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 e-commerce 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:

	•	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, we may not be able to compete successfully. Increased competition could adversely affect our sales, operating results and business.

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. We may not 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 an 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 41 countries outside of the U.S. Specifically, in fiscal 2003, approximately 61% 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,

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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, concerns over anti-dumping, work stoppages, economic uncertainties (including inflation), foreign government regulations, wars and fears of war, political unrest and other 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 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 such as fair labor standards and the prohibition on child labor. Non-governmental organizations might attempt to create an unfavorable impression of our sourcing practices or the practices of some of our vendors that could harm our image. If either of these occurs, we could lose customer goodwill and favorable brand recognition, which could negatively affect our business and operating results.

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 59% of our net revenues. We expect an increase of approximately 36 new and 19 remodeled retail stores in fiscal 2004 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. We may not be able to open new stores or, if opened, operate those stores profitably.

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 and the reliable data regarding the timing of those shipments, including shipments to our customers and to and from all of our stores. Accordingly, we are subject to the risks,

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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 our releases of new merchandise and promotional events, the success of marketing programs, and the 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 2003, 2002 and 2001 were 4.0%, 2.7% and 1.7%, respectively. Past comparable store sales are no indication of future results, and comparable store sales may 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, paper, printing costs and other catalog distribution 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 increase in the future. Although we have entered into long-term contracts for catalog paper and catalog printing, these contracts offer no assurance that our catalog

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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. Environmental organizations may attempt to create an unfavorable impression of our paper use in 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 Internet 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 in our Internet business, as well as damage our reputation and brands.

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. Actual merchandise returns may exceed our reserves. In addition, the introduction of new merchandise, changes in merchandise mix, changes in consumer confidence, or other competitive and general economic conditions may cause actual returns to exceed merchandise return reserves. Any significant increase in merchandise returns that exceeds our reserves could materially affect our business and operating results.

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 Internet 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 Internet business might cannibalize a significant portion of our retail and catalog businesses. While we recognize that our Internet 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 e-commerce 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 Internet business grows, it will not cannibalize a portion of our retail and catalog businesses.

We may not be able to introduce new brands and brand extensions that improve our business.

We have recently introduced two new brands, PBteen and West Elm, and expect to introduce additional new brands such as Williams-Sonoma Home and brand extensions in the future. 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 potential migration of existing brand customers to the new businesses. We may not be able to introduce new brands and brand extensions that improve our overall business and operating results.

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

During fiscal 2003, the increase in the cost of insurance moderated. However, insurance costs continue to be volatile, affected by natural catastrophes, fear of terrorism and financial irregularities and other fraud at publicly-traded companies. We believe that commercial insurance coverage is prudent for risk management and insurance costs may increase substantially in the future. In addition, for certain types or levels of risk, such as 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.

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. We may not be able to adequately protect our intellectual property. In addition, the costs of defending our intellectual property may 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 Internet business. The plaintiff in each case claims to hold a patent that covers certain website technology, which is allegedly infringed by the operation of the defendants’ e-commerce websites. We are currently a defendant in one such patent infringement case 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. Additional patent infringement claims may be brought against us, and the cost of defending such claims or the ultimate resolution of such claims may harm 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, we may not be able to 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 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. We may not successfully launch these new systems or

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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.

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, such funds may not 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.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

For one of the operating leases with a variable interest rate (2.4% at February 1, 2004), we have an interest rate cap contract at 5.88% with a notional amount as of February 1, 2004 of $12,083,000 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. Any gain or loss associated with this contract was recorded in selling, general, and administrative expenses and was not material to us in fiscal 2003, fiscal 2002, and fiscal 2001.

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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

As of February 1, 2004, we have 11 retail stores in Canada, which expose us to market risk associated with foreign currency exchange rate fluctuations. As necessary, we utilize 30-day foreign currency contracts to minimize any currency remeasurement risk associated with intercompany assets and liabilities of our Canadian subsidiary. These contracts are accounted for by adjusting the carrying amount of the contract to market and recognizing any gain or loss in selling, general and administrative expenses in each reporting period. We did not enter into any new contracts during fiscal 2003. Any gain or loss associated with these contracts in prior years was not material to us.

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Williams-Sonoma, Inc.

See Notes to Consolidated Financial Statements.

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Williams-Sonoma, Inc.