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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-K

Commission file number 000-24261

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

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

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

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

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

COMMON STOCK, $0.0001 PAR VALUE
(Title of class)

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

          Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) 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 Exchange Act).    ý  Yes    o  No

          The aggregate market value of common stock held by non-affiliates of the registrant was approximately $126,350,988 as of August 2, 2002 based upon the closing price of the registrant's common stock on The Nasdaq National Market reported for August 2, 2002. For purposes of this calculation, the registrant has assumed that only shares beneficially held by executive officers and directors of the registrant are deemed shares held by affiliates of the registrant. This assumption of affiliate status is not necessarily a conclusive determination of affiliate status for any other purpose.

          30,054,567 shares of the registrant's $.0001 par value common stock were outstanding on April 25, 2003.

TABLE OF CONTENTS

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

Documents Incorporated by Reference

        Portions of the registrant's proxy statement for its 2003 annual meeting of stockholders are incorporated by reference into Item 5 of Part II and Items 10,11, 12 and 13 of Part III of this Form 10-K.

PART I

ITEM 1. BUSINESS

GENERAL

        Our company, Restoration Hardware, Inc., together with our subsidiaries, is a specialty retailer of home furnishings, functional and decorative hardware and related merchandise that reflects our classic and authentic American point of view. We market our merchandise through retail locations, mail order catalogs and on the worldwide web at www.restorationhardware.com. Our merchandise strategy and our stores' architectural style create a unique and attractive selling environment designed to appeal to an affluent, well educated 35 to 60 year old customer. We were incorporated in California in June 1987 and were reincorporated in Delaware in 1998. We operated 105 stores in 31 states, the District of Columbia and in Canada at February 1, 2003. We operate on a 52 - 53 week fiscal year ending on the Saturday closest to January 31. The 2002 fiscal year was a 52-week year and ended on February 1, 2003.

        In addition to our retail stores, we operate a direct-to-customer sales channel which includes both catalog and Internet, and a wholly-owned furniture manufacturer. For additional information, see Note 13 to our consolidated financial statements in Part II, Item 8 of this annual report on Form 10-K.

        We commenced business in 1979 as a purveyor of fittings and fixtures for older homes. Since then, we have evolved into a unique home furnishings retailer offering consumers an array of distinctive, high quality and often hard-to-find merchandise. We display our broad assortment of merchandise in an architecturally inviting setting. Our product includes classic, high-quality furniture, lighting, home furnishings, premium-positioned home textiles and functional and decorative hardware. Our plan is to fill the void in the marketplace above the current home lifestyle retailers, and below the interior design trade.

        In 2001, we developed and initiated our repositioning plan for the company. The central component of this plan was the launch of a new merchandising strategy in April 2002, which included new merchandise offerings, adjustments of overall product mix, and the remodeling of our stores in order to best present the new merchandise. Other key elements of the plan included our fiscal 2001 equity financings which allowed us to reduce our debt, upgrading our management team, eliminating under-performing products and reducing the overall number of items in the merchandise assortment, closing under-performing stores, and growing our direct-to-customer business.

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

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        We make available free of charge through our website at www.restorationhardware.com under "Company Info" our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to these and other reports filed or furnished by us pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable after we file such materials with the Securities and Exchange Commission.

RETAIL STORES

Merchandising Mix

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

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

        The home furnishings category includes furniture, lighting and textiles. The hardware and accessories category includes bath and other functional and decorative hardware; vases, frames, and other accessories; seasonal merchandise such as holiday and garden; and gift items.

Product Selection, Purchasing and Sourcing

        We make merchandise purchases from over 400 vendors, almost half of which are located abroad. These vendors include major domestic manufacturers, specialty niche manufacturers and importers. We maintain agents in China, England, France, Japan, India, Portugal and Eastern Europe, and our merchandising team travels to Asia and Europe in search of new products. By sourcing a large proportion of products offshore, we seek to achieve increased buying effectiveness and ensure exclusivity for a portion of our product line. In many instances, we also work closely with our vendors to develop products that are unique to us.

DIRECT-TO-CUSTOMER—CATALOG AND INTERNET

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

        In the fiscal year ended February 1, 2003 ("fiscal 2002"), we distributed approximately 29.9 million catalogs as compared to approximately 20.5 million catalogs in the fiscal year ended February 2, 2002 ("fiscal 2001"). We mail catalogs to persons with demographic profiles similar to those of our retail customers and who also possess previous mail order purchase histories. In fiscal 2002, approximately 61% of catalogs were circulated to past customers, and the remaining catalogs were mailed to prospects. These prospects were obtained primarily from customer lists of other high-end mail order companies sharing similar customer demographics. We outsource to a third party the fulfillment aspects of the direct-to-customer business, including telemarketing, customer service and distribution.

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

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THE MICHAELS FURNITURE COMPANY, INC.

        Purchased by Restoration Hardware in 1998, The Michaels Furniture Company, Inc. ("Michaels") offers a line of furniture for the home and office. Specific product lines include living room, bedroom, dining room, home office and accessory items. Intercompany sales to Restoration Hardware represented virtually all of Michaels' total sales during fiscal 2002, and this trend is expected to continue. Michaels is located in Sacramento, California.

MANAGEMENT INFORMATION SYSTEMS

        Our retail management information systems include fully integrated store, merchandising, distribution and financial systems. We utilize STS Systems for our point-of-sale, merchandise management and warehouse management systems, and rely on STS for software support.

COMPETITION

        The retail market is highly competitive. We compete against a diverse group of retailers ranging from specialty stores to traditional furniture stores and department stores. Our product offerings also compete with a variety of national, regional and local retailers. We also compete with these and other retailers for customers, suitable retail locations, suppliers and qualified employees and management personnel. Many of our competitors have significantly greater financial, marketing and other resources. Moreover, increased competition may result, and has resulted, in potential or actual litigation between us and our competitors relating to such activities as competitive sales and hiring practices, exclusive relationships with key suppliers and manufacturers and other matters. As a result, increased competition may adversely affect our financial performance, and we cannot assure you that we will be able to compete successfully in the future.

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

TRADEMARKS

        We have registered our trademark "Restoration Hardware" in the United States, Mexico and Canada. Trademarks are generally valid as long as they are in use and their registrations can generally be renewed indefinitely so long as the marks are in use. Our trademark is of material importance to us.

EMPLOYEES

        At February 1, 2003, we had approximately 1,400 full-time employees and 1,800 part-time employees. We consider our employee relations to be good. None of our employees are represented by a collective bargaining agreement, nor have we ever experienced any work stoppage.

FACTORS THAT MAY AFFECT OUR FUTURE OPERATING RESULTS

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

        Our success depends on our ability to anticipate and respond to changing merchandise trends and consumer demands in a timely manner. If, for example, we misjudge market trends, we may significantly overstock unpopular products and be forced to take significant inventory markdowns, which would have a negative impact on our operating results. Conversely, shortages of popular items could result in loss of sales revenues and have a material adverse effect on our operating results.

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

        In fiscal 2002, we opened one new store and closed no existing stores. However, we are evaluating six to eight under-performing stores for potential closures through 2004. A material decline in sales and other adverse conditions resulting from our failure to accurately anticipate changes in merchandise trends and consumer demands may require us to close additional under-performing stores. The closure of such stores would subject us to additional costs including, but not limited to, employee severance costs, charges in connection with the impairment of assets and costs associated with the disposition of outstanding lease obligations.

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

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

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

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

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

        We expend a large amount of our available funds on advertising in advance of a particular season. Moreover, our advertising costs for the past three fiscal years have increased from approximately $14.9 million per year to approximately $23.5 million per year, and we expect to have similarly large advertising expenditures during the next fiscal year. As a result, if we misjudge the directions or trends in our market, we may expend large amounts of our cash on advertising that generates little return on investment, which would have a negative effect on our operating results. During the last three fiscal years, our advertising costs have increased while only recently have we had a corresponding revenue

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increase. If we spend increasing amounts of our cash on advertising without achieving overall revenue increases, it would have a negative impact on our operating results.

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

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

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

        A variety of factors affect our comparable store sales including, among other things, the general retail sales environment, our ability to efficiently source and distribute products, changes in our merchandise mix, promotional events, the impact of competition and our ability to execute our business strategy efficiently. Our comparable store sales results have fluctuated significantly in the past, and we believe that such fluctuations may continue. Our comparable store sales increased 6.2% in fiscal 2002, decreased 4.6% in fiscal 2001, and decreased 1% in the fiscal year ended February 3, 2001 ("fiscal 2000"). Past comparable store sales results may not be indicative of future results. As a result, the unpredictability of our comparable store sales may cause our revenues and operating results to vary from quarter to quarter, and an unanticipated decline in revenues may cause our stock price to fluctuate.

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

        We make merchandise purchases from over 400 vendors. Our performance depends on our ability to purchase our merchandise in sufficient quantities at competitive prices. Although we have many sources of merchandise, two of our vendors, Mitchell Gold, a manufacturer of upholstered furniture, and Robert Abbey Inc., a manufacturer of table and floor lamps, together accounted for approximately 16% of our aggregate merchandise purchases in fiscal 2002. In addition, our smaller vendors generally have limited resources, production capacities and operating histories, and some of our vendors have limited the distribution of their merchandise in the past. We have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products, and any vendor or distributor could discontinue selling to us at any time. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future, or be able to develop relationships with new vendors to expand our options or replace discontinued vendors. Our inability to acquire suitable merchandise in the future or the loss of one or more key vendors and our failure to replace any one or more of them may have a material adverse effect on our business, results of operations and financial condition.

        In addition, a single vendor supports the majority of our management information systems. A failure by the vendor to support our management information systems adequately in the future could have a material adverse effect on our business, results of operations and financial condition.

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        We have recently begun purchasing products from a number of new vendors, many of whom are located abroad. We cannot assure you that they will be reliable sources of our products. Moreover, a number of these manufacturers and suppliers are small and undercapitalized firms that produce limited numbers of items. Given their limited resources, these firms might be susceptible to production difficulties, quality control issues and problems in delivering agreed-upon quantities on schedule. We cannot assure you that we will be able, if necessary, to return products to these suppliers and obtain refunds of our purchase price or obtain reimbursement or indemnification from them if their products prove defective. These suppliers and manufacturers also may be unable to withstand the current downturn in the U.S. or worldwide economy. Significant failures on the part of these new suppliers or manufacturers could have a material adverse effect on our operating results.

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

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

        The distribution functions for our stores are currently handled from our facilities in Hayward and Tracy, California and Baltimore, Maryland. Any significant interruption in the operation of any of these facilities may delay shipment of merchandise to our stores and customers, damage our reputation or otherwise have a material adverse effect on our financial condition and results of operations. Moreover, a failure to successfully coordinate the operations of these facilities also could have a material adverse effect on our financial condition and results of operations. Significant disruptions to the operations of the third party vendor who handles the distribution and fulfillment functions for our direct-to-customer business on an outsourced basis could be expected to have similar negative consequences.

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

        We have significantly relied and may rely in the future on external funding sources to finance our operations and growth. Any reduction in cash flow from operations could increase our external funding requirements to levels above those currently available to us. While we currently have in place a $72.0 million credit facility, the amount available under this facility may be less than the $72.0 million stated maximum limit of the facility because the availability of eligible collateral for purposes of the borrowing base limitations in the credit facility usually reduces the overall credit amount otherwise available at any given time. We currently believe that our cash flow from operations and funds available under our credit facility will satisfy our capital requirements for at least the next 12 months. However, the weakening of, or other adverse developments concerning, our sales performance or adverse developments concerning the availability of credit under our credit facility due to covenant limitations or other factors could limit the overall availability of funds to us.

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

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

        Our business requires substantial liquidity in order to finance inventory purchases, the employment of sales personnel for the peak holiday period, publicity for the holiday buying season and other similar advance expenses. We currently have in place a credit facility with a syndicate of lenders, which includes Fleet Capital Corporation. The facility provides for an overall commitment of $72.0 million, of which $25.0 million is available for letters of credit. Over the past several years, we have entered into numerous modifications of this credit facility, primarily to address changes in the requirements to which we are subject. Additionally, in August 2002, we further amended the credit facility, primarily to: 1) reduce the overall commitment from $80.0 million to $72.0 million; 2) to provide, at our election, for an additional $5.0 million of availability above the maximum available designated by formula for any continuous 60-day period between August 1^st and October 31^st for any year (not to exceed the $72.0 million overall commitment); 3) to extend the expiration date of the credit facility by twelve months to June 30, 2004; and (4) to provide a more favorable interest structure. Finally, in November 2002, we amended and restated the credit facility to reflect a number of minor revisions and updates to the then-existing credit facility documentation.

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

        We have drawn upon the credit facility in the past and we expect to draw upon it in the future. As a result, failure to comply with the terms of the credit facility would entitle the secured lenders to foreclose on our assets, including our accounts receivable, inventory, general intangibles, equipment, goods, and fixtures. The secured lenders would be repaid from the proceeds of the liquidation of those assets before the assets would be available for distribution to other creditors and, lastly, to the holders of our capital stock. Our ability to satisfy the restrictive covenants may be affected by events beyond our control.

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

        High levels of interest and other expense have and could have negative effects on our operations. While our credit facility was amended at various times in 2001 and 2002 to provide us with more favorable interest rates and changes to some requirements, a significant portion of our cash flow from operations was used to pay our interest expense and was not available for other business purposes.

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

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

        For fiscal 2002, we purchased approximately 45% of our merchandise directly from vendors located abroad and expect that such purchases will increase as a percentage of total merchandise purchases for

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the fiscal year ending on January 31, 2004. As an importer, our future success will depend in large measure upon our ability to maintain our existing foreign supplier relationships and to develop new ones. While we rely on our long-term relationships with our foreign vendors, we have no long-term contracts with them. Additionally, many of our imported products are subject to existing duties, tariffs and quotas that may limit the quantity of some types of goods which we may import into the United States. Our dependence on foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, changes in import duties, tariffs and quotas, loss of "most favored nation" trading status by the United States in relation to a particular foreign country, work stoppages, delays in shipments, freight cost increases, economic uncertainties, including inflation, foreign government regulations, and political unrest and trade restrictions, including the United States retaliating against protectionist foreign trade practices. If any of these or other factors were to render the conduct of business in particular countries undesirable or impractical, our financial condition and results of operations could be materially adversely affected.

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

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

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

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

        We have invested additional resources in the expansion of our direct-to-customer business that could increase the risks associated with aspects of this business. In fiscal 2002, sales through our direct-to-customer channel grew by 33% as compared to the prior fiscal year. Increased activity in our direct-to-customer business could result in material changes in our operating costs, including increased merchandise inventory costs and costs for paper and postage associated with the distribution and shipping of catalogs and products. Although we intend to attempt to mitigate the impact of these increases by improving sales revenue and efficiencies, we cannot assure you that we will succeed in mitigating expenses with increased efficiency or that cost increases associated with our direct-to-customer business will not have an adverse effect on the profitability of our business. Additionally, while we outsource to a third party the fulfillment of our direct-to-customer division, including telemarketing, customer service and distribution, the third party may not have the capacity to accommodate our growth. This lack of capacity may result in delayed customer orders and deficiencies in customer service, both of which may adversely affect our reputation and cause us to lose sales revenue.

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

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

        The success of our business will continue to depend upon our key personnel, including our President and Chief Executive Officer, Gary G. Friedman. Competition for qualified employees and personnel in the retail industry is intense. The process of locating personnel with the combination of skills and attributes required to carry out our goals is often lengthy. In July 2001, our then Chief Financial Officer departed and was not replaced until December of 2001. Moreover, recent turnover in personnel and the recruitment and retention of new accounting staff for our finance department have created challenges for us. While we retained a new Corporate Controller in November 2002 and have made additional changes to our finance department and its staff, we have experienced difficulties in the transition and re-organization of our finance department and may experience similar or other difficulties related to this process in the future. Our ongoing efforts to improve our accounting controls and procedures may be hampered if we experience further difficulties in the transition and re-organization of our finance department.

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

Rapid growth of our company followed by changes in general economic conditions have impacted our profitability.

        In fiscal 2000, we experienced rapid growth and, as a result, our costs and expenditures outpaced our revenues. Following this growth, the economy in the United States began to weaken, while our costs and expenditures remained significant. The combination of these two factors affected our profitability. As a result, even though we took steps to reduce our costs and expenditures in fiscal 2001 and fiscal 2002, we were not profitable in fiscal 2000, 2001 or 2002. If similar factors continue to operate unmitigated, there will be a material adverse effect on our business, operating results and financial condition.

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

        The success of our business depends to a significant extent upon the level of consumer spending. A number of economic conditions affect the level of consumer spending on merchandise that we offer, including, among other things, the general state of the economy, general business conditions, the level of consumer debt, interest rates, taxation and consumer confidence in future economic conditions. More generally, reduced consumer confidence and spending may result in reduced demand for our products and limitations on our ability to increase prices, and may also require increased levels of selling and promotional expenses. Adverse economic conditions and any related decrease in consumer demand for discretionary items such as those offered by us could have a material adverse effect on our business, results of operations and financial condition.

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We face an extremely competitive specialty retail business market.

        The retail market is highly competitive. We compete against a diverse group of retailers ranging from specialty stores to traditional furniture stores and department stores. Our product offerings also compete with a variety of national, regional and local retailers. We also compete with these and other retailers for customers, suitable retail locations, suppliers and qualified employees and management personnel. Many of our competitors have significantly greater financial, marketing and other resources. Moreover, increased competition may result, and has resulted in the past, in potential or actual litigation between us and our competitors relating to such activities as competitive sales and hiring practices, exclusive relationships with key suppliers and manufacturers and other matters. As a result, increased competition may adversely affect our future financial performance, and we cannot assure you that we will be able to compete successfully in the future.

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

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

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

Our common stock price may be volatile.

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

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

        We cannot predict the effect, if any, that future sales of shares of our common stock or the availability for future sale of shares of our common stock or securities convertible into or exercisable for our common stock will have on the market price of our common stock prevailing from time to time. For example, in connection with our May 2001 common stock financing, we filed a registration statement on Form S-3 with the Securities and Exchange Commission to register approximately 4.5 million shares of our common stock acquired by the investors in the financing. The registration statement became effective on July 6, 2001. Additionally, in connection with our March 2001 preferred stock financing, we filed a registration statement on Form S-3 with the Securities and Exchange Commission to register approximately 6.4 million shares of our common stock issued, or to be issued, upon the conversion of our Series A preferred stock to some of our stockholders. And, in connection with our November 2001 common stock financing, we filed a registration statement on Form S-3 with the Securities and Exchange Commission to register approximately 4.5 million shares of our common stock issued to the investors in the financing. The latter two registration statements were declared effective by the Securities and Exchange Commission on October 31, 2002. Sale, or the availability for sale, of substantial amounts of common stock by our existing stockholders pursuant to an effective registration statement or under Rule 144, through the exercise of registration rights or the issuance of shares of common stock upon the exercise of stock options, or the conversion of our preferred stock, or the perception that such sales or issuances could occur, could adversely affect prevailing market prices for our common stock and could materially impair our future ability to raise capital through an offering of equity securities.

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

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

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

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

ITEM 2. PROPERTIES

        We currently lease three properties located in Corte Madera, California, which are used as our headquarters. The first property in Corte Madera consists of approximately 3,600 square feet of office space and approximately 18,000 square feet of warehouse space. The lease expires on December 31, 2003. The second and third properties in Corte Madera consist of approximately 34,000 square feet of office space in total and the leases expire on May 15, 2004.

        In connection with all of our business segments, we lease approximately 160,000 square feet of warehouse space in Hayward, California, for use as our west coast distribution center. This lease expires on July 31, 2004, with an option to extend for one additional five-year term. We lease an additional 191,000 square feet of warehouse space in Tracy, California, also for use as a distribution center. This lease expires on March 25, 2004, with an option to renew for one additional three-year term. We lease approximately 276,000 square feet of warehouse space in Baltimore, Maryland, for use as our east coast distribution center. The lease expires on September 30, 2006, with options to extend for two additional three-year terms.

        In connection with our retail business segment, as of February 1, 2003, we leased approximately 1,195,000 gross square feet for our 105 retail stores. Our retail stores' lease terms range from 3 to 20 years. Most leases for our retail stores provide for a minimum rent, typically including escalating rent increases, plus a percentage rent based upon sales after certain minimum thresholds are achieved. The leases generally require us to pay insurance, utilities, real estate taxes, and repair and maintenance expenses.

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

ITEM 3. LEGAL PROCEEDINGS

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

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

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

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PART II

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

MARKET INFORMATION

        Our common stock is listed on The Nasdaq National Market under the symbol "RSTO." The closing price of our common stock on Nasdaq was $3.82 on April 25, 2003.

STOCKHOLDERS

        As of April 25, 2003 there were 206 common stockholders of record of our common stock. This number excludes stockholders whose stock is held in nominee or street name by brokers.

DIVIDEND POLICY

        No dividends have been declared on our common stock since our 1998 initial public offering and it is not anticipated that we will pay any dividends in the foreseeable future on our common stock. In addition, restrictive covenants in our credit facility prohibit our payment of dividends and protective provisions in our Certificate of Designation of Series A and Series B Preferred Stock require the approval of two-thirds of the then outstanding shares of our Series A preferred stock, voting together as a single class, for us to declare or pay any dividend on any shares of common stock.

STOCK PRICE INFORMATION

        Set forth below are the high and low closing sale prices for shares of our common stock for each quarter during the fiscal years ended February 1, 2003 and February 2, 2002 as reported by The Nasdaq National Market.

        Information relating to the securities authorized for issuance under equity compensation plans will be set forth in the section with the caption "Equity Compensation Plan Information" in our definitive proxy statement. This information is incorporated herein by reference.

ITEM 6. SELECTED FINANCIAL DATA

        The following table sets forth selected, consolidated financial information for operations for the years indicated. This information is qualified by reference to and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," the

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consolidated financial statements, related notes thereto and other financial data included elsewhere in this annual report. The following results may not be indicative of our future operating results.

(1)

The results of operations and financial position data for fiscal 2001 give effect to a restatement of previously issued financial statements, as discussed in Note 17 of our consolidated financial statements in Part II, Item 8 of this annual report on Form 10-K.

(2)

Fiscal 2000 was a 53-week year. For purposes of the calculation of comparable store growth, results were calculated to correspond with a 52-week fiscal year.

(3)

The results of operations for 1998 include the results of Michaels from the date of acquisition on March 20, 1998.

(4)

Comparable store sales are defined as sales from stores whose gross square footage did not change by more than 20% in the previous 12 months and which have been open at least 12 full months. Stores generally become comparable in their 14th full month of operation.

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

        The following management's discussion and analysis of financial condition and results of operations gives effect to the restatement discussed in Note 17 of our consolidated financial statements in Part II, Item 8 of this annual report on Form 10-K.

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RESULTS OF OPERATIONS

Net Sales

        Net sales consist of the following components:

        Net sales for the 52 weeks ended February 1, 2003 ("fiscal 2002"), increased $33.9 million or 9.2% over net sales for the 52 weeks ended February 2, 2002 ("fiscal 2001"). The increase in total net sales was due to a $22.8 million increase in net sales from our retail stores and an $11.1 million increase in net sales from our direct-to-customer channel. We believe that these increases were a result of implementing our repositioning strategy in fiscal 2002, including introduction of new product lines, in particular our premium-positioned textiles; re-modeling our stores; increases in advertising and events associated with the re-launch of our remodeled stores; redesigning our catalog and website; and increases in the number of catalogs mailed, which drive sales in all channels.

        Net sales for fiscal 2001 (a 52 week year), increased $0.2 million or 0.1% over net sales for the 53 weeks ended February 3, 2001 ("fiscal 2000"). A decrease of $9.9 million in net sales from stores and a $0.9 million decrease in furniture manufacturing sales was offset by an increase of $11.0 million in net sales from our direct-to-customer channel. In addition to negative comparisons as a result of the extra week of sales in the prior year, we believe that fiscal 2001 net revenues were affected by the deterioration in the general economic environment which began in 2001, the events of September 11, 2001, and the transitional discounting and inventory reduction activity associated with the implementation of our new merchandising strategy.

        Furniture manufacturing sales were made only to employees in fiscal 2002 and 2001, and primarily to third parties in fiscal 2000.

        Total net sales include shipping fees of $8.4 million, $7.1 million and $5.7 million for fiscal 2002, fiscal 2001, and fiscal 2000, respectively. As of February 1, 2003, we operated 105 stores in 31 states, the District of Columbia and Canada.

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Retail Sales

        Retail sales increased by $22.8 million or 6.9% in fiscal 2002 as compared to fiscal 2001, primarily due to a $20.4 million or 6.2% increase in comparable store sales. Compared to fiscal 2001, one new store and a warehouse sale event in fiscal 2002 accounted for increased sales of $5.0 million, offset by a decrease of $2.7 million as a result of fiscal 2001 store closures. The comparable store sales increase resulted from the implementation of our repositioning strategy as described above; in particular, the introduction of our premium-positioned textiles, which increased sales in the textile product category to approximately 17% of sales in fiscal 2002 from approximately 7% of sales in fiscal 2001.

        Retail sales decreased 2.9% in fiscal 2001 as compared to the prior year, primarily due to a $15.1 million or 4.6% decrease in comparable store sales, the extra week in fiscal 2000 which contributed $6.2 million in that year, and the closure of three under-performing stores. Compared to fiscal 2000, new stores accounted for increased sales of $16.7 million in fiscal 2001, offset by the comparable store sales decline and a decrease of $5.5 million as a result of fiscal 2001 store closures. The comparable store sales decrease was due to weak consumer spending over most of fiscal 2001, related to the general economic slowdown and the events of September 11, 2001.

        Average revenue per retail transaction in fiscal 2002 increased 23% compared to fiscal 2001, while total retail transactions decreased by 14%. We attribute the increase in average revenue per transaction to the new product introductions and product mix changes implemented as the integral part of our repositioning strategy. We believe that the decline in the number of transactions may also be a result of the new product categories and changed mix. In fiscal 2001, the average revenue per transaction was approximately flat with fiscal 2000, while total retail transactions decreased by 3%. Average revenue per transaction is calculated by dividing the amount of gross sales, exclusive of delivery revenue and sales taxes, by the gross number of transactions.

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

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        Comparable store sales are defined as sales from stores whose gross square footage did not change by more than 20% in the previous 12 months and which have been open at least 12 full months. Stores generally become comparable in their 14th full month of operation. In any given period, the set of stores comprising comparable stores may be different from the set of comparable stores in the previous period, depending on when stores were opened. We believe that comparable store sales are a more useful indicator of store performance than the change in total net sales, since comparable store sales exclude the effects of changes in the number of stores open.

Direct-to-customer

        Direct-to-customer sales consist of catalog and Internet sales. Net direct-to-customer sales in fiscal 2002 increased $11.1 million or 33% as compared to fiscal 2001. This was a result of a 46% increase in the number of catalogs mailed in fiscal 2002, to 29.9 million from 20.5 million in fiscal 2001. We also believe that the new textile product introduction, as well as the redesign of our catalog and website, contributed to the sales increase.

        Net direct-to-customer sales in fiscal 2001 increased $11.1 million or 49% as compared to fiscal 2000. This was a result of a 71% increase in the number of catalogs mailed in fiscal 2001, to 20.5 million, from 12.0 million in fiscal 2000. Offsetting the circulation increase, we believe fiscal 2001 direct-to-customer sales to have been negatively affected by the events of September 11, 2001 and the subsequent anthrax scare.

        Average revenue per direct-to-customer transaction in fiscal 2002 increased 24% from fiscal 2001, and total direct-to-customer transactions increased 7% from fiscal 2001. We believe the increase in average revenue per transaction is a result of our new product introductions and changed product mix. In fiscal 2001, the average revenue per transaction increased by 13% from fiscal 2000, and the total number of transactions increased by 32%.

        In April 2002, in connection with our repositioning strategy, we redesigned our catalog and launched a new website to enhance the overall customer experience. We target our catalog circulation to drive sales in all channels, including the stores and Internet.

Furniture Manufacturing

        We have a wholly-owned furniture manufacturing company located in Sacramento, California, The Michaels Furniture Company (Michaels). Virtually all of the furniture produced at Michaels is sold through our retail or direct-to-customer sales channels, and such sales have been recognized in the sales channel from which the sale originated. Over the past 3 years, we have effectively eliminated sales by Michaels to third parties, in order to increase production capacity for inter-segment sales. Inter-segment sales to Restoration Hardware represented virtually all of Michaels' total sales during fiscal 2002 and fiscal 2001, and this trend is expected to continue.

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EXPENSES

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

COST OF SALES AND OCCUPANCY

        In fiscal 2002, cost of sales and occupancy expense expressed as a percentage of net sales decreased approximately 9.5 percentage points to 70.7%, from 80.2% in fiscal 2001. Approximately 4.5 percentage points of this decrease related to certain fiscal 2001 charges related to our strategic repositioning, which are detailed below. Approximately 3.5 percentage points of this decrease was due to improved product margin in fiscal 2002 compared to fiscal 2001, driven primarily by better initial markups on our merchandise purchases. This improvement was due to the addition to our product mix of merchandise with higher gross margin, particularly our new textile categories. Finally the last 1.5 percentage points of the decrease was due to the leveraging of buying and distribution and occupancy costs by increased sales in fiscal 2002.

        In fiscal 2001, cost of sales and occupancy expenses expressed as a percentage of net sales increased approximately 8.4 percentage points, to 80.2% from 71.9% in fiscal 2000. Approximately 4.7 percentage points of this increase was due to charges related to our strategic repositioning, as follows: a $5.3 million charge to reduce certain inventory being eliminated to its net realizable value, a $2.0 million increase in depreciation charges related to reduced lives of certain long-lived assets being replaced in our Spring 2002 store remodel program, and a $10.2 million charge related to the write-down of long-lived assets in eight under-performing stores. These charges are discussed in further detail in the "Special Items" section below. Approximately 3.6 percentage points of the increase was due to markdown and clearance activity associated with our repositioning strategy.

SELLING, GENERAL AND ADMINISTRATIVE

        Selling, general and administrative expense expressed as a percentage of net sales increased approximately 2.3 percentage points to 31.5% in fiscal 2002, from 29.2% in fiscal 2001. The increase was primarily due to increased advertising costs, resulting from an increase in the number of catalogs mailed to our customers (1.5 percentage points); increased home office personnel costs due to staffing upgrades and additions implemented in connection with our repositioning strategy (0.4 percentage points); and increased professional fees incurred in connection with implementing our new revenue recognition policy and the corresponding restatement of prior periods (0.3 percentage points).

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        Selling, general and administrative expenses expressed as a percentage of net sales increased approximately 1.0 percentage point to 29.2% in fiscal 2001 from 28.2% in fiscal 2000. The increase was largely due to increased marketing (0.4 percentage points) and other costs (0.5 percentage points) associated with our direct-to-customer division and increased professional fees associated with our repositioning strategy (0.5 percentage points); offset by reductions in store and home office payroll (0.4 percentage points).

INTEREST EXPENSE AND INTEREST INCOME

        Interest expense includes interest related to the amortization of debt issuance costs and interest on borrowings under our line of credit facility. In fiscal 2002, interest expense was $3.0 million as compared to $4.8 million in fiscal 2001. Excluding the non-cash amortization of debt issuance costs and interest expense related to warrants, interest expense was $1.5 million compared to $3.1 million for fiscal 2001, a decrease of $1.6 million. The decrease resulted from amendments to our credit facility to provide for more favorable interest rates. As a result of the paydown of high interest term loans in fiscal 2001, the average interest rate in fiscal 2002 decreased to 6.3% from 12.6% in fiscal 2001. Average borrowings in fiscal 2002 were $24.3 million, a slight increase over the average debt level of $23.6 million in fiscal 2001.

        On August 30, 2002 we amended our credit facility, primarily to (1) reduce the overall commitment from $80.0 million to $72.0 million; (2) to provide, at our election, for an additional $5.0 million of availability above the maximum available designated by formula for any continuous 60-day period between August 1 and October 31 of any year (not to exceed the $72.0 million overall commitment); (3) to extend the expiration date by twelve months to June 30, 2004; and (4) to provide a more favorable interest rate structure.

        In fiscal 2001, interest expense was $4.8 million as compared to $5.9 million in fiscal 2000. Excluding the non-cash amortization of debt issuance costs, net interest expense was $3.1 million compared to $5.1 million for fiscal 2001, a decrease of $2.0 million. The decrease resulted from the amendments of our credit facility to provide for more favorable interest rates and a reduction in debt made possible by the $56.0 million (net of fees) raised in our preferred and common stock financings in fiscal 2001, as discussed below.

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

        Interest income, which consists of income from our short-term investments and notes receivable, decreased $0.1 million in fiscal 2002 as compared to fiscal 2001. Interest income increased $0.2 million in fiscal 2001 as compared to fiscal 2000. The majority of the changes in 2001 was due to interest on a $2.1 million loan we provided to Mr. Friedman in connection with his purchase of common stock and preferred stock in March 2001. Mr. Friedman repaid the loan in full, including accrued interest, in August 2002.

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INCOME TAX BENEFIT

        Our effective tax benefit rate was 70% in fiscal 2002, as compared to a tax benefit rate of 22% in fiscal 2001, and a tax benefit rate of 37% in fiscal 2000. These rates reflect the effect of aggregate state tax rates based on a mix of retail sales and direct-to-customer sales in the various states in which we have sales revenue or conduct business.

        Additionally, the fiscal 2002 income tax benefit rate reflects a $4 million reduction in the valuation allowance previously established on our deferred tax assets. The reduction in the valuation allowance was due to the additional realization of net operating loss carryback amounts, resulting from the economic stimulus bill enacted on March 9, 2002. The fiscal 2001 income tax benefit was net of a $7 million valuation allowance provision to reduce deferred tax assets to an amount that management believed was more likely than not to be realized, as further discussed in "Critical Accounting Policies" below. Under the applicable accounting literature, we were not allowed to consider the potential effects of a tax law change when we established the valuation allowance at February 2, 2002. As a result, even though the economic stimulus bill was approved prior to the issuance of our financial statements, we were not allowed to reflect the potential positive effects on the overall valuation allowance until the year of the law change. As a result, we established the $7 million reserve at February 2, 2002 and reduced the reserve in the first quarter ended May 4, 2002.

FISCAL 2001 SPECIAL ITEMS

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

        Inventory lower of cost or market reserve—In connection with the elimination of approximately 30% of the items from our merchandise assortment during fiscal 2001, we recorded a charge of $5.3 million to write down discontinued merchandise to its estimated net realizable value.

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

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

        Tax Valuation Allowance—In the course of analyzing our projected taxable income, we determined that a valuation allowance of $7.0 million against our deferred tax assets was appropriate as of February 2, 2002. The valuation allowance reduced our deferred tax assets to an amount that is more likely than not to be realized.

LIQUIDITY AND CAPITAL RESOURCES

Operating Cash Flows:

        In fiscal 2002, net cash used in operating activities was $19.5 million compared to $4.3 million of net cash provided by operations in fiscal 2001. Cash was used in operations in fiscal 2002 to fund increased merchandise inventories from the unusually depressed inventory levels at the end of fiscal 2001, as we exited old product in preparation for the receipt of new goods for the launch of our merchandise repositioning. The cash used for inventory investment in fiscal 2002 was partially offset by

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our smaller operating loss, driven by increased sales and improved merchandise margins; and an increase in accounts payable and accrued expenses.

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

Investing Cash Flows:

        Net cash used in investing activities was $19.4 million in fiscal 2002, an increase of $20.9 million compared to $1.5 million of cash provided by investing activities in fiscal 2001. Cash was used primarily for the re-modeling of substantially all of our 105 stores (approximately $16 million), in addition to smaller investments to open one new store, re-engineer our website, and implement productivity enhancements in our distribution centers and Michael's furniture operation.

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

Financing Cash Flows:

        Net cash provided by financing activities was $18.2 million in fiscal 2002, an increase of $4.3 million from $13.8 million in fiscal 2001. In fiscal 2002 the net cash provided by financing activities was primarily from our credit facility, in addition to the repayment of a $2.1 million loan by Gary G. Friedman, our President and Chief Executive Officer.

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

        At February 1, 2003, we had in place a credit facility with an overall commitment of $72.0 million, of which $25.0 million was available for letters of credit. As of February 1, 2003, we had $15.2 million outstanding under the line of credit (before unamortized debt issuance costs of $1.3 million), and $14.0 million in outstanding letters of credit. Interest is paid monthly at the bank's reference rate or LIBOR plus a margin. As of February 1, 2003, the bank's reference rate was 5.75% and the LIBOR plus margin rate was 4.09%. The availability of credit at any given time under the credit facility is limited by reference to a borrowing base formula based upon numerous factors, including eligible inventory and eligible accounts receivable. The amount available under the credit facility may be less than the stated maximum of the facility. As of February 1, 2003, in addition to outstanding borrowings and letter of credit obligations totaling $29.2 million, we had availability to borrow up to $23.4 million. The credit facility contains various restrictive covenants, including limitations on our annual capital expenditures, ability to incur additional debt, acquisition of other businesses and payment of dividends and other distributions. The agreement expires on June 30, 2004.

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        In August 2002 we amended our credit facility, primarily to (1) reduce the overall commitment from $80.0 million to $72.0 million; (2) at our election, to provide for an additional $5.0 million of availability above the maximum available designated by formula for any continuous 60-day period between August 1 and October 31 of any year (not to exceed the $72.0 million overall commitment); (3) to extend the expiration date of the credit facility by twelve months to June 30, 2004; and (4) to provide a more favorable interest rate structure. In November 2002, the credit facility was further amended and restated to reflect a number of minor revisions and updates to the then-existing credit facility documentation.

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

        We currently believe that our cash flows from operations and funds available under our credit facility will satisfy our expected working capital and capital requirements, including our contractual commitments described below, for at least the next 12 months. However, the weakening of, or other adverse developments concerning our sales performance or adverse developments concerning the availability of credit under our credit facility due to covenant limitations or other factors could limit the overall availability of funds to us. Moreover, we may not have successfully anticipated our future capital needs and we may need to raise additional funds in order to take advantage of unanticipated opportunities. We also may need to raise additional funds to respond to changing business conditions or unanticipated competitive pressures. However, should the need arise, additional sources of financing may not be available or, if available, may not be on terms favorable to us or our stockholders. If we fail to raise sufficient funds, we may be required to delay or abandon some of our planned future expenditures or aspects of our current operations. For more information, please see the section "Factors That May Affect Our Future Operating Results," above, in particular the sections "We are dependent on external funding sources which may not make available to us sufficient funds when we need them," and "Because our business requires a substantial level of liquidity, we are dependent upon a credit facility with numerous restrictive covenants that limit our flexibility".

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Contractual Commitments:

        The following table summarizes significant contractual obligations of the Company as of February 1, 2003:

(1)

Amount outstanding under the revolving credit facility at February 1, 2003 was $13.9 million.

CRITICAL ACCOUNTING POLICIES

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

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

Inventory

        Our retail inventories are carried at the lower of cost or market with cost determined on a weighted average cost method. Manufacturing inventories are carried at the lower of cost or market with cost determined on a first-in, first-out method. We write-down inventories whenever permanent markdowns reduce the selling price below cost. Additionally, we provide for reserves on inventory based upon our estimate of shrink losses. At February 1, 2003 and February 2, 2002 we had reserves of $169,000 and $6.5 million, respectively, to adjust the carrying amount of our merchandise inventories to

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their estimated net realizable value. If actual market conditions are less favorable than those projected by management, or if liquidation of the inventory is more difficult than anticipated, additional inventory write-downs may be required.

Deferred Catalog Expenses

        Deferred catalog expenses consist of the cost to prepare, print and distribute catalogs. Such costs are amortized over the estimated sales volume of each catalog. We estimate expected sales volume based on historical experience. Typically over 90% of the cost of a catalog is amortized in the first four months, and all catalog costs are generally fully amortized within six months.

Property and Equipment

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

Impairment of Long-lived Assets

        We review long-lived tangible assets and intangible assets with finite useful lives for impairment whenever events or changes in circumstances indicate that their carrying values may not be recoverable. Using our best estimates based on reasonable assumptions and projections, we record an impairment loss to write the assets down to their estimated fair values if the carrying values of such assets exceed their related undiscounted expected future cash flows. In the course of performing this analysis, we recorded impairment charges in fiscal 2002 and fiscal 2001 of $0.6 million and $10.2 million, respectively.

        We had $4.6 million of goodwill at February 1, 2003 and February 2, 2002. We review goodwill and other intangibles with indefinite useful lives for impairment annually, or more frequently if events or changes in circumstances warrant. If the carrying values of such assets exceed their estimated fair values, we record an impairment loss to write the assets down to their estimated fair values. There were no impairment charges recorded against goodwill in fiscal 2002 or fiscal 2001.

        We generally evaluate long-lived tangible assets and intangible assets with finite useful lives at an individual store level, which is the lowest level at which independent cash flows can be identified. We evaluate corporate assets or other long-lived assets that are not store-specific at a consolidated entity or segment level, as appropriate.

        Since there is typically no active market for our long-lived tangible and intangible assets, we estimate fair values based on the expected present value of future cash flows. We estimate future cash flows based on store-level historical results, current trends and operating and cash flow projections. Our estimates are subject to substantial uncertainty and may be affected by a number of factors outside our control, including general economic conditions, the competitive environment and regulatory changes. If actual results differ from our estimates, we may record significant additional impairment charges in the future.

Store Closure Reserves

        Prior to January 1, 2003, we recorded the estimated costs associated with closing a store during the period in which the store was identified and approved by management under a plan of termination, which included the method of disposition and the expected date of completion. These costs include direct costs to terminate a lease, lease rental payments net of expected sublease income, and the difference between the carrying values and estimated recoverable values of long-lived tangible and intangible assets. We recorded severance and other employee-related costs in the period in which we communicated the closure and related severance packages to the affected employees.

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        Effective with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 146, Accounting for Costs Associated with Exit or Disposal Activities, on January 1, 2003 (see "Recent Accounting Developments" below), we recognize a liability for costs associated with closing a store when the liability is incurred. We record the present value of expected future lease costs and other closure costs when the store is closed. We record severance and other employee-related costs in the period in which we communicate the closure and related severance packages to the affected employees.

        Our calculation of store closure costs includes significant estimates about the amounts and timing of potential lease termination costs and future sublease income. These estimates are based on our historical experience, the condition and location of the property, the lease terms and current real estate leasing market conditions. If actual results differ from our estimates, we may significantly adjust our store closure reserves in future periods.

        While we do not currently have any reserves established for store closures, we periodically make judgments about which stores we should close and which stores we should continue to operate. All stores are subject to regular monitoring of their financial performance and cash flows, and many stores are subject to "kick out clauses" which allow us to terminate the store lease without further obligation if certain contractually specified sales levels are not achieved. If we decide to close a number of these stores, we may incur significant store closure costs for which we have not currently reserved.

Self Insurance

        We obtain insurance coverage for significant exposures as well as those risks required to be insured by law. It is generally our policy to retain a significant portion of certain losses related to workers' compensation, general liability, property losses, business interruptions and employee health care. We record provisions for these items based on claims experience, regulatory changes, an estimate of claims incurred but not yet reported and other relevant factors. The projections involved in this estimate are subject to substantial uncertainty because of several unpredictable factors, including actual claims experience, regulatory changes, litigation trends and changes in inflation.

        Our self-insurance exposure is concentrated in California, where the majority of our stores are located. California has experienced significant increases in workers' compensation costs as a result of legislative changes and rising medical costs. These increases have adversely affected our results of operations and may continue to adversely affect us in the future.

        If claims are greater than we originally estimate, or if costs increase beyond what we anticipated, our recorded reserves may not be sufficient, and we may record significant additional expense.

Income Taxes

        We account for income taxes under Statement of Financial Accounting Standards No. 109 ("SFAS 109") Accounting for Income Taxes. SFAS No. 109 requires income taxes to be accounted for under an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, all expected future events then known to us are considered, other than changes in the tax law or rates. Accordingly, we record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. An analysis of projected taxable income and the corresponding utilization of these tax assets indicated that valuation allowances of $3.0 million and $7.0 million were required as of February 1, 2003 and February 2, 2002, respectively. The amount of valuation allowance is based upon management's best estimate of the recoverability of its deferred tax assets. While future taxable income and ongoing prudent and feasible tax planning were considered in determining the amount of the valuation allowance, this allowance is subject to adjustment in the future. Specifically, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amounts, an adjustment to the deferred tax assets would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or

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part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made.

        The fiscal 2002 income tax benefit rate reflects a $4 million reduction in the valuation allowance previously established on our deferred tax assets. The reduction in the valuation allowance was due to the additional realization of net operating loss carryback amounts, resulting from the economic stimulus bill enacted on March 9, 2002. The fiscal 2001 income tax benefit was net of a $7 million valuation allowance provision to reduce deferred tax assets to an amount that management believed was more likely than not to be realized. Under the applicable accounting literature, we were not allowed to consider the potential effects of a tax law change when we established the valuation allowance at February 2, 2002. As a result, even though the economic stimulus bill was approved prior to the issuance of our financial statements, we were not allowed to reflect the potential positive effects on the overall valuation allowance until the year of the law change. As a result, we established the $7 million reserve at February 2, 2002 and reduced the reserve in the first quarter ended May 4, 2002.

Revenue Recognition

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

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

        Non-furniture—direct-to-customer (Catalog and Internet) sales:    Revenue is recognized at the time of customer receipt.

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

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

Contingencies and Litigation

        We are involved from time to time in legal proceedings, including litigation arising in the ordinary course of our business. Due to the uncertainties inherent in any legal proceeding, we cannot accurately predict the ultimate outcome of any proceeding and may incur substantial costs to defend the proceeding, irrespective of the merits. Unfavorable outcome of any legal proceeding could have an adverse impact on our business, financial condition, and results of operations. As appropriate, we assess the likelihood of any adverse outcomes and the potential range of probable losses. The amount of loss accrual, if any, is subject to adjustment if and when warranted by new developments or revised strategies. It is possible, however, that future results of operations for any particular quarterly or annual period could be materially affected by changes in our assumptions related to these proceedings. We accrue our best estimates of the probable cost for the resolution of legal claims. Such estimates are developed in consultation with outside counsel handling these matters and are based upon a combination of litigation and settlement strategies. To the extent additional information arises or our strategies change, it is possible that our best estimates of our probable liability in these matters may change.

Other Considerations

        The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by generally accepted accounting principles, with no need for management's judgment in their application. There are also areas in which management's judgment in selecting any available alternative would not produce

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a materially different result. See our audited consolidated financial statements and notes thereto, which contain accounting policies and other disclosures required by generally accepted accounting principles.

RECENT ACCOUNTING DEVELOPMENTS:

        In June 2001, the Financial Accounting Standards Board ("FASB") issued SFAS No. 142, Goodwill and Other Intangible Assets, which became effective for us on February 3, 2002. SFAS No. 142 specifies that goodwill and certain intangible assets will no longer be amortized but instead will be subject to periodic impairment testing. We adopted SFAS 142 in the first quarter of fiscal 2002. Upon adoption we discontinued the amortization of goodwill with a carrying value of $4.6 million as of February 3, 2002. See Note 2 in the notes to our consolidated financial statements for a reconciliation of reported loss per share to the amounts adjusted for the exclusion of amortization of goodwill and other intangible assets with indefinite lives, net of the related income tax effects.

        In August 2001, the FASB issued SFAS No. 144 Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 establishes new accounting and reporting standards for the impairment of long-lived assets and for long-lived assets to be disposed of. We adopted SFAS No. 144 in the first quarter of fiscal 2002. We recorded impairments of $10.2 million in the fourth quarter of fiscal 2001 using previously issued accounting standards, and of $0.6 million in the fourth quarter of fiscal 2002 under SFAS 144.

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

        In November 2002, the FASB issued Interpretation ("FIN") No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about obligations under certain guarantees that it has issued. It also requires that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The disclosure requirements of FIN No. 45 are effective for interim and annual periods ending after December 15, 2002, and the initial recognition and measurement requirements are effective prospectively for guarantees issued or modified after December 31, 2002. The initial adoption of FIN No. 45 did not have a material impact on our financial position or results of operations.

        In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation—Transition and Disclosure. SFAS No. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, SFAS No. 148 amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The transition guidance and annual disclosure provisions of SFAS No. 148 are effective for the Company's fiscal year ended February 1, 2003. The interim disclosure provisions are effective for the first quarter of the fiscal year ending January 31, 2004. The Company continues to account for stock-based compensation using the intrinsic value method in accordance with the provisions of APB Opinion No. 25, Accounting for Stock Issued to Employees, as allowed by SFAS No. 123. As a result, the adoption of SFAS No. 148 did not have any impact on the Company's consolidated financial results.

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        In November 2002, the Emerging Issues Tack Force ("EITF") reached a consensus regarding EITF Issue No. 02-16, Accounting by a Customer (including a Reseller) for Certain Consideration Received from a Vendor. Issue No. 02-16 addresses the timing of recognition and classification of consideration received from vendors, including rebates and allowances. The adoption of Issue No. 02-16 did not have a material impact on our financial statements.

        In January 2003, the FASB issued FIN No. 46, "Consolidation of Variable Interest Entities—an interpretation of ARB No. 51." FIN No. 46 requires that variable interest entities be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity's activities or is entitled to receive a majority of the entity's residual returns or both. FIN No. 46 also requires disclosures about variable interest entities that are not required to consolidate but in which a company has a significant variable interest. The consolidation requirements of FIN No. 46 will apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements will apply to entities established on or prior to January 31, 2003 in the first fiscal year or interim period beginning after June 15, 2003. The disclosure requirements will apply in all financial statements issued after January 31, 2003. The Company has not evaluated whether the application of FIN 46 will have a material effect on its financial statements.

RELATED PARTY TRANSACTIONS

        Stephen Gordon is Chairman of our Board of Directors. We lease our store in Eureka, California, from Mr. Gordon and his wife and Eureka Preservation Partnership, a partnership of which Mr. Gordon is a partner. The aggregate lease payments paid to Mr. and Mrs. Gordon and the partnership were $41,717, $65,657 and $65,657 for fiscal years 2002, 2001, and 2000, respectively. The lease term expires on May 31, 2004 and there are no renewal options. We believe that the lease arrangement with Mr. and Mrs. Gordon and the partnership of which Mr. Gordon is a partner was made on terms no less favorable to us than could have been obtained from unaffiliated third parties.

        In connection with the Series A and B preferred stock financing completed in March 2001, Gary Friedman, our Chief Executive Officer, purchased 455 shares of the Series A preferred stock and 545 shares of the Series B preferred stock for an aggregate purchase price of $1 million. In addition, as part of Mr. Friedman's compensation package, we sold Mr. Friedman 571,429 shares of common stock at $1.75 per share and Mr. Friedman exercised his option to purchase 1.2 million shares of common stock at $1.75 per share for an aggregate sales price of approximately $3.1 million. In connection with this sale of preferred and common stock to Mr. Friedman, we also made a loan to Mr. Friedman in the amount of $2.05 million. All of the loan proceeds were used by Mr. Friedman to purchase a portion of this stock. The loan was a full recourse loan secured by shares of the common stock and preferred stock purchased by Mr. Friedman. This loan was evidenced by a note, dated March 22, 2001. Pursuant to the terms of the note, the interest rate on the outstanding principal amount of the loan was 8.5% per annum, payable on the first, second and third anniversaries of the date of the note. The principal was due on March 22, 2004 but the due date could be accelerated due to a number of factors, including, failure to make payments due under the note, expiration of the six-month period following the date Mr. Friedman ceases to be an employee of our company as a result of termination by us for cause, or 90 days after the closing of an acquisition of our company. Mr. Friedman repaid this loan in full with interest in August 2002.

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

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RESTATEMENT

        Subsequent to the issuance of our consolidated financial statements as of and for the year ended February 2, 2002, we determined that certain errors existed in our previously issued consolidated financial statements. We determined that our accounts payable balances at February 2, 2002 were overstated resulting from the inclusion of fiscal 2002 payables in fiscal 2001. We also determined that our inventory at February 2, 2002 was understated as a result of our inventories in transit being excluded from our reported inventory balance. Finally, for the year ended February 2, 2002, we determined that we had understated certain payroll and insurance costs and overstated certain maintenance costs. As a result, the accompanying fiscal 2001 financial statements have been restated from amounts previously reported in Amendment No. 2 to Form 10-K/A filed on December 23, 2002.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

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

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

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

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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEPENDENT AUDITORS' REPORT

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

        We have audited the accompanying consolidated balance sheets of Restoration Hardware, Inc. and its subsidiaries as of February 1, 2003 and February 2, 2002, and the related consolidated statements of operations, redeemable convertible preferred stock and stockholders' equity, and cash flows for each of the three fiscal years in the period ended February 1, 2003. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.

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

        In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Restoration Hardware, Inc. and its subsidiaries as of February 1, 2003 and February 2, 2002, and the results of their operations and their cash flows for each of the three fiscal years in the period ended February 1, 2003 in conformity with accounting principles generally accepted in the United States of America.

        As discussed in Note 17, the accompanying financial statements for the fiscal year ended February 2, 2002 have been restated.

/s/ Deloitte & Touche LLP

San Francisco, California
May 2, 2003

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RESTORATION HARDWARE, INC.

CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

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

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RESTORATION HARDWARE, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

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

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RESTORATION HARDWARE, INC.

CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE
PREFERRED STOCK AND STOCKHOLDERS' EQUITY

(dollars in thousands)

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

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RESTORATION HARDWARE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)