UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

		(MARK ONE)

ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended May 3, 2003

o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to .

Commission File Number: 000-24261

RESTORATION HARDWARE, INC.

(Exact Name of Registrant as Specified in Its Charter)

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

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirement for the past 90 days.

Yes ý No o

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

Yes ý No o

As of May 21, 2003, 30,058,602 shares of the registrant’s common stock, $0.0001 par value per share, were outstanding.

FORM 10-Q

FOR THE QUARTER ENDED MAY 3, 2003

TABLE OF CONTENTS

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets as of May 3, 2003, February, 1, 2003 and May 4, 2002 (As Restated)

	Condensed Consolidated Statements of Operations for the three months ended May 3, 2003 and May 4, 2002 (As Restated)

	Condensed Consolidated Statements of Cash Flows for the three months ended May 3, 2003 and May 4, 2002 (As Restated)

	Notes to Condensed Consolidated Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings

Item 6.	Exhibits and Reports on Form 8-K

SIGNATURES

EXHIBIT INDEX

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

(Unaudited)

	May 3, 2003			February 1, 2003			May 4, 2002
							(As Restated)

ASSETS
Current assets:
Cash and cash equivalents	$	1,814		$	1,630		$	2,225
Accounts receivable	3,989			3,352			5,007
Merchandise inventories	99,702			94,500			77,982
Prepaid expense and other current assets	11,123			12,445			16,393
Total current assets	116,628			111,927			101,607
Property and equipment, net	86,023			90,038			96,760
Goodwill	4,560			4,560			4,560
Other long-term assets	22,953			19,703			20,096
Total assets	$	230,164		$	226,228		$	223,023

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	33,061		$	35,649		$	46,494
Deferred revenue	5,073			5,870			3,623
Revolving line of credit, net of debt issuance costs	—			—			8,475
Other current liabilities	8,659			9,322			8,966
Total current liabilities	46,793			50,841			67,558
Long-term line of credit, net of debt issuance costs	27,250			13,909			—
Deferred lease incentives	37,290			39,109			41,903
Deferred rent	14,324			14,163			13,100
Other long-term obligations	109			144			142
Total liabilities	125,766			118,166			122,703

Series A redeemable convertible preferred stock, $.0001 par value, 28,037 shares designated, 13,470 shares issued and outstanding, at May 3, 2003, February 1, 2003 and May 4, 2002, aggregate liquidation preference and redemption value of $15,426 at May 3, 2003	13,328			13,328			13,529

Common stock, $.0001 par value; 60,000,000 shares authorized: 30,054,900, 30,050,994 and 29,756,454 issued and outstanding, at May 3, 2003, February 1, 2003 and May 4, 2002, respectively	151,938			150,881			148,686
Stockholder loan	—			—			(2,050		)
Unearned compensation	(534		)	(659		)	(1,000		)
Accumulated other comprehensive income (loss)	211			(132		)	146
Accumulated deficit	(60,545		)	(55,356		)	(58,991		)
Total stockholders’ equity	91,070			94,734			86,791

Total liabilities, redeemable convertible preferred stock and stockholders’ equity	$	230,164		$	226,228		$	223,023

See Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(Unaudited)

	Three Months Ended
	May 3, 2003			May 4, 2002
				(As Restated)

Net sales	$	81,766		$	69,377
Cost of sales and occupancy	61,825			58,489
Gross profit	19,941			10,888
Selling, general and administrative expenses	28,029			27,458
Loss from operations	(8,088		)	(16,570		)

Interest expense	(569		)	(576		)
Interest income	7			83
Change in fair value of warrants	—			(278		)
Loss before income taxes	(8,650		)	(17,341		)
Income tax benefit	3,460			10,248
Net loss	(5,190		)	(7,093		)

Preferred shareholder return:
Dividends	—			(358		)

Net loss available to common stockholders	$	(5,190	)	$	(7,451	)

Net loss per common share:
Basic and diluted loss per share	$	(0.17	)	$	(0.25	)
Weighted average shares basic and diluted	30,052			29,246

See Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

(Unaudited)

	Three Months Ended
	May 3, 2003			May 4, 2002
				(As Restated)
Cash flows from operating activities:
Net loss	(5,190		)	(7,093		)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	4,955			4,870
Change in fair value of warrants	—			278
Deferred income taxes	(3,429		)	(6,157		)
Changes in assets and liabilities:
Accounts receivable	(637		)	(1,733		)
Merchandise inventories	(5,202		)	(14,785		)
Prepaid expenses and other assets	1,573			(6,836		)
Accounts payable and accrued expenses	(2,587		)	12,730
Deferred revenue	(797		)	768
Other current liabilities	(663		)	(215		)
Deferred rent	161			413
Deferred lease incentives	(1,818		)	299
Net cash used in operating activities	(13,634		)	(17,461		)

Cash flows from investing activities:
Capital expenditures	(352		)	(13,181		)
Net cash used in investing activities	(352		)	(13,181		)

Cash flows from financing activities:
Borrowings under revolving line of credit, net	13,110			10,164
Other long-term obligations	(36		)	(415		)
Proceeds received from Section 16(b) shareholder lawsuit settlement	1,050			—
Issuance of common stock	7			560
Net cash provided by financing activities	14,131			10,309

Effects of foreign currency exchange rate translation on cash	39			273
Net increase (decrease) in cash and cash equivalents	184			(20,060		)

Cash and cash equivalents:
Beginning of period	1,630			22,285
End of period	$	1,814		$	2,225

Additional cash flow information:
Cash paid during the period for interest (net of amount capitalized)	$	393		$	113
Cash (received) paid during the period for taxes	(30		)	62
Non-cash transactions:
Exercise of warrants	—			2,956
Dividends attributable to preferred stock	—			358

See Notes to Condensed Consolidated Financial Statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business

Restoration Hardware, Inc., a Delaware corporation, and its subsidiaries (collectively, the “Company”) is a specialty retailer of high-quality home furnishings, functional and decorative hardware and related merchandise. These products are sold through retail locations, catalogs and the Internet. As of May 3, 2003, the Company operated 105 retail stores in 31 states, the District of Columbia and Canada.

Basis of Presentation

The accompanying interim condensed consolidated financial statements have been prepared from the Company’s records without audit and, in management’s opinion, include all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position at May 3, 2003 and May 4, 2002; results of operations for the three months ended May 3, 2003 and May 4, 2002; and changes in cash flows for the three months ended May 3, 2003 and May 4, 2002. The balance sheet at February 1, 2003, as presented, has been derived from the Company’s audited financial statements for the fiscal year then ended.

Accounting policies followed by the Company are described in Note 1 to the audited consolidated financial statements included in the Company’s Form 10-K, as amended, for the fiscal year ended February 1, 2003 (“fiscal 2002”). Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted for purposes of the interim condensed consolidated financial statements. You should read the interim condensed consolidated financial statements in conjunction with the audited consolidated financial statements, including the notes, for fiscal 2002.

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

Stock-based Compensation

The Company has one stock-based employee compensation plan and accounts for stock-based employee compensation using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. The following table illustrates the effect on net loss and earnings per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, to all stock-based employee compensation. The Company’s calculations were made using the Black-Scholes option pricing model and assume that the estimated fair value of the options is amortized to expense over the options’ vesting period.

	May 3, 2003			May 4, 2002

Net loss available to common stockholders As reported	$	(5,190	)	$	(7,451	)
Add: Stock based compensation expense included in reported net loss (net of tax)	75			122
Deduct: Compensation expense for all stock based compensation (net of tax) calculated in accordance with the fair value method	(450		)	(734		)
Pro forma	$	(5,565	)	$	(8,063	)
Net loss per common share:
Basic and diluted, as reported	$	(0.17	)	$	(0.25	)
Basic and diluted, pro forma	$	(0.19	)	$	(0.28	)

Comprehensive Income (Loss)

Comprehensive income (loss) consists of net income (loss) and other comprehensive income (loss) (primarily foreign currency translations adjustments). The components of comprehensive income (loss) for the three months ended May 3, 2003 and May 4, 2002, are as follows (in thousands):

	First Quarter
	2003			2002
Components of comprehensive income (loss):
Net loss	$	(5,190	)	$	(7,451	)
Foreign currency translation adjustment	343			305
Total comprehensive loss	$	(4,847	)	$	(7,146	)

2. RECENTLY ISSUED ACCOUNTING STANDARDS

In June 2002, the Financial Accounting Standards Board (“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 (“EITF”) Issue No. 94-3. The Company has 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 EITF Issue No. 94-3, a liability for an exit cost was recognized at the date of the Company’s 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 FASB 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 the Company’s financial position or results of operations.

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 entities’ activities or is entitled to receive a majority of the entities’ 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 is in the process of evaluating whether the application of FIN 46 will have a material effect on its financial statements.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies the accounting for certain derivative instruments under SFAS No. 133, Accounting for Derivative and Hedging Activities. The amendments in SFAS No. 149 require that contracts with comparable characteristics be treated similarly. Additionally, SFAS No. 149 clarifies under what circumstances a contract with an initial investment meets the characteristics of a derivative according to SFAS No. 133 and when a financing component warrants special reporting in the statement of cash flows. In addition, SFAS No. 149 requires that the definition of an underlying conform to language used in FIN No. 45 and amends certain other existing pronouncements. The requirements of SFAS No. 149 are effective for contracts entered into or modified after June 30, 2003 and for hedging relationships after June 30, 2003. The Company does not believe the adoption of SFAS No. 149 will have a material effect in its financial condition or results of operation.

freestanding financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires companies to classify as liabilities financial instruments with certain specified characteristics. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim periods beginning after June 15, 2003. The Company has not yet determined the potential impact of this statement on its financial condition or results of operations.

3. GOODWILL

As of May 3, 2003 and May 4, 2002, the Company was carrying goodwill of $4.6 million associated with its purchase in 1998 of The Michaels Furniture Company, Inc. With the Company’s adoption of SFAS No. 142, Goodwill and Other Intangible Assets, at the beginning of fiscal 2002, this goodwill was no longer subject to amortization, but instead is subject to periodic impairment testing. Therefore, the Company’s results of operations for the three month periods ended May 3, 2003 and May 4, 2002 do not reflect any amortization expense associated with this goodwill.

4. REVOLVING LINE OF CREDIT AND DEBT

The Company has a credit facility with an overall commitment of $72.0 million, of which $25.0 million is available for letters of credit. As of May 3, 2003, $28.3 million was outstanding under the line of credit (before unamortized debt issuance costs of $1.1 million), and there was $10.9 million in outstanding letters of credit. Borrowings made under the credit facility are subject to interest at either the bank’s reference rate or LIBOR plus a margin. As of May 3, 2003, the bank’s reference rate was 5.75% and the LIBOR plus margin rate was 4.07%. 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 will generally be less than the stated maximum limit of the facility. As of May 3, 2003, in addition to outstanding borrowings and letter of credit obligations totaling $39.2 million, the Company has availability to borrow up to $12.7 million. The credit facility contains various restrictive covenants, including limitations on the Company’s annual capital expenditures, ability to incur additional debt, acquisition of other businesses and payment of dividends and other distributions.

5. INCOME TAXES

SFAS No. 109, Accounting for Income Taxes, requires income taxes to be accounted for under an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. In estimating future tax consequences, the Company generally takes into account all expected future events, except for changes in tax laws or rates, which are not permitted to be considered. Additionally, SFAS No. 109 allows deferred tax assets to be recognized only to the extent such deferred tax assets are more likely than not to be realized. During the first quarter of fiscal 2002, the Job Creation and Worker Assistance Act of 2002 was enacted into law. Among other things, this law provided for an extended carryback period from two years to five years for losses generated in fiscal 2002 and the fiscal year ended February 2, 2002 (“fiscal 2001”). As a result of this extended carryback period, the Company was able to carryback and has received cash for $4.0 million in net operating losses. As a result of the change in the law, the Company re-evaluated its deferred tax assets as of the Company’s fiscal quarter ended on May 4, 2002 and, consequently, reduced its valuation allowance at May 4, 2002 from $7.0 million to $3.0 million, reflective of a change of $4.0 million.

6. EARNINGS PER SHARE

Basic earnings per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding for the period. Diluted earnings per share is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock and dilutive common stock equivalents (stock options, convertible preferred stock and warrants) outstanding during the period. Diluted earnings per share reflects the potential dilution that could occur if options or warrants to issue common stock were exercised, or convertible preferred stock was converted into common stock. The following table reflects the potential dilutive effects of securities that were excluded from the diluted earnings per share calculation because their inclusion in net loss periods would be anti-dilutive to earnings per share, since the Company experienced a net loss in each of the fiscal quarters reported:

	First Quarter
	2003	2002

Common stock issuable upon conversion of the Series A preferred stock	6,762,386	6,747,822
Common stock subject to outstanding stock options	169,905	1,826,775

The above stock options represent only those stock options whose exercise prices are less than the average market price of the stock for the quarter. Had the Company been in a net income position, there would have been 3,620,445 and 454,545 stock options for the three months ended May 3, 2003 and May 4, 2002, that would have been excluded from the diluted earnings per share calculation because the option exercise price for those options exceeded the average stock price for those periods.

7. SEGMENT REPORTING

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

Financial information for the Company’s business segments is as follows (dollars in thousands):

	First Quarter
	2003			2002
Net Sales:
Retail	$	70,471		$	62,797
Direct-to-Customer	11,291			6,563
Furniture manufacturing	4,883			4,006
Intersegment furniture sales	(4,879		)	(3,989		)
Total net sales	$	81,766		$	69,377

	First Quarter
	2003			2002
Income (loss) from operations:
Retail	$	2,733		$	(4,868	)
Direct-to-Customer	1,653			287
Furniture manufacturing	(102		)	(112		)
Unallocated	(12,364		)	(11,139		)
Intersegment loss from operations	(8		)	(738		)
Total loss from operations	$	(8,088	)	$	(16,570	)

8. RESTATEMENT

As discussed in the Company’s annual report on Form 10-K, as amended, for the fiscal year ended February 1, 2003, subsequent to the issuance of the Company’s unaudited results for the first two quarterly periods of fiscal 2002 and the fourth quarter of fiscal 2001, the Company’s management determined that certain errors existed in previously issued consolidated financial statements. The Company determined that its accounts payable balances at February 2, 2002 were overstated resulting from the inclusion of fiscal 2002 payables in fiscal 2001. The Company also determined that its inventory at February 2, 2002 was understated as a result of owned inventories in transit being excluded from its reported inventory balance. Additionally, for fiscal 2001, the Company determined that it had understated certain payroll and insurance costs and overstated certain maintenance costs. As a result, the condensed consolidated financial statements as of and for the quarter ended May 4, 2002, were restated from the amounts previously reported. A summary of the significant effects of the restatement is as follows:

In thousands	As of May 4, 2002
	As previously reported		As restated
Merchandise inventories	78,786		77,982
Prepaid expense and other current assets	16,991		16,393
Other long-term assets	18,408		20,096
Accounts payable and accrued expenses	46,275		46,494
Deferred rent	13,114		13,100
Accumulated deficit	(59,072	)	(58,991	)
Total stockholders’ equity	86,710		86,791

(Dollars in thousands, except per share amounts)	First Quarter Ended May 4, 2002
	As previously reported			As restated

Net sales	$	69,377		$	69,377
Cost of sales and occupancy	58,489			58,489
Gross profit	10,888			10,888
Selling, general and administrative	27,070			27,458
Loss from operations	(16,182		)	(16,570		)
Interest expense	(576		)	(576		)
Interest income	83			83
Change in fair value of warrants	(278		)	(278		)
Loss before income taxes	(16,953		)	(17,341		)
Income tax benefit	10,103			10,248
Net loss	(6,850		)	(7,093		)
Net loss per share:
Basic	$	(0.25	)	$	(0.25	)
Diluted	$	(0.25	)	$	(0.25	)

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

OVERVIEW

Our company, Restoration Hardware, Inc. (Nasdaq: RSTO), together with our subsidiaries, is a specialty retailer of home furnishings, functional and decorative hardware and related merchandise that reflects our classic and authentic American point of view. We market our merchandise through retail locations, mail order catalogs and on the worldwide web at www.restorationhardware.com. Our merchandise strategy and our stores’ architectural style create a unique and attractive selling environment designed to appeal to an affluent, well educated 35 to 60 year old customer. We operate on a 52 – 53 week fiscal year ending on the Saturday closest to January 31^st. Our current fiscal year ends on January 31, 2004 (“fiscal 2003”) and our last completed fiscal year ended on February 1, 2003 (“fiscal 2002”).

We opened our first store in 1980 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.

As of May 3, 2003, we operated 105 stores in 31 states, the District of Columbia and Canada. In addition to our retail stores, we operate a direct-to-customer sales channel which includes both catalog and Internet, and a wholly-owned furniture manufacturer. Currently, we are planning to execute our right to terminate the leases in three under-performing stores during fiscal 2003 and are evaluating another 3 to 5 under-performing stores for potential closure through 2005.

For the first quarter ended May 3, 2003, net sales were $81.8 million, an 18% increase over net sales of $69.4 million for the first quarter ended May 4, 2002. Comparable stores sales for the first quarter of fiscal 2003 increased 11.9% over the same period a year ago. Direct-to-customer sales, which include catalog and Internet sales, in the first quarter of 2003 increased 72% over the prior year to $11.3 million.

Net loss available to common stockholders was $0.17 per share, or $5.2 million for the first quarter ended May 3, 2003, compared to a net loss available to common stockholders of $0.25 per share or $7.5 million for the first quarter ended May 4, 2002. The Company’s net loss for the first quarter of 2003 was 31% lower than the year ago period as higher sales levels and improved gross margin contributed to a significantly lower loss from operations. The first quarter 2002 results included a $4.0 million tax benefit as a result of the economic stimulus bill enacted March 9, 2002.

RESULTS OF OPERATIONS

NET SALES

Net sales consist of the following components:

(dollars in thousands)	First Quarter 2003				First Quarter 2002
	Dollars		% Total		Dollars		% Total

Retail	$	70,471	86	%	$	62,797	91	%
Direct-to-customer	11,291		14	%	6,563		9	%
Furniture manufacturing	4		0	%	17		0	%
Total net sales	$	81,766	100	%	$	69,377	100	%

Net sales for the first quarter of fiscal 2003 increased $12.4 million or 18% over net sales reported for the first quarter of fiscal 2002. The increase in net sales in the first quarter of this fiscal year compared to last year is principally due to an 11.9% increase in comparable store sales and strong sales growth in our direct-to-customer division.

Net sales amounts include shipping fees of $2.1 million for the first quarter of fiscal 2003 compared to $1.5 million for the first quarter of fiscal 2002.

Sales of furniture manufactured by us are reported in the sales channel through which they are sold. The furniture manufacturing sales noted above include only such sales made to our employees.

Retail Sales

	First Quarter
(dollars in thousands)	2003			2002

Retail sales	$	69,791		$	62,146
Shipping fees	680			651
Net retail sales	$	70,471		$	62,797
Net retail sales growth (decline) percentage	12.2		%	(2.5		)%
Comparable stores sales increase	11.9		%	0.4		%
Number of stores at period beginning	105			104
Store openings	—			1
Store closings	—			—
Number of stores at period end	105			105
Store selling sq. ft. at period end	688,634			688,634

Net retail sales in the first quarter of fiscal 2003 increased 12.2% as compared to the same period in fiscal 2002, primarily due to an 11.9% increase in comparable store sales. The comparable store sales increase resulted primarily from our repositioning strategy implemented in the first-half of fiscal 2002, which included the introduction of new merchandise offerings, adjustments of overall product mix, and the remodeling of our stores in order to best present the new merchandise. In particular, strong first quarter 2003 retail sales of our premium-positioned textiles, introduced in the first quarter of 2002 as part of the repositioning strategy, contributed to sales more than doubling within the textile product category from the first quarter of fiscal 2002. Sales within the textile product category accounted for approximately 21% of retail sales in the first quarter of fiscal 2003 compared to 11% of sales in the first quarter of fiscal 2002.

Average revenue per retail transaction in the first quarter of fiscal 2003 increased 21% compared to the first quarter of fiscal 2002, while total retail transactions decreased by 7% from the first quarter of fiscal 2002 as compared with the first quarter of fiscal 2003. We attribute the increase in average revenue per transaction to the new product introductions and product mix changes implemented as part of our repositioning strategy. Average revenue per transaction is calculated by dividing gross sales, exclusive of delivery revenue and sales taxes, by the gross number of transactions.

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

Direct-to-Customer

	First Quarter
(dollars in thousands)	2003			2002

Catalog sales	$	6,371		$	3,683
Internet sales	3,502			2,008
Net direct-to-customer sales	9,873			5,691
Shipping fees	1,418			872
Total direct-to-customer sales	$	11,291		$	6,563

Percent growth in direct-to-customer net sales	72		%	5		%
Percent growth in number of catalogs mailed	23		%	31		%

Direct-to-customer sales consist of catalog and Internet sales. Net direct-to-customer sales in the first quarter of fiscal 2003 increased 72% to $11.3 million as compared to the first quarter of fiscal 2002. We believe that the 2002 introduction of the new merchandise offerings and the redesign of our catalog and website primarily contributed to the increase in direct-to-customer sales. In addition, catalog circulation increased 23% in the first quarter of fiscal 2003 over the comparable period in fiscal 2002.

Average revenue per direct-to-customer transaction for the first quarter of fiscal 2003 increased 11% over the first quarter of fiscal 2002, and total direct-to-customer transactions in the first quarter of fiscal 2003 increased 38% from the first quarter of fiscal 2002. We believe the increase in average revenue per transaction is a result of our new product introductions and changed product mix.

Furniture Manufacturing

The Michaels Furniture Company, Inc. is our wholly-owned furniture manufacturing company. It is located in Sacramento, California. Furniture produced at The Michaels Furniture Company, Inc. is sold through our sales channels or to employees. There are no sales to third party resellers.

EXPENSES

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

	First Quarter
	2003		2002

Net sales	100	%	100	%
Cost of sales and occupancy	76	%	84	%
Gross profit	24	%	16	%
Selling, general and administrative	34	%	40	%
Loss from operations	(10	)%	(24	)%
Interest expense, change in fair value of warrants and interest income	(0	)%	(1	)%
Loss before income taxes	(10	)%	(25	)%
Income tax benefit	4	%	15	%
Net loss	(6	)%	(10	)%

COST OF SALES AND OCCUPANCY

Cost of sales and occupancy costs, expressed as a percentage of net sales, decreased 8 percentage points to 76% in the first quarter of fiscal 2003 from 84% in the first quarter of 2002. Approximately 4 percentage points of this decrease was due to a reduction in direct product costs resulting from increased sales of higher margin merchandise, particularly textiles, and savings resulting from our direct sourcing initiatives. In addition, 3 percentage points of the decrease in cost of sales and occupancy costs, expressed as a percentage of net sales, was due to the leveraging of relatively fixed occupancy costs over our higher sales levels. Finally, lower freight costs and the further leveraging of fixed distribution and buying costs over our higher sales levels, contributed to the final 1 percentage point improvement in cost of sales and occupancy costs.

SELLING, GENERAL AND ADMINISTRATIVE

Selling, general and administrative expenses expressed as a percentage of net sales decreased 6%, to 34% in the first quarter of fiscal 2003 from 40% in the first quarter of fiscal 2002. The decrease in selling, general and administrative expenses, as a percentage of net sales, was due to a 2 percentage point improvement in store payroll costs; a 2 percentage point improvement in home office costs, which remained flat in absolute dollars; and a 1 percentage point improvement in each of store display and signage and advertising costs, which were higher in the first quarter of fiscal 2002 due to the store remodeling and merchandise repositioning activities discussed above. Partially offsetting these favorable amounts, was a 1 percentage point increase in advertising and fulfillment costs associated with our direct-to-customer business.

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

Interest Expense

Interest expense includes interest on borrowings under our line of credit facility and amortization of debt issuance costs. Interest expense in both the first quarter of fiscal 2003 and fiscal 2002 was $0.6 million. The average interest rate in the first quarter of fiscal 2003 was 5.8% compared to 6.2% in the same period of fiscal 2002. Average borrowings outstanding in the first quarter of fiscal 2003 were $24.6 million compared to $3.7 million in the first quarter of fiscal 2002. Amortization of deferred financing costs in the first quarter of fiscal 2003 decreased to $0.2 million, from $0.5 million in the first quarter of fiscal 2002.

Warrants

We originally issued warrants in connection with a September 2000 amendment of our credit facility. Such warrants have been exercised into common stock over time and all warrants had been exercised by the end of the first quarter of fiscal 2002. As such, the $0.3 million expense recorded in the first quarter of fiscal 2002 as a result of the change in the fair value of the warrants represented the last such expense recorded by us associated with these warrants.

Interest Income

Interest income, which consists of income from our short-term investments and notes receivable, decreased $76,000, to $7,000 in the first quarter of fiscal 2003 as compared to $83,000 in the first quarter of fiscal 2002. The decrease is principally due to the repayment of a shareholder note by our President and Chief Executive Officer, Gary G. Friedman, during the third quarter of fiscal 2002, and higher average cash balances invested during the first quarter of 2002.

INCOME TAX BENEFIT

Our effective tax benefit rate was 40.0% for the first quarter of fiscal 2003. This rate reflects the effect of aggregate state tax rates based on a mix of retail sales and direct-to-customer sales in the various states in which we have sales revenue or conduct business.

Our income tax benefit for the first quarter of fiscal 2002 included a partial reversal of a deferred tax valuation allowance established at the end of the fiscal year ended February 2, 2002 (“fiscal 2001”). As a result of the Job Creation and Worker Assistance Act of 2002, enacted on March 9, 2002, $4.0 million of deferred tax assets became more likely than not to be realized, and was recognized as an additional tax benefit in the first quarter of fiscal 2002.

PREFERRED SHAREHOLDER DIVIDENDS

A dividend charge of $0.4 million was recognized in the first quarter of 2002 associated with our outstanding Series A preferred stock. Subsequently, pursuant to an August 2, 2002 Letter Agreement, holders of our Series A preferred stock agreed to waive their dividend participation right in the event we were to declare a dividend on our common stock. In the same agreement, we agreed that we will not declare any dividends payable to our common stock holders until we first obtain the approval of at least seventy percent of the then outstanding shares of Series A preferred stock. We have never declared or paid any dividends on our common stock and have no obligation to do so. As a result of the Letter Agreement, beginning with the second quarter of fiscal 2002, we no longer record dividend charges related to our outstanding Series A preferred stock.

LIQUIDITY AND CAPITAL RESOURCES

Operating cash flows

Net cash used in operating activities for the first quarter of fiscal 2003 was $13.6 million compared to $17.5 million for the first quarter of fiscal 2002. The decrease in net cash used in operating activities resulted primarily from

significantly lower merchandise inventory purchases, substantially offset by a decrease in accounts payable and accrued expenses. Merchandise inventory purchase activity was higher in the first quarter of fiscal 2002 as part of the launch of our merchandise repositioning strategy.

Investing cash flows

Net cash used in investing activities in the first quarter of fiscal 2003 was $0.4 million compared to $13.2 million in the first quarter of fiscal 2002. The decrease in net cash used in investing activities reflects the fact that we invested significant amounts of cash in the first quarter of fiscal 2002 primarily to remodel all of our 105 stores.

Financing cash flows

Net cash provided by financing activities for the first quarter of fiscal 2003 was $14.1 million compared to $10.3 million for the first quarter of fiscal 2002. Substantially all of the net cash provided by financing activities for the first three months of fiscal 2003 and fiscal 2002 resulted from net borrowings of $13.1 million and $10.2 million, respectively, under our credit facility. In addition, we received $1.1 million during the first quarter of fiscal 2003 in connection with the settlement of a claim under Section 16(b) of the Securities Exchange Act of 1934, as amended.

At May 3, 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 May 3, 2003, we had $28.3 million outstanding under the line of credit (before unamortized debt issuance costs of $1.1 million), and $10.9 million in outstanding letters of credit. Borrowings made under the credit facility are subject to interest at either the bank’s reference rate or LIBOR plus a margin. As of May 3, 2003, the bank’s reference rate was 5.75% and the LIBOR plus margin rate was 4.07%. The availability of credit at any given time under the credit facility is limited by reference to a borrowing base formula based upon numerous factors, including eligible inventory and eligible accounts receivable. The amount available under the credit facility may be less than the stated maximum limit of the facility. As of May 3, 2003, in addition to outstanding borrowings and letter of credit obligations totaling $39.2 million, we had availability to borrow up to $12.7 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.

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. Should the need arise, we may choose to raise additional funds to respond to changing business conditions or unanticipated competitive pressures. However, 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,” below, 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”.

Contractual Commitments

The following table summarizes our significant contractual obligations as of May 3, 2003 (dollars in thousands):

	Amount of Commitment Expiration Period
	Total		Less Than 1 Year		1 - 3 Years		4 - 5 Years		After 5 years

Contractual obligations:
Operating leases	$	303,250	$	37,168	$	69,736	$	66,110	$	130,236
Capital leases	166		133		33		—		—
Total contractual cash obligations	$	303,416	$	37,301	$	69,769	$	66,110	$	130,236

	Amount of Commitment Expiration Period
	Total		Less Than 1 Year		1 - 3 Years		4 - 5 Years		After 5 years

Other commercial commitments:
Revolving credit facility	$	61,141	$	—	$	61,141	$	—	$	—
Standby letters of credit	2,558		2,558		—		—		—
Trade letters of credit	8,301		8,301		—		—		—
Total commercial commitments	$	72,000	$	10,859	$	61,141	$	—	$	—

CRITICAL ACCOUNTING POLICIES

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements in our Form 10-K, as amended, for the fiscal year ended February 1, 2003, 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 affect their more significant judgments and estimates used 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 shrinkage losses. We also write down our slow-moving and discontinued inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about future demand and market conditions. 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 expected 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.

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 either the first quarter of fiscal 2003 or fiscal 2002.

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.

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, 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 SFAS No. 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, which are not permitted to be considered. Accordingly, we record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. The amount of valuation allowance is based upon management’s best estimate of the recoverability of our deferred tax assets. While future taxable income and ongoing prudent and feasible tax planning are considered in determining the amount of the valuation allowance, this allowance is subject to adjustment in the future. Specifically, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of their net recorded amounts, an adjustment to the deferred tax assets would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax assets in the future, an adjustment to the deferred tax assets would be charged to income in the period such determination was made.

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 a materially different result. See our audited consolidated financial statements and notes thereto to our Annual Report on Form 10-K, as amended, for the fiscal year ended February 1, 2003, which contain accounting policies and other disclosures required by generally accepted accounting principles.

Recently Issued Accounting Standards

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 entities’ activities or is entitled to receive a majority of the entities’ 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. We are in the process of evaluating whether the application of FIN 46 will have a material effect on our financial statements.

In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies the accounting for certain derivative instruments under SFAS No. 133, Accounting for Derivative and Hedging Activities. The amendments in SFAS No. 149 require that contracts with comparable characteristics be treated similarly. Additionally, SFAS No. 149 clarifies under what circumstances a contract with an initial investment meets the characteristics of a derivative according to SFAS No. 133 and when a financing component warrants special reporting in the statement of cash flows. In addition, SFAS No. 149 requires that the definition of an underlying conform to language used in FIN No. 45 and amends certain other existing pronouncements. The requirements of SFAS No. 149 are effective for contracts entered into or modified after June 30, 2003 and for hedging relationships after June 30, 2003. We do not believe the adoption of SFAS No. 149 will have a material effect on our financial condition or results of operations.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS No. 150 establishes standards for the classification and measurement of certain freestanding financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires companies to classify as liabilities financial instruments with certain specified characteristics. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim periods beginning after June 15, 2003. We have not yet determined the potential impact of this statement on our financial condition or results of operations.

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 potential sales revenues and have a material adverse effect on our operating results.

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. Currently, we are planning to execute our right to terminate the leases in three under-performing stores during fiscal 2003 and are evaluating another 3 to 5 under-performing stores for potential closure through 2005. A material decline in sales and other adverse conditions resulting from our failure to accurately anticipate changes in merchandise trends and consumer demands may cause us to close additional under-performing stores. The closure of such stores would subject us to additional costs including, but not limited to, employee severance costs, charges in connection with the impairment of assets and costs associated with the disposition of outstanding lease obligations.

Our success is highly dependent on improvements to our planning and 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 catalog and other marketing expenditures without increased revenues may have a negative impact on our operating results.

We expend a large amount of our available funds on catalog and other marketing costs in advance of a particular season. Moreover, these 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 make similarly large expenditures during the current fiscal year. As a result, if we misjudge the directions or trends in our market, we may expend large amounts of cash that generates little return on investment, which would have a negative effect on our operating results. During the last three fiscal years, our catalog and other marketing costs have increased while only recently have we had a corresponding revenue increase. If we spend increasing amounts of our cash on such costs 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, remodelings or relocations, shifts in the timing of holidays, timing of catalog releases or sales, competitive factors and general economic conditions. Accordingly, our profits or losses may fluctuate. Moreover, in response to competitive pressures, we may take certain pricing or marketing actions that could have a material adverse effect on our business, financial condition and results of operations. Therefore, we believe that period-to-period comparisons of our operating results are not necessarily meaningful and cannot be relied upon as indicators of future performance. If our operating results in any future period fall below the expectations of securities analysts and investors, 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 1.0% in the fiscal year ended February 3, 2001 (“fiscal 2000”). Comparable store sales increased 11.9% in the first quarter of fiscal 2003, as compared to a 0.4% increase in the first quarter of fiscal 2002. 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.

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.

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 had and could continue to 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 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.

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 expansion, 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.

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.

Threats of 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.

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 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 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.

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

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

This quarterly report on Form 10-Q contains “forward-looking statements,” within the meaning of the Private Securities Litigation Reform Act of 1995, that involve known and unknown risks. The safe harbor provisions of the Securities Exchange Act of 1934, as amended, and the Securities Act of 1933, as amended, apply to the forward-looking statements we make. Such forward-looking statements can be identified by the use of forward-looking terminology such as “believes,” “anticipates,” “estimates,” “expects,” “may,” “intends,” and words of similar import or statements of our management’s opinion. These forward-looking statements and assumptions involve known and unknown risks, uncertainties and other factors, including those risks, uncertainties and other factors identified in the section of this report entitled “Factors that May Affect our Future Operating Results” and those risks, uncertainties and other factors identified elsewhere in this report. Such risks, uncertainties and other factors are based on current expectations. These risks, uncertainties and other factors may cause our actual results, market performance or achievements to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Important factors that could cause such differences include, but are not limited to, changes in economic or business conditions in general, changes in product supply, fluctuations in comparable store sales, limitations resulting from restrictive covenants in our credit facility, failure of our management to anticipate changes in consumer trends, loss of key vendors, changes in the competitive environment in which we operate, changes in our management information needs, changes in management, failure to raise additional funds when required, changes in customer needs and expectations, governmental actions and consequences stemming from terrorist activities in or related to the United States. In preparing this report, we have made a number of assumptions and projections about the future of our business. These assumptions and projections could be inaccurate for several reasons, including, but not limited to, the factors described in the section of this report entitled “Factors that May Affect our Future Operating Results.” We undertake no obligation to update any forward-looking statements in order to reflect events or circumstances that may arise after the date of this report.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

Our market risk disclosures set forth in Item 7A of our Annual Report on Form 10-K, as amended, for the year ended February 1, 2003, have not changed materially.

Item 4. Controls and Procedures.

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

In April 2003, our audit committee was advised by our independent auditors, Deloitte & Touche LLP (“Deloitte & Touche”), that during the course of their audit of our financial statements for the fiscal year ended February 1, 2003, they had identified internal control deficiencies that they considered to be material weaknesses under standards established by the American Institute of Certified Public Accountants. These material weaknesses include deficiencies in our accounting and financial reporting infrastructure and the lack of sufficient expertise within the accounting and finance departments.

We are assigning the highest priority to the short-term and long-term correction of these internal control deficiencies. Our audit committee commenced an independent investigation by outside legal counsel of the circumstances surrounding certain accounting errors which had been previously disclosed, as well as the concerns raised by Deloitte & Touche. This investigation has now been completed.

Under the direction of our audit committee and with the participation of our senior management, we have taken steps designed to strengthen our disclosure controls and procedures and internal controls. These include the following items. In the last year, we hired an independent third party to perform a risk assessment and serve as our internal audit department. We hired additional staff in our finance department, including a new Corporate Controller in November 2002 and additional accounting department personnel in 2003. Additionally, we engaged consultants with experience at senior levels of accounting and financial management to assist and advise us in the implementation of policies and procedures to address the issues identified by our audit committee’s investigation and to support the existing accounting

and finance teams. We have made personnel changes in the senior financial accounting staff to eradicate persistent accounting issues that we have identified and are correcting. We established a disclosure committee to assist the CEO and CFO in overseeing the accuracy and timeliness of our public disclosures and evaluate regularly our disclosure controls and procedures. Further, we added an audit committee financial expert to our audit committee.

We are in the process of taking additional corrective actions. These include revising the manner in which certain reconciliations are performed to enhance the identification of matters requiring additional investigation. We also plan to adopt new accounting policies, procedures and internal controls for the periodic consolidated financial closing process including closer management review. In 2003, we intend to hire additional personnel in our accounting and finance departments and further enhance responsibility, supervision and training of existing personnel. Moreover, we will continue to review the performance of certain internal financial staff and, if deemed necessary, will take prompt corrective action as well as other appropriate action regarding our employees so as to strengthen our compliance with Sarbanes-Oxley Act compliance procedures.

While we are in the process of implementing a more efficient and reliable system of disclosure controls and procedures and internal controls, as noted above, we have, on an immediate basis, instituted additional interim controls and procedures, including the hiring of outside consultants to support the existing accounting and finance teams and the implementation of additional interim procedures. We believe that the additional procedures and controls currently being implemented, in addition to the interim steps we have taken, will address the material weaknesses and deficiencies identified by our independent auditors. Moreover, after the extensive investigative work of our staff and outside consultants, we believe that the information required to be disclosed in this quarterly report on Form 10-Q has been recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission. We will continue to identify and implement actions to improve the effectiveness of our disclosure controls and procedures and internal controls on an ongoing basis and will take further action as appropriate. These controls and procedures will require continued monitoring and updating as our business continues to evolve.

As a result of the steps taken to improve our disclosure controls and procedures and internal controls, including additional interim procedures, we believe that our disclosure controls and procedures are adequate to enable us to comply with our disclosure obligations and prevent material misstatements in our future consolidated financial results.

Other than as described above, there have been no other significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date we carried out our evaluation.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings.

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

Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits.

See attached exhibit index.

(b) Reports on Form 8-K.

On February 7, 2003, we filed with the Securities and Exchange Commission a current report on Form 8-K, which included reports under items 5 and 7 thereto and attached a press release issued on February 6, 2003, announcing our fourth quarter and year-end sales results for fiscal 2002.

On March 20, 2003, we filed with the Securities and Exchange Commission a current report on Form 8-K, which included reports under items 5 and 7 thereto and attached a press release issued on March 19, 2003, announcing our sales and earnings results for fiscal 2002.

SIGNATURES

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

	Restoration Hardware, Inc.

Date: June 13, 2003	By:	/s/ GARY G. FRIEDMAN
		Gary G. Friedman
		President and Chief Executive Officer

Date: June 13, 2003	By:	/s/ KEVIN W. SHAHAN
		Kevin W. Shahan
		Vice President and Chief Financial Officer (Principal Financial Officer)

RESTORATION HARDWARE, INC.

CERTIFICATION

I, Gary G. Friedman, certify that:

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

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

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

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

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

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

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

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

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

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

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

Date: June 13, 2003

	By:	/s/ GARY G. FRIEDMAN
		Gary G. Friedman
		Chief Executive Officer

I, Kevin W. Shahan, certify that:

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

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

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

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

Date: June 13, 2003

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

EXHIBIT INDEX

EXHIBIT NUMBER		DOCUMENT DESCRIPTIONS

3.1		Second Amended and Restated Certificate of Incorporation, as amended(1)
3.2		Amended and Restated Bylaws(2)
10.1		Separation Agreement and Release between Restoration Hardware, Inc. and Elizabeth (“Lisa”) Salamone, effective as of March 6, 2003(3)
10.2		Offer Letter, dated April 16, 2003, from Restoration Hardware, Inc. to Vivian Macdonald

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

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

(3) Incorporated by reference to Exhibit 10.59 to the annual report on Form 10-K for Restoration Hardware, Inc. for the fiscal year ended February 1, 2003 filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on May 2, 2003.