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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 August 2, 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 August 26, 2003, 30,191,814 shares of the registrant’s common stock, $0.0001 par value per share, were outstanding.

 

 



 

FORM 10-Q

 

FOR THE QUARTER ENDED AUGUST 2, 2003

 

TABLE OF CONTENTS

 

PART I.

FINANCIAL INFORMATION

 

 

Item 1.

Financial Statements (Unaudited)

 

 

 

Condensed Consolidated Balance Sheets as of August 2, 2003, February 1, 2003,  and August 3, 2002 (As Restated)

 

 

 

Condensed Consolidated Statements of Operations for the three and six months ended August 2, 2003 and August 3, 2002 (As Restated)

 

 

 

Condensed Consolidated Statements of Cash Flows for the six months ended August 2, 2003 and August 3, 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 4.

Submission of Matters to a Vote of Security Holders

 

 

Item 6.

Exhibits and Reports on Form 8-K

 

SIGNATURES

 

EXHIBIT INDEX

 

2



 

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements.

 

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(dollars in thousands)

(Unaudited)

 

 

 

August 2,
2003

 

February 1,
2003

 

August 3,
2002

 

 

 

 

 

 

 

(As Restated)

 

 

 

 

 

 

 

 

 

ASSETS

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

2,214

 

$

1,630

 

$

1,540

 

Accounts receivable

 

4,079

 

3,352

 

3,324

 

Merchandise inventories

 

92,289

 

94,500

 

89,234

 

Prepaid expense and other current assets

 

10,692

 

12,445

 

13,394

 

Total current assets

 

109,274

 

111,927

 

107,492

 

Property and equipment, net

 

83,587

 

90,038

 

96,306

 

Goodwill

 

4,560

 

4,560

 

4,560

 

Deferred tax asset

 

22,437

 

17,171

 

19,139

 

Other long-term assets

 

4,867

 

2,532

 

2,101

 

Total assets

 

$

224,725

 

$

226,228

 

$

229,598

 

 

 

 

 

 

 

 

 

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable and accrued expenses

 

$

31,923

 

$

35,649

 

$

41,698

 

Deferred revenue

 

4,828

 

5,870

 

3,779

 

Revolving line of credit, net of debt issuance costs

 

 

 

23,159

 

Other current liabilities

 

8,925

 

9,322

 

9,277

 

Total current liabilities

 

45,676

 

50,841

 

77,913

 

Long-term line of credit, net of debt issuance costs

 

25,909

 

13,909

 

 

Deferred lease incentives

 

36,190

 

39,109

 

41,161

 

Deferred rent

 

14,414

 

14,163

 

13,500

 

Other long-term obligations

 

140

 

144

 

80

 

Total liabilities

 

122,329

 

118,166

 

132,654

 

 

 

 

 

 

 

 

 

Series A redeemable convertible preferred stock, $.0001 par value, 28,037 shares designated, 13,470 shares issued and outstanding, at August 2, 2003, February 1, 2003 and August 3, 2002, aggregate liquidation preference and redemption value of $15,426 at August 2, 2003

 

13,328

 

13,328

 

13,529

 

 

 

 

 

 

 

 

 

Common stock, $.0001 par value; 60,000,000 shares authorized:  30,175,699, 30,050,994 and 29,870,210 issued and outstanding, at August 2, 2003, February 1, 2003 and August 3, 2002, respectively

 

152,376

 

150,881

 

149,417

 

Stockholder loan

 

 

 

(2,050

)

Unearned compensation

 

(409

)

(659

)

(904

)

Accumulated other comprehensive income (loss)

 

431

 

(132

)

(115

)

Accumulated deficit

 

(63,330

)

(55,356

)

(62,933

)

Total stockholders’ equity

 

89,068

 

94,734

 

83,415

 

 

 

 

 

 

 

 

 

Total liabilities, redeemable convertible preferred stock and stockholders’ equity

 

$

224,725

 

$

226,228

 

$

229,598

 

 

See Notes to Condensed Consolidated Financial Statements.

 

3



 

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(Unaudited)

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

August 2,
2003

 

August 3,
2002

 

August 2,
2003

 

August 3,
2002

 

 

 

 

 

(As Restated)

 

 

 

(As Restated)

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

95,973

 

$

85,019

 

$

177,739

 

$

154,396

 

Cost of sales and occupancy

 

71,160

 

62,716

 

132,985

 

121,205

 

Gross profit

 

24,813

 

22,303

 

44,754

 

33,191

 

Selling, general and administrative expenses

 

28,862

 

27,504

 

56,891

 

54,962

 

Loss from operations

 

(4,049

)

(5,201

)

(12,137

)

(21,771

)

 

 

 

 

 

 

 

 

 

 

Interest expense

 

(599

)

(811

)

(1,168

)

(1,385

)

Interest income

 

6

 

40

 

13

 

121

 

Change in fair value of warrants

 

 

 

 

(278

)

Loss before income taxes

 

(4,642

)

(5,972

)

(13,292

)

(23,313

)

Income tax benefit

 

1,857

 

2,154

 

5,317

 

12,402

 

Net loss

 

(2,785

)

(3,818

)

(7,975

)

(10,911

)

 

 

 

 

 

 

 

 

 

 

Preferred shareholder return:

 

 

 

 

 

 

 

 

 

Dividends

 

 

 

 

(358

)

 

 

 

 

 

 

 

 

 

 

Net loss attributable to common stockholders

 

$

(2,785

)

$

(3,818

)

$

(7,975

)

$

(11,269

)

 

 

 

 

 

 

 

 

 

 

Net loss per common share:

 

 

 

 

 

 

 

 

 

Basic and diluted loss per share

 

$

(0.09

)

$

(0.13

)

$

(0.27

)

$

(0.38

)

Weighted average shares basic and diluted

 

30,083

 

29,807

 

30,068

 

29,526

 

 

See Notes to Condensed Consolidated Financial Statements.

 

4



 

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(dollars in thousands)

(Unaudited)

 

 

 

Six Months Ended

 

 

 

August 2,
2003

 

August 3,
2002

 

 

 

 

 

(As Restated)

 

 

 

 

 

 

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(7,975

)

$

(10,911

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

9,831

 

9,580

 

Change in fair value of warrants

 

 

278

 

Deferred income taxes

 

(5,317

)

(8,732

)

Changes in assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(725

)

(47

)

Merchandise inventories

 

2,211

 

(28,183

)

Prepaid expenses and other assets

 

(445

)

(366

)

Accounts payable and accrued expenses

 

(3,726

)

7,759

 

Deferred revenue

 

(1,042

)

925

 

Other current liabilities

 

(397

)

94

 

Deferred rent

 

251

 

810

 

Deferred lease incentives and other long-term liabilities

 

(2,928

)

(448

)

Net cash used in operating activities

 

(10,262

)

(29,241

)

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Capital expenditures

 

(2,385

)

(16,770

)

Net cash used in investing activities

 

(2,385

)

(16,770

)

 

 

 

 

 

 

Cash flows from financing activities:

 

 

 

 

 

Borrowings under revolving line of credit, net

 

10,489

 

24,041

 

Other long-term obligations

 

4

 

(106

)

Proceeds received from Section 16(b) shareholder settlement

 

1,050

 

 

Issuance of common stock

 

1,495

 

1,273

 

Net cash provided by financing activities

 

13,038

 

25,208

 

 

 

 

 

 

 

Effects of foreign currency exchange rate translation on cash

 

193

 

58

 

Net increase (decrease) in cash and cash equivalents

 

584

 

(20,745

)

 

 

 

 

 

 

Cash and cash equivalents:

 

 

 

 

 

Beginning of period

 

1,630

 

22,285

 

End of period

 

$

2,214

 

$

1,540

 

 

 

 

 

 

 

Additional cash flow information:

 

 

 

 

 

Cash paid during the period for interest (net of amount capitalized)

 

$

732

 

$

419

 

Cash (received) paid during the period for taxes

 

114

 

118

 

Non-cash transactions:

 

 

 

 

 

Conversion of Preferred Series A stock to common stock

 

$

 

$

935

 

Exercise of warrants

 

 

2,956

 

Dividends attributable to preferred stock

 

 

358

 

 

See Notes to Condensed Consolidated Financial Statements.

 

5



 

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 August 2, 2003, the Company operated 102 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 August 2, 2003 and August 3, 2002; results of operations for the three and six months ended August 2, 2003 and August 3, 2002; and changes in cash flows for the six months ended August 2, 2003 and August 3, 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 disclosures normally included in the notes to 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. The interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements, including the notes, for fiscal 2002.

 

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

 

Certain reclassifications have been made to the prior year financials statements in order to conform to the current year presentation.

 

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.

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

August 2,
2003

 

August 3,
2002

 

August 2,
2003

 

August 3,
2002

 

 

 

 

 

(As Restated)

 

 

 

(As Restated)

 

Net loss attributable to common stockholders

 

 

 

 

 

 

 

 

 

As reported

 

$

(2,785

)

$

(3,818

)

$

(7,975

)

$

(11,269

)

Add:  Stock based compensation expense included in reported net loss (net of tax)

 

75

 

71

 

150

 

142

 

Deduct:  Compensation expense for all stock based compensation (net of tax) calculated in accordance with the fair value method

 

(525

)

(778

)

(975

)

(1,461

)

Pro forma

 

$

(3,235

)

$

(4,525

)

$

(8,800

)

$

(12,588

)

Net loss per common share:

 

 

 

 

 

 

 

 

 

Basic and diluted, as reported

 

$

(0.09

)

$

(0.13

)

$

(0.27

)

$

(0.38

)

Basic and diluted, pro forma

 

$

(0.11

)

$

(0.15

)

$

(0.29

)

$

(0.43

)

 

6



 

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 and six months ended August 2, 2003 and August 3, 2002, are as follows (in thousands):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

August 2,
2003

 

August 3,
2002

 

August 2,
2003

 

August 3,
2002

 

 

 

 

 

(As Restated)

 

 

 

(As Restated)

 

Components of comprehensive income (loss):

 

 

 

 

 

 

 

 

 

Net loss

 

$

(2,785

)

$

(3,818

)

$

(7,975

)

$

(10,911

)

Foreign currency translation adjustment

 

220

 

(261

)

563

 

44

 

Total comprehensive loss

 

$

(2,565

)

$

(4,079

)

$

(7,412

)

$

(10,867

)

 

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.  Costs incurred in connection with the Company’s closure of three underperforming stores were fully recognized during the second fiscal quarter of 2003 and no amounts remained accrued as of August 2, 2003.

 

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
 
7


 
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 initial adoption of SFAS No. 149 did not have a material effect on the Company’s financial position 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.  As of August 2, 2003, the Company had not determined the potential impact of this statement on its financial condition or results of operations.  The Company is in the process of evaluating whether the application of SFAS No. 150 will have a material effect on its financial statements.

 

3.  GOODWILL
 

As of August 2, 2003 and August 3, 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 and six month periods ended August 2, 2003 and August 3, 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 August 2, 2003, $26.7 million was outstanding under the line of credit (before unamortized debt issuance costs of $0.8 million), and there was $19.6 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 August 2, 2003, the bank’s reference rate was 5.0% and the LIBOR plus margin rate was 3.35%.  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.  As a result, the actual borrowing availability under the credit facility will generally be less than the stated maximum amount of the facility reduced by the actual borrowings and outstanding letters of credit.  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 the change in the law, the Company re-evaluated its deferred tax assets in the first quarter of fiscal 2002 and, consequently, reduced its valuation allowance at May 4, 2002 from $7.0 million to $3.0 million. The condensed consolidated statements of operations for the first six months of fiscal 2002 reflect the effect of this valuation allowance reduction as a $4.0 million tax benefit. The Company subsequently received cash of $4.0 million in fiscal 2002 associated with the carryback of these net operating losses.

 

8



 

6.  EARNINGS PER SHARE

 

Basic earnings per share is computed by dividing net income attributable 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 attributable 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:

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

August 2,
2003

 

August 3,
2002

 

August 2,
2003

 

August 3,
2002

 

 

 

 

 

(As Restated)

 

 

 

(As Restated)

 

 

 

 

 

 

 

 

 

 

 

Common stock issuable upon conversion of the Series A preferred stock

 

6,767,824

 

6,750,702

 

6,767,824

 

6,750,702

 

Common stock subject to outstanding stock options

 

479,782

 

1,047,827

 

268,489

 

1,349,831

 

 

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 2,489,809 and 1,439,673 stock options for the three months ended August 2, 2003 and August 3, 2002, respectively, and 3,495,836 and 1,094,769 stock options for the six months ended August 2, 2003 and August 3, 2002, respectively, 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 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):

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

August 2,
2003

 

August 3,
2002

 

August 2,
2003

 

August 3,
2002

 

 

 

 

 

(As Restated)

 

 

 

(As Restated)

 

 

 

 

 

 

 

 

 

 

 

Net Sales:

 

 

 

 

 

 

 

 

 

Retail

 

$

81,878

 

$

75,393

 

$

152,349

 

$

138,190

 

Direct-to-Customer

 

14,090

 

9,625

 

25,381

 

16,188

 

Furniture manufacturing

 

4,162

 

4,131

 

9,045

 

8,137

 

Intersegment furniture sales

 

(4,157

)

(4,130

)

(9,036

)

(8,119

)

Total net sales

 

$

95,973

 

$

85,019

 

$

177,739

 

$

154,396

 

 

 

 

Three Months Ended

 

Six Months Ended

 

 

 

August 2,
2003

 

August 3,
2002

 

August 2,
2003

 

August 3,
2002

 

 

 

 

 

(As Restated)

 

 

 

(As Restated)

 

Income (loss) from operations:

 

 

 

 

 

 

 

 

 

Retail

 

$

6,481

 

$

4,592

 

$

9,214

 

$

(276

)

Direct-to-Customer

 

1,643

 

1,003

 

3,296

 

1,290

 

Furniture manufacturing

 

72

 

(178

)

(30

)

(290

)

Unallocated

 

(12,088

)

(10,525

)

(24,452

)

(21,664

)

Intersegment loss from operations

 

(157

)

(93

)

(165

)

(831

)

Total loss from operations

 

$

(4,049

)

$

(5,201

)

$

(12,137

)

$

(21,771

)

 

9



 

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, 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.  As a result, the condensed consolidated financial statements as of and for the quarter ended August 3, 2002, were restated from the amounts previously reported as follows:

 

 

 

As of August 3, 2002

 

(in  thousands, except per share amounts)

 

As Previously
Reported

 

As Restated

 

 

 

 

 

 

 

Merchandise inventories

 

$

91,024

 

$

89,234

 

Prepaid expenses and other current assets

 

12,431

 

13,394

 

Deferred tax asset

 

19,460

 

19,139

 

Other long-term assets

 

930

 

2,101

 

Accounts payable and accrued expenses

 

41,409

 

41,698

 

Deferred rent

 

13,514

 

13,500

 

Accumulated deficit

 

(62,681

)

(62,933

)

Total stockholders’ equity

 

83,667

 

83,415

 

 

 

 

Three Months Ended August 3, 2002

 

Six Months Ended August 3, 2002

 

(Dollars in thousands, except per share amounts)

 

As previously
reported

 

As restated

 

As previously
reported

 

As restated

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

$

85,019

 

$

85,019

 

$

154,396

 

$

154,396

 

Cost of sales and occupancy

 

62,106

 

62,716

 

120,595

 

121,205

 

Gross profit

 

22,913

 

22,303

 

33,801

 

33,191

 

Selling, general and administrative

 

27,781

 

27,504

 

54,851

 

54,962

 

Loss from operations

 

(4,868

)

(5,201

)

(21,050

)

(21,771

)

Interest expense

 

(811

)

(811

)

(1,387

)

(1,385

)

Interest income

 

40

 

40

 

123

 

121

 

Change in fair value of warrants

 

 

 

(278

)

(278

)

Pretax loss

 

(5,639

)

(5,972

)

(22,592

)

(23,313

)

Income tax benefit

 

2,030

 

2,154

 

12,133

 

12,402

 

Net loss

 

(3,609

)

(3,818

)

(10,459

)

(10,911

)

Net loss per share:

 

 

 

 

 

 

 

 

 

Basic

 

$

(0.12

)

$

(0.13

)

$

(0.37

)

$

(0.38

)

Diluted

 

$

(0.12

)

$

(0.13

)

$

(0.37

)

$

(0.38

)

 

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

 

10



 

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 31st.  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 August 2, 2003, we operated 102 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.

 

During the second quarter of fiscal 2003, we closed three under-performing stores, and in August 2003 closed a fourth.  Currently, we are evaluating another 2 to 4 under-performing stores for potential closure through 2005.

 

For the second quarter of fiscal 2003, net sales were $96.0 million, a 13% increase over net sales of $85.0 million for the second quarter of fiscal 2002.  Comparable stores sales for the second quarter of fiscal 2003 increased 9.9% over the same period a year ago.  Direct-to-customer sales, which include catalog and Internet sales, in the second quarter of 2003 increased 46% over the prior year to $14.1 million.

 

Net sales were $177.7 million for the first six months of fiscal 2003, an increase of 15% over net sales of $154.4 million for the same period of fiscal 2002.  Comparable stores sales for the first six months of fiscal 2003 increased 10.8% over the same period in the prior year.  Direct-to-customer sales increased 57% for the first six months of fiscal 2003 over the same period of fiscal 2002 to $25.4 million.

 

Net loss attributable to common stockholders was $0.09 per share, or $2.8 million for the second quarter of fiscal 2003, compared to a net loss attributable to common stockholders of $0.13 per share or $3.8 million for the second quarter of fiscal 2002.

 

For the first six months of fiscal 2003, net loss attributable to common shareholders was $0.27 per share, or $8.0 million, compared to net loss attributable to common shareholders of $0.38 per share, or $11.3 million for the first six months of fiscal 2002.

 

The Company’s net loss attributable to common stockholders for the three and six months ended August 2, 2003 was 27% and 29% lower than the year ago periods as higher sales levels and improved gross margin contributed to a significantly lower loss from operations.

 

RESULTS OF OPERATIONS

 

NET SALES

 

Net sales consist of the following components:

 

 

 

Second Quarter 2003

 

Second Quarter 2002

 

Year to Date 2003

 

Year to Date 2002

 

(dollars in thousands)

 

Dollars

 

% Total

 

Dollars

 

% Total

 

Dollars

 

% Total

 

Dollars

 

% Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Retail

 

$

81,878

 

85.3

%

$

75,393

 

88.7

%

$

152,349

 

85.7

%

$

138,190

 

89.5

%

Direct-to-customer

 

14,090

 

14.7

%

9,625

 

11.3

%

25,381

 

14.3

%

16,188

 

10.5

%

Furniture manufacturing

 

5

 

0.0

%

1

 

0.0

%

9

 

0.0

%

18

 

0.0

%

 

 

$

95,973

 

100

%

$

85,019

 

100

%

$

177,739

 

100

%

$

154,396

 

100

%

 

11



 

Net sales for the second quarter of fiscal 2003 increased $11.0 million or 13% over net sales reported for the second quarter of fiscal 2002.  The increase in net sales in the second quarter of this fiscal year compared to last year is principally due to a 9.9% increase in comparable store sales and strong sales growth in our direct-to-customer division.

 

Net sales amounts include shipping fees of $2.8 million for the second quarter of fiscal 2003 compared to $1.8 million for the second 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

 

 

 

Second Quarter

 

Year to Date

 

(dollars in thousands)

 

2003

 

2002

 

2003

 

2002

 

Retail sales

 

$

81,112

 

$

74,702

 

$

150,902

 

$

136,847

 

Shipping fees

 

766

 

691

 

1,447

 

1,343

 

Net retail sales

 

$

81,878

 

$

75,393

 

$

152,349

 

$

138,190

 

Net retail sales growth percentage

 

9

%

9

%

10

%

4

%

Comparable stores sales increase

 

9.9

%

8.9

%

10.8

%

4.8

%

Number of stores at period beginning

 

105

 

105

 

105

 

104

 

Store openings

 

 

 

 

1

 

Store closings

 

(3

)

 

(3

)

 

Number of stores at period end

 

102

 

105

 

102

 

105

 

Store selling sq. ft. at period end

 

668,463

 

688,634

 

668,463

 

688,634

 

 

Net retail sales in the second quarter of fiscal 2003 increased 9% as compared to the same period in fiscal 2002, primarily due to a 9.9% increase in comparable store sales.  The comparable store sales increase resulted primarily from strong performance in textiles, bath hardware, and outdoor furniture.

 

For the first six months of fiscal 2003, retail sales increased 10% as compared to the same period of the prior year, primarily due to an increase in comparable store sales of 10.8%.  The comparable store sales increased primarily from strong performance in textiles, bath hardware, and outdoor furniture.

 

During the second quarter of fiscal 2003, we closed three under-performing stores.  The stores were located in Florida, Louisiana, and Pennsylvania.  In addition, in August 2003, we closed one other under-performing store located in Florida.

 

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

 

 

 

Second Quarter

 

Year to Date

 

(dollars in thousands)

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Catalog sales

 

$

7,586

 

$

5,727

 

$

13,957

 

$

9,409

 

Internet sales

 

4,515

 

2,762

 

8,017

 

4,771

 

Net direct-to-customer sales

 

12,101

 

8,489

 

21,974

 

14,180

 

Shipping fees

 

1,989

 

1,136

 

3,407

 

2,008

 

Total direct-to-customer sales

 

$

14,090

 

$

9,625

 

$

25,381

 

$

16,188

 

 

 

 

 

 

 

 

 

 

 

Percent growth in direct-to-customer total sales

 

46

%

40

%

57

%

23

%

Percent growth (decrease) in number of catalogs mailed

 

(27

)%

78

%

(3

)%

62

%

 

12



 

Direct-to-customer sales consist of catalog and Internet sales.  Total direct-to-customer sales in the second quarter of fiscal 2003 increased 46% to $14.1 million as compared to the second quarter of fiscal 2002. For the first six months of fiscal 2003, total direct-to-customer sales increased 57% to $25.4 million as compared to the same period of fiscal 2002.  We believe this growth was driven by an increase in the average page count per catalog, positive customer reaction to the product assortment offered in our catalog, and by increasing the amount of merchandise which is only available from our catalog or through our website.  Catalog circulation decreased by 27% and 3% in the three and six months ended August 2, 2003, respectively, over the comparable periods in fiscal 2002, as a result of timing changes in certain catalog mailings.

 

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.

 

 

 

Second Quarter

 

Year to Date

 

 

 

2003

 

2002

 

2003

 

2002

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

100

%

100

%

100

%

100

%

Cost of sales and occupancy

 

74

%

74

%

75

%

79

%

Gross profit

 

26

%

26

%

25

%

21

%

Selling, general and administrative

 

30

%

32

%

32

%

36

%

Loss from operations

 

(4

)%

(6

)%

(7

)%

(15

)%

Interest expense, change in fair value of warrants and interest income

 

(1

)%

(1

)%

(1

)%

(1

)%

Loss before income taxes

 

(5

)%

(7

)%

(8

)%

(15

)%

Income tax benefit

 

2

%

3

%

3

%

8

%

Net loss

 

(3

)%

(4

)%

(5

)%

(7

)%

 

COST OF SALES AND OCCUPANCY

 

Cost of sales and occupancy costs expressed as a percentage of net sales were 74% for both the second quarter of fiscal 2003 and the second quarter of fiscal 2002, as increased markdowns in the second quarter of fiscal 2002, which impacted outdoor furniture and textiles margins, were substantially offset by the leveraging of relatively fixed occupancy costs in the second quarter of fiscal 2003, which continued to decline as a percentage of sales.

 

Cost of sales and occupancy costs expressed as a percentage of net sales decreased 4 percentage points to 75% for the first six months of fiscal 2003 from 79% for the same period of fiscal 2002.  The majority 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, a portion 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.  Lastly, cost of sales and occupancy costs during the first six months of fiscal 2002, expressed as a percentage of net sales, were higher than in the first six months of fiscal 2003 due to markdowns incurred in connection with the final clearance of merchandise replaced or eliminated as a result of our fiscal 2002 repositioning

 

13



 

strategy.

 

SELLING, GENERAL AND ADMINISTRATIVE

 

Selling, general and administrative expenses expressed as a percentage of net sales decreased 2%, to 30% in the second quarter of fiscal 2003 from 32% in the second quarter of fiscal 2002.  The decrease in selling, general and administrative expenses, as a percentage of net sales, was due to a 1 percentage point improvement in store advertising costs, which were higher in the second quarter of fiscal 2002 due to extensive store remodeling and merchandise repositioning activities.  In addition, store payroll and operating costs declined as a percentage of sales by 1 percentage point.

 

Selling, general and administrative expenses expressed as a percentage of net sales decreased 4%, to 32% for the first six months of fiscal 2003 from 36% for the same period 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 costs, including store display and signage costs; a 1 percentage point improvement in store advertising costs, which were higher in the first six months of fiscal 2002 due to significant store remodeling and merchandise repositioning activities; and a 1 percentage point improvement in headquarters expenses.

 

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 for the second quarter of fiscal 2003 decreased $0.2 million from interest expense for the second quarter of fiscal 2002.  The average interest rate in the second quarter of fiscal 2003 was 5.09% compared to 6.78% in the same period of fiscal 2002.  Average borrowings outstanding in the second quarter of fiscal 2003 were $28.0 million compared to $23.8 million in the second quarter of fiscal 2002.  Amortization of deferred financing costs in the second quarter of fiscal 2003 decreased to $0.2 million, from $0.5 million in the second quarter of fiscal 2002.

 

Interest expense for the first six months of fiscal 2003 was $1.2 million, compared to $1.4 million for the same period of fiscal 2002.  The average interest rate for the first six months of fiscal 2003 was 5.41% compared to 8.48% in the same period of fiscal 2002.  Average borrowings outstanding for the first six months of fiscal 2003 were $26.4 million compared to $12.7 million in the same period of fiscal 2002.  Amortization of deferred financing costs for the first six months of fiscal 2003 decreased to $0.5 million, from $0.9 million in the same period 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 six months 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 to $6,000 and $13,000 for the three and six months ended August 2, 2003, from $40,000 and $121,000 for the three and six months ended August 3, 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.

 

INCOME TAX BENEFIT

 

Our effective tax benefit rate was 40% for the second 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 six months 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

 

14



 

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 during the first six months of fiscal 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 we 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 six months of fiscal 2003 was $10.3 million compared to $29.2 million for the same period of fiscal 2002.  The decrease in net cash used in operating activities resulted primarily from significantly lower merchandise inventory purchases, partially offset by a decrease in accounts payable and accrued expenses.  Merchandise inventory purchase activity was higher in the first half of fiscal 2002 as part of the launch of our merchandise repositioning strategy.

 

Investing cash flows

 

Net cash used in investing activities for the first six months of fiscal 2003 was $2.4 million compared to $16.8 million for the same period 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 six months of fiscal 2002 primarily to remodel all of our stores.

 

Financing cash flows

 

Net cash provided by financing activities for the first six months of fiscal 2003 was $13.0 million compared to $25.2 million for the same period of fiscal 2002.  Substantially all of the net cash provided by financing activities for the first six months of fiscal 2003 and fiscal 2002 resulted from net borrowings of $10.5 million and $24.0 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 August 2, 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 August 2, 2003, we had $26.7 million outstanding under the line of credit (before unamortized debt issuance costs of $0.8 million), and $19.6 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 August 2, 2003, the bank’s reference rate was 5.0% and the LIBOR plus margin rate was 3.35%.  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. As a result, the actual borrowing availability under the credit facility will generally be less than the stated maximum amount of the facility reduced by the actual borrowings and outstanding letters of credit. 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

 

15



 

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 August 2, 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

 

$

293,472

 

$

36,566

 

$

68,894

 

$

65,961

 

$

122,051

 

Capital leases

 

306

 

231

 

62

 

13

 

 

Total contractual cash obligations

 

$

293,778

 

$

36,797

 

$

68,956

 

$

65,974

 

$

122,051

 

 

 

 

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

 

$

52,443

 

$

 

$

52,443

 

$

 

$

 

Standby letters of credit

 

2,566

 

2,566

 

 

 

 

Trade letters of credit

 

16,991

 

16,991

 

 

 

 

Total commercial commitments

 

$

72,000

 

$

19,557

 

$

52,443

 

$

 

$

 

 

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

 

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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 of the first six month periods 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

 

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communicate the closure and related severance packages to the affected employees.  Costs incurred in connection with our closure of three underperforming stores were fully recognized during the second fiscal quarter of 2003 and no amounts remained accrued as of August 2, 2003.

 

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 may adversely affect our results of operations 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.

 

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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 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.  Costs incurred in connection with our closure of three underperforming stores were fully recognized during the second fiscal quarter of 2003 and no amounts remained accrued as of August 2, 2003.

 

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 our financial position or results of operations.

 

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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.  The initial adoption of SFAS No. 149 did not have a material effect on our financial position 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.  As of August 2, 2003, we had not determined the potential impact of this statement on our financial condition or results of operations.  We are in the process of evaluating whether the application of SFAS No. 150 will have a material effect on our financial statements.
 
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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.  During the second quarter of 2003, we closed three under-performing stores and in August 2003 we closed an additional under-performing store.  Currently, we are evaluating another 2 to 4 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.  While the company believes that it benefits financially in the aggregate by closing underperforming stores and reducing nonproductive costs, the closure of such stores would subject us to additional increased short-term 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.

 

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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 9.9% in the second quarter of fiscal 2003, as compared to an 8.9% increase in the second 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 - one, a manufacturer of upholstered furniture, and the other, a manufacturer of table and floor lamps -  together accounted for approximately 16% of our aggregate merchandise purchases in fiscal 2002. In addition, our smaller vendors generally have limited resources, production capacities and operating histories, and some of our vendors have limited the distribution of their merchandise in the past. We have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products, and any vendor or distributor could discontinue selling to us at any time. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future, or be able to develop relationships with new vendors to expand our options or replace discontinued vendors. Our inability to acquire suitable merchandise in the future or the loss of one or more key vendors and our failure to replace any one or more of them may have a material adverse effect on our business, results of operations and financial condition.

 

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

 

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We have 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

 

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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 1st and October 31st 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.  Moreover, 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 in the past and could have in the future negative effects on our operations. While our credit facility was amended at various times over the past several years to provide us with more favorable interest rates and changes to some requirements, a significant portion of our cash flow from operations was used in the past to pay our interest expense and was not available for other business purposes.  An increase in the variable interest rate under our credit facility coupled with an increase in our outstanding debt could result in material amounts otherwise available for other business purposes being use to pay for interest expense.

 

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, risks of damage, destruction or confiscation of products while in transit to our distribution centers located in the United States, 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 including without limitation as a result of events such as longshoremen strikes, transportation and other delays in shipments including without limitation as a result of heightened security screening and inspection processes or other port-of-entry limitations or restrictions in the United States, 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. Furthermore, some or all of our foreign vendors’ operations may be adversely affected by political, financial or other instabilities that are particular to their home countries, including without limitation local acts of terrorism or economic, environmental or health and welfare-related crises, which may in turn

 

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result in limitations or temporary or permanent halts to their operations, restrictions on the transfer of goods or funds and/or other trade disruptions.  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 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, hired two new financial managers in mid-2003, have made additional changes to our finance department and its staff, and have retained outside consultants to support our existing accounting and finance teams, 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,

 

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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, including the on-going U.S. interventions in Iraq and Afghanistan, further conflicts in the Middle East and in other developing countries, 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.

 

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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

 

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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.

 

As of August 2, 2003, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures.  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 assigned the highest priority to the short-term and long-term correction of these internal control deficiencies.  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 our internal control over financial reporting.  These

 

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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 and Deloitte & Touche and to support the existing accounting and finance teams.  We have also made a number of personnel changes in the senior financial accounting staff to address 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 a financial expert to our audit committee.

 

During the fiscal quarter ended August 2, 2003, we continued a number of these corrective actions and took additional measures to address the material internal control weaknesses identified by Deloitte & Touche.  Additional corrective actions implemented during the quarter ended August 2, 2003 included the following:

 

      We hired two financial managers with strong technical and operational accounting and financial reporting experience.

      We continued to strengthen the consolidated accounting closing process, including the timely preparation and review of account reconciliations and the enhancement of procedures surrounding the timely collection, review and reporting of key financial information.

      We continued to focus our enhanced internal technical accounting resources to timely identify and research new and emerging accounting and disclosure standards and to determine the proper accounting for new and unusual transactions.

 

While we have implemented a number of changes to our disclosure controls and procedures and internal control over financial reporting, as noted above, we are continuing to carry out additional interim controls and procedures, including the use of outside consultants to support the existing accounting and finance teams.  We believe that the improved procedures and controls currently being implemented, in addition to the interim steps we have taken and continue to take, address the material weaknesses and deficiencies identified by our independent auditors in our controls and procedures.  Moreover, 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 control over financial reporting 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.  We will also continue to evaluate the composition of our finance department and plan to add personnel and make other changes as required to assure that our finance organization can effectively administer our disclosure controls and procedures and internal control over financial reporting.

 

As a result of the steps taken to improve our disclosure controls and procedures and internal control over financial reporting, 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 has been no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.

 

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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 4. Submission of Matters to a Vote of Security Holders.

 

We held our 2003 annual meeting of stockholders on July 17, 2003.  The following proposals were voted on by our stockholders and the results of each proposal are as follows:

 

Proposal I:

 

i.

The following individuals were elected by holders of our common stock and Series A preferred stock, voting as a single class, as our Class II directors to serve for a three-year term until the 2006 annual meeting of stockholders or until their successors are duly elected and qualified:

 

 

 

 

Votes For

 

Votes Withheld

Robert E. Camp

 

28,209,124

 

1,153,372

John W. Tate

 

28,980,150

 

382,346

 

ii.

The following individual was elected by the holders of our Series A preferred stock, voting as a separate class, as our Class II director to serve for a three-year term until the 2006 annual meeting of stockholders or until his successor is duly elected and qualified:

 

 

 

 

Votes For

 

Votes Withheld

Mark J. Schwartz

 

3,717,812

 

0

 

Proposal II:

 

i.

The ratification of the selection of Deloitte & Touche LLP as our independent auditors for the fiscal year ending January 31, 2004.

 

For

 

Against

 

Abstain

 

Broker Non-Votes

29,102,394

 

250,048

 

10,054

 

0

 

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

 

(a) Exhibits.

 

See attached exhibit index.

 

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(b) Reports on Form 8-K.

 

On May 5, 2003, we filed with the Securities and Exchange Commission a current report on Form 8-K, which included reports under items 5, 7 and 12 thereto and attached a press release, dated May 2, 2003, announcing our final 2002 financial results.

 

On May 9, 2003, we filed with the Securities and Exchange Commission a current report on Form 8-K, which included reports under items 5, 7 and 12 thereto and attached a press release, dated May 8, 2003, announcing our sales results for the first quarter of fiscal 2003.

 

On May 21, 2003, we filed with the Securities and Exchange Commission a current report on Form 8-K, which included reports under items 5, 7 and 12 thereto and attached a press release, dated May 21, 2003, announcing our financial results for the first quarter of fiscal 2003.

 

On June 16, 2003, we filed with the Securities and Exchange Commission a current report on Form 8-K, which included reports under items 5, 7 and 12 thereto and attached our annual letter to shareholders.

 

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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:  September 10, 2003

By:

/s/ GARY G. FRIEDMAN

 

 

 

Gary G. Friedman

 

 

President and Chief Executive Officer

 

 

 

Date:  September 10, 2003

By:

/s/ KEVIN W. SHAHAN

 

 

 

Kevin W. Shahan

 

 

Vice President and Chief Financial Officer

 

 

(Principal Financial Officer)

 

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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

 

Amendment No. 1 to the Seventh Amended and Restated Loan and Security Agreement, dated April 28, 2003, by and among Restoration Hardware, Inc., The Michaels Furniture Company, Inc., Fleet Capital Corporation, and The CIT Group/Business Credit,  Inc.

31.1

 

Section 302 Certification of Chief Executive Officer of the Registrant

31.2

 

Section 302 Certification of Chief Financial Officer of the Registrant

32.1

 

Section 906 Certification of Chief Executive Officer of the Registrant

32.2

 

Section 906 Certification of Chief Financial Officer of the Registrant

 

 


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

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

 

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