UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 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 October 30, 2004

	or

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 November 29, 2004, 33,047,409 shares of the registrant’s common stock, $0.0001 par value per share, were outstanding.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except share data)

(Unaudited)

	October 30, 2004				January 31, 2004				November 1, 2003

ASSETS
Current assets:
Cash and cash equivalents	$		1,692		$		2,003		$	3,237
Accounts receivable	6,305				5,745				5,911
Merchandise inventories	157,457				102,926				122,810
Prepaid expense and other current assets	21,016				16,968				16,330
Total current assets	186,470				127,642				148,288
Property and equipment, net	82,701				83,518				84,170
Goodwill	4,560				4,560				4,560
Deferred tax asset	15,194				15,138				15,450
Other assets	7,947				1,422				8,901
Total assets	$	296,872			$	232,280			$		261,369

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$		65,949		$	45,292			$		46,909
Line of credit, net of debt issuance costs (as restated for November 1, 2003, see Note 2)	64,206				10,286				45,891
Deferred revenue and customer deposits	7,446				7,231				7,864
Other current liabilities	12,247				11,438				9,744
Total current liabilities	149,848				74,247				110,408
Deferred lease incentives	30,513				33,999				35,677
Deferred rent	15,053				14,455				14,554
Other long-term obligations	196				352				155
Total liabilities	195,610				123,053				160,794
Series A redeemable convertible preferred stock, $.0001 par value, 28,037 shares designated, 8,473, 8,683 and 8,683 shares issued and outstanding at October 30, 2004, January 31, 2004 and November 1, 2003, respectively, aggregate liquidation preference and redemption value of $10,429 at October 30, 2004	8,331				8,541				8,541
Stockholders’ equity:
Common stock, $.0001 par value; 60,000,000 shares authorized; 33,025,509, 32,768,065 and 32,718,511 issued and outstanding at October 30, 2004, January 31, 2004 and November 1, 2003, respectively	3				3				3
Additional paid-in capital	158,912				158,174				157,663
Unearned compensation	(22			)	(234			)	(284			)
Accumulated other comprehensive income	1,441				1,040				841
Accumulated deficit	(67,403			)	(58,297			)	(66,189			)
Total stockholders’ equity	92,931				100,686				92,034
Total liabilities, redeemable convertible preferred stock and stockholders’ equity	$		296,872		$	232,280			$		261,369

See Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share amounts)

(Unaudited)

	Third Quarter								First Nine Months
	Fiscal 2004				Fiscal 2003				Fiscal 2004			Fiscal 2003

Net revenue	$	118,165			$	95,814			$	337,965		$	273,553
Cost of revenue and occupancy	80,196				67,027				240,269			200,012
Gross profit	37,969				28,787				97,696			73,541
Selling, general and administrative expense	42,511				33,031				111,199			89,922
Loss from operations	(4,542			)	(4,244			)	(13,503		)	(16,381		)

Interest expense, net	(737			)	(519			)	(1,673		)	(1,674		)
Loss before income taxes	(5,279			)	(4,763			)	(15,176		)	(18,055		)
Income tax benefit	2,161				1,905				6,070			7,222
Net loss	$		(3,118	)	$		(2,858	)	$	(9,106	)	$	(10,833	)

Loss per share of common stock, basic and diluted	$		(0.09	)	$		(0.09	)	$	(0.28	)	$	(0.36	)
Weighted average shares outstanding, basic and diluted	33,017				30,602				32,904			30,246

See Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

	First Nine Months
	Fiscal 2004			Fiscal 2003
Cash flows from operating activities:
Net loss	$	(9,106	)	$	(10,833	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization	11,747			14,154
Changes in operating assets and liabilities:
Accounts receivable	(560		)	(2,559		)
Merchandise inventories	(54,531		)	(28,310		)
Prepaid expense and other current assets	(4,048		)	(2,249		)
Deferred tax and other assets	(6,581		)	(6,326		)
Accounts payable and accrued expenses	20,657			11,260
Deferred revenue and customer deposits	215			1,818
Other current liabilities	809			598
Deferred rent	598			391
Deferred lease incentives and other long-term liabilities	(3,486		)	(3,432		)
Net cash used by operating activities	(44,286		)	(25,488		)

Cash flows from investing activities:
Capital expenditures	(10,090		)	(6,817		)
Net cash used by investing activities	(10,090		)	(6,817		)

Cash flows from financing activities:
Borrowings under line of credit, net	53,555			31,368
(Repayments) borrowings of other long-term obligations	(156		)	11
Proceeds received from stockholder settlement	—			1,050
Issuance of common stock	528			948
Net cash provided by financing activities	53,927			33,377

Effects of foreign currency exchange rate translation on cash	138			535
Net (decrease) increase in cash and cash equivalents	(311		)	1,607

Cash and cash equivalents:
Beginning of period	2,003			1,630
End of period	$	1,692		$	3,237

Additional cash flow information:
Cash paid during the period for interest	$	1,332		$	1,116
Cash paid during the period for taxes	593			150
Non-cash transactions:
Conversion of preferred stock to common stock	$	210		$	4,787

See Notes to Condensed Consolidated Financial Statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business

Restoration Hardware, Inc., a Delaware corporation, and its subsidiaries (collectively, the “Company”) is a specialty retailer of high-quality home furnishings, functional and decorative hardware, bath ware and bath fixtures and related merchandise that reflects its classic and authentic American point of view. These products are sold through retail locations, catalogs and the Internet. As of October 30, 2004, the Company operated 102 retail stores in 30 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 October 30, 2004, January 31, 2004 and November 1, 2003, results of operations for the third quarters and nine months ended October 30, 2004 and November 1, 2003, respectively, cash flows for the nine months ended October 30, 2004 and November 1, 2003, respectively. The balance sheet at January 31, 2004, 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, for the fiscal year ended January 31, 2004 (“fiscal 2003”). Certain information and disclosures normally included in the notes to annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America 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 2003.

The results of operations for the third quarter and nine months ended October 30, 2004, 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 financial statements in order to conform to the current year presentation.

Stock-based Compensation

The Company accounts for stock-based employee compensation using the intrinsic value method in accordance with the provisions of Accounting Principals Board Opinion No. 25, “Accounting for Stock Issued to Employees.” The following table illustrates the effect on net loss and loss per share of common stock 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:

	Third Quarter						First Nine Months
(Dollars in thousands, except share data)	Fiscal 2004			Fiscal 2003			Fiscal 2004			Fiscal 2003

Net loss as reported	$	(3,118	)	$	(2,858	)	$	(9,106	)	$	(10,833	)
Add: Stock-based employee compensation expense for all options granted below fair market value included in reported net loss (net of tax)	23			75			127			225
Deduct: Compensation expense for all stock-based employee compensation (net of tax) calculated in accordance with the fair value method	(968		)	(540		)	(2,549		)	(1,515		)
Pro forma net loss	$	(4,063	)	$	(3,323	)	$	(11,528	)	$	(12,123	)

Loss per share of common stock:
Basic and diluted, as reported	$	(0.09	)	$	(0.09	)	$	(0.28	)	$	(0.36	)
Basic and diluted, pro forma	$	(0.12	)	$	(0.11	)	$	(0.35	)	$	(0.40	)

Comprehensive Loss

Comprehensive loss consists of net loss and foreign currency translation adjustments. The components of comprehensive loss for the third quarters and nine months ended October 30, 2004 and November 1, 2003, respectively, are as follows:

	Third Quarter							First Nine Months
	Fiscal 2004				Fiscal 2003			Fiscal 2004			Fiscal 2003
	(In thousands)
Components of comprehensive loss:
Net loss	$	(3,118		)	$	(2,858	)	$	(9,106	)	$	(10,833	)
Foreign currency translation adjustment	435				410			401			973
Total comprehensive loss	$		(2,683	)	$	(2,448	)	$	(8,705	)	$	(9,860	)

2. LINE OF CREDIT, NET

As of October 30, 2004, the Company’s revolving credit facility provided for an overall commitment of $100.0 million. The revolving credit facility was amended in June 2004 to provide for additional borrowing capacity, reduced borrowing rates and elimination of limitations on capital expenditures and store openings. In support of continued growth of the Company, the amendment increased the initial available commitment to $100.0 million, and further allows the Company to request and receive incremental increases beyond the initial available commitment of $100.0 million up to a maximum commitment of $150.0 million, provided no default or event of default exists and certain other conditions are met. The amendment also increased the amount available for letters of credit from $30.0 million to $50.0 million and modified certain other terms in the revolving credit facility, which had the effect of expanding the borrowing base.

As of October 30, 2004, $64.2 million was outstanding under the line of credit, net of unamortized debt issuance costs of $0.8 million, and there was $18.9 million in outstanding letters of credit. Borrowings made under the revolving credit facility are subject to interest at either the bank’s reference rate or LIBOR plus a margin. As of October 30, 2004, the bank’s reference rate was 5.25% and the LIBOR plus margin rate was 4.06%. The availability of credit at any given time under the revolving credit facility is limited by reference to a borrowing base formula based upon numerous factors, including the value of eligible inventory and eligible accounts receivable, and reserves established by the agent of the revolving credit facility. The revolving credit facility is structured to increase availability to meet seasonal needs. As a result of the borrowing base formula, the actual borrowing availability under the revolving credit facility could be less than the stated amount of the revolving credit facility reduced by the actual borrowings and outstanding letters of credit.

The revolving credit facility contains various restrictive covenants, including limitations on the ability to incur additional debt, acquisition of other businesses and payment of dividends and other distributions. The revolving credit facility does not contain any other significant financial or coverage ratio covenants, nor does the revolving credit facility require the Company to repay all borrowings for a proscribed “clean-up” period each year.

The Company’s revolving credit facility requires a lock-box arrangement, which provides for all receipts to be swept daily to reduce borrowings outstanding under the revolving credit facility. This arrangement, combined with the existence of a subjective acceleration clause in the revolving credit facility, necessitates that the revolving credit facility be classified a current liability on the balance sheet pursuant to guidance in the Financial Accounting Standards Board’s Emerging Issues Task Force Issue No. 95-22, “Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements That Include both a Subjective Acceleration Clause and a Lock-Box Arrangement.” The acceleration clause allows the Company’s lenders to forego additional advances should they determine there has been a material adverse change in the Company’s operations, business, properties, assets, liabilities, condition or prospects or a material adverse change in its financial position or prospects reasonably likely to result in a material adverse effect on the Company’s business, condition (financial or otherwise), operations, performance or properties. Management believes that no such material adverse change has occurred; further, at October 30, 2004, the Company’s lenders had not informed the Company that any such event had occurred. The revolving credit facility expires in June 2006. Management believes that it will continue to borrow on the line of credit to fund its operations over the term of the revolving credit facility. The November 1, 2003 balance sheet has been restated to classify as a current liability $45.9 million of borrowings under the revolving credit facility, which was previously reported as a long-term liability.

3. 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 then known to it, other than changes in the tax law or rates, which are not permitted to be considered. Accordingly, the Company records a valuation allowance to reduce its 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 its 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 the Company was to determine that it would be able to realize its 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 the Company determine that it would not be able to realize all or part of its 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.

As of October 30, 2004 and January 31, 2004, the Company recorded net deferred tax assets totaling $21.2 million, which primarily represent the income tax benefit associated with losses reported in prior years. These losses are subject to federal and state carry-forward provisions of up to 20 years. As of October 30, 2004 and January 31, 2004, the Company concluded that the net deferred tax asset balances of $21.2 million were more likely than not to be recovered. If the Company is not able to achieve positive operating results in the near future, a valuation allowance may need to be recorded. The Company recorded income tax benefits of $2.2 million and $6.1 million for the third quarter and first nine months of fiscal 2004, respectively, which are included in Other Assets on the balance sheet.

4. LOSS PER SHARE OF COMMON STOCK

Basic loss per share of common stock is computed by dividing net loss by the weighted average number of shares of common stock outstanding for the period. Diluted loss per share of common stock is computed by dividing net loss by the weighted average number of shares of common stock and potentially dilutive common stock equivalents outstanding during the period. Diluted loss per share of common stock reflects the potential dilution that could occur if options or warrants to issue common stock were exercised, or preferred stock was converted into common stock. The following table details potential dilutive effects of the weighted average number of certain common stock equivalents that have been excluded from diluted loss per share of common stock, because their inclusion would be anti-dilutive, since the Company experienced a net loss in each of the third quarters and first nine months of fiscal 2004 and 2003, respectively:

	Third Quarter		First Nine Months
	Fiscal 2004	Fiscal 2003	Fiscal 2004	Fiscal 2003
Common stock issuable upon conversion of the Series A preferred stock	4,260,572	6,431,752	4,314,982	6,656,027
Common stock subject to outstanding stock options	597,109	875,438	631,949	439,910

Total	4,857,681	7,307,190	4,946,931	7,095,937

The above stock options represent only those stock options whose exercise prices are less than the average market price of the stock for the periods. The stock options whose exercise prices exceeded the average market price of the stock for the periods are 4,754,306 and 1,776,495 for the third quarters of fiscal 2004 and 2003, respectively, and 4,143,719 and 2,682,336 for the first nine months of fiscal 2004 and 2003, respectively.

5. SEGMENT REPORTING

The Company classifies its business into two identifiable segments: retail and direct-to-customer. Segment income from operations consists of both direct-to-customer contribution and retail store contribution after district and regional management. The unallocated portion includes both the costs of corporate expenses as well as unallocated costs of merchandising, sourcing and distribution. The Company also has a wholly owned furniture manufacturing company located in Sacramento, California, The Michaels Furniture Company, Inc. (“Michaels”). Michaels revenue is recorded as either retail revenue or direct-to-customer revenue based on the channel in which the sale was initiated, and management decisions on resource allocation and performance assessment are made based on these two identifiable segments. As a result, management considers it is more appropriate to report its business activities into two rather than three identifiable segments. The Company evaluates performance and allocates resources based on results from operations, which excludes unallocated 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:

	Third Quarter						First Nine Months
(In thousands)	Fiscal 2004			Fiscal 2003			Fiscal 2004			Fiscal 2003
Net Revenue:
Retail	$	89,747		$	79,858		$	259,094		$	232,215
Direct-to-customer	28,418			15,956			78,871			41,338
Consolidated net revenue	$	118,165		$	95,814		$	337,965		$	273,553

	Third Quarter						First Nine Months
	Fiscal 2004			Fiscal 2003			Fiscal 2004			Fiscal 2003
Income (loss) from operations:
Retail	$	8,146		$	4,917		$	20,995		$	13,936
Direct-to-customer	1,867			1,091			9,423			4,387
Unallocated	(14,555		)	(10,252		)	(43,921		)	(34,704		)
Consolidated loss from operations	$	(4,542	)	$	(4,244	)	$	(13,503	)	$	(16,381	)

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

(Dollars in thousands, except per share data)	Third Quarter Fiscal 2004			% of Net Revenue		Third Quarter Fiscal 2003			% of Net Revenue		First Nine Months Fiscal 2004			% of Net Revenue		First Nine Months Fiscal 2003			% of Net Revenue

Retail net revenue	$	89,747		76.0	%	$	79,858		83.3	%	$	259,094		76.7	%	$	232,215		84.9	%
Direct-to-customer net revenue	28,418			24.0		15,956			16.7		78,871			23.3		41,338			15.1
Net revenue	118,165			100.0		95,814			100.0		337,965			100.0		273,553			100.0
Cost of revenue and occupancy	80,196			67.9		67,027			70.0		240,269			71.1		200,012			73.1
Gross profit	37,969			32.1		28,787			30.0		97,696			28.9		73,541			26.9
Selling, general and administrative expense	42,511			35.9		33,031			34.5		111,199			32.9		89,922			32.9
Loss from operations	(4,542		)	(3.8	)	(4,244		)	(4.5	)	(13,503		)	(4.0	)	(16,381		)	(6.0	)
Interest expense, net	(737		)	(0.6	)	(519		)	(0.5	)	(1,673		)	(0.5	)	(1,674		)	(0.6	)
Loss before income taxes	(5,279		)	(4.4	)	(4,763		)	(5.0	)	(15,176		)	(4.5	)	(18,055		)	(6.6	)
Income tax benefit	2,161			1.8		1,905			2.0		6,070			1.8		7,222			2.6
Net loss	$	(3,118	)	(2.6	)	$	(2,858	)	(3.0	)	$	(9,106	)	(2.7	)	$	(10,833	)	(4.0	)
Loss per share of common stock — basic and diluted	$	(0.09	)			$	(0.09	)			$	(0.28	)			$	(0.36	)

Loss from operations increased to $4.5 million for the third quarter of fiscal 2004 as compared to a loss from operations of $4.2 million for the third quarter of fiscal 2003. Net loss was $0.09 per share of common stock, or $3.1 million, for the third quarter of fiscal 2004, compared to a net loss of $0.09 per share of common stock, or $2.9 million, for the third quarter of fiscal 2003.

Loss from operations improved to $13.5 million for the first nine months of fiscal 2004 as compared to a loss from operations of $16.4 million for the first nine months of fiscal 2003. Net loss was $0.28 per share of common stock, or $9.1 million, for the first nine months of fiscal 2004, compared to a net loss of $0.36 per share of common stock, or $10.8 million, for the first nine months of fiscal 2003.

While net revenue increased 23% in the third quarter, as compared to the same period of fiscal 2003, operating results declined slightly as compared to the prior year quarter primarily due to higher advertising, distribution and compliance costs, which more than offset improvements in product margins. Total selling, general and administrative expense increased $9.5 million during the third quarter of fiscal 2004 as compared to the same period in the prior year, or 140 basis points, when stated as a percent of net revenue. The largest portion of this increase is attributable to a combination of higher advertising costs associated with circulating our catalog coupled with the costs of our initial brand advertising campaign. Revenue for the second fall catalog book drop fell substantially short of expectations, as we underestimated the influence on prior year sales of the promotional nature of the related book. This had the effect of deleveraging selling, general and administrative expense, negatively impacting results for the quarter by approximately $1 million. There were also increases in payroll expenses and professional fees, as well as other selling related expenses. In addition, we experienced higher costs during the third quarter of fiscal 2004 associated with our distribution and supply chain activities. This includes increases in freight costs as well as costs associated with investment in process improvement efforts including related temporary labor costs and consultants that had been retained to manage those operations. Those costs are reflected in cost of revenue and occupancy on our Condensed Consolidated Statements of Operations and are reflected in unallocated costs in footnote 5 to the financial statements, Segment Reporting.

On a year to date basis, the $2.9 million improvement in operating results for the first nine months of fiscal 2004 compared to the first nine months of the prior fiscal year resulted primarily from a $64.4 million, or 24%, increase in net

revenue as a result of increases in both our retail and direct-to-customer divisions, partially offset by a $40.3 million increase in cost of revenue and occupancy incurred to support this revenue growth, and a $21.3 million increase in selling, general and administrative expense. Net revenue growth for the first nine months of fiscal 2004, coupled with improved product margins, drove improvement in our results. Selling, general and administrative expense, expressed as a percent of net revenue for the first nine months of fiscal 2004 remained unchanged from the prior year period at 32.9% of net revenue. The $21.3 million increase in selling, general and administrative expense was primarily due to an increase in advertising expenses as well as increases in store and direct-to-customer selling expenses. Year to date results have also been negatively affected by higher costs of our distribution and supply chain activities which costs are reflected in cost of revenue and occupancy on our Condensed Consolidated Statements of Operations.

The increases in our net revenue resulted from continued growth of our direct-to-customer business, which increased $12.5 million, or 78%, in the third quarter of fiscal 2004 as compared to the third quarter of fiscal 2003, and $37.5 million, or 91%, in the first nine months of fiscal 2004 as compared to the first nine months of fiscal 2003. The revenue growth was also due to an increase in comparable store sales of 8.7% and 9.0%, for the third quarter and first nine months of fiscal 2004, respectively. The increases in net revenue in both our retail and direct-to-customer channels can be partially attributed to our catalog, which is our primary advertising vehicle.

Additionally, during both the third quarter and first nine months of fiscal 2004, our results were impacted by professional fees associated with the implementation of the requirements of the Sarbanes-Oxley Act of 2002, in particular, with respect to Section 404 requiring management to report on, and our independent registered public accounting firm to attest to, the effectiveness of our internal control over financial reporting. Those costs, reflected in selling, general and administrative expense, amounted to approximately $0.5 million in the third quarter of fiscal 2004 and approximately $1 million in the first nine months of fiscal 2004.

Our business is highly seasonal, which reflects a general pattern in the retail industry wherein the highest sales and earnings occur during the holiday season. Historically, a significant portion of our sales are in the fourth fiscal quarter. In our peak holiday selling season, we incur significant additional expenses in connection with, among other things, the hiring of additional seasonal employees in our retail stores and the production and mailing of a higher volume of our catalogs.

REVENUE

Retail Net Revenue

	Third Quarter								First Nine Months
(Dollars in thousands)	Fiscal 2004				Fiscal 2003				Fiscal 2004				Fiscal 2003
Retail net revenue	$	89,747			$	79,858			$	259,094			$	232,215
Retail net revenue growth percentage	12			%	—			%	12			%	6		%
Comparable store sales growth	8.7			%	2.9			%	9.0			%	8.0		%
Income from operations	$		8,146		$		4,917		$		20,995		$	13,936
Income from operations – percent of net revenue	9.1			%	6.2			%	8.1			%	6.0		%
Number of stores at beginning of period	102				102				103				105
Number of stores opened	—				2				1				2
Number of stores closed	—				(1			)	(2			)	(4		)
Number of stores at end of period	102				103				102				103
Store selling square feet at end of period	673,910				675,585				673,910				675,585

Retail net revenue for the third quarter of fiscal 2004 increased by $9.9 million, or 12%, as compared to the third quarter of fiscal 2003 primarily due to a $6.7 million, or 8.7%, increase in comparable store sales. Retail net revenue for the first nine months of fiscal 2004 increased by $26.9 million, or 12%, as compared to the first nine months of fiscal 2003 primarily due to a $20.1 million, or 9.0%, increase in comparable store sales. Additionally, several previously opened stores, although not open long enough to be included in calculations of comparable store sales, contributed positively to both the third quarter and first nine months of fiscal 2004. Retail net revenue for the first nine months of fiscal 2004 also reflects $3.6 million of revenue from a July warehouse sales event. Warehouse sales revenue is included in retail

revenue, but is excluded from our comparable store sales. A warehouse sale event was not held in the same period of fiscal 2003.

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. We believe that comparable store sales are a useful indicator of store performance, since comparable store sales exclude the effects of changes in the number of stores open.

Income from operations for the retail segment grew 66% to $8.1 million in the third quarter of fiscal 2004 from $4.9 million in the third quarter of fiscal 2003. Income from retail operations expressed as a percent of related segment net revenue grew 290 basis points to 9.1% from 6.2% in third quarter of fiscal 2003. The expansion of income from operations for the retail segment is attributable to higher product margins realized as well as improvements in payroll and supplies expense offset by the initial costs of brand advertising. Income from operations for the retail segment includes retail stores results less direct costs of the store field operations. For the first nine months of fiscal 2004, income from operations for the retail segment also experienced substantial growth of 51% as compared to the same period in the prior fiscal year, which improvement resulted from both increased revenue and operating margin expansion.

Direct-to-Customer Net Revenue

	Third Quarter						First Nine Months
(Dollars in thousands)	Fiscal 2004			Fiscal 2003			Fiscal 2004			Fiscal 2003
Catalog revenue	$	15,505		$	9,745		$	44,081		$	25,777
Internet revenue	12,913			6,211			34,790			15,561
Total direct-to-customer net revenue	$	28,418		$	15,956		$	78,871		$	41,338
Income from operations	$	1,867		$	1,091		$	9,423		$	4,387
Income from operations - percent of net revenue	6.6		%	6.8		%	11.9		%	10.6		%
Growth percentages:
Direct-to-customer net revenue	78		%	46		%	91		%	53		%
Number of catalogs mailed	—		%	48		%	15		%	16		%

Direct-to-customer net revenue consists of both catalog and Internet sales. Direct-to-customer net revenue for the third quarter of fiscal 2004 increased $12.5 million, or 78%, as compared to the third quarter of fiscal 2003. Revenue for the second fall catalog book drop fell substantially short of expectations and had the effect of deleveraging selling, general and administrative expense, negatively impacting results for the quarter by approximately $1 million.

Direct-to-customer net revenue for the first nine months of fiscal 2004 increased $37.5 million, or 91%, as compared to the first nine months of fiscal 2003. A portion of this increase was the result of a 15% increase in the number of catalogs mailed for the first nine months of fiscal 2004.

Income from operations for the direct-to-customer segment was $1.9 million in the third quarter of fiscal 2004 as compared to $1.1 million in the same quarter of the prior fiscal year, and it declined to 6.6% of related segment net revenue for the third quarter of 2004 as compared to 6.8% in the third quarter of fiscal 2003, and compared to 15.0% in the second quarter of fiscal 2004. Segment results were favorably impacted by product margin expansion and other non-advertising expense leverage but were more than offset by the deleveraging of advertising expense experienced during the third quarter with one of our catalog mailings. For the first nine months of fiscal 2004, income from operations for the direct-to-customer segment increased to $9.4 million, or 11.9%, of net segment revenue, as compared to $4.4 million, or 10.6%, of segment net revenue, for the same period in fiscal 2003.

EXPENSES

Cost of Revenue and Occupancy Expense

Total cost of revenue and occupancy increased $13.2 million during the third quarter of fiscal 2004 as compared to the same period in fiscal 2003. As a percentage of net revenue, these costs improved approximately 210 basis points to 67.9%, from 70.0% for the third quarter of fiscal 2003. Significant leverage was achieved in improved product margins and our relatively fixed store occupancy costs. These gains were partially offset by higher costs associated with our customer shipping, distribution and supply chain activities. These latter costs included increases in freight costs as well as costs associated with investment in process improvements, including costs with respect to temporary labor and consultants that had been retained to manage our customer shipping, distribution and supply chain operations. Those costs are reflected in cost of revenue and occupancy on our Condensed Consolidated Statements of Operations and in unallocated costs in footnote 5 to the financial statements, Segment Reporting. We recently hired a supply chain executive to oversee these operations who reports to our previously announced new chief operating officer.

For the first nine months of fiscal 2004, cost of revenue and occupancy expense expressed as a percentage of net revenue improved approximately 200 basis points to 71.1%, from 73.1% for the first nine months of fiscal 2003. Significant improvements were achieved due to the leveraging of relatively fixed store occupancy costs and improved product margins, which improvements were partially offset by increased costs related to customer shipping, distribution and supply chain operations.

Selling, General and Administrative Expense

Selling, general and administrative expense expressed as a percentage of net revenue increased approximately 140 basis points to 35.9% for the third quarter of fiscal 2004, from 34.5% for the third quarter of fiscal 2003. Selling, general and administrative expense expressed in absolute dollars increased $9.5 million, to $42.5 million for the third quarter of fiscal 2004 from $33.0 million for the third quarter of fiscal 2003. The increases in absolute dollars are primarily related to an increase in advertising, including catalog production and mailing costs, and to a lesser degree, an increase in payroll expense and professional fees as well as other selling related expenses.

The increase in selling, general and administrative expense as a percentage of net revenue for the third quarter of fiscal 2004 as compared to the same period of fiscal 2003 was primarily due to increases in advertising costs, partially offset by leveraging of retail payroll costs, which declined as a percentage of net revenue, reflecting continued management focus and the implementation of tools to manage retail payroll expense. Advertising costs include expenses associated with catalog production and mailing as well as the costs of the initial brand advertising campaign launched in the third quarter of fiscal 2004. Costs associated with the second drop of the fall catalog resulted in lower sales than expected and, coupled with the cost of the newly launched brand campaign, had the effect of deleveraging selling, general and administrative costs in the third quarter of fiscal 2004.

Selling, general and administrative expense expressed as a percentage of net revenue for the first nine months of fiscal 2004, remained unchanged at 32.9% as compared to the first nine months of fiscal 2003. Selling, general and administrative expense expressed in absolute dollars increased $21.3 million, to $111.2 million for the first nine months of fiscal 2004 from $89.9 million for the first nine months of fiscal 2003. As a percentage of net revenue, leverage of relatively fixed payroll, visual merchandising and other overhead costs, which declined as a percentage of net revenue, was offset by an increase in advertising costs. The increases in absolute dollars are primarily related to an increase in advertising, and to a lesser degree, an increase in store and direct-to-customer selling expenses. Advertising costs incurred during the first nine months of fiscal 2004 increased due to higher costs of catalog circulation and the launch of a brand advertising campaign in the third quarter of fiscal 2004.

In general, we expect that as the direct-to-customer channel revenue grows at a faster rate than retail revenue, the growth in the cost of advertising (primarily catalog circulation costs) will lead to increases in overall selling, general and administrative expense as a percentage of net revenue. In addition, due to lowered productivity of one of the fall catalog drops, this general dynamic inherent in our business model was more pronounced in both the third quarter and first nine months of fiscal 2004. In contrast, the cost of retail occupancy has declined as a percentage of net revenue, the benefit of which is reflected in improved gross margins. Other increases in selling, general and administrative expense in absolute dollars were incurred largely to support our increase in net revenue. Professional fee expenses have been incurred, and will continue to be incurred, with respect to the implementation of the requirements of the Sarbanes-Oxley Act of 2002, in particular, with respect to Section 404 requiring management to report on, and our independent registered public accounting firm to attest to, the effectiveness of our internal control over financial reporting. Those amounts totaled approximately $0.5 million in the third quarter of fiscal 2004 and approximately $1 million for the first nine months of fiscal 2004.

Interest Expense, Net

Interest expense, net includes interest on borrowings under our revolving credit facility and amortization of debt issuance costs. For the third quarter of fiscal 2004, interest expense, net was $0.7 million, an increase of $0.2 million as compared to $0.5 million for the third quarter of fiscal 2003. The increase in third quarter interest expense was due primarily to an increase in our average debt levels and secondarily to higher average borrowing rates, partially offset by a decline in amortization of debt issuance costs. For the first nine months of both fiscal 2004 and fiscal 2003, interest expense, net was $1.7 million, remaining flat due to higher average debt levels which were offset by lower interest rates year over year and a decline in amortization of debt issuance costs.

Income Tax Benefit

As of October 30, 2004, our full year effective tax rate is expected to approximate 40.0%. As a result, the effective tax rate for the third quarter of fiscal 2004 was 40.9%, bringing the effective tax rate for the first nine months of fiscal 2004 to 40.0%. This effective tax rate compares with a 40.0% rate utilized in the third quarter and first nine months of fiscal 2003.

As of October 30, 2004 and January 31, 2004, we recorded net deferred tax assets totaling $21.2 million, which primarily represent the income tax benefit associated with losses reported in prior years. These losses are subject to federal and state carry-forward provisions of up to 20 years. As of October 30, 2004 and January 31, 2004, we concluded that the net deferred tax asset balance of $21.2 million was more likely than not to be recovered. If we are not able to achieve positive operating results in the near future, a valuation allowance may need to be recorded. We recorded income tax benefits of $2.2 million and $6.1 million for the third quarter and first nine months of fiscal 2004, respectively, which are included in the Other Assets line on our Condensed Consolidated Balance Sheets.

LIQUIDITY AND CAPITAL RESOURCES

Operating Cash Flows

For the first nine months of fiscal 2004, net cash used by operating activities was $44.3 million compared to $25.5 million of net cash used by operating activities for the first nine months of fiscal 2003. The increase in net cash used by operating activities resulted primarily from higher merchandise inventory purchases related to our higher sales levels as well as the upcoming fourth quarter holiday season. In addition, under our current payment arrangements, our higher levels of foreign sourced merchandise in 2004 have had the effect of accelerating the timing of payments for goods. Additionally, net cash used by operating activities increased due to higher prepaid expenses associated with advertising. These increases in net cash used were partially offset by higher accounts payable and accrued expenses balances.

Investing Cash Flows

Net cash used by investing activities was $10.1 million for the first nine months of fiscal 2004, an increase of $3.3 million compared to $6.8 million for the first nine months of fiscal 2003. The cash used for investing activities for the first nine months of fiscal 2004 primarily related to the expansion of one of our stores, the opening of another store and to information systems upgrades.

Financing Cash Flows

Net cash provided by financing activities was $53.9 million for the first nine months of fiscal 2004, compared to $33.4 million for the first nine months of fiscal 2003. Substantially all of the increase in net cash provided by financing activities resulted from an increase in net borrowings of $53.6 million for the first nine months of fiscal 2004, as compared to $31.4 million for the first nine months of fiscal 2003, under our revolving credit facility. Cash financing requirements were higher in the first nine months of fiscal 2004 as compared to the same period of fiscal 2003 primarily due to the effect of higher inventory levels overall, and higher inventory of predominately foreign sourced merchandise, which under current payment arrangements, have resulted in an acceleration of the timing of payment for our goods.

As of October 30, 2004, our revolving credit facility provided for an overall commitment of $100.0 million. The revolving credit facility was amended in June 2004 to provide for additional borrowing capacity, reduced borrowing

rates and elimination of limitations on capital expenditures and store openings. In support of our expected continued growth, the amendment increased the initial available commitment to $100.0 million, and further allows us to request and receive incremental increases beyond the initial available commitment of $100.0 million up to a maximum commitment of $150.0 million, provided no default or event of default exists and certain other conditions are met. The amendment also increased the amount available for letters of credit from $30.0 million to $50.0 million and modified certain other terms in the revolving credit facility, which had the effect of expanding the borrowing base.

As of October 30, 2004, $64.2 million was outstanding under the line of credit, net of unamortized debt issuance costs of $0.8 million, and there was $18.9 million in outstanding letters of credit. Borrowings made under the revolving credit facility are subject to interest at either the bank’s reference rate or LIBOR plus a margin. As of October 30, 2004, the bank’s reference rate was 5.25 % and the LIBOR plus margin rate was 4.06%. The availability of credit at any given time under the revolving credit facility is limited by reference to a borrowing base formula based upon numerous factors, including the value of eligible inventory and eligible accounts receivable, and reserves established by the agent of the revolving credit facility. The revolving credit facility is structured to increase availability to meet seasonal needs. As a result of the borrowing base formula, the actual borrowing availability under the revolving credit facility could be less than the stated amount of the revolving credit facility reduced by the actual borrowings and outstanding letters of credit.

The revolving credit facility contains various restrictive covenants, including limitations on the ability to incur additional debt, acquisition of other businesses and payment of dividends and other distributions. The revolving credit facility does not contain any other significant financial or coverage ratio covenants, nor does the revolving credit facility require us to repay all borrowings for a proscribed “clean-up” period each year.

Our revolving credit facility requires a lock-box arrangement, which provides for all receipts to be swept daily to reduce borrowings outstanding under the revolving credit facility. This arrangement, combined with the existence of a subjective acceleration clause in the revolving credit facility, necessitates that the revolving credit facility be classified as a current liability on our balance sheet, pursuant to guidance in the Financial Accounting Standards Board’s Emerging Issues Task Force Issue No. 95-22, “Balance Sheet Classification of Borrowings Outstanding under Revolving Credit Agreements That Include both a Subjective Acceleration Clause and a Lock-Box Arrangement.” However, we do not expect to repay, or be required to repay, within one year, the balance of the revolving credit facility classified as a current liability. The acceleration clause, which is a typical requirement in commercial credit agreements such as ours, allows our lenders to forego additional advances should they determine there has been a material adverse effect in our operations, business, properties, assets, liabilities, condition or prospects or a material adverse change in our financial position or prospects that is reasonably likely to result in a material adverse effect on our business, condition (financial or otherwise), operations, performance or properties. However, the revolving credit facility does not expire or have a maturity date within one year, but rather has a final expiration date in June 2006. Additionally, our lenders have not notified us of any indication that a material adverse effect exists at October 30, 2004 or that a material adverse change has occurred. We believe that no material adverse change has occurred and we believe that we will continue to borrow on the line of credit to fund our operations over the term of the revolving credit facility. We do not anticipate any changes in our business practices that would result in any determination that there has been a material adverse effect in our operations, business, properties, assets, liabilities, condition or prospects. However, we cannot be certain that our lenders will not make such a determination in the future.

We currently believe that our cash flows from operations and funds available under our revolving credit facility will satisfy our expected working capital and 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 revolving credit facility due to covenant limitations or other factors could limit the overall availability of funds to us. Moreover, to the extent we increase the levels of foreign sourced merchandise that we purchase, we may need access to funds sooner than has typically been the case in the past in order to meet the accelerated timing requirements for payments of such goods. We may not have successfully anticipated our future capital needs or the timing of such needs and we may need to raise additional funds in order to take advantage of unanticipated opportunities. We also may need to raise additional funds to respond to changing business conditions or unanticipated competitive pressures. However, should the need arise, additional sources of financing may not be available or, if available, may not be on terms favorable to our stockholders or us. 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 revolving credit facility with numerous restrictive covenants that limit our flexibility.”

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 revenue 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 revenue 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. If this trend fails to continue to directly benefit us or if there is an overall decline in the trend, we could experience an adverse decline in 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 maintain a high level of quality control and service procedures or if we 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.

During the first nine months of fiscal 2004, we closed two under-performing stores.

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 we believe that we benefit in the long run financially by closing under-performing 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 revenue is 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 revenue and 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 the fourth quarter, our business, financial condition and annual operating results may be materially adversely affected.

Increased catalog and other marketing expenditures without increased revenue may have a negative impact on our operating results.

Over the past several fiscal years, we have substantially increased the amount that we spend on catalog and other marketing costs, and we expect to continue to invest at these increased levels in the current fiscal year and in the future. As a result, if we misjudge the directions or trends in our market, we may expend large amounts of cash that generate little return on investment, which would have a negative effect 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 or investors, or if our operating results do not meet the guidance that we issue from time to time, the market price of our shares of common stock would likely decline.

Fluctuations in comparable store sales may cause our revenue 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 increased 9.0 % for the first nine months of fiscal 2004 and 8.0% for the first nine months of fiscal 2003. 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 revenue and operating results to vary from quarter to quarter, and an unanticipated decline in revenue 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 revenue and significantly harm our operating results.

We make merchandise purchases from over 500 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 buying agent - together accounted for approximately 22% of our aggregate merchandise purchases for fiscal 2003. We expect this situation to continue in the future. In addition, our smaller vendors generally have limited resources, production capacities and operating histories, and some of our vendors have limited the distribution of their merchandise in the past. We have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products, and any vendor or distributor could discontinue selling to us at any time. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future, or be able to develop relationships with new vendors to expand our options or replace discontinued vendors. Our inability to acquire suitable merchandise in the future or the loss of one or more key vendors and our failure to replace any one or more of them may have a material adverse effect on our business, results of operations and financial condition.

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

We routinely purchase products from new vendors from time to time, 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 manufacturers 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 a downturn

in the U.S. or worldwide economy. Significant failures on the part of these 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 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 as well as all of our furniture orders 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. Separately, significant disruptions to the operations of the third party vendor who handles, among other things, the distribution and fulfillment functions for our direct-to-customer business on an outsourced basis could be expected to have similar negative consequences.

Labor activities could cause labor relations difficulties for us.

As of October 30, 2004, we had approximately 3,400 full and part time employees, and we believe our relations with our employees are generally good. While approximately 48 of our employees at our Baltimore, Maryland distribution facility voted in September 2003 to unionize, we currently do not have a contract with a union. We cannot predict the effect of any future organizational activities on our business and operations, although our distribution facilities to date have not experienced any material work stoppages. However, if we were to negotiate a contract with a union, or if we were to become subject to work stoppages, we could experience disruption in our operations and increases in our labor costs, either of which could materially adversely affect our business, financial condition or results of operations.

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 $100.0 million revolving credit facility, which may be increased to $150.0 million under certain circumstances, the amount available under this facility could be less than the stated amount if there is a shortfall in the availability of eligible collateral to support the borrowing base and reserves as established by the terms of the revolving credit facility. We currently believe that our cash flow from operations and funds available under our revolving credit facility will satisfy our capital and operating 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 revolving credit facility due to covenant limitations or other factors could limit the overall amount of funds available to us.

Our revolving credit facility contains a subjective borrowing provision, which is a typical requirement in commercial credit agreements such as ours. This clause allows our lenders to forego additional advances should they determine there has been a material adverse change in our operations, business, properties, assets, liabilities, condition or prospects or a condition or event that is reasonably likely to result in a material adverse change in our financial position or prospects reasonably likely to result in a material adverse effect on our business, condition (financial or otherwise), operations, performance or properties taken as a whole. However, our lenders have not notified us of any indication that a material adverse effect exists at October 30, 2004 or that a material adverse change has occurred. We believe that no material adverse change has occurred and we believe that we will continue to borrow on the line of credit to fund our operations over the term of the revolving credit facility. We do not anticipate any changes in our business practices that would result in any determination that there has been a material adverse effect in our operations, business, properties, assets, liabilities, condition or prospects. However, we cannot be certain that our lenders will not make such a determination in the future.

In particular, we may experience cash flow shortfalls in the future and we may require additional external funding beyond the amounts available under our revolving credit facility. 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 defer on taking other actions that otherwise may be important to our operations. Additionally, we may need to raise funds to take advantage of unanticipated opportunities. We also may need to raise funds to respond to changing business conditions or unanticipated competitive pressures. If we fail to raise sufficient additional 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 revolving 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, advertising for the holiday buying season and other similar advance expenses. We currently have in place a revolving credit facility that provides for an overall commitment of $100.0 million, which may be increased to $150.0 million under certain circumstances. Over the past several years, we have entered into modifications, amendments and restatements of this revolving credit facility, primarily to address changes in the requirements applicable to us under the revolving credit facility documents, and, most recently, to increase the stated amount of commitment under the facility.

Covenants in the revolving credit facility include, among others, ones that limit our ability to incur additional debt, make liens, make investments, consolidate, merge or acquire other businesses, sell assets, pay dividends or other distributions, and enter into transactions with affiliates. These covenants restrict numerous aspects of our business. The revolving credit facility also includes a borrowing base formula to address the availability of credit at any given time based upon numerous factors, including the value of eligible inventory and eligible accounts receivable, in each case, subject to the overall aggregate cap on borrowings. Consequently, for purposes of the borrowing base formula, the value of eligible inventory and eligible accounts receivable may limit our ability to borrow under the revolving credit facility.

We have drawn upon the revolving 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 revolving credit facility would entitle the secured lenders to prevent us from further borrowing, and upon acceleration by the lenders, they would be entitled to begin foreclosure procedures against our assets, including accounts receivable, inventory, general intangibles, equipment, goods, and fixtures. The secured lenders would then be repaid from the proceeds of such foreclosure proceedings, using all available assets. Only after such repayment and the payment of any other secured and unsecured creditors would the holders of our capital stock receive any proceeds from the liquidation of our assets. Our ability to comply with the terms of the revolving credit facility 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. An increase in the variable interest rate under our revolving credit facility coupled with an increase in our outstanding debt could result in material amounts otherwise available for other business purposes being used 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. Many of these factors are beyond our control. In addition, we may need to incur additional indebtedness in the future. 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 needs or 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.

During the third quarter of fiscal 2004, we purchased approximately 60% of our merchandise directly from vendors located abroad and we do not expect that such purchases will decline as a percentage of total merchandise purchases for the balance of fiscal 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 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.

Rapid growth in our direct-to-customer business may not be sustained and may not generate a corresponding increase in profits to our business.

For the third quarter of fiscal 2004, revenue through our direct-to-customer channel grew by 78% as compared to the same period in 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 customer service and non-furniture 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, cause us to lose sales revenue and limit or counter recent growth in our direct-to-customer 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. Our success depends to a significant degree upon our ability to attract, retain and motivate qualified management, marketing and sales personnel, in particular store managers, and upon the continued contributions of these people. We cannot assure you that we will be successful in attracting and retaining qualified executives and personnel.

In addition, our employees may voluntarily terminate their employment with us at any time. We also do not maintain any key man life insurance. The loss of the services of key personnel or our failure to attract additional qualified personnel could have a material adverse effect on our business, financial condition and results of operations.

Recent regulatory changes may cause us to incur increased costs.

Recent changes in the laws, regulations and rules affecting public companies, including the provisions of the Sarbanes-Oxley Act of 2002, will increase our expenses as we evaluate the implications of these new requirements and devote resources to respond to them. In particular, we expect to incur additional expenses as we implement Section 404 of the Sarbanes-Oxley Act of 2002 and the rules issued in connection with it, which require management to report on, and our independent registered public accounting firm to attest to, our internal control over financial reporting. Compliance with these new requirements could also result in continued diversion of management’s time and attention, which could prove to be disruptive to normal business operations. Further, the impact of these laws, regulations and rules and activities in response to them could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors or as executive officers, which could harm our business.

We are currently conducting evaluations required to ensure compliance with the management certification and attestation requirements under Section 404 of the Sarbanes-Oxley Act of 2002. As this is an evolving process, we have no precedent available by which to measure compliance adequacy. Consequently, we cannot be certain as to the timing of completion of our evaluation, testing, remediation (if and where necessary) and related actions or the impact of any of them on our operations. While we currently anticipate that we will timely complete all such actions, we are not certain of the consequences of a failure, although possible consequences include sanction or investigation by regulatory authorities, such as the Securities and Exchange Commission or The Nasdaq National Market, and an inability to timely file our next annual report on Form 10-K.

Changes in general economic conditions affect consumer spending and may significantly harm our revenue 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, revenue, costs and stock price.

Threats of terrorist attacks in the United States, as well as future events occurring in response to or in connection with 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. wars 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, revenue and costs and may result in the volatility of the future market price of our common stock.

Our common stock price may be volatile.

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

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

We cannot predict the effect, if any, that future sales of shares of our common stock or the availability for future sale of shares of our common stock or securities convertible into or exercisable for our common stock will have on the market price of our common stock prevailing from time to time. For example, in connection with our March 2001 preferred stock financing, we filed a registration statement on Form S-3 with the Securities and Exchange Commission to register approximately 6.4 million shares of our common stock issued, or to be issued, upon the conversion of our Series A preferred stock to some of our stockholders. The registration statement was declared effective by the Securities and Exchange Commission on October 31, 2002 and may remain effective under certain circumstances until as long as March 2009. Sale, or the availability for sale, of substantial amounts of common stock by our existing stockholders pursuant to an effective registration statement or under Rule 144, through the exercise of registration rights or the issuance of shares of common stock upon the exercise of stock options, or the conversion of our preferred stock, or the perception that such sales or issuances could occur, could adversely affect prevailing market prices for our common stock and could materially impair our future ability to raise capital through an offering of equity securities.

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

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

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

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

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

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. Such forward-looking statements include without limitation statements relating to our future plans, statements relating to anticipated future costs and expenses, in particular in connection with Section 404 under the Sarbanes-Oxley Act of 2002, statements relating to anticipated future revenue growth, statements relating to future availability under our revolving credit facility, statements relating to our working capital and capital expenditure needs, and other statements containing words such as “believe,” “anticipate,” “expect,” “may,” “intend,” and words of similar import or statements of our management’s opinion. These forward-looking statements and assumptions involve known and unknown risks, uncertainties and other factors that may cause our actual results, market performance or achievements to differ materially from any future results, performance or achievements expressed or implied by such forward-looking statements. Important factors that could cause such differences include, but are not limited to, changes in economic or business conditions in general, changes in product supply, fluctuations in comparable store sales, limitations resulting from restrictive covenants in our revolving 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 and governmental actions and consequences stemming from the continued wars in Iraq and Afghanistan or from terrorist activities in or related to the United States, and other factors described above in the section “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 quarterly report on Form 10-Q.

OTHER INFORMATION

We entered into a Letter Agreement, dated as of August 17, 2004, with some of our existing investors to amend the terms of our Amended and Restated Series A and B Preferred Stock Purchase Agreement, dated as of March 21, 2001, by and among us and the investors listed on Schedule A thereto. In particular, the Letter Agreement terminated, among other things, certain rights of the investors in connection with our board of directors and committees of our board of directors under the existing Amended and Restated Series A and B Preferred Stock Purchase Agreement. The Letter Agreement had no effect, however, on any rights granted to holders of our Series A preferred stock pursuant to our certificate of designation.

EXHIBIT INDEX

EXHIBIT NUMBER		DOCUMENT DESCRIPTIONS

3.1		Second Amended and Restated Certificate of Incorporation, as amended (incorporated by reference to exhibit number 3.1 of Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on October 24, 2001).
3.2		Certificate of Designation of Series A and Series B Preferred Stock (incorporated by reference to exhibit number 4.6 of Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on April 2, 2001).
3.3		Amended and Restated Bylaws, as amended to date (incorporated by reference to exhibit number 3.2 of Form 10-Q for the quarterly period ended October 31, 1998 filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on December 15, 1998).
10.1		Employment Agreement, effective as of May 24, 2004, by and between Restoration Hardware, Inc. and Stephen Gordon.
10.2		Employment Offer Letter dated August 13, 2004, from Restoration Hardware, Inc. to John W. Tate (incorporated by reference to exhibit number 99.2 of Form 8-K, filed by Restoration Hardware, Inc. with the Securities Exchange Commission on August 19, 2004).
10.3		Letter Agreement, dated as of August 17, 2004, by and among Restoration Hardware, Inc. and the investors named therein (incorporated by reference to exhibit number 10.5 of Form 10-Q for the quarterly period ended July 31, 2004 filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on August 30, 2004).
10.4		Notice of Grant of Stock Option and Stock Option Agreement between Restoration Hardware, Inc. and John W. Tate, dated August 24, 2004.
10.5		Notice of Grant of Stock Option and Stock Option Agreement between Restoration Hardware, Inc. and John W. Tate, dated August 24, 2004.
10.6		Form of Notice of Grant of Stock Option and Stock Option Agreement for the Discretionary Option Grant Program under the Restoration Hardware, Inc. 1998 Stock Incentive Plan as Amended and Restated October 9, 2002 (incorporated by reference to exhibit number 10.1 of Form 8-K filed by Restoration Hardware, Inc. with the Securities Exchange Commission on November 9, 2004).
10.7		Form of Notice of Grant of Stock Option, Stock Option Agreement and Early Exercise Stock Purchase Agreement for the Automatic Option Grant Program under the Restoration Hardware, Inc. 1998 Stock Incentive Plan as Amended and Restated October 9, 2002 (incorporated by reference to exhibit number 10.2 of Form 8-K filed by Restoration Hardware, Inc. with the Securities Exchange Commission on November 9, 2004).
10.8		Form of Notice of Grant of Stock Option and Stock Option Agreement for the Director Fee Option Grant Program under the Restoration Hardware, Inc. 1998 Stock Incentive Plan as Amended and Restated October 9, 2002 (incorporated by reference to exhibit number 10.3 of Form 8-K filed by Restoration Hardware, Inc. with the Securities Exchange Commission on November 9, 2004).
31.1		Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer.
31.2		Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer.
32.1		Section 1350 Certification of Chief Executive Officer.
32.2		Section 1350 Certification of Chief Financial Officer.


PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets as of October 30, 2004, January 31, 2004, and November 1, 2003 (as restated)

	Condensed Consolidated Statements of Operations for the third quarter and nine months ended October 30, 2004 and November 1, 2003

	Condensed Consolidated Statements of Cash Flows for the nine months ended October 30, 2004 and November 1, 2003

	Notes to Condensed Consolidated Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings

Item 6.	Exhibits

SIGNATURES

EXHIBIT INDEX.

	Restoration Hardware, Inc.

Date: December 1, 2004

	By:	/s/ Gary G. Friedman
		Gary G. Friedman
		President and Chief Executive Officer


	By:	/s/ Patricia A. McKay
		Patricia A. McKay
		Executive Vice President and Chief Financial Officer
		(Principal Financial Officer)


	By:	/s/ Murray Jukes
		Murray Jukes
		Vice President, Controller
		(Principal Accounting Officer)

WASHINGTON, D.C. 20549

FORM 10-Q

Commission File Number: 000-24261

Item 2. Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

REVENUE

Retail Net Revenue