Item 1. Consolidated Financial Statements

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except share data)

(Unaudited)

							May, 1
							2004
	April 30,			January 29,			(As restated
	2005			2005			– see Note 2)

ASSETS
Current assets:
Cash and cash equivalents	$	1,879		$	1,904		$	2,550
Accounts receivable	6,800			6,945			5,863
Merchandise inventories	144,152			144,185			117,786
Prepaid expense and other current assets	19,875			19,574			14,965
Total current assets	172,706			172,608			141,164
Property and equipment, net	80,192			81,886			80,843
Goodwill	4,560			4,560			4,560
Deferred tax assets, net	18,688			18,745			18,032
Other assets	2,766			1,464			4,157
Total assets	$	278,912		$	279,263		$	248,756

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	50,722		$	63,920		$	41,656
Line of credit, net of debt issuance	52,390			33,819			34,384
Deferred revenue and customer deposits	8,966			8,130			7,068
Other current liabilities	12,412			14,948			11,394
Total current liabilities	124,490			120,817			94,502
Deferred lease incentives	29,419			30,365			32,555
Deferred rent	20,218			20,321			20,124
Other long-term obligations	92			143			301
Total liabilities	174,219			171,646			147,482

Commitments and contingencies

Series A redeemable convertible preferred stock, $.0001 par value, 28,037 shares designated, 8,473, 8,473 and 8,613 shares issued and outstanding at April 30, 2005, January 29, 2005 and May 1, 2004, respectively, aggregate liquidation preference and redemption value of $10,429 at April 30, 2005	8,331			8,331			8,471

Stockholders’ equity:
Common stock, $.0001 par value; 60,000,000 shares authorized; 33,155,840, 33,084,223 and 32,848,088 issued and outstanding at April 30, 2005, January 29, 2005 and May 1, 2004, respectively	3			3			3
Additional paid-in capital	159,532			159,233			158,404
Unearned compensation	—			—			(133		)
Accumulated other comprehensive income	702			812			907
Accumulated deficit	(63,875		)	(60,762		)	(66,378		)
Total stockholders’ equity	96,362			99,286			92,803

Total liabilities, redeemable convertible preferred stock and stockholders’ equity	$	278,912		$	279,263		$	248,756

See Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except share data)

(Unaudited)

	First Quarter
	Fiscal 2005			Fiscal 2004 (As restated – see Note 2)

Net revenue	$	117,465		$	98,858
Cost of revenue and occupancy	81,823			71,328
Gross profit	35,642			27,530
Selling, general and administrative expense	39,986			33,516
Loss from operations	(4,344		)	(5,986		)

Interest expense, net	(825		)	(427		)
Loss before income taxes	(5,169		)	(6,413		)
Income tax benefit	2,056			2,501
Net loss	$	(3,113	)	$	(3,912	)

Loss per share of common stock, basic and diluted	$	(0.09	)	$	(0.12	)
Weighted average shares outstanding, basic and diluted	33,110			32,791

See Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

	First Quarter
	Fiscal 2005			Fiscal 2004 (As restated – see Note 2)

Cash flows from operating activities:
Net loss	$	(3,113	)	$	(3,912	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization	4,118			4,114
Changes in operating assets and liabilities:
Accounts receivable	145			(118		)
Merchandise inventories	33			(14,860		)
Prepaid expense, deferred tax and other assets	(1,506		)	(2,030		)
Accounts payable and accrued expenses	(13,198		)	(3,636		)
Deferred revenue and customer deposits	836			(163		)
Other current liabilities	(2,537		)	(44		)
Deferred rent	(103		)	(100		)
Deferred lease incentives	(946		)	(1,444		)
Net cash used by operating activities	(16,271		)	(22,193		)

Cash flows from investing activities:
Capital expenditures	(2,334		)	(1,318		)
Net cash used by investing activities	(2,334		)	(1,318		)

Cash flows from financing activities:
Borrowings under line of credit, net	18,443			23,984
Repayments – other long-term obligations	(51		)	(51		)
Issuance of common stock	260			160
Net cash provided by financing activities	18,652			24,093

Effects of foreign currency exchange rate translation	(72		)	(35		)
Net (decrease) increase in cash and cash equivalents	(25		)	547

Cash and cash equivalents:
Beginning of period	1,904			2,003
End of period	$	1,879		$	2,550

Additional cash flow information:
Cash paid during the period for interest	$	732		$	358
Cash paid during the period for taxes	337			98
Non-cash transactions:
Conversion of preferred stock to common stock	$	—		$	70

See Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(1) NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business

Restoration Hardware, Inc., a Delaware corporation, (together with its subsidiaries collectively, the “Company”), is a specialty retailer of high-quality home furnishings, bathware, hardware, textiles, accessories and related merchandise. These products are sold through retail locations, catalogs and the Internet. As of April 30, 2005, the Company operated 102 retail stores and two outlet 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 April 30, 2005, January 29, 2005 and May 1, 2004, results of operations for the first quarters ended April 30, 2005 and May 1, 2004, respectively, and cash flows for the first quarters ended April 30, 2005 and May 1, 2004, respectively. The balance sheet at January 29, 2005, as presented, has been derived from the Company’s audited consolidated financial statements for the fiscal year then ended. The condensed consolidated financial statements for the prior period have been restated. See Note 2 of the condensed consolidated financial statements for additional information. The cumulative effect of this restatement was an increase in accumulated deficit of $4.1 million as of May 1, 2004 and an increase in pre-tax results of $115 thousand ($70 thousand, after tax) for the first quarter ended May 1, 2004.

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 29, 2005 (“fiscal 2004”). 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 2004.

The results of operations for the first quarter ended April 30, 2005, presented in this Form 10-Q are not necessarily indicative of the results to be expected for the full year.

Stock-based Compensation

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

(Dollars in thousands, except share data)

	First Quarter
	Fiscal 2005			Fiscal 2004

Net loss as reported	$	(3,113	)	$	(3,912	)
Add: Stock-based employee compensation expense for options granted below fair market value included in reported net loss (net of tax)	—			62
Deduct: Compensation expense for all stock-based employee compensation (net of tax) calculated in accordance with the fair value method	(869		)	(672		)
Pro forma net loss	$	(3,982	)	$	(4,522	)

Loss per share of common stock:
Basic and diluted, as reported	$	(0.09	)	$	(0.12	)
Basic and diluted, pro forma	$	(0.12	)	$	(0.14	)

Comprehensive Loss

Comprehensive loss consists of net loss and foreign currency translation adjustments. The components of comprehensive loss for the first quarters ended April 30, 2005 and May 1, 2004, respectively, are as follows:

(Dollars in thousands, except share data)

	First Quarter
	Fiscal 2004			Fiscal 2005

Components of comprehensive loss:
Net loss	$	(3,113	)	$	(3,912	)
Foreign currency translation adjustment	(110		)	(148		)
Total comprehensive loss	$	(3,223	)	$	(4,060	)

(2) RESTATEMENT OF CONSOLIDATED FINANCIAL STATEMENTS

On February 7, 2005, the Office of the Chief Accountant of the Securities and Exchange Commission (“SEC”) issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain operating lease-related accounting issues and their treatment under generally accepted accounting principles in the United States of America (“GAAP”). In response to this letter, management reviewed its lease accounting and determined that the Company’s method of accounting for rent holidays was not in accordance with GAAP. As a result, the Company restated its accompanying Condensed Consolidated Financial Statements as of and for the first quarter ended May 1, 2004.

Historically, and consistent with industry practice, the Company has recognized the straight line rent expense for leases generally beginning on the store opening date, which had the effect of excluding the construction period of its stores (rent holiday) from the calculation of the period over which the Company expensed rent. The Company determined that the appropriate accounting treatment is to include the construction period in its calculation of straight line rent in accordance with Financial Accounting Standards Board (“FASB”) Technical Bulletin No. 85-3, “Accounting for Operating Leases with Scheduled Rent Increases.” The Company corrected its straight line rent accrual and deferred rent credits accordingly. The cumulative effect of this restatement was an increase in accumulated deficit of $3.5 million as of May 1, 2004 and an increase in pre-tax results of $115 thousand ($70 thousand, after tax) for the first quarter ended May 1, 2004. Additionally, the Company corrected an error recorded in fiscal 2001 related to tax accounting; the correction had the effect of increasing the accumulated deficit and decreasing prepaid tax assets by $0.6 million as of May 1, 2004.

Following is a summary of the effects of the restatement on the Company’s Condensed Consolidated Financial Statements as of and for the first quarter ended May 1, 2004 (in thousands except share data):

	Condensed Consolidated Statement of Operations
	As previously
	reported			Adjustments			As restated
Fiscal quarter ended May 1, 2004
Cost of revenue and occupancy	$	71,443		$	(115	)	$	71,328
Gross profit	27,415			115			27,530
Loss from operations	(6,101		)	115			(5,986		)
Loss before income taxes	(6,528		)	115			(6,413		)
Income tax benefit	2,546			(45		)	2,501
Net loss	(3,982		)	70			(3,912		)
Net loss per share of common stock—basic and diluted	$	(0.12	)	$	0.00		$	(0.12	)

	Condensed Consolidated Balance Sheet
	As previously
	reported			Adjustments			As restated
May 1, 2004
Prepaid expense and other current assets	$	16,263		$	(1,298	)	$	14,965
Deferred tax assets, net	15,119			2,913			18,032
Other assets	4,202			(45		)	4,157
Deferred rent	14,470			5,654			20,124
Accumulated deficit	(62,279		)	(4,099		)	(66,378		)
Total stockholders’ equity	96,887			(4,084		)	92,803

(3) LINE OF CREDIT, NET

As of April 30, 2005, the Company’s revolving credit facility provided for an overall commitment of $100 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 million, and further allowed the Company to request and receive incremental increases beyond the initial available commitment of $100 million up to a maximum commitment of $150 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 million to $50 million and modified certain other terms in the revolving credit facility, which had the effect of expanding the borrowing base.

As of April 30, 2005, $52.4 million was outstanding under the line of credit, net of unamortized debt issuance costs of $0.6 million, and there was $11.3 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 April 30, 2005, the bank’s reference rate was 6.25% and the LIBOR plus margin rate was 5.0%. 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 Consolidated Balance Sheet pursuant to guidance in the FASB’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.”

(4) 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 may record 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 would be 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. 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 April 30, 2005 and January 29, 2005, the Company recorded net deferred tax assets totaling approximately $26 million which primarily represent the income tax benefit associated with losses reported in prior years and different fixed asset bases. These losses are subject to federal and state carry-forward provisions of up to 20 years. As of April 30, 2005 and January 29, 2005, the Company concluded that the net deferred tax asset balances of approximately $26 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 $2.1 million for the first quarter of fiscal 2005, which is included in Other Assets on the balance sheet.

(5) 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 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 first quarters of fiscal 2005 and 2004, respectively:

	First Quarter
	Fiscal 2005	Fiscal 2004

Convertible preferred stock and options:
Shares of common stock subject to outstanding options	619,681	571,995
Shares of common stock subject to conversion from the Series A preferred stock	4,261,001	4,356,205
Total shares of common stock equivalents	4,880,682	4,928,200

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 4,331,374 and 3,898,946 for the first quarters of fiscal 2005 and 2004, respectively.

(6) 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. The unallocated portion includes both the costs of corporate expenses, shared service costs such as information technology, as well as the 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. Management decisions on resource allocations and performance assessments are made based on these two identifiable segments. As a result, management considers it is more appropriate to report its business activities into two 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:

(Dollars in thousands)

	First Quarter
	Fiscal 2005			Fiscal 2004
Net Revenue:
Retail	$	84,677		$	76,997
Direct-to-customer	32,788			21,861
Consolidated net revenue	$	117,465		$	98,858

	First Quarter
	Fiscal 2005			Fiscal 2004

Income (loss) from operations:
Retail	$	7,115		$	4,935
Direct-to-customer	4,600			3,019
Unallocated	(16,059		)	(13,940		)
Consolidated loss from operations	$	(4,344	)	$	(5,986	)

(7) SUBSEQUENT EVENT

On May 19, 2005, the Company approved plans to remodel a majority of its stores in the second quarter of fiscal 2005. This will enable the Company to expand the merchandise offerings in certain core businesses, particularly lighting and textiles, and present those offerings with more clarity and focus. The remodeling program is expected to require an investment of approximately $15 million and will be substantially completed in advance of the fall selling season. This will also require the removal of some existing store fixtures. The depreciated cost of those store fixtures is estimated at $1.2 million to $1.6 million and will be amortized over the remaining period of usage during the second quarter, resulting in a non-cash charge of $0.02 to $0.03 per share.

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 share data)	First Quarter Fiscal 2005			% of Net Revenue		First Quarter Fiscal 2004			% of Net Revenue

Retail net revenue	$	84,677		72.1	%	$	76,997		77.9	%
Direct-to-customer net revenue	32,788			27.9		21,861			22.1
Net revenue	117,465			100.0		98,858			100.0
Cost of revenue and occupancy	81,823			69.7		71,328			72.2
Gross profit	35,642			30.3		27,530			27.8
Selling, general and administrative expense	39,986			34.0		33,516			33.9
Loss from operations	(4,344		)	(3.7	)	(5,986		)	(6.1	)
Interest expense, net	(825		)	(0.7	)	(427		)	(0.4	)
Loss before income taxes	(5,169		)	(4.4	)	(6,413		)	(6.5	)
Income tax benefit	2,056			1.7		2,501			2.5
Net loss	$	(3,113	)	(2.7	)	$	(3,912	)	(4.0	)
Loss per share of common stock — basic and diluted	$	(0.09	)			$	(0.12	)

Loss from operations decreased to $4.3 million for the first quarter of fiscal 2005, an improvement of 27% compared to a loss from operations of $6.0 million for the first quarter of fiscal 2004. Net loss was $0.09 per share of common stock, or $3.1 million, for the first quarter of fiscal 2005, compared to a net loss of $0.12 per share of common stock, or $3.9 million, for the first quarter of fiscal 2004.

Net revenue increased 19% in the first quarter of fiscal 2005, as compared to the same period of fiscal 2004 on higher sales in both the retail and direct-to-customer channels. Operating results improved by 27% as compared to the prior year’s first quarter driven by higher sales and an increase in our gross margins. As compared to the prior year, we experienced higher product margins, occupancy leverage on higher sales, as well as cost improvements in our supply chain and distribution system which resulted in an increase in our gross margin expressed as a percentage of sales of 250 basis points to 30.3% for the quarter as compared to 27.8% last year. Selling, general and administrative expense expressed as a percentage of net revenue remained relatively flat, increasing 10 basis points during the first quarter of fiscal 2005 as compared to the prior year; in absolute dollars, selling, general and administrative expense increased $6.5 million for the first quarter of fiscal 2005 as compared to the prior year. Selling, general and administrative expenses were leveraged by 100 basis points in the first quarter as compared to the prior year excluding the effect of expected higher costs of production and mailing of our catalogs. As a result of these improvements, we experienced a 240 basis point increase in our operating results expressed as a percentage of sales for the first quarter of fiscal 2005 as compared to the first quarter of fiscal 2004.

The increases in our net revenue resulted from continued growth of our direct-to-customer business, which increased $10.9 million, or 50%, in the first quarter of fiscal 2005 as compared to the first quarter of fiscal 2004. The revenue growth was also due to an increase in comparable store sales of 5.0% for the first quarter of fiscal 2005 and revenue generated from outlet and warehouse sale events. The increases in net revenue in both our retail and direct-to-customer channels is attributable to growth of core merchandise categories, while contracting non-core discovery and fringe accessories categories. We believe our reduction of these non-core categories will enable the expansion of our higher margin core businesses this fall and is more consistent with our overall brand positioning.

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 percentage of our sales

occur 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. Our catalog continues to serve as our primary advertising vehicle.

REVENUE

Retail Net Revenue and Segment Results

(Dollars in thousands)

	First Quarter
	Fiscal 2005			Fiscal 2004
Retail net revenue	$	84,677		$	76,997
Retail net revenue growth percentage	10		%	9		%
Comparable store sales growth	5.0		%	9.0		%
Income from operations	$	7,115		$	4,935
Income from operations – percent of net revenue	8.4		%	6.4		%

Number of retail stores at beginning of period	102			103
Number of retail stores opened	—			—
Number of retail stores closed	—			1
Number of retail stores at end of period	102			102

Store selling square feet at end of period	676,520			672,604

Retail net revenue for the first quarter of fiscal 2005 increased by $7.7 million, or 10.0%, as compared to the first quarter of fiscal 2004 primarily due to a $3.8 million, or 5.0%, 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 the first quarter of fiscal 2005. Retail net revenue for the first quarter of fiscal 2005 also reflects $2.9 million of sales generated from our two outlet stores, coupled with revenue from first quarter warehouse sales events. Warehouse sales revenue is included in retail revenue, but is excluded from our comparable store sales calculation. A warehouse sale event was not held in the first quarter of fiscal 2004.

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 more useful indicator of store performance than the change in total net revenue, since comparable store sales exclude the effects of changes in the number of stores open.

Income from operations for the retail segment increased 44.2% to $7.1 million in the first quarter of fiscal 2005 from $4.9 million in the first quarter of fiscal 2004. Income from retail operations expressed as a percent of related segment net revenue grew 200 basis points to 8.4% from 6.4% in the first quarter of fiscal 2004. The expansion of income from operations for the retail segment is attributable to higher product margins, store occupancy leverage and cost improvements in distribution, supply chain and store payroll as compared to the prior year as expressed as a percentage of net sales. We believe higher product margins are the result of the benefits to a shift to a higher margin mix of products and the efforts of the vertically integrated product design, merchandise and sourcing organization. Income from operations for the retail segment includes the costs of retail stores results less direct costs of the store field operations.

Our current plans include the remodeling of a majority of our stores in the second quarter. This will enable us to expand the merchandise offerings in certain core businesses, particularly lighting and textiles, and present those offerings with more clarity and focus. The remodeling program is expected to require an investment of approximately $15 million and will be substantially completed in advance of the fall selling season. This will also require the removal of some existing store fixtures. The depreciated cost of those store fixtures is estimated

at $1.2 million to $1.6 million and will be amortized over the remaining period of usage during the second quarter, resulting in a non-cash charge of $0.02 to $0.03 per share.

Direct-to-Customer Net Revenue and Segment Results

(Dollars in thousands)

	First Quarter
	Fiscal 2005			Fiscal 2004
Catalog revenue	$	18,079		$	12,464
Internet revenue	14,709			9,397
Total direct-to-customer net revenue	$	32,788		$	21,861
Income from operations	$	4,600		$	3,019
Income from operations - percent of net revenue	14.0		%	13.8		%

Growth percentages:
Direct-to-customer net revenue	50		%	94		%
Number of catalogs mailed	20		%	18		%
Pages circulated	45		%	59		%

Direct-to-customer net revenue consists of both catalog and internet sales. Direct-to-customer net revenue for the first quarter of fiscal 2005 increased $10.9 million, or 50%, as compared to the first quarter of fiscal 2004. The higher sales reflect increased circulation coupled with improved productivity of our catalogs that resulted in higher sales per book mailed as compared to the prior year’s first quarter mailings. Internet sales benefited from our website marketing efforts coupled with growing customer familiarity with the Internet and from strong customer response to our spring and summer product offerings.

Income from operations for the direct-to-customer segment was $4.6 million in the first quarter of fiscal 2005 as compared to $3.0 million in the same quarter of the prior fiscal year, and it improved to 14.0% of related segment net revenue for the first quarter of fiscal 2005 as compared to 13.8% in the first quarter of fiscal 2004. Segment results were favorably impacted by product margin expansion and by the leveraging from higher sales of the costs of production and mailings of our catalogs.

EXPENSES

Cost of Revenue and Occupancy Expense

Total cost of revenue and occupancy increased $10.5 million during the first quarter of fiscal 2005 as compared to the same period in fiscal 2004. As a percentage of net revenue, these costs improved 250 basis points to 69.7%, from 72.2% for the first quarter of fiscal 2004. This improvement was achieved through a favorable mix of sales of higher margin products, improved margins in our core products and a lower level of distribution and supply chain costs and leverage achieved on relatively fixed store occupancy costs.

Selling, General and Administrative Expense

Selling, general and administrative expense expressed as a percentage of net revenue remained nearly flat, increasing 10 basis points to 34.0% for the first quarter of fiscal 2005, from 33.9% in the first quarter of fiscal 2004. Selling, general and administrative expenses were leveraged by 100 basis points in the first quarter as compared to the prior year excluding the effect of expected higher costs of production and mailing of our catalogs. In absolute dollars, selling, general and administrative expenses increased $6.5 million, to $40.0 million for the first quarter of fiscal 2005 from $33.5 million in the first quarter of fiscal 2004. The increase in absolute dollars is primarily related to an increase in catalog production and mailing costs, and an increase in payroll expense in support of our higher sales volume and our overall growth.

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 catalog circulation costs will lead to increases in overall selling, general and

administrative expense as a percentage of net revenue. This general dynamic inherent in our business model also occurred in the first quarter of fiscal 2004 and deleveraged selling, general and administrative expenses. 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.

Interest Expense, Net

Interest expense, net includes interest on borrowings under our revolving credit facility and amortization of debt issuance costs. For the first quarter of fiscal 2005, interest expense, net was $0.8 million, an increase of $0.4 million as compared to $0.4 million in the first quarter of fiscal 2004. The increase in first quarter interest expense was due primarily to an increase in our average debt levels and secondarily to higher average borrowing rates.

Income Tax Benefit

Our effective tax rate was 40% for the first quarter of fiscal 2005 as compared to 39% for the first quarter of fiscal 2004.

As of April 30, 2005 and January 29, 2005, we recorded net deferred tax assets totaling approximately $26 million, which primarily represent the income tax benefit associated with losses reported in prior years and the differences in fixed asset bases. The losses are subject to federal and state carry-forward provisions of up to 20 years. As of April 30, 2005 and January 29, 2005, we concluded that the net deferred tax asset balances of approximately $26 million were 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 $2.1 million for the first quarter of fiscal 2005, which is included in Other Assets in our Condensed Consolidated Balance Sheets.

OTHER MATTERS

We are currently exploring the launch of a new brand that is expected to be tested with the introduction of a new catalog in the fall of 2006 or the spring of 2007. We expect to incur expenses of approximately $1.0 million in 2005 to support this effort.

LIQUIDITY AND CAPITAL RESOURCES

Operating Cash Flows

For the first quarter of fiscal 2005, net cash used by operating activities was $16.3 million compared to $22.2 million of net cash used by operating activities for the first quarter of fiscal 2004. The net cash used by operating activities in the first quarter of fiscal 2005 resulted primarily from payment of inventory that was in-transit at our fiscal 2004 year-end.

Investing Cash Flows

Net cash used by investing activities was $2.3 million for the first quarter of fiscal 2005, an increase of $1.0 million compared to $1.3 million for the first quarter of fiscal 2004. The cash used for investing activities for the first quarter of fiscal 2005 primarily related to information technology assets, primarily associated with our internet sales effort, store spending, including the opening of outlet stores and to a lesser degree, distribution and supply chain improvements.

Financing Cash Flows

Net cash provided by financing activities was $18.7 million for the first quarter of fiscal 2005, compared to $24.1 million in the first quarter of fiscal 2004. Substantially all of the increase in net cash provided by financing activities for the first quarter of fiscal 2005 resulted from an increase in net borrowings under our revolving credit facility. Cash financing requirements were lower in the first quarter of fiscal 2005 as compared

to the same period of fiscal 2004 primarily due to the relative timing of seasonal inventory increases experienced in each year’s first quarter.

As of April 30, 2005, our revolving credit facility provided for an overall commitment of $100 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 million, and further allowed us to request and receive incremental increases beyond the initial available commitment of $100 million up to a maximum commitment of $150 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 million to $50 million and modified certain other terms in the revolving credit facility, which had the effect of expanding the borrowing base.

As of April 30, 2005, $52.4 million was outstanding under the line of credit, net of unamortized debt issuance costs of $0.6 million, and there was $11.3 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 April 30, 2005, the bank’s reference rate was 6.25 % and the LIBOR plus margin rate was 5.0%. 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.”

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 underperforming 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.

In addition, a material decline in sales and other adverse conditions resulting from our failure to accurately anticipate changes in merchandise trends and consumer demands could cause us to close additional underperforming stores. While we believe that we benefit in the long run financially by closing underperforming stores and reducing nonproductive costs, the closure of such stores would subject us to additional increased short-term costs including, but not limited to, employee severance costs, charges in connection with the impairment of assets and costs associated with the disposition of outstanding lease obligations.

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

An important part of our efforts to achieve efficiencies, cost reductions and sales growth is the identification and implementation of improvements to our planning, logistical and distribution infrastructure and our supply chain, including merchandise ordering, transportation and receipt processing. An inability to improve our planning and supply chain processes or to take full advantage of supply chain opportunities could result in loss of potential sales revenue, increased cost and 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, seasonality, 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 5.0 % in the first quarter of fiscal 2005 versus the first quarter of fiscal 2004, based on the same number of stores. 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 comparable store sales 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. 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 our point-of-sale, merchandise management and warehouse management systems. We also rely on the same vendor for software support. A failure by this 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 our 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 April 30, 2005, we had approximately 3,600 full and part time employees, and while we believe our relations with our employees are generally good, we cannot predict the effect that any future organizational activities will have on our business and operations. 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 million revolving credit facility, which may be increased to $150 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 April 30, 2005 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 certain 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. As described above, we currently have in place a revolving credit facility that provides for an overall commitment of $100 million, which may be increased to $150 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 fiscal year 2004, we purchased approximately 60% of our merchandise directly from vendors located abroad. 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 of America. 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 of America, changes in import duties, tariffs and quotas, loss of “most favored nation” trading status by the United States of America 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 of America, freight cost increases, economic uncertainties, including inflation, foreign government regulations, and political unrest and trade restrictions, including the United States of America

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 first quarter of fiscal year 2005, revenue through our direct-to-customer channel grew by 50% as compared to the prior fiscal year. Increased activity in our direct-to-customer business could result in material changes in our operating costs, including increased merchandise inventory costs and costs for paper and postage associated with the distribution and shipping of catalogs and products. Although we intend to attempt to mitigate the impact of these increases by improving sales revenue and efficiencies, we cannot assure you that we will succeed in mitigating expenses with increased efficiency or that cost increases associated with our direct-to-customer business will not have an adverse effect on the profitability of our business. Additionally, while we outsource to a third party the fulfillment of our direct-to-customer division, including 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 Chairman, President and Chief Executive Officer, Gary 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.

Regulatory changes may increase our costs.

Changes in the laws, regulations and rules affecting public companies may increase our expenses in connection with our compliance with these new requirements. 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.

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 discretionary items and luxury retail products, such as our products. Reduced consumer confidence and spending also may result in limitations on our ability to increase prices and may 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, 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 of America, 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 of America targets, rumors or threats of war, actual conflicts involving the United States of America or its allies, including the on-going U.S. conflicts 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 of America and worldwide financial markets and economies. Also, any of these events could result in economic recession in the United States of America 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.

Newly adopted accounting regulations that require companies to expense stock options will result in a decrease in our earnings and our stock price may decline.

The Financial Accounting Standards Board recently adopted the previously proposed regulations that will eliminate the ability to account for share-based compensation transactions using the intrinsic method that we currently use and generally would require that such transactions be accounted for using a fair-value-based method and recognized as an expense in our consolidated statement of operations. We will be required to expense stock options effective in periods beginning after January 28, 2006. Currently, we generally only disclose such expenses on a pro forma basis in the Notes to our Condensed Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America. The adoption of this new accounting regulation could have a significant impact on our results of operations and our stock price could decline accordingly.

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

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

For the quarterly period ended April 30, 2005

or

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

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)

PART I.	FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements (Unaudited)

	Condensed Consolidated Balance Sheets as of April 30, 2005, January 29, 2005, and May 1, 2004 (as restated)

	Condensed Consolidated Statements of Operations for the first quarters ended April 30, 2005 and May 1, 2004 (as restated)

	Condensed Consolidated Statements of Cash Flows for the first quarters ended April 30, 2005 and May 1, 2004 (as restated)

	Notes to Condensed Consolidated Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

PART II.	OTHER INFORMATION

Item 1.	Legal Proceedings

Item 6.	Exhibits

SIGNATURES

EXHIBIT INDEX

	Restoration Hardware, Inc.

Date: June 9, 2005

	By:	/s/ Gary G. Friedman
		Gary G. Friedman
		Chairman, 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)

EXHIBIT NO.		DOCUMENT DESCRIPTION
3.1		Second Amended and Restated Certificate of Incorporation, as amended (incorporated by reference to exhibit number 3.1 of the Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on October 24, 2001)
3.2		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)
3.3		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)
10.1		Form of Indemnification Agreement with Officers and Directors
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

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended April 30, 2005

Commission File Number: 000-24261

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

REVENUE

Retail Net Revenue and Segment Results

OTHER MATTERS