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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended October 31, 2004

or

For the transition period from              to             

Commission File Number: 0-15827

SHARPER IMAGE CORPORATION

(Exact name of registrant as specified in its charter)

650 Davis Street, San Francisco, California 94111

(Address of principal executive offices) (Zip Code)

Registrant’s telephone number, including area code: (415) 445-6000

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 requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock, as of the latest practicable date.

Common Stock, $0.01 par value, 15,706,830 shares as of December 8, 2004

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SHARPER IMAGE CORPORATION

FORM 10-Q

For the Quarter Ended October 31, 2004

INDEX

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Sharper Image Corporation

Condensed Balance Sheet

(In thousands, except share amounts)

See Notes to Condensed Financial Statements

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Sharper Image Corporation

Condensed Statements of Operations

(In thousands, except share and per-share amounts)

See Notes to Condensed Financial Statements

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Sharper Image Corporation

Condensed Statements of Cash Flows

(In thousands)

See Notes to Condensed Financial Statements

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

Sharper Image Corporation

Notes to Condensed Financial Statements

Three-month and nine-month periods ended October 31, 2004 and 2003

NOTE A- Interim Financial Statements

Basis of Presentation

The condensed balance sheets at October 31, 2004 and 2003, and the related condensed statements of operations for the three-month and nine-month periods ended October 31, 2004 and 2003 and related statements of cash flows for the nine-month periods ended October 31, 2004 and 2003 have been prepared by Sharper Image Corporation (the “Company”), without audit. In the opinion of management, the condensed financial statements include all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position, results of operations and cash flows as of October 31, 2004 and 2003, and for the three-month and nine-month periods then ended. The balance sheet at January 31, 2004, presented herein, has been derived from the audited balance sheet of the Company. Certain reclassifications were made in prior periods’ condensed financial statements to conform to current periods’ presentation.

Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted from these interim financial statements pursuant to the rules and regulations of the Securities and Exchange Commission (the “SEC”). Accordingly, these interim financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K filed with the SEC for the fiscal year ended January 31, 2004, which includes a complete set of footnote disclosures, including the Company’s significant accounting policies.

The Company’s business is highly seasonal, reflecting the general pattern associated with the retail industry of peak sales and earnings during the holiday shopping season. A substantial portion of the Company’s total revenues and all or most of the Company’s net earnings usually occur in the fourth quarter ending January 31. The Company, as is typical in the retail industry, generally experiences lower revenues and lower net operating results during the other quarters and has incurred and may continue to incur losses in these quarters. The results of operations for these interim periods are not necessarily indicative of the results for the full fiscal year.

Use of Estimates

The preparation of condensed financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect reported amounts and related disclosures. Actual results could differ materially from estimates and assumptions made.

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NOTE B - Employee Stock 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 (“APB 25”), “Accounting for Stock Issued to Employees.” No compensation expense has been recognized for employee stock options in the accompanying financial statements in accordance with the provisions of APB 25. Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation”, establishes a fair value method of accounting for stock options and other equity instruments. SFAS No. 123 requires the disclosure of pro forma income and earnings per share as if the Company had adopted the fair value method. For determining pro forma earnings per share, the fair value of the stock options and employees’ purchase rights were estimated using the Black-Scholes option pricing model. The Company’s calculations are based on a multiple option approach and forfeitures are recognized as they occur. Had compensation cost for these stock option and stock purchase plans been determined based on the fair value at the grant dates for awards under those plans consistent with the methods of SFAS No. 123, the Company’s net earnings and net earnings per share would have been as the pro forma amounts indicate below:

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NOTE C - Earnings per Share

Basic earnings per share is computed as net income available to common stockholders divided by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur from common shares to be issued through stock options.

The potential effects of stock options were excluded from the diluted earnings per share for the three and nine-month periods ended October 31, 2004 because their inclusion in net loss periods would be anti-dilutive to the earnings per share calculation. Options to purchase 2,746,317 shares of common stock were outstanding as of October 31, 2004.

Of these options, 836,724 stock options for the three months ended October 31, 2004 and 1,239,641 stock options for the nine months ended October 31, 2004 were excluded from dilutive earnings per share calculation because the Company was in a net loss position and their inclusion would have been anti-dilutive.

Had the Company been in a net income position, stock options of 982,600 for the three months ended October 31, 2004 and stock options of 64,750 for the nine months ended October 31, 2004, respectively, would have been excluded from the diluted earnings per share calculation because the option exercise price exceeded the average stock price for those periods.

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NOTE D - Revolving Loan and Notes Payable

The Company has a revolving secured credit facility with Wells Fargo Bank, National Association. The credit facility has a maturity date of October 31, 2006, and allows borrowings and letters of credit up to a maximum of $50 million at all times during the year, with a “borrowing base” determined by inventory levels and specified accounts receivable. The credit facility is secured by the Company’s inventory, accounts receivable, and specified other assets. Borrowings under the credit facility bear interest at either the adjusted LIBOR rate plus 1.50% or at Wells Fargo’s prime rate less 0.25%. The credit facility contains financial covenants that only apply during an event of default or when the borrowing base is drawn below a specified level. These financial covenants require the Company to maintain a minimum EBITDA (as defined) on a rolling 12-month basis of $35 million and to maintain capital expenditures below a specified level based on the Company’s projections. The credit facility contains limitations on incurring additional indebtedness, making additional investments and permitting a change of control. As of October 31, 2004, letter of credit commitments outstanding under the credit facility were $5.7 million.

NOTE E - Segment Information

The Company classifies its business interests into four reportable segments: retail stores, catalog and direct marketing, Internet and wholesale. The accounting policies of the segments are the same as those described in the summary of significant accounting policies in Note A of the 2003 Annual Report. The Company evaluates performance and allocates resources based on operating contribution, which excludes unallocated corporate general and administrative costs and income tax expense or benefit. The Company’s reportable segments are strategic business units that offer essentially the same products and utilize common merchandising, distribution, and marketing functions, as well as common information systems and corporate administration. The Company does not have intersegment sales, but the segments are managed separately because each segment has different channels for selling the product.

Financial information for the Company’s business segments is as follows:

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PART I - FINANCIAL INFORMATION

ITEM 2. Management’s Discussion and Analysis of

Results of Operations and Financial Condition

The following information should be read in conjunction with the historical financial information and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and Management’s Discussion and Analysis of Results of Operations and Financial Condition contained in our report on Form 10-K as filed with the Securities and Exchange Commission. The statements contained in this Form 10-Q that are not purely historical are forward-looking statements within the meaning of the federal securities laws. Such forward-looking statements may include but are not limited to statements regarding our future products and enhancements, business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Form 10-Q. Additionally, statements concerning future matters such as the development of new products or enhancements, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements. All forward-looking statements in this Form 10-Q are based upon information available to us as of the date hereof, and we assume no obligation to revise or update any such forward-looking statements in order to reflect any event or circumstance that may arise after the date of this Form 10-Q. Actual results could differ materially from our current expectations. Factors that could cause or contribute to such differences include, but are not limited to those set forth under “Factors Affecting Future Operating Results” below in this Quarterly Report, and elsewhere in this Quarterly Report.

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Overview

The Sharper Image is a multi-channel specialty retailer of innovative, high quality products that are useful and entertaining and are designed to make life easier and more enjoyable. Our unique assortment of products offers design, creativity and technological innovation, in addition to fun and entertainment. We market and sell our merchandise primarily through four integrated sales channels: The Sharper Image stores, The Sharper Image catalog, which includes revenue from all direct marketing activities and television infomercials, the Internet and wholesale. We also market to other businesses through our corporate sales, where revenues are recorded in each of our sales channels.

Our total revenues increased 19.9% to $153.6 million in the quarter ended October 31, 2004 from $128.1 million in the quarter ended October 31, 2003. For the nine-month period ended October 31, 2004, our total revenues increased 24.3% to $459.0 million from $369.1 million in the same period last year. The increases were due primarily to the popularity of our Sharper Image Design and Sharper Image branded products, including our air purification line of products, the opening of 31 new stores since October 31, 2003, a comparable store sales increase of 2.6%, and an increase in our multimedia advertising which we believe increased sales in all selling channels.

Our store operations generated the highest proportion of our sales, representing 52.2% and 54.4% of total revenues for the three-month period ended October 31, 2004 and October 31, 2003, respectively, and 53.9% and 56.3% for the nine-month period ended October 31, 2004 and October 31, 2003, respectively. As of October 31, 2004, we operated 170 The Sharper Image stores in 37 states and the District of Columbia. As part of our growth strategy for fiscal 2004, we anticipate 15-20% growth in the number of new stores with a goal of 26 new stores. As of October 31, 2004, we have opened 21 new stores toward achieving this goal and believe we are on track to reach our targeted goal. Our catalog and direct marketing operations, including revenue generated directly from catalogs, print advertising, single product mailers and television infomercials, generated 15.6% and 18.6% of our total revenues for the quarter ended October 31, 2004 and 2003, respectively, and 18.6% and 21.7% for the nine-month period ended October 31, 2004 and 2003, respectively. Our Internet operations generated 13.7% and 13.2% of total revenues in the third quarter of fiscal 2004 and 2003, respectively, and 14.7% and 13.9% for the nine-month period ended October 31, 2004 and 2003, respectively. Our wholesale operations generated 16.1% and 11.3% of total revenues in the quarter ended October 31, 2004 and 2003, respectively, and 10.4% and 5.6% for the nine-month period ended October 31, 2004 and 2003, respectively.

One of our goals is to continue to increase the percentage of total revenues attributable to Sharper Image Design and Sharper Image branded products, which typically generate higher margins than our third party branded products. Sharper Image Design and Sharper Image branded products were approximately 77% of net sales in the third quarter of fiscal 2004 and 73% in the third quarter of fiscal 2003. The percentage of our total revenues attributable to Sharper Image Design and Sharper Image branded products were approximately 77% for the nine-month period ended October 31, 2004 and approximately 75% for the nine-month period ended October 31, 2003. We believe the increase in percentage of revenues attributable to Sharper Image Design and Sharper Image branded products was due to the modification of certain third party branded products making them exclusive Sharper Image branded product offerings and the introduction of the Professional Series^™ line of Ionic Breeze^® Silent Air Purifiers.

Our business is highly seasonal, with sales peaks in the end-of-year holiday shopping seasons as well as for Mother’s Day, Father’s Day and graduation gift-giving. A substantial portion of our total revenues, and all or most of our net earnings, occur in our fourth fiscal quarter ending January 31. In addition, similar to many retailers, we make merchandising and inventory decisions for the holiday season well in advance of the holiday selling season. Accordingly, unfavorable economic conditions or deviations from projected demand for products during the fourth quarter could have a material adverse effect on our financial position or results of operations for the entire fiscal year. The fourth quarter accounted for more than 40% of total revenues in both fiscal 2003 and 2002. In addition, the fourth quarter accounted for all of our net earnings in fiscal 2002 and substantially all of our net earnings in 2003.

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Results of Operations

The following table sets forth the results of operations expressed as a percentage of total revenues for the periods indicated:

The following table sets forth the components of total revenues for the periods indicated:

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Revenues

Net sales for the third quarter increased $25.1 million, or 20.1%, from the comparable three-month period of the prior year. Increases in net sales for the three-month period ended October 31, 2004 were attributable to increases of $10.5 million from store sales, $10.3 million in wholesale sales, $4.1 million from Internet sales, and $0.2 million in catalog and direct marketing sales. Net sales for the nine-month period ended October 31, 2004 increased $88.1 million, or 24.5%, from the comparable period last year. Of the $88.1 million increase, $39.8 million related to increased store sales, $26.9 million from wholesale sales, $16.2 million from Internet sales and $5.2 million from catalog and direct marketing sales. Returns and allowances for the three-month and nine-month periods ended October 31, 2004, were 10.5% and 10.2% of sales, as compared with 10.5% and 11.1% of sales for the comparable prior year periods.

The increase in total revenues for the third quarter of fiscal 2004, as compared to the third quarter of fiscal 2003 was due primarily to the popularity of our Sharper Image Design and Sharper Image branded products, which continues to be a key factor in the increases in net sales in all selling channels. Sharper Image Design and Sharper Image branded products increased to approximately 77% of net sales in the third quarter of fiscal 2004, from approximately 73% for the same period of 2003, and increased to approximately 77% of net sales in the comparable first nine months of fiscal 2004, from approximately 75% for the nine-month period ended October 31, 2003. We believe that the continued development and introduction of new and popular products is a key strategic objective and important to our future success. During the third quarter ended October 31, 2004, we introduced the Professional Series^™ line of Ionic Breeze® Silent Air Purifiers, which we believe contributed to the increase in percentage of revenues attributable to Sharper Image Design and Sharper Image branded products. Also contributing to the increase in total revenues was a comparable store sales increase of 2.6% for the nine-month period ended October 31, 2004, the modification of certain third party branded products making them exclusive Sharper Image branded product offerings and the opening of 31 new stores since the third quarter of fiscal 2003. We believe the increased investment in our advertising initiatives in fiscal 2003 which continued through the third quarter of fiscal 2004, including the increase in the number of catalogs mailed, television infomercial, print advertising and Internet search engine placement advertising contributed to the higher revenues in all selling channels.

For the three-month and nine-month periods ended October 31, 2004, as compared with the same periods last year, net store sales increased $10.5 million, or 15.1%, and $39.8 million, or 19.2%, while comparable store sales decreased by 0.8% and increased by 2.6%, respectively. The increase in net store sales for the three-month and nine-month periods ended October 31, 2004 were primarily attributable to the popularity of Sharper Image Design and Sharper Image branded products, the opening of 31 new stores since October 31, 2003 and increased television infomercial advertising. The opening of 31 new stores resulted in an incremental increase to net store sales of $9.6 million for the third quarter of 2004 as compared with the third quarter of 2003, and $20.7 million for the nine-month period ended October 31, 2004, as compared with the same prior year period. The increase in net store sales for the three-month period ended October 31, 2004 as compared with the same prior year period reflects a 8.6% increase in average revenue per transaction and a 10.7% increase in total store transactions. Total store transactions increased 12.3% for the nine-month period ended October 31, 2004 and average revenue per transaction increased by 8.0%, compared with the same prior year period.

Comparable store sales are not a measure that has been defined under generally accepted accounting principles. We define comparable store sales as sales from stores where selling square feet did not change by more than 15% in the previous 12 months and which have been open for at least 12 months. Stores generally become comparable once they have 24 months of comparable sales for our annual calculation. We believe that comparable store sales, which excludes the effect of a change in the number of stores open, provides a more useful measure of the performance of our store sales channel than does the absolute change in aggregate net store sales.

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For the three-month and nine-month periods ended October 31, 2004, as compared with the same periods of the prior year, net catalog and direct marketing sales, which includes sales generated from catalog mailings, single product mailers, print advertising and television infomercials, increased $0.2 million, or 1.0%, and $5.2 million, or 6.5%, respectively. The increase of net catalog and direct marketing sales for the three-month period ended October 31, 2004 was due to a 59.7% increase in television infomercial advertising spending, a 132.0% increase in print advertising and a 20.8% increase in The Sharper Image catalog pages circulated, which includes a 9.0% increase in The Sharper Image catalogs circulated, partially offset by a 17.1% decrease in single product mailers circulated. The increase was mostly offset by a lower direct response rate on our television infomercial and catalog mailings as compared to the same prior year period. For the three-month period ended October 31, 2004, the increase in catalog and direct marketing sales also reflects a 17.4% increase in average revenue per transaction, partially offset by a 7.4% decrease in the number of transactions compared with the same prior year period.

The increase from net catalog and direct marketing activities for the nine-month period ended October 31, 2004, as compared to the same period last year, was due primarily to a 38.4% increase in television infomercial advertising, a 122.3% increase in print advertising and a 11.5% increase in the number of The Sharper Image catalogs circulated, which includes a 25.7% increase in catalog pages circulated, partially offset by a 7.3% decrease in single product mailers circulated. The increase was partially offset by a lower direct response rate on our television infomercial and catalog mailings as compared to the prior year period. For the nine-month period ended October 31, 2004, the increase in net catalog and direct marketing sales reflects increases of 0.3% in the number of transactions and 8.3% in average revenue per transaction compared with the same prior year period.

For the three-month and nine-month periods ended October 31, 2004, Internet sales from our sharperimage.com Website, which includes the Sharper Image and eBay auction sites, increased $4.1 million, or 23.9% and $16.2 million, or 31.5%, respectively, from the same periods last year. The Internet sales increase for the three months ended October 31, 2004 was attributable to an 18.2% increase in transactions and a 3.2% increase in average revenue per transaction as compared to the same period last year. The Internet sales increase for the nine months ended October 31, 2004 was attributable to a 27.8% increase in transactions and a 1.0% increase in average revenue per transaction as compared to the same period of the prior year. These increases in sales and transactions were in large part driven by a 62.9% and 79.9% increase for the three-month and nine-month periods ended October 31, 2004 in Internet advertising, primarily through search engine placement and affiliate revenue share programs, as well as increases in catalog circulations for the three-month and nine-month periods ended October 31, 2004.

For the three-month and nine-month periods ended October 31, 2004, wholesale sales increased $10.3 million, or 71.3%, and $26.9 million, or 130.0%, respectively, from the same periods of the prior year. The increase is primarily attributable to increasing Sharper Image Design product sales to our existing wholesale customer base and to test programs with new wholesale customers. We believe that the wholesale business strengthens our brand name and broadens our customer base. We also believe that although the additional wholesale business should add to overall company sales and profitability, this additional wholesale business may put pressure on sales made through our own Sharper Image selling channels.

Cost of Products

Cost of products for the three-month period ended October 31, 2004 increased $14.0 million, or 24.8% compared to the three-month period ended October 31, 2003. The gross margin rate for the three-month period ended October 31, 2004 was 54.1%, as compared to 55.9% for the same prior year period. The decrease in gross margin rate was primarily due to increased air freight costs due to the West Coast port slowdown, increases in promotional and incentive activities and selective product markdowns partially offset by the increase in gross margin generated from sales through the wholesale channel.

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Cost of products for the nine-month period ended October 31, 2004 increased $40.7 million, or 25.8%, from the comparable prior year period. The gross margin rate for the nine-month period ended October 31, 2004 was 56.8%, as compared to 57.3% for the same prior year period. The decrease in gross margin rate was primarily due to increased air freight costs due to the West Coast port slowdown, increases in promotional and incentive activities and selective product markdowns, partially offset by the increased gross margin generated from sales through our wholesale channels.

Our gross margin rate fluctuates with the changes in our merchandise mix, primarily Sharper Image Design and Sharper Image branded products, which changes as we make new items available in various categories or introduce new proprietary products. In addition, our gross margin rate can also fluctuate as sales shifts occur between our various selling channels. Because of our wholesale merchandise mix, to date our wholesale sales have improved our gross margin rates, but we cannot provide assurances that this trend will continue into the future. The variation in merchandise mix from category to category from year to year is characteristic of our sales results being driven by individual products rather than by general lines of merchandise. Additionally, the auction sites and other selected promotional activities, such as free shipping offers, will, in part, tend to offset the rate of increase in our gross margin rate. Our gross margins may not be comparable to those of other retailers, since some retailers include the costs related to their distribution network in cost of products while we, and other retailers, exclude them from gross margin and include them instead in general, selling and administrative expenses. We cannot accurately predict future gross margin rates, although our goal is to continue to increase sales of Sharper Image Design and Sharper Image branded products to capitalize on the higher margins realized on these products.

Buying and Occupancy

Buying and occupancy costs for the three-month and nine-month periods ended October 31, 2004 increased $2.6 million, or 18.4%, and $9.5 million, or 23.3%, from the comparable prior year periods. The increases reflect the occupancy costs associated with the 31 new stores opened since October 31, 2003 and rent increases associated with lease renewals since October 31, 2003, partially offset by lower percentage rents. Buying and occupancy costs as a percentage of total revenues decreased to 11.1% from 11.2% for the three-month period ended October 31, 2004, and decreased to 10.9% from 11.0% for the nine-month period ended October 31, 2004. Our goal is to continue to grow the number of new stores by 15%-20% on an annual basis by selectively opening new stores in locations with strong economics that support our product mix and business model, but we cannot assure you we will achieve this goal.

Advertising

Advertising for the three-month period ended October 31, 2004 increased $8.8 million, or 36.2% compared to the same prior year period. The increase was attributable primarily to a 59.7% increase in television infomercial advertising expense, a 132.0% increase in print media advertising, a 13.6% increase in catalog advertising, resulting from an 9.0% increase in the number of catalogs circulated, which includes a 20.8% increase in page count, and a 62.9% increase in Internet advertising which includes search engine key word placement and revenue share costs incurred for affiliate programs. These increases were partially offset by a 71.8% decrease in radio advertising expense and a 7.5% decrease in solo mailer advertising expense due to a decrease of 17.1% in solo mailers circulated.

Advertising for the nine-month period ended October 31, 2004 increased $23.2 million, or 30.6%, compared to the same prior year period. The increase was primarily attributable to a 38.4% increase in television infomercial advertising expense, a 122.3% increase in print media advertising, an 18.8% increase in catalog advertising due to an 11.5% increase in circulation, which includes a 25.7% increase in page count, and a 79.9% increase in Internet advertising. This was partially offset by a 7.4% decrease in solo mailer expense, due to a decrease of 7.3% in solo mailers circulated and a 6.8% decrease in radio advertising expense.

Although we believe they contributed to the increase in sales in the stores, catalog and direct marketing, Internet and wholesale channels, there can be no assurance of the continued success of these advertising initiatives.

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Advertising expenses as a percentage of total revenues increased to 21.5% for the three-month period ended October 31, 2004 compared to 18.9% for the comparable prior year period, and increased to 21.5% for the nine-month period ended October 31, 2004 compared to 20.5% in the prior year. We believe that the lower response rate and lower return on investment from infomercial advertising and to catalogs were partly attributable to the Summer Olympics, the political conventions and election activities. Although there is usually a declining marginal benefit obtained by increasing advertising expenditures, we monitor the effectiveness of our advertising in order to achieve a reasonable return on our investment in advertising.

We believe that the expansion of our multimedia advertising initiatives contributed to the sales increases for the first nine months of 2004 and increased brand awareness. Our advertising strategy will continue to be an important factor in our future revenue growth and as a result, we expect advertising costs to continue to be higher in fiscal 2004 compared to fiscal 2003.

General, Selling and Administrative Expenses

General, selling and administrative (“GS&A”) expenses for the three-month and nine-month periods ended October 31, 2004 increased $7.0 million, or 22.2%, and $21.4 million, or 23.4%, from the comparable prior year periods. Contributing to the three-month increase was a net increase of $1.8 million due primarily to variable expenses from increased net sales. Also contributing to the increase were increases of $1.8 million related to professional fees, $1.3 million for distribution center shipping costs incurred for product delivery to our stores primarily due to the increase of 31 new stores since October 31, 2003 and to increased air freight costs due to the West Coast port slowdown experienced this quarter. Contributing to the nine-month increase was a net increase of $7.9 million due primarily to variable expenses from increased net sales. Also contributing to the increase were increases of $4.3 million related to professional fees, $3.6 million for distribution center shipping costs incurred for product delivery to our stores, and $0.9 million for health care and insurance. GS&A expenses for the three-month period ended October 31, 2004 increased as a percentage of total revenues to 25.2% from 24.8% for the comparable prior year period. For the nine-month period ended October 31, 2004, GS&A expenses decreased as a percentage of total revenues to 24.6% from 24.8% in the prior year.

Other Income and Expense

The decrease in net other income for the three-month period ended October 31, 2004 as compared to the same prior year period is primarily due to an increase in other expenses due to disposals, partially offset by an increase in interest income. The decrease in net other income for the nine-month period ended October 31, 2004 as compared to the same prior year period is due to primarily to a decrease in interest income and an increase in other expenses due to disposals.

Liquidity and Capital Resources

We met our short-term liquidity needs and our capital requirements in the nine-month period ended October 31, 2004 with cash generated by operations, trade credit and existing cash balances.

Net cash used for operating activities totaled $23.0 million for the first nine months of fiscal 2004, a decrease of $23.5 million from the same period of fiscal 2003. The decrease in net cash used for operating activities of $23.0 million is primarily due to an increase in merchandise inventories, an increase in accounts receivable resulting from increased net sales in all selling channels, partially offset by increases in accounts payable resulting from the timing of invoices received as compared to the same period of fiscal 2003.

Net cash used for investing activities, primarily capital expenditures for new stores and remodels of existing stores, distribution centers, tooling costs for proprietary products and technological upgrades to our operational infrastructure, totaled $39.5 million in the first nine months of fiscal 2004 compared to $28.0 million in the same period of fiscal 2003. During the first nine months of fiscal 2004, we opened 21 new stores as compared to 15 new stores opened in the first nine months of fiscal 2003. We also purchased $4 million of short-term investments during the nine months ended October 31, 2003.

Net cash provided by financing activities totaled $3.8 million during the nine months ended October 31, 2004, which was the result of the proceeds from the issuance of common stock in connection with our stock option plan. The cash provided by financing activities for the first nine months of fiscal 2004 is compared to $40.8 million in the same period of fiscal year 2003, which resulted primarily from $38.5 million in proceeds from the issuance of common stock from our public offering.

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The Company has a revolving secured credit facility (“Credit Facility”) with Wells Fargo Bank, National Association. The Credit Facility has a maturity date of October 31, 2006, and allows borrowings and letters of credit up to a maximum of $50 million at all times during the year, with a “borrowing base” determined by inventory levels and specified accounts receivable. The Credit Facility is secured by the Company’s inventory, accounts receivable, and specified other assets. Borrowings under the Credit Facility bear interest at either the adjusted LIBOR rate plus 1.50% or at Wells Fargo’s prime rate less 0.25%. The Credit Facility contains financial covenants that only apply during an event of default or when the borrowing base is drawn below a specified level. These financial covenants require the Company to maintain a minimum EBITDA (as defined) on a rolling 12-month basis of $35 million and to maintain capital expenditures below a specified level based on our projections. The Credit Facility contains limitations on incurring additional indebtedness, making additional investments and permitting a change of control. As of October 31, 2004, letter of credit commitments outstanding under the Credit Facility were $5.7 million.

For the remainder of fiscal 2004, we plan to continue our accelerated new store unit growth goal with a 15% to 20% increase in the number of stores on an annual basis and to remodel 5 to 10 of our existing store locations. We plan to continue our capital investment in tooling costs for proprietary products and selectively continue our enhancement of our technology systems. We believe that our total capital expenditures for fiscal 2004 will be approximately $42 million to $45 million.

We believe we will be able to fund our capital expenditures for new and remodeled stores, technological enhancements and tooling costs for Sharper Image Design products through existing cash balances, cash generated from operations, trade credits, and, as necessary, our credit facility.

Seasonality

Our business is highly seasonal, reflecting the general pattern associated with the retail industry of peak sales and earnings during the holiday shopping season. In past years, a substantial portion of our total revenues and all or most of our net earnings occur in the fourth quarter ending January 31. The results of operations for these interim periods are not necessarily indicative of the results for the full fiscal year.

Factors Affecting Future Operating Results

The following factors, in addition to the other information contained in this report, should be considered carefully in evaluating us and our prospects. This report (including without limitation the following Factors Affecting Future Operating Results) contains forward-looking statements (within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934) regarding us and our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this report. Additionally, statements concerning future matters such as the development of new products, store expansions, possible changes in economic conditions and other statements regarding matters that are not historical are forward-looking statements.

Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors we currently know about. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, but are not limited to, those discussed below and in “Management’s Discussion and Analysis of Results of Operations and Financial Condition” as well as those discussed elsewhere in this report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of the report.

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If we fail to continuously offer new merchandise that our customers find attractive, the demand for our products may be limited.

In order to meet our strategic goals, we must successfully offer our customers new, innovative and high quality products on a continuous basis. Our product offerings must be affordable, useful to the customer, well-made, distinctive in design and not widely available from other retailers. We cannot predict with certainty that we will successfully offer products that meet these requirements in the future. Some products or a group of related products usually produce sales volumes that are significant to our total sales volume in a particular period.

If other retailers, especially department stores or discount retailers, offer the same products or products similar to those we sell, or if our products become less popular with our customers, our sales may decline or we may decide to offer our products at lower prices. If customers buy fewer of our products or if we have to reduce our prices, our revenues and earnings will decline.

Our products must appeal to a broad range of consumers whose preferences we cannot predict with certainty and may change between sales seasons. If we misjudge either the market for our products or our customers’ purchasing habits, our sales may decline, our inventories may increase or we may be required to sell our products at lower prices. This would have a negative effect on our business.

If we do not maintain sufficient inventory levels, or if we are unable to deliver our products to our customers in sufficient quantities, our operating results will be adversely affected.

We must be able to deliver our merchandise in sufficient quantities to meet the demands of our customers and deliver this merchandise to customers in a timely manner. We must be able to maintain sufficient inventory levels, particularly during the peak holiday selling season. If we fail to achieve these goals, we may be unable to meet customer demand, and our future results will be adversely affected if we are not successful in achieving these goals. Our success depends on our ability to anticipate and respond to changing product trends and consumer demands in a timely manner.

A significant portion of our sales during any given period of time may be generated by a particular product or line of products and if sales of those products or line of products decrease, our stock price may be adversely affected.

During fiscal 2002, fiscal 2003 and through the third quarter of fiscal 2004, the sales of our air purification line of products constituted a significant portion of our total revenues and net income. Although not as significant, the sales from our home and portable stereo system and massage product lines constituted a substantial portion of our total revenues and net income.

Our future growth will be substantially dependent on the continued increase in sales growth of existing core and new products, while at the same time maintaining or increasing our current gross margin rates. We cannot predict whether we will be able to increase the growth of existing core and new products or successfully introduce new products, increase our revenue level or maintain or increase our gross margin rate in future periods. Failure to do so may adversely affect our stock price.

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Poor economic conditions may reduce consumer spending on discretionary retail products such as the ones we offer.

Consumer spending patterns, particularly discretionary spending for products such as ours, are affected by, among other things, prevailing economic conditions, stock market volatility, increasing gas prices, threats of war, acts of terrorism, wage rates, interest rates, inflation, taxation, consumer confidence and consumer perception of economic conditions. General economic, political and market conditions, such as recessions, may adversely affect our business results and the market price of our common stock. We may not be able to accurately anticipate the magnitude of these effects on future quarterly results.

Our success depends in part on our ability to internally design and develop our Sharper Image Design products.

We have invested significant resources in and are increasingly dependent on the success of the Sharper Image Design products that we design and develop. These products have typically generated higher gross margins than other products and our merchandising strategy emphasizes these products. Some of these products or a group of related products, which are affected by customers’ demands and the level of our marketing and advertising efforts, can produce sales volumes that are significant to our total sales volume in a particular period. In order to be successful, we must continue to design and develop products that meet the demands of our customers, as well as create customer demand for these products. Our goal is to increase the percentage of total revenues attributable to Sharper Image Design and Sharper Image branded products, although we expect this percentage may decline from time to time, as it did from 2002 to 2003, and cannot assure you we will otherwise achieve our goal. If we are unable to successfully design and develop these products, our operating results may be adversely affected.

We rely on foreign sources of production and our business would be adversely affected if our suppliers are not able to meet our demand and alternative sources are not available.

We must ensure that the products we design and develop are manufactured cost-effectively. We rely solely on a select group of contract manufacturers, most of whom are located in Asia (primarily China), to produce these products in sufficient quantities to meet customer demand and to obtain and deliver these products to our customers in a timely manner. These arrangements are subject to the risks of relying on products manufactured outside the United States, including political unrest and trade restrictions, local business practice and political issues, including issues relating to compliance with domestic or international labor standards, currency fluctuations, work stoppages, economic uncertainties, including inflation and government regulations, availability of raw materials and other uncertainties. If we are unable to successfully obtain and timely deliver sufficient quantities of these products, our operating results may be adversely affected. There is increasing political pressure on China to permit the exchange rate of its currency, the Chinese Yuan (“CNY”), to float against the U.S. Dollar (“USD”). Although substantially all of our supply contracts in China are denominated in USD, our suppliers could attempt to renegotiate these contracts if the CNY/USD exchange rate were to change.

We had a single supplier for a number of our products, located in Asia that provided approximately 21% of the net merchandise purchases in fiscal 2003 and is expected to provide a comparable percentage in the future. If we were unable to obtain products from this supplier on a timely basis or on commercially reasonable terms, our operating results may be adversely affected.

Some of our smaller vendors have limited resources, limited production capacities and limited operating histories. We have no long-term purchase contracts or other contracts that provide continued supply, pricing or access to new products and any vendor or distributor could discontinue selling to us at any time. We compete with many other companies for production facilities and import quota capacity. We cannot assure you that we will be able to acquire the products we desire in sufficient quantities or on terms

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that are acceptable to us in the future. In addition, we cannot assure you that our vendors will make and deliver high quality products in a cost-effective, timely manner. We may also be unable to develop relationships with new vendors.

We depend on our vendors’ ability to timely deliver sufficient quantities of products and our business can be harmed by work stoppages or other interruptions to delivery of products.

All products we purchase from our vendors in Asia must be shipped to our distribution centers by freight carriers and we cannot assure you that we will be able to obtain sufficient freight capacity on a timely basis and at favorable rates. Our inability to acquire suitable products in a cost-effective, timely manner or the loss of one or more key vendors or freight carriers could have a negative effect on our business.

Many of our shipments that come from Asia move through the West Coast ports that have been negatively impacted by the West Coast port slowdown. During the third quarter of 2004, this slowdown caused our air freight costs to increase as we used alternative delivery methods to mitigate some of the impacts of the slowdown. The increased usage of air freight transportation had and will continue to have a negative impact on our gross margins.

Our ability to protect our proprietary technology, which is vital to our business, particularly our air purification products, is uncertain and our inability to protect these rights could impair our competitive advantage and cause us to incur substantial expense to enforce our rights.

We believe our registered house marks “The Sharper Image”, “sharperimage.com”, “Sharper Image Design” and “Sharper Image” as well as the trademark fame that we have established are of significant value. We actively pursue and protect, domestically and internationally, not only all of our corporate trademarks, but other intellectual property rights including patents, copyrights and trade secrets to ensure that the quality of our brand and the value of our proprietary rights are maintained. We protect our proprietary marketing strategies, illustrative catalogs and product packaging through numerous copyright registrations. We also seek patents to establish and protect our proprietary rights relating to the technologies and products we have developed, are in the process of developing, or that we may develop in the future. We have taken and will continue, in the future, to take all steps necessary to broaden and enhance our patent protection by obtaining both utility and design patent protection directed to our proprietary products. For instance, we currently own 49 U.S. utility patents, 105 U.S. design patents and 55 international patents.

We cannot assure you that a third party will not infringe upon or design around any patent issued or licensed to us, including the patents and license agreement related to our air purification line of products, or that these patents will otherwise be commercially viable. Litigation to establish the validity of patents, to defend against patent infringement claims of others and to assert patent infringement claims against others can be expensive and time-consuming even if the outcome is favorable to us. If the outcome is unfavorable to us, we may be required to pay damages, stop production and sales of infringing products or be subject to increased competition from similar products. We have taken and may, in the future, take steps to enhance our patent protection, but we cannot assure you that these steps will be successful or that, if unsuccessful, our patent protection will be adequate.

We also rely upon trade secrets, know-how, continuing technological innovations and licensing opportunities to develop and maintain our competitive position. We attempt to protect our proprietary technology in large part by confidentiality agreements with our employees, consultants and other contractors. We cannot assure you, however, that these agreements will not be breached, that we will have adequate remedies for any breach or that competitors will not know of or independently discover our trade secrets.

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Our quarterly operating results and comparable store sales are subject to significant fluctuations and seasonality.

Our business is seasonal, reflecting the general pattern of peak sales and earnings for the retail industry during the holiday shopping season. Typically, a substantial portion of our total revenues and all or most of our net earnings occur during our fourth quarter ending on January 31. The fourth quarter accounted for more than 40% of total revenues in both fiscal 2003 and 2002. In addition, the fourth quarter accounted for all of our net earnings in fiscal 2002 and substantially all of our net earnings in fiscal 2003. In anticipation of increased sales activity during the fourth quarter, we incur significant additional expenses, including significantly higher inventory costs and the costs of hiring a substantial number of temporary employees to supplement our regular store staff. If for any reason our sales were to be substantially below those normally expected during the fourth quarter, our annual operating results would be adversely affected. Due to this seasonality, our operating results for any one period may not be indicative of our operating results for the full fiscal year.

We generally experience lower revenues and net operating results during our first three quarters of the fiscal year and have historically experienced losses in these quarters. Our quarterly results of operations may fluctuate significantly as a result of a variety of factors, including, among other things, the timing of new store openings, net sales contributed by new stores, increases or decreases in comparable store sales, changes in our merchandise mix and net catalog sales.

In addition, like other retailers, we typically make merchandising and purchasing decisions well in advance of the holiday shopping season. As a result, poor economic conditions or differences from projected customer demand for our products during the fourth quarter could result in lower revenues and earnings.

Our comparable store sales also fluctuate significantly and can contribute to fluctuations in our quarterly operating results. Our comparable store sales are affected by a variety of factors, including customer demand in different geographic regions, our ability to efficiently source and distribute products, changes in our product mix, competition, advertising and our wholesale operations. Although we believe it is sound business strategy to take advantage of broadening our customer base and to leverage our brand and advertising through the increase in our wholesale business, the impact of selling our Sharper Image Design and Sharper Image branded products through an increased number of other selected retailers may put pressure on our own comparable store sales increase percentage.

Our comparable store sales have fluctuated significantly in the past and we believe that such fluctuations may continue. Our historic comparable net store sales changes from the prior fiscal year were as follows:

Comparable store sales are defined as sales from stores where selling square feet did not change by more than 15% in the previous 12 months and which have been open for at least 12 full months. Stores generally become comparable once they have a full year of comparable sales. We cannot assure you that our comparable store sales results will increase in the future. Any reduction in or failure to increase our comparable store sales results could impact our future operating performance and cause the price of our common stock to decrease.

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We are dependent on the success of our advertising and direct marketing efforts and our profitability will be adversely affected by increased costs associated with these efforts.

Our revenues depend in part on our ability to effectively market and advertise our products through The Sharper Image catalog and direct marketing operations. Increases in advertising, paper or postage costs may limit our ability to advertise without reducing our profitability. If we decrease our advertising efforts due to increased advertising costs, restrictions placed by regulatory agencies or for any other reason, our future operating results may be materially adversely affected. We are also utilizing and constantly testing other advertising media, such as television infomercials, radio, single product mailings and other print media. Our advertising expenditures increased by approximately $26.0 million or 26.7% in fiscal 2003 from the prior fiscal year. While we believe that increased expenditures on these and other media have resulted in increased revenues during fiscal 2003, we cannot assure you that this trend will continue in the future. If our advertising is ineffective and our increased advertising expenditures do not result in increased sales volumes, our sales and profits will be adversely affected. We depend on the continued availability of television infomercial time at reasonable prices. We expect to continue to spend on advertising and marketing at increased levels in the future, but may not continue to produce a sufficient level of sales to cover such expenditures, which would reduce our profitability.

The continued growth of our wholesale sales channel presents certain risks that could adversely affect us.

We sell products through a multi-channel strategy. While we believe that the wholesale sales channel offers growth opportunities and exposure to a greater customer base, this growth could adversely impact our business. In general, depending on product mix, our sales to wholesale partners carry lower gross margins than sales made through our other channels. In addition, the sales made through this channel could shift sales from our higher margin sales channels, particularly our retail and catalog channels.

Our business will be harmed if we are unable to successfully implement our growth strategy.

Our growth strategy primarily includes the following components:

Any failure on our part to successfully implement any or all of our growth strategies would likely have a material adverse effect on our financial condition, results of operations and cash flows. We believe our past growth has been attributable in large part to our success in meeting the merchandise, timing and service demands of an expanding customer base with changing demographic characteristics, but there is no assurance that we will be able to continue to have such success.

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The expansion of our store operations could result in increased expenses with no guarantee of increased profitability.

We plan to increase our number of stores by 15%-20% annually. We may not be able to attain our target new store openings, and any of our new stores that we open may not be profitable, either of which could have an adverse impact on our financial results. Our ability to expand by opening new stores will depend in part on the following factors:

Even though we continue to expand our store base, we have remained concentrated in limited geographic areas. This could increase our exposure to customer demand, weather, competition, distribution problems and poor economic conditions in these regions. In addition, our catalog sales, Internet sales, or existing store sales in a specific region may decrease as a result of new store openings.

In order to continue our expansion of stores, we will need to hire additional management and staff for our corporate offices and employees for each new store. We must also expand our management information systems and distribution systems to serve these new stores. If we are unable to hire necessary personnel or grow our existing systems, our expansion efforts may not succeed and our operations may suffer.

Some of our expenses will increase with the opening of new stores. If store sales are inadequate to support these new costs, our profitability will decrease. For example, inventory costs will increase as we increase inventory levels to supply additional stores. We may not be able to manage this increased inventory without decreasing our profitability. We may need financing in excess of that available under our current credit facility. Furthermore, our current credit facility has various loan covenants we must comply with in order to maintain the credit facility. We cannot predict whether we will be successful in obtaining additional funds or new credit facilities on favorable terms or at all.

We rely on our catalog operations which could have significant cost increases and could have unpredictable results.

Our success depends in part on the success of our catalog operations. We believe that the success of our catalog operations depends on the following factors:

Catalog production and mailings entail substantial paper, postage, merchandise acquisition and human resource costs, including costs associated with catalog development and increased inventories. We

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incur nearly all of these costs prior to the mailing of each catalog. As a result, we are not able to adjust the costs being incurred in connection with a particular mailing to reflect the actual performance of the catalog. Increases in costs of mailing, paper or printing would increase costs and would adversely impact our earnings if we were unable to pass such increases directly on to our customers or offset such increases by raising prices or by implementing more efficient printing, mailing, delivery and order fulfillment systems. If we were to experience a significant shortfall in anticipated revenue from a particular mailing, and thereby not recover the costs associated with that mailing, our future results would be adversely affected. In addition, response rates to our mailings and, as a result, revenues generated by each mailing are affected by factors such as consumer preferences, economic conditions, the timing and mix of catalog mailings, the timely delivery by the postal system of our catalog mailings and changes in our merchandise mix, several or all of which may be outside our control. Further, we have historically experienced fluctuations in the response rates to our catalog mailings. If we are unable to accurately target the appropriate segment of the consumer catalog market or to achieve adequate response rates, we could experience lower sales, significant markdowns or write-offs of inventory and lower margins, which would adversely affect our future results.

We have distribution and fulfillment operations located in Little Rock, Arkansas, Ontario, California and Richmond, Virginia. Any disruption of the operations in these centers could hurt our ability to make timely or cost effective delivery of our products.

We conduct the majority of our distribution operations and all of our catalog and Internet order processing fulfillment functions from our own facility in Little Rock, Arkansas, and leased facilities in Little Rock, Arkansas; Ontario, California and Richmond, Virginia. We also use contract fulfillment and warehouse facilities for additional seasonal requirements. Any disruption in the operations at any distribution center, particularly during the holiday shopping season, could result in late delivery of products and make it difficult to meet customer demand for our products.

In addition, we rely upon third party carriers for our product shipments, including shipments to and from all of our stores. As a result, we are subject to certain risks, including employee strikes and inclement weather, associated with such carriers’ ability to provide delivery services to meet our shipping needs.

We are also dependent on temporary employees to adequately staff our distribution facilities, particularly during busy periods such as the holiday shopping season. We cannot assure you that we will continue to receive adequate assistance from our temporary employees, or that we will continue to have access to sufficient sources of temporary employees.

We experience intense competition in the rapidly changing retail markets and if we are unable to compete effectively, we may not be able to maintain profitability.

We operate in a highly competitive environment. We principally compete with a variety of department stores, sporting goods stores, discount stores, specialty retailers and other catalogs that offer products similar to or the same as our products. We may increasingly compete with major Internet retailers. Many of our competitors are larger companies with greater financial resources, a wider selection of merchandise and greater inventory availability and offer the convenience of one-stop shopping. Specialty retailers, such as electronics stores, may offer only a certain category of products but often offer a wider range of selection within a particular category of product. Discount stores may offer analogous products at lower price points. We offer a more limited range of products compared to our competitors, and if we are unable to anticipate the preferences of our customers and effectively market and distinguish The Sharper Image brand or if we experience increased competition, our business and operating results could be adversely affected.

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The U.S. retail industry, the specialty retail industry in particular, and e-commerce sector are dynamic in nature and have undergone significant changes over the past several years. Our ability to anticipate and successfully respond to continuing challenges is critical to our long-term growth and we cannot assure you that we will anticipate and successfully respond to changes in the retail industry and e-commerce sectors.

We maintain a liberal merchandise return policy, which allows customers to return most merchandise, and as a result, excessive merchandise returns could harm our business.

We make allowances for returns of store, catalog and Internet sales in our financial statements based on historical return rates. We cannot assure you that actual merchandise returns will not exceed our allowances. In addition, because our allowances are based on historical return rates, we cannot assure you that the introduction of new merchandise in our stores or catalogs, the opening of new stores, the introduction of new catalogs, increased sales over the Internet, changes in our merchandise mix or other factors will not cause actual returns to exceed return allowances. Any significant increase in merchandise returns that exceed our allowances could have a material adverse effect on our future results.

We may be subject to risks associated with our products, including product liability or patent and trademark infringement claims.

Our current and future products may contain defects, which could subject us to product liability claims and product recalls. Although we maintain limited product liability insurance, if any successful product liability claim or product recalls is not covered by or exceeds our insurance coverage, our business, results of operations and financial condition would be harmed. Additionally, third parties may assert claims against us alleging infringement, misappropriation or other violations of patent, trademark or other proprietary rights, whether or not such claims have merit. Such claims can be time consuming and expensive to defend and could require us to cease using and selling the allegedly infringing products, which may have a significant impact on total company sales volume, and to incur significant litigation costs and expenses.

If we lose our key personnel, we may not be able to successfully develop and merchandise our products.

Our success depends to a significant extent upon the abilities of our senior management, particularly Richard Thalheimer, our Founder, Chairman and Chief Executive Officer. The loss of the services of any of the members of our senior management or of certain other key employees could have a significant adverse effect on our business, financial condition and operating results. We maintain key man life insurance on Mr. Thalheimer in the amount of $15 million. The terms of Mr. Thalheimer employment are governed by an employment agreement. Our future performance will depend upon our ability to attract and retain qualified management, merchandising and sales personnel. There can be no assurance that the members of our existing management team will be able to manage our company or our growth or that we will be able to attract and hire additional qualified personnel as needed in the future.

A single shareholder exerts considerable influence over our business affairs and may make business decisions which may not be in your best interest.

As of December 9, 2004, Richard Thalheimer, our Founder, Chairman and Chief Executive Officer, beneficially owned approximately 20% of our common stock. As a result, Mr. Thalheimer will continue to exert substantial influence over the election of directors and over our corporate actions.

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Our common stock price is volatile.

Our common stock is quoted on the NASDAQ National Market, which has experienced and is likely to experience in the future significant price and volume fluctuations, which could reduce the market price of our common stock without regard to our operating performance. From February 1, 2004 to October 31, 2004, the price per share of our common stock has ranged from a high of $39.88 to a low of $16.90. We believe that among other factors, any of the following factors could cause the price of our common stock to fluctuate substantially:

Our charter documents, Delaware law, our stockholders rights plan and other agreements may make a takeover of us more difficult.

We are a Delaware corporation. The Delaware General Corporation Law contains certain provisions that may make a change in control of our company more difficult or prevent the removal of incumbent directors. In addition, our Certificate of Incorporation and Bylaws and our stockholders rights plan and other agreements contain provisions that may have the same effect. These provisions may 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 stockholders for their common stock.

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PART I - FINANCIAL INFORMATION

ITEM 3. Quantitative and Qualitative Disclosure About Market Risk

The Company is exposed to market risks, which include changes in interest rates and, to a lesser extent, foreign exchange rates. The Company does not engage in financial transactions for trading or speculative purposes.

The interest payable on the Company’s credit facility is based on variable interest rates and is therefore affected by changes in market interest rates. If interest rates on existing variable debt rose 0.43% (10% from the bank’s reference rate) during the period ending October 31, 2004, the Company’s results from operations and cash flows would not have been materially affected. In addition, the Company has fixed and variable income investments consisting of cash equivalents and short-term investments, which are also affected by changes in market interest rates. The Company does not use derivative financial instruments in its investment portfolio.

The Company enters into a significant amount of purchase obligations outside of the U.S. that are settled in U. S. dollars, and therefore, has only minimal exposure to foreign currency exchange risks. The Company does not hedge against foreign currency risks and believes that foreign currency exchange risk is immaterial.

ITEM 4. Controls and Procedures

Disclosure Controls and Procedures

Our Chief Executive Officer and our Chief Financial Officer, after evaluating the effectiveness of the Company’s “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 (“Exchange Act”) Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this quarterly report, have concluded that our disclosure controls and procedures are effective based on their evaluation of these controls and procedures required by paragraph (b) of Exchange Act Rules 13a-15 or 15d-15.

Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Section 404 Assessment

Section 404 of the Sarbanes-Oxley Act requires management’s annual review and evaluation of our internal controls, and an attestation of the effectiveness of these controls by our independent registered public accountants beginning with our Form 10-K for the fiscal year ending on January 31, 2005. We are dedicating significant resources, including management time and effort, and incurring substantial costs in connection with our ongoing Section 404 assessment. We are currently documenting and testing our internal controls and considering whether any improvements are necessary for maintaining an effective control environment at our company. The evaluation of our internal controls is being conducted under the direction of our senior management in consultation with an independent third party consulting firm. In addition, our management is regularly discussing the results of our testing and any proposed improvements to our control environment with our Audit Committee. We will continue to work to improve our controls and procedures, and to educate and train our employees on our existing controls and procedures in connection with our efforts to maintain an effective controls infrastructure at our company. We do not believe that the recently announced departure of

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our Chief Financial Officer, which will be effective as of December 31, 2004, will adversely affect our ability to complete our ongoing Section 404 assessment.

ITEM 6. Exhibits

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SIGNATURES

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

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