Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended January 30, 2005.

OR

For the transition period from                          to                         

Commission file number 001-14077

WILLIAMS-SONOMA, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code (415) 421-7900

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act: None

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

As of August 1, 2004, the approximate aggregate market value of the registrant’s common stock held by non-affiliates was $3,126,069,000. It is assumed for purposes of this computation that an affiliate includes all persons as of August 1, 2004 listed as executive officers and directors with the Securities and Exchange Commission. This aggregate market value includes all shares held in the registrant’s Williams-Sonoma, Inc. Stock Fund.

As of March 27, 2005, 115,426,679 shares of the registrant’s Common Stock were outstanding.

Table of Contents

DOCUMENTS INCORPORATED BY REFERENCE

Portions of our definitive Proxy Statement for the 2005 Annual Meeting of Shareholders, also referred to in this Annual Report on Form 10-K as our Proxy Statement, which will be filed with the Securities and Exchange Commission, or SEC, on or about April 18, 2005, have been incorporated in Part III hereof.

FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K and the letter to shareholders contained in this annual report contain forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they do not fully materialize or prove incorrect, could cause our business and results of operations to differ materially from those expressed or implied by such forward-looking statements. Such forward-looking statements include, without limitation, any projections of earnings, revenues or financial items, statements of the plans, strategies and objectives of management for future operations, statements related to the future performance and growth potential of our brands, statements related to improved sourcing and enhanced retail execution in the Williams-Sonoma brand, statements related to our plans to increase retail leased square footage, statements related to increasing our distribution center square footage, statements related to strategic and operational benefits derived from our new east coast distribution center, statements related to increasing and expanding catalog circulation and increasing catalog page counts, statements related to market acceptance of new products and brands, statements related to identification and growth of underserved market segments, statements related to seasonal variations in demand, statements related to adequacy of current facilities, statements related to litigation matters, statements related to payment of dividends, statements related to tax incentives, statements related to introducing new core and seasonal merchandise assortments, statements related to enhancing product quality, statements related to reducing our customer backorders, improving our in-stock positions in key furniture programs and improving our order fulfillment rates, statements related to implementing new merchandising and inventory and order management systems, new merchandising programs, new store replenishment programs, new marketing initiatives and expanding on-line and electronic direct marketing initiatives, statements related to making investments in our emerging brands, statements related to our plans to open new retail stores, statements related to launching new websites, statements related to future comparable store sales, statements related to our fiscal 2005 income tax provision and effective tax rate, statements related to the use of our available cash, statements related to our projected capital expenditures, statements related to the timing of the replenishment of our inventory levels, statements related to our stock repurchase program, statements related to the impact of new accounting pronouncements, statements related to indemnifications under our agreements, statements related to legal proceedings and statements of belief and statements of assumptions underlying any of the foregoing. You can identify these and other forward-looking statements by the use of words such as “will,” “may,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “intends,” “potential,” “continue,” or the negative of such terms, or other comparable terminology.

The risks, uncertainties and assumptions referred to above that could cause our results to differ materially from the results expressed or implied by such forward-looking statements include, but are not limited to, those discussed under the heading “Risk Factors” in Item 7 hereto and the risks, uncertainties and assumptions discussed from time to time in our other public filings and public announcements. All forward-looking statements included in this document are based on information available to us as of the date hereof, and we assume no obligation to update these forward-looking statements.

1

Table of Contents

WILLIAMS-SONOMA, INC.

ANNUAL REPORT ON FORM 10-K

FISCAL YEAR ENDED JANUARY 30, 2005

TABLE OF CONTENTS

2

Table of Contents

PART I

ITEM 1.  BUSINESS

OVERVIEW

We are a specialty retailer of products for the home. The retail segment of our business sells our products through our five retail store concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Hold Everything and West Elm). The direct-to-customer segment of our business sells similar products through our eight direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed + Bath, PBteen, Hold Everything, West Elm and Williams-Sonoma Home) and six e-commerce websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com, westelm.com and holdeverything.com). Based on net revenues in fiscal 2004, retail net revenues accounted for 57.7% of our business and direct-to-customer net revenues accounted for 42.3% of our business. Based on their contribution to our net revenues in fiscal 2004, the core brands in both retail and direct-to-customer are: Pottery Barn, which sells contemporary tableware and home furnishings; Williams-Sonoma, which sells cookware essentials; and Pottery Barn Kids, which sells stylish children’s furnishings.

We were founded in 1956 by Charles E. Williams, currently a Director Emeritus, with the opening of our first store in Sonoma, California. Today, the Williams-Sonoma stores offer a wide selection of culinary and serving equipment, including cookware, cookbooks, cutlery, informal dinnerware, glassware, table linens, specialty foods and cooking ingredients. Our direct-to-customer business began in 1972 when we introduced our flagship catalog, “A Catalog for Cooks,” which marketed the Williams-Sonoma brand.

In 1983, we internally developed the Hold Everything catalog to offer innovative solutions for household storage needs by providing efficient organization solutions for every room in the house. The first Hold Everything store opened in 1985.

In 1986, we acquired Pottery Barn, a retailer and direct-to-customer merchandiser featuring a large assortment of items in casual home furnishings, flatware and table accessories that we design internally and source from around the world, to create a dynamic look in the home.

In 1989, we developed Chambers, a mail order merchandiser of high quality linens, towels, robes, soaps and accessories for the bed and bath.

In 1999, we launched both our Williams-Sonoma wedding and gift registry e-commerce website and our Williams-Sonoma e-commerce website. In addition, we launched the Pottery Barn Kids catalog, which offers stylish children’s furnishings.

In 2000, we opened our first Pottery Barn Kids stores across the U.S. In addition, we introduced our Pottery Barn e-commerce website and created Pottery Barn Bed + Bath, a catalog dedicated to bed and bath products.

In 2001, we launched our Pottery Barn Kids e-commerce website, Pottery Barn gift and bridal registry, and Pottery Barn Kids gift registry. Additionally, in 2001, we opened five new retail stores (two Williams-Sonoma, two Pottery Barn and one Pottery Barn Kids) in Toronto, Canada, our first stores operated by us outside of the U.S.

In 2002, we launched our West Elm catalog. The brand targets young, design conscious consumers looking to furnish and accessorize their apartments, lofts or first homes with quality products at accessible price points. West Elm product categories include furniture, decorative accessories, tabletop items and an extensive textile collection.

In 2003, we launched our West Elm e-commerce website, opened our first West Elm retail store and launched our newest extension of the Pottery Barn brand, PBteen, with the introduction of the PBteen catalog. PBteen offers exclusive collections of home furnishings and decorative accessories that are specifically designed to reflect the personalities of the teenage market. In late 2003, we launched our PBteen e-commerce website.

3

Table of Contents

In 2004, the Chambers brand was retired as a result of the launch of Williams-Sonoma Home, our newest brand. This new premium brand, offering classic home furnishings and decorative accessories, extends the Williams-Sonoma lifestyle beyond the kitchen into every room of the home.

In addition, in 2004, we launched our first Hold Everything e-commerce website, opened three new prototype stores, transitioned the merchandise assortment and improved the visual presentation of both the retail stores and the catalog.

RETAIL STORES

The retail segment has five merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Hold Everything and West Elm). As of January 30, 2005, we operated 552 retail stores, located in 43 states, Washington, D.C. and Canada. This represents 254 Williams-Sonoma, 183 Pottery Barn, 87 Pottery Barn Kids, 9 Hold Everything, 4 West Elm, and 15 Outlet stores (our Outlet stores carry merchandise from all merchandising concepts).

In fiscal 2005, we expect to increase retail leased square footage by approximately 8% to 9%, including 28 new stores (8 in Pottery Barn, 7 in West Elm, 5 in Williams-Sonoma, 3 in Pottery Barn Kids, 3 in Williams-Sonoma Home and 2 in Hold Everything) and 10 remodeled stores (7 in Williams-Sonoma, 2 in Pottery Barn and 1 Outlet store) offset by the anticipated permanent closure of 2 Williams-Sonoma stores. The average leased square footage for new and expanded stores in fiscal 2005 will be approximately 16,300 leased square feet for West Elm, 13,900 leased square feet for Williams-Sonoma Home, 11,400 leased square feet for Pottery Barn, 9,000 leased square feet for Hold Everything, 7,300 leased square feet for Pottery Barn Kids and 6,500 leased square feet for Williams-Sonoma. Detailed financial information about the retail segment is found in Note M to our Consolidated Financial Statements.

DIRECT-TO-CUSTOMER OPERATIONS

The direct-to-customer segment has seven merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, PBteen, Hold Everything, West Elm and Williams-Sonoma Home) and sells products through our eight direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed + Bath, PBteen, Hold Everything, West Elm and Williams-Sonoma Home) and six e-commerce websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com, westelm.com and holdeverything.com). Of these seven merchandising concepts, the Pottery Barn brand and its extensions have been the major source of sales growth in the direct-to-customer segment for the last several years. We believe that the success of the Pottery Barn brand and its extensions reflect our continuing investment in product design, product quality and multi-channel marketing.

The direct-to-customer channel over the past several years has been strengthened by the continued success of the Pottery Barn Kids brand, the introduction of e-commerce websites in all of our core brands and the launching of our newest brands, West Elm, PBteen and Williams-Sonoma Home. Although the amount of e-commerce sales that are incremental to our direct-to-customer channel cannot be identified precisely, we estimate that approximately 40% of our company-wide non-gift registry Internet sales are incremental to the direct-to-customer channel and approximately 60% are catalog-driven sales.

We send our catalogs to addresses from our proprietary customer list, as well as to names from lists from other mail order merchandisers, magazines and companies that we receive in exchange for either payment or new addresses, consistent with our published privacy policies. In accordance with prevailing industry practice, we rent our list to select merchandisers. Our customer list is continually updated to include new prospects and to eliminate non-responders.

The direct-to-customer business complements the retail business by building brand awareness and acting as an effective advertising vehicle. In addition, we believe that the mail order catalogs and the Internet act as a cost efficient means of testing market acceptance of new products and new brands. Detailed financial information about the direct-to-customer segment is found in Note M to our Consolidated Financial Statements.

4

Table of Contents

SUPPLIERS

We purchase our merchandise from numerous foreign and domestic manufacturers and importers, the largest of which individually accounted for approximately 2.5% of purchases during fiscal 2004. Approximately 62% of our merchandise purchases in fiscal 2004 were foreign-sourced from manufacturers in 38 countries, primarily from Asia and Europe. Substantially all of our foreign purchases of merchandise are negotiated and paid for in U.S. dollars.

COMPETITION AND SEASONALITY

The specialty retail business is highly competitive. Our specialty retail stores, mail order catalogs and e-commerce websites compete with other retail stores, including large department stores, discount stores, other specialty retailers offering home centered assortments, other mail order catalogs and other e-commerce websites. The substantial sales growth in the direct-to-customer industry within the last decade has encouraged the entry of many new competitors and an increase in competition from established companies. We compete on the basis of our brand authority, the quality of our merchandise, service to our customers and our proprietary customer list, as well as location and appearance of our stores. We believe that we compare favorably with many of our current competitors with respect to some or all of these factors.

Our business is subject to substantial seasonal variations in demand. Historically, a significant portion of our revenues and net earnings have been realized during the period from October through December, and levels of net revenues and net earnings have generally been lower during the period from January through September. We believe this is the general pattern associated with the direct-to-customer and retail industries. In anticipation of our peak season, we hire a substantial number of additional employees in our retail stores and direct-to-customer processing and distribution areas, and incur significant fixed catalog production and mailing costs.

PATENTS, TRADEMARKS, COPYRIGHTS AND DOMAIN NAMES

We own and/or have applied to register over 150 trademarks and service marks. We own and/or have applied to register our marks in the U.S., Canada and in approximately 20 additional jurisdictions. Exclusive rights to the trademarks and service marks are held by Williams-Sonoma, Inc. and are used by our subsidiaries under license. These marks include brand names for products as well as house marks for our subsidiaries and their signature publications and websites. The house marks in particular, including “Williams-Sonoma,” the Williams-Sonoma Grande Cuisine logo, “Pottery Barn,” “hold everything,” “pottery barn kids,” “PBteen,” “west elm” and “Williams-Sonoma Home” are of material importance to us. Trademarks are generally valid as long as they are in use and/or their registrations are properly maintained, and they have not been found to have become generic. Trademark registrations can generally be renewed indefinitely so long as the marks are in use. We own numerous copyrights and trade dress rights for our products, product packaging, catalogs, books, house publications and website designs, among other things, which are also used by our subsidiaries under license. We hold patents on certain product functions and product designs. Patents are generally valid for 20 years as long as their registrations are properly maintained. In addition, we have registered and maintain numerous Internet domain names, including “wsweddings.com,” “williams-sonoma.com,” “potterybarn.com,” “potterybarnkids.com,” “pbteen.com,” “westelm.com,” “holdeverything.com,” “williamssonomahome.com,” and “williams-sonomainc.com.” Collectively, the copyrights, trade dress rights, patents and domain names that we hold are of material importance to us.

EMPLOYEES

As of January 30, 2005, we had approximately 36,000 employees, approximately 7,200 of whom were full-time employees. During the fiscal 2004 peak season, we hired approximately 16,400 temporary employees in our stores and in our direct-to-customer processing and distribution centers.

5

Table of Contents

AVAILABLE INFORMATION

We file annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, proxy and information statements and amendments to reports filed or furnished pursuant to Sections 13(a), 14 and 15(d) of the Securities Exchange Act of 1934, as amended. The public may read and copy these materials at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. The public may obtain information on the operation of the public reference room by calling the SEC at 1-800-SEC-0330. The SEC also maintains a website at www.sec.gov that contains reports, proxy and information statements and other information regarding Williams-Sonoma, Inc. and other companies that file materials with the SEC electronically. You may also obtain copies of our annual reports, Forms 10-K, Forms 10-Q and Forms 8-K, free of charge, on our website at www.williams-sonomainc.com.

ITEM 2.  PROPERTIES

Our gross leased store space, as of January 30, 2005, totaled approximately 4,637,000 square feet for 552 stores compared to approximately 4,163,000 square feet for 512 stores, as of February 1, 2004. All of the existing stores are leased by us with original terms ranging generally from 5 to 22 years. Certain leases contain renewal options for periods of up to 20 years. The rental payment requirements in our store leases are typically structured as either minimum rent, minimum rent plus additional rent based on a percentage of store sales if a specified store sales threshold is exceeded, or rent based on a percentage of store sales if a specified store sales threshold or contractual obligations of the landlord have not been met. See Notes A and E to our Consolidated Financial Statements for more information.

We lease distribution facility space in the following locations:

One of our Olive Branch, Mississippi distribution center agreements contains an option to lease an additional 333,000 square feet of distribution space. As of January 30, 2005, we had not exercised our rights under this option, however, we expect to exercise this option during fiscal 2005.

Two of our distribution facilities in Memphis, Tennessee are leased from two partnerships whose partners include a Director and a Director Emeritus, both of whom are significant shareholders. Both partnerships were consolidated by us as of February 1, 2004. See Note F to our Consolidated Financial Statements for more information.

On August 18, 2004, we entered into an agreement to lease a 500,000 square foot distribution facility located in Memphis, Tennessee.

Our Cranbury, New Jersey distribution center agreement requires us to lease an additional 219,000 square feet of the facility in the event the current tenant vacates the premises.

In addition, we contract with a third party who provides furniture delivery and storage services in a 662,000 square foot distribution facility in Ontario, California. This distribution square footage is not included in the table above.

We lease call center space in the following locations:

6

Table of Contents

Our corporate facilities are located in San Francisco, California. Our primary headquarters, consisting of 122,000 square feet, was purchased in 1993. In February 2000, we purchased a 204,000 square foot facility in San Francisco, California for the purpose of consolidating certain headquarters staff and to provide for future growth. We believe that our facilities are adequate for our current needs and that suitable additional or substitute space will be available in the future to replace our existing facilities, if necessary, or to accommodate expansion of our operations.

We also lease office space, design/photo studio and warehouse space, and data center space in the following locations:

As of January 30, 2005, we entered into an agreement to lease an additional 88,000 square feet of warehouse space in Brisbane, California, which we occupied in February 2005. In addition, we entered into an agreement to lease a 52,000 square foot facility in New York City, which replaces our currently occupied New York facility. We expect to occupy this new facility in May 2005. Although these facilities were not occupied by us as of year-end, we have included them within the table above.

I TEM 3.  LEGAL PROCEEDINGS

On September 24, 2004, a purported class action lawsuit entitled Alvarez, et al. v. Williams-Sonoma, Inc., et al. was filed in the Superior Court of California, San Francisco County. The potential class consists of current and former store managers and assistant store managers in California Williams-Sonoma brand stores. The lawsuit alleges that the employees were improperly classified under California’s wage and hour and unfair business practice laws and seeks damages, penalties under California’s wage and hour laws, restitution and attorneys’ fees and costs. We are vigorously investigating and defending this litigation. Because the case is in the very early stages, the financial impact to us cannot yet be predicted.

In addition, we are involved in other lawsuits, claims and proceedings incident to the ordinary course of our business. These disputes, which are not currently material, are increasing in number as our business expands and our company grows larger. Litigation is inherently unpredictable. Any claims against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. The results of these lawsuits, claims and proceedings cannot be predicted with certainty. However, we believe that the ultimate resolution of these current matters will not have a material adverse effect on our consolidated financial statements taken as a whole.

There were no matters submitted to a vote of security holders during the fourth quarter of fiscal 2004.

7

Table of Contents

PART II

MARKET INFORMATION

Our common stock is traded on the New York Stock Exchange, or the NYSE, under the symbol WSM. The following table sets forth the high and low closing prices of our common stock on the NYSE for the periods indicated.

The closing sales price of our common stock on the NYSE on March 22, 2005 was $36.59. See Quarterly Financial Information on page 59 of this Annual Report on Form 10-K for the quarter-end closing sales price of our common stock for each quarter above.

SHAREHOLDERS

The number of shareholders of record of our common stock as of March 22, 2005 was approximately 516. This number excludes shareholders whose stock is held in nominee or street name by brokers.

DIVIDEND POLICY

We have never declared or paid a cash dividend on our common stock.

Additional information required by Item 5 is contained in Notes H and I to the Consolidated Financial Statements in this Annual Report on Form 10-K.

EQUITY COMPENSATION PLAN INFORMATION

The information required by this Item regarding equity compensation plans is incorporated by reference to the information set forth in Item 12 of this Annual Report on Form 10-K.

STOCK REPURCHASE PROGRAM

In May 2004, the Board of Directors authorized a stock repurchase program to acquire up to 2,500,000 shares of our outstanding common stock. During fiscal 2004, we repurchased and retired 2,057,700 shares of our common stock under this program, in addition to 215,000 shares under our previously authorized stock repurchase program, at a total cost of approximately $79,320,000, a weighted average cost of $34.90 per share. As of year-end, the remaining authorized number of shares eligible for repurchase was 442,300 shares. Stock repurchases under this program may be made through open market and privately negotiated transactions at times and in such amounts as management deems appropriate. The timing and actual number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements and other market

8

Table of Contents

conditions. The stock repurchase program does not have an expiration date and may be limited or terminated at any time without prior notice. The following table summarizes our repurchases of shares of our common stock during the fourth quarter of fiscal 2004:

9

Table of Contents

I TEM 6.  SELECTED FINANCIAL DATA

Five-Year Selected Financial Data

¹The fiscal year ended February 3, 2002 included 53 weeks.

²Per share amounts have been restated to reflect the 2-for-1 stock split in May 2002.

³Pre-tax operating margin is defined as earnings before income taxes.

The information set forth above is not necessarily indicative of future operations and should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements and notes thereto in this Annual Report on Form 10-K.

10

Table of Contents

OVERVIEW

In fiscal 2004, our diluted earnings per share increased by 21.2% to $1.60 and our net revenues increased 13.9% to $3.137 billion from $2.754 billion in fiscal 2003. The net revenues increase was primarily driven by increases in the Pottery Barn, Pottery Barn Kids, PBteen and Williams-Sonoma concepts. Increasing our revenues was a key strategic initiative for us in 2004 and we are pleased to have been able to deliver these results, despite a significantly weaker than expected consumer response to the holiday merchandising strategies in the Pottery Barn brand in the fourth quarter.

In our retail channel, net revenues increased 11.6% during fiscal 2004 versus fiscal 2003. This increase was primarily driven by a year-over-year increase in retail leased square footage of 11.4%, including 40 net new stores, and a comparable store sales increase of 3.5%. Net sales generated in the Pottery Barn, Williams-Sonoma, and Pottery Barn Kids brands were the primary contributors to the year-over-year sales increase, partially offset by the transitional impact of our Hold Everything brand realignment strategy. We achieved positive comparable store sales growth in each of our core brands in fiscal 2004.

In our direct-to-customer channel, net revenues increased 17.1% during fiscal 2004 versus fiscal 2003. This year-over-year increase was primarily driven by net sales generated in the Pottery Barn, PBteen, Pottery Barn Kids and West Elm brands resulting from increased catalog and page count circulation and the continued success of our e-commerce initiatives, as well as incremental net sales generated by the November launch of the Hold Everything e-commerce website. All of the brands in the direct-to-customer channel delivered positive growth during the fiscal year with the exception of the Chambers brand, which was retired in the second quarter of 2004 in anticipation of the launch of the Williams-Sonoma Home brand in the third quarter of 2004.

In our core brands, net sales increased 12.2% in 2004, primarily driven by net sales increases in both the Pottery Barn and Pottery Barn Kids brands and a mid-single digit net sales increase in the Williams-Sonoma brand.

In our emerging brands, including PBteen, West Elm, Hold Everything, and Williams-Sonoma Home, net sales increased 38.0%, primarily driven by strong performance in the PBteen and West Elm brands.

Net sales in 2004 in the PBteen brand increased 97.8% primarily driven by incremental sales from the e-commerce website that was launched in October 2003 and a 55% increase in catalog circulation. Although we continue to believe that it is too early to predict the ultimate growth potential of PBteen, the strong consumer response to this brand leads us to believe that we have identified another underserved market segment in the home, similar to Pottery Barn Kids, that could provide a significant long-term growth opportunity for the future.

Net sales in the West Elm brand increased 75.9% primarily driven by significant growth in the e-commerce channel and an extremely successful retail launch. In late 2004, we opened three new prototype stores in the West Elm brand, all of which currently rank in the top volume producing stores in the Company.

Net sales in 2004 in the Hold Everything brand increased 2.5%. Within the brand, 2004 was a year of significant transition in both the merchandising strategy and the lifestyle positioning of the brand. During 2004, we added significant management resources and infrastructure to support the future growth of the brand. In the direct-to-customer channel, we increased catalog prospecting to revitalize the customer database and launched the first Hold Everything e-commerce website in November. We also opened three new prototype stores in November. Although the overall growth in the Hold Everything brand met our expectations in 2004, its growth potential was limited by the breadth of the current merchandise assortment. We are currently in the process of developing substantially expanded assortments for 2005 and 2006.

Our newest brand, Williams-Sonoma Home, was launched in the third quarter of 2004. On a circulation of over 10 million catalogs, net sales in the brand were in line with the low end of our expectations. What we found especially encouraging about the initial consumer response to the overall merchandise assortment was the stronger than expected demand for custom upholstered furniture, which we believe speaks to the long-term competitive advantage that we can create in this brand by leveraging the strength of our supply chain organization.

11

Table of Contents

During fiscal 2004, we also continued to improve our pre-tax operating margin, increasing from 9.3% in 2003 to 9.9% in 2004. This increase in the pre-tax operating margin was the result of several successful operational initiatives, including:

During 2004, we made progress in building our infrastructure to support the growth of our core and emerging brands. In the information technology area, we entered into two strategic vendor partnerships with IBM: one to host and manage our data center and one to host our e-commerce websites. These agreements were entered into in order to more cost-effectively manage our information technology infrastructure, while at the same time, enhancing the functionality of our e-commerce websites. We also continued to invest in our new direct-to-customer order management and inventory management systems, which are currently in beta testing in our Hold Everything brand. These multi-phase, multi-year technology initiatives are at the heart of our long-term efforts to drive increased sales and reduced costs through productivity and operational efficiency.

In the area of inventory management and distribution operations, we increased our distribution center leased square footage, in part by opening our first east coast distribution center in Cranbury, New Jersey. We also made progress on our “weeks of supply” inventory management initiative, which resulted in a reduction in the base levels of our inventory due to more efficiently flowing merchandise through the supply chain. The sustainable benefit of this initiative, however, will not be realized until we implement our new merchandising systems in 2006.

As we enter 2005, we will continue to focus on our three long-term strategic initiatives: driving profitable top-line sales growth; increasing pre-tax operating margin; and enhancing shareholder value.

To drive profitable top-line sales growth, we expect to add 26 net new retail locations, increase catalog circulation, expand customer contacts through electronic direct marketing, and intensify the marketing support behind our bridal and gift registry businesses. In our emerging brands, we plan to focus on executing initiatives that we believe will build brand awareness and enhance customer access to the brands. In PBteen in 2005, we plan to increase catalog circulation and expand our successful on-line marketing initiatives. We also plan to drive aggressive name capture programs to expand our teen affinity database. In West Elm, we plan to increase catalog circulation and open seven new retail stores. We continue to believe that West Elm has the potential to be our largest brand, if we can successfully evolve the merchandising strategy, broaden the overall consumer appeal, and capture the mind share of the large consumer segment that West Elm targets. In Williams-Sonoma Home in 2005, we plan to increase catalog circulation, add catalog ordering functionality to the current e-catalog website, and open three new prototype stores in the third quarter. We believe that the retail launch in Williams-Sonoma Home is strategic to expanding the multi-channel reach of the brand due to the customer’s desire to interact with the product and fully experience the design authority of the brand. In Hold Everything, we plan to significantly refine our catalog circulation strategy, expand our on-line marketing initiatives, and open two additional prototype stores. We also plan to introduce new merchandise assortments throughout the year that will reflect the lifestyle transition of the brand, including a significantly enhanced assortment in furniture, casual upholstery, textiles, lighting, and tabletop.

12

Table of Contents

To increase our pre-tax operating margin, we expect to implement operational disciplines throughout the supply chain to reduce returns, replacements and damages, particularly in furniture; improve our furniture sourcing and inventory management disciplines by implementing a long-term capacity and production planning process with key strategic vendors; and in-source the management of a primary furniture hub to develop a new “gold standard” for customer service and to improve the overall operational efficiency of the furniture supply chain process. Additionally, we plan to test on a national basis a new store replenishment program. During 2005, we will begin replenishing our retail store inventories on a daily basis with UPS providing the transportation services. The long-term benefits of this new replenishment program are to improve customer service by reducing out of stocks in the stores, to reduce inventories in the back rooms of our stores and in local off-site storage locations, and to reduce inventory damages and shrinkage due to less handling of the merchandise. In the short-term, however, we expect to incur additional costs to implement this test, which we estimate at approximately $0.01 per share in 2005.

To enhance shareholder value, we remain committed to delivering against all three of our key strategies including reaching three new financial milestones: surpassing $3.5 billion in revenues, achieving a 10.0% pre-tax operating margin, and delivering the highest diluted earnings per share in the history of the Company.

13

Table of Contents

Results of Operations

NET REVENUES

Net revenues consist of retail sales, direct-to-customer sales and shipping fees. Retail sales include sales of merchandise to customers at our retail stores, direct-to-customer sales include sales of merchandise to customers through our catalogs and the Internet, and shipping fees consist of revenue received from customers for delivery of merchandise.

The following table summarizes our net revenues for the 52 weeks ended January 30, 2005 (“fiscal 2004”), February 1, 2004 (“fiscal 2003”) and February 2, 2003 (“fiscal 2002”).

Net revenues for fiscal 2004 increased by $382,563,000, or 13.9%, over fiscal 2003. The increase was primarily due to an increase in store leased square footage of 11.4% (including 43 new store openings and the remodeling and expansion of an additional 17 stores) and comparable store sales growth of 3.5% in fiscal 2004. The increase was further driven by increased catalog and page count circulation (12.1% and 19.5%, respectively) and continued strength in our Internet business, primarily due to our expanded efforts associated with our electronic direct marketing initiatives and the incremental sales generated by the late 2003 and 2004 launches of our emerging brands’ e-commerce websites. This increase was partially offset by the temporary closure of 15 stores and the permanent closure of 5 stores in fiscal 2004.

Net revenues for fiscal 2003 increased by $393,538,000, or 16.7%, over fiscal 2002. The increase was primarily due to an increase in store leased square footage of 11.8% (including 46 new store openings and the remodeling and expansion of an additional 19 stores) and comparable store sales growth of 4.0% in fiscal 2003. The increase was further driven by increased catalog and page count circulation (17.4% and 16.8%, respectively) and continued strength in our Internet business, primarily due to our expanded efforts associated with our electronic direct marketing initiatives. This increase was partially offset by the temporary closure of 21 stores and the permanent closure of 10 stores in fiscal 2003.

RETAIL REVENUES AND OTHER DATA

14

Table of Contents

Retail revenues in fiscal 2004 increased by $188,596,000, or 11.6%, over fiscal 2003 primarily due to an increase in store leased square footage of 11.4 % (including 43 new store openings and the remodeling and expansion of an additional 17 stores) and a comparable store sales increase of 3.5%. This increase was partially offset by the temporary closure of 15 stores and the permanent closure of 5 stores during fiscal 2004. Net sales generated in the Pottery Barn, Williams-Sonoma and Pottery Barn Kids brands were the primary contributors to the year-over-year sales increase, partially offset by the transitional impact of our Hold Everything brand realignment strategy. Pottery Barn and Pottery Barn Kids accounted for 65.8% of the growth in retail revenues from fiscal 2003 to fiscal 2004.

Retail revenues in fiscal 2003 increased by $198,390,000, or 13.9%, over fiscal 2002 primarily due to an increase in store leased square footage of 11.8% (including 46 new store openings and the remodeling and expansion of an additional 19 stores) and a comparable store sales increase of 4.0%. This increase was partially offset by the temporary closure of 21 stores and the permanent closure of 10 stores during fiscal 2003. Pottery Barn and Pottery Barn Kids accounted for 64.0% of the growth in retail revenues from fiscal 2002 to fiscal 2003.

As part of the Hold Everything brand realignment strategy, three new prototype stores were opened and two stores were closed in fiscal 2004. Five Hold Everything stores were closed during fiscal 2003 and two stores were closed during fiscal 2002. Most of these closures were smaller stores in non-strategic locations at or near their lease termination date.

Comparable Store Sales

Comparable stores are defined as those stores in which gross square footage did not change by more than 20% in the previous 12 months and which have been open for at least 12 consecutive months without closure for seven or more consecutive days. Comparable stores exclude new retail concepts until such time as the company believes that comparable store results in those concepts are meaningful to evaluating the performance of the retail strategy. In fiscal 2004, total company comparable store sales excluded one West Elm store. No stores were excluded in fiscal 2003. By measuring the year-over-year sales of merchandise in the stores that have a history of being open for a full comparable 12 months or more, we can better gauge how the core store base is performing since it excludes store expansions and closings. Percentages represent changes in comparable store sales versus the same period in the prior year.

15

Table of Contents

Various factors affect comparable store sales, including the number of stores we open, close and expand in any period, the general retail sales environment, consumer preferences and buying trends, changes in sales mix among distribution channels, our ability to efficiently source and distribute products, changes in our merchandise mix, competition, current local and global economic conditions, the timing of our releases of new merchandise and promotional events, the success of marketing programs, and the cannibalization of existing store sales by new stores. Among other things, weather conditions can affect comparable store sales because inclement weather can require us to close certain stores temporarily and thus reduce store traffic. Even if stores are not closed, many customers may decide to avoid going to stores in bad weather. These factors have caused our comparable store sales to fluctuate significantly in the past on an annual, quarterly and monthly basis and, as a result, we expect that comparable store sales will continue to fluctuate in the future.

DIRECT-TO-CUSTOMER REVENUES

Direct-to-customer revenues in fiscal 2004 increased by $193,967,000, or 17.1%, over fiscal 2003. This increase was primarily driven by net sales generated in the Pottery Barn, PBteen, Pottery Barn Kids and West Elm brands. All of our brands in the direct-to-customer channel delivered positive growth during the fiscal year with the exception of the Chambers brand, which was retired in the second quarter of 2004 in anticipation of the launch of the Williams-Sonoma Home brand in the third quarter of 2004.

Direct-to-customer revenues in fiscal 2003 increased by $195,148,000, or 20.8%, over fiscal 2002. This increase was primarily driven by net sales generated in the Pottery Barn and Pottery Barn Kids brands in addition to incremental sales from PBteen and West Elm. Net sales in the Pottery Barn brand were driven primarily by an increase in the number of catalogs circulated and the momentum in our Internet business where traffic on the website increased substantially over fiscal 2002 and where conversion rates (the percentage of visitors to our website who make a purchase) continued to exceed the industry norm. The net sales increase in the Pottery Barn Kids brand over fiscal 2002 was primarily driven by an increase in the number of catalogs circulated and increased productivity in on-line advertising, as well as the growth in our baby and gift registry sales.

Internet sales increased $144,622,000, or 43.4%, to $477,472,000 in fiscal 2004, from $332,850,000 in fiscal 2003, primarily driven by the Pottery Barn and Pottery Barn Kids brands, in addition to incremental net sales generated by the late 2003 launches of the PBteen and West Elm e-commerce websites, in addition to the November 2004 launch of the Hold Everything e-commerce website. Internet sales increased $132,448,000, or 66.1%, to $332,850,000 in fiscal 2003, from $200,402,000 in fiscal 2002, primarily driven by the Pottery Barn and Pottery Barn Kids brands. Although the amount of e-commerce sales that are incremental to our direct-to-customer channel cannot be identified precisely, we estimate that approximately 40% of our company-wide non-gift registry Internet sales are incremental to the direct-to-customer channel and approximately 60% are catalog-driven sales.

16

Table of Contents

COST OF GOODS SOLD

Cost of goods sold includes cost of goods, occupancy expenses and shipping costs. Cost of goods consists of cost of merchandise, inbound freight expenses, freight to store expenses and other inventory related costs such as shrinkage, damages and replacements. Occupancy expenses consist of rent, depreciation and other occupancy costs, including common area maintenance and utilities. Shipping costs consist of third party delivery services and shipping materials.

Our classification of expenses in cost of goods sold may not be comparable to other public companies, as we do not include non-occupancy related costs associated with our distribution network in cost of goods sold. These costs, which include distribution network employment, third party warehouse management, and other distribution-related administrative expenses are recorded in selling, general and administrative expenses.

Within our reportable segments, the direct-to-customer channel does not incur freight to store or store occupancy expenses, and typically operates with lower markdowns and inventory shrinkage than the retail channel. However, the direct-to-customer channel incurs higher shipping, damage and replacement costs than the retail channel.

Cost of Goods and Occupancy Expenses — Fiscal 2004 vs. Fiscal 2003

Cost of goods and occupancy expenses increased by $206,274,000, or 13.7%, in fiscal 2004 over fiscal 2003. As a percentage of net revenues, cost of goods and occupancy expenses decreased 10 basis points in fiscal 2004 from fiscal 2003, primarily driven by a rate reduction in occupancy expenses, partially offset by an increase in cost of goods sold. The rate reduction in occupancy expenses was primarily due to a greater percentage of total company net revenues being generated in the direct-to-customer channel, which does not incur store occupancy expenses. The rate increase in cost of goods sold was primarily due to a higher percentage of total company net revenues being driven by furniture, which generates a lower than average gross margin rate, in addition to higher returns, replacements and damages.

In the retail channel, cost of goods and occupancy expenses as a percentage of retail net revenues remained relatively flat in fiscal 2004 compared to fiscal 2003. This was primarily driven by a year-over-year rate decrease in merchandise cost of goods, offset by an increase in our store occupancy expense rate.

In the direct-to-customer channel, cost of goods and occupancy expenses as a percentage of direct-to-customer net revenues increased 70 basis points during fiscal 2004 compared to fiscal 2003. This increase was primarily the result of a higher cost of merchandise due to a higher percentage of net revenues being driven by furniture, which generates a lower than average gross margin, in addition to higher replacements and damages, partially offset by a rate reduction in occupancy expenses due to the continued leveraging of sales.

Cost of Goods and Occupancy Expenses — Fiscal 2003 vs. Fiscal 2002

Cost of goods and occupancy expenses increased by $218,989,000, or 17.1%, in fiscal 2003 over fiscal 2002. As a percentage of net revenues, cost of goods and occupancy expenses increased 20 basis points for fiscal 2003 from fiscal 2002. This percentage increase was primarily driven by increased inventory shrinkage and other inventory related costs due to an overall increase in inventory levels in addition to the negative impact of the strengthened euro. This increase was partially offset by a substantial rate reduction in occupancy expenses. The rate reduction in occupancy expenses was attributable to a greater percentage of our total company net revenues being generated in the direct-to-customer channel, which does not incur store occupancy expenses.

17

Table of Contents

In the retail channel, cost of goods and occupancy expenses as a percentage of retail net revenues increased approximately 100 basis points during fiscal 2003 compared to fiscal 2002. This change in rate was primarily driven by an increase in our cost of merchandise, including the negative impact of the strengthened Euro as well as higher markdowns, and a year-over-year increase in inventory shrinkage associated with the reinstatement of inventory to historical levels.

In the direct-to-customer channel, cost of goods and occupancy expenses as a percentage of direct-to-customer net revenues decreased 40 basis points during fiscal 2003 compared to fiscal 2002. This was primarily the result of a reduction in occupancy expenses, partially offset by an increase in our cost of merchandise, increased inventory shrinkage and other inventory related costs due to an overall increase in inventory levels. The reduction in the occupancy rate was attributable to a reduction in depreciation expense resulting from the development costs associated with certain e-commerce websites becoming fully depreciated.

Shipping Costs — Fiscal 2004 vs. Fiscal 2003

Shipping costs increased by $15,721,000, or 11.0%, in fiscal 2004 over fiscal 2003 due to a higher number of direct-to-customer shipments associated with the increase in direct-to-customer sales as well as a shift in the mix of product being shipped, with furniture accounting for a greater portion of the overall mix. We also incurred additional cost earlier in the year as we overcame initial challenges of balancing inventory allocations between the coastal distribution centers and a need to ship merchandise out of market to our customers in order to fill backorders. This increase was substantially offset by a lower cost per shipment due to the full year benefit of expense reductions in 2004 associated with the mid-2003 consolidation of freight providers, the in-sourcing of line-haul management in the furniture delivery network, and reductions in furniture delivery costs driven by efficiencies gained from the new east coast distribution center. As a result of these efficiencies, shipping costs, as a percentage of shipping fees, have continued to decline to 79.7% in fiscal 2004 from 82.7% in fiscal 2003 and 87.4% in fiscal 2002.

Shipping Costs — Fiscal 2003 vs. Fiscal 2002

Shipping costs increased $15,573,000, or 12.2%, in fiscal 2003 over fiscal 2002 due to a higher number of direct-to-customer shipments associated with the increase in direct-to-customer sales as well as a shift in the mix of product being shipped, with furniture accounting for a greater portion of the overall mix. This increase was substantially offset by a lower cost per shipment due to the consolidation of freight providers and the successful renegotiation of freight-to-customer contracts.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses consist of non-occupancy related costs associated with our retail stores, distribution warehouses, customer care centers, supply chain operations (buying, receiving and inspection), and corporate administrative functions. These costs include employment, advertising, third party credit card processing, and other general expenses.

Due to their distinct distribution and marketing strategies, we experience differing employment and advertising costs as a percentage of net revenues within the retail and direct-to-customer segments. Store employment costs represent a greater percentage of retail net revenues than employment costs as a percentage of net revenues within the direct-to-customer segment. However, catalog advertising expenses are greater within the direct-to-customer channel than the retail channel.

Fiscal 2004 vs. Fiscal 2003

Selling, general and administrative expenses increased by $105,386,000, or 12.3%, to $961,176,000 in fiscal 2004 from $855,790,000 in fiscal 2003. Selling, general and administrative expenses expressed as a percentage of net revenues decreased to 30.6% in fiscal 2004 from 31.1% in fiscal 2003. This 50 basis point improvement as a percentage of net revenues was primarily due to a rate reduction in year-over-year employment expenses. Contributing to the employment rate decrease were year-over-year reductions in workers’ compensation and other employment-related costs.

18

Table of Contents

In the retail channel, selling, general and administrative expenses as a percentage of retail net revenues increased approximately 30 basis points in fiscal 2004 versus fiscal 2003, primarily driven by increases in employment and advertising costs. The increase in the employment rate was due in part to the up front investment required in the emerging brands prior to the opening of our new store locations.

In the direct-to-customer channel, selling, general and administrative expenses as a percentage of direct-to-customer net revenues decreased by approximately 90 basis points in fiscal 2004 compared to fiscal 2003. This improvement was primarily driven by a rate reduction in catalog advertising and employment costs. The rate reduction in catalog advertising costs was driven by lower catalog circulation in the emerging brands coupled with continued sales generation by our e-commerce sites. This decrease was partially offset by growth in the rate of other general expenses primarily due to third party outsourcing of distribution services.

Fiscal 2003 vs. Fiscal 2002

Selling, general and administrative expenses increased by $106,491,000 to $855,790,000 in fiscal 2003 from $749,299,000 in fiscal 2002 and, as a percent of net revenues, decreased by 60 basis points to 31.1% in fiscal 2003 from 31.7% in fiscal 2002. The improvement in selling, general and administrative expenses as a percentage of net revenues was attributable to lower year-over-year employment expense, partially offset by an increase in catalog advertising expense. The employment cost decrease was primarily driven by a year-over-year reduction in incentive compensation and employee separation costs associated with the departure of our former Chief Executive Officer during fiscal 2002. The increase in catalog advertising expense as a percentage of net revenues was primarily driven by a greater percentage of total company net revenues in fiscal 2003 being generated by the direct-to-customer channel, which incurs substantially higher catalog advertising costs than the retail channel. In addition, significantly higher advertising costs as a percentage of net revenues were incurred in the new and emerging catalog concepts, PBteen and West Elm.

In the retail channel, selling, general and administrative expenses as a percentage of retail net revenues was unchanged in fiscal 2003 from fiscal 2002. Reductions in advertising expense as a percentage of net revenues offset increases in employment and other general expenses as a percentage of net revenues.

In the direct-to-customer channel, selling, general and administrative expenses as a percentage of direct-to-customer net revenues increased 90 basis points in fiscal 2003 versus fiscal 2002, primarily due to significantly higher advertising costs as a percentage of net revenues being incurred in the emerging brands resulting from higher levels of prospecting during the year.

INTEREST INCOME AND EXPENSE

Interest income was $1,939,000 in fiscal 2004, $873,000 in fiscal 2003, and $1,421,000 in fiscal 2002, comprised primarily of income from short-term investments classified as cash and cash equivalents.

Interest expense was $1,703,000 (net of capitalized interest of $1,689,000), $22,000 (net of capitalized interest of $2,142,000), and $1,441,000 (net of capitalized interest of $1,269,000) for fiscal 2004, fiscal 2003 and fiscal 2002, respectively. Interest expense increased by $1,681,000 to $1,703,000 in fiscal 2004, primarily due to additional interest expense of $1,525,000 associated with the consolidation of our Memphis-based distribution facilities. Prior to the adoption of Financial Accounting Standards Board (“FASB”) Interpretation No. (“FIN”) 46R, “Consolidation of Variable Interest Entities,” this expense would have been classified as occupancy expense. Interest expense decreased by $1,419,000 to $22,000 in fiscal 2003, primarily due to an increase in the amount of interest capitalized resulting from additional long-term capital projects under development in fiscal 2003 and lower interest expense on our senior notes and capital leases.

INCOME TAXES

Our effective tax rate was 38.4% for fiscal 2004 and 38.5% for fiscal 2003 and fiscal 2002. We currently expect our fiscal 2005 effective tax rate to be in the range of 38.1% to 38.5%.

19

Table of Contents

LIQUIDITY AND CAPITAL RESOURCES

As of January 30, 2005, we held $239,210,000 in cash and cash equivalent funds. As is consistent with our industry, our cash balances are seasonal in nature, with the fourth quarter representing a significantly higher level of cash than other periods. Throughout the fiscal year we utilize our cash balances to build our inventory levels in preparation for our fourth quarter holiday sales. In fiscal 2005, we plan to utilize our cash resources to fund our inventory and inventory related purchases, catalog advertising and marketing initiatives, and to support current store development and infrastructure strategies. In addition to the current cash balances on-hand, we had a $200,000,000 credit facility available as of January 30, 2005. No amounts were borrowed by us under the credit facility in either fiscal 2004 or fiscal 2003. However, as of January 30, 2005, $31,763,000 in issued but undrawn standby letters of credit were outstanding under the credit facility. We believe our cash on-hand, in addition to our available credit facilities, will provide adequate liquidity for our business operations and growth opportunities during fiscal 2005.

In fiscal 2004, net cash provided by operating activities was $304,437,000 as compared to net cash provided by operating activities of $209,351,000 in fiscal 2003. The cash provided by operating activities in fiscal 2004 was primarily attributable to net earnings, an increase in our deferred rent and lease incentives due to an increase in retail store openings, an increase in customer deposits due to an increase in unredeemed gift certificates and an increase in accounts payable due to an increase in accrued freight and the timing of expenditures, offset primarily by an increase in merchandise inventories. Our merchandise inventories increased in fiscal 2004 in order to support the increase in sales in our core and emerging brands and an increase in our leased and selling square footage of 11.4% and 10.9%, respectively.

In fiscal 2003, net cash provided by operating activities was $209,351,000 as compared to net cash provided by operating activities of $310,160,000 in fiscal 2002. The cash provided by operating activities in fiscal 2003 was primarily attributable to net earnings, an increase in our deferred rent and lease incentives due to an increase in retail store openings, and an increase in customer deposits due to an increase in unredeemed gift certificates, offset primarily by an increase in merchandise inventories. Our merchandise inventories increased in fiscal 2003 due to an increase in our leased and selling square footage of 11.8% and 11.4%, respectively, and our decision to increase our in-stock position on core merchandise inventories.

Net cash used in investing activities was $181,453,000 for fiscal 2004 as compared to $211,979,000 in fiscal 2003. Fiscal 2004 purchases of property and equipment were $181,453,000, comprised of $83,272,000 for 43 new and 17 remodeled stores, $53,830,000 for systems development projects (including e-commerce websites) and $44,351,000 for distribution, facility infrastructure and other projects (including the purchase of a corporate aircraft for approximately $11,500,000, previously leased under an operating lease).

In fiscal 2005, we anticipate investing $160,000,000 to $180,000,000 in the purchase of property and equipment, primarily for the construction of 28 new stores and 10 remodeled stores, systems development projects (including e-commerce websites), and distribution, facility infrastructure and other projects.

Net cash used in investing activities was $211,979,000 for fiscal 2003 as compared to $155,450,000 in fiscal 2002. Fiscal 2003 purchases of property and equipment were $211,979,000, comprised of $109,145,000 for 46 new and 19 remodeled stores, $56,083,000 for systems development projects (including e-commerce websites) and $46,751,000 for distribution, facility infrastructure and other projects (including the purchase of a corporate aircraft for approximately $36,980,000). We invested in the corporate aircraft in response to the increasing complexity of our global sourcing program, the continued expansion of our retail stores and distribution centers and the increasing difficulty and risks associated with worldwide travel.

For fiscal 2004, cash used in financing activities was $48,207,000, comprised primarily of $79,320,000 for the repurchase of common stock and $9,789,000 for the repayment of long-term obligations, including capital leases and long-term debt, partially offset by $26,190,000 in proceeds from the exercise of stock options and $15,000,000 in proceeds from the issuance of industrial development bonds associated with the Mississippi Debt Transaction. See Note C to our Consolidated Financial Statements.

20

Table of Contents

For fiscal 2003, cash used in financing activities was $28,226,000, comprised primarily of $59,695,000 for the repurchase of common stock and $7,610,000 for the repayment of long-term obligations, including capital leases and long-term debt, partially offset by $39,120,000 in proceeds from the exercise of stock options.

Stock Repurchase Program

In May 2004, the Board of Directors authorized a stock repurchase program to acquire up to 2,500,000 shares of our outstanding common stock. During fiscal 2004, we repurchased and retired 2,057,700 shares of our common stock under this program, in addition to 215,000 shares under our previously authorized stock repurchase program, at a total cost of approximately $79,320,000, a weighted average cost of $34.90 per share. As of year-end, the remaining authorized number of shares eligible for repurchase was 442,300 shares. Stock repurchases under this program may be made through open market and privately negotiated transactions at times and in such amounts as management deems appropriate. The timing and actual number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements and other market conditions. The stock repurchase program does not have an expiration date and may be limited or terminated at any time without prior notice.

Contractual Obligations

The following table provides summary information concerning our future contractual obligations as of January 30, 2005.

Long-Term Debt

At January 30, 2005, long-term debt of $22,716,000 consisted of unsecured senior notes of $5,716,000 and $17,000,000 of bond-related debt. The final payment on the senior notes is due in August 2005 with interest payable semi-annually at 7.2% per annum. The senior notes rank equally in right of payment with any of our existing and future unsubordinated, unsecured debt and contain certain financial covenants including a minimum tangible net worth covenant, a fixed charge coverage ratio and limitations on current and funded debt.

The bond-related debt pertains to the consolidation of our Memphis-based distribution facilities in accordance with FIN 46R. See discussion of the consolidation of our Memphis-based distribution facilities at Note F to our Consolidated Financial Statements.

21

Table of Contents

Industrial Development Bonds

In June 2004, in an effort to utilize tax incentives offered to us by the state of Mississippi, we entered into an agreement whereby the Mississippi Business Finance Corporation issued $15,000,000 in long-term variable rate industrial development bonds, the proceeds, net of debt issuance costs, of which were loaned to us to finance the acquisition and installation of leasehold improvements and equipment located in our newly leased Olive Branch distribution center (the “Mississippi Debt Transaction”). The bonds are marketed through a remarketing agent and are secured by a letter of credit issued under our $200,000,000 line of credit facility. The bonds mature on June 1, 2024. The bond rate resets each week based upon current market rates. The rate in effect at January 30, 2005 was 2.6%.

The bond agreement allows for each bondholder to tender their bonds to the trustee for repurchase, on demand, with seven days advance notice. In the event the remarketing agent fails to remarket the bonds, the trustee will draw upon the letter of credit to fund the purchase of the bonds. As of January 30, 2005, these bonds were classified as current debt. The bond proceeds are restricted for use in the acquisition and installation of leasehold improvements and equipment located in our Olive Branch, Mississippi facility. As of January 30, 2005, we had acquired and installed $9,546,000 of leasehold improvements and equipment associated with the facility.

Capital Leases

Our $5,673,000 of capital lease obligations consist primarily of in-store computer equipment leases with a term of 60 months. The in-store computer equipment leases include an early purchase option at 54 months for $2,496,000, which is approximately 25% of the acquisition cost. We have an end of lease purchase option to acquire the equipment at the greater of fair market value or 15% of the acquisition cost.

Other Contractual Obligations

We have other long-term liabilities reflected in our consolidated balance sheets, including deferred income taxes and insurance accruals. The payment obligations associated with these liabilities are not reflected in the table above due to the absence of scheduled maturities. The timing of these payments cannot be determined, except for amounts estimated to be payable in fiscal 2005 which are included in our current liabilities as of January 30, 2005.

Commercial Commitments

The following table provides summary information concerning our outstanding commercial commitments as of January 30, 2005.

Credit Facility

As of January 30, 2005, we had a credit facility that provided for $200,000,000 of unsecured revolving credit and contained certain financial covenants, including a minimum tangible net worth covenant, a maximum leverage ratio (funded debt adjusted for lease and rent expense to EBITDAR), a minimum fixed charge coverage ratio and a maximum annual capital expenditures covenant. The credit facility was due to expire on October 22, 2005. On February 22, 2005, we entered into the Third Amended and Restated Credit Agreement that amends and replaces our credit facility. The new credit facility provides for a $300,000,000 unsecured revolving line of credit that

22

Table of Contents

may be used for loans or letters of credit. Prior to August 22, 2009, we may, upon notice to the lenders, request an increase in the new credit facility of up to $100,000,000, to provide for a total of $400,000,000 of unsecured revolving credit. The new credit facility contains events of default that include, among others, non-payment of principal, interest or fees, inaccuracy of representations and warranties, violation of covenants, bankruptcy and insolvency events, material judgments, cross defaults to certain other indebtedness and events constituting a change of control. The occurrence of an event of default will increase the applicable rate of interest by 2.0% and could result in the acceleration of our obligations under the new credit facility, and an obligation of any or all of our U.S. subsidiaries to pay the full amount of our obligations under the new credit facility. The new credit facility matures on February 22, 2010, at which time all outstanding borrowings must be repaid and all outstanding letters of credit must be cash collateralized.

We may elect interest rates calculated at Bank of America’s prime rate (or, if greater, the average rate on overnight federal funds plus one-half of one percent) or LIBOR plus a margin based on our leverage ratio. During fiscal 2004 and fiscal 2003, no amounts were borrowed under the credit facility, however, as of January 30, 2005, $31,763,000 in issued but undrawn standby letters of credit were outstanding under the credit facility. As of January 30, 2005, we were in compliance with our financial covenants under the credit facility.

Letter of Credit Facilities

We have three unsecured commercial letter of credit reimbursement facilities for an aggregate of $125,000,000, each of which expires on July 2, 2005. As of January 30, 2005, an aggregate of $100,552,000 was outstanding under the letter of credit facilities. Such letters of credit represent only a future commitment to fund inventory purchases to which we had not taken legal title as of January 30, 2005. The latest expiration for the letters of credit issued under the facilities is November 29, 2005.

Standby Letters of Credit

As of January 30, 2005, we had issued and outstanding standby letters of credit under the credit facility in an aggregate amount of $31,763,000. The standby letters of credit were issued to secure the liabilities associated with workers’ compensation, other insurance programs and the Mississippi Debt Transaction.

OFF BALANCE SHEET ARRANGEMENTS

Operating Leases

We lease store locations, warehouses, corporate facilities, call centers and certain equipment under operating and capital leases for original terms ranging generally from 3 to 22 years. Certain leases contain renewal options for periods up to 20 years. The rental payment requirements in our store leases are typically structured as either minimum rent, minimum rent plus additional rent based on a percentage of store sales if a specified store sales threshold is exceeded, or rent based on a percentage of store sales if a specified store sales threshold or contractual obligations of the landlord have not been met. See Notes A and E to our Consolidated Financial Statements.

We have an operating lease for a 1,002,000 square foot retail distribution facility located in Olive Branch, Mississippi. The lease has an initial term of 22.5 years, expiring January 2022, with two optional five-year renewals. The lessor, an unrelated party, is a limited liability company. The construction and expansion of the distribution facility was financed by the original lessor through the sale of $39,200,000 Taxable Industrial Development Revenue Bonds, Series 1998 and 1999, issued by the Mississippi Business Finance Corporation. The bonds are collateralized by the distribution facility. As of January 30, 2005, approximately $32,180,000 was outstanding on the bonds. We are required to make annual rental payments of approximately $3,816,000, plus applicable taxes, insurance and maintenance expenses.

We have an operating lease for an additional 1,103,000 square foot retail distribution facility located in Olive Branch, Mississippi. The lease has an initial term of 22.5 years, expiring January 2023, with two optional five- year renewals. The lessor, an unrelated party, is a limited liability company. The construction of the distribution facility was financed by the original lessor through the sale of $42,500,000 Taxable Industrial Development

23

Table of Contents

Revenue Bonds, Series 1999, issued by the Mississippi Business Finance Corporation. The bonds are collateralized by the distribution facility. As of January 30, 2005, approximately $35,235,000 was outstanding on the bonds. We are required to make annual rental payments of approximately $4,181,000, plus applicable taxes, insurance and maintenance expenses.

In December 2003, we entered into an agreement to lease an additional 780,000 square foot distribution facility located in Olive Branch, Mississippi. The lease has an initial term of six years, with two optional two-year renewals. The agreement includes an option to lease an additional 333,000 square feet of the same distribution center. As of January 30, 2005, we had not exercised this option, however, we expect to exercise this option during fiscal 2005. We are required to make annual rental payments of approximately $1,927,000, plus applicable taxes, insurance and maintenance expenses.

On February 2, 2004, we entered into an agreement to lease 781,000 square feet of a distribution center located in Cranbury, New Jersey. The lease has an initial term of seven years, with three optional five-year renewals. The agreement requires us to lease an additional 219,000 square feet of the facility in the event the current tenant vacates the premises. We are required to make annual rental payments of approximately $3,397,000, plus applicable taxes, insurance and maintenance expenses.

On August 18, 2004, we entered into an agreement to lease a 500,000 square foot distribution facility located in Memphis, Tennessee. The lease has an initial term of four years, with one optional three-year and nine-month renewal. We are required to make annual rental payments of approximately $1,025,000, plus applicable taxes, insurance and maintenance expenses.

In November 2002, the FASB issued FIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” which requires certain guarantees to be recorded at fair value. In general, the interpretation applies to contracts or indemnification agreements that contingently require the guarantor to make payments to the guaranteed party based on changes in an underlying obligation that is related to an asset, liability, or an equity security of the guaranteed party. We leased an aircraft over a term of 60 months, which ended in January 2005. At the end of the lease term, the lease allowed us to either purchase the aircraft for $11,500,000 or sell it. If the proceeds were less than $11,500,000, we were required to pay the lessor the difference up to $9,080,000. In January 2005, we purchased the aircraft for $11,500,000 and the lessor released our guarantee requirements.

In addition, we are party to a variety of contractual agreements under which we may be obligated to indemnify the other party for certain matters. These contracts primarily relate to our commercial contracts, operating leases, trademarks, intellectual property, financial agreements and various other agreements. Under these contracts, we may provide certain routine indemnifications relating to representations and warranties or personal injury matters. The terms of these indemnifications range in duration and may not be explicitly defined. Historically, we have not made significant payments for these indemnifications. We believe that if we were to incur a loss in any of these matters, the loss would not have a material effect on our financial condition or results of operations.

CONSOLIDATION OF MEMPHIS-BASED DISTRIBUTION FACILITIES

Our Memphis-based distribution facilities include an operating lease entered into in July 1983 for a distribution facility in Memphis, Tennessee. The lessor is a general partnership (“Partnership 1”) comprised of W. Howard Lester, Chairman of the Board of Directors and a significant shareholder, and James A. McMahan, a Director Emeritus and a significant shareholder. Partnership 1 does not have operations separate from the leasing of this distribution facility and does not have lease agreements with any unrelated third parties.

Partnership 1 financed the construction of this distribution facility through the sale of a total of $9,200,000 of industrial development bonds in 1983 and 1985. Annual principal payments and monthly interest payments are required through maturity in December 2010. The Partnership 1 industrial development bonds are collateralized by the distribution facility and the individual partners guarantee the bond repayments. As of January 30, 2005, $2,341,000 was outstanding under the Partnership 1 industrial development bonds.

24

Table of Contents

The operating lease for this distribution facility requires us to pay annual rent of $618,000 plus interest on the bonds calculated at a variable rate determined monthly (2.3% in January 2005), applicable taxes, insurance and maintenance expenses. Although the current term of the lease expires in August 2005, we are obligated to renew the operating lease until these bonds are fully repaid.

Our other Memphis-based distribution facility includes an operating lease entered into in August 1990 for another distribution facility that is adjoined to the Partnership 1 facility in Memphis, Tennessee. The lessor is a general partnership (“Partnership 2”) comprised of W. Howard Lester, James A. McMahan and two unrelated parties. Partnership 2 does not have operations separate from the leasing of this distribution facility and does not have lease agreements with any unrelated third parties.

Partnership 2 financed the construction of this distribution facility and related addition through the sale of a total of $24,000,000 of industrial development bonds in 1990 and 1994. Quarterly interest and annual principal payments are required through maturity in August 2015. The Partnership 2 industrial development bonds are collateralized by the distribution facility and require us to maintain certain financial covenants. As of January 30, 2005, $14,659,000 was outstanding under the Partnership 2 industrial development bonds.

The operating lease for this distribution facility requires us to pay annual rent of approximately $2,600,000, plus applicable taxes, insurance and maintenance expenses. This operating lease has a term of 15 years expiring in August 2006, with three optional five-year renewal periods. We are, however, obligated to renew the lease until the bonds are fully repaid.

As of February 1, 2004, the Company adopted FIN 46R, which requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. The two partnerships described above qualify as variable interest entities under FIN 46R due to their related party relationship and our obligation to renew the leases until the bonds are fully repaid. Accordingly, the two related party variable interest entity partnerships from which we lease our Memphis-based distribution facilities were consolidated by us as of February 1, 2004. As of January 30, 2005, the consolidation had resulted in increases to our consolidated balance sheet of $18,882,000 in assets (primarily buildings), $17,000,000 in long-term debt, and $1,882,000 in other long-term liabilities. Consolidation of these partnerships did not have an impact on our net income. However, the interest expense associated with the partnerships’ long-term debt, shown as occupancy expense in fiscal 2003, is now recorded as interest expense. In fiscal 2004, this interest expense approximated $1,525,000.

IMPACT OF INFLATION

The impact of inflation on our results of operations for the past three fiscal years has not been significant.

CRITICAL ACCOUNTING POLICIES

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. The estimates and assumptions are evaluated on an on-going basis and are based on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results may differ significantly from these estimates.

We believe the following critical accounting policies affect the significant judgments and estimates used in the preparation of our consolidated financial statements.

Merchandise Inventories

Merchandise inventories, net of an allowance for excess quantities and obsolescence, are stated at the lower of cost (weighted average method) or market. We estimate a provision for damaged, obsolete, excess and slow- moving inventory based on inventory aging reports and specific identification. We reserve, based on inventory aging reports, for 50% of the cost of all inventory between one and two years old and 100% of the cost of all

25

Table of Contents

inventory over two years old. If actual obsolescence is different from our estimate, we will adjust our provision accordingly. Specific reserves are also recorded in the event the cost of the inventory exceeds the fair market value. In addition, on a monthly basis, we estimate a reserve for expected shrinkage at the concept and channel level based on historical shrinkage factors and our current inventory levels. Actual shrinkage is recorded at year-end based on the results of our physical inventory count and can vary from our estimates due to such factors as changes in operations within our distribution centers, the mix of our inventory (which ranges from large furniture to small tabletop items) and execution against loss prevention initiatives in our stores, off-site storage locations, and our third party transportation providers.

Prepaid Catalog Expenses

Prepaid catalog expenses consist of third party incremental direct costs, including creative design, paper, printing, postage and mailing costs for all of our direct response catalogs. Such costs are capitalized as prepaid catalog expenses and are amortized over their expected period of future benefit. Such amortization is based upon the ratio of actual revenues to the total of actual and estimated future revenues on an individual catalog basis. Estimated future revenues are based upon various factors such as the total number of catalogs and pages circulated, the probability and magnitude of consumer response and the assortment of merchandise offered. Each catalog is generally fully amortized over a six to nine month period, with the majority of the amortization occurring within the first four to five months. Prepaid catalog expenses are evaluated for realizability on a monthly basis by comparing the carrying amount associated with each catalog to the estimated probable remaining future profitability (remaining net revenues less merchandise cost of goods sold, selling expenses and catalog related-costs) associated with that catalog. If the catalog is not expected to be profitable, the carrying amount of the catalog is impaired accordingly.

Property and Equipment

Depreciation is computed using the straight-line method over the estimated useful lives of the assets. The decision to close, relocate, remodel or expand a store prior to the end of its lease term can result in accelerated depreciation over the revised useful life of the long-lived assets. For any early store closures where a lease obligation still exists, we record the estimated future liability associated with the rental obligation on the date the store is closed in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities.” However, most store closures occur upon the lease expiration.

We review the carrying value of all long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” we review for impairment all stores for which current cash flows from operations are negative or the construction costs are significantly in excess of the amount originally expected. Impairment results when the carrying value of the assets exceeds the undiscounted future cash flows over the life of the lease. Our estimate of undiscounted future cash flows over the lease term (typically 5 to 22 years) is based upon our experience, historical operations of the stores and estimates of future store profitability and economic conditions. The future estimates of store profitability and economic conditions require estimating such factors as sales growth, employment rates, lease escalations, inflation on operating expenses and the overall economics of the retail industry for up to twenty years in the future, and are therefore subject to variability and difficult to predict. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the carrying value and the asset’s fair value. The fair value is estimated based upon future cash flows (discounted at a rate that approximates our weighted average cost of capital) or other reasonable estimates of fair market value. See Note A to the Consolidated Financial Statements for additional information regarding property and equipment.

Self-Insured Liabilities

We are primarily self-insured for workers’ compensation, employee health benefits and product and general liability insurance. We record self-insurance liabilities based on claims filed, including the development of those claims, and an estimate of claims incurred but not yet reported. Factors affecting this estimate include future inflation rates, changes in severity, benefit level changes, medical costs, and claim settlement patterns. Should a

26

Table of Contents

different amount of claims occur compared to what was estimated or costs of the claims increase or decrease beyond what was anticipated, reserves may need to be adjusted accordingly in future periods. Our workers’ compensation liability is determined by an actuary. Reserves for self-insurance liabilities are recorded within accrued salaries, benefits and other on our consolidated balance sheet.

Revenue Recognition

We recognize revenues and the related cost of goods sold (including shipping costs) at the time the products are received by customers in accordance with the provisions of Staff Accounting Bulletin (“SAB”) No. 101, “Revenue Recognition in Financial Statements” as amended by SAB No. 104, “Revenue Recognition.” Revenue is recognized for retail sales (excluding home-delivered merchandise) at the point of sale in the store and for home-delivered merchandise and direct-to-customer sales when the merchandise is delivered to the customer. Discounts provided to customers are accounted for as a reduction of sales. We record a reserve for estimated product returns in each reporting period. Shipping and handling fees charged to the customer are recognized as revenue at the time the products are delivered to the customer.

Sales Return Reserve

Our customers may return purchased items for an exchange or refund. We record a reserve for estimated product returns, net of cost of goods sold, based on historical return trends together with current product sales performance. If actual returns, net of cost of goods sold, are different than those projected by management, the estimated sales return reserve will be adjusted accordingly.

Income Taxes

We record reserves for estimates of probable settlements of foreign and domestic tax audits. At any one time, many tax years are subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. Our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings.

Stock-Based Compensation

We account for stock options granted to employees using the intrinsic value method in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees.” Accordingly, no compensation expense has been recognized in the consolidated financial statements for stock options, as we grant all stock options with an exercise price equal to the market price of our common stock at the date of grant. SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” however, requires the disclosure of pro forma net earnings and earnings per share as if we had adopted the fair value method. Under SFAS No. 123, the fair value of stock-based awards to employees is calculated through the use of option pricing models. These models require subjective assumptions, including future stock price volatility and expected time to exercise, which affect the calculated values. Our calculations are based on a single option valuation approach, and forfeitures are recognized as they occur.

NEW ACCOUNTING PRONOUNCEMENTS

In December 2004, the FASB issued SFAS No. 123R, “Share Based Payment.” SFAS No. 123R will require us to measure and record compensation expense in our consolidated financial statements for all employee share-based compensation awards using a fair value method. In addition, the adoption of SFAS No. 123R requires additional accounting and disclosure related to the income tax and cash flow effects resulting from share-based payment arrangements. We expect to adopt this Statement using the modified prospective application transition method beginning in the third quarter of fiscal 2005. We are currently in the process of determining the impact of the adoption of this Statement on our consolidated financial statements.

In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an Amendment of ARB No. 43, Chapter 4,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and

27

Table of Contents

spoilage. We are required to adopt the provisions of SFAS No. 151 effective January 30, 2006, however, early adoption is permitted. We do not expect the adoption of this Statement to have a material impact on our consolidated financial position, results of operations or cash flows.

In December 2004, the FASB issued SFAS No. 153, “Exchange of Non-Monetary Assets – An Amendment of ARB Opinion No. 29,” which requires non-monetary asset exchanges to be accounted for at fair value. We are required to adopt the provisions of SFAS No. 153 effective January 30, 2006, however, early adoption is permitted. We do not expect the adoption of this Statement to have a material impact on our consolidated financial position, results of operations or cash flows.

RISK FACTORS

The following information describes certain significant risks and uncertainties inherent in our business. You should carefully consider such risks and uncertainties, together with the other information contained in this Annual Report on Form 10-K and in our other public filings. If any of such risks and uncertainties actually occurs, our business, financial condition or operating results could differ materially from the plans, projections and other forward-looking statements included in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report and in our other public filings. In addition, if any of the following risks and uncertainties, or if any other disclosed risks and uncertainties, actually occurs, our business, financial condition or operating results could be harmed substantially, which could cause the market price of our stock to decline, perhaps significantly.

We must successfully anticipate changing consumer preferences and buying trends, and manage our inventory commensurate with customer demand.

Our success depends upon our ability to anticipate and respond in a timely manner to changing merchandise trends and customer demands. Consumer preferences cannot be predicted with certainty and may change between sales seasons. Changes in customer preferences and buying trends may also affect our brands differently. If we misjudge either the market for our merchandise or our customers’ purchasing habits, our sales may decline significantly, and we may be required to mark down certain products to sell the resulting excess inventory or to sell such inventory through our outlet stores or other liquidation channels at prices which are significantly lower than our retail prices, each of which would negatively impact our business and operating results.

In addition, we must manage our inventory effectively and commensurate with customer demand. Much of our inventory is sourced from vendors located outside the U.S. Thus, we usually must order merchandise, and enter into contracts for the purchase and manufacture of such merchandise, well in advance of the applicable selling season and frequently before trends are known. The extended lead times for many of our purchases may make it difficult for us to respond rapidly to new or changing trends. Our vendors may also not have the capacity to handle our demands. In addition, the seasonal nature of the specialty home products business requires us to carry a significant amount of inventory prior to peak selling season. As a result, we are vulnerable to demand and pricing shifts and to misjudgments in the selection and timing of merchandise purchases. If we do not accurately predict our customers’ preferences and acceptance levels of our products, our inventory levels will not be appropriate, and our business and operating results may be negatively impacted.

Our business depends, in part, on factors affecting consumer spending that are out of our control.

Our business depends on consumer demand for our products and, consequently, is sensitive to a number of factors that influence consumer spending, including general economic conditions, disposable consumer income, fuel prices, recession and fears of recession, war and fears of war, inclement weather, consumer debt, interest rates, sales tax rates and rate increases, consumer confidence in future economic conditions and political conditions, and consumer perceptions of personal well-being and security. These factors may also affect our various brands and channels differently. Adverse changes in factors affecting discretionary consumer spending could reduce consumer demand for our products, thus reducing our sales and negatively impacting our business and operating results.

28

Table of Contents

We face intense competition from companies with brands or products similar to ours.

The specialty retail and direct-to-customer business is highly competitive. Our specialty retail stores, mail order catalogs and e-commerce websites compete with other retail stores, other mail order catalogs and other e-commerce websites that market lines of merchandise similar to ours. We compete with national, regional and local businesses utilizing a similar retail store strategy, as well as traditional furniture stores, department stores and specialty stores. The substantial sales growth in the direct-to-customer industry within the last decade has encouraged the entry of many new competitors and an increase in competition from established companies.

The competitive challenges facing us include:

In light of the many competitive challenges facing us, we may not be able to compete successfully. Increased competition could negatively impact our sales, operating results and business.

We depend on key domestic and foreign vendors for timely and effective sourcing of our merchandise, and we are subject to various risks and uncertainties that might affect our vendors’ ability to produce quality merchandise.

Our performance depends on our ability to purchase our merchandise in sufficient quantities at competitive prices. We purchase our merchandise from numerous foreign and domestic manufacturers and importers. We have no contractual assurances of continued supply, pricing or access to new products, and any vendor could change the terms upon which they sell to us or 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. Better than expected sales demand may also lead to customer backorders and lower in-stock positions of our products.

Any inability to acquire suitable merchandise on acceptable terms or the loss of one or more key vendors could have a negative effect on our business and operating results because we would be missing products that we felt were important to our assortment, unless and until alternative supply arrangements are secured. We may not be able to develop relationships with new vendors, and products from alternative sources, if any, may be of a lesser quality and/or more expensive than those we currently purchase.

In addition, we are subject to certain risks, including availability of raw materials, labor disputes, union organizing activities, vendor financial liquidity, inclement weather, natural disasters, rising fuel prices and general economic and political conditions, that could limit our vendors’ ability to provide us with quality merchandise on a timely basis and at a price that is commercially acceptable. For these or other reasons, one or more of our vendors might not adhere to our quality control standards, and we might not identify the deficiency before merchandise ships to our stores or customers. In addition, our vendors may have difficulty adjusting to our changing demands and growing business. Our vendors’ failure to manufacture or import quality merchandise in a timely and effective manner could damage our reputation and brands, and could lead to an increase in customer litigation against us and an attendant increase in our routine litigation costs.

Our dependence on foreign vendors subjects us to a variety of risks and uncertainties.

In fiscal 2004, we sourced our products from manufacturers in 38 countries outside of the United States. Approximately 62% of our merchandise purchases were foreign-sourced, primarily from Asia and Europe. Our dependence on foreign vendors means that we may be affected by declines in the relative value of the U.S. dollar to other foreign currencies. Although substantially all of our foreign purchases of merchandise are negotiated and paid for in U.S. dollars, declines in foreign currencies and currency exchange rates might negatively affect the profitability and business prospects of one or more of our foreign vendors. This, in turn, might cause such foreign vendors to demand higher prices for merchandise, delay merchandise shipments to us, or discontinue selling to us, any of which could ultimately reduce our sales or increase our costs.

29

Table of Contents

We are also subject to other risks and uncertainties associated with changing economic and political conditions in foreign countries. These risks and uncertainties include import duties and quotas, concerns over anti-dumping, work stoppages, economic uncertainties (including inflation), foreign government regulations, war and fears of war, political unrest, natural disasters, rising fuel prices and other trade restrictions. We cannot predict whether any of the countries in which our products are currently manufactured or may be manufactured in the future will be subject to trade restrictions imposed by the U.S. or foreign governments or the likelihood, type or effect of any such restrictions. Any event causing a disruption or delay of imports from foreign vendors, including the imposition of additional import restrictions, restrictions on the transfer of funds and/or increased tariffs or quotas, or both, against home-centered items could increase the cost or reduce the supply of merchandise available to us and adversely affect our business, financial condition and operating results. Furthermore, some or all of our foreign vendors’ operations may be adversely affected by political and financial instability resulting in the disruption of trade from exporting countries, restrictions on the transfer of funds and/or other trade disruptions.

In addition, although we continue to improve our global compliance program, there remains a risk that one or more of our foreign vendors will not adhere to our global compliance standards such as fair labor standards and the prohibition on child labor. Non-governmental organizations might attempt to create an unfavorable impression of our sourcing practices or the practices of some of our vendors that could harm our image. If either of these occurs, we could lose customer goodwill and favorable brand recognition, which could negatively affect our business and operating results.

The growth of our sales and profits depends, in large part, on our ability to successfully open new stores.

In each of the past three fiscal years, approximately 60% of our net revenues have been generated by our retail stores. During 2004, we opened 43 new and 17 remodeled retail stores as part of our growth strategy. The growth of our sales and profits depend, in large part, on our ability to successfully open new stores.

Our ability to open additional stores successfully will depend upon a number of factors, including:

Many of these factors are beyond our control. For example, for the purpose of identifying suitable store locations, we rely, in part, on demographic surveys regarding the location of consumers in our target market segments. While we believe that the surveys and other relevant information are helpful indicators of suitable store locations, we recognize that the information sources cannot predict future consumer preferences and buying trends with complete accuracy. In addition, changes in demographics, in the types of merchandise that we sell and in the pricing of our products may reduce the number of suitable store locations. Further, time frames for lease negotiations and store development vary from location to location and can be subject to unforeseen delays. Construction and other delays in store openings could have a negative impact on our business and operating results. We may not be able to open new stores or, if opened, operate those stores profitably.

We must timely and effectively deliver merchandise to our stores and customers.

We cannot control all of the various factors that might affect our fulfillment rates in direct-to-customer sales and timely and effective merchandise delivery to our stores. We rely upon third party carriers for our merchandise shipments and reliable data regarding the timing of those shipments, including shipments to our customers and to and from all of our stores. Accordingly, we are subject to the risks, including labor disputes such as the west coast port strike of 2002, union organizing activity, inclement weather, natural disasters, and possible acts of

30

Table of Contents

terrorism associated with such carriers’ ability to provide delivery services to meet our shipping needs. Failure to deliver merchandise in a timely and effective manner could damage our reputation and brands. In addition, fuel costs have increased substantially and airline companies struggle to operate profitably, which could lead to increased fulfillment expenses. The increased fulfillment costs could negatively affect our business and operating results by increasing our transportation costs and, therefore, decreasing the efficiency of our shipments.

Our failure to successfully manage our order-taking and fulfillment operations and our e-commerce websites could have a negative impact on our business.

The operation of our direct-to-customer business depends on our ability to maintain the efficient and uninterrupted operation of our order-taking and fulfillment operations and our e-commerce websites. Disruptions or slowdowns in these areas could result from disruptions in telephone service or power outages, inadequate system capacity, system issues, security breaches, human error, changes in programming, union organizing activity, natural disasters or adverse weather conditions. These problems could result in a reduction in sales as well as increased selling, general and administrative expenses.

In addition, we face the risk that we cannot hire enough qualified employees, especially during our peak season, to support our direct-to-customer operations, due to war or other circumstances that reduce the relevant workforce. The need to operate with fewer employees could negatively impact our customer service levels and our operations.

Our facilities and systems, as well as those of our vendors, are vulnerable to natural disasters and other unexpected events, and any of these events could result in an interruption in our business.

Our corporate offices, distribution centers, infrastructure projects and direct-to-customer operations, as well as the operations of vendors from which we receive goods and services, are vulnerable to damage from earthquakes, fire, floods, power loss, telecommunications failures, and similar events. If any of these events results in damage to our facilities or systems, or those of our vendors, we may experience interruptions in our business until the damage is repaired, resulting in the potential loss of customers and revenues. In addition, we may incur costs in repairing any damage beyond our applicable insurance coverage.

We experience fluctuations in our comparable store sales.

Our success depends, in part, upon our ability to increase sales at our existing stores. Various factors affect comparable store sales, including the number of stores we open, close and expand in any period, the general retail sales environment, consumer preferences and buying trends, changes in sales mix among distribution channels, our ability to efficiently source and distribute products, changes in our merchandise mix, competition, current local and global economic conditions, the timing of our releases of new merchandise and promotional events, the success of marketing programs, and the cannibalization of existing store sales by new stores. Among other things, weather conditions can affect comparable store sales because inclement weather can require us to close certain stores temporarily and thus reduce store traffic. Even if stores are not closed, many customers may decide to avoid going to stores in bad weather. These factors may cause our comparable store sales results to differ materially from prior periods and from earnings guidance we have provided.

Our comparable store sales have fluctuated significantly in the past on an annual, quarterly and monthly basis, and we expect that comparable store sales will continue to fluctuate in the future. Our comparable store sales increases for fiscal years 2004, 2003 and 2002 were 3.5%, 4.0% and 2.7%, respectively. Past comparable store sales are no indication of future results, and comparable store sales may decrease in the future. Our ability to maintain and improve our comparable store sales results depends in large part on maintaining and improving our forecasting of customer demand and buying trends, selecting effective marketing techniques, providing an appropriate mix of merchandise for our broad and diverse customer base and using more effective pricing strategies. Any failure to meet the comparable store sales expectations of investors and security analysts in one or more future periods could significantly reduce the market price of our common stock.

31

Table of Contents

Our failure to successfully manage the costs and performance of our catalog mailings might have a negative impact on our business.

Postal rate increases, paper costs, printing costs and other catalog distribution costs affect the cost of our catalog mailings. We rely on discounts from the basic postal rate structure, such as discounts for bulk mailings and sorting by zip code and carrier routes. Our cost of paper has fluctuated significantly during the past three fiscal years, and our paper costs are expected to increase in the future. Although we have entered into a long-term contract for catalog printing, this contract offers no assurance that our catalog production costs will not substantially increase following its expiration. Future increases in postal rates or paper or printing costs would have a negative impact on our operating results to the extent that we are unable to pass such increases on directly to customers or offset such increases by raising prices or by implementing more efficient printing, mailing, delivery and order fulfillment systems.

We have historically experienced fluctuations in customer response to our catalogs. Customer response to our catalogs is substantially dependent on merchandise assortment, merchandise availability and creative presentation, as well as the sizing and timing of delivery of the catalogs. In addition, environmental organizations may attempt to create an unfavorable impression of our paper use in catalogs. The failure to effectively produce or distribute our catalogs could affect the timing of catalog delivery, which could cause customers to forego or defer purchases.

We must successfully manage our Internet business.

The success of our Internet business depends, in part, on factors over which we have limited control. In addition to changing consumer preferences and buying trends relating to Internet usage, we are vulnerable to certain additional risks and uncertainties associated with the Internet, including changes in required technology interfaces, website downtime and other technical failures, changes in applicable federal and state regulation, security breaches, and consumer privacy concerns. Our failure to successfully respond to these risks and uncertainties might adversely affect the sales in our Internet business, as well as damage our reputation and brands.

Our failure to successfully anticipate merchandise returns might have a negative impact on our business.

We record a reserve for merchandise returns based on historical return trends together with current product sales performance in each reporting period. If actual returns are greater than those projected by management, additional sales returns might be recorded in the future. Actual merchandise returns may exceed our reserves. In addition, to the extent that returned merchandise is damaged, we may not receive full retail value from the resale or liquidation of the merchandise. Further, the introduction of new merchandise, changes in merchandise mix, changes in consumer confidence, or other competitive and general economic conditions may cause actual returns to exceed merchandise return reserves. Any significant increase in merchandise returns that exceeds our reserves could negatively impact our business and operating results.

We must successfully manage the complexities associated with a multi-channel and multi-brand business.

During the past few years, with the launch and expansion of our Internet business, new brands and brand expansions, our overall business has become substantially more complex. The changes in our business have forced us to develop new expertise and face new challenges, risks and uncertainties. For example, we face the risk that our Internet business might cannibalize a significant portion of our retail and catalog businesses. While we recognize that our Internet sales cannot be entirely incremental to sales through our retail and catalog channels, we seek to attract as many new customers as possible to our e-commerce websites. We continually analyze the business results of our three channels and the relationships among the channels, in an effort to find opportunities to build incremental sales. However, as our Internet business grows and as we add e-commerce websites for more of our concepts, these increased Internet sales may cannibalize a portion of our retail and catalog businesses.

32

Table of Contents

We may not be able to introduce new brands and brand extensions, or to re-position existing brands, to improve our business.

We have recently introduced three new brands – West Elm, PBteen and Williams-Sonoma Home, and repositioned our Hold Everything brand, and may introduce new brands and brand extensions, or reposition existing brands, in the future. If we devote time and resources to new brands, brand extensions or brand repositioning, and those businesses are not as successful as we planned, then we risk damaging our overall business results. Alternatively, if our new brands, brand extensions or repositioned brands prove to be very successful, we risk hurting our other existing brands through the potential migration of existing brand customers to the new businesses. We may not be able to introduce new brands, brand extensions or to reposition brands in a manner that improves our overall business and operating results.

Our inability to obtain commercial insurance at acceptable prices might have a negative impact on our business.

Insurance costs continue to be volatile, affected by natural catastrophes, fear of terrorism and financial irregularities and other fraud at publicly-traded companies. We believe that commercial insurance coverage is prudent for risk management and insurance costs may increase substantially in the future. In addition, for certain types or levels of risk, such as risks associated with earthquakes or terrorist attacks, we might determine that we cannot obtain commercial insurance at acceptable prices. Therefore, we might choose to forego or limit our purchase of relevant commercial insurance, choosing instead to self-insure one or more types or levels of risks. If we suffer a substantial loss that is not covered by commercial insurance, the loss and attendant expenses could negatively impact our business and operating results.

Our inability or failure to protect our intellectual property would have a negative impact on our business.

Our trademarks, service marks, copyrights, patents, trade dress rights, trade secrets, domain names and other intellectual property are valuable assets that are critical to our success. The unauthorized reproduction or other misappropriation of our intellectual property could diminish the value of our brands or goodwill and cause a decline in our sales. We may not be able to adequately protect our intellectual property. In addition, the costs of defending our intellectual property may adversely affect our operating results.

We have been sued and may be named in additional lawsuits in a growing number of industry-wide business method patent litigation cases relating to our business operations.

There appears to be a growing number of business method patent infringement lawsuits instituted against companies such as ours. The plaintiff in each case claims to hold a patent that covers certain technology or methodologies which are allegedly infringed by the operation of the defendants’ business. We are currently a defendant in such patent infringement cases and may be named in others in the future, as part of an industry-wide trend. Even in cases where a plaintiff’s claim lacks merit, the defense costs in a patent infringement case can be high. Additional patent infringement claims may be brought against us, and the cost of defending such claims or the ultimate resolution of such claims may negatively impact our business and operating results.

We need to successfully manage our employment, occupancy and other operating costs.

To be successful, we need to manage our operating costs and continue to look for opportunities to reduce costs. We recognize that we may need to increase the number of our employees, especially in peak sales seasons, and incur other expenses to support new brands and brand extensions, as well as the opening of new stores and direct-to-customer growth of our existing brands. Although we strive to secure long-term contracts with our service providers and other vendors and to otherwise limit our financial commitment to them, we may not be able to avoid unexpected operating cost increases in the future. In addition, there appears to be a growing number of wage and hour lawsuits against retail companies, especially in California. We are currently a defendant in such cases and may be named in others in the future.

From time to time we may also experience union organizing activity in currently non-union distribution facilities, stores and direct-to-customer operations. Union organizing activity may result in work slowdowns or stoppages

33

Table of Contents

and higher labor costs, which would harm our business and operating results. Further, we incur substantial costs to warehouse and distribute our inventory. Significant increases in our inventory levels may result in increased warehousing and distribution costs. Higher than expected costs, particularly if coupled with lower than expected sales, would negatively impact our business and operating results.

We are planning certain systems changes that might disrupt our supply chain operations.

Our success depends on our ability to source and distribute merchandise efficiently through appropriate systems and procedures. We are in the process of substantially modifying our information technology systems supporting the product pipeline, including design, sourcing, merchandise planning, forecasting and purchase order, inventory, distribution, transportation and price management. Modifications will involve updating or replacing legacy systems with successor systems during the course of several years. There are inherent risks associated with replacing our core systems, including supply chain and merchandising systems disruptions that affect our ability to get the correct products into the appropriate stores and delivered to customers. We may not successfully launch these new systems, or the launch may result in supply chain and merchandising systems disruptions. Any such disruptions could negatively impact our business and operating results.

We are implementing changes to our data center information technology infrastructure that might disrupt our business and cost more than expected.

We have engaged IBM to host and manage certain aspects of our data center information technology infrastructure. Accordingly, we are subject to the risks associated with IBM’s ability to provide information technology services to meet our needs. Our operations will depend significantly upon IBM’s and our ability to make our servers, software applications and websites available and to protect our data from damage or interruption from human error, computer viruses, intentional acts of vandalism, labor disputes, natural disasters and similar events. If the cost of IBM hosting and managing certain aspects of our data center information technology infrastructure is more than expected, or if IBM or we are unable to adequately protect our data and information is lost or our ability to deliver our services is interrupted, then our business and results of operations may be negatively impacted.

Our operating and financial performance in any given period might not meet the extensive guidance that we have provided to the public.

We provide extensive public guidance on our expected operating and financial results for future periods. Although we believe that this guidance provides investors and analysts with a better understanding of management’s expectations for the future, and is useful to our shareholders and potential shareholders, such guidance is comprised of forward-looking statements subject to the risks and uncertainties described in this report and in our other public filings and public statements. Our guidance may not always be accurate. If in the future our operating or financial results for a particular period do not meet our guidance or the expectations of investment analysts or if we reduce our guidance for future periods, the market price of our common stock could decline.

Our quarterly results of operations might fluctuate due to a variety of factors, including seasonality.

Our quarterly results have fluctuated in the past and may fluctuate in the future, depending upon a variety of factors, including shifts in the timing of holiday selling seasons, including Valentine’s Day, Easter, Halloween, Thanksgiving and Christmas, and the strategic importance of fourth quarter results. A significant portion of our revenues and net earnings have been realized during the period from October through December. In anticipation of increased holiday sales activity, we incur certain significant incremental expenses, including the hiring of a substantial number of temporary employees to supplement our existing workforce. If, for any reason, we were to realize significantly lower-than-expected revenues or net earnings during the October through December selling season, our business and results of operations would be materially adversely affected.

34

Table of Contents

We may require external funding sources for operating funds.

We regularly review and evaluate our liquidity and capital needs. We currently believe that our available cash, cash equivalents, cash flow from operations and cash available under our existing credit facilities will be sufficient to finance our operations and expected capital requirements for at least the next twelve months. However, as we continue to grow, we might experience peak periods for our cash needs during the course of our fiscal year, and we might need additional external funding to support our operations. Although we believe we would have access to additional debt and/or capital market funding if needed, such funds may not be available to us on acceptable terms. If the cost of such funds is greater than expected, it could adversely affect our expenses and our operating results.

We are exposed to potential risks from recent legislation requiring companies to evaluate controls under Section 404 of the Sarbanes-Oxley Act of 2002.

We have evaluated our internal controls in order to allow management to report on, and our registered independent public accounting firm to attest to, our internal controls, as required by Section 404 of the Sarbanes-Oxley Act of 2002. We have performed the system and process evaluation and testing required in an effort to comply with the management certification and auditor attestation requirements of Section 404. As a result, we have incurred significant additional expenses and a diversion of management’s time. If we are not able to continue to meet the requirements of Section 404 in a timely manner or with adequate compliance, we might be required to disclose material weaknesses if they develop or are uncovered and we may be subject to sanctions or investigation by regulatory authorities, such as the SEC or the NYSE. Any such action could negatively impact the financial market’s perception of us and our business.

Changes to existing accounting rules or regulations may adversely affect our results of operations.

Changes to existing accounting rules or regulations may impact our future results of operations. For example, on December 16, 2004, the FASB issued SFAS No. 123R, “Share Based Payment,” which will require us, starting in the third quarter of fiscal year 2005, to measure and record compensation expense for all employee share-based compensation awards using a fair value method. Other new accounting rules or regulations and varying interpretations of existing accounting rules or regulations have occurred and may occur in the future. Future changes to accounting rules or regulations or the questioning of current accounting practices, may adversely affect our results of operations.

Changes to estimates related to our property and equipment, or results that are lower than our current estimates at certain store locations, may cause us to incur impairment charges.

We make certain estimates and projections in connection with impairment analyses for certain of our store locations in accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long-Lived Assets.” We review for impairment all stores for which current cash flows from operations are negative or the construction costs are significantly in excess of the amount originally expected. Impairment results when the carrying value of the asset exceeds the undiscounted future cash flows over the life of the lease. These calculations require us to make a number of estimates and projections of future results, often up to twenty years into the future. If these estimates or projections change or prove incorrect, we may be required to take impairment charges on certain of these store locations. If these impairment charges are significant, our results of operations would be adversely affected.

35

Table of Contents

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risks, which include changes in U.S. interest rates and foreign exchange rates. We do not engage in financial transactions for trading or speculative purposes.

Interest Rate Risk

The interest payable on our credit facility, industrial development bonds and the bond-related debt associated with our Memphis-based distribution facilities is based on variable interest rates and is therefore affected by changes in market interest rates. If interest rates on existing variable rate debt rose 33 basis points (an approximate 10% increase in the associated variable rates as of January 30, 2005), our results from operations and cash flows would not be materially affected.

In addition, we have fixed and variable income investments consisting of short-term investments classified as cash and cash equivalents, which are also affected by changes in market interest rates. An increase in interest rates of 10% would have an immaterial effect on the value of these investments. Declines in interest rates would, however, decrease the income derived from these investments.

Foreign Currency Risks

We purchase a significant amount of inventory from vendors outside of the U.S. in transactions that are denominated in U.S. dollars. Approximately 7% of our international purchase transactions are in currencies other than the U.S. dollar. As of January 30, 2005, any currency risks related to these transactions were not significant to us. A decline in the relative value of the U.S. dollar to other foreign currencies could, however, lead to increased purchasing costs.

As of January 30, 2005, we have 11 retail stores in Canada, which expose us to market risk associated with foreign currency exchange rate fluctuations. As necessary, we have utilized 30-day foreign currency contracts to minimize any currency remeasurement risk associated with intercompany assets and liabilities of our Canadian subsidiary. These contracts are accounted for by adjusting the carrying amount of the contract to market and recognizing any gain or loss in selling, general and administrative expenses in each reporting period. We did not enter into any new foreign currency contracts during fiscal 2004. Any gain or loss associated with these contracts in prior years was not material to us.

36

Table of Contents

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Williams-Sonoma, Inc.

Consolidated Statements of Earnings

See Notes to Consolidated Financial Statements.

37

Table of Contents

Williams-Sonoma, Inc.

Consolidated Balance Sheets

See Notes to Consolidated Financial Statements.

38

Table of Contents

Williams-Sonoma, Inc.

Consolidated Statements of Shareholders’ Equity