**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

**FORM 10-K**

**(MARK ONE)**

**x**                              Annualreport pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**Forthe fiscal year ended JANUARY 29, 2005**

**or**

**o**                                 Transitionreport pursuant to Section 13 or 15(d) of the Securities Exchange Actof 1934

**Forthe transition periodfrom                   to                   **

**Commissionfile number 000-24261**

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RESTORATION HARDWARE, INC.

(Exact Name of Registrantas Specified in Its Charter)

| DELAWARE                                                            | **68-0140361**                         |
|---------------------------------------------------------------------|----------------------------------------|
| **(State or Other Jurisdiction of  Incorporation or Organization)** | **(IRS Employer  Identification No.)** |

**15KOCH ROAD, SUITE J, CORTE MADERA, CA 94925**

(Address of PrincipalExecutive Offices) (Zip Code)

**(415) 924-1005**

(Registrant’s TelephoneNumber, Including Area Code)

Securities registeredpursuant to Section 12(b) of the Act: **None**

| Title of each class | ** ** | **Name of each exchange   on which registered** |
|---------------------|------------|-------------------------------------------------|
| NONE                |       | NONE                                            |

Securities registeredpursuant to Section 12 (g) of the Act:

**COMMON STOCK, $0.0001 PARVALUE**

(Title of class)

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed by Section 13or 15 (d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementfor the past 90 days.  x  Yes     ̈  No

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405of this chapter) is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K.    ̈

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

The aggregate market valueof common stock, par value $0.0001 per share, held by non-affiliates of theregistrant based on the closing price for the common stock on The NasdaqNational Market on the last business day of the registrant’s most recentlycompleted fiscal second quarter (July 31, 2004), was approximately $216 million.For purposes of this calculation, the registrant has assumed that only sharesbeneficially held by executive officers and directors of the registrant aredeemed shares held by affiliates of the registrant. This assumption ofaffiliate status is not necessarily a conclusive determination of affiliatestatus for any other purpose.

33,103,829shares of the registrant’s common stock were outstanding on April 1, 2005.

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**TABLE OF CONTENTS**
|               | ** ** | ** **                                                                                                                      | ** ** | **PAGE** |
|---------------|------------|---------------------------------------------------------------------------------------------------------------------------------|------------|----------|
| PART I   |       |                                                                                                                            |       |     |   |   |
| Item 1.       |       | Business                                                                                                                        |       |     | 3 |   |
| Item 2.       |       | Properties                                                                                                                      |       |     | 14 |   |
| Item 3.       |       | Legal Proceedings                                                                                                               |       |     | 15 |   |
| Item 4.       |       | Submission of Matters to a Vote of  Security Holders                                                                            |       |     | 15 |   |
| PART II  |       |                                                                                                                            |       |     |   |   |
| Item  5.      |       | Market for Registrant’s Common  Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities              |       |     | 16 |   |
| Item 6.       |       | Selected Financial Data                                                                                                         |       |     | 17 |   |
| Item 7.       |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations       |       |     | 18 |   |
| Item  7A      |       | Quantitative and Qualitative  Disclosures About Market Risk                                                                     |       |     | 32 |   |
| Item 8.       |       | Consolidated Financial Statements  and Supplementary Data                                                                       |       |     | 33 |   |
| Item 9.       |       | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                  |       |     | 61 |   |
| Item  9A      |       | Controls and Procedures                                                                                                         |       |     | 61 |   |
| Item  9B      |       | Other Information                                                                                                               |       |     | 62 |   |
| PART III |       |                                                                                                                            |       |     |   |   |
| Item  10.     |       | Directors and Executive Officers  of the Registrant                                                                             |       |     | 63 |   |
| Item  11.     |       | Executive Compensation                                                                                                          |       |     | 63 |   |
| Item  12.     |       | Security Ownership of Certain  Beneficial Owners and Management and Related Stockholder Matters                  |       |     | 63 |   |
| Item  13.     |       | Certain Relationships and Related  Transactions                                                                                 |       |     | 63 |   |
| Item  14.     |       | Principal Accountant Fees and  Services                                                                                         |       |     | 63 |   |
| PART IV  |       |                                                                                                                            |       |     |   |   |
| Item  15.     |       | Exhibits and Consolidated Financial  Statement Schedules                                                                        |       |     | 64 |   |
| SIGNATURES    |       |                                                                                                                            | 65         |     |
| SCHEDULE II   |       |                                                                                                                            | 66         |     |
| EXHIBIT INDEX |       |                                                                                                                            | 67         |     |

 

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This annual report on Form 10-Kcontains forward-looking statements that are based on the beliefs of, andestimates made by and information currently available to, our management. Thewords “believe,” “anticipate,” “expect,” “may,” “intend,” “plan” and similarexpressions identify forward-looking statements. These statements are subjectto risks and uncertainties. Actual results could differ materially from thosediscussed here. Factors that could cause or contribute to such differencesinclude, but are not limited to, those discussed below in “Factors That May AffectOur Future Operating Results” and elsewhere in this annual report on Form 10-K.We assume no obligation to update this information.

**DocumentsIncorporated by Reference**

Portions of the registrant’sproxy statement for its 2005 annual meeting of stockholders are incorporated byreference into Item 5 of Part II and Items 10, 11, 12, 13 and 14 of Part IIIof this Form 10-K.

**PART I**

**ITEM 1.     BUSINESS**

Our Company, Restoration Hardware, Inc., togetherwith our subsidiaries, is a specialty retailer of hardware, bathware,furniture, lighting, textiles, accessories and related merchandise thatreflects our classic and authentic American point of view. We commencedbusiness in 1979 as a purveyor of fittings and fixtures for older homes. Sincethen, we have evolved into a unique home furnishings retailer offeringconsumers an array of distinctive and high quality merchandise. Our merchandisestrategy and our stores’ architectural style create a unique and attractiveselling environment designed to appeal to an affluent, well educated 35 to60 year old customer. Our plan is to fill the void in the marketplaceabove the current home lifestyle retailers, and below the interior designtrade.

We were incorporated in California in June 1987and were reincorporated in Delaware in 1998. We operated 102 stores and oneoutlet store in 30 states, the District of Columbia and in Canada at January 29,2005. We operate on a 52 - 53 week fiscal year ending on the Saturdayclosest to January 31. The fiscal years ended January 29, 2005 (“fiscal2004”), January 31, 2004 (“fiscal 2003”), and February 1, 2003 (“fiscal2002”) consisted of 52 weeks.

In addition to our retail stores, we operate adirect-to-customer (“direct”) sales channel, which includes both catalog andInternet, and a wholly-owned furniture manufacturer. For additional informationon our business segments, see Note 13 to our consolidated financialstatements in Part II, Item 8 of this annual report on Form 10-K.

We are a multi-channel business and our catalogdistribution drives sales across our retail, catalog and Internet businesses. Weuse our catalog as our primary marketing vehicle, marketing to new customersand return customers, both in and outside the retail trade area. We believe ourcatalog is a key resource to further market our brand to all our current andnew customers.

We launched a new merchandising strategy in April 2002,which included new merchandise offerings, adjustments of overall product mix,and the remodeling of our stores in order to best present the new merchandise. Inaddition, to drive sales in our direct channels we expanded our productassortment of catalog and Internet only items. In 2003, we built on the prioryear’s successful launch by refining and expanding our core merchandiseofferings, which include premium textiles, bath fixtures and hardware,lighting, and furniture and in 2004, we re-merchandised our furnitureassortment and revamped our accessories offering. We also redesigned ourcatalog in 2004 to improve the presentation of our core businesses and moreclearly communicate the quality positioning of our offerings. Our customershave responded positively to the new merchandise introductions presented in allchannels. We intend to further build on our core merchandise offerings in 2005.This shift will require some additional fixturing in our 

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retail stores toaccomplish the presentation of the expanded assortment. Our catalog andInternet presentations will also reflect this expanded assortment.

In fiscal 2004, we opened one traditional retailstore, remodeled another and opened our first outlet store. The outlet storestrategy enables us to more effectively liquidate overstocked, discontinued,damaged merchandise and over time, we believe will eliminate the need for theless productive warehouse sales events that we have historically held.

During fiscal 2004, we continued other programsinitiated in prior years to improve the operating results of the Company, whichincluded the improvement of selling margins through sourcing changes, inparticular, the expansion of our international sourcing. We also effectedsignificant changes in management in fiscal 2004 particularly in the area ofoperations, including the hiring of a new Chief Operating Officer and thehiring into the new role of Senior Vice President of Supply Chain. We believethese initiatives and added operational leadership will provide a strongfoundation for margin expansion, operational efficiencies and cost reductionsas well as provide a springboard for future growth.

We make available free ofcharge through our website at *www.restorationhardware.com*under “Company Information,” our annual reports on Form 10-K; quarterlyreports on Form 10-Q; current reports on Form 8-K; and amendments tothese and other reports filed or furnished by us pursuant to Section 13(a) or15(d) of the Securities Exchange Act of 1934, as soon as reasonablypracticable after we file such materials with the Securities and ExchangeCommission.

**RETAIL STORES**

***Merchandising Mix***

We offer a broad but carefully edited selection ofmerchandise that provides a consistent point of view throughout our stores. Ourcollection of merchandise, not traditionally found in a single storeenvironment, includes hardware, bathware, furniture, lighting, textiles andrelated merchandise. Our merchandise mix also includes proprietary productsselected from non-traditional distribution channels that appear unique to ourcustomers.

Thepercentage of total revenue contributed by major merchandising categories wasas follows:
| ** **               | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|--------------------------|------------|----------|------------|----------|------------|----------|------------|
| Home furnishings         |       |     | 55         | %        |       |     | 52         | % |   |   | 51 | % |   |
| Hardware and accessories |       |     | 45         | %        |       |     | 48         | % |   |   | 49 | % |   |

 

The home furnishingscategory includes furniture, lighting and textiles. The hardware andaccessories category includes bath and other functional and decorativehardware; vases, frames and other accessories; seasonal merchandise such asholiday and garden; and gift items.

***Product Selection, Purchasing and Sourcing***

We make merchandisepurchases from over 500 vendors and source some of our furniture through ourwholly-owned subsidiary, The Michaels Furniture Company, Inc. Only onevendor, (at 7%) accounted for more than 5% of aggregate merchandise purchasesin fiscal 2004. Our vendors include major domestic manufacturers, specialtyniche manufacturers and importers. We maintain agents in China, England,France, Japan, India, Portugal and Eastern Europe, and our merchandising teamtravels to Asia and Europe in search of new products. Approximately 60% of ourpurchases are sourced from vendors located abroad. By sourcing a largeproportion of products offshore, we seek to achieve increased buyingeffectiveness and ensure exclusivity for a portion of our product line. In manyinstances, we also work closely with our vendors to develop products that areunique to us.

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**DIRECT-TO-CUSTOMER—CATALOGAND INTERNET**

Our catalog business complements our retail businessby building customer awareness of our merchandise concepts, increasing customertraffic in our stores, enhancing brand image and acting as an effectiveadvertising vehicle. In addition, we maintain a website, *www.restorationhardware.com*,designed to sell our products, promote consumer awareness of RestorationHardware and generate store traffic.

In fiscal 2004, wedistributed approximately 15% more catalogs than in fiscal 2003. We mailcatalogs to persons with demographic profiles similar to those of our retailcustomers and who also possess previous mail order purchase histories. Infiscal 2004, approximately 63% of catalogs were circulated to past customers,and the remaining catalogs were mailed to prospects. These prospects wereobtained primarily from customer lists of other high-end mail order companiessharing similar customer demographics. We outsource to a third party thefulfillment aspects of the direct-to-customer business, including customerservice and non-furniture distribution.

**THE MICHAELSFURNITURE COMPANY, INC.**

Purchased by RestorationHardware in 1998, The Michaels Furniture Company, Inc. (“Michaels”) offersa line of high quality furniture for the home and office. Specific productlines include bedroom, living room, dining room, home office and occasionalitems. Intercompany sales to Restoration Hardware represented virtually all ofMichaels’ total sales during fiscal 2004, and this is expected to continue.Michaels is located in Sacramento, California.

**MANAGEMENTINFORMATION SYSTEMS**

Our retail managementinformation systems include integrated store, merchandising, distribution andfinancial systems. We utilize one vendor for our point-of-sale, merchandisemanagement and warehouse management systems, and rely on that vendor forsoftware support as well.

**COMPETITION**

The retail market ishighly competitive. We compete against a diverse group of retailers rangingfrom specialty stores to traditional furniture stores and department stores.Our product offerings also compete with a variety of national, regional andlocal retailers. We also compete with these and other retailers for customers,suitable retail locations, suppliers and qualified employees and managementpersonnel. Many of our competitors have significantly greater financial,marketing and other resources. Moreover, increased competition may result, andhas resulted, in potential or actual litigation between us and our competitorsrelating to such activities as competitive sales and hiring practices,exclusive relationships with key suppliers and manufacturers and other matters.As a result, increased competition may adversely affect our financialperformance, and we cannot assure you that we will be able to competesuccessfully in the future.

We believe that ourability to compete successfully is determined by several factors, including,among other things, the strength of our management team, the breadth andquality of our product selection, effective merchandise presentation, customerservice, pricing and store locations. Although we believe that we are able to competefavorably on the basis of these factors, we may not ultimately succeed incompeting with other retailers in our market.

**TRADEMARKS**

We have registered ourtrademark “Restoration Hardware” in the United States, Mexico and Canada.Trademarks are generally valid as long as they are in use and theirregistrations typically can be renewed indefinitely so long as the marks are inuse. Our trademark is of material importance to us.

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**EMPLOYEES**

At January 29, 2005,we had approximately 1,500 full-time employees and 1,900 part-time employees.We consider our employee relations to be good.

**FACTORS THAT MAY AFFECTOUR FUTURE OPERATING RESULTS**

**We may not be ableto successfully anticipate changes in consumer trends and our failure to do somay lead to loss of sales revenue and the closing of underperforming stores.**

Our success depends on our ability to anticipate andrespond to changing merchandise trends and consumer demands in a timely manner.If, for example, we misjudge market trends, we may significantly overstockunpopular products and be forced to take significant inventory markdowns, whichwould have a negative impact on our operating results. Conversely, shortages ofpopular items could result in loss of potential sales revenue and have amaterial adverse effect on our operating results.

We believe there is a lifestyle trend toward increasedinterest in home renovation and interior decorating, and we further believe weare benefiting from such a trend. If this trend fails to continue to directlybenefit us or if there is an overall decline in the trend, we could experiencean adverse decline in consumer interest in our major product lines. Moreover,our products must appeal to a broad range of consumers whose preferences cannotalways be predicted with certainty and may change between sales seasons. If wemisjudge either the market for our merchandise or our customers’ purchasinghabits, we may experience a material decline in sales or be required to sellinventory at reduced margins. We could also suffer a loss of customer goodwillif we do not maintain a high level of quality control and service procedures orif we otherwise fail to ensure satisfactory quality of our products. Theseoutcomes may have a material adverse effect on our business, operating resultsand financial condition.

**During fiscal year2004, we closed two underperforming stores and could close additional stores inthe future.**

A material decline in sales and other adverseconditions resulting from our failure to accurately anticipate changes inmerchandise trends and consumer demands could cause us to close additionalunderperforming stores. While we believe that we benefit in the long runfinancially by closing underperforming stores and reducing nonproductive costs,the closure of such stores would subject us to additional increased short-termcosts including, but not limited to, employee severance costs, charges inconnection with the impairment of assets and costs associated with thedisposition of outstanding lease obligations.

**Our success ishighly dependent on improvements to our planning and supply chain processes.**

An important part of our efforts to achieveefficiencies, cost reductions and sales growth is the identification andimplementation of improvements to our planning, logistical and distributioninfrastructure and our supply chain, including merchandise ordering,transportation and receipt processing. An inability to improve our planning andsupply chain processes or to take full advantage of supply chain opportunitiescould result in loss of potential sales revenue, increased cost and have amaterial adverse effect on our operating results.

**Because our revenueis subject to seasonal fluctuations, significant deviations from projecteddemand for products in our inventory during a selling season could have amaterial adverse effect on our financial condition and results of operations.**

Our business is highly seasonal. We make decisionsregarding merchandise well in advance of the season in which it will be sold,particularly for the holiday selling season. The general pattern associatedwith the retail industry is one of peak sales and earnings during the holidayseason. Due to the importance of the holiday selling season, the fourth quarterof each year has historically contributed, and we expect it 

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will continue tocontribute, a disproportionate percentage of our net revenue and our grossprofit for the entire year. In anticipation of increased sales activity duringthe fourth quarter, we incur significant additional expenses both prior to andduring the fourth quarter. These expenses may include acquisition of additionalinventory, catalog preparation and mailing, advertising, in-store promotions,seasonal staffing needs and other similar items. If, for any reason, our saleswere to fall below our expectations in the fourth quarter, our business,financial condition and annual operating results may be materially adverselyaffected.

**Increased catalogand other marketing expenditures without increased revenue may have a negativeimpact on our operating results.**

Over the past several fiscal years, we havesubstantially increased the amount that we spend on catalog and other marketingcosts, and we expect to continue to invest at these increased levels in thecurrent fiscal year and in the future. As a result, if we misjudge thedirections or trends in our market, we may expend large amounts of cash thatgenerate little return on investment, which would have a negative effect on ouroperating results.

**Our quarterlyresults fluctuate due to a variety of factors and are not a meaningfulindicator of future performance.**

Our quarterly results have fluctuated in the past andmay fluctuate significantly in the future, depending upon a variety of factors,including, among other things, the mix of products sold, the timing and levelof markdowns, promotional events, store openings, closings, seasonality, remodelingsor relocations, shifts in the timing of holidays, timing of catalog releases orsales, competitive factors and general economic conditions. Accordingly, ourprofits or losses may fluctuate. Moreover, in response to competitivepressures, we may take certain pricing or marketing actions that could have amaterial adverse effect on our business, financial condition and results ofoperations. Therefore, we believe that period-to-period comparisons of ouroperating results are not necessarily meaningful and cannot be relied upon asindicators of future performance. If our operating results in any future periodfall below the expectations of securities analysts or investors, or if ouroperating results do not meet the guidance that we issue from time to time, themarket price of our shares of common stock would likely decline.

**Fluctuations incomparable store sales may cause our revenue and operating results from period-to-periodto vary.**

A variety of factors affect our comparable store salesincluding, among other things, the general retail sales environment, ourability to efficiently source and distribute products, changes in ourmerchandise mix, promotional events, the impact of competition and our abilityto execute our business strategy efficiently. Our comparable store salesincreased 7.8 % in fiscal 2004 compared to 5.2% for fiscal 2003. Pastcomparable store sales results may not be indicative of future results. As aresult, the unpredictability of our comparable store sales may cause ourrevenue and operating results to vary from quarter to quarter, and anunanticipated decline in comparable store sales may cause our stock price to fluctuate.

**We depend on anumber of key vendors to supply our merchandise and provide critical services,and the loss of any one of our key vendors may result in a loss of salesrevenue and significantly harm our operating results.**

We make merchandise purchases from over 500 vendors.Our performance depends on our ability to purchase our merchandise insufficient quantities at competitive prices. Our smaller vendors generally havelimited resources, production capacities and operating histories, and some of ourvendors have limited the distribution of their merchandise in the past. We haveno long-term purchase contracts or other contractual assurances of continuedsupply, pricing or access to new products, and any vendor or distributor coulddiscontinue selling to us at any time. We may not be able to acquire desiredmerchandise in sufficient quantities on terms acceptable to us in the future,or be able to develop relationships with new 

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vendors to expand ouroptions or replace discontinued vendors. Our inability to acquire suitablemerchandise in the future or the loss of one or more key vendors and ourfailure to replace any one or more of them may have a material adverse effecton our business, results of operations and financial condition.

In addition, a single vendor supports ourpoint-of-sale, merchandise management and warehouse management systems. We alsorely on the same vendor for software support. A failure by this vendor tosupport our management information systems adequately in the future could have amaterial adverse effect on our business, results of operations and financialcondition.

We routinely purchase products from new vendors fromtime to time, many of whom are located abroad. We cannot assure you that theywill be reliable sources of our products. Moreover, a number of thesemanufacturers and suppliers are small and undercapitalized firms that producelimited numbers of items. Given their limited resources, these firms might besusceptible to production difficulties, quality control issues and problems indelivering agreed-upon quantities on schedule. We cannot assure you that wewill be able, if necessary, to return products to these suppliers andmanufacturers and obtain refunds of our purchase price or obtain reimbursementor indemnification from them if their products prove defective. These suppliersand manufacturers also may be unable to withstand a downturn in the U.S. orworldwide economy. Significant failures on the part of these suppliers ormanufacturers could have a material adverse effect on our operating results.

In addition, many of these suppliers and manufacturersrequire extensive advance notice of our requirements in order to produceproducts in the quantities we desire. This long lead time requires us to placeorders far in advance of the time when certain products will be offered forsale, thereby exposing us to risks relating to shifts in customer demands andtrends, and any downturn in the U.S. economy.

**A disruption in anyof our distribution operations would materially affect our operating results.**

The distribution functionsfor our stores as well as all of our furniture orders are currently handledfrom our facilities in Hayward and Tracy, California and Baltimore, Maryland.Any significant interruption in the operation of any of these facilities maydelay shipment of merchandise to our stores and our customers, damage ourreputation or otherwise have a material adverse effect on our financialcondition and results of operations. Moreover, a failure to successfully coordinatethe operations of these facilities also could have a material adverse effect onour financial condition and results of operations. For example, increases inoperating income for fiscal 2004 due to higher revenue and improved productmargins were offset by increases in costs of distribution. Separately,significant disruptions to the operations of the third party vendor whohandles, among other things, the distribution and fulfillment functions for ourdirect-to-customer business on an outsourced basis could beexpected to have similar negative consequences.

**Labor activities could cause labor relationsdifficulties for us.**

As of January 29, 2005, we had approximately3,400 full and part time employees, and while we believe our relations with ouremployees are generally good, we cannot predict the effect that any futureorganizational activities will have on our business and operations. If we wereto become subject to work stoppages, we could experience disruption in ouroperations and increases in our labor costs, either of which could materiallyadversely affect our business, financial condition or results of operations.

**We are dependent onexternal funding sources, which may not make available to us sufficient fundswhen we need them.**

We have significantlyrelied and may rely in the future on external funding sources to finance ouroperations and growth. Any reduction in cash flow from operations couldincrease our external funding requirements to levels above those currentlyavailable to us. While we currently have in place a $100.0 millionrevolving credit facility, which may be increased to $150.0 million undercertain 

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circumstances,the amount available under this facility could be less than the stated amountif there is a shortfall in the availability of eligible collateral to supportthe borrowing base and reserves as established by the terms of the revolvingcredit facility. We currently believe that our cash flow from operations andfunds available under our revolving credit facility will satisfy our capitaland operating requirements for at least the next 12 months. However, theweakening of, or other adverse developments concerning, our sales performanceor adverse developments concerning the availability of credit under ourrevolving credit facility due to covenant limitations or other factors couldlimit the overall amount of funds available to us.

Our revolving creditfacility contains a subjective borrowing provision, which is a typicalrequirement in commercial credit agreements such as ours. This clause allowsour lenders to forego additional advances should they determine there has beena material adverse change in our operations, business, properties, assets,liabilities, condition or prospects or a condition or event that is reasonablylikely to result in a material adverse change in our financial position orprospects reasonably likely to result in a material adverse effect on ourbusiness, condition (financial or otherwise), operations, performance orproperties taken as a whole. However, our lenders have not notified us of anyindication that a material adverse effect exists at January 29, 2005 orthat a material adverse change has occurred. We believe that no materialadverse change has occurred and we believe that we will continue to borrow onthe line of credit to fund our operations over the term of the revolving creditfacility. We do not anticipate any changes in our business practices that wouldresult in any determination that there has been a material adverse effect inour operations, business, properties, assets, liabilities, condition orprospects. However, we cannot be certain that our lenders will not make such adetermination in the future.

In particular, we mayexperience cash flow shortfalls in the future and we may require additionalexternal funding beyond the amounts available under our revolving creditfacility. However, we cannot assure you that we will be able to raise funds onfavorable terms, if at all, or that future financing requirements would not bedilutive to holders of our capital stock. In the event that we are unable toobtain additional funds on acceptable terms or otherwise, we may be unable ordetermine not to take advantage of new opportunities or defer on taking otheractions that otherwise may be important to our operations. Additionally, we mayneed to raise funds to take advantage of unanticipated opportunities. We alsomay need to raise funds to respond to changing business conditions orunanticipated competitive pressures. If we fail to raise sufficient additionalfunds, we may be required to delay or abandon some of our planned futureexpenditures or aspects of our current operations.

**Because ourbusiness requires a substantial level of liquidity, we are dependent upon arevolving credit facility with certain restrictive covenants that limit ourflexibility.**

Our business requires substantial liquidity in orderto finance inventory purchases, the employment of sales personnel for the peakholiday period, advertising for the holiday buying season and other similaradvance expenses. As described above, we currently have in place a revolvingcredit facility that provides for an overall commitment of $100.0 million,which may be increased to $150.0 million under certain circumstances. Over thepast several years, we have entered into modifications, amendments andrestatements of this revolving credit facility, primarily to address changes inthe requirements applicable to us under the revolving credit facilitydocuments, and, most recently, to increase the stated amount of commitmentunder the facility.

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

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We have drawn upon the revolving credit facility inthe past and we expect to draw upon it in the future. As a result, failure tocomply with the terms of the revolving credit facility would entitle thesecured lenders to prevent us from further borrowing, and upon acceleration bythe lenders, they would be entitled to begin foreclosure procedures against ourassets, including accounts receivable, inventory, general intangibles,equipment, goods, and fixtures. The secured lenders would then be repaid from theproceeds of such foreclosure proceedings, using all available assets. Onlyafter such repayment and the payment of any other secured and unsecuredcreditors would the holders of our capital stock receive any proceeds from theliquidation of our assets. Our ability to comply with the terms of therevolving credit facility may be affected by events beyond our control.

**Future increases ininterest and other expense may impact our future operations.**

High levels of interest and other expense have had inthe past and could have in the future negative effects on our operations. Anincrease in the variable interest rate under our revolving credit facility,coupled with an increase in our outstanding debt, could result in materialamounts otherwise available for other business purposes being used to pay forinterest expense.

Our ability to continue to meet our future debt andother obligations and to minimize our average debt level depends on our futureoperating performance and on economic, financial, competitive and other factors.Many of these factors are beyond our control. In addition, we may need to incuradditional indebtedness in the future. We cannot assure you that our businesswill generate sufficient cash flow or that future financings will be available toprovide sufficient proceeds to meet our needs or obligations or to service ourtotal debt.

**We are subject totrade restrictions and other risks associated with our dependence on foreignimports for our merchandise.**

During fiscal year 2004, we purchased approximately60% of our merchandise directly from vendors located abroad. As an importer,our future success will depend in large measure upon our ability to maintainour existing foreign supplier relationships and to develop new ones. While werely on our long-term relationships with our foreign vendors, we have nolong-term contracts with them. Additionally, many of our imported products aresubject to existing duties, tariffs and quotas that may limit the quantity ofsome types of goods, which we may import into the United States of America. Ourdependence on foreign imports also makes us vulnerable to risks associated withproducts manufactured abroad, including, among other things, risks of damage,destruction or confiscation of products while in transit to our distributioncenters located in the United States of America, changes in import duties,tariffs and quotas, loss of “most favored nation” trading status by the UnitedStates of America in relation to a particular foreign country, work stoppages includingwithout limitation as a result of events such as longshoremen strikes,transportation and other delays in shipments including without limitation as aresult of heightened security screening and inspection processes or otherport-of-entry limitations or restrictions in the United States of America,freight cost increases, economic uncertainties, including inflation, foreigngovernment regulations, and political unrest and trade restrictions, includingthe United States of America retaliating against protectionist foreign tradepractices. Furthermore, some or all of our foreign vendors’ operations may beadversely affected by political, financial or other instabilities that areparticular to their home countries, including without limitation local acts ofterrorism or economic, environmental or health and welfare-related crises,which may in turn result in limitations or temporary or permanent halts totheir operations, restrictions on the transfer of goods or funds and/or othertrade disruptions. If any of these or other factors were to render the conductof business in particular countries undesirable or impractical, our financialcondition and results of operations could be materially adversely affected.

While we believe that we could find alternativesources of supply, an interruption or delay in supply from our foreign sources,or the imposition of additional duties, taxes or other charges on theseimports, could have a material adverse effect on our business, financialcondition and results of operations unless 

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and until alternativesupply arrangements are secured. Moreover, products from alternative sourcesmay be of lesser quality and/or more expensive than those we currentlypurchase, resulting in reduction or loss of our profit margin on such items.

**As an importer weare subject to the effects of currency fluctuations related to our purchases offoreign merchandise.**

While most of our purchases outside of the UnitedStates currently are settled in U.S. dollars, it is possible that a growingnumber of them in the future may be made in currencies other than the U.S.dollar. Historically, we have not hedged our currency risk and do not currentlyanticipate doing so in the future. However, because our financial results arereported in U.S. dollars, fluctuations in the rates of exchange between theU.S. dollar and other currencies may decrease our sales margins or otherwisehave a material adverse effect on our financial condition and results ofoperations in the future.

**Rapid growth in ourdirect-to-customer business may not be sustained and may not generate acorresponding increase in profits to our business.**

For fiscal year 2004, revenue through ourdirect-to-customer channel grew by 75% as compared to the prior fiscal year.Increased activity in our direct-to-customer business could result in materialchanges in our operating costs, including increased merchandise inventory costsand costs for paper and postage associated with the distribution and shippingof catalogs and products. Although we intend to attempt to mitigate the impactof these increases by improving sales revenue and efficiencies, we cannotassure you that we will succeed in mitigating expenses with increasedefficiency or that cost increases associated with our direct-to-customer businesswill not have an adverse effect on the profitability of our business.Additionally, while we outsource to a third party the fulfillment of ourdirect-to-customer division, including customer service and non-furnituredistribution, the third party may not have the capacity to accommodate ourgrowth. This lack of capacity may result in delayed customer orders anddeficiencies in customer service, both of which may adversely affect ourreputation, cause us to lose sales revenue and limit or counter recent growthin our direct-to-customer business.

**We depend on key personneland could be affected by the loss of their services because of the limitednumber of qualified people in our industry.**

The success of our business will continue to dependupon our key personnel, including our President, Chief Executive Officer, and Chairmanof the Board, Gary Friedman. Competition for qualified employees and personnelin the retail industry is intense. The process of locating personnel with thecombination of skills and attributes required to carry out our goals is oftenlengthy. Our success depends to a significant degree upon our ability toattract, retain and motivate qualified management, marketing and salespersonnel, in particular store managers, and upon the continued contributionsof these people. We cannot assure you that we will be successful in attractingand retaining qualified executives and personnel. In addition, our employeesmay voluntarily terminate their employment with us at any time. We also do notmaintain any key man life insurance. The loss of the services of key personnelor our failure to attract additional qualified personnel could have a materialadverse effect on our business, financial condition and results of operations.

**Recent regulatorychanges may continue to increase our costs.**

Recent changes in the laws, regulations and rules affectingpublic companies, including the provisions of the Sarbanes-Oxley Act of 2002,have increased and may continue to increase our expenses in connection with ourcompliance with these new requirements. In particular, we have incurredincreased expenses to comply with Section 404 of the Sarbanes-Oxley Act of2002 and the rules issued in connection with it, which require managementto report on, and our registered independent public accountants to attest to,our internal control over financial reporting. Compliance with these newrequirements could also result in continued diversion of management’s time andattention, which could prove to be disruptive to 

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normal business operations.Further, the impact of these laws, regulations and rules and activities inresponse to them could also make it more difficult for us to attract and retainqualified persons to serve on our board of directors or as executive officers,which could harm our business.

**Changes in generaleconomic conditions affect consumer spending and may significantly harm ourrevenue and results of operations.**

The success of our business depends to a significantextent upon the level of consumer spending. A number of economic conditionsaffect the level of consumer spending on merchandise that we offer, including,among other things, the general state of the economy, general businessconditions, the level of consumer debt, interest rates, taxation and consumerconfidence in future economic conditions. More generally, reduced consumerconfidence and spending may result in reduced demand for discretionary itemsand luxury retail products, such as our products. Reduced consumer confidenceand spending also may result in limitations on our ability to increase pricesand may require increased levels of selling and promotional expenses. Adverseeconomic conditions and any related decrease in consumer demand fordiscretionary items such as those offered by us could have a material adverseeffect on our business, results of operations and financial condition.

**We face anextremely competitive specialty retail business market.**

The retail market is highly competitive. We competeagainst a diverse group of retailers ranging from specialty stores totraditional furniture stores and department stores. Our product offerings alsocompete with a variety of national, regional and local retailers. We alsocompete with these and other retailers for customers, suitable retail locations,suppliers, qualified employees and management personnel. Many of ourcompetitors have significantly greater financial, marketing and otherresources. Moreover, increased competition may result, and has resulted in thepast, in potential or actual litigation between us and our competitors relatingto such activities as competitive sales and hiring practices, exclusiverelationships with key suppliers and manufacturers and other matters. As aresult, increased competition may adversely affect our future financialperformance, and we cannot assure you that we will be able to competesuccessfully in the future.

We believe that our ability to compete successfully isdetermined by several factors, including, among other things, the breadth andquality of our product selection, effective merchandise presentation, customerservice, pricing and store location. Although we believe that we are able tocompete favorably on the basis of these factors, we may not ultimately succeedin competing with other retailers in our market.

**Terrorist attacksand threats or actual war may negatively impact all aspects of our operations,revenue, costs and stock price.**

Threats of terrorist attacks in the United States ofAmerica, as well as future events occurring in response to or in connectionwith them, including, without limitation, future terrorist attacks or threatsagainst United States of America targets, rumors or threats of war, actualconflicts involving the United States of America or its allies, including theon-going U.S. conflicts in Iraq and Afghanistan, further conflicts in theMiddle East and in other developing countries, or military or trade disruptionsaffecting our domestic or foreign suppliers of merchandise, may impact ouroperations. The potential impact to our operations includes, among otherthings, delays or losses in the delivery of merchandise to us and decreasedsales of the products we carry. Additionally, any of these events could causeconsumer confidence and spending to decrease or result in increased volatilityin the United States of America and worldwide financial markets and economies.Also, any of these events could result in economic recession in the UnitedStates of America or abroad. Any of these occurrences could have a significantimpact on our operating results, revenue and costs and may result in thevolatility of the future market price of our common stock.

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**Our common stock price may be volatile.**

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

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

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

**Newly adoptedaccounting regulations that require companies to expense stock options willresult in a decrease in our earnings and our stock price may decline.**

The Financial Accounting Standards Board recentlyadopted the previously proposed regulations that will eliminate the ability toaccount for share-based compensation transactions using the intrinsic methodthat we currently use and generally would require that such transactions beaccounted for using a fair-value-based method and recognized as an expense inour consolidated statement of operations. We will be required to expense stockoptions effective in periods beginning after July 1, 2005. Currently, wegenerally only disclose such expenses on a pro forma basis in the Notes to our ConsolidatedFinancial Statements in accordance with accounting principles generallyaccepted in the United States of America. The adoption of this new accountingregulation could have a significant impact on our results of operations and ourstock price could decline accordingly.

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**We are subject to anti-takeover provisions and theterms and conditions of our preferred stock financing that could delay orprevent an acquisition and could adversely affect the price of our commonstock.**

Our Second Amended and Restated Certificate ofIncorporation, as amended, and Amended and Restated Bylaws, certain provisionsof Delaware law and the Certificate of Designation governing the rights,preferences and privileges of our preferred stock may make it difficult in somerespects to cause a change in control of our company and replace incumbentmanagement. For example, our Second Amended and Restated Certificate ofIncorporation, as amended, and Amended and Restated Bylaws provide for aclassified board of directors. With a classified board of directors, at least twoannual meetings of stockholders, instead of one, will generally be required toeffect a change in the majority of the board. As a result, a provision relatingto a classified board may discourage proxy contests for the election ofdirectors or purchases of a substantial block of our common stock because itsprovisions could operate to prevent obtaining control of the board in arelatively short period of time.

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

In addition, our board ofdirectors has the authority to fix the rights and preferences of, and to issueshares of, our preferred stock, which may have the effect of delaying orpreventing a change in control of our company without action by holders of ourcommon stock.

**ITEM 2.     PROPERTIES**

We currently lease approximately 80,000 square feet ofspace for use as our headquarters, including 29,000 square feet of warehousespace, located in Corte Madera, California. The leases for this space expirebetween April 2005 and April 2009.

As of January 29, 2005, we leased space in threeseparate distribution facilities and outsourced the distribution efforts fornon-furniture in the direct to customer channel. We lease approximately 160,000square feet of warehouse space in Hayward, California, which primarily supportsour non-furniture distribution for the west coast of the United States. Thislease expires in October 2006 with an option to extend for a twelve-monthterm. In June 2004, we relocated our Tracy, California furnituredistribution center to a new facility. The lease for this facility provides for195,000 square feet of warehouse space and for expansion up to 284,000 squarefeet and expires in September 2011, with options to renew for oneadditional five-year term. We also lease approximately 470,000 square feet ofwarehouse space in Baltimore, Maryland, for use as our east coast distributioncenter. The lease expires in September 2006, with options to extend fortwo additional three-year terms.

As of January 29, 2005, we leased approximately1,178,000 gross square feet for our 102 retail stores and our one outlet store.The initial lease term of our retail stores generally range from 10 to20 years. Certain leases contain renewal options for up to 15 years. Mostleases for our retail stores provide for a minimum rent, typically includingescalating rent increases, plus a percentage rent based upon sales after 

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certain minimum thresholdsare achieved. The leases generally require us to pay insurance, utilities, realestate taxes and repair and maintenance expenses.

In connection with ourwholly owned furniture manufacturing subsidiary, The Michaels Furniture Company(“Michaels”), we lease two properties used for the manufacturing and storage offurniture, in Sacramento, California. We lease one of the properties from theprevious owner and current president of Michaels. The main property consists ofapproximately 100,000 square feet of manufacturing space and 7,000 square feetof office space. The lease expires in February 2008, with options toextend the lease for two additional five-year terms. The second propertyconsists of approximately 46,000 square feet of warehouse space, which is usedto house finished goods. This lease expires in July 2006.

**ITEM 3.     LEGAL PROCEEDINGS**

There are no materialpending legal proceedings against us. We are, however, involved from time totime in legal proceedings, including litigation arising in the ordinary courseof our business. At the present time, we believe no legal proceedings will havea material adverse effect on our consolidated financial condition or results ofoperations. However, we cannot assure you that the results of any proceedingwill be in our favor. Moreover, due to the uncertainties inherent in any legalproceeding, we cannot accurately predict the ultimate outcome of any proceedingand may incur substantial costs to defend the proceeding, irrespective of the merits.The unfavorable outcome of any legal proceeding could have an adverse impact onour business, financial condition and results of operations.

**ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS**

No matters were submittedto a vote of security holders during the fourth quarter of the fiscal yearcovered by this annual report on Form 10-K.

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**PART II**

**ITEM 5.**                MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES

**MARKET INFORMATION**

Our common stock is listedon The Nasdaq National Market (“NASDAQ”) under the symbol “RSTO.” The closingprice of our common stock on Nasdaq was $5.42 on April 1, 2005.

**STOCKHOLDERS**

As of April 1, 2005there were 493 stockholders of record of our common stock. This number excludesstockholders whose stock is held in nominee or street name by brokers.

**DIVIDEND POLICY**

No dividends have beendeclared on our common stock since our 1998 initial public offering and it isnot anticipated that we will pay any dividends in the foreseeable future on ourcommon stock. In addition, restrictive covenants in our revolving creditfacility limit our ability to pay dividends and protective provisions in ourCertificate of Designation of Series A and Series B preferred stockrequire the approval of two-thirds of the then outstanding shares of our Series Apreferred stock, voting together as a single class, for us to declare or payany dividend on any shares of common stock. As part of our Letter Agreement,dated as of August 2, 2002, with certain holders of our Series Apreferred stock, these Series A holders agreed to waive their right tocertain dividends in the event we were to declare a dividend on our commonstock. In the same agreement, we agreed that we will not declare any dividendpayable to our common stockholders unless and until we first obtain theapproval of the holders of at least seventy percent of the then outstandingshares of Series A preferred stock.

**STOCK PRICEINFORMATION**

Setforth below are the high and low closing sale prices for shares of our commonstock for each quarter during the fiscal years ended January 29, 2005 and January 31,2004 as reported by The Nasdaq National Market.
| **Quarter Ending** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------|------------|------------|------------|----------|------------|---------|------------|
| May 3, 2003        |       | 4.17       |       | 2.02     |       |
| August 2,  2003    |       | 6.41       |       | 3.86     |       |
| November 1,  2003  |       | 8.26       |       | 5.47     |       |
| January 31,  2004  |       | 8.28       |       | 3.70     |       |
| May 1, 2004        |       | 7.25       |       | 3.57     |       |
| July 31,  2004     |       | 8.00       |       | 4.99     |       |
| October 30,  2004  |       | 6.68       |       | 4.82     |       |
| January 29, 2005   |       | 6.37       |       | 4.87     |       |

 

Information relating to the securities authorized forissuance under equity compensation plans will be set forth in the section withthe caption “Equity Compensation Plan Information” in our definitive proxystatement. This information is incorporated herein by reference.

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**ITEM 6.**                SELECTED FINANCIALDATA

The following table setsforth selected, consolidated financial information as of and for the yearsindicated. All prior year periods have been restated to reflect adjustmentsthat are further discussed in Note 2 “Restatement of Consolidated FinancialStatements” under Notes to the Consolidated Financial Statements included inItem 8, “Consolidated Financial Statements and Supplementary Data.” Thisinformation is qualified by reference to and should be read in conjunction with“Management’s Discussion and Analysis of Financial Condition and Results ofOperations,” the Consolidated Financial Statements, related notes thereto andother financial data included elsewhere in this annual report on Form 10-K.The following results may not be indicative of our future operating results.
| ** **                                        | ** ** | **Fiscal Year**                                                            | ** ** |        |
|---------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|-------------|
| ** **                                        | ** ** | **2004**                                                                        | ** ** | **2003(3)** | ** ** | **2002(3)** | ** ** | **2001(3)** | ** ** | **2000(1)(3)** | ** ** |
| ** **                                        | ** ** | **(Dollars in thousands, except per share data)** | ** ** |        |
| Results of Operations:                            |       |                                                                            |       |        |   |   |   |   |   |   |   |   |
| Net revenue                                       |       | $                                                                               | 525,823    |        | $ | 438,508 |   | $ | 400,337 |   | $ | 366,473 |   | $ | 366,236 |   |   |
| Income (loss) before income taxes                 |       | 1,604                                                                           |       | (4,029      | ) | (10,864 | ) | (39,704 | ) | (6,269 | ) |   |
| Net income (loss)                                 |       | 1,704                                                                           |       | (2,518      | ) | (2,845 | ) | (32,136 | ) | (4,708 | ) |   |
| Income (loss) attributable to common stockholders |       | 1,704                                                                           |       | (2,518      | ) | (3,203 | ) | (34,953 | ) | (4,708 | ) |   |
| Income (loss) per common share—basic         |       | $                                                                               | 0.05       |        | $ | (0.08 | ) | $ | (0.11 | ) | $ | (1.49 | ) | $ | (0.28 | ) |   |
| Income (loss) per common share—diluted       |       | $                                                                               | 0.04       |        | $ | (0.08 | ) | $ | (0.11 | ) | $ | (1.49 | ) | $ | (0.28 | ) |   |
| Financial  Position:                              |       |                                                                            |       |        |   |   |   |   |   |   |   |   |
| Working capital                                   |       | $                                                                               | 51,791     |        | $ | 52,097 |   | $ | 49,398 |   | $ | 56,094 |   | $ | 7,077 |   |   |
| Total assets                                      |       | 279,263                                                                         |       | 233,895     |   | 228,135 |   | 209,460 |   | 237,615 |   |   |
| Line of credit & other current debt           |       | 33,819                                                                          |       | 10,286      |   | 13,909 |   | — |   | 38,858 |   |   |
| Other long-term obligations                       |       | 143                                                                             |       | 352         |   | 144 |   | 3,236 |   | 612 |   |   |
| Redeemable convertible preferred  stock           |       | 8,331                                                                           |       | 8,541       |   | 13,328 |   | 14,106 |   | — |   |   |
| Stockholders’ equity                         |       | $                                                                               | 99,286     |        | $ | 96,532 |   | $ | 90,142 |   | $ | 84,105 |   | $ | 73,105 |   |   |
| Retail Stores:                                    |       |                                                                            |       |        |   |   |   |   |   |   |   |   |
| Store count at year-end(4)                        |       | 102                                                                             |       | 103         |   | 105 |   | 104 |   | 106 |   |   |
| Comparable store sales growth(2)                  |       | 7.8                                                                             | %          | 5.2         | % | 6.2 | % | (4.6 | )% | (1.0 | )% |   |
| Store selling  square feet at year-end            |       | 676,520                                                                         |       | 679,300     |   | 688,634 |   | 682,936 |   | 701,628 |   |   |
|                                                   |            |                                                                                 |            |             |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)   Fiscal2000 was a 53-week fiscal year. For purposes of the calculation ofcomparable store growth, results were calculated to correspond with a 52-weekfiscal year.

(2)   Comparablestore sales are defined as sales from stores whose gross square footage did notchange by more than 20% in the previous 12 months and which have been open atleast 12 full months and excludes warehouse and outlet store sales.

(3)   Theresults for fiscal years 2000 through 2003 were restated due to the impact ofthe correction in accounting for leases (see Note 2 to the ConsolidatedFinancial Statements). The results of fiscal year 2001 were restated to correctan error related to tax accounting.

(4)   Storecount at year-end excludes the one outlet location opened in the fourth quarterof fiscal 2004.

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**ITEM 7.**                MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

**OVERVIEW**

Our Company, RestorationHardware, Inc. (Nasdaq: RSTO), together with our subsidiaries, is aspecialty retailer of high quality bathware, hardware, lighting, furniture,textiles and accessories that reflects our classic and authentic American pointof view. We commenced business in 1979 as a purveyor of fittings and fixturesfor older homes. Since then, we have evolved into a unique home furnishingsretailer offering consumers an array of distinctive and high qualitymerchandise. We market our merchandise through retail locations, mail ordercatalogs and on the Internet at *www.restorationhardware.com*.

Our merchandise strategy and ourstores’ architectural style create a unique and attractive selling environmentdesigned to appeal to an affluent, well educated 35 to 60 year oldcustomer. Over the next decade, we believe the fastest growing segment of theU.S. population will be 45 to 60 year olds. We believe that as thesecustomers evolve, so will their purchasing needs and desires. We believe thatour products can fulfill their aspirations to have homes designed with a highquality, classic and timeless style. Our plan is to fill the void in themarketplace above the current home lifestyle retailers, and below the interiordesign trade, by providing products targeted to 35 to 60 year olds and centeredaround our core businesses that reflect a predictable, high-quality promise toour customers.

We operate on a 52 – 53 weekfiscal year ending on the Saturday closest to January 31. Our currentfiscal year ended on January 29, 2005 (“fiscal 2004”), and the priorfiscal year ended on January 31, 2004 (“fiscal 2003”) and fiscal 2002ended on February 1, 2003 (“fiscal 2002”). Fiscal 2004, 2003 and 2002 eachconsisted of 52 weeks.

As of January 29, 2005, weoperated 102 stores and one outlet store in 30 states, the District of Columbiaand Canada. In addition to our retail stores, we operate a direct-to-customer (“direct”)sales channel that includes both catalog and Internet, and a wholly-ownedfurniture manufacturer.

In fiscal 2001, we determinedthat we needed to implement a repositioning strategy to expand and clarify our corebusinesses, adjust down our proportion of lower margin furniture sales whileincreasing our higher margin textiles category, increase our direct imports,grow our direct-to-customer business and close underperforming stores. Welaunched a new merchandising strategy in April 2002, which included newmerchandise offerings, adjustments of overall product mix, and the remodelingof our stores in order to best present the new merchandise. In addition, todrive sales in our direct channels, we expanded our product assortment ofcatalog and Internet only items. In 2003, we built on the prior year’ssuccessful launch by refining and expanding our core merchandise offerings,which include premium textiles, bath fixtures and hardware, lighting, andfurniture and in 2004, we re-merchandised our furniture assortment and revampedour accessories offering. We also redesigned our catalog in 2004 to improve thepresentation of our core businesses and more clearly communicate the qualitypositioning of our offerings. Our customers have continued to respondpositively to the new merchandise introductions in all channels. We intend tofurther build on our core merchandise offerings in 2005. This shift willrequire some additional fixturing in our retail stores to accomplish thepresentation of the expanded assortment. Our catalog and Internet presentationswill also reflect this expanded assortment.

In fiscal 2004, we opened one traditional retailstore, remodeled another store and opened our first outlet store. The outletstore strategy enables us to more effectively liquidate overstocked,discontinued, damaged merchandise and over time, we believe will eliminate theneed for the less productive warehouse sales events that we have historicallyheld.

During fiscal 2004, we continued programs initiated inprior years to improve our operating results, which included increases in ourselling margins through sourcing changes, in particular, the expansion of 

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our internationalsourcing. We also effected significant changes in management in fiscal 2004,particularly in the area of operations including the hiring of a new ChiefOperating Officer and the hiring into the new role of Senior Vice President ofSupply Chain. We believe these initiatives and added operational leadershipwill provide a strong foundation for margin expansion, operational efficienciesand cost reductions as well as provide a springboard for future growth.

On an ongoing basis, weevaluate stores for closure based on underperformance. During fiscal 2004, weclosed two underperforming stores, and cumulatively since fiscal 2001, we haveclosed 9 stores. A material declinein sales and other adverse conditions resulting from our failure to accuratelyanticipate changes in merchandise trends and consumer demands may cause us toclose additional underperforming stores. As of January 29, 2005, weanticipated opening one new store in fiscal 2005, and had no current plans toclose any stores.

***Restatement of Consolidated Financial Statements***

On February 7, 2005, the Office of the ChiefAccountant of the Securities and Exchange Commission (“SEC”) issued a letter tothe American Institute of Certified Public Accountants expressing its viewsregarding certain operating lease-related accounting issues and their treatmentunder generally accepted accounting principles in the United States of America(“GAAP”). In response to this letter, management reviewed its lease accountingand determined that the Company’s method of accounting for rent holidays wasnot in accordance with GAAP. As a result, we restated our Consolidated FinancialStatements for fiscal years 2003 and prior.

Historically, and consistent with industry practice,we have recognized the straight line rent expense for leases generallybeginning on the store opening date which had the effect of excluding theconstruction period of our stores (rent holiday) from the calculation of theperiod over which we expensed rent. We determined that the appropriateaccounting treatment is to include the construction period in our calculationof straight line rent in accordance with Financial Accounting Standards Board (“FASB”)Technical Bulletin No. 85-3, “*Accounting for OperatingLeases with Scheduled Rent Increases.*” We corrected our straightline rent accrual and deferred rent credits accordingly.

The cumulative effect of this restatement was anincrease in accumulated deficit of $4.8 million as of February 2, 2002 andincreases in pre-tax results of $0.7 million ($0.4 million, after tax) and$1.3 million ($0.8 million, after tax) for fiscal years ended January 31,2004 and February 1, 2003, respectively. Additionally, we corrected anerror recorded in fiscal 2001 related to tax accounting; the correction had theeffect of increasing accumulated deficit and decreasing prepaid tax assets by$0.6 million as of February 2, 2002.

The corrections aresummarized in Note 2 to the Consolidated Financial Statements of this report.The accompanying Management’s Discussion and Analysis of Financial Conditionand Results of Operations gives effect to these corrections.

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***Summary Consolidated Statements of Operations***

Thefollowing table sets forth for the periods indicated the amount and percentageof net revenue represented by certain line items in our Consolidated Statementsof Operations:
| ** **                                            | *** *** | **Fiscal**                                                                      | *** *** | **%** of Net  | *** *** | **Fiscal** | *** *** | **%** of Net  | *** *** | **Fiscal** | *** *** | **%** of Net  | *** *** |
|-------------------------------------------------------|--------------|---------------------------------------------------------------------------------|--------------|------------------------------|--------------|------------|--------------|------------------------------|--------------|------------|--------------|------------------------------|--------------|
| ** **                                            | *** *** | **2004**                                                                        | *** *** | **Revenue**                  | *** *** | **2003**   | *** *** | **Revenue**                  | *** *** | **2002**   | *** *** | **Revenue**                  | *** *** |
| ** **                                            | *** *** | **(Dollars in thousands, except per share data)** | *** *** |
| Retail net revenue                                    |         | $                                                                               | 406,833      |                         |         | 77.4       | %            |                         | $            | 370,609    |         |                         | 84.5         | % |   | $ | 355,632 |   |   | 88.8 | % |   |   |
| Direct-to-customer net revenue                        |         | 118,990                                                                         |         |                         | 22.6         |       |         | 67,899                       |         |       | 15.5         |                         |         | 44,705 |   |   | 11.2 |   |   |   |
| Net revenue                                           |         | 525,823                                                                         |         |                         | 100.0        |       |         | 438,508                      |         |       | 100.0        |                         |         | 400,337 |   |   | 100.0 |   |   |   |
| Cost of revenue and occupancy                         |         | 359,808                                                                         |         |                         | 68.4         |       |         | 305,265                      |         |       | 69.6         |                         |         | 281,815 |   |   | 70.4 |   |   |   |
| Gross profit                                          |         | 166,015                                                                         |         |                         | 31.6         |       |         | 133,243                      |         |       | 30.4         |                         |         | 118,522 |   |   | 29.6 |   |   |   |
| Selling, general and administrative expense           |         | 161,939                                                                         |         |                         | 30.8         |       |         | 135,118                      |         |       | 30.8         |                         |         | 126,290 |   |   | 31.5 |   |   |   |
| Income (loss) from operations                         |         | 4,076                                                                           |         |                         | 0.8          |       |         | (1,875                       | )            |       | (0.4         | )                            |         | (7,768 | ) |   | (1.9 | ) |   |   |
| Interest expense, net and other                       |         | (2,472                                                                          | )            |                         | (0.5         | )          |         | (2,154                       | )            |       | (0.5         | )                            |         | (3,096 | ) |   | (0.8 | ) |   |   |
| Income (loss) before income   taxes                   |         | 1,604                                                                           |         |                         | 0.3          |       |         | (4,029                       | )            |       | (0.9         | )                            |         | (10,864 | ) |   | (2.7 | ) |   |   |
| Income tax benefit                                    |         | 100                                                                             |         |                         | —       |       |         | 1,511                        |         |       | 0.3          |                         |         | 8,019 |   |   | 2.0 |   |   |   |
| Net income (loss)                                     |         | $                                                                               | 1,704        |                         |         | 0.3        |         |                         | $            | (2,518     | )            |                         | (0.6         | ) |   | $ | (2,845 | ) |   | (0.7 | ) |   |   |
| Preferred stockholder return:                         |         |                                                                            |         |                         |         |       |         |                         |         |       |         |                         |         |   |   |   |   |   |   |   |
| Dividends                                             |         | —                                                                          |         |                         |         |       |         | —                       |         |       |         |                         |         | (358 | ) |   | (0.1 | ) |   |   |
| Income (loss) attributable to common stockholders     |         | $                                                                               | 1,704        |                         |         | 0.3        |         |                         | $            | (2,518     | )            |                         | (0.6         | ) |   | $ | (3,203 | ) |   | (0.8 | ) |   |   |
| Income (loss) per share of common stock—basic    |         | $                                                                               | 0.05         |                         |         |       |         |                         | $            | (0.08      | )            |                         |         |   |   | $ | (0.11 | ) |   |   |   |   |   |
| Income  (loss) per share of common stock—diluted |         | $                                                                               | 0.04         |                         |         |       |         |                         | $            | (0.08      | )            |                         |         |   |   | $ | (0.11 | ) |   |   |   |   |   |

 

Income from operations improved to $4.1 million in fiscal2004 as compared to a loss from operations of $1.9 million in fiscal 2003. Werecorded a net benefit for income taxes for the year of $100 thousand. Thisreflects the reduction of the income tax provision of $3.0 million from thereversal of the valuation allowance established in prior years, offset by $2.1million of tax contingency and other adjustments. Net income was $0.04 pershare, or $1.7 million for fiscal 2004, compared to a net loss of $0.08 pershare, or $2.5 million, for fiscal 2003.

The improvement in operating results of $6.0 million,to $4.1 million of income from operations in fiscal 2004 from a loss fromoperations of $1.9 million in fiscal 2003, is the result of cost leverageachieved on higher revenue from all channels and the expansion of productmargins, which were somewhat offset by higher costs of distribution. Netrevenue increased $87.3 million in fiscal 2004 as compared to fiscal 2003, or20%, which largely resulted from a $51.1 million, or 75%, increase in ourdirect-to-customer sales, and a $27.7 million, or 7.8%, increase in comparablestore sales, over fiscal 2003. The increase in comparable store sales overfiscal 2003 was driven by our ongoing focus on building “brand authority” inour core merchandise offerings and through annual, product-focused sales eventssuch as our Famous Fall Lighting Sale and our Annual Bath Event. The increasein net revenue in both our retail and direct channels can also be attributed toour focus on growing our catalog circulation, as the catalog is our primaryadvertising vehicle. Additionally, revenue from an outlet store and warehousesales events totaled $5.7 million for fiscal 2004, compared to $2.7 million ofrevenue from a warehouse sales event in fiscal 2003.

The cost of revenue and occupancy increased by $54.5million in fiscal 2004 as compared to fiscal 2003, or 18%, primarily in supportof our revenue growth. These costs rose at a lower rate than revenue as 

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the expansion of productmargins and the leverage of our store occupancy costs more than offset thehigher costs that we continued to experience throughout most of fiscal 2004 inour distribution and supply chain activities. This includes increases infreight costs as well as costs associated with investment in processimprovement efforts including related labor costs and consultants that had beenretained to temporarily manage those operations. We have eliminated the needfor temporary labor and consultants in our distribution centers as of the endof fiscal 2004. Those costs are reflected in cost of revenue and occupancy onour Consolidated Statements of Operations and are reflected in unallocatedcosts in Note 13 to the Consolidated Financial Statements, Segment Reporting. Theincrease in selling, general and administrative expense of $26.8 million infiscal 2004 over fiscal 2003, or 20%, was primarily driven by variable costsincurred in support of the revenue increase such as store payroll andadvertising, and such expenses were also impacted by increases in professional fees and brandadvertising. The increase in professional fees was primarily related to theimplementation of the requirements of the Sarbanes-Oxley Act of 2002, inparticular, with respect to Section 404 requiring management to report on,and our registered independent public accountants to attest to, theeffectiveness of our internal control over financial reporting. As apercent of revenue, selling, general and administrative expense remained at30.8% of net revenue in fiscal 2004 and cost of revenue and occupancy improved120 basis points to 68.4% of net revenue in fiscal 2004.

Loss from operations improved to $1.9 million infiscal 2003 as compared to a loss from operations of $7.8 million in fiscal2002. Net loss was $0.08 per share, or $2.5 million for fiscal 2003, comparedto a net loss of $0.11 per share, or $3.2 million in fiscal 2002. Fiscal year2002 included a one-time tax benefit of $4.0 million, or $0.13 per share,related to the economic stimulus bill enacted on March 9, 2002.

The improvement in the loss from operations in fiscal2003 of $5.9 million, to a loss of $1.9 million as compared to a loss fromoperations of $7.8 million in fiscal 2002, is the result of cost leverageachieved on higher sales, expansion of product margins and leverage of storeoccupancy which was somewhat offset by increased costs of distribution. Theincrease in net revenue of $38.2 million in fiscal 2003 as compared to fiscal2002, or 10%, resulted from a 5.2% increase in comparable store sales, andgrowth of our direct-to-customer business, which increased $23.2 million, or52%, over fiscal 2002. The increase in comparable store sales over fiscal 2002was driven by our brand-building initiatives for our core merchandise offeringsand the growth of our catalog circulation, which is our primary advertisingvehicle. Selling, general and administrative expenses increased by $8.8 millionin fiscal 2003 as compared to fiscal 2002, and such increase was primarilyattributable to higher payroll expenses and advertising costs which wereincurred in support of our revenue growth. Selling, general and administrativeexpenses, expressed as a percentage of revenue, improved 70 basis points infiscal 2003 to 30.8% of net revenue versus fiscal 2002 from leverage on highersales, and the cost of revenue and occupancy improved 80 basis points to 69.6%of net revenue in fiscal 2003.

Our business is highlyseasonal, which reflects a general pattern in the retail industry wherein thehighest sales and earnings occur during the holiday season. Historically, asignificant percentage of our sales have occurred in the fourth fiscal quarter.In our peak holiday selling season, we incur significant additional expenses inconnection with, among other things, the hiring of additional seasonalemployees in our retail stores and the production and mailing of a higher volumeof our catalogs.

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**REVENUE AND SEGMENTRESULTS**

***Retail Net Revenue and Segment Results***
| ** **                                          | ** ** | **Fiscal Year**                 | ** ** |
|-----------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                          | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                          | ** ** | **(Dollars in thousands)** | ** ** |
| Retail net  revenue                                 |       | $                                    | 406,833    |   | $ | 370,609 |   | $ | 355,632 |   |
| Retail net  revenue growth percentage               |       | 10                                   | %          | 4 | % | 7 | % |
| Comparable store  sales growth                      |       | 7.8                                  | %          | 5.2 | % | 6.2 | % |
| Income from operations                              |       | 51,932                               |       | 39,611 |   | 36,709 |   |
| Income from  operations—percent of net revenue |       | 12.8                                 | %          | 10.7 | % | 10.3 | % |
| Number of retail stores at beginning of year        |       | 103                                  |       | 105 |   | 104 |   |
| Number of retail  stores opened                     |       | 1                                    |       | 2 |   | 1 |   |
| Number of retail  stores closed                     |       | 2                                    |       | 4 |   | — |   |
| Number of retail  stores at year-end                |       | 102                                  |       | 103 |   | 105 |   |
| Store selling  square feet at year-end              |       | 676,520                              |       | 679,300 |   | 688,634 |   |
|                                                     |            |                                      |            |  |  |  |  |  |  |  |

 

Retail net revenue for fiscal 2004 increased by $36.2million, or 10%, as compared to fiscal 2003, primarily due to a$27.7 million, or 7.8%, increase in comparable store sales. Additionally,several previously opened stores, although not open long enough to be includedin the calculation of comparable store sales, contributed positively to fiscal 2004results. Fiscal 2004 retail net revenue also reflects $5.7 million in revenuefrom outlet revenue and warehouse sales events, as compared to $2.7 million infiscal 2003 for a warehouse sale event held in that year. We periodically holdwarehouse sale events to liquidate our overstocked, discontinued and damagedinventory. In the fourth quarter of fiscal 2004, we opened our first outletstore, and over time we believe will eliminate the need for separate warehousesales events as we open further outlet stores. Warehouse and outlet salesrevenue is included in retail revenue, but is excluded from our comparablestore sales.

For fiscal 2004, income from operations for the retailsegment increased to $51.9 million from $39.6 million in fiscal 2003. As apercent of segment net revenue, income from operations for the retail segmentgrew 210 basis points, to 12.8% of retail net revenue, as compared to 10.7% forthe prior fiscal year. This improvement resulted from occupancy cost leverageachieved on higher sales, expansion of product margins as well as improvementsin payroll and other store expenses expressed as a percentage of net revenue,offset by higher costs of freight and distribution and the costs of brandadvertising. Income from operations for the retail segment reflects the resultsassociated with store operations less retail field management costs.

Retail net revenue for fiscal 2003 increased by $15.0million or, 4%, from fiscal 2002 primarily due to an $18.0 million or 5.2%increase in comparable store sales. The 5.2% increase in comparable store salesin fiscal 2003 was driven primarily by strong performance in our coremerchandise offerings. This increase was partially offset by decreased salesrelated to the closure of four underperforming stores during fiscal 2003 andthe temporary closure of one store for expansion.

Income from operations for the retail segment forfiscal 2003 was $39.6 million, as compared to $36.7 million in fiscal 2002. Incomefrom operations for the retail segment as a percent of segment revenueincreased 40 basis points, to 10.7% of retail net revenue from 10.3% of retailnet revenue for fiscal 2002, primarily due to occupancy cost leverage fromincreases in comparable stores sales assisted by improved margins offset byhigher costs of distribution.

Comparable store sales aredefined as sales from stores whose gross square footage did not change by morethan 20% in the previous 12 months and which have been open at least 12full months. We believe that comparable store sales are a more useful indicatorof store performance than the change in total net 

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revenue,since comparable store sales exclude the effects of changes in the number ofstores open. Revenue from outlet stores and warehouse sales events are notincluded in comperable store sales.

***Direct-to-Customer Net Revenue and Segment Results***
| ** **                                         | ** ** | **Fiscal Year**                 | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                         | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                         | ** ** | **(Dollars in thousands)** | ** ** |
| Catalog revenue                                    |       | $                                    | 65,458     |   | $ | 40,909 |   | $ | 29,461 |   |
| Internet revenue                                   |       | 53,532                               |       | 26,990 |   | 15,244 |   |
| Total direct-to-customer net revenue               |       | $                                    | 118,990    |   | $ | 67,899 |   | $ | 44,705 |   |
| Income from operations                             |       | $                                    | 14,280     |   | $ | 8,538 |   | $ | 3,062 |   |
| Income from operations—percent of net revenue |       | 12.0                                 | %          | 12.6 | % | 6.8 | % |
| Growth percentages:                                |       |                                 |       |   |   |   |   |
| Direct-to-customer net revenue                     |       | 75                                   | %          | 52 | % | 33 | % |
| Number of  catalogs mailed                         |       | 15                                   | %          | 9 | % | 46 | % |
| Pages circulated                              |       | 48                                   | %          | 40 | % | 57 | % |

 

Direct-to-customer net revenue consists of bothcatalog and Internet sales. Direct-to-customer net revenue for fiscal 2004increased $51.1 million, or 75%, as compared to fiscal 2003. This increasewas attributable to an expansion of the merchandise offerings in both thecatalog and on the Internet, coupled with an increase in the catalogs mailedduring fiscal 2004.

For fiscal 2004, income from operations for thedirect-to-customer segment increased to $14.3 million, or 12.0% of segment net revenue,as compared to $8.5 million, or 12.6% of segment net revenue, for fiscal 2003. Segmentresults were favorably impacted by higher sales for the segment and productmargin expansion, which was more than offset by higher distribution andadvertising costs expressed as a percentage of revenue. Income from operationsfor the direct segment reflects the results associated with catalog and Internetsales, less direct management costs.

Direct-to-customer net revenue during fiscal 2003increased $23.2 million, or 52%, from fiscal 2002. A portion of this increasewas the result of a 9% increase in the number of catalogs mailed in fiscal2003, as well as a change in our product mix in the catalog and an increase incatalog-only furniture offerings. Additionally, we believe our websitemarketing efforts coupled with growing consumer familiarity with the Internetand growth in high-speed Internet consumers also helped drive customers to ourwebsite.

Income from operations forfiscal 2003 increased to $8.5 million, or 12.6% of related segment net revenue,from $3.1 million, or 6.8%, of related segment net revenue for fiscal 2002,primarily due to the increase in our direct-to customer revenue andimprovements in our product margins, slightly offset by increases in sellinggeneral and administrative expense primarily due to advertising costs relatedto catalog production and mailing costs.

**EXPENSES**

***Cost of Revenue and Occupancy Expense***

For fiscal 2004, cost of revenue and occupancy expenseexpressed as a percentage of net revenue improved approximately 120 basispoints to 68.4%, from 69.6% in fiscal 2003. Significant improvements wereachieved due to the leveraging of relatively fixed store occupancy costs andimproved product margins, which improvements were significantly offset byincreased costs related to customer shipping, distribution and supply chainoperations.

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In fiscal 2003, cost ofrevenue and occupancy expense expressed as a percentage of net revenue improvedapproximately 80 basis points to 69.6%, from 70.4% in fiscal 2002. The majorityof the improvement was achieved due to the leveraging of relatively fixed storeoccupancy costs and was partially offset by increases in distribution costs.

***Selling, General and Administrative Expense***

Selling, general and administrative expense expressedin absolute dollars increased $26.8 million, to $161.9 million for fiscal2004 from $135.1 million in fiscal 2003. The increase in absolute dollarsis primarily related to an increase in advertising, including catalogproduction and mailing costs, and to a lesser degree, an increase in payrollexpense and professional fees as well as other selling related expenses.Selling, general and administrative expense expressed as a percentage of netrevenue was consistent at 30.8% for fiscal 2004 and fiscal 2003. We generatedcost savings in retail payroll costs, which declined as a percentage of netrevenue, reflecting continued management focus and the implementation of toolsto manage retail payroll expense, as well as reductions in other storeexpenses. Higher levels of advertising costs and professional fees for fiscal2004 largely offset these improvements. Advertising costs include expensesassociated with catalog production and mailing as well as the costs of a brandadvertising campaign. In general, we expect that as the direct-to-customerchannel revenue grows at a faster rate than retail revenue, the growth in thecost of advertising (primarily catalog circulation costs) will lead toincreases in overall selling, general and administrative expense as apercentage of net revenue, and this general dynamic inherent in our businessmodel impacted our results for fiscal 2004. In contrast, the cost of retailoccupancy has declined as a percentage of net revenue, the benefit of which isreflected in improved gross margins. Additionally, higher professional feeswere incurred with the implementation of the requirements of the Sarbanes-OxleyAct of 2002, in particular, with respect to Section 404 requiringmanagement to report on, and our registered independent public accountants toattest to, the effectiveness of our internal control over financial reporting.

Selling, general andadministrative expense expressed as a percentage of net revenue improvedapproximately 70 basis points to 30.8% in fiscal 2003, from 31.5% in fiscal2002. Selling, general and administrative expense expressed in absolute dollarsincreased $8.8 million, to $135.1 million in fiscal 2003 from $126.3 million infiscal 2002. The increase in absolute dollars primarily related to an increasein payroll expense and to a lesser degree, an increase in catalog productioncosts and credit card fees. The improvement in selling, general andadministrative expense as a percentage of net revenue was primarily due to theleveraging of store payroll costs, which declined as a percentage of netrevenue; cost saving initiatives for supplies; partially offset by increases inadvertising costs as well as increased credit card fees related to theconclusion in fiscal 2003 of our incentive program in connection with ourprivate label credit card. Advertising expense for fiscal 2003 primarilyrepresents costs associated with catalog production and mailing. The increasesin selling, general and administrative expense in absolute dollars wereincurred largely to support our increase in net revenue.

***Interest Expense, Net and Other***

Interest expense, net and other includes interest onborrowings under our revolving credit facility and amortization of debtissuance costs. For fiscal 2004, interest expense, net and other was $2.5million compared to $2.2 million in fiscal 2003. The $0.3 million increase wasdue to higher average debt levels that were offset by lower average interestrates year over year and lower amortization of debt issuance costs.

In fiscal 2003, interestexpense, net and other was $2.2 million, a decrease of $0.9 million as comparedto $3.1 million in fiscal 2002. The decrease was due to lower average borrowingrates and lower average borrowings outstanding.

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***Income Tax Benefit***

We recorded an income tax benefit for fiscal 2004 of$100 thousand on pre-tax income of $1.6 million. The fiscal 2004 income taxbenefit reflects a benefit of $3.0 million from the reversal of the valuationallowance established in prior years, offset by $2.1 million of tax contingencyand other adjustments. Excluding these items, our effective tax rate would havebeen 47% for fiscal 2004.

Our effective tax rate was 38% in fiscal 2003,compared to an effective tax rate of 74% in fiscal 2002. The fiscal 2002 ratereflects a $4.0 million benefit realized due to the economic stimulus billenacted in that year, which resulted in a reduction of the valuation allowancerecorded in fiscal 2001. This reduction in the valuation allowance had theeffect of increasing our fiscal 2002 tax benefit rate by 37 percentage points.

As of January 29,2005 and January 31, 2004, we recorded net deferred tax assets totaling$25.9 million and $23.4 million, respectively, which primarily represent theincome tax benefit associated with losses reported in prior years anddifferences in fixed asset bases. These losses are subject to federal and statecarry-forward provisions of up to 20 years. As of January 29, 2005 and January 31,2004, we concluded that the net deferred tax asset balances of $25.9 millionand $23.4 million, respectively, were more likely than not to be recovered. Ifwe are not able to maintain positive operating results in the future, avaluation allowance may need to be recorded.

**PREFERRED STOCKHOLDERDIVIDENDS**

Dividend charges of $0.4million were recognized during fiscal 2002 associated with our outstanding Series Apreferred stock. Subsequently, pursuant to an August 2, 2002 LetterAgreement, holders of our Series A preferred stock agreed to waive theirdividend participation right in the event we were to declare a dividend on ourcommon stock. In the same agreement, we agreed that we would not declare anydividends payable to our common stock holders until we first obtain theapproval of at least seventy percent of the then outstanding shares of Series Apreferred stock. We have never declared or paid any dividends on our commonstock and we have no obligation to do so. As a result of the Letter Agreement,beginning with the second quarter of fiscal 2002, we no longer record dividendcharges related to our outstanding Series A preferred stock.

**LIQUIDITY ANDCAPITAL RESOURCES**

***Operating Cash Flows***

For fiscal 2004, net cash used by operating activitieswas $9.8 million compared to $11.4 million of net cash provided byoperating activities for fiscal 2003. The change in net cash (used) provided byoperating activities resulted primarily from higher inventory purchases in support of higher salesand the acceleration of inventory receipts at year-end (including $20 millionof shipments in transit) due to outdoor furniture and other spring sellingprograms. We also experienced acceleration of the timing of payment for goodsdue to increases in the levels of foreign sourced merchandise that tend to havefaster payment terms than domestic vendors. Additionally, net cash used byoperating activities increased due to higher prepaid expenses associated with catalogcosts. These increases in net cash used were partially offset by higheraccounts payable and accrued expenses balances.

In fiscal 2003, net cashprovided by operating activities was $11.4 million compared to$19.5 million of net cash used by operating activities in fiscal 2002. Thechange in net cash provided (used) by operating activities resulted primarilyfrom significantly lower merchandise inventory purchases from that required inthe initial year of re-merchandising efforts; our improved operating results;and an increase in our accounts payable and accrued expenses. The impact ofthese items was partially offset by a decrease in deferred lease incentives andother long-term obligations.

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***Investing Cash Flows***

Net cash used by investing activities was $13.4million for fiscal 2004, an increase of $4.2 million compared to$9.2 million for fiscal 2003. The cash used for investing activities forfiscal 2004 primarily related to the opening and remodeling of two retailstores, the opening of our first outlet store and capital associated withdistribution facility improvements and relocations.

Net cash used by investingactivities was $9.2 million in fiscal 2003, a decrease of $10.2 millioncompared to $19.4 million of cash used by investing activities in fiscal2002. The $9.2 million of cash used for investing activities in fiscal 2003primarily related to capital expenditures associated with the opening of two retailstores, as well as the remodeling of one store.

***Financing Cash Flows***

Net cash provided by financing activities was $23.5 millionfor fiscal 2004, compared to net cash used by financing activities of $2.6million for fiscal 2003. Substantially all of the change in net cash provided (used)by financing activities resulted from an increase in net borrowings of$23.2 million for fiscal 2004, as compared to a repayment of borrowings of$3.9 million for fiscal 2003, under our revolving credit facility. Cashfinancing requirements were higher in fiscal 2004 as compared to the sameperiod of fiscal 2003 primarily due to the effect of higher inventory levelsoverall, and higher inventory of predominately foreign sourced merchandise,which have resulted in an acceleration of the timing of payment for our goods.

Net cash used by financing activities was$2.6 million in fiscal 2003, and net cash provided by financing activitieswas $18.2 million in fiscal 2002. Substantially all of the change in netcash provided (used) by financing activities resulted from net repayments of$3.9 million in fiscal 2003, as compared to net borrowings of $15.2 million infiscal 2002, under our revolving credit facility. We reduced the borrowingsoutstanding under our line of credit in fiscal 2003 due to expense leveragegained on increased sales. In addition, we received $1.1 million during fiscal2003 in connection with the settlement of a claim, and $1.1 million from theexercise of stock options.

As of January 29, 2005, our revolving creditfacility provided for an overall commitment of $100.0 million. The revolvingcredit facility was amended in June 2004 to provide for additionalborrowing capacity, reduced borrowing rates and elimination of limitations oncapital expenditures and store openings. In support of our expected continued****growth, the amendment increased the initial availablecommitment to $100.0 million, and further allowed us to request and receiveincremental increases beyond the initial available commitment of $100.0 millionup to a maximum commitment of $150.0 million, provided no default or event ofdefault exists and certain other conditions are met. The amendment alsoincreased the amount available for letters of credit from $30.0 million to $50.0million and modified certain other terms in the revolving credit facility,which had the effect of expanding the borrowing base.

As of January 29, 2005, $33.8 million wasoutstanding under the line of credit, net of unamortized debt issuance costs of$0.7 million, and there was $12.0 million in outstanding letters of credit. Borrowingsmade under the revolving credit facility are subject to interest at either thebank’s reference rate or LIBOR plus a margin. As of January 29, 2005, thebank’s reference rate was 5.75 % and the LIBOR plus margin rate was 4.59%. Theavailability of credit at any given time under the revolving credit facility islimited by reference to a borrowing base formula based upon numerous factors,including the value of eligible inventory and eligible accounts receivable, andreserves established by the agent of the revolving credit facility. Therevolving credit facility is structured to increase availability to meetseasonal needs. As a result of the borrowing base formula, the actual borrowingavailability under the revolving credit facility could be less than the statedamount of the revolving credit facility reduced by the actual borrowings andoutstanding letters of credit. The Company had actual remaining availabilityunder the revolving credit facility of $28.2 million as of January 29, 2005.

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

Our revolving credit facility requires a lock-boxarrangement, which provides for all receipts to be swept daily to reduceborrowings outstanding under the revolving credit facility. This arrangement,combined with the existence of a subjective acceleration clause in therevolving credit facility, necessitates that the revolving credit facility beclassified as a current liability on our Consolidated Balance Sheet, pursuantto guidance in the Financial Accounting Standards Board’s Emerging Issues TaskForce Issue No. 95-22, “*Balance SheetClassification of Borrowings Outstanding under Revolving Credit Agreements ThatInclude both a Subjective Acceleration Clause and a Lock-Box Arrangement*.”However, we do not expect to repay, or be required to repay, within one year,the balance of the revolving credit facility classified as a current liability.

We currently believe thatour cash flows from operations and funds available under our revolving creditfacility will satisfy our expected working capital and capital requirements,for at least the next 12 months. However, the weakening of, or otheradverse developments concerning our sales performance or adverse developmentsconcerning the availability of credit under our revolving credit facility dueto covenant limitations or other factors could limit the overall availabilityof funds to us. We may not have successfully anticipated our future capitalneeds or the timing of such needs and we may need to raise additional funds inorder to take advantage of unanticipated opportunities. We also may need toraise additional funds to respond to changing business conditions orunanticipated competitive pressures. However, should the need arise, additionalsources of financing may not be available or, if available, may not be on termsfavorable to our stockholders or us. If we fail to raise sufficient funds, wemay be required to delay or abandon some of our planned future expenditures oraspects of our current operations. For more information, please see the section“Factors That May Affect Our Future Operating Results,” in particular thesections “We are dependent on external funding sources which may not makeavailable to us sufficient funds when we need them,” and “Because our businessrequires a substantial level of liquidity, we are dependent upon a revolvingcredit facility with certain restrictive covenants that limit our flexibility.”

***Contractual Commitments***

Thefollowing table summarizes our significant contractual cash obligations andother commercial commitments as of January 29, 2005:
| ** **                          | ** ** | **Payments Due By Period** | ** ** |
|-------------------------------------|------------|-------------------------------------------|------------|
| ** **                          | ** ** | **Total**                                 | ** ** | ** Fiscal 2005 ** | ** ** | **Fiscal 2006  through 2007** | ** ** | **Fiscal 2008  through 2009** | ** ** | ** Thereafter ** | ** ** |
| ** **                          | ** ** | **(Dollars in thousands)**      | ** ** |
| Operating leases                    |       | $                                         | 265,446    |   |   | $ | 40,295 |   |   |   | $ | 74,535 |   |   |   | $ | 66,328 |   |   |   | $ | 84,288 |   |   |
| Capital leases                      |       | 342                                       |       |   | 204 |   |   |   | 137 |   |   |   | 1 |   |   |   | — |   |   |
| Line of  credit(1)             |       | 34,500                                    |       |   | 34,500 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Standby letters  of credit          |       | 7,937                                     |       |   | 7,937 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Trade letters of  credit            |       | 4,078                                     |       |   | 4,078 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase  obligations for inventory |       | 76,518                                    |       |   | 76,518 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total                               |       | $                                         | 388,821    |   |   | $ | 163,532 |   |   |   | $ | 74,672 |   |   |   | $ | 66,329 |   |   |   | $ | 84,288 |   |   |

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(1)          Gross of debt issuance costs of $0.7 million.We do not expect to be required to repay, within one year, the revolvingcredit facility that is classified as a current liability.

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**CRITICAL ACCOUNTINGPOLICIES**

Our discussion and analysis of our financial conditionand results of operations are based upon our consolidated financial statements,which were prepared in accordance with accounting principles generally acceptedin the United States of America (“GAAP”). The preparation of our Consolidated FinancialStatements requires us to make certain estimates and judgments that affect the reportedamounts of assets, liabilities, revenue and expenses, and related disclosure ofcontingent assets and liabilities. On an ongoing basis, we evaluate ourestimates, including those related to sales returns, inventories, goodwill,income taxes, financing operations, contingencies and litigation. We base ourestimates on historical experience and on various other facts and assumptions,including current and expected economic conditions and product mix, that arebelieved to be reasonable under the circumstances, the results of which formthe basis for making judgments about the carrying values of assets andliabilities that are not readily apparent from other sources. Actual resultsmay differ from these estimates under different assumptions or conditions.

Our management believesthe following critical accounting policies require significant judgments andestimates in the preparation of our Consolidated Financial Statements:

***Revenue Recognition***

Revenue:   Revenue is recognized at the time ofcustomer receipt. This can occur when an item is purchased in the store, orwhen the item is delivered to the customer. We record the sale as revenue inthe channel where the transaction originated.

Shipping and handling:   We record shipping and handling fees asrevenue in the revenue channel that originated the sales transaction. Costs ofshipping and handling are included in cost of revenue and occupancy.

Returns:   We providean allowance for sales returns based on historical return rates.

***Merchandise Inventories***

Ourretail inventories are carried at the lower of cost or market with costdetermined on a weighted average cost method. Manufacturing inventories arecarried at the lower of cost or market with cost determined at standard costs,approximating average costs. Costs include certain buying and distributioncosts, including payroll and other costs related to the purchase of inventory. Wewrite down inventories whenever markdowns reduce the selling price below cost.Additionally, we provide for reserves on inventory based upon our estimate ofshrinkage losses. We also write down our slow-moving and discontinued inventoryto its estimated market value based upon assumptions about future demand and marketconditions. If actual market conditions are less favorable than those projectedby management, or if liquidation of the inventory is more difficult thananticipated, additional inventory write-downs may be required.

***Prepaid Catalog Expenses***

Prepaid catalog expensesconsist of the cost to prepare, print and distribute catalogs. Such costs areamortized over the expected revenue generated from each catalog based onhistorical experience. Typically the cost of a catalog is amortized overapproximately five months.

***Property and Equipment***

Property and equipment arestated at cost. Depreciation is calculated using the straight-line method overthe estimated useful life of the asset, typically ranging from three to tenyears for all property and equipment except for leasehold improvements andlease acquisition costs. The cost of leasehold 

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improvementsand lease acquisitions is amortized over the lesser of the useful life of theasset or applicable lease term.

***Operating Leases***

We lease retail stores, distribution facilities andoffice space under operating leases. Most lease agreements contain tenantimprovement allowances, rent holidays, lease premiums, rent escalation clausesand/or contingent rent provisions. For purposes of recognizing incentives,premiums and minimum rental expenses on a straight-line basis over the terms ofthe leases, we use the date of initial possession to begin amortization, whichis generally when we enter the space and begin to make improvements inpreparation of intended use. For tenant improvement allowances and rentholidays, we record a deferred rent liability and report it as a long-termliability on the consolidated balance sheets and amortize the deferred rentover the terms of the leases as adjustments to rent expense.

For scheduled rent changes during the lease terms orfor rental payments commencing at a date other than the date of initialoccupancy (rent holidays), we record minimum rental expenses on a straight-linebasis over the terms of the leases.

Certain leases provide forcontingent rents, which are determined as a percentage of gross sales in excessof specified levels. We record a contingent rent liability in “other currentliabilities” and the corresponding rent expense when specified levels have beenachieved or when management determines that achieving the specified levelsduring the fiscal year is probable.

***Impairment of Long-lived Assets***

We review long-lived tangible assets and intangibleassets with finite useful lives for impairment whenever events or changes incircumstances indicate that their carrying values may not be recoverable. Usingour best estimates based on reasonable assumptions and projections, we recordan impairment loss to write the assets down to their estimated fair values ifthe carrying values of such assets exceed their related discounted expectedfuture cash flows.

We review goodwill and other intangibles withindefinite useful lives for impairment annually, or more frequently if eventsor changes in circumstances warrant. If the carrying values of such assetsexceed their estimated fair values, we record an impairment loss to write theassets down to their estimated fair values.

We generally evaluate long-lived tangible assets andintangible assets with finite useful lives at an individual store level, whichis the lowest level at which independent cash flows can be identified. Weevaluate corporate assets or other long-lived assets that are notstore-specific at a consolidated entity or reporting unit level, asappropriate.

Since there is typicallyno active market for our long-lived tangible and intangible assets, we estimatefair values based on the expected future cash flows. We estimate future cashflows based on store-level historical results, current trends and operating andcash flow projections. Our estimates are subject to substantial uncertainty andmay be affected by a number of factors outside our control, including generaleconomic conditions, the competitive environment and regulatory changes. Ifactual results differ from our estimates of future cash flows, we may recordsignificant additional impairment charges in the future.

***Store Closure Reserves***

The Statement of Financial Accounting Standards (“SFAS”)No. 146, *“Accounting for CostsAssociated with Exit or Disposal Activities,”* requires that for exitor disposal activities, initiated after December 31, 2002, we recognize aliability for costs associated with closing a store when the liability isincurred. We record the present value of expected future lease costs and otherclosure costs when the store is closed. We 

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record severance and otheremployee-related costs in the period in which we communicate the closure andrelated severance packages to the affected employees.

While we do not currentlyhave any reserves established for store closures, we periodically makejudgments about which stores we should close and which stores we shouldcontinue to operate. All stores are subject to regular monitoring of theirfinancial performance and cash flows, and many stores are subject to “kick outclauses” which allow us to terminate the store lease if certain contractuallyspecified sales levels are not achieved. If we decide to close a number ofthese stores, we may incur significant store closure costs for which we havenot currently reserved.

***Self Insurance***

We obtain insurance coverage for significant exposuresas well as those risks that, by law, must be insured. It is generally ourpolicy to retain a significant portion of certain losses related to workers’compensation, general liability, property losses, business interruption andemployee health care. We record provisions for these items based on an actuaryreport, claims experience, regulatory changes, an estimate of claims incurredbut not yet reported and other relevant factors. The projections involved inthis process are subject to substantial uncertainty because of several unpredictablefactors, including actual future claims experience, regulatory changes,litigation trends and changes in inflation.

At January 29, 2005 andJanuary 31, 2004, we had recorded accruals for these liabilities of approximately$3.1 million and $2.4 million, respectively.

***Income Taxes***

We account for incometaxes under SFAS No. 109, *“Accountingfor Income Taxes.”* SFAS No.109 requires income taxes to be accountedfor under an asset and liability approach that requires the recognition ofdeferred tax assets and liabilities for the expected future tax consequences ofevents that have been recognized in our Consolidated Financial Statements ortax returns. In estimating future tax consequences, we generally take intoaccount all expected future events then known to us, other than changes in thetax law or rates, which are not permitted to be considered. Accordingly, ifneeded we may record a valuation allowance to reduce our deferred tax assets tothe amount that is more likely than not to be realized. The amount of valuationallowance would be based upon management’s best estimate of the recoverabilityof our deferred tax assets. While future taxable income and ongoing prudent andfeasible tax planning are considered in determining the amount of the valuationallowance, the necessity for an allowance is subject to adjustment in thefuture. Specifically, in the event we were to determine that we would not beable to realize our deferred tax assets in the future in excess of their netrecorded amounts, an adjustment to the deferred tax assets would decreaseincome in the period such determination was made.

***Contingenciesand Litigation***

We are involved from timeto time in legal proceedings, including litigation arising in the ordinarycourse of our business. Due to the uncertainties inherent in any legalproceeding, we cannot accurately predict the ultimate outcome of any proceedingand may incur substantial costs to defend the proceeding, irrespective of themerits. Unfavorable outcome of any legal proceeding could have an adverseimpact on our business, financial condition and results of operations. Asappropriate, we assess the likelihood of any adverse outcomes and the potentialrange of probable losses. The amount of loss accrual, if any, is subject toadjustment if and when warranted by new developments or revised strategies. Itis possible, however, that future results of operations for any particularquarterly or annual period could be materially affected by changes in ourassumptions related to these proceedings. We accrue our best estimates of theprobable settlement for the resolution of legal claims. Such estimates aredeveloped in consultation with outside 

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counselhandling these matters and are based upon a combination of litigation andsettlement strategies. To the extent additional information arises or ourstrategies change, it is possible that our best estimates of our probableliability in these matters may change.

***Other Considerations***

The above listing is notintended to be a comprehensive list of all of our accounting policies. In manycases, the accounting treatment of a particular transaction is specificallydictated by generally accepted accounting principles, with no need formanagement’s judgment in their application. There are also areas in whichmanagement’s judgment in selecting any available alternative would not producea materially different result. See our audited consolidated financialstatements and notes thereto in this annual report on Form 10-K,which contain accounting policies and other disclosures required by generallyaccepted accounting principles.

**RECENTLY ISSUEDACCOUNTING STANDARDS**

In November 2004, the FASB issued SFAS No. 151,*“Inventory Costs”*which clarifiesthe accounting for abnormal amounts of idle facility expense, freight, handlingcosts and wasted material (spoilage). This statement is effective for our 2005fiscal year-end. We believe the adoption of SFAS 151 will not have asignificant impact on the overall results of operations or financial position.

In December 2004, theFASB issued the revised SFAS No. 123(R) “*Share-Based Payment.*” SFAS 123(R) requires therecognition of stock-based compensation expense relating to share-based paymenttransactions in consolidated financial statements. That expense will bemeasured based on the fair value of the equity or liability instruments issuedas of the grant date, based on the estimated number of awards that are expectedto vest. SFAS 123(R) covers a wide range of share-based compensationarrangements including share options, restricted share plans, performance-basedawards, share appreciation rights, and employee share purchase plans. SFAS 123(R) iseffective for interim periods that begin after June 15, 2005. The Companyis allowed to select from three alternative transition methods, each havingdifferent reporting implications. We have not completed our evaluation ordetermined the impact of adopting SFAS 123(R).

**OFF-BALANCE SHEETARRANGEMENTS**

Except for our operationallease commitments, we do not have any other off-balance sheet arrangements, assuch term is defined in recently enacted rules by the Securities andExchange Commission, that have or are reasonably likely to have a current orfuture effect on our financial condition, changes in financial condition,revenue or expenses, results of operations, liquidity, capital expenditures orcapital resources that are material to investors.

**RELATED PARTYTRANSACTIONS**

During fiscal 2004, Stephen Gordon was Chairman of ourBoard of Directors. Our store in Eureka, California involves two leases, oneinvolving Mr. Gordon directly and the other involving a partnership inwhich Mr. Gordon is a partner. The aggregate lease payments paid to Mr. Gordonand the partnership were $42,000 for fiscal 2004, 2003 and 2002. We believethat the lease arrangements involving Mr. Gordon and the partnership inwhich Mr. Gordon is a partner were made on terms no less favorable to usthan could have been obtained from unaffiliated third parties. In January 2005,Mr. Gordon resigned from his role within the Company and as Chairman ofthe Board**.**

Jason Camp, a Senior Vice President of our Company andthe son of one of our directors, Robert E. Camp, was asked to relocate toCalifornia in 2001 as part of his job function. In connection with thisrelocation, we made a full recourse loan to him in the principal amount of$200,000. The interest on the 

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outstanding principalamount of the loan is 8.0% per annum, compounded annually, and the entireamount of interest and all outstanding principal is due and payable on August 15,2006, if not earlier pre-paid in full with interest.

We lease one of ourproperties from the previous owner and current president of The MichaelsFurniture Company. Total annual payments made in fiscal 2004, 2003 and 2002were $456,000.

**CAUTIONARYSTATEMENT REGARDING FORWARD-LOOKING STATEMENTS**

This annual report on Form 10-Kcontains “forward-looking statements,” within the meaning of the PrivateSecurities Litigation Reform Act of 1995, that involve known and unknown risks.Such forward-looking statements include without limitation statements relatingto our future plans, in particular with respect to store openings and closings;statements relating to anticipated future costs and expenses; statements aboutnew merchandise initiatives and website marketing efforts; statements relatingto anticipated future revenue growth, including statements about marginexpansion, operational efficiencies and cost reductions; statements relating tofuture availability under our revolving credit facility; statements relating toour working capital and capital expenditure needs, and other statementscontaining words such as “believe,” “anticipate,” “expect,” “may,” “intend,”and words of similar import or statements of our management’s opinion. Theseforward-looking statements and assumptions involve known and unknown risks,uncertainties and other factors that may cause our actual results, marketperformance or achievements to differ materially from any future results,performance or achievements expressed or implied by such forward-looking statements.Important factors that could cause such differences include, but are notlimited to, changes in economic or business conditions in general, changes inproduct supply, fluctuations in comparable store sales, limitations resultingfrom restrictive covenants in our revolving credit facility, failure of ourmanagement to anticipate changes in consumer trends, loss of key vendors,changes in the competitive environment in which we operate, changes in ourmanagement information needs, changes in management, failure to raiseadditional funds when required, changes in customer needs and expectations andgovernmental actions and consequences stemming from the continued wars in Iraqand Afghanistan or from terrorist activities in or related to the United Statesof America, and other factors described above in the section “Factors That May AffectOur Future Operating Results.” We undertake no obligation to update anyforward-looking statements in order to reflect events or circumstances that mayarise after the date of this annual report on Form 10-K.

**ITEM 7A.**        QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risks, which include changesin interest rates and, to a lesser extent, foreign exchange rates. We do notengage in financial transactions for trading or speculative purposes.

The interest payable on our revolving credit facilityis based on variable interest rates and is, therefore, affected by changes inmarket interest rates. If interest rates on existing variable rate debt rosemore than 10% from the bank’s reference rate, our results of operations andcash flows would not be materially affected.

We do enter into a significant amount of purchaseobligations outside of the United States of America which, to date, have been settledmostly in U.S. dollars and, therefore, we have only minimal exposure at presentto foreign currency exchange risks. Historically, we have not hedged ourcurrency risk and do not currently anticipate doing so in the future. However,it is possible that in the future a growing number of our purchases outside ofthe United States of America will be made in currencies other than the U.S.dollar. Consequently, fluctuations in the rates of exchange between the U.S.dollar and other currencies may subject us to foreign currency exchange risksin the future.

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**ITEM 8.**                CONSOLIDATED FINANCIALSTATEMENTS AND SUPPLEMENTARY DATA

**RESTORATIONHARDWARE, INC.CONSOLIDATED BALANCE SHEETS(Dollars in thousands)**
| ** **                                                                                                                                                                                                                                                                                                | ** ** | ** **                 | ** ** | **January 31,  2004 **             | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                | ** ** | **January 29,  2005** | ** ** | **(As restated—see  Note 2)** | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                |       |                       |       |                                         |       |   |   |   |   |
| Current assets:                                                                                                                                                                                                                                                                                           |       |                       |       |                                         |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                                                                                                                                                                                                |       |                       | $          | 1,904                                        |       |   |   | $ | 2,003 |   |   |
| Accounts  receivable                                                                                                                                                                                                                                                                                      |       |                       | 6,945      |                                         |       |   | 5,745 |   |   |
| Merchandise  inventories                                                                                                                                                                                                                                                                                  |       |                       | 144,185    |                                         |       |   | 102,926 |   |   |
| Deferred tax assets,  current portion, net                                                                                                                                                                                                                                                                |       |                       | 7,119      |                                         |       |   | 5,371 |   |   |
| Prepaid expense  and other current assets                                                                                                                                                                                                                                                                 |       |                       | 12,455     |                                         |       |   | 10,299 |   |   |
| Total current  assets                                                                                                                                                                                                                                                                                     |       |                       | 172,608    |                                         |       |   | 126,344 |   |   |
| Property and  equipment, net                                                                                                                                                                                                                                                                              |       |                       | 81,886     |                                         |       |   | 83,518 |   |   |
| Goodwill                                                                                                                                                                                                                                                                                                  |       |                       | 4,560      |                                         |       |   | 4,560 |   |   |
| Deferred tax assets,  net                                                                                                                                                                                                                                                                                 |       |                       | 18,745     |                                         |       |   | 18,051 |   |   |
| Other assets                                                                                                                                                                                                                                                                                              |       |                       | 1,464      |                                         |       |   | 1,422 |   |   |
| Total assets                                                                                                                                                                                                                                                                                              |       |                       | $          | 279,263                                      |       |   |   | $ | 233,895 |   |   |
| **LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED  STOCK AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                                                    |       |                       |       |                                         |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                                                                                                                      |       |                       |       |                                         |       |   |   |   |   |
| Accounts payable  and accrued expenses                                                                                                                                                                                                                                                                    |       |                       | $          | 63,920                                       |       |   |   | $ | 45,292 |   |   |
| Line of credit,  net of debt issuance                                                                                                                                                                                                                                                                     |       |                       | 33,819     |                                         |       |   | 10,286 |   |   |
| Deferred revenue  and customer deposits                                                                                                                                                                                                                                                                   |       |                       | 8,130      |                                         |       |   | 7,231 |   |   |
| Other current  liabilities                                                                                                                                                                                                                                                                                |       |                       | 14,948     |                                         |       |   | 11,438 |   |   |
| Total current  liabilities                                                                                                                                                                                                                                                                                |       |                       | 120,817    |                                         |       |   | 74,247 |   |   |
| Deferred lease  incentives                                                                                                                                                                                                                                                                                |       |                       | 30,365     |                                         |       |   | 33,999 |   |   |
| Deferred rent                                                                                                                                                                                                                                                                                             |       |                       | 20,321     |                                         |       |   | 20,224 |   |   |
| Other long-term  obligations                                                                                                                                                                                                                                                                              |       |                       | 143        |                                         |       |   | 352 |   |   |
| Total liabilities                                                                                                                                                                                                                                                                                         |       |                       | 171,646    |                                         |       |   | 128,822 |   |   |
| Series A  redeemable convertible preferred stock, $.0001 par value, 28,037 shares  designated, 8,473 and 8,683 shares outstanding at January 29, 2005 and  January 31, 2004, respectively, aggregate liquidation preference and  redemption value of $10,429 at January 29, 2005 |       |                       | 8,331      |                                         |       |   | 8,541 |   |   |
| Stockholders’ equity:                                                                                                                                                                                                                                                                                |       |                       |       |                                         |       |   |   |   |   |
| Common stock,  $.0001 par value, 60,000,000 shares authorized, 33,084,223 and 32,768,065  shares issued and outstanding at January 29, 2005 and January 31,  2004, respectively                                                                                                                 |       |                       | 3          |                                         |       |   | 3 |   |   |
| Additional paid-in  capital                                                                                                                                                                                                                                                                               |       |                       | 159,233    |                                         |       |   | 158,174 |   |   |
| Unearned  compensation                                                                                                                                                                                                                                                                                    |       |                       | —     |                                         |       |   | (234 | ) |   |
| Accumulated other  comprehensive income                                                                                                                                                                                                                                                                   |       |                       | 812        |                                         |       |   | 1,055 |   |   |
| Accumulated  deficit                                                                                                                                                                                                                                                                                      |       |                       | (60,762    | )                                            |       |   | (62,466 | ) |   |
| Total  stockholders’ equity                                                                                                                                                                                                                                                                          |       |                       | 99,286     |                                         |       |   | 96,532 |   |   |
| Total liabilities,  redeemable convertible preferred stock and stockholders’ equity                                                                                                                                                                                                                  |       |                       | $          | 279,263                                      |       |   |   | $ | 233,895 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**RESTORATIONHARDWARE, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(Dollars in thousands, except per share amounts)**
| ** **                                        | ** ** | **Fiscal Year Ended**        | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                        | ** ** | ** **                             | ** ** | **January 31,  2004** | ** ** | **February 1,  2003** | ** ** |
| ** **                                        | ** ** | ** January 29,   2005** | ** ** | **(As restated—see  Note 2)** | ** ** | **(As restated—see   Note 2)** | ** ** |
| Net revenue                                       |       |                                   | $          | 525,823 |   |   |   | $ | 438,508 |   |   |   | $ | 400,337 |   |   |
| Cost of revenue  and occupancy                    |       |                                   | 359,808    |   |   |   | 305,265 |   |   |   | 281,815 |   |   |
| Gross profit                                      |       |                                   | 166,015    |   |   |   | 133,243 |   |   |   | 118,522 |   |   |
| Selling, general  and administrative expense      |       |                                   | 161,939    |   |   |   | 135,118 |   |   |   | 126,290 |   |   |
| Income (loss) from operations                     |       |                                   | 4,076      |   |   |   | (1,875 | ) |   |   | (7,768 | ) |   |
| Interest expense,  net                            |       |                                   | (2,472     | ) |   |   | (2,154 | ) |   |   | (2,818 | ) |   |
| Change in fair  value of warrants                 |       |                                   | —     |   |   |   | — |   |   |   | (278 | ) |   |
| Income (loss) before income taxes                 |       |                                   | 1,604      |   |   |   | (4,029 | ) |   |   | (10,864 | ) |   |
| Income tax  benefit                               |       |                                   | 100        |   |   |   | 1,511 |   |   |   | 8,019 |   |   |
| Net income (loss)                                 |       |                                   | 1,704      |   |   |   | (2,518 | ) |   |   | (2,845 | ) |   |
| Preferred stockholder  return:                    |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Dividends                                         |       |                                   | —     |   |   |   | — |   |   |   | (358 | ) |   |
| Income (loss) attributable to common stockholders |       |                                   | $          | 1,704 |   |   |   | $ | (2,518 | ) |   |   | $ | (3,203 | ) |   |
| Income (loss) per share of common stock, basic    |       |                                   | $          | 0.05 |   |   |   | $ | (0.08 | ) |   |   | $ | (0.11 | ) |   |
| Income (loss) per share of common stock, diluted  |       |                                   | $          | 0.04 |   |   |   | $ | (0.08 | ) |   |   | $ | (0.11 | ) |   |
| Weighted average shares outstanding, basic        |       |                                   | 32,940     |   |   |   | 30,873 |   |   |   | 29,754 |   |   |
| Weighted average  shares outstanding, diluted     |       |                                   | 38,183     |   |   |   | 30,873 |   |   |   | 29,754 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**RESTORATIONHARDWARE, INC.CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLEPREFERRED STOCK AND STOCKHOLDERS’ EQUITY(Dollars in thousands)**
| ** **                                            | ** ** | **Redeemable  Convertible  Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional  Paid-In** | ** ** | **Stockholder**  | ** ** | **Unearned** | ** ** | **Accumulated  Other  Comprehensive** | ** **     | **Accumulated**  | ** ** | **Total  Stockholders’** | ** **                                        | **Total  Comprehensive  Income** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------------|------------|-----------------------|------------|-------------------------|------------|------------------|------------|--------------|------------|---------------------------------------|----------------|------------------|------------|-------------------------------|---------------------------------------------------|----------------------------------|------------|
| ** **                                            | ** ** | **Shares**                                        | ** ** | **Amount**            | ** ** | **Shares**              | ** ** | ** Amount** | ** ** | **Capital**  | ** ** | **Loan**                              | ** **     | **Compensation** | ** ** | **Income**                    | ** **                                        | **Deficit**                      | ** ** | **Equity** | ** ** | **(Loss)** | ** ** |
| BALANCE AT  FEBRUARY 2, 2002  (As restated)           |       | 14,320                                            |       | 14,106                |       | 28,827,883              |       |             | 3          |         |       |                                  | 144,159        |             |       |                          | (2,050                                            | )                                |       |   | (1,103 | ) |   |   | (159 | ) |   |   | (56,745 | ) |   |   | 84,105 |   |   |   |   |   |   |
| Issuance of common  stock                             |       | —                                            |       | —                |       | 490,700                 |       |             | —     |         |       |                                  | 1,770          |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,770 |   |   |   |   |   |   |
| Repayment of  stockholder loan                        |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | 2,050                                             |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 2,050 |   |   |   |   |   |   |
| Tax benefit on  exercise of stock options             |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | 873            |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 873 |   |   |   |   |   |   |
| Preferred stock  issuance costs                       |       | —                                            |       | (201                  | )          | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | — |   |   |   |   |   |   |
| Conversion of  preferred stock to common stock   |       | (850                                              | )          | (935                  | )          | 425,809                 |       |             | —     |         |       |                                  | 935            |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 935 |   |   |   |   |   |   |
| Exercise of  warrants                                 |       | —                                            |       | —                |       | 306,602                 |       |             | —     |         |       |                                  | 2,957          |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 2,957 |   |   |   |   |   |   |
| Accretion of  cumulative dividends of preferred stock |       | —                                            |       | 358                   |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | (358 | ) |   |   | (358 | ) |   |   |   |   |   |
| Stock compensation                                    |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | 184            |             |       |                          | —                                            |                             |       |   | (92 | ) |   |   | — |   |   |   | — |   |   |   | 92 |   |   |   |   |   |   |
| Amortization of  unearned stock compensation          |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | 536 |   |   |   | — |   |   |   | — |   |   |   | 536 |   |   |   |   |   |   |
| Foreign currency  translation adjustment              |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | — |   |   |   | 27 |   |   |   | — |   |   |   | 27 |   |   |   | 27 |   |   |
| Net loss (As  restated)                               |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | (2,845 | ) |   |   | (2,845 | ) |   |   | (2,845 | ) |   |
| BALANCE AT  FEBRUARY 1, 2003  (As restated)           |       | 13,470                                            |       | 13,328                |       | 30,050,994              |       |             | 3          |         |       |                                  | 150,878        |             |       |                          | —                                            |                             |       |   | (659 | ) |   |   | (132 | ) |   |   | (59,948 | ) |   |   | 90,142 |   |   |   | (2,818 | ) |   |
| Issuance of common  stock                             |       | —                                            |       | —                |       | 311,775                 |       |             | —     |         |       |                                  | 1,110          |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,110 |   |   |   |   |   |   |
| Stockholder  settlement                               |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | 1,050          |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 1,050 |   |   |   |   |   |   |
| Tax benefit on  exercise of stock options             |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | 276            |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 276 |   |   |   |   |   |   |
| Conversion of  preferred stock to common stock   |       | (4,787                                            | )          | (4,787                | )          | 2,405,296               |       |             | —     |         |       |                                  | 4,787          |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 4,787 |   |   |   |   |   |   |
| Stock compensation                                    |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | 73             |             |       |                          | —                                            |                             |       |   | (73 | ) |   |   | — |   |   |   | — |   |   |   | — |   |   |   |   |   |   |
| Amortization of  unearned stock compensation          |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | 498 |   |   |   | — |   |   |   | — |   |   |   | 498 |   |   |   |   |   |   |
| Foreign currency  translation adjustment              |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | — |   |   |   | 1,187 |   |   |   | — |   |   |   | 1,187 |   |   |   | 1,187 |   |   |
| Net loss (As  restated)                               |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | (2,518 | ) |   |   | (2,518 | ) |   |   | (2,518 | ) |   |
| BALANCE AT JANUARY  31, 2004  (As restated)           |       | 8,683                                             |       | 8,541                 |       | 32,768,065              |       |             | 3          |         |       |                                  | 158,174        |             |       |                          | —                                            |                             |       |   | (234 | ) |   |   | 1,055 |   |   |   | (62,466 | ) |   |   | 96,532 |   |   |   | (1,331 | ) |   |
| Issuance of common  stock                             |       | —                                            |       | —                |       | 210,606                 |       |             | —     |         |       |                                  | 704            |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 704 |   |   |   |   |   |   |
| Tax benefit on exercise  of stock options             |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | 145            |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 145 |   |   |   |   |   |   |
| Conversion of  preferred stock to common stock   |       | (210                                              | )          | (210                  | )          | 105,552                 |       |             | —     |         |       |                                  | 210            |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | — |   |   |   | 210 |   |   |   |   |   |   |
| Amortization of  unearned stock compensation          |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | 234 |   |   |   | — |   |   |   | — |   |   |   | 234 |   |   |   |   |   |   |
| Foreign currency  translation adjustment              |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | — |   |   |   | (243 | ) |   |   | — |   |   |   | (243 | ) |   |   | (243 | ) |   |
| Net income                                            |       | —                                            |       | —                |       | —                  |       |             | —     |         |       |                                  | —         |             |       |                          | —                                            |                             |       |   | — |   |   |   | — |   |   |   | 1,704 |   |   |   | 1,704 |   |   |   | 1,704 |   |   |
| BALANCE AT JANUARY  29, 2005                          |       | 8,473                                             |       | $  8,331    |       | 33,084,223              |       |             | $ 3   |         |       |                                  | $ 159,233 |             |       |                          | $       — |                             |       |   | $       — |   |   |   | $  812 |   |   |   | $ (60,762 | ) |   |   | $ 99,286 |   |   |   | $ 1,461 |   |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

35

 

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**RESTORATIONHARDWARE, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Dollars in thousands)**
| ** **                                                                            | ** ** | **Fiscal Year Ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                            | ** ** | ** **                      | ** ** | **January 31** | ** ** | **February 1,** | ** ** |
| ** **                                                                            | ** ** | ** **                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | **January 29,**            | ** ** | **(As restated—see ** | ** ** | **(As restated—see ** | ** ** |
| ** **                                                                            | ** ** | **2005**                        | ** ** | **Note 2)** | ** ** | **Note 2)** | ** ** |
| Cash flows from operating  activities:                                                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Net income (loss)                                                                     |       |                            | $          | 1,704 |   |   |   | $ | (2,518 | ) |   |   | $ | (2,845 | ) |   |
| Adjustments to  reconcile net income (loss) to net cash used by operating activities: |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Change in fair value of warrants                                                      |       |                            | —     |   |   |   | — |   |   |   | 278 |   |   |
| Depreciation and amortization                                                         |       |                            | 15,946     |   |   |   | 18,021 |   |   |   | 18,641 |   |   |
| Impairment of property and equipment                                                  |       |                            | —     |   |   |   | — |   |   |   | 555 |   |   |
| Deferred income taxes                                                                 |       |                            | (2,442     | ) |   |   | (1,975 | ) |   |   | (3,606 | ) |   |
| Other                                                                                 |       |                            | —     |   |   |   | — |   |   |   | 88 |   |   |
| Changes in  operating assets and liabilities:                                         |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Accounts receivable                                                                   |       |                            | (1,200     | ) |   |   | (2,393 | ) |   |   | (74 | ) |   |
| Merchandise inventories                                                               |       |                            | (41,259    | ) |   |   | (8,426 | ) |   |   | (32,910 | ) |   |
| Prepaid expense, other current assets and other  assets                               |       |                            | (2,198     | ) |   |   | 1,163 |   |   |   | (2,277 | ) |   |
| Accounts payable and accrued expenses                                                 |       |                            | 18,628     |   |   |   | 9,643 |   |   |   | 1,726 |   |   |
| Deferred revenue and customer deposits                                                |       |                            | 899        |   |   |   | 1,185 |   |   |   | 2,332 |   |   |
| Other current liabilities                                                             |       |                            | 3,655      |   |   |   | 2,292 |   |   |   | 891 |   |   |
| Deferred rent                                                                         |       |                            | 97         |   |   |   | (438 | ) |   |   | 217 |   |   |
| Deferred lease incentives and other long-term  obligations                            |       |                            | (3,634     | ) |   |   | (5,110 | ) |   |   | (2,537 | ) |   |
| Net cash (used) provided by operating activities                                      |       |                            | (9,804     | ) |   |   | 11,444 |   |   |   | (19,521 | ) |   |
| Cash flows from  investing activities:                                                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Capital expenditures                                                                  |       |                            | (13,380    | ) |   |   | (9,229 | ) |   |   | (19,390 | ) |   |
| Net cash used by investing activities                                                 |       |                            | (13,380    | ) |   |   | (9,229 | ) |   |   | (19,390 | ) |   |
| Cash  flows from financing activities:                                                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Borrowings (repayments) under line of credit, net                                     |       |                            | 23,202     |   |   |   | (3,917 | ) |   |   | 15,215 |   |   |
| Debt issuance costs                                                                   |       |                            | (161       | ) |   |   | (434 | ) |   |   | (806 | ) |   |
| Repayment of stockholder loan                                                         |       |                            | —     |   |   |   | — |   |   |   | 2,050 |   |   |
| Proceeds received from stockholder settlement                                         |       |                            | —     |   |   |   | 1,050 |   |   |   | — |   |   |
| Borrowings (repayments)—other long-term obligations                              |       |                            | (209       | ) |   |   | (385 | ) |   |   | — |   |   |
| Issuance of common stock                                                              |       |                            | 704        |   |   |   | 1,110 |   |   |   | 1,770 |   |   |
| Net cash provided (used) by financing activities                                      |       |                            | 23,536     |   |   |   | (2,576 | ) |   |   | 18,229 |   |   |
| Effects of foreign currency exchange rate translation                                 |       |                            | (451       | ) |   |   | 734 |   |   |   | 27 |   |   |
| Net (decrease) increase in cash and cash equivalents                                  |       |                            | (99        | ) |   |   | 373 |   |   |   | (20,655 | ) |   |
| Cash and cash equivalents:                                                            |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Beginning of period                                                                   |       |                            | 2,003      |   |   |   | 1,630 |   |   |   | 22,285 |   |   |
| End of period                                                                         |       |                            | $          | 1,904 |   |   |   | $ | 2,003 |   |   |   | $ | 1,630 |   |   |
| Additional cash  flow information:                                                    |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Cash paid during the year for interest                                                |       |                            | $          | 1,880 |   |   |   | $ | 1,554 |   |   |   | $ | 1,513 |   |   |
| Cash paid (received) during the year for taxes                                        |       |                            | 598        |   |   |   | (1,427 | ) |   |   | (4,096 | ) |   |
| Non-cash transactions:                                                                |       |                            |       |   |   |   |   |   |   |   |   |   |   |
| Dividends attributable to preferred stock                                             |       |                            | —     |   |   |   | — |   |   |   | $ | (358 | ) |   |
| Property and equipment acquired under capital leases                                  |       |                            | —     |   |   |   | 593 |   |   |   | — |   |   |
| Exercise of warrants                                                                  |       |                            | —     |   |   |   | — |   |   |   | 2,957 |   |   |
| Conversion of  preferred stock to common stock                                        |       |                            | $          | 210 |   |   |   | $ | 4,787 |   |   |   | $ | 935 |   |   |

 

The accompanying notes are an integral part of these consolidated financial statements.

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**RESTORATIONHARDWARE, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**(1)   SUMMARYOF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES**

**Nature of Business**

Restoration Hardware, Inc.,a Delaware corporation (together with its subsidiaries collectively, the “Company”),is a specialty retailer of high-quality home furnishings, bathware, hardware,textiles, accessories and related merchandise. These products are sold throughretail locations, catalogs and the Internet. At January 29, 2005, theCompany operated a total of 102 retail stores and one outlet store in 30states, the District of Columbia and in Canada.

**Basis ofPresentation and Fiscal Years**

The consolidated financialstatements include the accounts of Restoration Hardware, Inc. and itssubsidiaries. All inter-company balances and transactions are eliminated inconsolidation. The Company operates on a 52—53 week fiscal year ending on theSaturday closest to January 31. The fiscal years ended January 29,2005 (“Fiscal 2004”), January 31, 2004 (“Fiscal 2003”), and February 1,2003 (“Fiscal 2002”) consisted of 52 weeks.

**Use of AccountingEstimates**

The preparation ofconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosures of contingent assets and liabilities at the date ofthe consolidated financial statements and the reported amounts of revenue andexpenses during the reporting period. The Company’s significant accountingestimates include lower of cost or market write-downs on inventory, expectedfuture cash flows in the review for impairment on long-lived assets, theadequacy of self insurance reserves, realization of deferred tax assets,including the potential need for valuation allowances on these tax assets andsales returns reserves. Actual results for these and other estimates coulddiffer from those estimates. Particularly, if the Company is not able tocontinue to achieve positive operating results in the future, a valuationallowance for some or all of the deferred tax might need to be recorded againstfuture operations. Additionally, with regard to the Company’s valuation oflong-lived assets, its estimates are subject to substantial uncertainty and maybe affected by a number of factors outside its control, including generaleconomic conditions, the competitive environment and regulatory changes. Ifactual results differ from the Company’s estimates of future cash flows, it mayrecord significant impairment charges in the future.

**Cash and CashEquivalents**

The Company considers allhighly liquid investments with original maturities of three months or less tobe cash equivalents.

**Accounts Receivable**

Accounts receivableconsist primarily of receivables from the Company’s credit card processors forsales transactions, and tenant improvement allowances from the Company’slandlords in connection with new leases. The Company has typically not providedan allowance for doubtful accounts for these receivables, as its bad debtexperience has been insignificant.

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**MerchandiseInventories**

The Company’s retail inventories are carried at the lower ofcost or market with cost determined on a weighted average cost method. Manufacturinginventories are carried at the lower of cost or market with cost determined atstandard costs, approximating average costs. Costs include certain buying anddistribution costs, including payroll and other costs related to the purchaseof inventory. The Company writes down inventories whenever markdowns reduce theselling price below cost. Additionally, it provides for reserves on inventorybased upon estimated shrinkage losses. The Company also writes down itsslow-moving and discontinued inventory to its estimated market value based uponassumptions about future demand and market conditions. If actual marketconditions are less favorable than those projected by management, or ifliquidation of the inventory is more difficult than anticipated, additionalinventory write-downs may be required.

**Prepaid Catalog andAdvertising Expenses**

Prepaid catalog expenses consist of the cost toprepare, print and distribute catalogs. Such costs are amortized over theexpected revenue generated from each catalog based on historical experience.Typically the cost of a catalog is amortized over approximately five months. AtJanuary 29, 2005 and January 31, 2004, the Company had$5.5 million and $3.6 million, respectively, of prepaid catalog coststhat are included in prepaid expense and other on the accompanying ConsolidatedBalance Sheets.

Advertising costsprimarily represent those associated with the Company’s catalog mailings, aswell as print and web site marketing. For the fiscal years ended January 29,2005, January 31, 2004 and February 1, 2003, advertising costs wereapproximately $40.2 million, $26.5 million and $23.5 million,respectively.

**Property andEquipment**

Property and equipment are stated at cost.Depreciation is calculated using the straight-line method over the estimateduseful life of the asset, typically ranging from three to ten years for allproperty and equipment except for leasehold improvements and lease acquisitioncosts. The cost of leasehold improvements and lease acquisitions is amortizedover the lesser of the useful life of the asset or the applicable lease term.

Assets acquired undernon-cancelable leases, which meet the criteria of capital leases, arecapitalized in property and equipment and amortized over the lesser of the usefullife of the related assets or the applicable lease term.

**Goodwill**

Goodwill represents theexcess of the purchase price over the fair value of the net assets acquired inthe purchase of The Michaels Furniture Company, Inc. The Company reviewsgoodwill and other intangibles with indefinite useful lives for impairmentannually, or more frequently if events or changes in circumstances warrant. Ifthe carrying values of such assets were to exceed their estimated fair values,the Company would record an impairment loss to write the assets down to theirestimated fair values. There were no impairment charges recorded againstgoodwill in fiscal 2004, 2003 or 2002. The Company had $4.6 million ofgoodwill as of January 29, 2005 and January 31, 2004.

**Impairment ofLong-lived Assets**

The Company reviews long-lived tangible assets andintangible assets with finite useful lives for impairment whenever events orchanges in circumstances indicate that their carrying values may not berecoverable. Using the Company’s best estimates based on reasonable assumptionsand projections, the 

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Company records animpairment loss to write the assets down to their estimated fair values if thecarrying values of such assets exceed their related discounted expected futurecash flows.

The Company generally evaluates long-lived tangibleassets and intangible assets with finite useful lives at an individual storelevel, which is the lowest level at which independent cash flows can beidentified. The Company evaluates corporate assets or other long-lived assetsthat are not store-specific at a consolidated entity or reporting unit level,as appropriate.

Since there is typically no active market for ourlong-lived tangible and intangible assets, the Company estimates fair valuesbased on the expected future cash flows. The Company estimates future cashflows based on store-level historical results, current trends and operating andcash flow projections. The Company’s estimates are subject to substantialuncertainty and may be affected by a number of factors outside its control,including general economic conditions, the competitive environment andregulatory changes. If actual results differ from the Company’s estimates offuture cash flows, it may record significant additional impairment charges inthe future.

For the fiscal year ended February 1,2003, the Company recorded a $0.6 million impairment charge on thelong-lived assets of one underperforming store. The impairment charge was equalto the difference between the carrying value of the long-lived assets and thepresent value of estimated future cash flows for that store. For the fiscalyears ended January 29, 2005 and January 31, 2004, respectively, noimpairment charges were recorded.

**Operating Leases**

The Company leases retail stores, distributionfacilities and office space under operating leases. Most lease agreementscontain tenant improvement allowances, rent holidays, lease premiums, rentescalation clauses and/or contingent rent provisions. For purposes ofrecognizing incentives, premiums and minimum rental expenses on a straight-linebasis over the terms of the leases, the Company uses the date of initialpossession to begin amortization, which is generally when the Company entersthe space and begins to make improvements in preparation of intended use. Fortenant improvement allowances and rent holidays, the Company records a deferredrent liability and reports it as a long-term liability on the consolidatedbalance sheets and amortizes the deferred rent over the terms of the leases asadjustments to rent expense.

For scheduled rent changes during the lease terms orfor rental payments commencing at a date other than the date of initialoccupancy (rent holidays), the Company records minimum rental expenses on astraight-line basis over the terms of the leases.

Certain leases provide forcontingent rents, which are determined as a percentage of gross sales in excessof specified levels. The Company records a contingent rent liability in “othercurrent liabilities” and the corresponding rent expense when specified levelshave been achieved or when management determines that achieving the specifiedlevels during the fiscal year is probable.

**Store ClosureReserves**

Statement of Financial Accounting Standards (“SFAS”) No. 146,*“Accounting for Costs Associated with Exitor Disposal Activities,”* requires that for exit or disposalactivity, initiated after December 31, 2002, the Company recognizes aliability for costs associated with closing a store when the liability isincurred. The Company records the present value of expected future lease costsand other closure costs when the store is closed. The Company records severanceand other employee-related costs in the period in which it communicates theclosure and related severance packages to the affected employees. Costsincurred in connection with closure of two underperforming stores were fullyrecognized during fiscal 2004 and no amounts remained accrued as of January 29,2005 and January 31, 2004.

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While the Company does notcurrently have any reserves established for store closures, it periodicallymakes judgments about which stores it should close and which stores it shouldcontinue to operate. All stores are subject to regular monitoring of theirfinancial performance and cash flows, and many stores are subject to “kick outclauses” which allow the Company to terminate the store lease without furtherobligation if certain contractually specified sales levels are not achieved. Ifthe Company decides to close a number of its underperforming stores, theCompany may incur significant store closure costs for which store closurereserves have not currently been established.

**Accounts Payable**

Accounts payablerepresents amounts owed to third parties at the end of the period. Accountspayable included negative cash balances, due to outstanding checks, ofapproximately $9.5 million and $12.5 million at January 29, 2005 and January 31,2004, respectively.

**Self Insurance**

The Company obtains insurance coverage for significantexposures as well as those risks that, by law, must be insured. It is generallythe Company’s policy to retain a significant portion of certain losses relatedto workers’ compensation, general liability, property losses, businessinterruption and employee health care. The Company records provisions for theseitems based on an actuary report, claims experience, regulatory changes, anestimate of claims incurred but not yet reported and other relevant factors. Theprojections involved in this process are subject to substantial uncertaintybecause of several unpredictable factors, including actual future claimsexperience, regulatory changes, litigation trends and changes in inflation.

At January 29, 2005and January 31, 2004, the Company had recorded accruals for theseliabilities of approximately $3.1 million and $2.4 million, respectively.

**Revenue Recognition**

Revenue:   Revenue is recognized at the time ofcustomer receipt of merchandise. This can occur when an item is purchased inthe store, or when an item is delivered to the customer. The Company recordsthe sale as revenue in the channel where the transaction originated.

Shipping and handling:   The Company recordsshipping and handling fees as revenue in the revenue channel that originatedthe sales transaction. Costs of shipping and handling are included in cost ofrevenue and occupancy.

Returns:   The Companyprovides an allowance for sales returns based on historical return rates. AtJanuary 29, 2005 and January 31, 2004, the allowance for sales returns wasapproximately $1.3 million and $1.2 million, respectively.

**Store Pre-OpeningActivities**

All store pre-openingcosts are expensed as incurred.

**Income Taxes**

SFAS No. 109, “*Accountingfor Income Taxes*,” requires income taxes to be accounted for underan asset and liability approach that requires the recognition of deferred taxassets and liabilities for the expected future tax consequences of events thathave been recognized in the Company’s Consolidated Financial Statements or taxreturns. In estimating future tax consequences, the Company generally takesinto account all expected future events then known to it, other than changes inthe tax law or rates, which are not permitted to be considered. Accordingly,the Company may record a valuation allowance to reduce 

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its deferred tax assets tothe amount that is more likely than not to be realized. The amount of valuationallowance would be based upon management’s best estimate of the recoverabilityof its deferred tax assets. Future taxable income and ongoing prudent andfeasible tax planning are considered in determining the amount of the valuationallowance, and the amount of the allowance is subject to adjustment in thefuture. Specifically, in the event the Company was to determine that it wouldnot be able to realize its deferred tax assets in the future, an adjustment tothe deferred tax assets valuation allowance would decrease income in the periodsuch determination was made.

As of January 29,2005 and January 31, 2004, the Company recorded net deferred tax assetstotaling $25.9 and $23.4 million, respectively, which primarily represent theincome tax benefit associated with losses reported in prior years and differentfixed asset bases. These losses are subject to federal and state carry-forwardprovisions of up to 20 years. The Company has performed an analysis of thedeferred tax assets for realization, including an evaluation of applicableavailable evidence, both positive and negative. This included an analysis ofresults of operations for fiscal year 2004 and prior years, as well as currentoperating trends and financial projections for future years. As of January 29,2005, the Company has concluded that the net deferred tax assets balance of$25.9 million is more likely than not to be recovered and the previouslyestablished valuation allowance was reversed.

**Estimated FairValue of Financial Instruments**

The carrying values ofcash and cash equivalents, accounts receivable, accounts payable and borrowingsunder the revolving line of credit approximate their estimated fair values.Estimated fair values have been determined by the Company, using availablemarket information and appropriate valuation methodologies. However,considerable judgment is required in interpreting market data to develop theestimates of fair value. Accordingly, the estimates presented herein are notnecessarily indicative of the amounts that the Company could realize in acurrent market exchange. The use of different market assumptions and estimationmethodologies may have a material effect on the estimated fair value amounts.

**Earnings (Loss) PerShare of Common Stock**

Basicearnings (loss) per share of common stock is computed by dividing net income bythe weighted average number of common shares of common stock outstanding forthe period. Diluted earnings (loss) per share of common stock is computed bydividing net income (loss) by the weighted average number of shares of commonstock and potentially dilutive shares of common stock equivalents outstandingduring the period. Diluted earnings (loss) per share of common stock reflects thepotential dilution that could occur if options or warrants to issue shares ofcommon stock were exercised, or shares of preferred stock were converted intoshares of common stock. The following table details potentially dilutive sharesof common stock equivalents that have been included in fiscal 2004 dilutedearnings per share but excluded from diluted loss per share for fiscal 2003 and2002, because their inclusion would be anti-dilutive:
| ** **                                                                           | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                           | ** ** | **2004**             | ** ** | **2003** | ** ** | **2002** | ** ** |
| Convertible preferred  stock and options                                             |       |                 |       |   |   |   |   |
| Shares of common stock subject to outstanding  options                               |       | 940,332              |       | 478,816 |   | 996,110 |   |
| Shares of common stock subject to conversion from the  Series A preferred stock |       | 4,302,029            |       | 6,077,417 |   | 6,764,425 |   |
| Total shares of  common stock equivalents                                            |       | 5,242,361            |       | 6,556,233 |   | 7,760,535 |   |

 

Theabove stock options represent only those stock options whose exercise pricesare less than the average market price of the stock for the years. The numberof shares of common stock subject to the stock 

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options whose exercise prices exceeded the averagemarket price of the stock for the years are 2,650,311, 2,741,516 and 1,206,652for fiscal 2004, 2003 and 2002, respectively.

**ComprehensiveIncome (Loss)**

Comprehensive income(loss) consists of net income (loss) and foreign currency translationadjustments. The components of comprehensive income (loss) are presented in theconsolidated statements of stockholders’ equity.

**Foreign CurrencyTranslation**

Localcurrencies are generally considered the functional currencies outside theUnited States of America. The assets and liabilities of the Company and itssubsidiaries which are denominated in currencies other than the U.S. dollar aretranslated to U.S. dollars at the rate of exchange in effect at the balancesheet date; income and expenses are translated at average rates of exchangeprevailing during the year. The related translation adjustments are reflectedin the other comprehensive income (loss) section of the consolidated statementsof stockholders’ equity. Foreign currency gains and losses resulting fromtransactions denominated in foreign currencies are included in consolidatedstatements of operations.

**Stock-basedCompensation**

TheCompany has one stock-based employee compensation plan, as described inNote 9. The Company accounts for stock-based employee compensation usingthe intrinsic value method in accordance with the provisions of Accounting PrinciplesBoard (“APB”) Opinion No. 25, “*Accounting for StockIssued to Employees*.” The following table illustrates the effect onnet income (loss) and earnings (loss) per share of common stock if the Companyhad applied the fair value recognition provisions of SFAS No. 123, *“Accounting for Stock-Based Compensation,”* to allstock-based employee compensation:
| ** **                                                                                                                                       | ** ** | **Fiscal Year**                                                               | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                       | ** ** | ** **                                                                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                                                                                                                       | ** ** | **2004**                                                                           | ** ** | **(As restated—see  Note 2)** | ** ** | **(As restated—see  Note 2)** | ** ** |
| ** **                                                                                                                                       | ** ** | **(Dollars in thousands, except per share amounts)** | ** ** |
| Net income (loss),  as reported                                                                                                                  |       | $                                                                                  | 1,704      |   |   | $ | (2,518 | ) |   |   | $ | (2,845 | ) |   |
| Add: stock-based  employee compensation expense for options granted below fair market value  included in reported net income (loss) (net of tax) |       | 141                                                                                |       |   | 308 |   |   |   | 336 |   |   |
| Deduct:  compensation expense for all stock-based  employee compensation (net of tax) calculated in accordance with the fair  value method       |       | (3,344                                                                             | )          |   | (1,800 | ) |   |   | (3,056 | ) |   |
| Pro forma net loss                                                                                                                               |       | (1,499                                                                             | )          |   | (4,010 | ) |   |   | (5,565 | ) |   |
| Preferred  stockholder return:                                                                                                                   |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Dividends                                                                                                                                        |       | —                                                                             |       |   | — |   |   |   | (358 | ) |   |
| Pro forma loss  attributable to common stockholders                                                                                              |       | $                                                                                  | (1,499     | ) |   | $ | (4,010 | ) |   |   | $ | (5,923 | ) |   |
| Net income (loss)  per share of common stock:                                                                                                    |       |                                                                               |       |   |   |   |   |   |   |   |   |
| Basic, as reported                                                                                                                               |       | $                                                                                  | 0.05       |   |   | $ | (0.08 | ) |   |   | $ | (0.11 | ) |   |
| Basic, pro forma                                                                                                                                 |       | $                                                                                  | (0.05      | ) |   | $ | (0.13 | ) |   |   | $ | (0.20 | ) |   |
| Diluted, as reported                                                                                                                             |       | $                                                                                  | 0.04       |   |   | $ | (0.08 | ) |   |   | $ | (0.11 | ) |   |
| Diluted, pro  forma                                                                                                                              |       | $                                                                                  | (0.05      | ) |   | $ | (0.13 | ) |   |   | $ | (0.20 | ) |   |

 

42

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TheCompany estimates the fair value of stock option grants using the Black-Scholesoption pricing model, with the following weighted average assumptions:
| ** **               | ** ** | **Fiscal Year** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **2004**             | ** ** | **2003** | ** ** | **2002** | ** ** |
| Dividend yield           |       | —               |       | — |   | — |   |
| Expected  volatility     |       | 65                   | %          | 75 | % | 102 | % |
| Risk-free  interest rate |       | 3.47                 | %          | 3.00 | % | 3.71 | % |
| Expected life (years)    |       | 4.5                  |       | 4.5 |   | 4.5 |   |

 

**New Accounting Pronouncements**

In November 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 151, “*Inventory Costs*”which clarifies the accounting for abnormal amounts of idle facility expense,freight, handling costs and wasted material (spoilage). This statement is effectivefor the Company’s 2005 fiscal year-end. The Company believes the adoption ofSFAS 151 will not have a significant impact on the overall results ofoperations or financial position.

In December 2004, theFASB issued SFAS No. 123(R) “*Share-BasedPayment.*” SFAS 123(R) requires the recognition of compensation expenserelating to share-based payment transactions in consolidated financialstatements. That expense will be measured based on the fair value of the equityor liability instruments issued as of the grant date, based on the estimatednumber of awards that are expected to vest. SFAS 123(R) covers a widerange of share-based compensation arrangements including share options,restricted share plans, performance-based awards, share appreciation rights,and employee share purchase plans. SFAS 123(R) replaces SFAS 123, “*Accounting for Stock Based Compensation*,”and supersedes APB Opinion No. 25, “*Accountingfor Stock Issued to Employee*s.” SFAS 123(R) is effective forinterim periods that begin after June 15, 2005. The Company is allowed toselect from three alternative transition methods, each having differentreporting implications. The Company has not completed its evaluation ordetermined the impact of adopting SFAS 123(R).

**Reclassifications**

Certain reclassificationshave been made to the presentation of prior year results in order to conform tothe current year presentation.

**(2)   RESTATEMENTOF CONSOLIDATED FINANCIAL STATEMENTS**

On February 7, 2005, the Office of the ChiefAccountant of the Securities and Exchange Commission (“SEC”) issued a letter tothe American Institute of Certified Public Accountants expressing its viewsregarding certain operating lease-related accounting issues and their treatmentunder generally accepted accounting principles in the United States of America(“GAAP”). In response to this letter, management reviewed its lease accountingand determined that the Company’s method of accounting for rent holidays wasnot in accordance with GAAP. As a result, the Company restated its ConsolidatedFinancial Statements for fiscal years 2003 and 2002.

Historically, and consistent with industry practice,the Company has recognized the straight line rent expense for leases generallybeginning on the store opening date, which had the effect of excluding theconstruction period of its stores (rent holiday) from the calculation of theperiod over which the Company expensed rent. The Company determined that theappropriate accounting treatment is to include the construction period in itscalculation of straight line rent in accordance with FASB Technical Bulletin No. 85-3,“*Accounting for Operating Leases with Scheduled RentIncreases.*” The Company corrected its straight line rent accrual anddeferred rent credits accordingly.

43

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The cumulative effect of this restatement was anincrease in accumulated deficit of $4.8 million as of February 2, 2002 andincreases in pre-tax results of $0.7 million ($0.4 million, after tax) and$1.3 million ($0.8 million, after tax) for fiscal years ended January 31,2004 and February 1, 2003, respectively. Additionally, the Companycorrected an error recorded in fiscal 2001 related to tax accounting; thecorrection had the effect of increasing the accumulated deficit and decreasingprepaid tax assets by $0.6 million as of February 2, 2002.

Followingis a summary of the effects of the restatement on the Company’s Consolidated FinancialStatements of January 31, 2004 and for fiscal years 2003 and 2002. (*in thousands except share data*):
| ** **                                        | ** ** | **Consolidated Statements of Operations** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                        | ** ** | **As previously**                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                        | ** ** | **reported**                                             | ** ** | **Adjustments** | ** ** | **As restated** | ** ** |
| *Fiscal year ended  January 31, 2004*        |       |                                                     |       |   |   |   |   |   |   |   |   |
| Cost of revenue  and occupancy                    |       |                                                     | $          | 305,980 |   |   |   | $ | (715 | ) |   | $ | 305,265 |   |
| Gross profit                                      |       |                                                     | 132,528    |   |   |   | 715 |   |   | 133,243 |   |
| Loss from  operations                             |       |                                                     | (2,590     | ) |   |   | 715 |   |   | (1,875 | ) |
| Loss before  income taxes                         |       |                                                     | (4,744     | ) |   |   | 715 |   |   | (4,029 | ) |
| Income tax  benefit                               |       |                                                     | 1,803      |   |   |   | (292 | ) |   | 1,511 |   |
| Net loss                                          |       |                                                     | (2,941     | ) |   |   | 423 |   |   | (2,518 | ) |
| Net loss per  common share—basic and diluted |       |                                                     | $          | (0.10 | ) |   |   | $ | 0.02 |   |   | $ | (0.08 | ) |
| *Fiscal  year ended February 1, 2003*        |       |                                                     |       |   |   |   |   |   |   |   |   |
| Cost of revenue  and occupancy                    |       |                                                     | $          | 283,072 |   |   |   | $ | (1,257 | ) |   | $ | 281,815 |   |
| Gross profit                                      |       |                                                     | 117,265    |   |   |   | 1,257 |   |   | 118,522 |   |
| Loss from  operations                             |       |                                                     | (9,025     | ) |   |   | 1,257 |   |   | (7,768 | ) |
| Loss before income  taxes                         |       |                                                     | (12,121    | ) |   |   | 1,257 |   |   | (10,864 | ) |
| Income tax  benefit                               |       |                                                     | 8,518      |   |   |   | (499 | ) |   | 8,019 |   |
| Net loss                                          |       |                                                     | (3,603     | ) |   |   | 758 |   |   | (2,845 | ) |
| Net loss  attributable to common stockholders     |       |                                                     | (3,961     | ) |   |   | 758 |   |   | (3,203 | ) |
| Net loss per common  share—basic and diluted |       |                                                     | $          | (0.13 | ) |   |   | $ | 0.02 |   |   | $ | (0.11 | ) |

 
| ** **                                | ** ** | **Consolidated Balance Sheet** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                | ** ** | **As previously**                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **reported**                             | ** ** | **Adjustments** | ** ** | **As restated** | ** ** |
| *January 31, 2004*                   |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Deferred tax  asset, current portion      |       |                                     | $          | 6,022 |   |   |   | (651 | ) |   |   | 5,371 |   |   |
| Prepaid expense  and other current assets |       |                                     | 10,946     |   |   |   | (647 | ) |   |   | 10,299 |   |   |
| Deferred tax  asset                       |       |                                     | 15,138     |   |   |   | 2,913 |   |   |   | 18,051 |   |   |
| Deferred rent                             |       |                                     | 14,455     |   |   |   | 5,769 |   |   |   | 20,224 |   |   |
| Accumulated  deficit                      |       |                                     | (58,297    | ) |   |   | (4,169 | ) |   |   | (62,466 | ) |   |
| Total stockholders’  equity          |       |                                     | 100,686    |   |   |   | (4,154 | ) |   |   | 96,532 |   |   |
|                                           |            |                                          |            |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                    | ** ** | **Consolidated Statements of Stockholders’ Equity** | ** ** |
|-------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                    | ** ** | **  As previously  **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                    | ** ** | **reported**                                                                 | ** ** | **  Adjustments  ** | ** ** | **  As restated  ** | ** ** |
| *As of February 2, 2002* |       |                                                                         |       |   |   |   |   |   |   |   |   |   |   |
| Accumulated deficit           |       |                                                                         | $          | (51,395 | ) |   |   | $ | (5,350 | ) |   |   | $ | (56,745 | ) |   |
|                               |            |                                                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

44

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**(3)   PROPERTYAND EQUIPMENT**

Propertyand equipment consists of the following:
| ** **                                      | ** ** | **January 29, 2005**       | ** ** | **January 31, 2004** | ** ** |
|-------------------------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **(Dollars in thousands)** | ** ** |
| Leasehold  improvements                         |       |                                 | $          | 135,637                        |       |   |   | $130,994 |   |   |
| Furniture,  fixtures and equipment              |       |                                 | 18,817     |                           |       |   | 16,943 |   |   |
| Machinery and  equipment                        |       |                                 | 9,703      |                           |       |   | 8,870 |   |   |
| Computer software                               |       |                                 | 9,524      |                           |       |   | 8,662 |   |   |
| Equipment under  capital leases(1)              |       |                                 | 571        |                           |       |   | 646 |   |   |
| Total                                           |       |                                 | 174,252    |                           |       |   | 166,115 |   |   |
| Less accumulated  depreciation and amortization |       |                                 | (92,366    | )                              |       |   | (82,597 | ) |   |
| Property and  equipment, net                    |       |                                 | $          | 81,886                         |       |   |   | $ | 83,518 |   |   |
|                                                 |            |                                      |            |                                |            |  |  |  |  |  |  |

----

(1)          Accumulatedamortization of $202 thousand and $68 thousand for fiscal 2004 and 2003,respectively, relates to equipment classified as capital leases. During fiscal2003, the Company exercised its right to buy out certain capital leases withexpiring lease terms.

**(4)   LEASES**

The Company leases certain property consisting ofretail stores, corporate offices, distribution centers and equipment. Leasesexpire at various dates through 2018. The retail stores, distribution centersand corporate office leases generally provide that the Company assumes themaintenance and all or a portion of the property tax obligations on the leasedproperty. Most store leases also provide for minimum annual rentals, withprovisions for additional rent based on a percentage of sales and for paymentof certain expenses.

Theaggregate future minimum rental payments under leases in effect at January 29,2005 (including renewals and substitute leases entered into after year end) areas follows:
| **FISCAL YEAR ENDING**           | ** ** | ** **                           | ** ** | **Capital Leases** | ** ** | **Operating Leases** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|--------------------------------------|------------|-------------------------|------------|---------------------------|------------|-----------|------------|
| ** **                                 | ** ** | **(Dollars in thousands)** | ** ** |
| 2005                                       |       |                                 | $          | 204                     |       |                      |       | $         | 40,295     |   |   | $ | 40,499 |   |
| 2006                                       |       |                                 | 129        |                    |       |                      | 37,986     |      |       | 38,115 |   |
| 2007                                       |       |                                 | 8          |                    |       |                      | 36,549     |      |       | 36,557 |   |
| 2008                                       |       |                                 | 1          |                    |       |                      | 34,693     |      |       | 34,694 |   |
| 2009                                       |       |                                 | —     |                    |       |                      | 31,635     |      |       | 31,635 |   |
| Thereafter                                 |       |                                 | —     |                    |       |                      | 84,288     |      |       | 84,288 |   |
| Minimum lease commitments                  |       |                                 | 342        |                    |       |                      | $          | 265,446   |       |   | $ | 265,788 |   |
| Less amount representing interest          |       |                                 | (28        | )                       |       |                      |       |      |       |   |   |
| Present value of capital lease obligations |       |                                 | 314        |                    |       |                      |       |      |       |   |   |
| Less current portion                       |       |                                 | (182       | )                       |       |                      |       |      |       |   |   |
| Long-term portion                          |       |                                 | $          | 132                     |       |                      |       |      |       |   |   |   |

 

45

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Minimumand contingent rental expense, which is based upon certain factors such assales volume, under operating leases, was as follows:
| ** **                 | ** ** | **Fiscal Year**                 | ** ** |
|----------------------------|------------|--------------------------------------|------------|
| ** **                 | ** ** | **2004**                             | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                 | ** ** | **(Dollars in thousands)** | ** ** |
| Operating leases:          |       |                                 |       |   |   |   |   |
| Minimum rental  expense    |       | $                                    | 39,324     |   | $ | 37,816 |   | $ | 37,482 |   |
| Contingent rental  expense |       | 777                                  |       | 429 |   | 613 |   |
| Total                      |       | $                                    | 40,101     |   | $ | 38,245 |   | $ | 38,095 |   |

 

**(5)   LINE OFCREDIT, NET**

As of January 29, 2005, the Company’s revolvingcredit facility provided for an overall commitment of $100.0 million. Therevolving credit facility was amended in June 2004 to provide foradditional borrowing capacity, reduced borrowing rates and elimination oflimitations on capital expenditures and store openings. In support of continuedgrowth of the Company, the amendment increased the initial available commitmentto $100.0 million, and further allowed the Company to request and receiveincremental increases beyond the initial available commitment of $100.0 millionup to a maximum commitment of $150.0 million, provided no default or event ofdefault exists and certain other conditions are met. The amendment alsoincreased the amount available for letters of credit from $30.0 million to$50.0 million and modified certain other terms in the revolving creditfacility, which had the effect of expanding the borrowing base.

As of January 29, 2005, $33.8 million wasoutstanding under the line of credit, net of unamortized debt issuance costs of$0.7 million, and there was $12.0 million in outstanding letters of credit. Borrowingsmade under the revolving credit facility are subject to interest at either thebank’s reference rate or LIBOR plus a margin. As of January 29, 2005, thebank’s reference rate was 5.75% and the LIBOR plus margin rate was 4.59 %. Theavailability of credit at any given time under the revolving credit facility islimited by reference to a borrowing base formula based upon numerous factors,including the value of eligible inventory and eligible accounts receivable, andreserves established by the agent of the revolving credit facility. Therevolving credit facility is structured to increase availability to meetseasonal needs. As a result of the borrowing base formula, the actual borrowingavailability under the revolving credit facility could be less than the statedamount of the revolving credit facility reduced by the actual borrowings andoutstanding letters of credit. The Company had actual remaining availabilityunder the revolving credit facility of $28.2 million as ofJanuary 29, 2005.

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

The Company’s revolving credit facility requires alock-box arrangement, which provides for all receipts to be swept daily toreduce borrowings outstanding under the revolving credit facility. Thisarrangement, combined with the existence of a subjective acceleration clause inthe revolving credit facility, necessitates that the revolving credit facilitybe classified a current liability on the Consolidated Balance Sheet pursuant toguidance in the FASB’s Emerging Issues Task Force Issue No. 95-22, “*Balance Sheet Classification of BorrowingsOutstanding under Revolving Credit Agreements That Include both a SubjectiveAcceleration Clause and a Lock-Box Arrangement*.”

As of January 31,2004, $10.3 million was outstanding under the line of credit, net ofunamortized debt issuance costs of $1.0 million, and there was $11.5 million inoutstanding letters of credit.

46

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**(6)   INCOMETAXES**

The Company accounts for income taxes using the assetand liability method under SFAS No. 109, “*Accountingfor Income Taxes*.” The Company provides a deferred tax expense orbenefit for differences between financial accounting and tax reporting.Deferred income taxes represent future net tax effects of temporary differencesbetween the Consolidated Financial Statement and tax basis of assets andliabilities, using enacted tax rates in effect for the year in which thedifferences are expected to reverse.

Theincome tax benefit consisted of:
| ** **                           | ** ** | **Fiscal Year**                 | ** ** |
|--------------------------------------|------------|--------------------------------------|------------|
| ** **                           | ** ** | **2004**                             | ** ** | **2003  (As restated—  See Note 2)** | ** ** | **2002  (As restated—  See Note 2)** | ** ** |
| ** **                           | ** ** | **(Dollars in thousands)** | ** ** |
| Current:                             |       |                                 |       |   |   |   |   |   |   |   |   |
| Federal                              |       | $                                    | 1,816      |   |   | $ | 429 |   |   |   | $ | (4,170 | ) |   |
| State                                |       | 108                                  |       |   | 35 |   |   |   | (243 | ) |   |
| Foreign                              |       | 483                                  |       |   | — |   |   |   | — |   |   |
| Total current tax  expense (benefit) |       | 2,407                                |       |   | 464 |   |   |   | (4,413 | ) |   |
| Deferred:                            |       |                                 |       |   |   |   |   |   |   |   |   |
| Federal                              |       | (3,011                               | )          |   | (1,938 | ) |   |   | (3,217 | ) |   |
| State                                |       | 57                                   |       |   | (420 | ) |   |   | (368 | ) |   |
| Foreign                              |       | 447                                  |       |   | 383 |   |   |   | (21 | ) |   |
| Total deferred tax  benefit          |       | (2,507                               | )          |   | (1,975 | ) |   |   | (3,606 | ) |   |
| Total income tax benefit             |       | $                                    | (100       | ) |   | $ | (1,511 | ) |   |   | $ | (8,019 | ) |   |

 

Significantcomponents of the Company’s deferred tax assets and liabilities are as follows:
| ** **                                             | ** ** | ** **                           | ** ** | **January 31,  2004**                   | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|----------------------------------------------|------------|
| ** **                                             | ** ** | **January 29,  2005**           | ** ** | **(As restated—see  Note 2)** | ** ** |
| ** **                                             | ** ** | **(Dollars in thousands)** | ** ** |
| Current deferred tax assets (liabilities):             |       |                                 |       |                                         |       |   |   |   |   |
| Accrued expense                                        |       |                                 | $          | 2,568                                        |       |   |   | $ | 2,222 |   |   |
| State tax benefit                                      |       |                                 | (483       | )                                            |       |   | (387 | ) |   |
| Inventory                                              |       |                                 | 3,664      |                                         |       |   | 3,662 |   |   |
| Deferred revenue                                       |       |                                 | 4,116      |                                         |       |   | 1,981 |   |   |
| Prepaid expense and  other                             |       |                                 | (2,746     | )                                            |       |   | (2,107 | ) |   |
| Net current deferred tax  assets                       |       |                                 | 7,119      |                                         |       |   | 5,371 |   |   |
| Long-term deferred tax assets (liabilities):           |       |                                 |       |                                         |       |   |   |   |   |
| State tax benefit                                      |       |                                 | (1,382     | )                                            |       |   | (1,497 | ) |   |
| Derivative warrant  liability                          |       |                                 | —     |                                         |       |   | 661 |   |   |
| Deferred lease credits                                 |       |                                 | (4,568     | )                                            |       |   | (2,405 | ) |   |
| Property and equipment                                 |       |                                 | 13,186     |                                         |       |   | 11,752 |   |   |
| Net operating loss  carryforwards                      |       |                                 | 11,557     |                                         |       |   | 12,438 |   |   |
| Other                                                  |       |                                 | (48        | )                                            |       |   | 102 |   |   |
| Net long-term deferred  tax assets                     |       |                                 | 18,745     |                                         |       |   | 21,051 |   |   |
| Total deferred tax  assets before valuation allowance  |       |                                 | 25,864     |                                         |       |   | 26,422 |   |   |
| Valuation allowance                                    |       |                                 | —     |                                         |       |   | (3,000 | ) |   |
| Total deferred tax assets, net of valuation  allowance |       |                                 | $          | 25,864                                       |       |   |   | $ | 23,422 |   |   |

 

47

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Areconciliation of the federal statutory tax rate to the Company’s effective taxrate is as follows:
| ** **                                     | ** ** | **Fiscal Year** | ** ** |
|------------------------------------------------|------------|----------------------|------------|
| ** **                                     | ** ** | ** **           | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                     | ** ** | **2004**             | ** ** | **(As restated—see  Note 2)** | ** ** | **(As restated—see  Note 2)** | ** ** |
| Provision at  statutory tax rate               |       | 34.0                 | %          |   | (34.0 | )% |   |   | (34.0 | )% |   |
| State income  taxes, net of federal tax impact |       | 4.2                  |       |   | (5.9 | ) |   |   | (3.7 | ) |   |
| Foreign income                                 |       | 4.1                  |       |   | 1.3 |   |   |   | — |   |   |
| Net adjustments  to tax accruals and other     |       | 138.6                |       |   | 1.1 |   |   |   | 0.7 |   |   |
| Valuation  allowance reversed                  |       | (187.1               | )          |   | — |   |   |   | (36.8 | ) |   |
| Total                                          |       | (6.2                 | )%         |   | (37.5 | )% |   |   | (73.8 | )% |   |

 

As of January 29, 2005, the Company had federaland state net operating loss carryforwards of approximately $27 millionand $33 million, respectively. These net operating loss carryforwards willexpire between 2006 and 2023.

While the Company believes that its tax returnprovisions are supportable, the tax provision includes sufficient accruals forpossible assessments that may result from the examination of federal, state orinternational tax returns. In fiscal 2004, the Company established certain taxcontingency accruals for identified exposures, and the effect on the Company’seffective tax rate is included in the above table under “net adjustments to taxaccruals and other.” These accruals may be adjusted if there are any changes incircumstances, such as changes in tax law, tax audits or other factors that maycause management to revise its estimates. The amounts ultimately paid on futureassessments may differ from the amounts accrued and may result in an increaseor reduction to the effective tax rate in the year of resolution. The Companybelieves that the tax contingency accruals reflect the probable outcome of theknown contingencies.

The Company has performed an analysis of the deferredtax assets for realization, including an evaluation of applicable availableevidence, both positive and negative. This included an analysis of results ofoperations for fiscal year 2004 and prior years, as well as current operatingtrends and financial projections for future years. As of January 29, 2005,the Company has concluded that the net deferred tax assets balance of $25.9million is more likely than not to be recovered and the previously establishedvaluation allowance was reversed. If the Company is not able to continue toachieve positive operating results in the future, a valuation allowance forsome or all of the $25.9 million deferred tax assets might need to be recordedagainst future operations.

The fiscal 2002 income taxbenefit rate reflects a $4.0 million reduction in the valuation allowanceestablished on the Company’s deferred tax assets. The reduction in thevaluation allowance was due to the realization of net operating loss carrybackamounts, resulting from the economic stimulus bill enacted on March 9,2002.

**(7)   REDEEMABLECONVERTIBLE PREFERRED STOCK**

In March 2001, the Company completed a sale ofthe preferred stock with aggregate proceeds to the Company of approximately$15.0 million. The initial sale in March 2001 included the sale of6,820 shares of Series A preferred stock and 8,180 shares of Series Bpreferred stock, for $1,000 per share. The shares of Series B preferredstock were converted on a one-for-one basis into shares of Series Apreferred stock upon the approval of such conversion by the Company’s stockholdersin July 2001. Each share of preferred stock has a par value of $.0001 pershare.

48

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**Convertibility**

The Series Apreferred stock is immediately convertible at the option of the holder intoshares of the Company’s common stock. The initial conversion formula is equalto the original issue price ($1,000) divided by $2.00 per share. Therefore,each share of Series A preferred stock is initially convertible into 500shares of common stock. The conversion price of the Series A preferredstock is subject to certain adjustments for future dilutive events. The Companymay require conversion of the Series A preferred stock, in whole or inpart, by sending written notice of the request for conversion to holders of Series Apreferred stock at any time after March 22, 2004, if the average closingprice per share of the common stock exceeds three times the then-currentconversion price of the Series A preferred stock for the 20 trading daysending 3 business days preceding the date that the written request is sent.Upon the Company’s notice of conversion, holders of Series A preferredstock shall be deemed to have demanded registration of their shares of commonstock received upon conversion of the Series A preferred stock. If suchholders subsequently choose not to include their shares in a registrationstatement, they may request redemption of their shares of Series Apreferred stock, in which case the Company must redeem the shares of Series Apreferred stock in accordance with the terms of the Certificate of Designationof Series A and Series B preferred stock (the “Certificate ofDesignation”). Any such redemption would be at a redemption price of $1,000plus all accrued and unpaid dividends. If the holders do not include theircommon stock in the registration statement, but also do not request redemption,their shares of Series A preferred stock will automatically convert intocommon stock. The conversion price into common stock of $2.00 represents adiscount to the fair market value of the common stock of $2.1875 at March 21,2001, the date on which the preferred stock equity financing was entered into(herein referred to as a “beneficial conversion feature”). The beneficialconversion feature on the Series A preferred stock of $639,375 wasrecorded as a return to the preferred stockholders in March 2001 since theSeries A preferred stock were immediately convertible into common stock.The beneficial conversion feature on the Series B of $766,875 wasinitially being recorded as a return to the preferred stockholders over threeyears, the minimum period at which these stockholders could realize a return throughthe conversion to common stock. In the second quarter of fiscal 2001, upon theconversion of Series B preferred stock into Series A preferred stock,the unamortized balance of the beneficial conversion feature of approximately$707,000 was recorded as a return to the preferred stockholders as the sharesbecame immediately convertible into common stock.

**Redemption**

The Company may redeem theSeries A preferred stock, in whole or part, at any time after March 22,2006, on at least 30 days prior written notice requesting redemption, at aredemption price per share equal to the greater of (a) the average of theclosing price per share of the common stock for 20 trading days ending threebusiness days prior to the date that the written request is sent, or (b) $1,000per share plus all accrued and unpaid dividends.

**Dividends**

If the Company’s Board of Directors declares adividend, each share of Series A preferred stock is entitled to dividendsat the rate of $100 per share per annum. Such dividends are cumulative anddeemed to have accrued from the original date of issuance of the Series Apreferred stock for purposes of determining the liquidation preferences of theholders of the Series A preferred stock and in connection with theexercise of the Company’s redemption rights and the redemption rights of theholders of Series A preferred stock electing to redeem the Company’sconversion rights described above and in the Certificate of Designation. Suchdividends shall not be deemed to be cumulative and shall not be deemed to haveso accrued upon any conversion of the Series A preferred stock into commonstock. The Company shall not pay or declare any dividend on any common stock orany of its other securities that are junior to the 

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Series A preferredstock during any fiscal year unless and until full dividends on the Series Apreferred stock are declared and paid for such fiscal year.

In August 2002, theholders of the Company’s Series A preferred stock agreed to waive theirdividend participation right in the event the Company were to declare adividend on its common stock. In the same agreement, the Company agreed that itwill not declare any dividends payable to its common stock holders until theCompany first obtains the approval of the holders of at least seventy percentof the then outstanding shares of Series A preferred stock. The Companyhas never declared or paid any dividends on its common stock and has noobligation to do so. Beginning with the second quarter of fiscal 2002, theCompany no longer records dividend charges related to its outstanding Series Apreferred stock. Such charges totaled $0.4 million for fiscal 2002.

**Voting**

Holders of the Series Apreferred stock generally have the right to one vote for each share of commonstock into which such Series A preferred stock is convertible. Subject tothe terms of the preferred stock purchase agreement entered into by and amongthe Company and the holders of Series A preferred stock named therein andthe Certificate of Designation, the holders of the Series A preferredstock are entitled to elect two designees to the Board of Directors. At leastone of the designees shall also be entitled to serve on all committees of theBoard of Directors. In addition, the holders of Series A preferred stockvote separately as a class in certain circumstances, including, withoutlimitation, amendments to the Company’s Second Amended and Restated Certificateof Incorporation, as amended, creation or issuance by the Company of any newclass of securities having a preference senior to or on parity with the Series Apreferred stock, declaration or payment by the Company of any dividends orother distributions on the common stock, or the Company entering into certaintransactions involving a merger, consolidation, or sale of all or substantiallyall of its assets.

**LiquidationPreference**

If the Company were dissolved or liquidated,voluntarily or involuntarily, the holders of the Series A preferred stockwould be entitled to receive, prior and in preference to any distribution ofthe Company’s assets to the holders of any of its other equity securities, anamount equal to the greater of: (a) $1,000 per share (as adjusted for anystock splits, stock dividends and recapitalizations) plus accrued and unpaiddividends; or (b) the amount which such holder of the Series Apreferred stock would have received assuming all shares of Series Apreferred stock had been converted into common stock at the then applicableconversion rate immediately prior to any such dissolution or liquidation. Ifthe Company has insufficient assets and funds to distribute to the holders of Series Apreferred stock their full liquidation preference, then all of its assets andfunds legally available for distribution shall be distributed pro rata amongthe holders of the Series A preferred stock in proportion to thepreferential amount each such holder is entitled to receive.

In addition, certainevents, including, without limitation, a sale of all or substantially all ofthe Company’s assets, or a change of control of the Company, may be designatedby holders of Series A preferred stock as a liquidation or dissolution, inwhich case, the above-described mechanisms for distribution of the Company’sassets are applicable.

**Registration**

As part of this privateplacement of preferred stock, the Company filed with the Securities andExchange Commission on October 1, 2001 a registration statement on Form S-3for the resale of the common stock issued or issuable upon conversion of the Series Apreferred stock to certain stockholders. The registration statement becameeffective on October 31, 2002.

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**(8)**   COMMON STOCK

In June 1998, following the Company’sreincorporation in Delaware, the Company adopted a Second Amended and RestatedCertificate of Incorporation. In October 2001, the Company amended itsSecond Amended and Restated Certificate of Incorporation to increase the numberof authorized shares of the Company. The Second Amended and RestatedCertificate of Incorporation, as amended, authorizes the Company to issue up to60,000,000 shares of common stock, par value $.0001 per share, and 5,000,000shares of preferred stock, par value $.0001 per share.

At January 29,2005, the Company has reserved the following shares of common stock forissuance in connection with:
| ** **                     | ** ** | ** Issuable upon   conversion or  exercise of  outstanding  securities** | ** ** | ** Available for   future sales  and grants** | ** ** | **Total shares of  common stock  reserved** | ** ** |
|--------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Series A  preferred stock |       |                                                                                              | 4,236,500  |                                                                   |       |                                                       | —     |   |   |   | 4,236,500 |   |   |
| Stock options                  |       |                                                                                              | 6,389,110  |                                                                   |       |                                                       | 1,868,687  |   |   |   | 8,257,797 |   |   |
| Total                          |       |                                                                                              | 10,625,610 |                                                                   |       |                                                       | 1,868,687  |   |   |   | 12,494,297 |   |   |

 

May financing—On May 17, 2001, the Companycompleted a private placement sale with various institutional investors of4,515,762 shares of common stock at $5.43 per share, resulting in aggregate netproceeds of approximately $24.5 million. As part of this private placementfinancing, the Company filed with the Securities and Exchange Commission on June 1,2001, a registration statement on Form S-3 for the resale of the commonstock acquired by these investors. The registration statement became effectiveon July 6, 2001. Subsequently, the Company filed with the Securities andExchange Commission certain post-effective amendments to the registrationstatement, which such amendments were declared effective as of September 22,2003. Accordingly, all shares of common stock of the Company initiallyregistered on the registration statement and not otherwise sold by the sellingstockholders described therein pursuant to the registration statement prior to May 17,2003 have been de-registered.

November financing—On November 6, 2001, theCompany completed a private placement sale with various institutional investorsof 4,487,178 shares of the Company’s common stock at $3.90 per share, resultingin aggregate net proceeds of approximately $17.5 million. As part of thisprivate placement financing, the Company filed with the Securities and ExchangeCommission on December 6, 2001, a registration statement on Form S-3for the resale of the common stock acquired by these investors. Theregistration statement became effective on October 31, 2002. Subsequently,the Company filed with the Securities and Exchange Commission a post-effectiveamendment to the registration statement, which was declared effective as of March 2,2004. Accordingly, all shares of common stock of the Company initiallyregistered on the registration statement and not otherwise sold by the sellingstockholders described therein pursuant to the registration statement prior to November 6,2003 have been de-registered.

In February 2003,the Company recorded additional paid in capital in the amount of $1.1 million,net of attorney’s fees and expenses, which represents cash received inconnection with settlement of a claim under Section 16(b) of theSecurities Exchange Act of 1934, as amended.

**(9)**   STOCK OPTION PLANS

**Stock-BasedCompensation Plans**

In April 1998, the Company’s Board of Directorsapproved the 1998 Stock Incentive Plan (“1998 Plan”), which serves as thesuccessor to the Company’s 1995 Stock Option Plan (“the Predecessor Plan”). The1998 Plan is divided into five separate components: (i) the DiscretionaryOption Grant Program, 

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(ii) the StockIssuance Program, (iii) the Salary Investment Option Grant Program, (iv) theAutomatic Option Grant Program and (v) the Director Fee Option GrantProgram. The Discretionary Option Grant Program and Stock Issuance Program areadministered by the Compensation Committee for Section 16 insiders and bya Secondary Committee of the Board of Directors for non-Section 16insiders.

Under the 1998 Plan, the Company originally authorizedthe Board of Directors to grant options of shares of common stock to keyemployees, directors and consultants to purchase an aggregate of 3,287,662shares of common stock. Such share reserve consists of (i) the number ofshares available for issuance under the Predecessor Plan on June 19, 1998,including the shares subject to outstanding options, and (ii) anadditional increase of 980,000 shares. In addition, the number of shares ofcommon stock reserved for issuance under the 1998 Plan will automatically beincreased on the first trading day of each calendar year, beginning in calendaryear 2000, by an amount equal to the lessor of (i) three percent of thetotal number of shares of common stock outstanding on the last trading day ofthe preceding calendar year or (ii) 966,202 shares. On January 2,2005, January 2, 2004, and January 2, 2003, the Company added 966,202shares, 966,202 shares, and 901,520 shares, respectively, to the 1998 Plan inaccordance with the automatic increase provisions. Additionally, in July 2001,the Company’s stockholders approved an increase of 1,000,000 shares of commonstock under the 1998 Plan, as well as various other amendments to the 1998Plan. In no event, however, may any one participant in the 1998 Plan receiveoption grants, separately exercisable stock appreciation rights or direct stockissuances for more than 1,000,000 shares of common stock in the aggregate percalendar year.

For all options granted under the Discretionary OptionGrant Program, the vesting, exercise prices and other terms of the options arefixed by the Compensation Committee or Secondary Committee, as applicable.Under the Discretionary Option Grant Program and the Automatic Option GrantProgram, both incentive stock options and non-statutory stock options aregranted at exercise prices not less than 100% of the fair market value on thedate of grant. Under the Salary Investment Option Grant Program and theDirector Fee Option Grant Program, the non-statutory stock options are grantedat exercise prices not less than 331/3%of the fair market value on the date of grant. These options generally expireten years from the date of grant and vest ratably either over a one-yearperiod, three-year period or four-year period. The plan administrator shallhave the discretion to grant options which are exercisable for unvested shares ofcommon stock. If any such options are exercised before becoming vested, theholder cannot sell or transfer the shares received upon exercise until suchshares have vested. If the holder leaves the Company before such shares arefully vested, the Company has the right to repurchase such unvested shares atthe holder’s original exercise price.

In May 2001, the Company’s Board of Directorsadopted a stock option program (the “Program”) outside of the Company’s 1998Plan pursuant to which options exercisable for up to 1,000,000 shares of commonstock may be granted. Under the Program, the Board of Directors authorized aspecial purpose committee of the Board of Directors to administer the Program.The special purpose committee was authorized to make non-statutory stock optiongrants to individuals as inducements to enter employment with the Company or,to the extent otherwise allowed under Nasdaq rules, as inducements to continuetheir employment with the Company, provided that in either case the terms ofsuch grants were substantially similar to the terms of the stock option grantsmade pursuant to the 1998 Plan. However, the special purpose committee was notauthorized to grant an option to acquire more than 50,000 shares to any oneindividual. Additionally, under the Program, options were allowed to be grantedwith an exercise price below the market price on The Nasdaq National Market onthe date of grant, provided the special purpose committee first obtainedapproval of such grants from either the Board of Directors or the CompensationCommittee. In no event was any option to have an exercise price less than $2.00per share. Vesting, exercise prices and other terms of the options were fixedby the special committee. Generally, options vest in one-fourth increments overa four-year period and have a term of not more than ten years from the grantdate. The Board of Directors or the Compensation Committee could, in either’ssole 

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discretion and at anytime, restrict or withdraw from the special purpose committee, as to anyparticular matters or categories of matters, the authority to make any orparticular option grants under the Program.

Asummary of all employee option activity is set forth below (see Note 1 forfair value assumptions used):
| ** **                                                                            | ** ** | **Number Of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------------------|------------|
| Outstanding and  exercisable, February 2, 2002                                   |       | 3,836,778                  |       |                                   | $          | 6.52 |   |   |
| Granted with exercise price at fair value (weighted  average fair value  of $5.86)    |       | 1,147,820                  |       |                                   | 7.03       |   |   |
| Granted with exercise price below fair value  (weighted average fair value of $3.03)  |       | 56,607                     |       |                                   | 1.14       |   |   |
| Exercised                                                                             |       | (347,330                   | )          |                                   | 3.95       |   |   |
| Canceled                                                                              |       | (533,745                   | )          |                                   | 8.85       |   |   |
| Outstanding and  exercisable, February 1, 2003                                   |       | 4,160,130                  |       |                                   | 6.44       |   |   |
| Granted with exercise price at fair value (weighted  average fair value  of $2.74)    |       | 1,312,079                  |       |                                   | 4.25       |   |   |
| Granted with exercise price below fair value  (weighted average fair value of $10.00) |       | 23,088                     |       |                                   | 1.57       |   |   |
| Exercised                                                                             |       | (311,775                   | )          |                                   | 3.55       |   |   |
| Canceled                                                                              |       | (833,530                   | )          |                                   | 6.31       |   |   |
| Outstanding and  exercisable, January 31, 2004                                   |       | 4,349,992                  |       |                                   | 5.98       |   |   |
| Granted with  exercise price at fair value (weighted average fair value of $4.93)     |       | 3,403,216                  |       |                                   | 5.80       |   |   |
| Exercised                                                                             |       | (210,606                   | )          |                                   | 3.35       |   |   |
| Canceled                                                                              |       | (1,153,492                 | )          |                                   | 6.03       |   |   |
| Outstanding and  exercisable, January 29, 2005                                   |       | 6,389,110                  |       |                                   | $          | 5.97 |   |   |
| Vested at  February 1, 2003                                                      |       | 1,891,512                  |       |                                   | $          | 7.59 |   |   |
| Vested at  January 31, 2004                                                      |       | 2,391,471                  |       |                                   | $          | 6.83 |   |   |
| Vested at  January 29, 2005                                                      |       | 2,313,263                  |       |                                   | $          | 6.65 |   |   |
| Available for future  grant at January 29, 2005                                  |       | 1,868,687                  |       |                                   |       |   |   |

 

Additionalinformation regarding options outstanding as of January 29, 2005 is asfollows:
| **RANGE OF  EXERCISE PRICES** | ** ** | ** ** | ** ** | **Number   Outstanding ** | ** ** | **Weighted  Average  Remaining  Contractual  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Vested** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-----------------------------------------|------------|------------|------------|-------------------------------------|------------|------------------------------------------------------------------|------------|----------------------------------------|------------|--------------------|------------|----------------------------------------|------------|
| $  0.32  - $  4.35  |       |       | 1,820,476  |                                |       |                                                             | 7.42       |                                   |       |               | $          | 3.17                                   |       |   | 841,828 |   |   | $ | 2.50 |   |   |
| $  4.39  - $  5.11  |       |       | 1,467,125  |                                |       |                                                             | 8.85       |                                   |       |               | 4.81       |                                   |       | 223,004 |   |   | 4.63 |   |   |
| $  5.15  - $  6.65  |       |       | 1,378,587  |                                |       |                                                             | 8.51       |                                   |       |               | 5.88       |                                   |       | 481,628 |   |   | 6.06 |   |   |
| $  6.68  - $10.49             |       |       | 1,324,331  |                                |       |                                                             | 8.04       |                                   |       |               | 8.25       |                                   |       | 391,310 |   |   | 8.42 |   |   |
| $10.50 - $22.00                         |       |       | 398,591    |                                |       |                                                             | 4.34       |                                   |       |               | 15.82      |                                   |       | 375,493 |   |   | 16.10 |   |   |
| $  0.32 -  $22.00             |       |       | 6,389,110  |                                |       |                                                             | 7.92       |                                   |       |               | $          | 5.97                                   |       |   | 2,313,263 |   |   | $ | 6.65 |   |   |

 

**Employee StockPurchase Plan**

In April 1998,the Company’s Board of Directors adopted the 1998 Employee Stock Purchase Plan(the “Purchase Plan”). The Purchase Plan was designed to allow eligibleemployees, based on specified 

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length of service requirements, of the Company andparticipating subsidiaries to purchase shares of common stock, at semi-annualintervals, through their periodic payroll deductions under the Purchase Plan. Areserve of 475,000 shares of common stock was established for this purpose.During fiscal 2002, employees purchased approximately 140,967 shares of theCompany’s common stock under the Purchase Plan at a weighted average per shareprice of $2.20. The Board of Directors suspended the Purchase Plan on August 30,2002. Therefore, no shares are presently available for future issuance underthe Purchase Plan.

**(10)**   EMPLOYEE BENEFIT PLANS

TheCompany has a 401(k) plan for its employees who meet certain service andage requirements. Participants may contribute up to 15% of their salaries to amaximum of $14,000 and $13,000, for fiscal 2005 and 2004, respectively. TheCompany matches 50% of the employees’ contribution up to a maximum of 3% oftheir base salary. The Company contributed approximately $353,000, $302,000 and$328,000 in fiscal 2004, 2003 and 2002, respectively.

**(11)**   OTHER RELATED PARTY TRANSACTIONS

During fiscal 2004, Stephen Gordon was the Chairman ofthe Board of Directors. The Company’s store in Eureka, California involves twoleases, one involving Mr. Gordon directly and a partnership in which Mr. Gordonis a partner. The aggregate lease payments paid to Mr. Gordon and thepartnership were $42,000 for fiscal 2004, 2003 and 2002. The Company believesthat the lease arrangements involving Mr. Gordon and the partnership inwhich Mr. Gordon is a partner were made on terms no less favorable thancould have been obtained from unaffiliated third parties. In January 2005,Mr. Gordon resigned from his role within the Company and as Chairman ofthe Board.

Jason Camp, a Senior Vice President of the Company andthe son of one of the directors, Robert E. Camp, was asked to relocate toCalifornia in 2001 as part of his job function. In connection with thisrelocation, the Company made a full recourse loan to him in the principalamount of $200,000. The interest on the outstanding principal amount of theloan is 8.0% per annum, compounded annually, and the entire amount of interestand all outstanding principal is due and payable on August 15, 2006, ifnot earlier pre-paid in full with interest.

TheCompany leases one of its properties from the previous owner and currentpresident of The Michaels Furniture Company. Total annual payments made infiscal year 2004, 2003 and 2002 were $456,000.

**(12)**   COMMITMENTS AND CONTINGENCIES

TheCompany is a party from time to time to various legal claims, actions andcomplaints. Although the ultimate resolution of legal proceedings cannot bepredicted with certainty, management of the Company currently believes thatdisposition of any such matters will not have a material adverse effect on theCompany’s consolidated financial statements.

**(13)**   SEGMENT REPORTING

The Company classifies itsbusiness into two identifiable segments: retail and direct-to-customer. Segmentincome from operations consists of direct-to-customer contribution and retailstore contribution. The unallocated portion includes both the costs ofcorporate expenses, shared service costs such as information technology, aswell as the costs of merchandising, sourcing and distribution. The Company also has a wholly owned furnituremanufacturing company located in Sacramento, California, The Michaels FurnitureCompany, Inc. (“Michaels”). Michaels’ revenue is recorded as either retailrevenue or direct-to-customer revenue based on the channel in which the salewas initiated. Management decisions on 

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resourceallocations and performance assessments are made based on these twoidentifiable segments. As a result, management considers it is most appropriateto report its business activities into two identifiable segments. The Company evaluates performance and allocatesresources based on results from operations, which excludes unallocated costs.Certain segment information, including segment assets, asset expenditures andrelated depreciation expense, is not presented as all of the Company’s assetsare commingled and are not available by segment.

Financialinformation for the Company’s business segments is as follows:
| ** **                                  | ** ** | **Fiscal Year**                 | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|
| ** **                                  | ** ** | ** **                           | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                  | ** ** | **2004**                             | ** ** | **(As restated—see  Note 2)** | ** ** | **(As restated—see  Note 2)** | ** ** |
| ** **                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Net revenue:                                |       |                                 |       |   |   |   |   |   |   |   |   |
| Retail                                      |       | $                                    | 406,833    |   |   | $ | 370,609 |   |   |   | $ | 355,632 |   |   |
| Direct-to-customer                          |       | 118,990                              |       |   | 67,899 |   |   |   | 44,705 |   |   |
| Consolidated net  revenue                   |       | $                                    | 525,823    |   |   | $ | 438,508 |   |   |   | $ | 400,337 |   |   |
| Income (loss) from  operations:             |       |                                 |       |   |   |   |   |   |   |   |   |
| Retail                                      |       | 51,932                               |       |   | 39,611 |   |   |   | 36,709 |   |   |
| Direct-to-customer                          |       | 14,280                               |       |   | 8,538 |   |   |   | 3,062 |   |   |
| Unallocated                                 |       | (62,136                              | )          |   | (50,024 | ) |   |   | (47,539 | ) |   |
| Consolidated income  (loss) from operations |       | $                                    | 4,076      |   |   | $ | (1,875 | ) |   |   | $ | (7,768 | ) |   |

** **

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**(14)**   QUARTERLYFINANCIAL INFORMATION (UNAUDITED)
| **Fiscal year ended January 29, 2005** | ** **                                   | ** **                                            | ** **                                   | **First  Quarter** | ** **                                   | **Second  Quarter** | ** **          | **Third  Quarter** | ** ** | ** ** | ** ** |
|-----------------------------------------------------------------|----------------------------------------------|-------------------------------------------------------|----------------------------------------------|--------------------|----------------------------------------------|---------------------|---------------------|--------------------|------------|------------|------------|
| ** **                                                      | **(As restated—see  Note 2)** | ** **                                            | **(As restated—see  Note 2)** | ** **         | **(As restated—see  Note 2)** | ** **          | **Fourth  Quarter** | ** **         |
| ** **                                                      | ** **                                   | **(Dollars in thousands, except per share  amounts)** | ** **                                   |
| Net revenue                                                     |                                         |                                                  | $                                            | 98,858             |                                         |                |                | $                  | 120,942    |       |       |   | $ | 118,165 |   |   | $ | 187,858 |   |
| Cost of revenue  and occupancy, as previously reported          |                                         |                                                  | 71,443                                       |               |                                         |                | 88,630              |               |       |       | 80,196     |   |   |   |   |
| Cost of revenue  and occupancy (as restated, see Note 2)        |                                         |                                                  | 71,328                                       |               |                                         |                | 88,425              |               |       |       | 80,134     |   |   | 119,921 |   |
| Gross profit, as  previously reported                           |                                         |                                                  | 27,415                                       |               |                                         |                | 32,312              |               |       |       | 37,969     |   |   |   |   |
| Gross profit (as  restated, see Note 2)                         |                                         |                                                  | 27,530                                       |               |                                         |                | 32,517              |               |       |       | 38,031     |   |   | 67,937 |   |
| Selling, general  and administrative expense               |                                         |                                                  | 33,516                                       |               |                                         |                | 35,172              |               |       |       | 42,511     |   |   | 50,740 |   |
| Loss from  operations, as previously reported                   |                                         |                                                  | (6,101                                       | )                  |                                         |                | (2,860              | )                  |       |       | (4,542     | ) |   |   |   |
| Income (loss)  from operations (as restated, see Note 2)        |                                         |                                                  | (5,986                                       | )                  |                                         |                | (2,655              | )                  |       |       | (4,480     | ) |   | 17,197 |   |
| Interest expense,  net                                          |                                         |                                                  | (427                                         | )                  |                                         |                | (509                | )                  |       |       | (737       | ) |   | (799 | ) |
| Loss before  income taxes, as previously reported               |                                         |                                                  | (6,528                                       | )                  |                                         |                | (3,369              | )                  |       |       | (5,279     | ) |   |   |   |
| Income (loss)  before income taxes (as restated, see Note 2)    |                                         |                                                  | (6,413                                       | )                  |                                         |                | (3,164              | )                  |       |       | (5,217     | ) |   | 16,398 |   |
| Income tax  benefit, as previously  reported                    |                                         |                                                  | 2,546                                        |               |                                         |                | 1,363               |               |       |       | 2,161      |   |   |   |   |
| Income tax  benefit (expense) (as  restated, see Note 2)(3)     |                                         |                                                  | 2,501                                        |               |                                         |                | 1,280               |               |       |       | 2,136      |   |   | (5,817 | ) |
| Net loss, as  previously reported                               |                                         |                                                  | (3,982                                       | )                  |                                         |                | (2,006              | )                  |       |       | (3,118     | ) |   |   |   |
| Net income (loss)  (as restated, see  Note 2)                   |                                         |                                                  | (3,912                                       | )                  |                                         |                | (1,884              | )                  |       |       | (3,081     | ) |   | 10,581 |   |
| Income (loss) per share:                                        |                                         |                                                  |                                         |               |                                         |                |                |               |       |       |       |   |   |   |   |
| Basic(1), as previously reported                                |                                         |                                                  | $                                            | (0.12              | )                                            |                |                | $                  | (0.06      | )          |       |   | $ | (0.09 | ) |   | $ | 0.32 |   |
| Basic(1) (as restated, see Note 2)                         |                                         |                                                  | $                                            | (0.12              | )                                            |                |                | $                  | (0.06      | )          |       |   | $ | (0.09 | ) |   | $ |   |   |
| Diluted(2), as previously reported                              |                                         |                                                  | $                                            | (0.12              | )                                            |                |                | $                  | (0.06      | )          |       |   | $ | (0.09 | ) |   | $ | 0.28 |   |
| Diluted(2) (as  restated, see Note 2)                      |                                         |                                                  | $                                            | (0.12              | )                                            |                |                | $                  | (0.06      | )          |       |   | $ | (0.09 | ) |   | $ |   |   |

 

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| ** **                                                      | ** ** | **First  Quarter**                                                                 | ** ** | **Second  Quarter**                          | ** ** | **Third  Quarter**                           | ** ** | **Fourth  Quarter**                          | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| **Fiscal year ended January 31, 2004** | ** ** | ** **                                                                         | ** ** | **(As restated—see  Note 2)** | ** ** | **(As restated—see  Note 2)** | ** ** | **(As restated—see  Note 2)** | ** ** | **(As restated—see  Note 2)** | ** ** |
| ** **                                                      | ** ** | **(Dollars in thousands, except per share amounts)** | ** ** |
| Net revenue                                                     |       |                                                                               | $          | 81,766                                       |       |                                         |       | $                                            | 95,973     |   |   |   | $ | 95,814 |   |   |   | $ | 164,955 |   |   |
| Cost of revenue and  occupancy, as previously reported          |       |                                                                               | 61,825     |                                         |       |                                         | 71,160     |                                         |       |   | 67,027 |   |   |   | 105,968 |   |   |
| Cost of revenue and  occupancy (as restated, see Note 2)        |       |                                                                               | 61,692     |                                         |       |                                         | 70,669     |                                         |       |   | 67,084 |   |   |   | 105,820 |   |   |
| Gross profit, as  previously reported                           |       |                                                                               | 19,941     |                                         |       |                                         | 24,813     |                                         |       |   | 28,787 |   |   |   | 58,987 |   |   |
| Gross profit (as  restated, see Note 2)                         |       |                                                                               | 20,074     |                                         |       |                                         | 25,304     |                                         |       |   | 28,730 |   |   |   | 59,135 |   |   |
| Selling, general and  administrative expense                    |       |                                                                               | 28,029     |                                         |       |                                         | 28,862     |                                         |       |   | 33,031 |   |   |   | 45,196 |   |   |
| Income (loss) from  operations, as previously reported          |       |                                                                               | (8,088     | )                                            |       |                                         | (4,049     | )                                            |       |   | (4,244 | ) |   |   | 13,791 |   |   |
| Income (loss) from  operations (as restated, see Note 2)        |       |                                                                               | (7,955     | )                                            |       |                                         | (3,558     | )                                            |       |   | (4,301 | ) |   |   | 13,939 |   |   |
| Interest expense, net                                           |       |                                                                               | (562       | )                                            |       |                                         | (593       | )                                            |       |   | (519 | ) |   |   | (480 | ) |   |
| Income (loss) before  income taxes, as previously reported      |       |                                                                               | (8,650     | )                                            |       |                                         | (4,642     | )                                            |       |   | (4,763 | ) |   |   | 13,311 |   |   |
| Income (loss) before  income taxes (as restated, see Note 2)    |       |                                                                               | (8,517     | )                                            |       |                                         | (4,151     | )                                            |       |   | (4,820 | ) |   |   | 13,459 |   |   |
| Income tax benefit  (expense), as previously reported           |       |                                                                               | 3,460      |                                         |       |                                         | 1,857      |                                         |       |   | 1,905 |   |   |   | (5,419 | ) |   |
| Income tax benefit  (expense) (as restated, see Note 2)         |       |                                                                               | 3,407      |                                         |       |                                         | 1,661      |                                         |       |   | 1,928 |   |   |   | (5,485 | ) |   |
| Net income (loss), as  previously reported                 |       |                                                                               | (5,190     | )                                            |       |                                         | (2,785     | )                                            |       |   | (2,858 | ) |   |   | 7,892 |   |   |
| Net income (loss) (as  restated, see Note 2)               |       |                                                                               | (5,110     | )                                            |       |                                         | (2,490     | )                                            |       |   | (2,892 | ) |   |   | 7,974 |   |   |
| Income (loss) per share:                                        |       |                                                                               |       |                                         |       |                                         |       |                                         |       |   |   |   |   |   |   |   |   |
| Basic(1), as previously  reported                               |       |                                                                               | $          | (0.17                                        | )          |                                         |       | $                                            | (0.09      | ) |   |   | $ | (0.09 | ) |   |   | $ | 0.24 |   |   |
| Basic(1) (as  restated, see Note 2)                        |       |                                                                               | $          | (0.17                                        | )          |                                         |       | $                                            | (0.08      | ) |   |   | $ | (0.09 | ) |   |   | $ | 0.24 |   |   |
| Diluted(2), as  previously reported                             |       |                                                                               | $          | (0.17                                        | )          |                                         |       | $                                            | (0.09      | ) |   |   | $ | (0.09 | ) |   |   | $ | 0.21 |   |   |
| Diluted(2) (as restated, see Note 2)                       |       |                                                                               | $          | (0.17                                        | )          |                                         |       | $                                            | (0.08      | ) |   |   | $ | (0.09 | ) |   |   | $ | 0.21 |   |   |
|                                                                 |            |                                                                                    |            |                                              |            |                                              |            |                                              |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Basic earnings (loss) pershare is calculated for interim periods including the effect of stock optionsexercised in prior interim periods. Basic earnings (loss) per share for thefiscal year is calculated using weighted shares outstanding based on the datestock options were exercised. Therefore, basic income (loss) per share for thecumulative four quarters may not equal fiscal year basic earnings per share.

(2)          Diluted earnings pershare for the fiscal year and for quarters with net earnings are computed basedon weighted average common shares outstanding, which include potentiallydilutive common stock equivalents. Net loss per share for quarters with net lossesis computed based solely on weighted average common shares outstanding.Therefore, the net income (loss) per share for the cumulative four quarters donot equal the income (loss) per share for the full fiscal year.

(3)   Fourthquarter fiscal 2004 income tax expense includes the reversal of the valuationallowance, offset by the tax contingency accrual.

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM**

Boardof Directors and StockholdersRestoration Hardware, Inc.:

We have audited the accompanying consolidated balancesheets of Restoration Hardware, Inc. and subsidiaries (the “Company”) as ofJanuary 29, 2005 and January 31, 2004, and the related consolidated statementsof operations, redeemable convertible preferred stock and stockholders’ equity,and cash flows for each of the three years in the period ended January 29,2005. Our audits also included the financial statement schedule listed inItem 15(a)(2). These financial statements and financial statement schedule arethe responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements and financial statementschedule based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall consolidated financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statementspresent fairly, in all material respects, the financial position of RestorationHardware, Inc. and subsidiaries at January 29, 2005 and January 31, 2004, andthe results of their operations and their cash flows for each of the threeyears in the period ended January 29, 2005, in conformity with accountingprinciples generally accepted in the United States of America. Our audits ofthe consolidated financial statements referred to in our aforementioned reportsalso included the consolidated financial statement schedule of RestorationHardware Inc. and subsidiaries listed in Item 15(a)(2). The consolidatedfinancial statement schedule is the responsibility of the Company’s management.Our responsibility is to express an opinion based on our audits. In ouropinion, such consolidated financial statement schedule, when considered inrelation to the basic consolidated financial statements taken as a whole,presents fairly in all material respects the information set forth therein.

As discussed in Note 2, the accompanying fiscal 2003and 2002 financial statements have been restated.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of the Company’s internal control over financialreporting as of January 29, 2005, based on the criteria established in *Internal Control—Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commissionand our report dated April 14, 2005 expressed an unqualified opinion onmanagement’s assessment of the effectiveness of the Company’s internal controlover financial reporting and an adverse opinion on the effectiveness of theCompany’s internal control over financial reporting because of a materialweakness.

SanFrancisco, CaliforniaApril 14, 2005

 

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

Board of Directors andStockholdersRestoration Hardware, Inc.:

We have audited management’s assessment, included in theaccompanying “*Management’s Report on Internal Control overFinancial Reporting*”, that Restoration Hardware, Inc. andsubsidiaries (the “Company”) did not maintain effective internal control overfinancial reporting as of January 29, 2005, because of the effects of thematerial weakness identified in managements’ assessment, based on criteriaestablished in *Internal Control—IntegratedFramework* issued bythe Committee of Sponsoring Organizations of the Treadway Commission. TheCompany’s management is responsible for maintaining effective internal controlover financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is toexpress an opinion on management’s assessment and an opinion on theeffectiveness of the Company’s internal control over financial reporting basedon our audit.

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (UnitedStates). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our auditincluded obtaining an understanding of internal control over financialreporting, evaluating management’s assessment, testing and evaluating thedesign and operating effectiveness of internal control, and performing suchother procedures as we considered necessary in the circumstances. Webelieve that our audit provides a reasonable basis for our opinions.

A company’s internal control over financial reportingis a process designed by, or under the supervision of, the company’s principalexecutive and principal financial officers, or persons performing similarfunctions, and effected by the company’s board of directors, management, andother personnel to provide reasonable assurance regarding the reliability offinancial reporting and the preparation of consolidated financial statementsfor external purposes in accordance with generally accepted accountingprinciples. A company’s internal control over financial reporting includesthose policies and procedures that (1) pertain to the maintenance of recordsthat, in reasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonable assurancethat transactions are recorded as necessary to permit preparation ofconsolidated financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of the company’sassets that could have a material effect on the consolidated financialstatements.

Because of the inherent limitations of internalcontrol over financial reporting, including the possibility of collusion orimproper management override of controls, material misstatements due to erroror fraud may not be prevented or detected on a timely basis. Also,projections of any evaluation of the effectiveness of the internal control overfinancial reporting to future periods are subject to the risk that the controlsmay become inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

A material weakness is a significant deficiency, orcombination of signification deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim consolidatedfinancial statements will not be prevented or detected. The following materialweakness has been identified and included in management’s assessment: The Companydid not design and implement appropriate internal control over the accountingand disclosure for certain leases. This material weakness resulted in the restatementof the Company’s interim and annual consolidated financial statements. 

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Consolidated financialstatements as described in Note 2 to the consolidated financial statements.This material weakness was considered in determining the nature, timing andextent of audit tests applied in our audit of the consolidated financialstatements and financial statement schedules of the Company as of and for theyear ended January 29, 2005, and this report does not affect our report on suchfinancial statements.

In our opinion, management’s assessment that theCompany did not maintain effective internal control over financial reporting asof January 29, 2005, is fairly stated, in all material respects, based on thecriteria established in *InternalControl—Integrated Framework* issued by the Committee of Sponsoring Organizations of the TreadwayCommission. Also in our opinion, because of the effect of the materialweaknesses described above on the achievement of the objectives of the controlcriteria, the Company has not maintained effective internal control overfinancial reporting as of January 29, 2005, based on the criteria establishedin *Internal Control—Integrated Framework* issued by the Committee ofSponsoring Organizations of the Treadway Commission.

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated financial statements and schedule as of andfor the year ended January 29, 2005 of the Company and our report dated April14, 2005 expressed an unqualified opinion on those consolidated financialstatements and schedule.

SanFrancisco, CaliforniaApril 14, 2005

60

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**ITEM 9.**                CHANGES IN ANDDISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

**ITEM 9A.**   CONTROLSAND PROCEDURES

**Disclosure Controlsand Procedures**

Our management, with theparticipation of Gary Friedman, our Chief Executive Officer and, Patricia McKay,our Chief Financial Officer, has evaluated the effectiveness of our disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) and15d-15(e) under the Securities Act of 1934, as amended (the“Exchange Act”)) as of the January 29, 2005. In performing this evaluation,management reviewed our method for lease accounting. As a result of thisreview, management concluded that our previous method of accounting for rentholidays was not appropriate under generally accepted accounting principles inthe United States of America (“GAAP”). Accordingly, as described in Note 2 tothe Consolidated Financial Statements, management concluded and recommendedthat our Audit Committee approve, the correction of this error by therestatement of our previously issued Consolidated Financial Statements. Additionally,based on their evaluation, these officers have concluded that, solely due toour restatement related to lease accounting as detailed above, our disclosurecontrols and procedures were not effective as of January 29, 2005 for thepurpose of alerting them on a timely basis to material information required tobe included in the Company’s reports filed or submitted under the Exchange Act.

**Management’s Reporton Internal Control Over Financial Reporting**

Our management is responsible for establishing andmaintaining adequate internal control over financial reporting, as such term isdefined in Exchange Act Rule 13a-15(f). Our internal control overfinancial reporting is a process designed to provide reasonable assuranceregarding the reliability of financial reporting and the preparation ofconsolidated financial statements for external purposes in accordance withGAAP. Our internal control over financial reporting includes those policies andprocedures that:

(1)   pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect our transactions and dispositions of assets;

(2)   providereasonable assurance that transactions are recorded as necessary to permitpreparation of consolidated financial statements in accordance with GAAP, andthat our receipts and expenditures are being made only in accordance withauthorizations of our management and Board of Directors; and

(3)   providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of our assets that could have a materialeffect on the consolidated financial statements.

Because of its inherent limitations, internal controlover financial reporting may not prevent or detect misstatements. Also,projections of any evaluation of effectiveness to future periods are subject tothe risk that controls may become inadequate because of changes in conditions,or that the degree of compliance with the policies or procedures maydeteriorate.

Under the supervision and with the participation ofour management, including our Chief Executive Officer and Chief FinancialOfficer, we conducted an evaluation of the effectiveness of our internalcontrol over financial reporting as of January 29, 2005. Our assessmentwas based on criteria set forth by the Committee of Sponsoring Organizations ofthe Treadway Commission in *Internal Control—IntegratedFramework* (“COSO Framework”).

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In performing this assessment, we reviewed our leaseaccounting in light of views expressed by the Office of the Chief Accountant ofthe Securities and Exchange Commission in a letter issued to the AmericanInstitute of Certified Public Accountants on February 7, 2005. As a result ofthis review, we concluded that our control over determining and accounting for therent holiday period was not effective as of January 29, 2005. On March 4, 2005,we determined that it was appropriate to restate our previously issuedConsolidated Financial Statements to correct these errors in our leaseaccounting. We evaluated the impact of this restatement in our assessment ofinternal control over financial reporting and concluded that the controldeficiencies that resulted in incorrect lease accounting represented a materialweakness as of January 29, 2005.

A material weakness in internal control over financialreporting is a control deficiency (within the meaning of the Public CompanyAccounting Oversight Board’s (“PCAOB”) Auditing Standard No. 2), or acombination of control deficiencies, that results in there being a more thanremote likelihood that a material misstatement of the annual or interimconsolidated financial statements will not be prevented or detected. PCAOBAuditing Standard No. 2 identifies a number of circumstances that, because oftheir likely significant negative effect on internal control over financialreporting, are to be regarded as at least significant deficiencies, as well asstrong indicators of a material weakness, including the restatement ofpreviously issued consolidated financial statements to reflect the correctionof a misstatement. As a result of the material weakness related to our leaseaccounting, we have concluded that, as of January 29, 2005, our internalcontrol over financial reporting was not effective based on the criteria setforth in the COSO framework. We identified no other material weaknesses inperforming our assessment and reaching our conclusion.

Deloitte & ToucheLLP, our independent auditors, has issued an attestation report on management’sassessment of the Company’s internal control over financial reporting, which isincluded in their report on page 59.

**Changes in InternalControls over Financial Reporting**

During the fourth quarter, the Company implementedenhanced procedures and internal controls over its tax accounting and had fullyremediated the internal control deficiencies over tax accounting as of January29, 2005. There were no other changes in our internal control over financialreporting that occurred during the fourth quarter of fiscal 2004 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

Subsequent to the fourthquarter, the Company remediated the material weakness in internal control overfinancial reporting relating to lease accounting, by correcting our method ofaccounting for rent holidays to be in accordance with GAAP.

**ITEM 9B.**       OTHER INFORMATION

Not applicable.

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**PART III**

Certain informationrequired by Part III is omitted from this annual report on Form 10-Kin that we will have filed our definitive proxy statement pursuant toRegulation 14A no later than 120 days after the end of the fiscalyear covered by this annual report on Form 10-K and certain informationincluded in such proxy statement is incorporated herein by reference.

**ITEM 10.**         DIRECTORS AND EXECUTIVEOFFICERS OF THE REGISTRANT

Information relating toour executive officers and directors will be set forth in the sections with thecaptions “Executive Officers and Directors” and “Compliance with Section 16(a) ofthe Securities Exchange Act” in our definitive proxy statement. Thisinformation is incorporated herein by reference.

**ITEM 11.**         EXECUTIVE COMPENSATION

Information relating toexecutive compensation will be set forth in the section with the caption “ExecutiveCompensation and Other Information” in our definitive proxy statement. Thisinformation is incorporated herein by reference.

**ITEM 12.**         SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

Information relating tothe securities authorized for issuance under equity compensation plans will beset forth in the section with the caption “Equity Compensation Plan Information”in our definitive proxy statement and information relating to the securityownership of our common stock by our management and other beneficial ownerswill be set forth in the section with the caption “Security Ownership ofCertain Beneficial Owners and Management and Related Stockholder Matters” inour definitive proxy statement. This information is incorporated herein byreference.

**ITEM 13.**         CERTAIN RELATIONSHIPS ANDRELATED TRANSACTIONS

Information relating tocertain relationships and related transactions between our Company anddirectors, executive officers and stockholders owning greater than five percentof any class of voting securities will be set forth in the sections with thecaptions “Employment Contracts, Termination of Employment and Change in ControlArrangements” and “Certain Relationships and Related Transactions” in ourdefinitive proxy statement. This information is incorporated herein byreference.

**ITEM 14.**         PRINCIPAL ACCOUNTANT FEESAND SERVICES

Information relating toprincipal accounting fees and services will be set forth in the section withthe caption “Audit and Non-Audit Fees” in our definitive proxy statement. Thisinformation is incorporated herein by reference.

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**PART IV**

**ITEM 15.**         EXHIBITS AND CONSOLIDATEDFINANCIAL STATEMENT SCHEDULES

(a)   Thefollowing Consolidated Financial Statements are filed as a part of this annualreport on Form 10-K:

1.                 The following ConsolidatedFinancial Statements, together with notes thereto and the report thereon ofDeloitte & Touche LLP are set forth in Item 8 of Part II of thisannual report on Form 10-K:

(i)            Consolidated BalanceSheets at January 29, 2005 and January 31, 2004 (As restated);

(ii)        Consolidated Statements ofOperations for the fiscal years ended January 29, 2005, January 31,2004 (As restated), and February 1, 2003 (As restated);

(iii)    Consolidated Statements ofRedeemable Convertible Preferred Stock and Stockholders’ Equity for the fiscalyears ended January 29, 2005, January 31, 2004 (As restated),and February 1, 2003 (As restated);

(iv)      ConsolidatedStatements of Cash Flows for the fiscal years ended January 29, 2005, January 31,2004 (As restated), and February 1, 2003 (As restated).

2.                 Consolidated FinancialStatement Schedule:

Schedule II—Valuationand Qualifying Accounts*.*

3.                 Exhibits:

The exhibits filed as part of this annual report on Form 10-Kare listed in the Exhibit Index immediately preceding such exhibits, whichExhibit Index is incorporated herein by reference.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                           |     | RESTORATION  HARDWARE, INC.                                |
|---------------------------|----------|-----------------------------------------------------------------|
|                      | By:      | /s/  GARY G. FRIEDMAN                                 |
| Date: April 14, 2005 | * * | Gary G. Friedman                                                |
|                      | * * | *President, Chief Executive Officer and Chairman  of the Board* |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the registrant and inthe capacities and on the dates indicated.
|                                  | **SIGNATURE** | ** **                                           | ** ** | ** **          | **TITLE** | ** ** | ** ** | ** ** | **DATE** | ** ** |
|----------------------------------|---------------|------------------------------------------------------|------------|---------------------|-----------|------------|------------|------------|----------|------------|
| /s/  GARY G. FRIEDMAN  |          | President, Chief  Executive Officer and              |       | April 14, 2005 |
| Gary G. Friedman                 |          | Chairman of the Board  (Principal Executive Officer) |       |                |
| /s/  PATRICIA A. MCKAY |          | Chief Financial Officer  (Principal                  |       | April 14, 2005 |
| Patricia A. McKay                |          | Financial Officer)                                   |       |                |
| /s/  MURRAY JUKES      |          | Vice President,  Controller (Principal               |       | April 14, 2005 |
| Murray Jukes                     |          | Accounting Officer)                                  |       |                |
| /s/  DAMON H. BALL     |          | Director                                             |       | April 14, 2005 |
| Damon H. Ball                    |          |                                                 |       |                |
| /s/  ROBERT E. CAMP    |          | Director                                             |       | April 14, 2005 |
| Robert E. Camp                   |          |                                                 |       |                |
| /s/  RAYMOND C. HEMMIG |          | Director                                             |       | April 14, 2005 |
| Raymond C. Hemmig                |          |                                                 |       |                |
| /s/  GLENN J. KREVLIN  |          | Director                                             |       | April 14, 2005 |
| Glenn J. Krevlin                 |          |                                                 |       |                |
| /s/  M. ANN RHOADES    |          | Director                                             |       | April 14, 2005 |
| M. Ann Rhoades                   |          |                                                 |       |                |
| /s/  MARK J. SCHWARTZ  |          | Director                                             |       | April 14, 2005 |
| Mark J. Schwartz                 |          |                                                 |       |                |
| /s/  T. MICHAEL YOUNG  |          | Director                                             |       | April 14, 2005 |
| T. Michael Young                 |          |                                                 |       |                |

 

 

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**SCHEDULE II**VALUATION AND QUALIFYING ACCOUNTS

**AS OF AND FOR THEFISCAL YEARS ENDED JANUARY 29, 2005,JANUARY 31, 2004 AND FEBRUARY 1, 2003**

**(Dollars in Thousands)**
| **Column A**                                  | ** ** | **Column B** | ** ** | **Column C**                               | ** ** | **Column D**                                        | ** ** | **Column E**                    | ** ** |
|----------------------------------------------------|------------|-------------------|------------|-------------------------------------------------|------------|----------------------------------------------------------|------------|--------------------------------------|------------|
| **Description**                                    | ** ** | ** **        | ** ** | **Balances at  Beginning  of Period** | ** ** | **Additions  Charged to  Costs and  Expenses** | ** ** | **Charged to  Other  Accounts** | ** ** | **Deductions(1)** | ** ** | **Balances at  End of  Period** | ** ** |
| AMOUNTS DEDUCTED FROM  ASSETS TO WHICH THEY APPLY: |       |              |       |                                            |       |                                                     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Inventory  reserves for the fiscal year ended(1):  |       |              |       |                                            |       |                                                     |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| February 1, 2003                              |       |              | $          | 6,497                                           |       |                                                     |       | $                                    | 6,877      |   |   |   | $ | — |   |   |   | $ | (10,126 | ) |   |   | $ | 3,248 |   |   |
| January 31, 2004                              |       |              | 3,248      |                                            |       |                                                     | 6,435      |                                 |       |   | — |   |   |   | (8,290 | ) |   |   | 1,393 |   |   |
| January 29,  2005                             |       |              | 1,393      |                                            |       |                                                     | 8,138      |                                 |       |   | — |   |   |   | (7,583 | ) |   |   | 1,948 |   |   |
|                                                    |            |                   |            |                                                 |            |                                                          |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Includes valuationreserves for shortages and lower of cost or market adjustments to inventory.

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**EXHIBIT INDEX**
| EXHIBIT   NUMBER | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                | ** ** | **DOCUMENT DESCRIPTION** |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|
| 3.1              |       | Second Amended and  Restated Certificate of Incorporation, as amended (incorporated by reference  to exhibit number 3.1 of the Form 8-K filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  October 24, 2001)                                                                                                                        |
| 3.2              |       | Amended and  Restated Bylaws, as amended to date (incorporated by reference to exhibit  number 3.2 of Form 10-Q for the quarterly period ended October 31,  1998 filed by Restoration Hardware, Inc. with the Securities and  Exchange Commission on December 15, 1998)                                                                                               |
| 3.3              |       | Reference is made  to Exhibit 4.5                                                                                                                                                                                                                                                                                                                                                    |
| 4.1              |       | Reference is made  to Exhibit 3.1                                                                                                                                                                                                                                                                                                                                                    |
| 4.2              |       | Reference is made  to Exhibit 3.2                                                                                                                                                                                                                                                                                                                                                    |
| 4.3              |       | Specimen Common  Stock Certificate (incorporated by reference to exhibit number 4.3 of the  Registration Statement on Form S-1/A (File No. 333-51027) filed by  Restoration Hardware, Inc. with the Securities and Exchange Commission  on June 2, 1998)                                                                                                              |
| 4.4              |       | Specimen  Series A Preferred Stock Certificate (incorporated by reference to  exhibit number 4.4 of Form 8-K filed by Restoration Hardware, Inc.  with the Securities and Exchange Commission on April 2, 2001)                                                                                                                                                       |
| 4.5              |       | Certificate of  Designation of Series A and Series B Preferred Stock (incorporated  by reference to exhibit number 4.6 of Form 8-K filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  April 2, 2001)                                                                                                                           |
| 4.6              |       | Consent and  Waiver Regarding Additional Financing (incorporated by reference to exhibit  number 10.2 of Form 8-K filed by Restoration Hardware, Inc.  with the Securities and Exchange Commission on May 23, 2001)                                                                                                                                                   |
| 4.7              |       | Amended and  Restated Letter Agreement, dated as of March 21, 2001, by and among  certain holders of Series A preferred stock (incorporated by reference  to exhibit number 4.9 of the Registration Statement on Form S-3/A  (File No. 333-70624) filed by Restoration Hardware, Inc. with the  Securities and Exchange Commission on January 4, 2002) |
| 4.8              |       | Amendment to  Letter Agreement, effective as of November 1, 2001, by and among certain  holders of Series A preferred stock (incorporated by reference to  exhibit number 4.10 of the Registration Statement on Form S-3/A  (File No. 333-70624) filed by Restoration Hardware, Inc. with the  Securities and Exchange Commission on June 3, 2002)     |
| 10.1             |       | Form of 1995  Stock Option Plan (incorporated by reference to exhibit number 10.1 of the  Registration Statement on Form S-1 (File No. 333-51027) filed by  Restoration Hardware, Inc. with the Securities and Exchange Commission  on April 24, 1998)                                                                                                           |
| 10.2             |       | Form of 1998  Employee Stock Purchase Plan (incorporated by reference to exhibit number  10.3 of the Registration Statement on Form S-1 (File No. 333-51027)  filed by Restoration Hardware, Inc. with the Securities and Exchange  Commission on April 24, 1998)                                                                                                |
| 10.3             |       | Form of  Indemnification Agreement for Officers and Directors (incorporated by  reference to exhibit number 10.4 of the Registration Statement on  Form S-1 (File No. 333-51027) filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on April 24,  1998)                                                                            |
| 10.4             |       | Lease Agreement,  dated May 4, 1994, between Restoration Hardware, Inc. and Stephen  and Christine Gordon (incorporated by reference to exhibit number 10.8 of the  Registration Statement on Form S-1 (File No. 333-51027) filed by  Restoration Hardware, Inc. with the Securities and Exchange Commission  on April 24, 1998)                            |

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| 10.5  |   | Office Lease, dated  February 21, 1997, between Restoration Hardware, Inc. and Paradise  Point Partners (incorporated by reference to exhibit number 10.10 of the  Registration Statement on Form S-1 (File No. 333-51027) filed by  Restoration Hardware, Inc. with the Securities and Exchange Commission  on April 24, 1998)                                           |
|-------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6  |   | Standard  Industrial/Commercial Multi-Tenant Lease-Gross, dated May 12, 1997,  between Restoration Hardware, Inc. and Mortimer B. Zuckerman  (incorporated by reference to exhibit number 10.11 of the Registration  Statement on Form S-1 (File No. 333-51027) filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  April 24, 1998) |
| 10.7  |   | Amended and  Restated Investor Rights Agreement, dated as of March 21, 2001, between  Restoration Hardware, Inc. and the Series A and B Preferred Stock  Investors (incorporated by reference to exhibit number 10.18 of  Form 8-K filed by Restoration Hardware, Inc. with the Securities  and Exchange Commission on April 2, 2001)                                |
| 10.8  |   | Amended and  Restated Series A and B Preferred Stock Purchase Agreement, dated as of  March 21, 2001, between Restoration Hardware, Inc. and the  Series A and B Preferred Stock Investors (incorporated by reference to  exhibit number 10.19 of Form 8-K filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  April 2, 2001)  |
| 10.9  |   | Offer of  Employment Letter for Mr. Gary G. Friedman dated as of  March 15, 2001 (incorporated by reference to exhibit number 10.30  of Form 8-K filed by Restoration Hardware, Inc. with the Securities  and Exchange Commission on April 2, 2001)                                                                                                                  |
| 10.10 |   | Stock Purchase  Agreement between Restoration Hardware, Inc. and Gary G. Friedman,  dated as of March 18, 2001 (incorporated by reference to exhibit  number 10.33 of Form 8-K filed by Restoration Hardware, Inc.  with the Securities and Exchange Commission on April 2, 2001)                                                                                    |
| 10.11 |   | Early Exercise  Stock Purchase Agreement between Restoration Hardware, Inc. and  Gary G. Friedman, dated as of March 18, 2001 (incorporated by  reference to exhibit number 10.34 of Form 8-K filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  April 2, 2001)                                                                    |
| 10.12 |   | Notice of Grant  of Stock Option for Gary G. Friedman (incorporated by reference to  exhibit number 10.36 of Form 8-K filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  April 2, 2001)                                                                                                                                                      |
| 10.13 |   | Stock Option  Agreement between Restoration Hardware, Inc. and Gary G. Friedman,  dated as of March 18, 2001 (incorporated by reference to exhibit  number 10.37 of Form 8-K filed by Restoration Hardware, Inc.  with the Securities and Exchange Commission on April 2, 2001)                                                                                      |
| 10.14 |   | Form of  Non-Plan Notice of Grant of Stock Option and Stock Option Agreement  (incorporated by reference to exhibit number 10.42 of Form 10-Q for  the quarterly period ended November 3, 2001 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on December 18,  2001)                                                                    |
| 10.15 |   | Letter Agreement  between Restoration Hardware, Inc. and certain investors named therein,  dated as of August 2, 2002 (incorporated by reference to exhibit number  10.1 of Form 10-Q for the quarterly period ended August 3, 2002  filed by Restoration Hardware, Inc. with the Securities and Exchange  Commission on September 17, 2002)                              |
| 10.16 |   | Notice of Grant  of Stock Option and Option Agreement between Restoration Hardware, Inc.  and Gary G. Friedman, dated March 18, 2001 (incorporated by  reference to exhibit number 10.3 of Form 10-Q for the quarterly period  ended August 3, 2002 filed by Restoration Hardware, Inc. with the  Securities and Exchange Commission on September 17, 2002)          |
| 10.17 |   | 1998 Stock Incentive  Plan Amended and Restated on October 9, 2002 (incorporated by reference  to exhibit number 10.1 of Form 10-Q for the quarterly period ended  November 2, 2002 filed by Restoration Hardware, Inc. with the  Securities and Exchange Commission on December 23, 2002)                                                                                     |

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| 10.18 |   | Seventh Amended and  Restated Loan and Security Agreement, dated as of November 26, 2002, by  and among Restoration Hardware, Inc., The Michaels Furniture  Company, Inc., Fleet Capital Corporation, and The CIT Group/Business  Credit,  Inc. (incorporated by reference to exhibit number 99.1 of Form 10-Q  for the quarterly period ended November 2, 2002 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  December 23, 2002)                      |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.19 |   | Amendment  No. 1 to the Seventh Amended and Restated Loan and Security Agreement,  dated April 28, 2003, by and among Restoration Hardware, Inc., The  Michaels Furniture Company, Inc., Fleet Capital Corporation, and The CIT  Group/Business Credit,  Inc. (incorporated by reference to exhibit  number 10.1 of Form 10-Q for the quarterly period ended August 2,  2003 filed by Restoration Hardware, Inc. with the Securities and  Exchange Commission on September 10, 2003)    |
| 10.20 |   | Amendment  No. 2 to the Seventh Amended and Restated Loan and Security Agreement,  dated September 12, 2003, by and among Restoration Hardware, Inc.,  The Michaels Furniture Company, Inc., Fleet Capital Corporation, and The  CIT Group/Business Credit, Inc. (incorporated by reference to exhibit  number 10.1 of Form 10-Q for the quarterly period ended November 1,  2003 filed by Restoration Hardware, Inc. with the Securities and  Exchange Commission on December 9, 2003) |
| 10.21 |   | Amendment  No. 3 to the Seventh Amended and Restated Loan and Security Agreement,  dated November 18, 2003, by and among Restoration Hardware, Inc.,  The Michaels Furniture Company, Inc., Fleet Capital Corporation, and The  CIT Group/Business Credit, Inc. (incorporated by reference to exhibit  number 10.2 of Form 10-Q for the quarterly period ended November 1,  2003 filed by Restoration Hardware, Inc. with the Securities and Exchange  Commission on December 9, 2003)  |
| 10.22 |   | Employment Offer  Letter between Restoration Hardware, Inc. and Patricia McKay, dated  October 3, 2003 (incorporated by reference to exhibit number 10.3 of  Form 10-Q for the quarterly period ended November 1, 2003 filed by  Restoration Hardware, Inc. with the Securities and Exchange Commission  on December 9, 2003)                                                                                                                                                                          |
| 10.23 |   | Notice of Grant  of Stock Option and Stock Option Agreement between Restoration  Hardware, Inc. and Patricia McKay, dated October 6, 2003  (incorporated by reference to exhibit number 10.4 of Form 10-Q for the  quarterly period ended November 1, 2003 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  December 9, 2003)                                                                                                                                      |
| 10.24 |   | Notice of Grant  of Stock Option and Stock Option Agreement between Restoration  Hardware, Inc. and Patricia McKay, dated October 6, 2003  (incorporated by reference to exhibit number 10.5 of Form 10-Q for the  quarterly period ended November 1, 2003 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  December 9, 2003)                                                                                                                                      |
| 10.25 |   | Amendment  No. 4 to the Seventh Amended and Restated Loan and Security Agreement,  dated March 15, 2004, by and among Restoration Hardware, Inc., The  Michaels Furniture Company, Inc., Fleet Capital Corporation, and The CIT  Group/Business Credit, Inc. (incorporated by reference to exhibit number  10.38 of Form 10-K for the year ended January 31, 2004 filed by  Restoration Hardware, Inc. with the Securities and Exchange Commission  on April 12, 2004)                  |
| 10.26 |   | Full Recourse  Promissory Note, dated August 15, 2001, by Jason Camp (incorporated by  reference to exhibit number 10.38 of Form 10-K for the year ended  January 31, 2004 filed by Restoration Hardware, Inc. with the  Securities and Exchange Commission on April 12, 2004)                                                                                                                                                                                                                              |
| 10.27 |   | Form of  Notice of Grant of Stock Option and Stock Option Agreement for the  Discretionary Option Grant Program under the Restoration Hardware, Inc.  1998 Stock Incentive Plan as Amended and Restated October 9, 2002  (incorporated by reference to exhibit number 10.1 of Form 8-K filed  by Restoration Hardware, Inc. with the Securities and Exchange  Commission on November 9, 2004)                                                                                                     |

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| 10.28 |   | Form of Notice of  Grant of Stock Option, Stock Option Agreement and Early Exercise Stock  Purchase Agreement for the Automatic Option Grant Program under the  Restoration Hardware, Inc. 1998 Stock Incentive Plan as Amended and  Restated October 9, 2002 (incorporated by reference to exhibit  number 10.2 of Form 8-K filed by Restoration Hardware, Inc.  with the Securities and Exchange Commission on November 9, 2004) |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.29 |   | Form of  Notice of Grant of Stock Option and Stock Option Agreement for the Director  Fee Option Grant Program under the Restoration Hardware, Inc. 1998 Stock  Incentive Plan as Amended and Restated October 9, 2002 (incorporated by  reference to exhibit number 10.3 of Form 8-K filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  November 9, 2004)                                       |
| 10.30 |   | Employment  Agreement, effective as of May 24, 2004, by and between Restoration  Hardware, Inc. and Stephen Gordon (incorporated by reference to exhibit  number 10.1 of Form 10-Q for the quarterly period ended October 30,  2004 filed by Restoration Hardware, Inc. with the Securities and  Exchange Commission on December 3, 2004)                                                                                               |
| 10.31 |   | Notice of Grant  of Stock Option and Stock Option Agreement between Restoration  Hardware, Inc. and John W. Tate, dated August 24, 2004  (incorporated by reference to exhibit number 10.4 of Form 10-Q for the  quarterly period ended October 30, 2004 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  December 3, 2004)                                                                         |
| 10.32 |   | Notice of Grant  of Stock Option and Stock Option Agreement between Restoration  Hardware, Inc. and John W. Tate, dated August 24, 2004  (incorporated by reference to exhibit number 10.5 of Form 10-Q for the  quarterly period ended October 30, 2004 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  December 3, 2004)                                                                         |
| 10.33 |   | Lease Agreement  between Restoration Hardware, Inc. and ProLogis, dated March 9, 2004  (incorporated by reference to exhibit number 10.1 of Form 10-Q for the  quarterly period ended May 1, 2004 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  June 7, 2004)                                                                                                                                    |
| 10.34 |   | Compensation and  Severance Agreement between Restoration Hardware, Inc. and Gary G.  Friedman, amended and restated February 5, 2004 (incorporated by  reference to exhibit number 10.2 of Form 10-Q for the quarterly  period ended May 1, 2004 filed by Restoration Hardware, Inc. with  the Securities and Exchange Commission on June 7, 2004)                                                                           |
| 10.35 |   | Notice of Grant  of Stock Option and Stock Option Agreement between Restoration  Hardware, Inc. and Gary G. Friedman, dated February 5,  2004 (incorporated by reference to exhibit number 10.3 of Form 10-Q  for the quarterly period ended May 1, 2004 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  June 7, 2004)                                                              |
| 10.36 |   | Notice of Grant  of Stock Option and Stock Option Agreement between Restoration  Hardware, Inc. and Gary G. Friedman, dated February 5,  2004 (incorporated by reference to exhibit number 10.4 of Form 10-Q  for the quarterly period ended May 1, 2004 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  June 7, 2004)                                                              |
| 10.37 |   | Notice of Grant  of Stock Option and Stock Option Agreement between Restoration  Hardware, Inc. and Gary G. Friedman, dated February 5,  2004 (incorporated by reference to exhibit number 10.5 of Form 10-Q  for the quarterly period ended May 1, 2004 filed by Restoration  Hardware, Inc. with the Securities and Exchange Commission on  June 7, 2004)                                                              |
| 10.38 |   | Restoration  Hardware, Inc. 2004 Senior Executive Bonus Plan (incorporated by  reference to exhibit number 10.7 of Form 10-Q for the quarterly  period ended May 1, 2004 filed by Restoration Hardware, Inc. with  the Securities and Exchange Commission on June 7, 2004)                                                                                                                                                              |

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| 10.39 |   | Amendment No. 5 to  the Seventh Amended and Restated Loan and Security Agreement, dated  June 3, 2004, by and among Restoration Hardware, Inc., The Michaels  Furniture Company, Inc., Fleet Retail Group, Inc., and The CIT  Group/Business Credit, Inc. (incorporated by reference to exhibit  number 10.8 of Form 10-Q for the quarterly period ended May 1,  2004 filed by Restoration Hardware, Inc. with the Securities and  Exchange Commission on June 7, 2004) |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.40 |   | Letter Agreement,  dated as of August 17, 2004, by and among Restoration  Hardware, Inc. and the investors named therein (incorporated by  reference to exhibit number 10.5 of Form 10-Q for the quarterly period  ended July 31, 2004 filed by Restoration Hardware, Inc. with the  Securities and Exchange Commission on August 30, 2004)                                                                                                                                                      |
| 10.41 |   | Employment Offer  Letter, dated May 13, 2004, from Restoration Hardware, Inc. to  Murray Jukes (incorporated by reference to exhibit number 10.4 of  Form 10-Q for the quarterly period ended July 31, 2004 filed by  Restoration Hardware, Inc. with the Securities and Exchange Commission  on August 30, 2004)                                                                                                                                                                                |
| 10.42 |   | Employment Offer  Letter, dated August 13, 2004, from Restoration Hardware, Inc. to  John W. Tate (incorporated by reference to exhibit number 99.2 of  Form 8-K filed by Restoration Hardware, Inc. with the Securities  and Exchange Commission on August 19, 2004)                                                                                                                                                                                                                            |
| 10.43 |   | Notice of Grant  of Stock Option and Stock Option Agreement between Restoration Hardware, Inc.  and John W. Tate, dated August 24, 2004 (incorporated by reference to  exhibit number 10.4 of Form 10-Q for the quarterly period ended  October 30, 2004 filed by Restoration Hardware, Inc. with the  Securities and Exchange Commission on December 3, 2004)                                                                                                                                   |
| 21    |   | List of  Subsidiaries                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| 23.1  |   | Independent  Registered Public Accounting Firm’s’ Consent and Report on Schedule                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 31.1  |   | Rule 13a-14(a)/15d-14(a) Certification  of Chief Executive Officer                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 31.2  |   | Rule 13a-14(a)/15d-14(a) Certification  of Chief Financial Officer                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 32.1  |   | Section 1350  Certification of Chief Executive Officer                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
| 32.2  |   | Section 1350  Certification of Chief Financial Officer                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |

 

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