**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,DC 20549**

**FORM 10-K**

**(MARK ONE)**

x     Annual report pursuant to Section 13 or 15(d) ofthe Securities Exchange Act of 1934

**Forthe fiscal year ended JANUARY 28, 2006**

**or**

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

**Forthe transition periodfrom                   to                   **

**Commission file number 000-24261**

----

**RESTORATION HARDWARE, INC.**

(Exact Name of Registrantas Specified in Its Charter)

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

 

**15KOCH ROAD, SUITE J, CORTE MADERA, CA 94925**(Addressof Principal Executive Offices) (Zip Code)

**(415) 924-1005**(Registrant’sTelephone Number, 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 registered pursuant to Section 12 (g) ofthe Act:

**COMMON STOCK, $0.0001 PARVALUE**

(Title of class)

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act. o Yes    x No

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. o Yes    x No

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    o No

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§ 229.405 of this chapter) is not contained herein, and will not becontained, to the best of registrant’s knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

| Large accelerated filer   o |   | Accelerated filer   x |   | Non-accelerated  filer   o |
|---------------------------------------|--------|---------------------------------|--------|--------------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Act). o Yes    x No

The aggregate market value of common stock, par value$0.0001 per share, held by non-affiliates of the registrant based on theclosing price for the common stock on The Nasdaq National Market on the lastbusiness day of the registrant’s most recently completed fiscal second quarter(July 30, 2005), was approximately $305 million. For purposes of thiscalculation, the registrant has assumed that only shares beneficially held byexecutive officers and directors of the registrant are deemed shares held byaffiliates of the registrant. This assumption of affiliate status is notnecessarily a conclusive determination of affiliate status for any otherpurpose. 37,773,289 shares of the registrant’s common stock were outstanding onMarch 30, 2006.

 

----

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 “Risk Factors” andelsewhere in this annual report on Form 10-K. We assume noobligation to update this information.

**Documents Incorporated by Reference**

Portions of the registrant’sproxy statement for its 2006 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.

**TABLE OF CONTENTS**

|                | ** ** | ** **                                                                                                         | ** ** | **PAGE** | ** ** |
|----------------|------------|--------------------------------------------------------------------------------------------------------------------|------------|----------|------------|
| PART I    |       |                                                                                                               |       |     |       |   |   |
| Item  1.       |       | Business                                                                                                           |       |     | 3          |   |   |
| Item  1A.      |       | Risk  Factors                                                                                                      |       |     | 5          |   |   |
| Item 1B.       |       | Unresolved Staff Comments                                                                                          |       |     | 14         |   |   |
| Item  2.       |       | Properties                                                                                                         |       |     | 15         |   |   |
| 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 and Other  Non-Financial Information                                                       |       |     | 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                              |       |     | 57         |   |   |
| Item 9A.       |       | Controls and Procedures                                                                                            |       |     | 57         |   |   |
| Item  9B.      |       | Other  Information                                                                                                 |       |     | 58         |   |   |
| PART III  |       |                                                                                                               |       |     |       |   |   |
| Item 10.       |       | Directors and Executive Officers of  the Registrant                                                                |       |     | 58         |   |   |
| Item 11.       |       | Executive Compensation                                                                                             |       |     | 58         |   |   |
| Item 12.       |       | Security Ownership of Certain  Beneficial Owners and Management and Related Stockholder Matters                    |       |     | 58         |   |   |
| Item 13.       |       | Certain Relationships and Related  Transactions                                                                    |       |     | 58         |   |   |
| Item 14.       |       | Principal Accountant Fees and  Services                                                                            |       |     | 58         |   |   |
| PART IV   |       |                                                                                                               |       |     |       |   |   |
| Item 15.       |       | Exhibits and Consolidated Financial  Statement Schedules                                                           |       |     | 59         |   |   |
| SIGNATURES     |       |                                                                                                               | 60         |     |       |
| EXHIBIT  INDEX |       |                                                                                                               | 61         |     |       |

 

2

----

**PART I**

**ITEM 1.**                BUSINESS

Restoration Hardware, Inc., and subsidiaries,(the “Company”, “we”, or “our”) 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 103 stores and sixoutlet stores in 30 states, the District of Columbia and Canada at January 28,2006. We operate on a 52 - 53 week fiscal year ending on the Saturdayclosest to January 31. The fiscal years ended January 28, 2006 (“fiscal2005”), January 29, 2005 (“fiscal 2004”), and January 31, 2004 (“fiscal2003”) 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 12 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.We use 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.

Since 2002, the Company history is as follows:

In 2002, we launched a new merchandising strategywhich included new merchandise offerings, adjustments of overall product mix,and the remodeling of our stores in order to best present the new merchandise.In addition, to drive sales in our direct channels, we expanded our productassortment of catalog and Internet only items.

In 2003, we built on the prior year’s successfullaunch by refining and expanding our core merchandise offerings, which includedpremium textiles, bath fixtures and hardware, lighting, and furniture.

In 2004, we re-merchandised our furniture assortmentand revamped our accessories offering. We also redesigned our catalog in 2004to improve the presentation of our core businesses and more clearly communicatethe quality positioning of our offerings. In addition, we opened our firstoutlet store.

In 2005, we remodeled the majority of our stores andopened one traditional retail store and five outlet stores. The remodeledstores enabled us to expand the merchandise offerings in certain core categories,particularly lighting and textiles, and present those offerings with moreclarity and focus. The expansion of our outlet store strategy will enable us tomore effectively liquidate overstocked, discontinued and damaged merchandiseand over time, we believe will substantially reduce the need for the lessproductive warehouse sales events that we have historically held. During theyear, we also continued to upgrade our management team, particularly in thearea of operations.

Our customers have continued to respond positively tothe new merchandise introductions presented in all channels. We believe there-merchandising focus, the remodeling efforts and added operational leadershipwill provide a strong foundation for margin expansion, operational efficienciesand cost reductions, as well as provide a springboard for future growth.

3

----

We make available free ofcharge through our website at*www.restorationhardware.com* under “Company Information” our annualreports on Form 10-K; quarterly reports on Form 10-Q; currentreports on Form 8-K; and amendments to these and other reports filedor furnished by us pursuant to Section 13(a) or 15(d) of theSecurities Exchange Act of 1934, as soon as reasonably practicable after wefile such materials with the Securities and Exchange Commission.

**RETAIL STORES**

***Merchandising Mix***

We offer a broad butcarefully edited selection of merchandise that provides a consistent point ofview throughout our stores. Our collection of merchandise, not traditionallyfound in a single store environment, includes hardware, bathware, furniture,lighting, textiles, accessories and related merchandise. Our merchandise mixalso includes proprietary products selected from non-traditional distributionchannels that appear unique to our customers.

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

We make merchandisepurchases from over 400 vendors and source some of our furniture through ourwholly-owned subsidiary, The Michaels Furniture Company, Inc. (“Michaels”).Our vendors include major domestic manufacturers, specialty niche manufacturersand importers. We maintain agents in China, England, France, Germany, India,Indonesia, Italy, Japan, Philippines, Portugal, Vietnam and Eastern Europe.Approximately 62% of our purchases are sourced from vendors located abroad. Bysourcing a large proportion of products offshore, we seek to achieve increasedbuying effectiveness and ensure exclusivity for a portion of our product line.In many instances, we also work closely with our vendors to develop productsthat are unique to us.

**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 tosell our products, promote consumer awareness of our brand and generate storetraffic.

In fiscal 2005, wecirculated approximately 1% more catalogs but approximately 19% more catalog pages thanin fiscal 2004. We mail catalogs to persons with demographic profiles similarto those of our retail customers and who also possess previous mail orderpurchase histories. In fiscal 2005, approximately 61% of catalogs werecirculated to past customers, and the remaining catalogs were mailed toprospects. These prospects were obtained primarily from customer lists of otherhigh-end mail order companies sharing similar customer demographics. Weoutsource to a third party the fulfillment aspects of the direct-to-customerbusiness, including customer service and non-furniture distribution.

**THEMICHAELS FURNITURE COMPANY, INC. (“Michaels”)**

Purchased by RestorationHardware in 1998, Michaels offers a line of high quality furniture for the homeand office. Specific product lines include bedroom, living room, dining room,home office and occasional items. Intercompany sales to Restoration Hardwarerepresented all of Michaels’ total sales in fiscal 2005, fiscal 2004 and fiscal2003, and this is expected to continue. Michaels is located in Sacramento,California.

4

----

**MANAGEMENT INFORMATION 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 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 competewith 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, inpotential or actual litigation between us and our competitors relating to suchactivities as competitive sales and hiring practices, exclusive relationshipswith key suppliers and manufacturers and other matters. As a result, increasedcompetition may adversely affect our financial performance, and we cannot assureyou that we will be able to compete successfully 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 tocompete favorably on the basis of these factors, we may not ultimately succeedin competing with other retailers in our market.

**TRADEMARKS**

We have registered ourtrademark “Restoration Hardware” in the United States of America, Mexico andCanada. 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.

**EMPLOYEES**

At January 28, 2006,we had approximately 1,600 full-time employees and 2,200 part-time employees.We consider our employee relations to be good.

**ITEM 1A.**        RISKFACTORS

We face a variety of risks that may affect ouroperations or financial results and many of those risks are driven by factorsthat we cannot control or predict. The following discussion addresses thoserisks that management believes are the most significant, although there may beother risks that could arise, or may prove to be more significant thanexpected, that may affect our operations or financial results.

**Our success dependsupon consumer responses to our product offerings; if we fail to successfully anticipatechanges in consumer trends or consumers otherwise do not respond to our productofferings, our results of operations may be adversely affected.**

Our success depends on consumer responses to ourproduct offerings and our ability to anticipate and respond to changingmerchandise trends and consumer demands in a timely manner. If, for example,consumers do not respond to our product offering or we misjudge market trends,we may significantly overstock unpopular products and be forced to takesignificant inventory markdowns, which would have a negative impact on ouroperating results. Conversely, shortages of popular items could result in lossof potential sales revenue and have a material adverse effect on our operatingresults.

We believe there is a lifestyletrend toward increased interest in home renovation and interior decorating, andwe further believe we are benefiting from such a trend. If this trend fails tocontinue to 

5

----

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.

In addition, a materialdecline in sales and other adverse conditions resulting from our failure toaccurately anticipate changes in merchandise trends and consumer demands couldcause us to close underperforming stores. While we believe that we benefit inthe long run financially by closing underperforming stores and reducingnonproductive costs, the closure of such stores would subject us to additionalincreased short-term costs including, but not limited to, employee severancecosts, charges in connection with the impairment of assets and costs associatedwith the disposition of outstanding lease obligations. At January 28,2006, we did not expect, and therefore did not reserve for, any store closures.

**Our success is highly dependent on improvements to ourplanning, order acceptance and fulfillment and supply chain processes.**

Our product mix isincreasingly dependent upon the efficiency of our supply chain infrastructureand order acceptance and fulfillment processes. Our in store customer saleshave recently consisted of higher percentages of merchandise that must beshipped to the customer or is custom ordered as we have refined our productofferings. Such transactions put additional pressure on our order acceptanceand fulfillment 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, increase our costs and have amaterial adverse effect on our operating results.

**Because our revenue is subject to seasonalfluctuations, significant deviations from projected demand for products in ourinventory during a selling season could have a material adverse effect on ourfinancial condition and results of operations.**

Our business is highlyseasonal. We make decisions regarding merchandise well in advance of the seasonin which it will be sold, particularly for the holiday selling season. Thegeneral pattern associated with the retail industry is one of peak sales and earningsduring the holiday season. Due to the importance of the holiday selling season,the fourth quarter of each fiscal year has historically contributed, and weexpect it will continue to contribute, a disproportionate percentage of our netrevenue and our gross profit for the entire fiscal year. In anticipation ofincreased sales activity during the fourth quarter, we incur significantadditional expenses both prior to and during the fourth quarter. These expensesmay include acquisition of additional inventory, catalog preparation andmailing, advertising, in-store promotions, seasonal staffing needs and othersimilar items. If, for any reason, our sales were to fall below ourexpectations in the fourth quarter, our business, financial condition and annualoperating results may be materially adversely affected.

**Increased catalog and other marketing expenditureswithout increased revenue may have a negative impact 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.

6

----

**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,remodelings or relocations, shifts in the timing of holidays, timing of catalogreleases or sales, timing of delivery of orders, competitive factors andgeneral economic conditions. Accordingly, our profits or losses may fluctuate.Moreover, in response to competitive pressures, we may take certain pricing ormarketing actions that could have a material adverse effect on our business,financial condition and results of operations. Therefore, we believe thatperiod-to-period comparisons of our operating results are not necessarilymeaningful and cannot be relied upon as indicators of future performance. Ifour operating results in any future period fall below the expectations ofsecurities analysts or investors, or if our operating results do not meet theguidance that we issue from time to time, the market price of our shares ofcommon stock would likely decline.

**Fluctuations incomparable store sales may cause our revenue and operating results fromperiod-to-period to 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, the timing ofdelivery of orders and our ability to execute our business strategyefficiently. Our comparable store sales decreased 0.3% in fiscal 2005. 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 tofluctuate.

**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 400 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 ofour vendors have limited the distribution of their merchandise in the past. Wehave no long-term purchase contracts or other contractual assurances ofcontinued supply, pricing or access to new products, and any vendor ordistributor could discontinue selling to us at any time. We may not be able toacquire desired merchandise in sufficient quantities on terms acceptable to usin the future, or be able to develop relationships with new vendors to expandour offerings or replace discontinued vendors. Our inability to acquiresuitable merchandise in the future or the loss of one or more key vendors andour failure to replace any one or more of them may have a material adverseeffect on 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 toadequately support our management information systems in the future could havea material adverse effect on our business, results of operations and financialcondition.

We routinely purchase products from new vendors, manyof whom are located abroad. We cannot assure you that they will be reliablesources of our products. Moreover, a number of these manufacturers andsuppliers are small and undercapitalized firms that produce limited numbers ofitems. Given their limited resources, these firms might be susceptible toproduction difficulties, quality control issues and problems in deliveringagreed-upon quantities on schedule. We cannot assure you that we will be able,if 

7

----

necessary, to returnproducts to these suppliers and manufacturers and obtain refunds of ourpurchase price or obtain reimbursement or indemnification from them if theirproducts prove defective. These suppliers and manufacturers also may be unableto withstand a downturn in the U.S. or worldwide economy. Significant failureson the part of these suppliers or manufacturers could have a material adverseeffect 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.

**Operationaldifficulties in any of our distribution and order acceptance and fulfillmentoperations would materially affect our operating results.**

A growing percentage of our business depends upon thesuccessful operation of our distribution and order acceptance and fulfillmentservices either because the business is generated through our Catalog andInternet channels or because the customer’s purchase in the store must becompleted through a shipment of product to the customer. The distributionfunctions for our stores as well as all of our furniture orders are currentlyhandled from our facilities in Hayward and Tracy, California and Baltimore,Maryland. Operational difficulties such as a significant interruption in theoperation of any of these facilities may delay shipment of merchandise to ourstores and our customers, damage our reputation or otherwise have a materialadverse effect on our financial condition and results of operations. Moreover,a failure to successfully coordinate the operations of these facilities couldalso have a material adverse effect on our financial condition and results ofoperations. Separately, significant disruptions to the operations of the thirdparty vendor who handles, among other things, the distribution and fulfillmentfunctions for our direct-to-customer business on an outsourced basis could beexpected to have similar negative consequences.

**Labor activitiescould cause labor relations difficulties for us.**

As of January 28, 2006, we had approximately3,800 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, including the terms of our revolving credit facility,which may not make available to us sufficient funds when we need them.**

We have significantly relied and may rely in the futureon external funding sources to finance our operations and growth. Any reductionin cash flow from operations could increase our external funding requirementsto levels above those currently available to us. While we currently have inplace a $150.0 million revolving credit facility, the amount availableunder this facility will be less than the stated amount (i) if there is ashortfall in the availability of eligible collateral to support the borrowingbase and reserves as established by the terms of the revolving credit facilityand (ii) at times when we are not in compliance with the requirements ofthe fixed charge coverage ratio for us to access incremental advances under thecredit facility when the remaining availability for additional borrowing underthe facility is less than 10% of the applicable borrowing base for the line ofcredit at the time . We currently believe that our cash flow from operationsand funds available under our revolving credit facility will satisfy ourcapital and operating requirements for at least the next 12 months.However, the weakening of, or other adverse developments concerning our salesperformance or adverse developments concerning the availability of credit underour revolving credit facility due to covenant limitations or other factorscould limit the overall amount of funds available to us.

8

----

Our revolving credit facility provides for incrementaladvances with availability determined from the application of a higher advancerate on eligible inventory and eligible accounts receivables. In order toobtain these incremental advances, we are required to maintain a minimum fixedcharge coverage ratio if the remaining availability for additional borrowingunder the facility is less than 10% of the applicable borrowing base for theline of credit at the time.

Our revolving credit facility also contains a clausewhich allows our lenders to forego additional advances should they determinethere has been a material adverse change in our operations, business,properties, assets, liabilities, condition or prospects or a condition or eventthat is reasonably likely to result in a material adverse change in ourfinancial position or prospects reasonably likely to result in a materialadverse effect on our business, condition (financial or otherwise), operations,performance or properties taken as a whole. However, our lenders have notnotified us of any indication that a material adverse effect exists at January 28,2006 or that a material adverse change has occurred. We believe that nomaterial adverse change has occurred and we believe that we will continue toborrow on the line of credit subject to its terms and conditions ofavailability in order to fund our operations over the term of the revolvingcredit facility which expires in June 2009. We do not anticipate anychanges in our business practices that would result in any determination thatthere has been a material adverse effect in our operations, business,properties, assets, liabilities, condition or prospects. However, we cannot becertain that our lenders will not make such a determination in the future.

We may experience cash flow shortfalls in the futureand we may otherwise require additional external funding beyond the amountsavailable under our revolving credit facility. However, we cannot assure youthat we will be able to raise funds on favorable terms, if at all, or thatfuture financing requirements would not be dilutive to holders of our capitalstock. In the event that we are unable to obtain additional funds on acceptableterms or otherwise, we may be unable or determine not to take advantage of newopportunities or defer on taking other actions that otherwise may be importantto our operations. Additionally, we may need to raise funds to take advantageof unanticipated opportunities. We also may need to raise funds to respond tochanging business conditions or unanticipated competitive pressures. If we failto raise sufficient additional funds, we may be required to delay or abandonsome of our planned future expenditures 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, mailings of catalogs and other advertising costs for theholiday buying season and other similar advance expenses. As described above,we currently have in place a revolving credit facility that provides for anoverall commitment of $150.0 million. Over the past several years, we haveentered into modifications, amendments and restatements of this revolvingcredit facility, primarily to address changes in the requirements applicable tous under the revolving credit facility documents, and, most recently, toincrease the stated amount of commitment under the facility amongst otherthings.

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. In addition, the incremental advance portion of our revolvingcredit facility includes a fixed charge coverage ratio covenant that isexpected to limit our ability to access incremental advances during certainmonths of the year. Although we have been able to obtain incremental advanceswhen needed to provide the capital required for our business to date, there maybe times in the future when the terms and conditions of availability for ourline of credit, including the restrictions applicable to the incrementaladvance provisions, would limit our ability 

9

----

to access working capitalas and to the extent we require for the operation of our business, potentiallyhaving an adverse affect on our results of operation.

These covenants restrict numerous aspects of ourbusiness. The revolving credit facility also includes a borrowing base formula(which includes an adjustment to the advance rate against eligible inventoryand eligible accounts receivable for incremental advances as described above)to address the availability of credit at any given time based upon numerousfactors, including the value of eligible inventory and eligible accountsreceivable, in each case, subject to the overall aggregate cap on borrowings.Consequently, for purposes of the borrowing base formula, the value of eligibleinventory and eligible accounts receivable may limit our ability to borrowunder the revolving credit facility.

We have drawn upon the revolving credit facility inthe past and we expect to draw upon it in the future. Failure to comply withthe terms of the revolving credit facility would entitle the secured lenders toprevent us from further borrowing, and upon acceleration by the lenders, theywould be entitled to begin foreclosure procedures against our assets, includingaccounts receivable, inventory, general intangibles, equipment, goods, andfixtures. The secured lenders would then be repaid from the proceeds of suchforeclosure proceedings, using all available assets. Only after such repaymentand the payment of any other secured and unsecured creditors would the holdersof our capital stock receive any proceeds from the liquidation of our assets.Our ability to comply with the terms of the revolving credit facility may beaffected 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 otherfactors. Many of these factors are beyond our control. In addition, we may needto incur additional indebtedness in the future. We cannot assure you that ourbusiness will generate sufficient cash flow or that future financings will beavailable to provide sufficient proceeds to meet our needs or obligations or toservice our total debt.

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

During fiscal 2005, we purchased approximately 62% ofour merchandise directly from vendors located abroad. As an importer, ourfuture success will depend in large measure upon our ability to maintain ourexisting foreign supplier relationships and to develop new ones. While we relyon our long-term relationships with our foreign vendors, we have no long-termcontracts with them. Additionally, many of our imported products are subject toexisting duties, tariffs and quotas that may limit the quantity of some typesof goods which we may import into the United States of America. Our dependenceon foreign imports also makes us vulnerable to risks associated with productsmanufactured 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 

10

----

against protectionistforeign trade practices. Furthermore, some or all of our foreign vendors’operations may be adversely affected by political, financial or otherinstabilities that are particular to their home countries, including withoutlimitation local acts of terrorism or economic, environmental or health andwelfare-related crises, which may in turn result in limitations or temporary orpermanent halts to their operations, restrictions on the transfer of goods orfunds and/or other trade disruptions. If any of these or other factors were torender the conduct of business in particular countries undesirable orimpractical, our financial condition and results of operations could bematerially 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 and until alternative supplyarrangements are secured. Moreover, products from alternative sources may be oflesser quality and/or more expensive than those we currently purchase,resulting in reduction or loss of our profit margin on such items.

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

While most of our purchases outside of the UnitedStates of America currently are settled in U.S. dollars, it is possible that agrowing number of them in the future may be made in currencies other than theU.S. dollar. Historically, we have not hedged our currency risk and we do notcurrently anticipate doing so in the future. However, because our financialresults are reported in U.S. dollars, fluctuations in the rates of exchangebetween the U.S. dollar and other currencies may decrease our sales margins orotherwise have a material adverse effect on our financial condition and resultsof operations 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 2005, revenue through ourdirect-to-customer channel grew by 34% 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-customerbusiness will 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 keypersonnel and could be affected by the loss of their services because of thelimited number of qualified people in our industry.**

The success of our business will continue to dependupon our key personnel, including our Chairman, President, and Chief ExecutiveOfficer, Gary Friedman. We recently announced the intention of our ChiefOperating Officer to resign and that we have commenced a search for a new ChiefOperating Officer. Competition for qualified employees and personnel in theretail 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 

11

----

employment with us at anytime. We do not maintain any key man life insurance. The loss of the servicesof key management personnel, employee turnover in important areas of ourbusiness or our failure to attract additional qualified personnel oreffectively handle management transitions could have a material adverse effecton our business, financial condition and results of operations.

**Regulatory changesmay increase our costs.**

Changes in the laws, regulations and rules affectingpublic companies may increase our expenses in connection with our compliancewith these new requirements. Compliance with these new requirements could alsoresult in continued diversion of management’s time and attention, which couldprove to be disruptive to normal business operations. Further, the impact ofthese laws, regulations and rules and activities in response to them couldalso make it more difficult for us to attract and retain qualified persons toserve on our board of directors or as executive officers, which could harm ourbusiness.

**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, rising oil prices,taxation and consumer confidence in future economic conditions. More generally,reduced consumer confidence and spending may result in reduced demand fordiscretionary items and luxury retail products, such as our products. Reducedconsumer confidence and spending also may result in limitations on our abilityto increase prices and may require increased levels of selling and promotionalexpenses. Adverse economic conditions and any related decrease in consumerdemand for discretionary items such as those offered by us could have amaterial adverse effect on our business, results of operations and financialcondition.

**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 competewith 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 locations. 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 attacks,war, natural disasters and other catastrophic events may negatively impact allaspects 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 

12

----

conflicts in the MiddleEast and in other developing countries, or military or trade disruptionsaffecting our domestic or foreign suppliers of merchandise, may impact ouroperations. Our operations also may be affected by natural disasters or othersimilar events, including floods, hurricanes, earthquakes, or fires. Thepotential impact of any of these events to our operations includes, among otherthings, delays or losses in the delivery of merchandise to us or our customersand decreased sales of the products we carry. Additionally, any of these eventscould cause consumer confidence and spending to decrease or result in increasedvolatility in the United States of America and worldwide financial markets andeconomies. Also, any of these events could result in economic recession in theUnited States of America or abroad. Any of these occurrences could have asignificant impact on our operating results, revenue and costs and may resultin the volatility of the future market price of our common stock.

**Our common stock price maybe 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 declinesignificantly in the future. In addition, the United States of America equitymarkets have from time to time experienced significant price and volumefluctuations that have particularly affected the market prices for the stocksof companies such as ours. These broad market fluctuations may materiallyadversely affect the market price of our common stock in the future. Variationsin the market price of our common stock may be the result of changes in thetrading characteristics that prevail in the market for our common stock,including low trading volumes, trading volume fluctuations and other similarfactors that are particularly common among highly volatile securities.Variations also may be the result of changes in our business, operations orprospects, announcements or activities by our competitors, entering into newcontractual relationships with key suppliers or manufacturers by us or ourcompetitors, proposed acquisitions by us or our competitors, financial resultsthat fail to meet our guidance or public market analysts’ expectations, changesin stock market analysts’ recommendations regarding us, other retail companiesor the retail industry in general, and domestic and international market andeconomic 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. During fiscal 2005, theremaining holders of the Series A preferred stock elected to convert theirshares of Series A preferred stock into common stock. Sale, or the availabilityfor sale, 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.

13

----

**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 (“FASB”)recently adopted regulations that will eliminate the Company’s ability toaccount for share-based compensation transactions using the intrinsic methodand would require that such transactions be accounted for using afair-value-based method and be recognized as an expense in our ConsolidatedStatement of Operations. We are required to expense stock options effective inperiods beginning after January 28, 2006. For prior periods, we onlydisclosed 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. Effective with the beginning of thefirst quarter of fiscal 2006, we will adopt Statement of Financial AccountingStandards No. 123 (R) (“SFAS 123(R)”) using the modifiedprospective method. Under this method, the unvested portions of previouslygranted share-based payments, as well as the fair value of awards granted afteradoption are included in operating expenses over the appropriate serviceperiod. We have decided to use the Black Scholes model to estimate the fairvalue of our stock options, unless additional information becomes available inthe future that indicates another model would be more appropriate for us, or ifgrants issued in future periods have characteristics that cannot be reasonablyestimated using this model. Based on stock options granted to employees throughJanuary 28, 2006, we expect the adoption of SFAS 123(R) will increasefirst quarter expenses by approximately $1.3 million ($0.03 per share, basic)and increase full year fiscal 2006 expenses by approximately $4.0 million ($0.11per share, basic).

**We are subject toanti-takeover provisions and other terms and conditions 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 a classifiedboard of directors. With a classified board of directors, at least two annualmeetings of stockholders, instead of one, will generally be required to effecta change in the majority of the board. As a result, a provision relating to aclassified board may discourage proxy contests for the election of directors orpurchases of a substantial block of our common stock because its provisionscould operate to prevent obtaining control of the board in a relatively shortperiod of time.

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. These provisions may create a potentially discouraging effect on,among other things, any third party’s interest in completing a merger,consolidation, acquisition or similar type of transaction with us.Consequently, the existence of these anti-takeover provisions may collectivelyhave a negative impact on the price of our common stock, may discouragethird-party bidders from making a bid for our Company or may reduce anypremiums paid to our stockholders for their common stock.

**ITEM 1B.**       UNRESOLVEDSTAFF COMMENTS

None.

14

----

**ITEM 2.**                PROPERTIES

We currently lease approximately 112,000 square feetof space for use as our headquarters, including approximately 44,000 squarefeet of warehouse space, located in Corte Madera, California. The leases forthis space expire between April 2006 and May 2010. We leaseapproximately 7,000 square feet of office space in New York, New York. Thelease for this space expires between May 2006 and January 2011.

As of January 28, 2006, 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 ofAmerica. This lease expires in October 2006 with an option to extend for atwelve-month term. We lease approximately 284,000 square feet of warehousespace in Tracy, California, which acts as a furniture distribution center. The leasefor this facility expires in September 2011, with an option to renew forone additional five-year term. We also lease approximately 508,000 square feetof warehouse space in Baltimore, Maryland, for use as our east coastdistribution center. The lease for this space expires in September 2008.

As of January 28, 2006, we leased approximately1,263,000 gross square feet for our 103 retail stores, six outlet stores, andan outlet store that will open in April 2006. The initial lease term ofour retail stores generally range from 10 to 20 years. Certain leasescontain renewal options for up to 15 years. Most leases for our retail storesprovide for a minimum rent, typically including escalating rent increases, plusa percentage rent based upon sales after certain minimum thresholds areachieved. The leases generally require us to pay insurance, utilities, realestate taxes and repair and maintenance expenses.

In connection with our wholly-owned furnituremanufacturing subsidiary, Michaels, we lease two properties used for themanufacturing and storage of furniture, in Sacramento, California. We lease oneof the properties from the previous owner and current president of Michaels.The main property consists of approximately 100,000 square feet of manufacturingspace and 7,000 square feet of office space. The lease expires in February 2008,with options to extend the lease for two additional five-year terms. The secondproperty consists of approximately 46,000 square feet of warehouse space, whichis used to house finished goods. This lease expires in July 2006.

We intend to renew thoseleases expiring in the near term.

**ITEM 3.**                LEGALPROCEEDINGS

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 financial condition or results of operations.However, we cannot assure you that the results of any proceeding will be in ourfavor. Moreover, due to the uncertainties inherent in any legal proceeding, wecannot accurately predict the ultimate outcome of any proceeding and may incursubstantial costs to defend the proceeding, irrespective of the merits. Theunfavorable outcome of any legal proceeding could have an adverse impact on ourbusiness, financial condition and results of operations.

**ITEM 4.**                SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS

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.

15

----

**PART II**

**ITEM 5.**                MARKETFOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUERPURCHASES OF EQUITY 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 $5.75 on March 30, 2006.

**STOCKHOLDERS**

As of March 30, 2006there were 470 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.

**STOCK PRICE INFORMATION**

Setforth below are the high and low closing sale prices for shares of our commonstock for each quarter during the fiscal years ended January 28, 2006 and January 29,2005, as reported by The Nasdaq National Market.

| **Quarter Ending** | ** ** | ** ** | ** ** | **High** | ** ** | **Low** | ** ** |
|-------------------------|------------|------------|------------|----------|------------|---------|------------|
| 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     |       |
| April 30,  2005    |       | 6.71       |       | 5.05     |       |
| July 30,  2005     |       | 9.00       |       | 5.63     |       |
| October 29,  2005  |       | 8.63       |       | 5.47     |       |
| January 28, 2006   |       | 6.60       |       | 4.94     |       |

 

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. This information is incorporated herein byreference.

16

----

**ITEM 6.**                SELECTEDFINANCIAL DATA AND OTHER NON-FINANCIAL INFORMATION

Thefollowing table sets forth selected, consolidated financial information andother non-financial information as of and for the years indicated. Thisinformation is qualified by reference to, and should be read in conjunctionwith, “Management’s Discussion and Analysis of Financial Condition and Resultsof Operations,” the Consolidated Financial Statements, related notes theretoand other 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** | ** ** | ** ** |
|---------------------------------------------------------------------------|------------|----------------------|------------|------------|
| ** **                                                                | ** ** | **2005**             | ** ** | **2004**   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | ** ** |
| **(Dollars  in thousands, except per share and selected operating data)** | ** ** | ** **           |       |       |   |   |   |   |   |   |   |   |
| ***Results  of Operations:***                                             |       |                 |       |       |   |   |   |   |   |   |   |   |
| Net revenue                                                               |       | $                    | 581,657    |       | $ | 525,823 |   | $ | 438,508 |   | $ | 400,337 |   | $ | 366,473 |   |   |
| (Loss) income  before income taxes                                        |       | (3,106               | )          | 1,604      |   | (4,029 | ) | (10,864 | ) | (39,704 | ) |   |
| Net (loss) income                                                         |       | (29,307              | )          | 1,704      |   | (2,518 | ) | (2,845 | ) | (32,136 | ) |   |
| (Loss) income  attributable to common stockholders                        |       | (29,307              | )          | 1,704      |   | (2,518 | ) | (3,203 | ) | (34,953 | ) |   |
| (Loss) income per  common stock—basic                                |       | $                    | (0.83      | )          | $ | 0.05 |   | $ | (0.08 | ) | $ | (0.11 | ) | $ | (1.49 | ) |   |
| (Loss) income per  common stock—diluted                              |       | $                    | (0.83      | )          | $ | 0.04 |   | $ | (0.08 | ) | $ | (0.11 | ) | $ | (1.49 | ) |   |
| ***Financial  Position:***                                                |       |                 |       |       |   |   |   |   |   |   |   |   |
| Working capital                                                           |       | $                    | 87,483     |       | $ | 51,791 |   | $ | 52,097 |   | $ | 49,398 |   | $ | 56,094 |   |   |
| Total assets                                                              |       | 274,268              |       | 279,263    |   | 233,895 |   | 228,135 |   | 209,460 |   |   |
| Line of  credit & other current debt                             |       | —               |       | 33,819     |   | 10,286 |   | 13,909 |   | — |   |   |
| Long term debt  and other long-term obligations                           |       | 58,177               |       | 143        |   | 352 |   | 144 |   | 3,236 |   |   |
| Redeemable  convertible preferred stock                                   |       | —               |       | 8,331      |   | 8,541 |   | 13,328 |   | 14,106 |   |   |
| Stockholders’  equity                                                |       | $                    | 80,132     |       | $ | 99,286 |   | $ | 96,532 |   | $ | 90,142 |   | $ | 84,105 |   |   |
| ***Retail  Stores:***                                                     |       |                 |       |       |   |   |   |   |   |   |   |   |
| Store count at  year-end(1)                                               |       | 103                  |       | 102        |   | 103 |   | 105 |   | 104 |   |   |
| Comparable store  sales (decline) growth(2)                               |       | (0.3                 | )%         | 7.8        | % | 5.2 | % | 6.2 | % | (4.6 | )% |   |
| Store selling  square feet at year-end(1)                                 |       | 685,672              |       | 676,520    |   | 679,300 |   | 688,634 |   | 682,936 |   |   |
| ***Direct-to-Customer:***                                                 |       |                 |       |       |   |   |   |   |   |   |   |   |
| Total  direct-to-customer net revenue                                     |       | $                    | 159,991    |       | $ | 118,990 |   | $ | 67,899 |   | $ | 44,705 |   | $ | 33,647 |   |   |
| Net revenue growth  percentage                                            |       | 34                   | %          | 75         | % | 52 | % | 33 | % | 49 | % |   |

----

(1)          Store count at year-endexcludes the outlet locations. At January 28, 2006 and January 29,2005, the Company had six outlets and one outlet, respectively.

(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.

17

----

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

**OVERVIEW**

Our Company, Restoration Hardware, Inc. (Nasdaq:RSTO), together with our subsidiaries, is a specialty retailer of high qualitybathware, hardware, lighting, furniture, textiles and accessories that reflectour classic and authentic American point of view. We commenced business in 1979as a purveyor of fittings and fixtures for older homes. Since then, we haveevolved into a unique home furnishings retailer offering consumers an array ofdistinctive and high quality merchandise. We market our merchandise throughretail locations, mail order catalogs and on the Internet at*www.restorationhardware.com*.

Our merchandise strategy and our stores’ architecturalstyle create a unique and attractive selling environment designed to appeal toan affluent, well-educated, 35 to 60 year old customer. Over the nextdecade, we believe the fastest growing segment of the U.S. population will be45 to 60 year olds. We believe that as these customers evolve, so willtheir purchasing needs and desires. We believe that our products can fulfilltheir aspirations to have homes designed with a high quality, classic andtimeless style. Our plan is to fill the void in the marketplace above thecurrent home lifestyle retailers, and below the interior design trade, byproviding products targeted to 35 to 60 year olds and centered around our corebusinesses that reflect a predictable, high-quality promise to our customers.

We operate on a 52 - 53 week fiscal year ending on theSaturday closest to January 31. Our current fiscal year ended on January 28,2006 (“fiscal 2005”), the prior fiscal year ended on January 29, 2005 (“fiscal2004”) and the prior fiscal year ended on January 31, 2004 (“fiscal 2003”).Fiscal 2005, 2004 and 2003 each consisted of 52 weeks.

As of January 28, 2006, we operated 103 storesand six outlet stores in 30 states, the District of Columbia and Canada. Inaddition to our retail stores, we operate a direct-to-customer (“direct”) saleschannel that includes both catalog and Internet, and a wholly-owned furnituremanufacturer.

Over the pastseveral years, we have made significant progress in our evolution.

·       In2002, we began the transformation required to reposition our brand. Thisincluded new merchandise offerings, the adjustment of our overall product mix,and also the remodeling of our stores in order to best present the newmerchandise. In addition, to drive sales in our direct channels, we expandedour product assortment of catalog and internet only items.

·       In2003, we built on the prior year’s successful launch by further refining andexpanding our core merchandise offerings, including the repositioning of ourpremium textiles, bath fixtures and hardware categories and enhancements in ourlighting and furniture categories.

·       Were-merchandised our furniture assortment in 2004 and revamped our accessoriesoffering. We also redesigned our catalog in fiscal 2004 to improve thepresentation of our core businesses and more clearly communicate the qualitypositioning of our offerings.

In 2005, wefinalized the major changes in our assortment with a repositioning of ourlighting and window categories. In addition, our efforts focused on three keypriorities:

·       *Create dominant assortments in key categories*.   Wereconfigured our stores to appropriately present our repositioned lighting andwindow treatment categories. These changes, in addition to the remodeling workdone in 2002, allow us to project dominance in our key core categories:  textiles, bath fixtures and hardware, lighting,and window treatments. Our Catalog and Internet presentations also reflectedthis improved presentation.

18

----

·       *Maximize product margin opportunities*.   We target corecategories that are high-margin businesses. The product and merchandisingdifferentiation we offer our customers, and our sourcing strategies, supportsthis margin improvement strategy. Additionally, we believe we can furtherstrengthen the overall business’s margin through the use of outlet stores toliquidate overstocked and discontinued goods. In 2005, we expanded our outletstrategy by opening five new outlet stores. We believe these stores will helpus efficiently and cost-effectively manage our inventories, reducing the needfor the less productive warehouse sales events that we have historically held.In 2006, we intend to open an additional 2-3 outlet stores.

·       *Strengthen the supply chain.*   In 2005, we made progresson improving our in-stock position in key categories. Additionally, we beganwork on upgrading the systems and processes for placing and fulfilling customerorders. In 2006, we plan to continue this work.

The store remodeling programin 2005 required an investment of approximately $16.5 million and has beenreflected as capital expenditures in our Consolidated Statements of Cash Flow.The effort also required the removal of some existing store fixtures. The costof accelerating the depreciation associated with those fixtures of $1.6 millionwas fully expensed in the second quarter and reflected in selling, general andadministrative expense in fiscal 2005.

In 2006, while we continueto drive further progress against our key priorities, we will also pursue brandcategory extensions such as the Restoration Hardware outdoor catalog which weinitiated in the first quarter of 2006. In addition, we expect to test a newconcept targeting a broader-value market with a catalog mailing in September.

On an ongoing basis, weevaluate stores for closure based on underperformance. During fiscal 2005, wedid not close any underperforming stores. In fiscal 2005, we recorded a$0.3 million impairment charge on the long-lived assets of two underperformingstores. Cumulatively since fiscal 2001, we have closed nine stores. A materialdecline in sales and other adverse conditions resulting from our failure toaccurately anticipate changes in merchandise trends and consumer demands maycause us to close additional underperforming stores. For fiscal 2006, we haveno current plans to close any stores.

***SummaryConsolidated 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  2005**                                                                | ** ** | **% of Net  Revenue** | ** ** | **Fiscal  2004** | ** ** | **% of Net  Revenue** | ** ** | **Fiscal  2003** | ** ** | **% of Net  Revenue** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|---------------------------------|------------|------------------|------------|---------------------------------|------------|------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **(Dollars in thousands, except per share data)** | ** ** |
| Retail net revenue                                     |       | $                                                                               | 421,666    |                            |       | 72.5             | %          |                            | $          | 406,833          |       |                            | 77.4       | % |   | $ | 370,609 |   |   | 84.5 | % |   |
| Direct-to-customer  net revenue                        |       | 159,991                                                                         |       |                            | 27.5       |             |       | 118,990                         |       |             | 22.6       |                            |       | 67,899 |   |   | 15.5 |   |   |
| Net revenue                                            |       | 581,657                                                                         |       |                            | 100.0      |             |       | 525,823                         |       |             | 100.0      |                            |       | 438,508 |   |   | 100.0 |   |   |
| Cost of revenue  and occupancy                         |       | 384,244                                                                         |       |                            | 66.1       |             |       | 359,808                         |       |             | 68.4       |                            |       | 305,265 |   |   | 69.6 |   |   |
| Gross profit                                           |       | 197,413                                                                         |       |                            | 33.9       |             |       | 166,015                         |       |             | 31.6       |                            |       | 133,243 |   |   | 30.4 |   |   |
| Selling, general  and administrative expense           |       | 196,469                                                                         |       |                            | 33.7       |             |       | 161,939                         |       |             | 30.8       |                            |       | 135,118 |   |   | 30.8 |   |   |
| Income (loss) from  operations                         |       | 944                                                                             |       |                            | 0.2        |             |       | 4,076                           |       |             | 0.8        |                            |       | (1,875 | ) |   | (0.4 | ) |   |
| Interest expense,  net                                 |       | (4,050                                                                          | )          |                            | (0.7       | )                |       | (2,472                          | )          |             | (0.5       | )                               |       | (2,154 | ) |   | (0.5 | ) |   |
| (Loss) income  before income taxes                     |       | (3,106                                                                          | )          |                            | (0.5       | )                |       | 1,604                           |       |             | 0.3        |                            |       | (4,029 | ) |   | (0.9 | ) |   |
| Income tax  (expense) benefit                          |       | (26,201                                                                         | )          |                            | (4.5       | )                |       | 100                             |       |             | —     |                            |       | 1,511 |   |   | 0.3 |   |   |
| Net (loss) income                                      |       | $                                                                               | (29,307    | )                               |       | (5.0             | )          |                            | $          | 1,704            |       |                            | 0.3        |   |   | $ | (2,518 | ) |   | (0.6 | ) |   |
| (Loss) income per  share of common  stock—basic   |       | $                                                                               | (0.83      | )                               |       |             |       |                            | $          | 0.05             |       |                            |       |   |   | $ | (0.08 | ) |   |   |   |   |
| (Loss) income per share  of common  stock—diluted |       | $                                                                               | (0.83      | )                               |       |             |       |                            | $          | 0.04             |       |                            |       |   |   | $ | (0.08 | ) |   |   |   |   |

** **

19

----

**2005 Results**

Income from operationsdecreased to $0.9 million in fiscal 2005 from $4.1 million in fiscal 2004. Werecorded a net expense for income taxes for fiscal 2005 of $26.2 million, whichincludes a full valuation allowance provided against our net deferred tax assetsof $27.9 million. Net loss was $0.83 per share, or $29.3 million for fiscal2005, compared to net income of $0.04 per fully diluted share, or $1.7 million,for fiscal 2004.

The decrease in operatingresults of $3.2 million to $0.9 million of income from operations in fiscal2005 is primarily the result of a 290 basis point increase in selling, general,and administrative expense expressed as a percentage of revenue, offset by a230 basis point improvement in cost of revenue and occupancy expressed as apercentage of revenue. Due to the expected growth of our direct-to-customerchannel as a percentage of our total business mix, we believe that catalogcirculation costs will continue to increase to support the growth, thus causingselling, general and administrative costs to continue deleveraging as apercentage of revenue in future quarters. Net revenue increased $55.8 million,or 11%, in fiscal 2005 as compared to fiscal 2004, which largely resulted froma $41.0 million, or 34%, increase in our direct-to-customer net revenue, and a$14.8 million increase in revenue generated from our retail segment. Comparablestore sales for fiscal 2005 decreased 0.3%, or $1.2 million, compared to fiscal2004. Net revenue related to our outlet stores and warehouse sales events was$18.2 million for fiscal 2005 compared to $5.7 million for fiscal 2004. Outletstore and warehouse sales events revenue is included in retail revenue, but isexcluded from comparable store sales. The increase in net revenue in both ourretail and direct channels can also be attributed to our focus on growing ourcatalog page count, as the catalog is our primary advertising vehicle.

The cost of revenue andoccupancy increased by $24.4 million, or 7%, in fiscal 2005 as compared tofiscal 2004, primarily in support of our revenue growth. The 230 basis pointexpansion of our gross margin to 33.9% in fiscal 2005 from 31.6% in fiscal 2004was attributable to continued improvements in our product margin of 120 basispoints, a 100 basis point improvement in supply chain and distribution costs,and a 10 basis point improvement in occupancy costs as a percentage of netrevenue. Selling, general and administrative expense increased $34.5 million,or 21%, in fiscal 2005 over fiscal 2004. As a percent of revenue, selling,general and administrative expense increased to 33.7% of net revenue in fiscal2005 from 30.8% in fiscal 2004. This included the $1.6 million non-cash chargefor the acceleration of depreciation of certain fixtures removed as part of thestore remodeling effort, and expressed as a percentage of revenue, was higherthan fiscal 2004. We also recorded a $0.3 million impairment charge on thelong-lived assets of two underperforming stores. The increase of 290 basispoints was driven primarily by a combination of higher catalog circulationcosts expressed as a percent of revenue of 130 basis points, increasedoccupancy and related costs of 60 basis points, increased direct-to-customercall center and fulfillment costs of 50 basis points, increased other variablecosts of 20 basis points, and a 30 basis point increase for the non-cash chargeassociated with the store remodeling efforts.

We recorded an income taxexpense for fiscal 2005 of $26.2 million on a pre-tax loss of $3.1 millionwhich included a fourth quarter non-cash charge of $27.9 million to provide afull valuation allowance against our net deferred tax assets. We concluded,under the guidance provided in Statement of Financial Accounting Standards (“SFAS”)No. 109, “*Accounting for Income Taxes*”,that our cumulative losses through 2003 and our three year cumulative lossthrough 2005 necessitated providing a valuation allowance against our netdeferred tax assets as of January 28, 2006. Under generally acceptedaccounting principles, when our results demonstrate a pattern of futureprofitability, in reversal of the current cumulative loss trend, this valuationallowance may be adjusted and may result in the reinstatement of all or a partof the net deferred tax assets. This fiscal 2005 adjustment will have no impacton our cash flow or future prospects, nor does it alter our ability to utilizethe underlying tax net operating loss and credit carryforwards in the future;the utilization of which is limited to achieving future taxable income. Due to 

20

----

thevaluation allowance provided against our net deferred tax assets, we do notexpect any significant income tax benefit or expense for fiscal 2006.

**2004 Results**

Income from operationsimproved to $4.1 million in fiscal 2004 as compared to a loss from operationsof $1.9 million in fiscal 2003. We recorded a net benefit for income taxes forthe year of $0.1 million. This reflects the reduction of the income taxprovision of $3.0 million from the reversal of the valuation allowanceestablished in prior years, offset by $2.1 million of tax contingency and otheradjustments. Net income was $0.04 per fully diluted share, or $1.7 million forfiscal 2004, compared to a net loss of $0.08 per share, or $2.5 million infiscal 2003.

The improvement in theincome from operations in fiscal 2004 of $6.0 million, to an income of $4.1million as compared to a loss from operations of $1.9 million in fiscal 2003,is the result of cost leverage achieved on higher sales, expansion of productmargins and leverage of store occupancy which was somewhat offset by increasedcosts of distribution. The increase in net revenue of $87.3 million in fiscal2004 as compared to fiscal 2003, or 20%, resulted from a 7.8% increase incomparable store sales, and growth of our direct-to-customer business, whichincreased $51.1 million, or 75%, over fiscal 2003. The increase in comparablestore sales over fiscal 2003 was driven by our brand-building initiatives forour core merchandise offerings and the growth of our catalog circulation, whichis our primary advertising vehicle.

The cost of revenue and occupancyincreased by $54.5 million in fiscal 2004 as compared to fiscal 2003, or 18%,primarily in support of our revenue growth. These costs rose at a lower ratethan revenue as the expansion of product margins by 130 basis points and theleverage of our store occupancy costs of 220 basis points more than offset thehigher costs that we continued to experience throughout most of fiscal 2004 inour distribution and supply chain activities of 230 basis points. Productmargins expanded in 2004 due to continued shifts in our product mix to highermargin core businesses such as premium textiles, as well as cost improvementsrealized from the expansion of our international sourcing programs. Theincrease in selling, general and administrative expense of $26.8 million infiscal 2004 over fiscal 2003, or 20%, was primarily incurred in support ofhigher sales. Approximately half of the increase was related to catalogproduction and mailing costs, with one fourth of the increase attributable tohigher payroll costs. The remaining increase is primarily attributable tovarious selling related expense such as credit card fees and to a lesser extentadministrative expenses including professional fees as well as brandadvertising costs. As a percent of revenue we generated savings in storepayroll costs which declined by approximately 90 basis points, reflectingcontinued management focus and the implementation of tools to manage payrollexpense, as well as reductions in other store expenses. However, due to rapidgrowth in our direct-to-customer segment, higher levels of catalog productionand mailing had the effect of deleveraging selling, general and administrativecosts by 150 basis points and offset the improvements in payroll expenseleverage realized in other cost areas. As a percent of revenue, selling,general and administrative expense remained at 30.8% of net revenue in fiscal2004 and cost of revenue and occupancy improved 120 basis points to 68.4% ofnet revenue in fiscal 2004.

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 highervolume of our catalogs.

21

----

**REVENUE AND SEGMENTRESULTS**

***Retail Net Revenueand Segment Results***

| ** **                                                        | ** ** | **Fiscal Year**                 | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                        | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                        | ** ** | **(Dollars in thousands)** | ** ** |
| Retail net  revenue                                               |       | $                                    | 421,666    |   | $ | 406,833 |   | $ | 370,609 |   |
| Retail net  revenue growth percentage                             |       | 4                                    | %          | 10 | % | 4 | % |
| Comparable store  sales (decline) growth                          |       | (0.3                                 | )%         | 7.8 | % | 5.2 | % |
| Income from retail operations                                     |       | $                                    | 49,154     |   | $ | 51,932 |   | $ | 39,611 |   |
| Income from  retail operations—percent of retail net revenue |       | 11.7                                 | %          | 12.8 | % | 10.7 | % |
| Number of retail stores at beginning of year                      |       | 102                                  |       | 103 |   | 105 |   |
| Number of retail  stores opened                                   |       | 1                                    |       | 1 |   | 2 |   |
| Number of retail  stores closed                                   |       | —                               |       | 2 |   | 4 |   |
| Number of retail  stores at year-end                              |       | 103                                  |       | 102 |   | 103 |   |
| Retail store  selling square feet at year-end                     |       | 685,672                              |       | 676,520 |   | 679,300 |   |
| Number of outlet  stores at year-end                              |       | 6                                    |       | 1 |   | — |   |

 

Retail net revenue for fiscal 2005 increased by $14.8million, or 4%, as compared to fiscal 2004, primarily due to a $12.6 millionincrease in revenue generated from our outlet stores. Comparable store salesfor fiscal 2005 declined 0.3%, or $1.2 million, compared to fiscal 2004.Additionally, several previously opened stores, although not open long enoughto be included in the calculation of comparable store sales, contributedapproximately $7.3 million to fiscal 2005 results. Warehouse sales decreased byapproximately $1.0 million compared to fiscal 2004, primarily due to theopening of additional outlet stores. Outlet store and warehouse sales revenueis included in retail revenue, but is excluded from comparable store sales. Inthe fourth quarter of fiscal 2004, we opened our first outlet store. Duringfiscal 2005 we opened five additional outlet stores. The expansion of ouroutlet store strategy enables us to more effectively liquidate overstocked,discontinued, damaged merchandise and over time, we believe will substantiallyreduce the need for the less productive warehouse sales events that we havehistorically held.

For fiscal 2005, income from operations for the retailsegment decreased to $49.2 million from $51.9 million in fiscal 2004. As apercent of segment net revenue, income from operations for the retail segmentdecreased 110 basis points, to 11.7% of retail net revenue, as compared to12.8% for the prior fiscal year. This decrease was primarily due to a 190 basispoint increase in selling, general and administrative expense, somewhat offsetby an 80 basis point improvement in gross margin. Selling, general andadministrative expense for the segment increased by 190 basis points, due to a110 basis point increase in store selling expenses, 40 basis points related toadvertising costs and 40 basis points related to the $1.6 million remodelingnon-cash charge. Gross margin improved 80 basis points from a combination ofthe following: supply chain and distribution cost savings of 90 basis pointsand an increase in product margin of 70 basis points, partially offset by anincrease in store occupancy costs of 80 basis points as a percent of revenue.Income from operations for the retail segment includes the costs of retailstores results less the direct costs of the store field operations.

Retail net revenue for fiscal 2004 increased by $36.2million, or 10%, from fiscal 2003 primarily due to a $27.7 million, or 7.8%,increase in comparable store sales. The 7.8% increase in comparable store salesin fiscal 2004 was driven primarily by strong performance in our coremerchandise offerings.

Income from operations for the retail segment forfiscal 2004 was $51.9 million, as compared to $39.6 million in fiscal 2003.Income from operations for the retail segment, as a percent of segment revenue,increased 210 basis points, to 12.8% of retail net revenue from 10.7% of retailnet revenue for fiscal 2003, 

22

----

primarily due to occupancycost leverage of 140 basis points from increases in comparable stores sales andimproved margins, offset by higher 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 revenue, since comparablestore sales exclude the effects of changes in the number of stores open.Revenue from outlet stores and warehouse sales events are not included incomparable store sales.

***Direct-to-CustomerNet Revenue and Segment Results***

| ** **                                                                                | ** ** | **Fiscal Year**                 | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                | ** ** | **(Dollars in thousands)** | ** ** |
| Catalog revenue                                                                           |       | $                                    | 83,695     |   | $ | 65,458 |   | $ | 40,909 |   |
| Internet revenue                                                                          |       | 76,296                               |       | 53,532 |   | 26,990 |   |
| Total direct-to-customer  net revenue                                                     |       | $                                    | 159,991    |   | $ | 118,990 |   | $ | 67,899 |   |
| Income from direct-to-customer operations                                                 |       | $                                    | 21,329     |   | $ | 14,280 |   | $ | 8,538 |   |
| Income from  direct-to-customer operations—percent of direct-to-customer net revenue |       | 13.3                                 | %          | 12.0 | % | 12.6 | % |
| Growth percentages:                                                                       |       |                                 |       |   |   |   |   |
| Direct-to-customer  net revenue                                                           |       | 34                                   | %          | 75 | % | 52 | % |
| Number of  catalogs mailed                                                                |       | 1                                    | %          | 15 | % | 9 | % |
| Pages circulated                                                                     |       | 19                                   | %          | 48 | % | 40 | % |

 

Direct-to-customer (“direct”) net revenue consists ofboth Catalog and Internet sales. Direct net revenue for fiscal 2005 increased$41.0 million, or 34%, as compared to fiscal 2004. This increase wasattributable to an expansion of the merchandise offerings in both the Catalogand on the Internet, as well as a continued focus on increasing Catalog andInternet only merchandise which drives improved response rates and catalogproductivity.

For fiscal 2005, income from operations for the directsegment increased to $21.3 million, or 13.3% of segment net revenue, ascompared to $14.3 million, or 12.0% of segment net revenue, for fiscal 2004.This increase of $7.0 million, or 49%, represents a 130 basis point improvementand is primarily the result of a 250 basis point increase in gross margin dueto a 140 basis point improvement in supply chain and distribution costs and a110 basis point improvement in product margin. This is offset by a 120 basispoint increase in selling, general and administrative expense from higherpayroll costs of 40 basis points, call center and fulfillment costs of 20 basispoints, higher catalog circulation costs of 50 basis points, and higher othervariable costs of 10 basis points. Income from operations for the directsegment reflects the results associated with Catalog and Internet sales, lessdirect management costs.

Direct net revenue during fiscal 2004 increased $51.1million, or 75%, from fiscal 2003. A portion of this increase was the result ofa 15% increase in the number of catalogs mailed in fiscal 2004, as well as achange in our product mix in the Catalog and an increase in Catalog-onlyfurniture offerings. Additionally, we believe our website marketing effortscoupled with growing consumer familiarity with the Internet and growth inhigh-speed Internet consumers also helped drive customers to our website.

Income from operations forfiscal 2004 increased to $14.3 million, or 12.0%, of related segment netrevenue, from $8.5 million, or 12.6%, of related segment net revenue for fiscal2003, primarily due to the 75% increase in our revenue and improvements in ourproduct margins of 20 basis points, offset by increases in selling general andadministrative expense of 80 basis points primarily due to advertising costsrelated to catalog production and mailing costs.

23

----

**EXPENSES**

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

For fiscal 2005, cost of revenue and occupancy expenseexpressed as a percentage of net revenue improved approximately 230 basispoints to 66.1%, from 68.4% in fiscal 2004. These improvements wereattributable to a 120 basis point increase in product margins, a 100 basispoint improvement in**our supplychain and distribution costs and the decrease of relatively fixed storeoccupancy costs by 10 basis points.

In fiscal 2004, cost ofrevenue and occupancy expense expressed as a percentage of net revenue improvedapproximately 120 basis points to 68.4%, from 69.6% in fiscal 2003. These costsrose at a lower rate than revenue due to the expansion of product margins by130 basis points and the leverage of our store occupancy costs of 220 basispoints which more than offset the higher costs that we continued to experiencethroughout most of fiscal 2004 in our distribution and supply chain activitiesof 230 basis points.

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

Selling, general and administrative expense expressedin absolute dollars increased $34.5 million, to $196.5 million for fiscal2005 from $161.9 million in fiscal 2004. Expressed as a percentage of netrevenue, selling, general, and administrative expense increased to 33.7% forfiscal 2005 from 30.8% in fiscal 2004. The 290 basis point increase in expensewas driven by higher catalog circulation costs expressed as a percent ofrevenue of 130 basis points, increased direct-to-customer call center andfulfillment costs as a percent of revenue of 50 basis points, increasedoccupancy and related costs of 60 basis points and 30 basis points for the $1.6million non-cash charge for accelerated depreciation of certain fixturesassociated with remodeling efforts. We expect that as the direct-to-customerchannel revenue grows at a faster rate than retail revenue, the costs ofcatalog circulation will continue to have the effect of deleveraging selling,general and administrative expense as a percentage of net revenue, as occurredin fiscal 2005 and fiscal 2004.

Selling, general andadministrative expense increased $26.8 million, to $161.9 million for fiscal2004 from $135.1 million in fiscal 2003. Approximately half of the increase wasrelated to catalog production and mailing costs, with one fourth of the increaseattributable to higher payroll costs. Both of these increases were largelyincurred in support of higher sales. The remaining increase is primarilyattributable to various selling related expenses such as credit card fees andto a lesser extent administrative expenses including professional fees as wellas brand advertising costs. Selling, general and administrative expenseexpressed as a percentage of net revenue was consistent at 30.8% for fiscal2004 and 2003. We did generate savings in store payroll costs which declined byapproximately 90 basis points, reflecting continued management focus and theimplementation of tools to manage payroll expense, as well as reductions inother store expenses. However, due to rapid growth in our direct-to-customersegment, higher levels of catalog production and mailing had the effect ofdeleveraging selling, general and administrative costs by 150 basis points andoffset the improvements in payroll expense leverage realized in other costareas.

***Interest Expense, Net***

Interest expense, net includes interest on borrowingsunder our revolving credit facility and amortization of debt issuance costs.For fiscal 2005, interest expense, net was $4.1 million compared to $2.5million in fiscal 2004. Of the $1.6 million increase, approximately half wasdue to higher average debt levels and approximately half was due to higheraverage interest rates year over year.

In fiscal 2004, interestexpense, net was $2.5 million, an increase of $0.3 million as compared to $2.2million in fiscal 2003. The increase was due to higher average borrowing ratesand higher average borrowings outstanding.

24

----

***Income Tax (Expense) Benefit***

We recorded an income tax expense for fiscal 2005 of$26.2 million on a pre-tax loss of $3.1 million, which includes a fullvaluation allowance provided against our net deferred tax assets of $27.9million.

Statement of Financial Accounting Standards (“SFAS”) No. 109,“*Accounting for Income Taxes*,” requiresthat a valuation allowance be established when it is “more likely than not”that all or a portion of a deferred tax asset will not be realized. A review ofall available positive and negative evidence must be considered in judging thelikelihood of realizing tax benefits. Forming a conclusion that a valuationallowance is not needed can be difficult when there is negative evidence suchas cumulative losses in recent years. During the fourth quarter of fiscal 2005,it became evident that we would not meet our forecast of profitability infiscal 2005, and this lessened the weight that we could assign to futureprospects for returning to consistent profitability. That, combined with ourhistory of losses through fiscal 2003 and cumulative losses for the last threeyears, represented sufficient negative evidence and it was difficult toovercome this with positive evidence under the evaluation guidance of SFAS No. 109.As a result of our assessment in applying SFAS 109, we concluded that a fullvaluation allowance against our net deferred tax assets was required as of January 28,2006. The effect was to include a non-cash charge of $27.9 million in thefourth quarter of fiscal 2005. This adjustment will have no impact on our cashflow or future prospects, nor does it alter our ability to utilize theunderlying tax net operating loss and credit carryforwards in the future; the utilizationof which is limited to achieving future taxable income. Due to the valuationallowance provided against our net deferred tax assets, we do not expect anysignificant income tax benefit or expense for the fiscal 2006.

In fiscal 2004 our effective tax rate was 6% comparedto an effective tax rate of 38% in fiscal 2003. We recorded an income taxbenefit for fiscal 2004 of $0.1 million on pre-tax income of $1.6 million. Thefiscal 2004 income tax benefit reflects a net benefit of $0.9 million from thereversal of the valuation allowance established in prior years, somewhat offsetby reserves established for certain income tax contingencies. Excluding theseitems, our effective tax rate would have been 47% for fiscal 2004.

As of January 28,2006, we had net deferred tax assets of zero reflecting net deferred tax assetstotaling $27.9 million, which primarily represented the income tax benefitassociated with losses reported in prior years and differences in fixed assetbases offset by a full valuation allowance of $27.9 million. These losses aresubject to federal and state carry-forward provisions of up to 20 years.

**LIQUIDITYAND CAPITAL RESOURCES**

| ** **                                             | ** ** | **Fiscal Year**                 | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                             | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                             | ** ** | **(Dollars in thousands)** | ** ** |
| Net cash provided  (used) by operating activities      |       | $                                    | 4,401      |   | $ | (9,804 | ) | $ | 11,444 |   |
| Net cash used by  investing activities                 |       | (29,695                              | )          | (13,380 | ) | (9,229 | ) |
| Net cash provided  (used) by financing activities      |       | 25,398                               |       | 23,536 |   | (2,576 | ) |
| Net increase (decrease)  in cash and cash  equivalents |       | $                                    | 86         |   | $ | (99 | ) | $ | 373 |   |

 

***Operating Cash Flows***

For fiscal 2005, net cash provided by operatingactivities was $4.4 million compared to $9.8 million of net cash used byoperating activities for fiscal 2004. Net cash provided by operating activitiesreflects the effect of the $27.9 million non-cash charge for establishing afull valuation allowance for our net deferred tax assets. The majority of theincrease in net cash provided in fiscal 2005 compared to net cash used infiscal 2004 results from the smaller increases in inventory and accountspayable in fiscal 2005 compared to fiscal 2004. The increase in inventory infiscal 2005 of 10% is consistent with the higher sales recorded in 

25

----

the period and does notreflect the same timing of inventory receipts at year-end as occurred in theprior year.

For fiscal 2004, net cashused by operating activities was $9.8 million compared to $11.4 million ofnet cash provided by operating activities for fiscal 2003. The increase in netcash used by operating activities resulted primarily from higher inventorypurchases in support of higher sales and the acceleration of inventory receiptsat year-end (including $20 million of shipments in transit) due to outdoorfurniture and other spring selling programs. We also experienced accelerationof the timing of payment for goods due to increases in the levels of foreignsourced merchandise that tend to have faster payment terms than domesticvendors. Additionally, net cash used by operating activities increased due tohigher prepaid expenses. These increases in net cash used were partially offsetby higher accounts payable and accrued expenses balances.

***Investing Cash Flows***

Net cash used by investing activities was $29.7million for fiscal 2005, an increase of $16.3 million compared to$13.4 million for fiscal 2004. The cash used for investing activities forfiscal 2005 primarily related to the $16.5 million expenditure for theremodeling of the majority of our retail stores, the opening of one retailstore and five outlet stores, and capital associated with distribution facilityimprovements.

Net cash used by investingactivities was $13.4 million in fiscal 2004, an increase of $4.2 millioncompared to $9.2 million of cash used by investing activities in fiscal2003. The $13.4 million of cash used for investing activities in fiscal 2004primarily related to capital expenditures associated with the opening andremodeling of two retail stores, the opening of our first outlet store anddistribution facility improvements and relocations.

***Financing Cash Flows***

Net cash provided by financing activities in fiscal2005 was $25.4 million, compared to $23.5 million for fiscal 2004. The$1.9 million increase in cash provided by financing activities for fiscal 2005primarily related to a $0.9 million increase in borrowings under our revolvingcredit facility, net of debt issuance costs and a $0.9 million increase inproceeds from the exercise of stock options.

Net cash provided by financing activities was$23.5 million in fiscal 2004, and net cash used by financing activitieswas $2.6 million in fiscal 2003. Substantially all of the change in netcash provided (used) by financing activities resulted from an increase in netborrowings under our revolving credit facility of $23.2 million for fiscal2004, as compared to a repayment of borrowings of $3.9 million for fiscal 2003.Cash financing 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. Wereduced the borrowings outstanding under our line of credit in fiscal 2003 dueto expense leverage gained on increased sales. In addition, we received $1.1million during fiscal 2003 in connection with the settlement of a claim, and$1.1 million from the exercise of stock options.

On July 29, 2005 the Company entered into anagreement (the “Amendment”) to amend its existing revolving credit facility.The Amendment increased the revolving loan commitment available to the Companyunder the facility from $100.0 million to $150.0 million and provided for anextension of the maturity date of the revolving loan from June 30, 2006 toJune 30, 2009. In addition, the Amendment reduced the interest rate on baserate advances and provided for incremental advances with availabilitydetermined from the application of a higher advance rate on eligible inventoryand eligible accounts receivables constituting part of the Company’s borrowingbase. Those incremental advances would be subject to higher interest rates. Tothe extent that borrowings are outstanding under the incremental advanceprovision and if the remaining availability for additional borrowing under thefacility is less than 

26

----

10% of the applicableborrowing base for the line of credit at the time, the Company would berequired to maintain a minimum fixed charge coverage ratio. The Amendment alsoeliminated the lock box restriction except upon the occurrence of certainevents, such as an event of default. Other elements of the revolving creditfacility remain materially unchanged.

As of January 28, 2006, $58.1 million wasoutstanding under the facility, net of unamortized debt issuance costs of $0.9million, and there was $11.8 million in outstanding letters of credit. As aresult of the Amendment, the balance of $58.1 million at January 28, 2006is considered a long-term liability rather than a current liability and hasbeen classified accordingly. Borrowings made under the revolving creditfacility are subject to interest at either the bank’s reference rate or LIBORplus a margin. As of January 28, 2006, the bank’s reference rate was 7.25%and the LIBOR plus margin rate was 5.97%. Borrowings that are incrementaladvances under the revolving credit facility are subject to interest at eitherthe bank’s reference rate plus a margin or LIBOR plus a higher margin. Theavailability of credit at any given time under the revolving credit facility islimited by reference to a borrowing base formula (which includes an adjustmentto the advance rate against eligible inventory and eligible accountsreceivables for incremental advances as described above) based upon numerousfactors, including the value of eligible inventory and eligible accountsreceivable, and reserves established by the agent of the revolving creditfacility. As a result of the borrowing base formula, and the other terms andconditions of the credit facility, the actual borrowing availability under thefacility could be less than the stated amount of the facility (reduced by theactual borrowings and outstanding letters of credit). As of January 28,2006, we had availability under the facility of $25.5 million.

The revolving credit facility contains variousrestrictive covenants, including limitations on the ability to make liens, makeinvestments, sell assets, incur additional debt, merge, consolidate or acquireother businesses, pay dividends or other distributions, and enter intotransactions with affiliates. The revolving credit facility does not containany other significant financial or coverage ratio covenants unless the Companytakes advantage of the incremental advance provision. If we receive an advanceunder the incremental advance provision and if the remaining availability foradditional borrowing under the facility is less than 10% of the applicableborrowing base for the line of credit at the time, the Company is required tomaintain a fixed charge coverage ratio. The revolving credit facility also doesnot require that we repay all borrowings for a prescribed “clean-up” periodeach year.

We currently believe thatour cash flows from operations and funds available under our revolving creditfacility will satisfy our expected working capital and capital requirements forat least the next 12 months. However, the weakening of, or other adversedevelopments 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“Risk Factors,” in particular the sections “We are dependent on externalfunding sources, including the terms of our revolving credit facility, whichmay not make available to us sufficient funds when we need them,” and “Becauseour business requires a substantial level of liquidity, we are dependent upon arevolving credit facility with certain restrictive covenants that limit ourflexibility.”

27

----

***Contractual Commitments***

Thefollowing table summarizes our significant contractual cash obligations andother commercial commitments as of January 28, 2006:

| ** **                              | ** ** | **Payments Due By Period** | ** ** |
|-----------------------------------------|------------|-------------------------------------------|------------|
| ** **                              | ** ** | **Total**                                 | ** ** | **Fiscal 2006** | ** ** | **Fiscal 2007  through 2008** | ** ** | **Fiscal 2009  through 2010** | ** ** | **Thereafter** | ** ** |
| ** **                              | ** ** | **(Dollars in thousands)**      | ** ** |
| Operating leases (1)                    |       | $                                         | 271,025    |   |   | $ | 42,754 |   |   |   | $ | 82,280 |   |   |   | $ | 65,282 |   |   |   | $ | 80,709 |   |   |
| Capital leases                          |       | 180                                       |       |   | 153 |   |   |   | 27 |   |   |   | — |   |   |   | — |   |   |
| Line of credit (2)                 |       | 59,025                                    |       |   | — |   |   |   | — |   |   |   | 59,025 |   |   |   | — |   |   |
| Interest (3)                            |       | 16,275                                    |       |   | 6,025 |   |   |   | 8,250 |   |   |   | 2,000 |   |   |   | — |   |   |
| Standby letters  of credit              |       | 9,967                                     |       |   | 9,967 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Trade letters of  credit                |       | 1,839                                     |       |   | 1,839 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Purchase  obligations for inventory (4) |       | 88,397                                    |       |   | 88,397 |   |   |   | — |   |   |   | — |   |   |   | — |   |   |
| Total                                   |       | $                                         | 446,708    |   |   | $ | 149,135 |   |   |   | $ | 90,557 |   |   |   | $ | 126,307 |   |   |   | $ | 80,709 |   |   |

----

(1)          Operating leasecontractual commitments exclude insurance, real estate taxes, and repair andmaintenance expenses related to those operating leases. In fiscal 2005, theCompany incurred $18.8 million for these costs.

(2)          The costs reflect ourlong-term debt, gross of debt issuance costs of $0.9 million.

(3)          Interest payments in thefuture periods have been reflected based on fiscal 2005 debt and interestlevels and reflects the June 2009 maturity date of the line of credit.

(4)          Represents estimatedcommitments at year-end to purchase inventory in the normal course of businessto meet operating requirements.

**OFF-BALANCE SHEET ARRANGEMENTS**

Except for our operationallease commitments, we do not have any other off-balance sheet arrangements, assuch term is defined by the Securities and Exchange Commission, that haveor are reasonably likely to have a current or future effect on our financialcondition, changes in financial condition, revenue or expenses, results ofoperations, liquidity, capital expenditures or capital resources that arematerial to investors.

**RELATED PARTY TRANSACTIONS**

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 outstanding principal amount of the loan is 8.0%per annum, compounded annually, and the entire amount of interest and alloutstanding principal is due and payable on August 15, 2006, if notearlier pre-paid in full with interest.

We lease one of ourproperties from the previous owner and current employee of Michaels. Annualpayments made in fiscal 2005, 2004 and 2003 were $456,000 per year.

**CRITICAL ACCOUNTING POLICIES**

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”). For a complete review of thosepolicies, 

28

----

reference is made to our “Notesto our Consolidated Financial Statements, Summary of Business and SignificantAccounting Policies.” The preparation of our Consolidated Financial Statementsrequires 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:

***Sales Returns Reserve***

We provide an allowancefor sales returns based on historical return rates which generally considersboth the level of merchandise returns and the time elapsed from the date ofsale to the date of the return. This reserve is booked on a gross basis,reducing both total sales and cost of sales each period. Should actual returnrate levels increase by 10% in fiscal 2006 or the customer return time lengthenby 10% in fiscal 2006, our results would be negatively impacted byapproximately $0.2 million. At January 28, 2006 and January 29, 2005,the allowance for sales returns was approximately $1.8 million and $1.3 million,respectively.

***Merchandise Inventories***

Our retail inventories arecarried at the lower of cost or market with cost determined on a weightedaverage cost method. Manufacturing inventories are carried at the lower of costor market with cost determined at standard costs, approximating average costs.Costs include certain buying and distribution costs, including payroll and othercosts related to the purchase of inventory. We write down inventories whenevermarkdowns reduce the selling price below cost. Additionally, we provide formonthly reserves on inventory based upon our estimate of shrinkage losses.Actual shrinkage is recorded at year-end based on the results of our physicalinventory count. We also write down our slow-moving and discontinued inventoryto its estimated market value based upon assumptions about future demand andmarket conditions. If actual market conditions are less favorable than thoseprojected by management, or if liquidation of the inventory is more difficultthan anticipated, additional inventory write-downs may be required.

***Impairment of Long-Lived Assets***

We review long-lived tangible assets for impairmentwhenever events or changes in circumstances indicate that their carrying valuesmay not be recoverable. Using our best estimates based on reasonableassumptions and projections, we record an impairment loss to write the assetsdown to their estimated fair values if the carrying values of such assetsexceed their related discounted expected future 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 at anindividual store level, which is the lowest level at which independent cashflows can be identified. We evaluate corporate assets or other long-livedassets that are not store-specific at a consolidated entity or reporting unitlevel, as appropriate.

29

----

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. For the fiscal yearended January 28, 2006, the Company recorded a $0.3 million impairmentcharge on the long-lived assets of two underperforming stores.

***Self Insurance***

We obtain insurancecoverage for significant exposures as well as those risks that, by law, must beinsured. It is generally our policy to retain a significant portion of certainlosses related to workers’ compensation, general liability, property losses,business interruption and employee health care. We record provisions for theseitems based on an actuary report, claims experience, regulatory changes, anestimate of claims incurred but not yet reported and other relevant factors.The projections 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.Should the amount of claims be more or less than what we estimated or shouldthe costs of claims increase or decrease beyond what we anticipated, reservesmay need to be adjusted accordingly in future periods. At January 28, 2006and January 29, 2005, we had recorded accruals for these liabilities ofapproximately $4.6 million and $3.1 million, respectively.

***Income Taxes and Valuation Allowance***

We account for incometaxes under SFAS No. 109,*“Accounting for IncomeTaxes.”* SFAS No.109 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 our Consolidated Financial Statements or tax returns.In estimating future tax consequences, we generally take into account allexpected future events then known to us, other than changes in the tax law orrates, which are not permitted to be considered. Accordingly, if needed we mayrecord a valuation allowance to reduce our net deferred tax assets to theamount 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 net deferred tax assets. While future taxable income and ongoing prudentand feasible tax planning are considered in determining the amount of thevaluation allowance, the necessity for an allowance is subject to adjustment inthe future. Specifically, in the event we were to determine that we would notbe able to realize our net deferred tax assets in the future in excess of theirnet recorded amounts, an adjustment to the deferred tax assets would decreaseincome in the period such determination was made. Accordingly, we recorded afull valuation allowance for our net deferred tax assets of $27.9 million inthe fourth quarter of fiscal 2005. The effect was to include a non-cash chargeof $27.9 million in the fourth quarter of fiscal 2005. This fiscal 2005adjustment will have no impact on our cash flow or future prospects, nor doesit alter our ability to utilize the underlying tax net operating loss andcredit carryforwards in the future; the utilization of which is limited toachieving future taxable income. Due to the valuation allowance providedagainst our net deferred tax assets, we do not expect any significant incometax benefit or expense for the fiscal 2006.

***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 

30

----

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.

**RECENTLYISSUED ACCOUNTING STANDARDS**

In November 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 151,*“Inventory Costs,”* which clarifies the accounting forabnormal amounts of idle facility expense, freight, handling costs and wastedmaterial (spoilage). This statement is effective for our 2006 fiscal year. Webelieve the adoption of SFAS 151 will not have a significant impact on theoverall results of operations or financial position.

In December 2004, the FASB issued SFAS No. 123(R) ”*Share-Based Payment.*”  SFAS 123(R)requires the recognition of compensation expense relating to share-basedpayment transactions in consolidated financial statements. That expense will bemeasured based on the fair value of the equity or liability instruments issuedas of the grant date, for the estimated number of awards that are expected tovest. 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) replacesSFAS 123, “*Accounting for Stock BasedCompensation*,” and supersedes Accounting Principles Board (“APB”)Opinion No. 25, “*Accounting for StockIssued to Employee*s.” SFAS 123(R) is effective for interimperiods that begin after December 15, 2005. Effective with the beginningof the first quarter of fiscal 2006, we will adopt SFAS 123(R) using themodified prospective method. Under this method, the unvested portions ofpreviously granted share-based payments, as well as the fair value of awardsgranted after adoption are included in operating expenses over the appropriateservice period. We have decided to use the Black Scholes model to estimate thefair value of our stock options, unless additional information becomesavailable in the future that indicates another model would be more appropriatefor us, or if grants issued in future periods have characteristics that cannotbe reasonably estimated using this model. Based on stock options granted toemployees through January 28, 2006, we expect the adoption of SFAS 123(R) willincrease first quarter expenses by approximately $1.3 million ($0.03 per share,basic) and increase full year fiscal 2006 expenses by approximately $4.0million ($0.11 per share, basic).

In May 2005, the FASB issued SFAS No. 154,*“Accounting Changes and Error Corrections,”*which changes the requirements for reporting a change in accounting principle.This statement is effective beginning January 1, 2006. SFAS 154 replacesAPB No. 20, “*Accounting Changes*,”and SFAS No. 3, “*ReportingAccounting Changes in Interim Financial Statements.*” We believethe adoption of SFAS 154 will not have a significant impact on the overallresults of operations or financial position.

In October 2005, theFASB issued FASB Staff Position (“FSP”) 13-1, *“Accountingfor Rental Costs Incurred During a Construction Period,”* to clarifythe proper accounting for rental costs incurred on building or ground operatingleases during a construction period. The FSP requires that rental costsincurred during a construction period be expensed, not capitalized. Thestatement is effective for the first reporting period beginning after December 15,2005. The Company believes the adoption of FSP 13-1 will not have asignificant impact on the overall results of operations or financial position.

**CAUTIONARYSTATEMENT REGARDING FORWARD-LOOKING STATEMENTS**

This annual report on Form 10-K contains “forward-lookingstatements,” within the meaning of the Private Securities Litigation Reform Actof 1995, that involve known and unknown risks. Such forward-looking statementsinclude without limitation statements relating to our future plans, inparticular with respect to store openings and closings; statements relating toanticipated future costs and expenses; 

31

----

statementsabout new merchandise initiatives and website marketing efforts; statementsrelating to anticipated future revenue growth, including statements aboutmargin expansion, operational efficiencies and cost reductions; statementsrelating to future availability under our revolving credit facility; statementsrelating to our working capital and capital expenditure needs; statementsrelating to the level of deferred revenue and other categories of delayed salesin future periods and the impact thereof on quarterly results; and otherstatements containing 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-lookingstatements. Important factors that could cause such differences include, butare not limited to, customer reactions to our current and anticipatedmerchandising and marketing programs and strategies, timely introduction andcustomer acceptance of our merchandise, positive customer reaction to ourCatalog and Internet offerings, revised product mix, prototype stores and corebusinesses, timely and effective sourcing of our merchandise from our foreignand domestic vendors and delivery of merchandise through our supply chain toour stores and customers, changes in product supply, effective inventory andcatalog management, actual achievement of cost savings and improvements tooperating efficiencies, effective sales performance, the actual impact of keypersonnel of the Company on the development and execution of our strategies,changes in investor perceptions of the Company, changes in economic or businessconditions in general, fluctuations in comparable store sales, limitations resultingfrom restrictive covenants in our revolving credit facility, consumer responsesto our product offerings and 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,governmental actions, and other factors described above in the section “RiskFactors.” We undertake no obligation to update any forward-looking statementsin order to reflect events or circumstances that may arise after the date ofthis annual report on Form 10-K.

**ITEM 7A.**        QUANTITATIVEAND QUALITATIVE 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 beensettled mostly in U.S. dollars and, therefore, we have only minimal exposure atpresent to foreign currency exchange risks. Historically, we have not hedgedour currency risk and do not currently anticipate doing so in the future.However, it is possible that in the future a growing number of our purchasesoutside of the United States of America will be made in currencies other thanthe U.S. dollar. Consequently, fluctuations in the rates of exchange betweenthe U.S. dollar and other currencies may subject us to foreign currencyexchange risks in the future.

32

----

**ITEM 8.**                CONSOLIDATEDFINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

**RESTORATIONHARDWARE, INC.**

**CONSOLIDATED BALANCESHEETS**

**(Dollars in thousands)**

| ** **                                                                                                                                                                                           | ** ** | **January 28,  2006** | ** ** | **January 29,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                                                                           |       |                       |       |                       |       |   |   |   |   |
| Current assets:                                                                                                                                                                                      |       |                       |       |                       |       |   |   |   |   |
| Cash and cash  equivalents                                                                                                                                                                           |       |                       | $          | 1,990                      |       |   |   | $ | 1,904 |   |   |
| Accounts  receivable                                                                                                                                                                                 |       |                       | 5,884      |                       |       |   | 6,945 |   |   |
| Merchandise  inventories                                                                                                                                                                             |       |                       | 158,647    |                       |       |   | 144,185 |   |   |
| Deferred tax  assets, current portion, net                                                                                                                                                           |       |                       | —     |                       |       |   | 7,119 |   |   |
| Prepaid expense  and other current assets                                                                                                                                                            |       |                       | 9,590      |                       |       |   | 12,455 |   |   |
| Total current  assets                                                                                                                                                                                |       |                       | 176,111    |                       |       |   | 172,608 |   |   |
| Property and  equipment, net                                                                                                                                                                         |       |                       | 92,360     |                       |       |   | 81,886 |   |   |
| Goodwill                                                                                                                                                                                             |       |                       | 4,560      |                       |       |   | 4,560 |   |   |
| Deferred tax  assets, net                                                                                                                                                                            |       |                       | —     |                       |       |   | 18,745 |   |   |
| Other assets                                                                                                                                                                                         |       |                       | 1,237      |                       |       |   | 1,464 |   |   |
| Total assets                                                                                                                                                                                         |       |                       | $          | 274,268                    |       |   |   | $ | 279,263 |   |   |
| **LIABILITIES, REDEEMABLE  CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY**                                                                                                               |       |                       |       |                       |       |   |   |   |   |
| Current liabilities:                                                                                                                                                                                 |       |                       |       |                       |       |   |   |   |   |
| Accounts payable  and accrued expenses                                                                                                                                                               |       |                       | $          | 62,818                     |       |   |   | $ | 63,920 |   |   |
| Line of credit,  net of debt issuance                                                                                                                                                                |       |                       | —     |                       |       |   | 33,819 |   |   |
| Deferred revenue  and customer deposits                                                                                                                                                              |       |                       | 8,304      |                       |       |   | 8,130 |   |   |
| Other current  liabilities                                                                                                                                                                           |       |                       | 17,506     |                       |       |   | 14,948 |   |   |
| Total current  liabilities                                                                                                                                                                           |       |                       | 88,628     |                       |       |   | 120,817 |   |   |
| Long-term debt, net of debt issuance                                                                                                                                                                 |       |                       | 58,126     |                       |       |   | — |   |   |
| Deferred lease  incentives                                                                                                                                                                           |       |                       | 27,465     |                       |       |   | 30,365 |   |   |
| Deferred rent                                                                                                                                                                                        |       |                       | 19,866     |                       |       |   | 20,321 |   |   |
| Other long-term  obligations                                                                                                                                                                         |       |                       | 51         |                       |       |   | 143 |   |   |
| Total liabilities                                                                                                                                                                                    |       |                       | 194,136    |                       |       |   | 171,646 |   |   |
| Commitments  and contingencies (Note 11)                                                                                                                                                             |       |                       |       |                       |       |   |   |   |   |
| Series A  redeemable convertible preferred stock, $.0001 par value, 28,037 shares  designated, 0 and 8,473 shares outstanding at January 28, 2006 and  January 29, 2005, respectively |       |                       | —     |                       |       |   | 8,331 |   |   |
| Stockholders’ equity:                                                                                                                                                                           |       |                       |       |                       |       |   |   |   |   |
| Common stock,  $.0001 par value, 60,000,000 shares authorized, 37,762,629 and 33,084,223  shares issued and outstanding at January 28, 2006 and January 29, 2005,  respectively            |       |                       | 4          |                       |       |   | 3 |   |   |
| Additional paid-in  capital                                                                                                                                                                          |       |                       | 169,187    |                       |       |   | 159,233 |   |   |
| Unearned  compensation                                                                                                                                                                               |       |                       | —     |                       |       |   | — |   |   |
| Accumulated other  comprehensive income                                                                                                                                                              |       |                       | 1,010      |                       |       |   | 812 |   |   |
| Accumulated  deficit                                                                                                                                                                                 |       |                       | (90,069    | )                          |       |   | (60,762 | ) |   |
| Total  stockholders’ equity                                                                                                                                                                     |       |                       | 80,132     |                       |       |   | 99,286 |   |   |
| Total liabilities,  redeemable convertible preferred stock and stockholders’ equity                                                                                                             |       |                       | $          | 274,268                    |       |   |   | $ | 279,263 |   |   |

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

33

----

**RESTORATIONHARDWARE, INC.CONSOLIDATED STATEMENTS OF OPERATIONS(Dollars in thousands, except per share amounts)**

| ** **                                        | ** ** | **Fiscal Year Ended** | ** ** |
|---------------------------------------------------|------------|---------------------------------|------------|
| ** **                                        | ** ** | **January 28,  2006**      | ** ** | **January 29,  2005** | ** ** | **January 31,  2004** | ** ** |
| Net revenue                                       |       |                            | $          | 581,657 |   |   |   | $ | 525,823 |   |   |   | $ | 438,508 |   |   |
| Cost of revenue  and occupancy                    |       |                            | 384,244    |   |   |   | 359,808 |   |   |   | 305,265 |   |   |
| Gross profit                                      |       |                            | 197,413    |   |   |   | 166,015 |   |   |   | 133,243 |   |   |
| Selling, general  and administrative expense      |       |                            | 196,469    |   |   |   | 161,939 |   |   |   | 135,118 |   |   |
| Income (loss)  from operations                    |       |                            | 944        |   |   |   | 4,076 |   |   |   | (1,875 | ) |   |
| Interest expense,  net                            |       |                            | (4,050     | ) |   |   | (2,472 | ) |   |   | (2,154 | ) |   |
| (Loss) income  before income taxes                |       |                            | (3,106     | ) |   |   | 1,604 |   |   |   | (4,029 | ) |   |
| Income tax  (expense) benefit                     |       |                            | (26,201    | ) |   |   | 100 |   |   |   | 1,511 |   |   |
| Net (loss) income                                 |       |                            | $          | (29,307 | ) |   |   | $ | 1,704 |   |   |   | $ | (2,518 | ) |   |
| (Loss) income per  share of common stock, basic   |       |                            | $          | (0.83 | ) |   |   | $ | 0.05 |   |   |   | $ | (0.08 | ) |   |
| (Loss) income per  share of common stock, diluted |       |                            | $          | (0.83 | ) |   |   | $ | 0.04 |   |   |   | $ | (0.08 | ) |   |
| Weighted average  shares outstanding, basic       |       |                            | 35,441     |   |   |   | 32,940 |   |   |   | 30,873 |   |   |
| Weighted average shares  outstanding, diluted     |       |                            | 35,441     |   |   |   | 38,183 |   |   |   | 30,873 |   |   |

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

34

----

**RESTORATIONHARDWARE, INC.**

**CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE**

**PREFERREDSTOCK AND STOCKHOLDERS’ EQUITY**

**(Dollars in thousands)**

| ** **                                    | ** ** | ** **               | ** ** | ** **            | ** ** | ** **     | ** ** | ** **   | ** ** | ** **        | ** ** | ** **       | ** ** | ** **             | ** **     | ** **        | ** ** |       |
|-----------------------------------------------|------------|--------------------------|------------|-----------------------|------------|----------------|------------|--------------|------------|-------------------|------------|------------------|------------|------------------------|----------------|-------------------|------------|------------|
| ** **                                    | ** ** | **Redeemable**           | ** ** | ** **            | ** ** | ** **     | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** **       | ** ** | ** **             | ** **     | **Total**         | ** ** |       |
| ** **                                    | ** ** | **Convertible**          | ** ** | ** **            | ** ** | **Additional** | ** ** | ** **   | ** ** | **Other**         | ** ** | ** **       | ** ** | **Total**              | ** **     | **Comprehensive** | ** ** |       |
| ** **                                    | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Paid-In**    | ** ** | **Unearned** | ** ** | **Comprehensive** | ** ** | **Accumulated**  | ** ** | **Stockholders’** | ** **     | **(Loss)**        | ** ** |       |
| ** **                                    | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**     | ** ** | **Amount**   | ** ** | **Capital**       | ** ** | **Compensation** | ** ** | **Income**             | ** **     | **Deficit**       | ** ** | **Equity** | ** ** | **Income** | ** ** |   |
| BALANCE AT FEBRUARY 1, 2003              |       |                     | 13,470     |                  |       | $ 13,328  |       | 30,050,994   |       |              | $ 3   |             |       |                   | $ 150,878 |              |       |       | $ (659 | ) |   |   | $ (132 | ) |   |   | $ (59,948 | ) |   |   | $ 90,142 |   |   |   |   |   |   |
| 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                                      |       |                     | —     |                  |       | —         |       | —       |       |              | —     |             |       |                   | —         |              |       |       | — |   |   |   | — |   |   |   | (2,518 | ) |   |   | (2,518 | ) |   |   | (2,518 | ) |   |
| BALANCE AT JANUARY 31, 2004              |       |                     | 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 |   |   |
| Issuance of common stock                      |       |                     | —     |                  |       | —         |       | 418,262      |       |              | —     |             |       |                   | 1,623          |              |       |       | — |   |   |   | — |   |   |   | — |   |   |   | 1,623 |   |   |   |   |   |   |
| Conversion of preferred stock to common stock |       |                     | (8,473     | )                     |       | (8,331         | )          | 4,260,144    |       |              | 1          |             |       |                   | 8,331          |              |       |       | — |   |   |   | — |   |   |   | — |   |   |   | 8,332 |   |   |   |   |   |   |
| Foreign currency translation adjustment       |       |                     | —     |                  |       | —         |       | —       |       |              | —     |             |       |                   | —         |              |       |       | — |   |   |   | 198 |   |   |   | — |   |   |   | 198 |   |   |   | 198 |   |   |
| Net loss                                      |       |                     | —     |                  |       | —         |       | —       |       |              | —     |             |       |                   | —         |              |       |       | — |   |   |   | — |   |   |   | (29,307 | ) |   |   | (29,307 | ) |   |   | (29,307 | ) |   |
| BALANCE AT  JANUARY 28, 2006             |       |                     | —     |                  |       | —         |       | 37,762,629   |       |              | $ 4   |             |       |                   | $ 169,187 |              |       |       | — |   |   |   | $ 1,010 |   |   |   | $ (90,069 | ) |   |   | $ 80,132 |   |   |   | $ (29,109 | ) |   |

 

The accompanyingnotes are an integral part of these Consolidated Financial Statements.

35

** **

----

**RESTORATIONHARDWARE, INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(Dollars in thousands)**

| ** ** | ** ** | **Fiscal Year Ended** | ** ** |
|------------|------------|---------------------------------|------------|
| ** ** | ** ** | **January 28,  2006**      | ** ** | **January 29,  2005** | ** ** | **January 31  2004** | ** ** |
|            |            |                                 |            |  |  |  |  |

 

| Cash flows from  operating activities:                                                           |   |   |                     |   |   |   |                                     |   |   |   |          |   |   |
|--------------------------------------------------------------------------------------------------|--------|--------|--------------------------|--------|--------|--------|------------------------------------------|--------|--------|--------|---------------|--------|--------|
| Net (loss) income                                                                                |   |   | $ (29,307           | )      |   |   | $   1,704                 |   |   |   | $ (2,518 | )      |   |
| Adjustments to reconcile  net (loss) income to net cash provided (used) by operating activities: |   |   |                     |   |   |   |                                     |   |   |   |          |   |   |
| Depreciation and  amortization                                                                   |   |   | 19,603                   |   |   |   | 15,946                                   |   |   |   | 18,021        |   |   |
| Impairment of  property and equipment                                                            |   |   | 294                      |   |   |   | —                                   |   |   |   | —        |   |   |
| Deferred income  taxes                                                                           |   |   | 25,864                   |   |   |   | (2,442                                   | )      |   |   | (1,975        | )      |   |
| Changes in operating  assets and liabilities:                                                    |   |   |                     |   |   |   |                                     |   |   |   |          |   |   |
| Accounts  receivable                                                                             |   |   | 1,799                    |   |   |   | (1,200                                   | )      |   |   | (2,393        | )      |   |
| Merchandise  inventories                                                                         |   |   | (14,462                  | )      |   |   | (41,259                                  | )      |   |   | (8,426        | )      |   |
| Prepaid expense,  other current assets and other assets                                          |   |   | 3,092                    |   |   |   | (2,198                                   | )      |   |   | 1,163         |   |   |
| Accounts payable  and accrued expenses                                                           |   |   | (1,401                   | )      |   |   | 18,628                                   |   |   |   | 9,643         |   |   |
| Deferred revenue  and customer deposits                                                          |   |   | 174                      |   |   |   | 899                                      |   |   |   | 1,185         |   |   |
| Other current  liabilities                                                                       |   |   | 2,838                    |   |   |   | 3,655                                    |   |   |   | 2,292         |   |   |
| Deferred rent                                                                                    |   |   | (455                     | )      |   |   | 97                                       |   |   |   | (438          | )      |   |
| Deferred lease  incentives and other long-term obligations                                       |   |   | (3,638                   | )      |   |   | (3,634                                   | )      |   |   | (5,110        | )      |   |
| Net cash provided  (used) by operating activities                                                |   |   | 4,401                    |   |   |   | (9,804                                   | )      |   |   | 11,444        |   |   |
| Cash flows from  investing activities:                                                           |   |   |                     |   |   |   |                                     |   |   |   |          |   |   |
| Capital  expenditures                                                                            |   |   | (29,695                  | )      |   |   | (13,380                                  | )      |   |   | (9,229        | )      |   |
| Net cash used by  investing activities                                                           |   |   | (29,695                  | )      |   |   | (13,380                                  | )      |   |   | (9,229        | )      |   |
| Cash flows from  financing activities:                                                           |   |   |                     |   |   |   |                                     |   |   |   |          |   |   |
| Borrowings  (repayments) under line of credit, net                                               |   |   | 24,475                   |   |   |   | 23,202                                   |   |   |   | (3,917        | )      |   |
| Debt issuance  costs                                                                             |   |   | (575                     | )      |   |   | (161                                     | )      |   |   | (434          | )      |   |
| Proceeds received  from stockholder settlement                                                   |   |   | —                   |   |   |   | —                                   |   |   |   | 1,050         |   |   |
| Repayment—other  long-term obligations                                                      |   |   | (125                     | )      |   |   | (209                                     | )      |   |   | (385          | )      |   |
| Issuance of  common stock                                                                        |   |   | 1,623                    |   |   |   | 704                                      |   |   |   | 1,110         |   |   |
| Net cash provided  (used) by financing activities                                                |   |   | 25,398                   |   |   |   | 23,536                                   |   |   |   | (2,576        | )      |   |
| Effects of  foreign currency exchange rate translation                                           |   |   | (18                      | )      |   |   | (451                                     | )      |   |   | 734           |   |   |
| Net increase  (decrease) in cash and cash equivalents                                            |   |   | 86                       |   |   |   | (99                                      | )      |   |   | 373           |   |   |
| Cash and cash  equivalents:                                                                      |   |   |                     |   |   |   |                                     |   |   |   |          |   |   |
| Beginning of  period                                                                             |   |   | 1,904                    |   |   |   | 2,003                                    |   |   |   | 1,630         |   |   |
| End of period                                                                                    |   |   | $   1,990 |   |   |   | $   1,904                 |   |   |   | $ 2,003  |   |   |
| Additional cash flow  information:                                                               |   |   |                     |   |   |   |                                     |   |   |   |          |   |   |
| Cash paid during  the year for interest                                                          |   |   | $   3,353 |   |   |   | $   1,880                 |   |   |   | $ 1,554  |   |   |
| Cash paid  (received) during the year for taxes                                                  |   |   | 1,138                    |   |   |   | 598                                      |   |   |   | (1,427        | )      |   |
| Non-cash transactions:                                                                           |   |   |                     |   |   |   |                                     |   |   |   |          |   |   |
| Property and  equipment acquired under capital leases                                            |   |   | 54                       |   |   |   | —                                   |   |   |   | 593           |   |   |
| Conversion of preferred  stock to common stock                                                   |   |   | $   8,332 |   |   |   | $      210 |   |   |   | $ 4,787  |   |   |

 

The accompanying notes are an integral part of these Consolidated Financial Statements.

36

----

**RESTORATIONHARDWARE, INC.NOTES TO CONSOLIDATED 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 furniture, bathware, hardware, lighting, textiles,accessories and related merchandise. Through the Company’s subsidiary, TheMichaels Furniture Company, Inc. (“Michaels”), the Company manufactures aline of high quality furniture for the home and office. These products are soldthrough retail locations, catalogs and the Internet. At January 28, 2006,the Company operated a total of 103 retail stores and six outlets stores in 30states, the District of Columbia and in Canada.

**Basisof Presentation 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 28,2006 (“fiscal 2005”), January 29, 2005 (“fiscal 2004”), and January 31,2004 (“fiscal 2003”) consisted of 52 weeks.

**Use of Accounting Estimates**

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 reserving for sales returns, lower of cost or marketwrite-downs on inventory, the impairment of long-lived assets, the adequacy ofself insurance reserves and realization of net deferred tax assets, includingthe valuation allowances on these tax assets. Actual results for these andother estimates could differ from those estimates.

**Cash and Cash Equivalents**

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

**Accounts Receivable**

Accounts receivable consistprimarily of receivables from the Company’s credit card processors for salestransactions and tenant improvement allowances from the Company’s landlords inconnection with new leases. The Company has an immaterial allowance fordoubtful accounts for these receivables, as its bad debt experience has beeninsignificant.

**Merchandise Inventories**

The Company’s retailinventories are carried at the lower of cost or market with cost determined ona weighted average cost method. Manufacturing inventories are carried at thelower of cost or market with cost determined at standard costs, approximatingaverage costs. Costs include certain buying and 

37

----

distributioncosts, including payroll and other costs related to the purchase of inventory.The Company writes down inventories whenever markdowns reduce the selling pricebelow cost. Additionally, it provides for reserves on inventory based uponestimated shrinkage losses. The Company also writes down its slow-moving anddiscontinued inventory to its estimated market value based upon assumptionsabout future demand and market conditions. If actual market conditions are lessfavorable than those projected by management, or if liquidation of theinventory is more difficult than anticipated, additional inventory write-downsmay be required.

**PrepaidCatalog and Advertising 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 28, 2006 and January 29, 2005, the Company had$6.9 million and $5.5 million, respectively, of prepaid catalog coststhat are included in prepaid expense and other current assets on theaccompanying Consolidated Balance Sheets.

Advertising costsprimarily represent the costs associated with the Company’s catalog mailings,as well as print and web site marketing. For the fiscal years ended January 28,2006, January 29, 2005, and January 31, 2004, advertising costs wereapproximately $52.2 million, $40.2 million and $26.5 million,respectively.

**Property and Equipment, net**

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 amortized overthe 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 theuseful life 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 Michaels. The Company reviews goodwill for impairment annually,or more frequently if events or changes in circumstances warrant. If thecarrying values of such assets were to exceed their estimated fair values, theCompany would record an impairment loss to write the assets down to theirestimated fair values. There were no impairment charges recorded againstgoodwill in fiscal 2005, 2004 or 2003. The Company had $4.6 million ofgoodwill as of January 28, 2006 and January 29, 2005.

**Impairment of Long-Lived Assets**

The Company reviews long-lived tangible assets forimpairment whenever events or changes in circumstances indicate that theircarrying values may not be recoverable. Using the Company’s best estimates,based on reasonable assumptions and projections, the 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 at an individual store level, which is the lowest level at whichindependent cash flows can be identified. The Company evaluates corporateassets or 

38

----

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 theCompany’s long-lived tangible assets, the Company estimates fair values basedon the expected future cash flows. The Company estimates future cash flowsbased on store-level historical results, current trends and operating and cashflow 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 January 28,2006, the Company recorded a $0.3 million impairment charge on thelong-lived assets of two underperforming stores. The impairment charge wasequal to the difference between the carrying value of the long-lived assets andthe present value of estimated future cash flows for the stores. For the fiscalyears ended January 29, 2005 and January 31, 2004, no impairmentcharges 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 Closure Reserves**

Statement of Financial Accounting Standards (“SFAS”) No. 146,*“Accounting for Costs Associated with Exit orDisposal Activities,”* requires that for exit or disposal activitiesinitiated after December 31, 2002, the Company recognizes a liability forcosts associated with closing a store when the liability is incurred. TheCompany records the present value of expected future lease costs and otherclosure costs when the store is closed. The Company records severance and otheremployee-related costs in the period in which it communicates the closure andrelated severance packages to the affected employees. Costs incurred inconnection with closure of two underperforming stores were fully recognizedduring fiscal 2004 and no amounts remained accrued as of January 28, 2006and January 29, 2005, respectively.

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 

39

----

subjectto “kick out clauses” which allow the Company to terminate the store leasewithout further obligation if certain contractually specified sales levels arenot achieved.

**AccountsPayable and Accrued Expenses**

Accounts payable andaccrued expenses represent amounts owed to third parties at the end of theperiod. Accounts payable and accrued expenses included negative cash balancesdue to outstanding checks of approximately $7.6 million and $9.5 millionat January 28, 2006 and January 29, 2005, 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.The projections 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 28, 2006and January 29, 2005, the Company had recorded accruals for theseliabilities of approximately $4.6 million and $3.1 million, respectively.

**Revenue Recognition**

*Revenue:*   TheCompany recognizes revenues and the related cost of goods sold when themerchandise is received by customers in accordance with the provisions of StaffAccounting Bulletin (“SAB”) No. 101, “*Revenue  Recognition in Financial Statements*”as amended by SAB No. 104, “*Revenue Recognition*.”Revenue from retail sales (excluding home-delivered merchandise) is recognizedat the point of sale in the store and from direct-to-customer andhome-delivered sales is recognized when the merchandise is delivered to thecustomer. The Company records the sale as revenue in the channel where thetransaction originated. Sales tax collected is not recognized as revenue and isincluded on the Consolidated Balance Sheet in accounts payable and accruedexpenses.

*Shippingand handling:*   The Company records shipping andhandling fees as revenue when the merchandise is delivered to the customer inthe revenue channel where the sales transaction originated. Costs of shippingand handling are included in cost of revenue and occupancy.

*Returns:*   TheCompany provides an allowance for sales returns based on historical returnrates. At January 28, 2006 and January 29, 2005, the allowance forsales returns was approximately $1.8 million and $1.3 million, respectively.

**Cost of Revenue and Occupancy**

Cost of revenue andoccupancy expense includes the invoice cost of products sold, inbound freightand related importation costs, inventory shrinkage and valuation costs,merchandise procurement and receiving costs, store occupancy costs, productdistribution network costs, including occupancy and payroll, and costs ofdelivery to customers.

**Selling,General and Administrative Expense**

Selling, general andadministrative expense includes employment costs related to store and corporateassociates, catalog production and mailing costs, other marketing costs, creditcard fees, occupancy costs 

40

----

forcorporate associates, professional fees and other store and administrativecosts including costs of insurance.

**Store Pre-Opening Activities**

All store pre-openingcosts are expensed as incurred.

**Income Taxes**

SFAS No. 109, “*Accounting for Income Taxes*,” requiresincome taxes to be accounted for under an asset and liability approach thatrequires the recognition of deferred tax assets and liabilities for theexpected future tax consequences of events that have been recognized in theCompany’s Consolidated Financial Statements or tax returns. In estimatingfuture tax consequences, the Company generally takes into account all expectedfuture events then known to it, other than changes in the tax law or rates,which are not permitted to be considered. Accordingly, the Company may record avaluation allowance to reduce its net deferred tax assets to the amount that ismore likely than not to be realized. The amount of valuation allowance would bebased upon management’s best estimate of the recoverability of the Company’snet deferred tax assets. Future taxable income and ongoing prudent and feasibletax 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 net deferred tax assets in the future, an adjustmentto the net deferred tax assets valuation allowance would decrease income in theperiod such determination was made. Accordingly, the Company recorded a fullvaluation allowance against the Company’s net deferred tax assets of $27.9million in the fourth quarter of fiscal 2005. This fiscal 2005 adjustment willhave no impact on the Company’s cash flow or future prospects, nor does italter the Company’s ability to utilize the underlying tax net operating lossand credit carryforwards in the future; the utilization of which is limited toachieving future taxable income.

**EstimatedFair Value 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.

41

----

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

Basic(loss) earnings per share of common stock is computed by dividing net (loss)income by the weighted average number of common shares of common stockoutstanding for the period. Diluted (loss) earnings per share of common stockis computed by dividing net (loss) income by the weighted average number ofshares of common stock and potentially dilutive shares of common stockequivalents outstanding during the period. Diluted (loss) earnings per share ofcommon stock reflects the potential dilution that could occur if options orwarrants to issue shares of common stock were exercised, or shares of preferredstock were converted into shares of common stock. The following table detailspotentially dilutive shares of common stock equivalents that have been excludedfrom fiscal 2005 and fiscal 2003 diluted loss per share because their inclusionwould be anti-dilutive but included in diluted earnings per share for fiscal2004:

| ** **                                                                           | ** ** | **Fiscal Year** | ** ** |
|--------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                           | ** ** | **2005**             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Convertible preferred  stock and options:                                            |       |                 |       |   |   |   |   |
| Shares of common  stock subject to outstanding options                               |       | 876,218              |       | 940,332 |   | 478,816 |   |
| Shares of common  stock subject to conversion from the Series A preferred stock |       | 2,130,072            |       | 4,302,029 |   | 6,077,417 |   |
| Total shares of common  stock equivalents                                            |       | 3,006,290            |       | 5,242,361 |   | 6,556,233 |   |

 

The above stock options represent only those stockoptions whose exercise prices are less than the average market price of thestock for the years. The number of shares of common stock subject to the stockoptions whose exercise prices exceeded the average market price of the stockfor the years are 4,052,768; 2,650,311; and 2,741,516 for fiscal 2005, 2004 and2003, respectively.

**Total Comprehensive (Loss) Income**

Total comprehensive (loss)income consists of net (loss) income and foreign currency translationadjustments. The components of total comprehensive (loss) income are presentedin the Consolidated Statements of Redeemable Convertible Preferred Stock andStockholders’ Equity.

**ForeignCurrency Translation**

Local currencies aregenerally considered the functional currencies outside the United States ofAmerica. The assets and liabilities of the Company and its subsidiaries, whichare denominated in currencies other than the U.S. dollar, are translated to U.S.dollars at the rate of exchange in effect at the balance sheet date; income andexpenses are translated at average rates of exchange prevailing during theyear. The related translation adjustments are reflected in the accumulatedother comprehensive income section of the Consolidated Statements of RedeemableConvertible Preferred Stock and Stockholders’ Equity. Foreign currency gainsand losses resulting from transactions denominated in foreign currencies areincluded in the Consolidated Statements of Operations.

42

----

**Stock-based Compensation**

TheCompany has one stock-based employee compensation plan, as described inNote 8. The Company accounts for stock-based employee compensation usingthe intrinsic value method in accordance with the provisions of AccountingPrinciples Board (“APB”) Opinion No. 25, “*Accountingfor Stock Issued to Employees*.” The following table illustrates theeffect on net (loss) income and (loss) earnings per share of common stock ifthe Company had applied the fair value recognition provisions of SFAS No. 123,*“Accounting for Stock-Based Compensation,”*to all stock-based employee compensation:

| ** **                                                                                                                                       | ** ** | **Fiscal Year**                                                           | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                       | ** ** | **2005**                                                                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                       | ** ** | **(Dollars in thousands,  except per share amounts)** | ** ** |
| Net (loss)  income, as reported                                                                                                                  |       | $                                                                              | (29,307    | ) | $ | 1,704 |   | $ | (2,518 | ) |
| Add: stock-based  employee compensation expense for options granted below fair market value  included in reported net (loss) income (net of tax) |       | —                                                                         |       | 141 |   | 308 |   |
| Deduct:  compensation expense for all stock-based employee compensation (net of tax)  calculated in accordance with the fair value method        |       | (4,573                                                                         | )          | (3,344 | ) | (1,800 | ) |
| Pro forma net  loss                                                                                                                              |       | $(33,880                                                                       | )          | $ | (1,499 | ) | $(4,010 | ) |
| Net (loss) income per  share of common stock:                                                                                                    |       |                                                                           |       |   |   |   |   |
| Basic, as  reported                                                                                                                              |       | $                                                                              | (0.83      | ) | $ | 0.05 |   | $ | (0.08 | ) |
| Basic, pro forma                                                                                                                                 |       | $                                                                              | (0.96      | ) | $ | (0.05 | ) | $ | (0.13 | ) |
| Diluted, as  reported                                                                                                                            |       | $                                                                              | (0.83      | ) | $ | 0.04 |   | $ | (0.08 | ) |
| Diluted, pro forma                                                                                                                               |       | $                                                                              | (0.96      | ) | $ | (0.05 | ) | $ | (0.13 | ) |

 

The Company estimates the fair value of stock optiongrants using the Black-Scholes option pricing model, with the following weightedaverage assumptions:

| ** **               | ** ** | **Fiscal Year** | ** ** |
|--------------------------|------------|----------------------|------------|
| ** **               | ** ** | **2005**             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Dividend yield           |       | —               |       | — |   | — |   |
| Expected  volatility     |       | 52                   | %          | 65 | % | 75 | % |
| Risk-free  interest rate |       | 4.40                 | %          | 3.47 | % | 3.00 | % |
| Expected life  (years)   |       | 4.5                  |       | 4.5 |   | 4.5 |   |
| Assumed tax rate         |       | 0                    | %          | 40 | % | 40 | % |

 

No tax benefits were attributed to the stock-basedemployee compensation expense during fiscal 2005 due to providing a fullvaluation allowance on net deferred tax assets.

**New Accounting Pronouncements**

In November 2004, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 151,*“Inventory Costs,”* which clarifies the accounting forabnormal amounts of idle facility expense, freight, handling costs and wastedmaterial (spoilage). This statement is effective for the Company’s 2006 fiscalyear. The Company believes the adoption of SFAS 151 will not have asignificant impact on the overall results of operations or financial position.

In December 2004, the FASB issued SFAS No. 123(R) ”*Share-Based Payment.*”  SFAS 123(R)requires the recognition of compensation expense relating to share-basedpayment transactions in consolidated financial statements. That expense will bemeasured based on the fair value of the equity or liability instruments issuedas of the grant date, for the estimated number of awards that are expected tovest. SFAS 123(R) covers a wide range of share-based compensationarrangements including share 

43

----

options, restricted shareplans, performance-based awards, share appreciation rights and employee sharepurchase plans. SFAS 123(R) replaces SFAS 123, “*Accounting for Stock Based Compensation*,” and supersedes APBOpinion No. 25, “*Accounting for StockIssued to Employee*s.” SFAS 123(R) is effective for interimperiods that begin after December 15, 2005. The Company is allowed toselect from three alternative transition methods, each having differentreporting implications. Effective with the beginning of the first quarter offiscal 2006, the Company will adopt SFAS 123(R) using the modifiedprospective method. Under this method, the unvested portions of previouslygranted share-based payments, as well as the fair value of awards granted afteradoption are included in operating expenses over the appropriate serviceperiod. The Company has decided to use the Black Scholes model to estimate thefair value of the Company’s stock options, unless additional informationbecomes available in the future that indicates another model would be moreappropriate for the Company, or if grants issued in future periods havecharacteristics that cannot be reasonably estimated using this model. Based onstock options granted to employees through January 28, 2006, the Companyexpects the adoption of SFAS 123(R) will increase first quarter expensesby approximately $1.3 million and increase full year fiscal 2006 expenses byapproximately $4.0 million.

In May 2005, the FASB issued SFAS No. 154,*“Accounting Changes and Error Corrections,”*which changes the requirements for reporting a change in accounting principle.This statement is effective beginning January 1, 2006. SFAS 154 replacesAPB No. 20, “*Accounting Changes*,”and SFAS No. 3, ”*ReportingAccounting Changes in Interim Financial Statements.*”  TheCompany believes the adoption of SFAS 154 will not have a significantimpact on the overall results of operations or financial position.

In October 2005,the FASB issued FASB Staff Position (“FSP”) 13-1, *“Accountingfor Rental Costs Incurred During a Construction Period,”* to clarifythe proper accounting for rental costs incurred on building or ground operatingleases during a construction period. The FSP requires that rental costsincurred during a construction period be expensed, not capitalized. Thestatement is effective for the first reporting period beginning after December 15,2005. The Company believes the adoption of FSP 13-1 will not have asignificant impact on the overall results of operations or financial position.

**(2)**                                              PROPERTYAND EQUIPMENT, NET

Propertyand equipment, net consists of the following:

| ** **                                      | ** ** | **January 28, 2006**       | ** ** | **January 29, 2005** | ** ** |
|-------------------------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|
| ** **                                      | ** ** | **(Dollars in thousands)** | ** ** |
| Leasehold  improvements                         |       |                                 | $          | 153,448                        |       |   |   | $ | 135,637 |   |   |
| Furniture,  fixtures and equipment              |       |                                 | 20,731     |                           |       |   | 18,817 |   |   |
| Machinery and  equipment                        |       |                                 | 12,528     |                           |       |   | 9,703 |   |   |
| Computer software                               |       |                                 | 10,875     |                           |       |   | 9,524 |   |   |
| Equipment under  capital leases(1)              |       |                                 | 548        |                           |       |   | 571 |   |   |
| Total                                           |       |                                 | 198,130    |                           |       |   | 174,252 |   |   |
| Less accumulated  depreciation and amortization |       |                                 | (105,770   | )                              |       |   | (92,366 | ) |   |
| Property and equipment,  net                    |       |                                 | $          | 92,360                         |       |   |   | $ | 81,886 |   |   |

----

(1)          Accumulatedamortization of $0.3 million and $0.2 million for fiscal 2005 and 2004,respectively, relates to equipment classified as capital leases.

**(3)**                                              LEASES

The Company leases certain property consisting ofretail and outlet stores, corporate offices, distribution centers andequipment. Leases expire at various dates through 2018. The retail stores, 

44

----

distribution centers andcorporate 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 28,2006 (including renewals and substitute leases entered into after year end) areas follows:

| **FISCAL YEAR**                        | ** ** | ** **                           | ** ** | **Capital  Leases** | ** ** | **Operating  Leases** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|---------------------|------------|-----------------------|------------|-----------|------------|
| ** **                                  | ** ** | **(Dollars in thousands)** | ** ** |
| 2006                                        |       |                                 | $          | 153                 |       |                  | $          | 42,754    |       | $ | 42,907 |   |
| 2007                                        |       |                                 | 23         |                |       | 42,591                |       | 42,614    |       |
| 2008                                        |       |                                 | 4          |                |       | 39,689                |       | 39,693    |       |
| 2009                                        |       |                                 | —     |                |       | 35,254                |       | 35,254    |       |
| 2010                                        |       |                                 | —     |                |       | 30,028                |       | 30,028    |       |
| Thereafter                                  |       |                                 | —     |                |       | 80,709                |       | 80,709    |       |
| Minimum lease  commitments                  |       |                                 | 180        |                |       | $                     | 271,025    |      | $          | 271,205 |   |
| Less amount  representing interest          |       |                                 | (9         | )                   |       |                  |       |      |       |
| Present value of  capital lease obligations |       |                                 | 171        |                |       |                  |       |      |       |
| Less current  portion                       |       |                                 | (145       | )                   |       |                  |       |      |       |
| Long-term portion                           |       |                                 | $          | 26                  |       |                  |       |      |       |   |

 

Leasepayments that depend on factors that are not measurable at the inception of thelease, such as future sales volume, are contingent rentals and are excludedfrom minimum lease payments and included in the determination of total rentalexpense when it is probable that the expense has been incurred and the amountis reasonably estimable. Future payments for insurance, real estate taxes, andrepair and maintenance to which the Company is obligated are excluded fromminimum lease payments. Minimum and contingent rental expense under operatingleases was as follows:

| ** **                 | ** ** | **Fiscal Year**                 | ** ** |
|----------------------------|------------|--------------------------------------|------------|
| ** **                 | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                 | ** ** | **(Dollars in thousands)** | ** ** |
| Operating leases:          |       |                                 |       |   |   |   |   |
| Minimum rental  expense    |       | $                                    | 42,262     |   | $ | 39,324 |   | $ | 37,816 |   |
| Contingent rental  expense |       | 783                                  |       | 777 |   | 429 |   |
| Total                      |       | $                                    | 43,045     |   | $ | 40,101 |   | $ | 38,245 |   |

 

**(4)**                                              LONG-TERMDEBT, NET OF DEBT ISSUANCE

On July 29, 2005, the Company entered into anagreement (the “Amendment”) to amend its existing revolving credit facility.The Amendment increased the revolving loan commitment available to the Companyunder the facility from $100.0 million to $150.0 million and provided for anextension of the maturity date of the revolving loan from June 30, 2006 toJune 30, 2009. In addition, the Amendment reduced the interest rate onbase rate advances and provided for incremental advances with availabilitydetermined from the application of a higher advance rate on eligible inventoryand eligible accounts receivables constituting part of the Company’s borrowingbase. Those incremental advances would be subject to higher interest rates. Tothe extent that borrowings are outstanding under the incremental advanceprovision and if the remaining availability for additional borrowing under thefacility is less than 10% of the applicable borrowing base for the line ofcredit at the time, the Company would be required to maintain a minimum fixedcharge coverage ratio. The Amendment also eliminated the lock box restriction 

45

----

except upon the occurrenceof certain events, such as an event of default. Other elements of the revolvingcredit facility remain materially unchanged.

As of January 28, 2006, $58.1 million wasoutstanding under the facility, net of unamortized debt issuance costs of $0.9million, and there was $11.8 million in outstanding letters of credit. As aresult of the Amendment, the balance of $58.1 million at January 28, 2006is considered a long-term liability rather than a current liability and hasbeen classified accordingly. Borrowings made under the revolving creditfacility are subject to interest at either the bank’s reference rate or LIBORplus a margin. As of January 28, 2006, the bank’s reference rate was 7.25%and the LIBOR plus margin rate was 5.97%. Borrowings that are incrementaladvances under the revolving credit facility are subject to interest at thebank’s reference rate plus a margin or LIBOR plus a higher margin. Theavailability of credit at any given time under the revolving credit facility islimited by reference to a borrowing base formula (which includes an adjustmentto the advance rate against eligible inventory and eligible accountsreceivables for incremental advances as described above) based upon numerousfactors, including the value of eligible inventory and eligible accountsreceivable, and reserves established by the agent of the revolving creditfacility. As a result of the borrowing base formula, the actual borrowingavailability under the facility could be less than the stated amount of thefacility reduced by the actual borrowings and outstanding letters of credit. Asof January 28, 2006, the Company had availability under the facility of$25.5 million.

The revolving credit facility contains variousrestrictive covenants, including limitations on the ability to make liens, makeinvestments, sell assets, incur additional debt, merge, consolidate or acquireother businesses, pay dividends and other distributions, and enter intotransactions with affiliates. The revolving credit facility does not containany other significant financial or coverage ratio covenants unless the Companytakes advantage of the incremental advance provision and availability under therevolving credit facility is less than 10%. If the Company does receive anadvance under the incremental advance provision and if the remainingavailability for additional borrowing under the facility is less than 10% ofthe applicable borrowing base for the line of credit at the time, the Companyis required to maintain a fixed charge coverage ratio. The revolving creditfacility also does not require that the Company repay all borrowings for a prescribed“clean-up” period each year.

As of January 29,2005, $33.8 million was outstanding under the line of credit, net ofunamortized debt issuance costs of $0.7 million, and there was $12.0 million inoutstanding letters of credit.

**(5)**                                              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 Statements and tax basis of assets andliabilities, using enacted tax rates in effect for the year in which thedifferences are expected to reverse.

46

----

Theincome tax expense (benefit) consisted of:

| ** **                            | ** ** | **Fiscal Year**                 | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|
| ** **                            | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **(Dollars in thousands)** | ** ** |
| Current:                              |       |                                 |       |   |   |   |   |
| Federal                               |       | $                                    | 32         |   | $ | 1,816 |   | $ | 429 |   |
| State                                 |       | 40                                   |       | 108 |   | 35 |   |
| Foreign                               |       | 383                                  |       | 483 |   | — |   |
| Total current tax  expense            |       | 455                                  |       | 2,407 |   | 464 |   |
| Deferred:                             |       |                                 |       |   |   |   |   |
| Federal                               |       | 19,942                               |       | (3,011 | ) | (1,938 | ) |
| State                                 |       | 5,487                                |       | 57 |   | (420 | ) |
| Foreign                               |       | 317                                  |       | 447 |   | 383 |   |
| Total deferred  tax expense (benefit) |       | 25,746                               |       | (2,507 | ) | (1,975 | ) |
| Total income tax expense  (benefit)   |       | $                                    | 26,201     |   | $ | (100 | ) | $ | (1,511 | ) |

 

Significantcomponents of the Company’s deferred tax assets and liabilities are as follows:

| ** **                                                 | ** ** | **January 28,  2006**           | ** ** | **January 29,  2005** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|----------------------------|------------|
| ** **                                                 | ** ** | **(Dollars in thousands)** | ** ** |
| Current deferred tax  assets (liabilities):                |       |                                 |       |                       |       |   |   |   |   |
| Accrued expense                                            |       |                                 | $          | 3,417                      |       |   |   | $ | 2,568 |   |   |
| State tax benefit                                          |       |                                 | (500       | )                          |       |   | (483 | ) |   |
| Inventory                                                  |       |                                 | 4,439      |                       |       |   | 3,664 |   |   |
| Deferred revenue                                           |       |                                 | 3,305      |                       |       |   | 4,116 |   |   |
| Prepaid expense  and other                                 |       |                                 | (3,578     | )                          |       |   | (2,746 | ) |   |
| Net current  deferred tax assets                           |       |                                 | 7,083      |                       |       |   | 7,119 |   |   |
| Long-term deferred tax  assets (liabilities):              |       |                                 |       |                       |       |   |   |   |   |
| State tax benefit                                          |       |                                 | (1,429     | )                          |       |   | (1,382 | ) |   |
| Deferred lease  credits                                    |       |                                 | (6,723     | )                          |       |   | (4,568 | ) |   |
| Property and  equipment                                    |       |                                 | 15,959     |                       |       |   | 13,186 |   |   |
| Net operating  loss carryforwards                          |       |                                 | 12,880     |                       |       |   | 11,557 |   |   |
| Other                                                      |       |                                 | 99         |                       |       |   | (48 | ) |   |
| Net long-term  deferred tax assets                         |       |                                 | 20,786     |                       |       |   | 18,745 |   |   |
| Total net  deferred tax assets before valuation allowance  |       |                                 | 27,869     |                       |       |   | 25,864 |   |   |
| Valuation  allowance                                       |       |                                 | (27,869    | )                          |       |   | — |   |   |
| Total net deferred tax  assets, net of valuation allowance |       |                                 | $          | —                     |       |   |   | $ | 25,864 |   |   |

 

Areconciliation of the federal statutory tax rate to the Company’s effective taxrate is as follows:

| ** **                                     | ** ** | **Fiscal Year** | ** ** |
|------------------------------------------------|------------|----------------------|------------|
| ** **                                     | ** ** | **2005**             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Provision at  statutory tax rate               |       | (34.0                | )%         | 34.0 | % | (34.0 | )% |
| State income  taxes, net of federal tax impact |       | (2.8                 | )          | 4.2 |   | (5.9 | ) |
| Foreign income                                 |       | (1.2                 | )          | 4.1 |   | 1.3 |   |
| Net adjustments  to tax accruals and other     |       | 1.2                  |       | 138.6 |   | 1.1 |   |
| Valuation  allowance                           |       | 880.3                |       | (187.1 | ) | — |   |
| Total                                          |       | 843.5                | %          | (6.2 | )% | (37.5 | )% |

 

47

----

As of January 28, 2006, the Company had federaland state net operating loss carryovers of approximately $30 million and $31million, respectively. These net operating loss carryovers will expire between2006 and 2026. Internal Revenue Code Section 382 and similar state rules placea limitation on the amount of taxable income which can be offset by netoperating loss carryforwards after a change in ownership (generally greaterthan 50% change in ownership). Due to these provisions, utilization of the netoperating loss carryforwards may be limited.

The Company accounts for income taxes under SFAS No. 109,*“Accounting for Income Taxes.”* SFAS No.109 requires incometaxes to be accounted for under an asset and liability approach that requiresthe recognition of deferred tax assets and liabilities for the expected futuretax consequences of events that have been recognized in the Company’s ConsolidatedFinancial Statements or tax returns. In estimating future tax consequences, theCompany generally takes into account all expected future events then known,other than changes in the tax law or rates, which are not permitted to beconsidered. Accordingly, if needed the Company may record a valuation allowanceto reduce net deferred tax assets to the amount that is more likely than not tobe realized. The amount of valuation allowance would be based upon management’sbest estimate of the recoverability of the net deferred tax assets. Whilefuture taxable income and ongoing prudent and feasible tax planning areconsidered in determining the amount of the valuation allowance, the necessityfor an allowance is subject to adjustment in the future. Specifically, in theevent the Company were to determine that the Company would not be able torealize the net deferred tax assets in the future in excess of their netrecorded amounts, an adjustment to the net deferred tax assets would decreaseincome in the period such determination was made. Accordingly, the Companyrecorded a full valuation allowance against the net deferred tax assets. Theeffect was to include a non-cash charge of $27.9 million in the fourth quarterof fiscal 2005. This fiscal 2005 adjustment will have no impact on the Company’scash flow or future prospects, nor does it alter the Company’s ability toutilize the underlying tax net operating loss and credit carryforwards in thefuture; the utilization of which is limited to achieving future taxable income.

**(6)**                                              CONVERSIONOF SERIES A 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’sstockholders in July 2001. Each share of preferred stock has a par valueof $.0001 per share.

AtJanuary 29, 2005, there were 8,473 shares outstanding. As of July 30,2005 the remaining holders of the Series A preferred stock elected to converttheir shares of Series A preferred stock into common stock. Pursuant tothe Company’s Certificate of Designation of Series A and Series Bpreferred stock, each share of Series A preferred stock was convertibleinto such number of shares of common stock as determined by dividing $1,000 bythe conversion price, which was $1.9889 at the time of such conversion. As aresult of the conversion, the 8,473 shares of Series A preferred stockoutstanding on July 30, 2005 were converted into 4,260,144 shares of commonstock.

48

----

**(7)**                                              COMMONSTOCK

The Company is authorized to issue up to 60,000,000shares of common stock, par value of $.0001 per share, and 5,000,000 shares ofpreferred stock, par value of $.0001 per share.

AtJanuary 28, 2006, the Company has reserved the following shares of commonstock for issuance in connection with:

| ** **    | ** ** | **Issuable upon  conversion or  exercise of  outstanding  securities** | ** ** | **Available for  future sales  and grants** | ** ** | **Total shares of  common stock  reserved** | ** ** |
|---------------|------------|---------------------------------------------------------------------------------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------|------------|
| Stock options |       |                                                                                  | 6,696,158  |                                                       |       |                                                       | 2,109,579  |   |   |   | 8,805,737 |   |   |
|               |            |                                                                                       |            |                                                            |            |                                                            |            |  |  |  |  |  |  |

 

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.

**(8)**                                              STOCKOPTION PLANS

**Stock-Based Compensation 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, (ii) the Stock Issuance Program, (iii) theSalary Investment Option Grant Program, (iv) the Automatic Option GrantProgram and (v) the Director Fee Option Grant Program. The DiscretionaryOption Grant Program and Stock Issuance Program are administered by theCompensation Committee for Section 16 insiders and by a SecondaryCommittee of the Board of Directors for non-Section 16 insiders. TheDirector Fee Option Grant Program is not currently in use by the Company.

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 lesser 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 2,2006, January 2, 2005 and January 2, 2004, the Company added 966,202shares, 966,202 shares and 966,202 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.

49

----

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. Theseoptions generally expire ten years from the date of grant and vest ratablyeither over a one-year period, three-year period or four-year period. The planadministrator shall have the discretion to grant options which are exercisablefor unvested shares of common stock. If any such options are exercised beforebecoming vested, the holder cannot sell or transfer the shares received uponexercise until such shares have vested. If the holder leaves the Company beforesuch shares are fully vested, the Company has the right to repurchase suchunvested shares at the 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 discretion and at any time, restrict or withdraw from the special purposecommittee, as to any particular matters or categories of matters, the authorityto make any or particular option grants under the Program.

50

----

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 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 |   |   |
| Granted with  exercise price at fair value  (weighted average fair value of $3.69)     |       | 1,675,443                  |       |                                   | 6.42       |   |   |
| Exercised                                                                              |       | (418,262                   | )          |                                   | 3.88       |   |   |
| Canceled                                                                               |       | (950,133                   | )          |                                   | 7.81       |   |   |
| Outstanding and  exercisable, January 28, 2006                                    |       | 6,696,158                  |       |                                   | $          | 5.95 |   |   |
| Vested at  January 31, 2004                                                       |       | 2,391,471                  |       |                                   | $          | 6.83 |   |   |
| Vested at  January 29, 2005                                                       |       | 2,313,263                  |       |                                   | $          | 6.65 |   |   |
| Vested at  January 28, 2006                                                       |       | 2,720,900                  |       |                                   | $          | 6.11 |   |   |
| Available for future  grant at January 28, 2006                                   |       | 2,109,579                  |       |                                   |       |   |   |

 

Additionalinformation regarding options outstanding as of January 28, 2006 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                           |       |       | 1,484,898  |                    |       |                                                             | 6.69       |                                   |       |               | $          | 3.25                                   |       |   | 854,807 |   |   | $ | 2.87 |   |   |
| $4.39 - $5.31                           |       |       | 1,437,519  |                    |       |                                                             | 8.04       |                                   |       |               | 4.84       |                                   |       | 481,821 |   |   | 4.80 |   |   |
| $5.41 - $6.10                           |       |       | 1,437,359  |                    |       |                                                             | 8.30       |                                   |       |               | 5.89       |                                   |       | 402,405 |   |   | 5.82 |   |   |
| $6.11 - $8.23                           |       |       | 1,420,039  |                    |       |                                                             | 8.22       |                                   |       |               | 6.83       |                                   |       | 479,689 |   |   | 6.96 |   |   |
| $8.29 - $22.00                          |       |       | 916,343    |                    |       |                                                             | 6.31       |                                   |       |               | 10.81      |                                   |       | 502,178 |   |   | 12.32 |   |   |
| $0.32 - $22.00                          |       |       | 6,696,158  |                    |       |                                                             | 7.60       |                                   |       |               | $          | 5.95                                   |       |   | 2,720,900 |   |   | $ | 6.11 |   |   |

 

**Employee Stock Purchase 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 length of service requirements, of the Companyand participating subsidiaries to purchase shares of common stock, atsemi-annual intervals, through their periodic payroll deductions under thePurchase Plan. A reserve of 475,000 shares of common stock was established forthis purpose. During fiscal 2002, employees purchased approximately 140,967shares of the Company’s common stock under the Purchase 

51

----

Plan at a weighted average per share price of $2.20.The Board of Directors suspended the Purchase Plan on August 30, 2002.Therefore, no shares are presently available for future issuance under thePurchase Plan.

**(9)**                                              EMPLOYEEBENEFIT 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 (thislimit increases to 50% as of April 1, 2006) to a maximum of $15,000 and$14,000, for calendar years 2006 and 2005, respectively. The Company matches50% of the employees’ contribution up to a maximum of 3% of their base salary.The Company contributed approximately $429,000, $353,000, and $302,000 infiscal 2005, 2004 and 2003, respectively.

**(10)**                                       RELATEDPARTY TRANSACTIONS

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 current employeeof Michaels. Annual payments made in fiscal 2005, 2004 and 2003 were $456,000per year.

**(11)**                                       COMMITMENTSAND 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.

**(12)**                                       SEGMENTREPORTING

The Company classifies its business into twoidentifiable segments: retail and direct-to-customer. Segment income fromoperations consists of direct-to-customer contribution and retail storecontribution. The unallocated portion includes both the costs of corporateexpenses, shared service costs such as information technology, as well as thecosts of merchandising, sourcing and distribution. The Company also has awholly-owned furniture manufacturing company, Michaels, located in Sacramento,California. Michaels’ revenue is recorded as either retail revenue or direct-to-customerrevenue based on the channel in which the sale was initiated. Managementdecisions on resource allocations and performance assessments are made based onthese two identifiable segments. As a result, management considers it is mostappropriate to report its business activities into two identifiable segments.The Company evaluates performance and allocates resources based on results fromoperations, which excludes unallocated costs. Certain segment information,including segment assets, asset expenditures and related depreciation expense,is not presented as all of the Company’s assets are commingled and are notavailable by segment.

52

----

Financialinformation for the Company’s business segments is as follows:

| ** **                                  | ** ** | **Fiscal Year**                 | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|
| ** **                                  | ** ** | **2005**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                  | ** ** | **(Dollars in thousands)** | ** ** |
| Net revenue:                                |       |                                 |       |   |   |   |   |
| Retail                                      |       | $                                    | 421,666    |   | $ | 406,833 |   | $ | 370,609 |   |
| Direct-to-customer                          |       | 159,991                              |       | 118,990 |   | 67,899 |   |
| Consolidated net  revenue                   |       | $                                    | 581,657    |   | $ | 525,823 |   | $ | 438,508 |   |
| Income (loss) from  operations:             |       |                                 |       |   |   |   |   |
| Retail                                      |       | 49,154                               |       | 51,932 |   | 39,611 |   |
| Direct-to-customer                          |       | 21,329                               |       | 14,280 |   | 8,538 |   |
| Unallocated                                 |       | (69,539                              | )          | (60,136 | ) | (50,024 | ) |
| Consolidated income  (loss) from operations |       | $                                    | 944        |   | $ | 4,076 |   | $ | (1,875 | ) |

 

**(13)**                                       QUARTERLYFINANCIAL INFORMATION (UNAUDITED)

Summarizedquarterly financial information for fiscal 2005 and 2004 is as follows:

| **Fiscal year ended January 28, 2006** | ** ** | ** **                                                                         | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                                      | ** ** | **(Dollars in thousands, except per share amounts)** | ** ** |
| Net revenue                                                     |       | $                                                                                  | 117,465    |               | $          | 144,781             |       | $                  | 128,402    |                | $          | 191,009 |   |
| Cost of revenue  and occupancy                                  |       | 81,823                                                                             |       | 101,507            |       | 84,033              |       | 116,881            |       |
| Gross profit                                                    |       | 35,642                                                                             |       | 43,274             |       | 44,369              |       | 74,128             |       |
| Selling, general  and administrative expense                    |       | 39,986                                                                             |       | 46,437             |       | 50,302              |       | 59,744             |       |
| (Loss) income  from operations                                  |       | (4,344                                                                             | )          | (3,163             | )          | (5,933              | )          | 14,384             |       |
| Interest expense,  net                                          |       | (825                                                                               | )          | (834               | )          | (1,164              | )          | (1,227             | )          |
| (Loss) income  before income taxes                              |       | (5,169                                                                             | )          | (3,997             | )          | (7,097              | )          | 13,157             |       |
| Income tax  (expense) benefit(3)                                |       | 2,056                                                                              |       | 1,535              |       | 2,887               |       | (32,679            | )          |
| Net loss                                                        |       | $                                                                                  | (3,113     | )                  | $          | (2,462              | )          | $                  | (4,210     | )                   | $          | (19,522 | ) |
| Loss per share:                                                 |       |                                                                               |       |               |       |                |       |               |       |
| Basic(1)                                                        |       | $                                                                                  | (0.09      | )                  | $          | (0.07               | )          | $                  | (0.11      | )                   | $          | (0.52 | ) |
| Diluted(2)                                                      |       | $                                                                                  | (0.09      | )                  | $          | (0.07               | )          | $                  | (0.11      | )                   | $          | (0.52 | ) |

 

| **Fiscal year ended January 29, 2005** | ** ** | ** **                                                                         | ** ** | **First  Quarter** | ** ** | **Second  Quarter** | ** ** | **Third  Quarter** | ** ** | **Fourth  Quarter** | ** ** |
|-----------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|--------------------|------------|---------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                                      | ** ** | **(Dollars in thousands, except per share amounts)** | ** ** |
| Net revenue                                                     |       | $                                                                                  | 98,858     |               | $          | 120,942             |       | $                  | 118,165    |                | $          | 187,858 |   |
| Cost of revenue  and occupancy                                  |       | 71,328                                                                             |       | 88,425             |       | 80,134              |       | 119,921            |       |
| Gross profit                                                    |       | 27,530                                                                             |       | 32,517             |       | 38,031              |       | 67,937             |       |
| Selling, general  and administrative expense                    |       | 33,516                                                                             |       | 35,172             |       | 42,511              |       | 50,740             |       |
| Income (loss)  from operations                                  |       | (5,986                                                                             | )          | (2,655             | )          | (4,480              | )          | 17,197             |       |
| Interest expense,  net                                          |       | (427                                                                               | )          | (509               | )          | (737                | )          | (799               | )          |
| Income (loss)  before income taxes                              |       | (6,413                                                                             | )          | (3,164             | )          | (5,217              | )          | 16,398             |       |
| Income tax  benefit (expense)(4)                                |       | 2,501                                                                              |       | 1,280              |       | 2,136               |       | (5,817             | )          |
| Net income (loss)                                               |       | $                                                                                  | (3,912     | )                  | $          | (1,884              | )          | $                  | (3,081     | )                   | $          | 10,581 |   |
| Income (loss) per share:                                        |       |                                                                               |       |               |       |                |       |               |       |
| Basic(1)                                                        |       | $                                                                                  | (0.12      | )                  | $          | (0.06               | )          | $                  | (0.09      | )                   | $          | 0.32 |   |
| Diluted(2)                                                      |       | $                                                                                  | (0.12      | )                  | $          | (0.06               | )          | $                  | (0.09      | )                   | $          | 0.28 |   |

 

53

----

----

(1)          Basic earnings (loss)per share is calculated for interim periods including the effect of stockoptions exercised in prior interim periods. Basic earnings (loss) per share forthe fiscal year is calculated using weighted shares outstanding based on thedate stock options were exercised. Therefore, basic income (loss) per share forthe cumulative four quarters may not equal fiscal year basic earnings (loss)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 netlosses is 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)          Fourth quarter fiscal2005 income tax expense includes a full valuation allowance against netdeferred tax assets, net of $27.9 million.

(4)          Fourth quarter fiscal2004 income tax expense includes the reversal of the valuation allowance,offset by the tax contingency accrual.

54

----

**REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

Board of Directors andStockholdersRestoration Hardware, Inc.Corte Madera, California

We have audited the accompanying consolidated balancesheets of Restoration Hardware, Inc. and subsidiaries (the “Company”) asof January 28, 2006 and January 29, 2005, and the relatedconsolidated statements of operations, stockholders’ equity and cash flows foreach of the three years in the period ended January 28, 2006. We also haveaudited management’s assessment, included in the accompanying “Management’sAnnual Report on Internal Control Over Financial Reporting,”, that the Companymaintained effective internal control over financial reporting as of January 28,2006, based on criteria established in *InternalControl—Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission.  The Company’s management is responsible forthese financial statements, for maintaining effective internal control overfinancial reporting, and for its assessment of the effectiveness of internalcontrol over financial reporting. Our responsibility is to express an opinionon these financial statements, an opinion on management’s assessment, and anopinion on the effectiveness of the Company’s internal control over financialreporting based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement and whether effective internal control over financial reportingwas maintained in all material respects. Our audit of financial statementsincluded examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, and evaluating the overallfinancial statement presentation. Our audit of internal control over financialreporting included obtaining an understanding of internal control overfinancial reporting, evaluating management’s assessment, testing and evaluatingthe design and operating effectiveness of internal control, and performing suchother procedures as we considered necessary in the circumstances. We believethat our audits provide 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 financial statements for externalpurposes in accordance with generally accepted accounting principles. A company’sinternal control over financial reporting includes those policies andprocedures that (1) pertain to the maintenance of records that, inreasonable detail, accurately and fairly reflect the transactions anddispositions of the assets of the company; (2) provide reasonableassurance that transactions are recorded as necessary to permit preparation offinancial statements in accordance with generally accepted accountingprinciples and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

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, projectionsof any evaluation of the effectiveness of the internal control over financialreporting to future periods are subject to the risk that the controls maybecome inadequate because of changes in conditions, or that the degree ofcompliance with the policies or procedures may deteriorate.

55

----

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of the Company as of January 28,2006 and January 29, 2005, and the results of their operations and theircash flows for each of the three years in the period ended January 28,2006, in conformity with accounting principles generally accepted in the UnitedStates of America. Also, in our opinion, management’s assessment that theCompany maintained effective internal control over financial reporting as of January 28,2006, is fairly stated, in all material respects, based on the criteriaestablished in *Internal Control—IntegratedFramework*issued by the Committee of Sponsoring Organizations of theTreadway Commission. Furthermore, in our opinion, the Company maintained, inall material respects, effective internal control over financial reporting asof January 28, 2006, based on the criteria established in *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission*.*

/s/ DELOITTE &TOUCHE LLP

San Francisco, CaliforniaApril 11, 2006

56

----

**ITEM 9.**                CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

Not applicable.

**ITEM 9A.**        CONTROLSAND PROCEDURES

**Disclosure Controls and Procedures**

Our management, with theparticipation of Gary Friedman, our Chief Executive Officer and, Chris Newman,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 “ExchangeAct”)) as of the end of our fiscal year, January 28, 2006.

**Management’sReport on Internal Control Over Financial Reporting**

Our management isresponsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rule 13a-15(f).Our internal control over financial reporting is a process designed to providereasonable assurance regarding the reliability of financial reporting and thepreparation of consolidated financial statements for external purposes inaccordance with GAAP. Our internal control over financial reporting includesthose policies and procedures that:

(1)         pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect our transactions and dispositions of assets;

(2)         provide reasonableassurance that transactions are recorded as necessary to permit preparation ofconsolidated financial statements in accordance with GAAP, and that ourreceipts and expenditures are being made only in accordance with authorizationsof our management and Board of Directors; and

(3)         provide reasonableassurance regarding prevention or timely detection of unauthorized acquisition,use, or disposition of our assets that could have a material effect on theConsolidated 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 28, 2006 based on criteriaset forth by the Committee of Sponsoring Organizations of the TreadwayCommission in*Internal Control—IntegratedFramework* (“COSO Framework”). Based on that evaluation, our ChiefExecutive Officer and Chief Financial Officer concluded that our internalcontrol over financial reporting was effective as of January 28, 2006.

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 55.

57

----

**Changesin Internal Controls over Financial Reporting**

There has been no changein our internal control over financial reporting that occurred during fiscal2005 that has materially affected or is reasonably likely to materially affectour internal control over financial reporting.

**ITEM 9B**.       OTHER INFORMATION

Not applicable.

**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 certaininformation included in such proxy statement is incorporated herein byreference.

**ITEM 10.**         DIRECTORSAND EXECUTIVE OFFICERS 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.**         EXECUTIVECOMPENSATION

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.**         SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

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.**         CERTAINRELATIONSHIPS AND RELATED 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.**         PRINCIPALACCOUNTANT FEES AND 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.

58

----

**PART IV**

**ITEM 15.**         EXHIBITSAND CONSOLIDATED FINANCIAL STATEMENT SCHEDULES

(a)   The followingConsolidated Financial Statements are filed as a part of this annual report on Form 10-K:

1.                The followingConsolidated Financial Statements, together with notes thereto and the reportthereon of Deloitte & Touche LLP are set forth in Item 8 of Part IIof this annual report on Form 10-K:

(i)             Consolidated BalanceSheets at January 28, 2006 and January 29, 2005;

(ii)         Consolidated Statementsof Operations for the fiscal years ended January 28, 2006, January 29,2005, and January 31, 2004;

(iii)     Consolidated Statements ofRedeemable Convertible Preferred Stock and Stockholders’ Equity for the fiscalyears ended January 28, 2006, January 29, 2005, and January 31,2004;

(iv)       Consolidated Statements ofCash Flows for the fiscal years ended January 28, 2006, January 29,2005, and January 31, 2004.

2.                ConsolidatedFinancial Statement Schedule:

Not applicable

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.

59

----

**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 11, 2006 |     | Gary G. Friedman                                  |
| * *                  | * * | *Chairman, President and Chief Executive Officer* |

 

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  |       | Chairman, President and  Chief                  |       | April 11, 2006 |
| Gary G. Friedman                  |       | Executive Officer (Principal Executive Officer) |       |                |
| /s/  CHRIS  NEWMAN      |       | Senior Vice President  and Chief Financial      |       | April 11, 2006 |
| Chris Newman                      |       | Officer (Principal Financial Officer)           |       |                |
| /s/  MURRAY  JUKES      |       | Vice President,  Controller                     |       | April 11, 2006 |
| Murray Jukes                      |       | (Principal Accounting Officer)                  |       |                |
| /s/  DAMON  H. BALL     |       | Director                                        |       | April 11, 2006 |
| Damon H. Ball                     |       |                                            |       |                |
| /s/  ROBERT  E. CAMP    |       | Director                                        |       | April 11, 2006 |
| Robert E. Camp                    |       |                                            |       |                |
| /s/ ROBERT  C. HAMER III     |       | Director                                        |       | April 11, 2006 |
| Robert C. Hamer  III              |       |                                            |       |                |
| /s/  RAYMOND  C. HEMMIG |       | Director                                        |       | April 11, 2006 |
| Raymond C. Hemmig                 |       |                                            |       |                |
| /s/  GLENN  J. KREVLIN  |       | Director                                        |       | April 11, 2006 |
| Glenn J. Krevlin                  |       |                                            |       |                |
| /s/  M.  ANN RHOADES    |       | Director                                        |       | April 11, 2006 |
| M. Ann Rhoades                    |       |                                            |       |                |
| /s/  T.  MICHAEL YOUNG  |       | Director                                        |       | April 11, 2006 |
| T. Michael Young                  |       |                                            |       |                |

 

60

----

**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              |       | 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)                                                                                                                                         |
| 4.5              |       | 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)                                                                                                                                                                |
| 4.6              |       | 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)              |
| 4.7              |       | 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 with Officers  and Directors (incorporated by reference to exhibit number 10.1 of  Form 10-Q for the quarterly period ended April 30, 2005 filed  by Restoration Hardware, Inc. with the Securities and Exchange  Commission on June 9, 2005)                                                                                               |
| 10.4             |       | 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)                                          |
| 10.5             |       | 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) |

61

----

 
| 10.6  |   | 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)                                                                                                                                       |
|-------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.7  |   | 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)                                                                                                          |
| 10.8  |   | 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)                                                                                                                                                                                                                         |
| 10.9  |   | 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)                                                                                                                                                                                           |
| 10.10 |   | 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)                                                                                                                                                                            |
| 10.11 |   | 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)                                                                                                                                                                                                                                                              |
| 10.12 |   | 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)                                                                                                                                                                                             |
| 10.13 |   | 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)                                                                                                                                                                            |
| 10.14 |   | 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)                                                                                                                                     |
| 10.15 |   | 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)                                                                                                                 |
| 10.16 |   | 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)                                                                                                                                                                                            |
| 10.17 |   | 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) |

62

----

 
| 10.18 |   | 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)    |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.19 |   | 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) |
| 10.20 |   | 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)  |
| 10.21 |   | 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)                                                                                                                                                                           |
| 10.22 |   | 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)                                                                                                                                       |
| 10.23 |   | 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 10.5 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)                                                                                                                                       |
| 10.24 |   | 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)                  |
| 10.25 |   | 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)                                                                                                                                                                                                                              |
| 10.26 |   | 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)                                                                                                      |

63

----

 
| 10.27 |   | 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) |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.28 |   | 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)                                       |
| 10.29 |   | 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)                                                                          |
| 10.30 |   | 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)                                                                          |
| 10.31 |   | 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)                                                                                                                                     |
| 10.32 |   | 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)                                                                           |
| 10.33 |   | 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)                                                              |
| 10.34 |   | 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)                                                              |
| 10.35 |   | 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 10.5 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)                                                               |
| 10.36 |   | 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)                                                                                                                                                              |

64

----

 
| 10.37 |   | 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) |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.38 |   | 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)                                                                                                                                                      |
| 10.39 |   | 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)                                                                                                                                                                                 |
| 10.40 |   | 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)                                                                                                                                                                                                                       |
| 10.41 |   | 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)                                                                                                                                   |
| 10.42 |   | Amendment No. 6 to the Seventh Amended and  Restated Loan and Security Agreement dated as of July 29, 2005, among  Restoration Hardware, Inc., The Michaels Furniture Company, Inc.,  Fleet Retail Group, LLC, The CIT Group/Business Credit, Inc. and Wells  Fargo Retail Finance, LLC (incorporated by reference to exhibit number 10.1  of Form 8-K filed by Restoration Hardware, Inc. with the  Securities and Exchange Commission on August 4, 2005)                             |
| 10.43 |   | Letter Agreement dated as of July 30, 2005,  between Restoration Hardware, Inc and Holders of Series A Preferred  Stock Regarding Conversion of Series A Preferred Stock and Waiver of  Certain Rights (incorporated by reference to exhibit number 10.1 of  Form 10-Q for the quarterly period ended July 30, 2005 filed  by Restoration Hardware, Inc. with the Securities and Exchange  Commission on September 6, 2005)                                                                 |
| 10.44 |   | Employment Offer Letter, dated February 28,  2006, from Restoration Hardware, Inc. to Chris Newman                                                                                                                                                                                                                                                                                                                                                                                                              |
| 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                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |

 

65

----