##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549



FORM 10-K/A  Annual Report Pursuant to Section 13 or 15(d)

of the Securities Exchange Act of 1934(Amendment No. 2)





For the fiscal year ended FEBRUARY 2, 2002

Commission file number 000-24261



RESTORATION HARDWARE, INC.  (Exact name of registrant as
 specified in its charter)




|DELAWARE                                                        |                                      
|--------------------------------------------------------------- | -------------------------------------
|(State or
 other jurisdiction of incorporation of organization) | 68-0140361                           
|                                                                | (I.R.S.
 Employer Identification No.)
|15 KOCH ROAD, SUITE J                                           |                                      
|CORTE MADERA, CALIFORNIA                                        | 94925                                
|(Address
 of principal executive offices)                       | (Zip Code)                           

Registrants telephone
 number, including area code (415) 924-1005

Securities registered pursuant
 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) of the Act:

COMMON STOCK, $.0001 PAR VALUE

(Title of class)

Indicate by
 check mark whether the registrant (1) has filed all reports required to be filed
 by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding
 12 months (or for such shorter period that the registrant was required to file such
 reports), and (2) has been subject to such filing requirements for the past 90 days.
 [X] Yes [   ] No

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

The aggregate
 market value of common stock held by non-affiliates of the registrant was approximately
 $171,499,690 as of April 23, 2002 based upon the closing price of the registrants
 common stock on The Nasdaq National Market reported for April 23, 2002. Shares
 of common stock held by each executive officer and director and by each person who
 on that date beneficially owned more than 5% of the outstanding common stock have
 been excluded in that such persons may under certain circumstances be deemed to
 be affiliates. This determination of affiliate status is not necessarily a conclusive
 determination of affiliate status for any other purpose.

29,709,356
 shares of the registrants $.0001 par value common stock were outstanding on
 April 23, 2002.



---



##### 



TABLE OF CONTENTS






|INTRODUCTORY NOTE | 2                                                                                     
|----------------- | --------------------------------------------------------------------------------------
|PART I           
|Item 1.           | Business                                                                              
|Item 2.           | Properties                                                                            
|Item 3.           | Legal Proceedings                                                                     
|Item 4.           | Submission of Matters to a Vote of Security Holders                                   
|PART II          
|Item 5.           | Market for Registrants Common Equity and
 Related Stockholder Matters                
|Item 6.           | Selected Financial Data                                                               
|Item 7.           | Managements Discussion and Analysis of
 Financial Condition and Results of Operations
|Item 7A           | Quantitative and Qualitative Disclosures About Market Risk                            
|Item 8.           | Financial Statements and Supplementary Data                                           
|Item 9.           | Changes in and Disagreements with Accountants on
 Accounting and Financial Disclosure 
|PART III         
|Item 10.          | Directors and Executive Officers of the
 Registrant Executive Compensation            
|Item 11.          | Executive Compensation and Other Information                                          
|Item 12.          | Security Ownership of Certain Beneficial Owners
 and Management                       
|Item 13.          | Certain Relationships and Related Transactions                                        
|PART IV          
|Item 14.          | Exhibits, Financial Statement Schedules, and
 Reports on Form 8-K                     
|SIGNATURES        | 46                                                                                    
|SCHEDULE II       | 48                                                                                    
|EXHIBIT INDEX     | 49                                                                                    




INTRODUCTORY NOTE




We issued a press release on December 18,
 2002, included as an exhibit to our Form 8-K filed with the Securities and Exchange
 Commission on December 19, 2002, relating to our intention to restate our annual financial
 statements for fiscal year 2001 and the first two quarters of fiscal year 2002.
 This amendment on Form 10-K/A (Amendment No. 2) amends our annual report on Form
 10-K/A (Amendment No. 1) for the fiscal year ended February 2, 2002, as filed with the Securities
 and Exchange Commission on September 17, 2002, and is being filed to give effect to the
 restatement of our consolidated financial statements. The consolidated financial statements and Items 6, 7 and 8 in Part II of
this amended annual report on Form 10-K/A (Amendment No. 2) have been
amended to give effect to the restatement discussed in Note 13 to
the consolidated financial statements. This amendment incorporates certain revisions
 to historical financial data and related descriptions as well as certain minor typographical
 or factual corrections but is not intended to update other information presented
 in this annual report as originally filed, except where specifically noted.







This amended annual report on Form 10-K/A
 (Amendment No. 2) contains forward-looking statements that are based on the beliefs
 of, and estimates made by and information currently available to, our management.
 The words expect, anticipate, intend, plan
 and similar expressions identify forward-looking statements. These statements
 are subject to risks and uncertainties. Actual results could differ materially from
 those discussed here. Factors that could cause or contribute to such differences
 include, but are not limited to, those discussed below in Factors That May
 Affect Our Future Operating Results and elsewhere in this amended annual report
 on Form 10-K/A (Amendment No. 2). We assume no obligation to update this information.




Documents incorporated by reference: portions
 of the registrants proxy statement for its 2002 annual meeting of stockholders
 are incorporated by reference.

2



---



##### 



PART I

ITEM 1. BUSINESS

GENERAL

Our company,
 Restoration Hardware, Inc., together with our subsidiaries, is a specialty retailer
 of home furnishings, functional and decorative hardware and related merchandise
 that reflects our classic and authentic American point of view. We market our merchandise
 through retail locations, mail order catalogs and on the worldwide web at www.restorationhardware.com.
 Our merchandise strategy and our stores architectural style create a unique
 and attractive selling environment designed to appeal to an affluent, well educated
 35 to 60 year old customer. We operated 104 stores in 31 states, the District of
 Columbia and in Canada at February 2, 2002. We operate on a 52  53 week fiscal
 year ending on the Saturday closest to January 31. The 2001 fiscal year was a 52-week
 year and ended on February 2, 2002.

In addition
 to our retail stores, we operate a direct-to-customer sales channel which includes
 both catalog and Internet, and a wholly-owned furniture manufacturer.

We commenced
 business more than 20 years ago as a purveyor of fittings and fixtures for older
 homes. Since then, we have evolved into a unique home furnishings retailer offering
 consumers an array of distinctive, high quality and often hard-to-find merchandise.
 We display our broad assortment of merchandise in an architecturally inviting setting.
 We believe that we create an attractive and entertaining environment in our stores
 by virtue of our eclectic product mix, which includes classic, high-quality furniture,
 lighting, home furnishings, premium-positioned home textiles and functional and
 decorative hardware. Integral to the shopping experience, most product displays
 are complemented by our unique in-store signage program, which provides historical,
 anecdotal and sometimes nostalgic descriptions of products.

In 2001 we
 developed and initiated a repositioning plan for the company. The central component
 of this plan was the launch of a new merchandising strategy targeted for April 2002,
 which included the introduction of a number of new merchandise offerings, adjustment
 of overall product mix, and remodeling of our stores in order to best present the
 new merchandise. Other key elements of the plan included strengthening our balance
 sheet, upgrading the management team, eliminating under-performing products and
 reducing the overall number of items in the merchandise assortment, closing under-performing
 stores, and growing our direct-to-customer business. Over the course of 2001 substantial
 progress was made in each of these areas.

In the first
 quarter of 2002 we have introduced premium-positioned home textiles and new bath
 hardware collections, as well as completed the remodeling of our stores. Also in
 connection with our repositioning plan, in April 2002 we redesigned our catalog
 and website to enhance the overall customer experience.

RETAIL STORES

Merchandising Mix

We offer a
 broad but carefully edited selection of merchandise that provides a consistent point
 of view throughout our stores. Our collection of merchandise, not traditionally
 found in a single store environment, includes classic American-styled furniture,
 home furnishings, lighting, functional and decorative hardware, premium-positioned
 home textiles and discovery items. Our merchandise mix also includes proprietary
 products and hard-to-find products selected from non-traditional distribution channels
 that appear unique to our customers.

The percentage
 of total revenue contributed by major merchandising categories is as follows:



|                          |     | 2001 | 2000 | 1999 | 
|------------------------- | --- | ---- | ---- | ---- | 
|                          |     |      |     
|Home furnishings          | 45% | 45%  | 59% 
|Hardware and
 accessories | 55% | 55%  | 41% 

3



---



##### 



Product Selection, Purchasing and Sourcing

We make merchandise
 purchases from over 460 vendors. These vendors include major domestic manufacturers,
 specialty niche manufacturers and importers. We maintain agents in China, England,
 France, Japan, India, Portugal and Eastern Europe, and our merchandising team travels
 to Asia and Europe in search of new products. By sourcing products offshore, we
 seek to achieve increased buying effectiveness and ensure exclusivity for a portion
 of our product line. In many instances, we also work closely with our vendors to
 develop products which are unique to us.

DIRECT-TO-CUSTOMER  CATALOG AND INTERNET

Our catalog
 business complements our retail business by building customer awareness of a concept,
 increasing customer traffic in our stores, enhancing brand image and acting as an
 effective advertising vehicle. In addition, we maintain a website, www.restorationhardware.com,
 designed to sell our products, promote consumer awareness of Restoration Hardware
 and generate store traffic.

In fiscal
 2001, we distributed approximately 20.5 million catalogs as compared to approximately
 12 million catalogs in fiscal 2000. We mail catalogs to persons with demographic
 profiles similar to those of our retail customers and who also possess previous
 mail order purchase histories. In fiscal 2001, approximately 65% of catalogs were
 circulated to past customers, and the remaining catalogs were mailed to prospects.
 These prospects were obtained primarily from customer lists of other high-end mail
 order companies sharing similar customer demographics. We out-source the fulfillment
 aspects of the business, including telemarketing, customer service and distribution,
 to a third party located in Portland, Tennessee.

We believe
 our catalog is a key resource to further market our brand to both retail customers
 and customers outside of the retail trade areas.

THE MICHAELS FURNITURE COMPANY, INC.

Purchased
 by Restoration Hardware in 1998, Michaels offers a line of furniture for the home
 and office. Specific product lines include living room, bedroom, dining room, home
 office and accessory items. Inter-company sales to Restoration Hardware represented
 virtually all of Michaels total sales during the fiscal year ended February
 2, 2002 and this trend is expected to continue. Michaels is located in Sacramento,
 California.

MANAGEMENT INFORMATION SYSTEMS

Our retail
 management information systems include fully integrated store, merchandising, distribution
 and financial systems. We utilize STS Systems for our point-of-sale, merchandise
 management and warehouse management systems, and rely on STS for software support.
 Recently we implemented a new e-commerce application and upgraded our merchandise
 analysis tool.

COMPETITION

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

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

4



---



##### 



TRADEMARKS

We have registered
 our trademark Restoration Hardware in the United States, Mexico and
 Canada.

EMPLOYEES

At February
 2, 2002, we had approximately 1,500 full-time employees and 1,700 part-time employees.
 We consider our employee relations to be good. None of our employees are represented
 by a collective bargaining agreement, nor have we ever experienced any work stoppage.

Factors that may affect our future operating
 results

We may not be able to successfully anticipate
 changes in consumer trends and our failure to do so may lead to loss of sales revenues
 and the closing of under-performing stores.

Our success depends on our ability to anticipate
 and respond to changing merchandise trends and consumer demands in a timely manner.
 Moreover, our new management team has adopted a repositioning strategy for the company
 which includes redefining and redirecting the focus of our stores, remodeling our
 stores, increasing our direct-to-customer business, and implementing a new merchandising
 strategy which involves introducing a variety of new merchandise offerings, as well
 as adjusting the overall mix of our product offerings. We have incurred and continue
 to incur, substantial costs in implementing this repositioning strategy. This repositioning
 strategy may create a number of significant challenges for us. If, for example,
 we misjudge market trends, we may significantly overstock unpopular products and
 be forced to take significant inventory markdowns, which would have a negative impact
 on our operating results. Conversely, shortages of popular items could result in
 loss of sales revenues and have a material adverse effect on our operating results.
 Moreover, the substantial costs we have incurred in implementing our repositioning
 strategy may not generate a corresponding increase in profits to our business.

We believe there is a lifestyle trend toward
 increased interest in home renovation and interior decorating, and we further believe
 we are benefiting from such a trend. The failure of this trend to materialize or
 a decline in such a trend could adversely affect consumer interest in our major
 product lines. Moreover, our products must appeal to a broad range of consumers
 whose preferences cannot always be predicted with certainty and may change between
 sales seasons. If we misjudge either the market for our merchandise or our customers
 purchasing habits, we may experience a material decline in sales or be required
 to sell inventory at reduced margins. We could also suffer a loss of customer goodwill
 if we do not adhere to our quality control or service procedures or otherwise fail
 to ensure satisfactory quality of our products. These outcomes may have a material
 adverse effect on our business, operating results and financial condition.

In fiscal year 2001, we closed three underperforming
 stores. We anticipate closing an additional six to eight underperforming stores
 through 2004. A material decline in sales and other adverse conditions resulting
 from our failure to accurately anticipate changes in merchandise trends and consumer
 demands may require us to close additional under-performing stores. The closure
 of such stores would subject us to additional costs including, but not limited to,
 employee severance costs, charges in connection with the impairment of assets and
 costs associated with the disposition of outstanding lease obligations.

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

An important part of our efforts to achieve
 efficiencies, cost reductions and sales growth is the identification and implementation
 of improvements to our planning, logistical and distribution infrastructure and
 our supply chain, including merchandise ordering, transportation and receipt processing.
 An inability to improve our planning and control processes or to take full advantage
 of supply chain opportunities could have a material adverse effect on our operating
 results.

In addition, we have recently incurred significant
 costs to implement a new e-commerce application and upgrade our merchandise analysis
 tools. However, we cannot assure you that these changes and the substantial costs
 we incurred to effect these changes will generate a corresponding financial return
 for our business.

5



---



##### 



Because our revenues are subject to seasonal
 fluctuations, significant deviations from projected demand for products in our inventory
 during a selling season could have a material adverse effect on our financial condition
 and results of operations.

Our business is highly seasonal. We make
 decisions regarding merchandise well in advance of the season in which it will be
 sold, particularly for the holiday selling season. The general pattern associated
 with the retail industry is one of peak sales and earnings during the holiday season.
 Due to the importance of the holiday selling season, the fourth quarter of each
 year has historically contributed, and we expect it will continue to contribute,
 a disproportionate percentage of our net sales and most of our net income for the
 entire year. In anticipation of increased sales activity during the fourth quarter,
 we incur significant additional expenses both prior to and during the fourth quarter.
 These expenses may include acquisition of additional inventory, catalog preparation
 and mailing, advertising, in-store promotions, seasonal staffing needs and other
 similar items. If, for any reason, our sales were to fall below our expectations
 in November and December, our business, financial condition and annual operating
 results may be materially adversely affected.

Increased advertising expenditure without
 increased revenues may have a negative impact on our operating results.

We expend a large amount of our available
 funds on advertising in advance of a particular season. Moreover, our advertising
 costs for the past three fiscal years have increased from approximately $11.2 million
 per year to approximately $16.1 million per year, and we expect to continue to increase
 our advertising expenditures in fiscal 2002. As a result, if we misjudge the directions
 or trends in our market, we may expend large amounts of our cash on advertising
 that generates little return on investment, which would have a negative effect on
 our operating results. During the last three fiscal years, our advertising costs
 have increased while our overall revenues have declined. Accordingly, we have spent
 increasing cash on advertising without achieving overall revenue increases and,
 if this trend were to continue, it would have a negative impact on our operating
 results.

Our quarterly results fluctuate due to
 a variety of factors and are not a meaningful indicator of future performance.

Our quarterly results have fluctuated in
 the past and may fluctuate significantly in the future, depending upon a variety
 of factors, including, among other things, the mix of products sold, the timing
 and level of markdowns, promotional events, store openings, closings, remodels or
 relocations, shifts in the timing of holidays, timing of catalog releases or sales,
 competitive factors and general economic conditions. Accordingly, our profits or
 losses may fluctuate. Moreover, in response to competitive pressures, we may take
 certain pricing or marketing actions that could have a material adverse effect on
 our business, financial condition and results of operations. Therefore, we believe
 that period-to-period comparisons of our operating results are not necessarily meaningful
 and cannot be relied upon as indicators of future performance. If our operating
 results in any future period fall below the expectations of securities analysts
 and investors, the market price of our securities would likely decline.

Fluctuations in comparable store sales
 may cause our revenues and operating results from period to period to vary.

A variety of factors affect our comparable
 store sales including, among other things, the general retail sales environment,
 our ability to efficiently source and distribute products, changes in our merchandise
 mix, promotional events, the impact of competition and our ability to execute our
 business strategy efficiently. Our comparable store sales results have fluctuated
 significantly in the past, and we believe that such fluctuations may continue. Our
 comparable store sales decreased 4.6% in fiscal 2001, decreased 1% in fiscal 2000,
 and increased 0.8% in fiscal 1999. Past comparable store sales results may not be
 indicative of future results. As a result, the unpredictability of our comparable
 store sales may cause our revenues and operating results to vary quarter to quarter,
 and an unanticipated decline in revenues may cause our stock price to fluctuate.

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

We make merchandise purchases from over
 460 vendors. Our performance depends on our ability to purchase our merchandise
 in sufficient quantities at competitive prices. Although we have many sources of
 merchandise, two of our vendors, Mitchell Gold, a manufacturer of upholstered furniture,
 and Robert Abbey Inc., a manufacturer of table and floor lamps, together accounted
 for approximately 19% of our aggregate merchandise purchases in the fiscal year
 ended February 2, 2002. In addition, our smaller vendors generally have limited
 resources, production capacities and operating histories, and some of our vendors
 have limited the distribution of their merchandise in the past. We have no long-term
 purchase contracts or other contractual assurances of continued supply, pricing
 or access to new products, and any vendor or distributor could discontinue selling
 to us at any time. We may not be able to acquire desired merchandise in sufficient
 quantities on terms acceptable to us in the future, or be able to develop relationships
 with new vendors to expand our options or replace discontinued vendors. Our inability
 to acquire suitable merchandise in the future or

6



---



##### 



the loss of one or more key vendors
 and our failure to replace any one or more of them may have a material adverse effect
 on our business, results of operations and financial condition.

In addition, a single vendor supports the
 majority of our management information systems, and we have historically employed
 a single general contractor to oversee the construction of our new stores. A failure
 by the vendor to support our management information systems or by the contractor
 to provide its services adequately upon request in the future could have a material
 adverse effect on our business, results of operations and financial condition.

A disruption in any of our three distribution
 centers operations would materially affect our operating results.

The distribution functions for our stores
 are currently handled from our facilities in Hayward and Tracy, California and Baltimore,
 Maryland. Any significant interruption in the operation of any of these facilities
 may delay shipment of merchandise to our stores and customers, damage our reputation
 or otherwise have a material adverse effect on our financial condition and results
 of operations. Moreover, a failure to successfully coordinate the operations of
 these facilities also could have a material adverse effect on our financial condition
 and results of operations.

We are dependent on external funding
 sources which may not make available to us sufficient funds when we need them.

We, like other emerging-growth retailers,
 rely significantly on external funding sources to finance our operations and growth.
 Any reduction in cash flow from operations could increase our external funding requirements
 to levels above those currently available to us. While we currently have in place
 an $80.0 million credit facility, the amount available under this facility is typically
 much less than the $80.0 million stated maximum limit of the facility because the
 availability of eligible collateral for purposes of the borrowing base limitations
 in the credit facility usually reduces the overall credit amount otherwise available
 at any given time. We currently believe that the combination of the March 2001 preferred
 stock financing, the May and November 2001 common stock financings, our cash flow
 from operations and funds available under our credit facility will satisfy our capital
 requirements for at least the next 12 months. However, continued weakening of, or
 other adverse developments concerning, our sales performance or adverse developments
 concerning the availability of credit under our credit facility due to covenant
 limitations or other factors could limit the overall availability of funds to us.

In particular, we may experience cash flow
 shortfalls in the future and we may require additional external funding. However,
 we cannot assure you that we will be able to raise funds on favorable terms, if
 at all, or that future financing requirements would not be dilutive to holders of
 our capital stock. In the event that we are unable to obtain additional funds on
 acceptable terms or otherwise, we may be unable or determine not to take advantage
 of new opportunities or take other actions that otherwise may be important to our
 operations. Additionally, we may need to raise additional funds in order to take
 advantage of unanticipated opportunities. We also may need to raise additional funds
 to respond to changing business conditions or unanticipated competitive pressures.
 If we fail to raise sufficient funds, we may be required to delay or abandon some
 of our planned future expenditures or aspects of our current operations.

Because our business requires a substantial
 level of liquidity, we are dependent upon a credit facility with numerous restrictive
 covenants that limit our flexibility.

Our business requires substantial liquidity
 in order to finance inventory purchases, the employment of sales personnel for the
 peak holiday period, publicity for the holiday buying season and other similar advance
 expenses. In addition, other activities such as expenses of our direct-to-customer
 business may require additional capital expenditures. We currently have in place
 a credit facility with a syndicate of lenders, which includes, among others, Fleet
 Capital Corporation. The facility provides for an overall commitment of $80.0 million,
 of which $20.0 million is available for letters of credit. Over the past several
 years, we have entered into numerous modifications of this credit facility, primarily
 to address changes in the covenant requirements to which we are subject.

Covenants in the credit facility include,
 among others, ones that limit our ability to incur additional debt, make liens,
 make investments, consolidate, merge or acquire other businesses and sell assets,
 pay dividends and other distributions, and enter into transactions with affiliates.
 These covenants restrict numerous aspects of our business. Moreover, financial performance
 covenants require us, among other things, not to exceed particular capital expenditure
 limits. The credit facility also includes a borrowing base formula to address the
 availability of credit under the facility at any given time based upon numerous
 factors, including eligible inventory and eligible accounts receivable (subject
 to the overall maximum cap on total borrowings). Consequently, the availability
 of eligible collateral for purposes of the borrowing base formula may limit our
 ability to borrow under the credit facility.

7



---



##### 



As of February 2, 2002, we had no debt outstanding
 under our credit facility. However, we expect to draw upon the credit facility in
 the future. If we do, failure to comply with the terms of the credit facility would
 entitle the secured lenders to foreclose on our assets, including our accounts receivable,
 inventory, general intangibles, equipment, goods, fixtures and chattel paper. The
 secured lenders would be repaid from the proceeds of the liquidation of those assets
 before the assets would be available for distribution to other creditors and, lastly,
 to the holders of our capital stock. Our ability to satisfy the financial and other
 restrictive covenants may be affected by events beyond our control.

Future increases in interest and other
 expense may impact our future operations.

High levels of interest and other expense
 have had and could have negative effects on our future operations. Interest expense
 decreased $1.1 million to $4.8 million in the fiscal year ended February 2, 2002,
 from $5.9 million the fiscal year ended February 3, 2001. This decrease resulted
 from reduced debt levels, partially offset by an increase in the average interest
 rate. In the fiscal year ended February 3, 2001, interest expense increased $4.5
 million to $5.9 million from the prior year. In the fiscal year ended January 29,
 2000, interest expense increased $0.5 million to $1.4 million. The increased interest
 expense in these fiscal years resulted primarily from an increase in the average
 borrowings outstanding. In the fiscal year ended February 2, 2002, cash raised in
 various equity financings together with cash generated from operations allowed the
 Company to reduce during the course of the year the outstanding balances under its
 credit facility and to end the year with no outstanding balance under the facility.
 In addition, while our credit facility was amended in March 2001 and September 2001
 to provide us with more favorable interest rates and changes to some financial covenants,
 a substantial portion of our cash flow from operations was used to pay our interest
 expense and will not be available for other business purposes.

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

We are subject to trade restrictions
 and other risks associated with our dependence on foreign imports for our merchandise.

For the fiscal year ended February 2, 2002,
 we purchased approximately 32% of our merchandise directly from vendors located
 abroad and expect that such purchases will increase as a percentage of total merchandise
 purchases for the fiscal year ending on February 1, 2003. As an importer, our future
 success will depend in large measure upon our ability to maintain our existing foreign
 supplier relationships and to develop new ones. While we rely on our long-term relationships
 with our foreign vendors, we have no long-term contracts with them. Additionally,
 many of our imported products are subject to existing duties, tariffs and quotas
 that may limit the quantity of some types of goods which we may import into the
 United States. Our dependence on foreign imports also makes us vulnerable to risks
 associated with products manufactured abroad, including, among other things, changes
 in import duties, tariffs and quotas, loss of most favored nation trading
 status by the United States in relation to a particular foreign country, work stoppages,
 delays in shipments, freight cost increases, economic uncertainties, including inflation,
 foreign government regulations, and political unrest and trade restrictions, including
 the United States retaliating against protectionist foreign trade practices. If
 any of these or other factors were to render the conduct of business in particular
 countries undesirable or impractical, our financial condition and results of operations
 could be materially adversely affected.

While we believe that we could find alternative
 sources of supply, an interruption or delay in supply from our foreign sources,
 or the imposition of additional duties, taxes or other charges on these imports,
 could have a material adverse effect on our business, financial condition and results
 of operations unless and until alternative supply arrangements are secured. Moreover,
 products from alternative sources may be of lesser quality and/or more expensive
 than those we currently purchase, resulting in a loss of sales revenues to us.

As an importer we are subject to the
 effects of currency fluctuations related to our purchases of foreign merchandise.

While most of our purchases outside of the
 United States currently are settled in U.S. dollars, it is possible that a growing
 number of them in the future may be made in currencies other than the U.S. dollar.
 Historically, we have not hedged our currency risk and do not currently anticipate
 doing so in the future. However, because our financial results are reported in U.S.
 dollars, fluctuations in the rates of exchange between the U.S. dollar and other
 currencies may decrease our sales margins or otherwise have a material adverse effect
 on our financial condition and results of operations in the future.

8



---



##### 



Increased investments related to our
 direct-to-customer business may not generate a corresponding increase in profits
 to our business.

We have invested additional resources in
 the expansion of our direct-to-customer business which could increase the risks
 associated with aspects of this business. In fiscal year 2001, sales through our
 direct-to-customer channel grew by 49 percent. Increased activity in our direct-to-customer
 business could result in material changes in our operating costs, including increased
 merchandise inventory costs and costs for paper and postage associated with the
 distribution and shipping of catalogs and product. Although we intend to attempt
 to mitigate the impact of these increases by improving efficiencies, we cannot assure
 you that we will succeed in mitigating expenses with increased efficiency or that
 cost increases associated with our direct-to-customer business will not have an
 adverse effect on the profitability of our business. Additionally, while we out-source
 the fulfillment of our direct-to-customer division, including telemarketing, customer
 service and distribution, to a third party, the third party may not have the capacity
 to accommodate our growth. This lack of capacity may result in delayed customer
 orders and deficiencies in customer service, both of which may adversely affect
 our reputation and cause us to lose sales revenue.

Our success is highly dependent on new
 manufacturers and suppliers with whom we do not have a long history working together.

In connection with our repositioning strategy,
 we are implementing a new merchandising strategy which will entail changing the
 nature and types of the many products that we sell. We anticipate changes in some
 of the manufacturers and suppliers of our products. Many of these manufacturers
 and suppliers will be new to us, and many of them will be located abroad. We cannot
 assure you that they will be reliable sources of our products. Moreover, these manufacturers
 and suppliers may be small and undercapitalized firms which produce limited numbers
 of items. Given their limited resources, these firms might be susceptible to production
 difficulties, quality control issues and problems in delivering agreed-upon quantities
 on schedule. We cannot assure you that we would be able, if necessary, to return
 products to these suppliers and obtain refunds of our purchase price or obtain reimbursement
 or indemnification from them if their products prove defective. These suppliers
 and manufacturers also may be unable to withstand the current downturn in the U.S.
 or worldwide economy. Significant failures on the part of these new suppliers or
 manufacturers could have a material adverse effect on our operating results.

In addition, many of these suppliers and
 manufacturers will require extensive advance notice of our requirements in order
 to produce products in the quantities we desire. This long lead time requires us
 to place orders far in advance of the time when certain products will be offered
 for sale, thereby exposing us to risks relating to shifts in customer demands and
 trends, and any downturn in the U.S. economy.

We depend on key personnel and could
 be affected by the loss of their services because of the limited number of qualified
 people in our industry.

The success of our business will continue
 to depend upon our key personnel, including our President and Chief Executive Officer,
 Mr. Gary G. Friedman. During the last year, we have experienced significant turnover
 in our executive staff, including the departure of our Chief Operating Officer and
 Chief Financial Officer. We have hired a new Chief Financial Officer, a new Chief
 Operating Officer and a number of other new executive personnel. Eight out of our
 twelve vice presidents are new. Although we believe that the hiring of such personnel
 will offer an opportunity to expand our management team with persons that can assist
 in implementing our new direction, turnover in personnel and the recruitment and
 retention of a new executive staff created a number of significant challenges for
 us. For instance, the responsibilities of the Chief Financial Officer include budgeting,
 financial forecasting and related areas of financial management. We have experienced
 transitional difficulties in administration in these areas in connection with the
 departure of our former Chief Financial Officer. However, the retention of our new
 Chief Financial Officer has allowed us to move rapidly to address these transitional
 issues. In so doing, we have discovered related and unrelated problems which we
 have been obligated to address and resolve and in certain cases, which we continue
 to work through. In particular, we are continuing to evaluate the various procedures
 used in our accounting systems and as a part of this evaluation we will implement
 such changes as necessary.

Additionally, competition for qualified
 employees and personnel in the retail industry is intense. The process of locating
 personnel with the combination of skills and attributes required to carry out our
 goals is often lengthy. Our success depends to a significant degree upon our ability
 to attract, retain and motivate qualified management, marketing and sales personnel,
 in particular store managers, and upon the continued contributions of these people.
 We cannot assure you that we will be successful in attracting and retaining qualified
 executives and personnel. In addition, our employees may voluntarily terminate their
 employment with us at any time. We also do not maintain any key man life insurance.
 The loss of the services of key personnel or our failure to attract additional qualified
 personnel could have a material adverse effect on our business, financial condition
 and results of operations.

9



---



##### 



Rapid growth of our company coupled with
 change in general economic conditions has impacted our profitability.

In fiscal years 1999 and 2000, we experienced
 rapid growth and, as a result, our costs and expenditures outpaced our revenues.
 Following this growth, the economy in the United States of America began to weaken.
 The combination of these two factors affected our profitability. As a result of
 these factors in fiscal years 1999, 2000 and 2001, we were not profitable. If similar
 factors continue to operate unmitigated, there will be a material adverse effect
 on our business, operating results and financial condition.

Changes in general economic conditions
 affect consumer spending and may significantly harm our revenues and results of
 operations.

We believe that general trends in the economy
 have adversely affected retail sales, and that we may continue to be hurt by such
 trends. In particular, a weakening environment for retail sales could adversely
 affect consumer interest in our major product lines. Our comparable store sales
 decreased 4.6% for the fiscal year ended February 2, 2002. Additionally, in fiscal
 years 2001, 2000 and 1999, we were not profitable. The success of our business depends
 to a significant extent upon the level of consumer spending. A number of economic
 conditions affect the level of consumer spending on merchandise that we offer, including,
 among other things, the general state of the economy, general business conditions,
 the level of consumer debt, interest rates, taxation and consumer confidence in
 future economic conditions. More generally, reduced consumer confidence and spending
 may result in reduced demand for our products and limitations on our ability to
 increase prices, and may also require increased levels of selling and promotional
 expenses. Adverse economic conditions and any related decrease in consumer demand
 for discretionary items such as those offered by us could have a material adverse
 effect on our business, results of operations and financial condition.

We face an extremely competitive specialty
 retail business market.

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

Terrorist attacks and threats or actual
 war may negatively impact all aspects of our operations, revenues, costs and stock
 price.

Recent terrorist attacks in the United States,
 as well as future events occurring in response or connection to them, including,
 without limitation, future terrorist attacks or threats against United States targets,
 rumors or threats of war, actual conflicts involving the United States or its allies
 or military or trade disruptions affecting our domestic or foreign suppliers of
 merchandise, may impact our operations. The potential impact to our operations includes,
 among other things, delays or losses in the delivery of merchandise to us and decreased
 sales of the products we carry. Additionally, any of these events could cause consumer
 confidence and spending to decrease or result in increased volatility in the U.S.
 and worldwide financial markets and economy. They also could result in economic
 recession in the U.S. or abroad. Any of these occurrences could have a significant
 impact on our operating results, revenues and costs and may result in the volatility
 of the market price for our common stock and on the future price of our common stock.

Our common stock price may be volatile.

The market price of our common stock has
 fluctuated significantly in the past, and is likely to continue to be highly volatile.
 In addition, the trading volume in our common stock has fluctuated, and significant
 price variations can occur as a result. We cannot assure you that the market price
 of our common stock will not fluctuate or decline significantly in the future. In
 addition, the U.S. equity markets have from time to time experienced significant
 price and volume fluctuations that have particularly affected the market prices
 for the stocks of emerging-growth companies. These broad market fluctuations may
 materially adversely affect the market price of our common stock in the future.
 Such variations may be the result of changes in the trading characteristics that
 prevail in the market for our common stock, including low trading volumes, trading
 volume fluctuations and other similar factors that are particularly common among
 highly volatile securities of emerging-growth companies. Variations also may be
 the result of changes in our business, operations or prospects, announcements or
 activities by our competitors, entering into new contractual relationships with
 key

10



---



##### 



suppliers or manufacturers by us or our competitors, proposed acquisitions by
 us or our competitors, financial results that fail to meet public market analysts
 expectations, changes in stock market analysts recommendations regarding
 us, other retail companies or the retail industry in general, and domestic and international
 market and economic conditions.

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

We cannot predict the effect, if any, that
 future sales of shares of our common stock or the availability for future sale of
 shares of our common stock or securities convertible into or exercisable for our
 common stock will have on the market price of our common stock prevailing from time
 to time. For example, in connection with our May 2001 common stock financing, we
 filed a registration statement on Form S-3 with the Securities and Exchange Commission
 on June 1, 2001 to register approximately 4.5 million shares of our common stock
 acquired by the investors in the financing. The registration statement became effective
 on July 6, 2001. Additionally, in connection with our March 2001 preferred stock
 financing, we filed a registration statement on Form S-3 with the Securities and
 Exchange Commission to register up to 6.8 million shares of our common stock issued,
 or to be issued upon the conversion of our Series A preferred stock, to the investors
 in the financing. And, in connection with our November 2001 common stock financing,
 we filed a registration statement on Form S-3 with the Securities and Exchange Commission
 to register approximately 4.5 million shares of our common stock issued to the investors
 in the financing. Sale, or the availability for sale, of substantial amounts of
 common stock by our existing stockholders pursuant to an effective registration
 statement or under Rule 144, through the exercise of registration rights or the
 issuance of shares of common stock upon the exercise of stock options, or the conversion
 of our preferred stock, or the perception that such sales or issuances could occur,
 could adversely affect prevailing market prices for our common stock and could materially
 impair our future ability to raise capital through an offering of equity securities.

We are subject to anti-takeover provisions
 and the terms and conditions of our preferred stock financing that could delay or
 prevent an acquisition and could adversely affect the price of our common stock.

Our Second Amended and Restated Certificate
 of Incorporation, as amended and Amended and Restated Bylaws, certain provisions
 of Delaware law and the certificate of designation governing the rights, preferences
 and privileges of our preferred stock may make it difficult in some respects to
 cause a change in control of our company and replace incumbent management. For example,
 our Second Amended and Restated Certificate of Incorporation, as amended and Amended
 and Restated Bylaws provide for a classified board of directors. With a classified
 board of directors, at least two annual meetings of stockholders, instead of one,
 will generally be required to effect a change in the majority of the board. As a
 result, a provision relating to a classified board may discourage proxy contests
 for the election of directors or purchases of a substantial block of our common
 stock because its provisions could operate to prevent obtaining control of the board
 in a relatively short period of time.

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

In addition, our board of directors has
 the authority to fix the rights and preferences of, and to issue shares of, our
 preferred stock, which may have the effect of delaying or preventing a change in
 control of our company without action by holders of our common stock.

ITEM 2. PROPERTIES

We currently
 lease three properties located in Corte Madera, California, which are used as our
 headquarters. The first property in Corte Madera consists of approximately 3,600
 square feet of office space and approximately 11,000 square feet of warehouse space.
 The lease expires on December 31, 2003. The second and third properties in Corte
 Madera consist of approximately 30,000 square feet of office space in total and
 the leases expire on May 15, 2003.

11



---



##### 



We lease approximately
 160,000 square feet of warehouse space in Hayward, California, for use as our west
 coast distribution center. This lease expires on July 31, 2004, with an option to
 extend for one additional five-year term. We lease an additional 191,000 square
 feet of warehouse space in Tracy, California, also for use as a distribution center.
 This lease expires on September 1, 2003. We lease approximately 276,000 square feet
 of warehouse space in Baltimore, Maryland, for use as our east coast distribution
 center. The lease expires on September 30, 2006, with options to extend for two
 additional three-year terms.

As of February
 2, 2002, we leased approximately 1,187,000 gross square feet for our 104 retail
 stores. Our retail stores lease terms range from 10 to 15 years. Most leases
 for our retail stores provide for a minimum rent, typically including escalating
 rent increases, plus a percentage rent based upon sales after certain minimum thresholds
 are achieved. The leases generally require us to pay insurance, utilities, real
 estate taxes, and repair and maintenance expenses.

Michaels leases
 two properties used for the manufacturing and storage of furniture, in Sacramento,
 California. The main property consists of approximately 100,000 square feet of manufacturing
 space and 7,000 square feet of office space. The lease expires on February 28, 2008,
 with options to extend the lease for two additional 5-year terms. The second property
 consists of approximately 46,000 square feet of warehouse space which is used to
 house finished upholstered goods. This lease expires on July 31, 2006.

ITEM 3. LEGAL PROCEEDINGS

There are
 no material pending legal proceedings against us. We are, however, involved in routine
 litigation arising in the ordinary course of our business. We believe that the final
 outcome of such proceedings should not have a material adverse effect on our consolidated
 financial condition or results of operations. However, we cannot assure you that
 the result of any proceeding will be in our favor.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE
 OF SECURITY HOLDERS

No matters
 were submitted to a vote of security holders during the fourth quarter of the fiscal
 year covered by this annual report other than a request for approval by the holders
 of our Series A preferred stock in connection with our November 6, 2001 common stock
 financing transaction. With regard to this approval, we held, on November 5, 2001,
 a special meeting of holders of our Series A preferred stock. As of the date of
 the special meeting, we had 15,000 shares of our Series A preferred stock outstanding
 and entitled to vote on the proposal presented at the special meeting, held by 17
 stockholders of record. Of these outstanding shares, 91.5% or 13,730 shares of Series
 A preferred stock were represented at such meeting, which constituted a quorum.
 The matter voted upon at the special meeting was the approval, pursuant to the requirements
 of our certificate of designation, of a financing transaction in an amount of not
 more than $17.5 million, which financing would be obtained by the issuance of our
 common stock at a price per share between $3.75 and $3.90 and which might involve
 a holder of 5% or greater of our outstanding shares of common stock and common stock
 equivalents, a holder of our preferred stock or their respective affiliates. The
 result of the voting as to such matter was as follows:



|       | For | Against | Abstentions | Broker
 Non-Votes | 
|------ | --- | ------- | ----------- | ----------------- | 
|       |     |         |            
|13,730 | 0   | n/a     | n/a        



12



---



##### 



PART II

ITEM 5. MARKET FOR REGISTRANTS COMMON
 EQUITY AND RELATED STOCKHOLDER MATTERS

MARKET INFORMATION

Our common
 stock is listed on The Nasdaq National Market under the symbol RSTO.
 The closing price of our common stock on Nasdaq was $11.76 on April 23, 2002.

STOCKHOLDERS

The number
 of our common stockholders of record as of April 23, 2002 was 206. This number excludes
 stockholders whose stock is held in nominee or street name by brokers.

DIVIDEND POLICY

No dividends
 have been declared on our common stock since our 1998 initial public offering and
 it is not anticipated that we will pay any dividends in the foreseeable future on
 our common stock.

STOCK PRICE INFORMATION

Set forth
 below are the high and low closing sale prices for shares of our common stock for
 each quarter during the fiscal years ended February 2, 2002 and February 3, 2001
 as reported by The Nasdaq National Market.



|QUARTER
 ENDING   | HIGH |       | LOW
|----------------- | ---- | ----- | ---
|                  |      |       |    
|January 29,
 2000 | $    | 10.38 |    
|April 29,
 2000   |      | 7.00  |    
|July 29, 2000     |      | 6.44  |    
|October 28,
 2000 |      | 6.00  |    
|February 3,
 2001 |      | 2.94  |    
|May 5, 2001       |      | 6.12  |    
|August 4,
 2001   |      | 7.25  |    
|November 3,
 2001 |      | 4.83  |    
|February 2,
 2002 |      | 10.50 |    



13



---



##### 



ITEM 6. SELECTED FINANCIAL DATA

The following
 table sets forth selected, consolidated financial information for operations for
 the years indicated. This information is qualified by reference to and should be
 read in conjunction with Managements Discussion and Analysis of Financial
 Condition and Results of Operations, the consolidated financial statements,
 related notes thereto and other financial data included elsewhere in this annual
 report. The following results may not be indicative of our future operating results.






|                                                                        | Fiscal
2001     |          | Fiscal
2000 (2) |  | Fiscal
1999 |         | Fiscal
1998 (1) |  | Fiscal
1997
|----------------------------------------------------------------------- | --------------- | -------- | --------------- |  | ----------- | ------- | --------------- |  | -----------
|                                                                        |                 |          |                 |  |             |         |                 |  |            
|                                                                        | As Restated
(5) |          |                 |  |             |         |                 |  |            
|Results
 of Operations (Dollars in thousands except per share amounts): |                 |          |                 |  |             |         |                 |  |            
|Net sales                                                               | $               | 366,473  |                 |  | $           | 366,236 |                 |  | $          
|Earnings (loss) before income taxes                                     |                 | (42,232  | )               |  |             | (5,977  | )               |  |            
|Net earnings (loss)                                                     |                 | (33,025  | )               |  |             | (4,560  | )               |  |            
|Net earnings
 (loss) available to common shareholders                   |                 | (35,842  | )               |  |             | (4,560  | )               |  |            
|Basic EPS                                                               |                 | (1.53    | )               |  |             | (0.27   | )               |  |            
|Diluted EPS                                                             |                 | (1.53    | )               |  |             | (0.27   | )               |  |            
|Financial Position:                                                     |                 |          |                 |  |             |         |                 |  |            
|Working capital                                                         |                 | 51,362   |                 |  |             | 36,196  |                 |  |            
|Total assets                                                            |                 | 206,742  |                 |  |             | 233,871 |                 |  |            
|Debt
 and other liabilities                                             |                 | 3,236 (4 | )               |  |             | 39,470  |                 |  |            
|Redeemable
 convertible preferred stock                                 |                 | 14,106   |                 |  |             |        |                 |  |            
|Stockholders equity                                                    |                 | 88,986   |                 |  |             | 78,875  |                 |  |            
|Retail Stores:                                                          |                 |          |                 |  |             |         |                 |  |            
|Store count                                                             |                 | 104      |                 |  |             | 106     |                 |  |            
|Comparable store
 sales growth (3)                                      |                 | (4.6     | %)              |  |             | (1.0    | %)              |  |            
|Store
 selling sq. ft. at year-end                                      |                 | 682,936  |                 |  |             | 701,628 |                 |  |            






|    |                                                                                                                                                                                                                                                                         
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The results
 of operations for 1998 include the results of Michaels from the date of acquisition
 on March 20, 1998.                                                                                                                                                    
|    |                                                                                                                                                                                                                                                                         
|(2) | Fiscal 2000
 was a 53-week year. For purposes of the calculation of comparable store growth,
 results were calculated to correspond with 52-week fiscal year.                                                                                                           
|    |                                                                                                                                                                                                                                                                         
|(3) | Comparable
 store sales are defined as sales from stores whose gross square feet did not change
 by more than 20% in the previous 12 months and which have been open at least 12
 full months. Stores generally become comparable in their 14th full month of operation.
|    |                                                                                                                                                                                                                                                                         
|(4) | As of February
 2, 2002, we had no outstanding bank debt.                                                                                                                                                                                                               
|    |                                                                                                                                                                                                                                                                         
|(5) | See
Note 13 to the consolidated financial statements.                                                                                                                                                                                                                   



|ITEM 7. | MANAGEMENTS
 DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- | --------------------------------------------------------------------------------------

The
following managements discussion and analysis of financial
condition and results of operations gives effect to the restatement
discussed in Note 13 to the consolidated financial
statements.

RESULTS OF OPERATIONS

Net Sales

Net sales
 consist of the following components:



|                         | 2001                   |         | % OF
TOTAL |  | 2000 |       | % OF
TOTAL |  | 1999 |         | % OF
TOTAL
|------------------------ | ---------------------- | ------- | ---------- |  | ---- | ----- | ---------- |  | ---- | ------- | ----------
|                         |                        |         |            |  |      |       |            |  |      |         |           
|                         | (Dollars in thousands)
|Retail sales             | $                      | 332,783 |            |  |      | 90.8  | %          |  | $    | 342,687 |           
|Direct-to-customer       |                        | 33,647  |            |  |      | 9.2   | %          |  |      | 22,554  |           
|Furniture
 manufacturing |                        | 43      |            |  |      |      |            |  |      | 995     |           
|                         |                        |         |            |  |      |       |            |  |      |         |           
|Total net sales          | $                      | 366,473 |            |  |      | 100.0 | %          |  | $    | 366,236 |           
|                         |                        |         |            |  |      |       |            |  |      |         |           

14



---



##### 



Net sales
 for the 52 weeks ended February 2, 2002 (fiscal 2001), increased $0.2
 million or 0.1% over net sales for the 53 weeks ended February 3, 2001 (fiscal
 2000). Net sales for fiscal 2000 increased $67.3 million, or 22.5%, over net
 sales for the 52 weeks ended January 29, 2000 (fiscal 1999). The furniture
 manufacturing sales include only those sales to employees of The
Michaels Furniture Company, Inc. and third parties. Total net sales include
 shipping fees of $7.1 million, $5.7 million and $4.0 million for fiscal 2001, fiscal
 2000, and fiscal 1999, respectively. As of February 2, 2002, we operated 104 stores
 in 31 states, the District of Columbia and Canada.

Retail Sales



|                                       | 2001                                                                      |         | 2000 |  | 1999
|-------------------------------------- | ------------------------------------------------------------------------- | ------- | ---- |  | ----
|                                       |                                                                           |         |      |  |     
|                                       | (in thousands except percentages, sq. ft.amounts
 and retail stores data)
|Retail sales                           | $                                                                         | 332,783 |      |  | $   
|Retail
 growth percentage              |                                                                           | (2.9    | %)   |  |     
|Comparable store
 sales growth         |                                                                           | (4.6    | %)   |  |     
|Number of stores
 at beginning of year |                                                                           | 106     |      |  |     
|Number of stores opened                |                                                                           | 1       |      |  |     
|Number of stores closed                |                                                                           | 3       |      |  |     
|Number of stores at year-end           |                                                                           | 104     |      |  |     
|Store selling sq. ft. at year-end      |                                                                           | 682,936 |      |  |     

Retail sales
 decreased 2.9% in fiscal 2001 as compared to the prior year, primarily due to a
 4.6% decrease in comparable store sales and the closure of three underperforming
 stores. As further discussed in Liquidity and Capital Resources, below,
 in the first and second quarters of fiscal 2001, we received cash proceeds from
 a third party to cancel leases and close three of our underperforming stores. The
 cash proceeds received of $5.3 million approximated the net book value of the assets
 that were written off as a part of the store closures.

Over the second
 half of fiscal 2001, as part of our repositioning strategy, we reduced the number
 of items in our merchandise assortment by 30%, from approximately 7,000 to approximately
 5,000 items. In connection with this process, under-performing products were eliminated
 and new products were introduced, resulting in the introduction of approximately
 60% new product in the first quarter of fiscal 2002.

Retail sales
 in fiscal 2000 increased 22.7% as compared to the prior year, primarily due to new
 store openings.

Comparable
 store sales are defined as sales from stores whose gross square feet did not change
 by more than 20% in the previous 12 months and which have been open at least 12
 full months. Stores generally become comparable in their 14th full month of operation.
 In any given period, the set of stores comprising comparable stores may be different
 from the set of the comparable stores in the previous period, depending on when
 stores were opened.

Direct-to-customer

Direct-to-customer
 sales consist of catalog and Internet sales. Net direct-to-customer sales in fiscal
 2001 increased $11.1 million or 49.2% as compared to fiscal 2000. Total catalogs
 mailed in fiscal 2001 increased to 20.5 million, as compared to approximately 12
 million catalogs in fiscal 2000.

Of the total
 catalogs mailed in fiscal 2001, 12.2 million were mailed into our retail trade areas,
 versus 4.9 million in the prior year. We believe that the strategy of mailing catalogs
 into retail trade areas increases customer traffic in

our stores and enhances the overall brand
 image. In April 2002, in connection with our repositioning strategy, we redesigned
 our catalog and launched a new website to enhance the overall customer experience.

Net direct-to-customer
 sales in fiscal 2000 increased $9.8 million as compared to fiscal 1999. Approximately
 half of the increase was from sales from our website, which was launched in August
 1999. Total catalogs mailed in fiscal 2000 increased to 12.2 million, from 7.2 million
 in fiscal 1999.

15



---



##### 



Furniture Manufacturing




We own a wholly-owned
 furniture manufacturing company located in Sacramento, California, The Michaels
 Furniture Company (Michaels). The large majority of furniture produced at Michaels
 is sold through the Companys sales channels. Additionally, since we acquired
 Michaels, there have been sales of Michaels furniture to third party customers.
 Over the past 3 years, we have significantly reduced these sales to third parties
 in order to increase production capacity for inter-segment sales. Inter-segment
 sales to Restoration Hardware represented virtually all of Michaels total
 sales during fiscal 2001, and this trend is expected to continue.




COST OF SALES AND OCCUPANCY




In fiscal
 2001, cost of sales and occupancy expenses expressed as a percentage of net sales
 increased 9.0% to 78.3% from 69.3% in fiscal 2000.







In the fourth
 quarter of fiscal 2001 we had charges due to special items totaling $17.5 million
 which accounted for 4.8% of the 9.0% increase in the cost of sales expressed as
 a percentage of net sales. These charges included: a $5.3 million charge to reduce
 certain inventory being eliminated in our repositioning strategy to its net realizable
 value, a $2.0 million accelerated depreciation charge related to reduced lives of
 certain long-lived assets being replaced in our Spring 2002 store remodel program,
 and a $10.2 million charge related to the write-down of long-lived assets in eight
 under-performing stores. These charges are further discussed below in the section
 Special Items.




Merchandise
 markdown and clearance activity associated with our repositioning strategy resulted
 in a 5.2% deterioration in merchandise margins. Partially offsetting these negative
 factors, the cost of sales component which pertains to buying and distribution costs
 expressed as a percent of sales improved 0.6% in fiscal 2001 as compared to fiscal
 2000, primarily as a result of lower freight expense to our stores, and lower payroll
 in our distribution centers.

In fiscal
 2000, cost of sales and occupancy expressed as a percentage of sales remained unchanged
 at 69.3% compared to the fiscal 1999. Merchandise margin improvements in fiscal
 2000 as a result of better sourcing and product flow were offset by higher occupancy
 costs.

SELLING, GENERAL AND ADMINISTRATIVE

Selling, general
 and administrative expenses expressed as a percentage of net sales increased 0.5%
 to 31.3% in fiscal 2001 from 30.8% in fiscal 2000. The increase is largely due to
 increased marketing and fulfillment charges in the direct-to-customer division,
 increased professional fees associated with our repositioning strategy and increased
 health and benefit costs for our employees. Selling, general and administrative
 expenses expressed as a percentage of net sales decreased 1.0% to 30.8% in fiscal
 2000 from 31.8% in fiscal 1999. The decrease was primarily attributable to improvements
 store payroll and other store controllable expenses.

INTEREST EXPENSE AND INTEREST INCOME

Interest expense
 includes interest related to the amortization of debt issuance costs and interest
 on borrowings under our line of credit facility. In fiscal 2001, such interest expense
 was $4.8 million as compared to $5.9 million in fiscal 2000. After eliminating non-cash
 interest charges related to amortization of debt issuance costs for both fiscal
 years, interest expense was $3.1 million for fiscal 2001 as compared to $5.1 million
 for fiscal 2000, a decrease of $2.0 million.

The decrease
 resulted from the amendments of our credit facility to provide for more favorable
 interest rates and a reduction in debt made possible by the $56.0 million (net of
 fees) raised in our preferred and common stock financings in fiscal 2001, as discussed
 below.

We completed
 three financing transactions in fiscal 2001. In March 2001, we completed a preferred
 stock financing, appointed a new Chief Executive Officer, and amended our credit
 facility. In May and November, we completed two common stock financings. Combined
 net proceeds from our preferred stock and common stock transactions of $56.0 million
 (net of fees) were used to pay down our revolving line of credit and for other general
 corporate purposes. As a result, average borrowings in fiscal 2001 decreased to
 $23.6 million from $48.4 million in fiscal 2000. The average interest rate during
 the same period increased from 11.2% to 12.6%, primarily as a result of two high-interest
 term loans that were part of the amendment of the credit facility in September 2000.
 Until the anniversary of the amendment in September of fiscal 2001, the existence
 of these term loans negatively impacted our average interest rate in fiscal 2001
 as compared to the prior year. The two term loans were paid off in the second and
 fourth quarters of fiscal 2001.

16



---



##### 



In fiscal
 2000, interest expense was $5.9 million as compared to $1.4 million in fiscal 1999,
 an increase of $4.5 million. During fiscal 2000 our average borrowings outstanding
 increased to $48.4 million from $20.8 million in fiscal 1999. Interest expense in
 fiscal 2000 included $0.7 million of amortization of debt issuance costs.

Interest income,
 which consists of income from our short-term investments and notes receivable, increased
 $0.2 million in fiscal 2001 as compared to fiscal 2000. The majority of the increase
 was due to interest on a $2.05 million loan we provided to Mr. Friedman in connection
 with his purchase of common stock and preferred stock in March 2001. Interest income
 in fiscal 2000 increased $0.1 million as compared to fiscal 1999.

INCOME TAXES




The fiscal
 2001 income tax benefit included a valuation allowance charge of $7 million, as
 more further discussed in Critical Accounting Policies below. After
 adjusting for this charge, our effective tax benefit rate was 21.8% in fiscal 2001,
 as compared to a tax benefit rate of 37.4% in fiscal 2000 and a tax provision rate
 of 36.3% in fiscal 1999. These rates reflect the effect of aggregate state tax rates
 based on a mix of retail sales and direct-to-customer sales in the various states
 in which we have sales revenue or conduct business.




SPECIAL ITEMS

Fiscal 2001
 included special item charges of approximately $24.5 million. A discussion of these
 charges follows.

Inventory
 lower of cost or market reserve  In connection with the elimination of approximately
 30% of the items from our merchandise assortment, we recorded a charge of $5.3 million
 to write down discontinued merchandise at year-end to its estimated net realizable
 value.

Accelerated
 depreciation  At the beginning of the fourth quarter 2001, concurrent with
 our November, 2001 private placement of common stock, we finalized our decision
 to remodel our stores in the first quarter of fiscal 2002. As a result, we recorded
 an accelerated depreciation charge of $2.0 million in order to reflect the shortened
 useful life of store fixtures and leasehold assets which were scheduled to be replaced.

Asset impairment
 charge  In the course of performing our periodic cash flow analysis of our
 mature stores, we determined that an asset impairment charge of $10.2 million was
 required for eight underperforming locations. The impairment charge was calculated
 as the difference between the net book value of the stores long-lived assets
 and the present value of the stores estimated future cash flows over the remaining
 life of the lease.

Tax Valuation
 Allowance  In the course of analyzing our projected taxable income, we determined
 that a valuation allowance of $7.0 million against our deferred tax assets was appropriate.
 The valuation allowance reduced our deferred tax assets to an amount that is more
 likely than not to be realized.

LIQUIDITY AND CAPITAL RESOURCES

Operating Cash Flows:

In fiscal
 2001, net cash provided by operating activities decreased $15.1 million to $4.3
 million, from $19.4 million in fiscal 2000. Cash decreased largely because of the
 following factors: the increased net losses resulting from a deterioration in merchandise
 margins due to increased cost of sales associated with our repositioning strategy;
 increased cash use in reducing accounts payable and other accrued expenses; and
 a reduction in cash provided from deferred lease incentives. These factors were
 partially offset by a reduction in the investment in inventory as a result of lower
 inventory balances, and a reduction in accounts receivable.

In fiscal
 2000, net cash provided by operating activities increased $15.1 million, to $19.4
 million from $4.3 million in fiscal 1999. Cash increased largely because of a reduction
 during fiscal 2000 in the use of cash for building merchandise inventories, and
 improved operating margins before depreciation expense resulting from expense reductions.
 These factors were partially offset by reductions in cash provided from deferred
 lease incentives, and an increased use of cash in reducing accounts payable and
 other accrued expenses.

17



---



##### 



Investing Cash Flows:

Net cash from
 investing activities increased $25.1 million, to a source of cash of $1.5 million
 in fiscal 2001, from a use of cash of $23.6 million in fiscal 2000. The majority
 of the change is due to a reduction in capital expenditures as a result of opening
 only one store in fiscal 2001 as compared to 13 in fiscal 2000. Additionally, in
 fiscal 2001, we entered into agreements with a third party to cancel leases and
 close three of our under-performing locations, for which we received $5.3 million.

Net cash used
 in investing activities decreased $23.6 million, to $23.6 million in fiscal 2000
 from $47.2 million in fiscal 1999, primarily due to a decrease in the number of
 new stores. In fiscal 2000, 13 new stores were added as compared to 28 stores in
 fiscal 1999.

In connection
 with our repositioning strategy, in the first quarter of 2002 we remodeled our stores
 and launched a new website. Capital expenditures for these projects are expected
 to total approximately $15 million.

Financing Cash Flows:

Net cash provided
 by financing activities increased $11.6 million, to $13.8 million in fiscal 2001
 from $2.2 million in fiscal 2000. In March of 2001, we completed a preferred stock
 financing, appointed a new Chief Executive Officer and amended our credit facility.
 In May and November of 2001, we completed two common stock financings with various
 institutional investors. Combined net proceeds from our preferred stock financing
 and common stock transactions were $56.0 million and were used primarily to pay
 down our line of credit and for other general corporate purposes.

In fiscal
 2000, net cash provided by financing activities decreased $37.1 million to $2.2
 million from $39.3 million in fiscal 1999, principally due to reduced borrowings
 under our line of credit.

On March 21,
 2001, we amended our existing credit facility. The amendment reduced the overall
 commitment under the line of credit from $111 million to $89 million, increased
 the amounts available for letters of credit from $10 million to $20 million and
 eliminated the minimum earnings before interest, taxes, depreciation and amortization
 (EBITDA) requirement. Additionally, the borrowing base calculation was
 modified to provide us with more available borrowings due to the pledge of additional
 collateral, and the interest rate was reduced by 0.25%, with possible additional
 reductions based on achievement of future EBITDA. The amended credit facility contains
 minimum availability requirements based on seasonality.

The amended
 credit facility included two high-interest term loans. The first of these term loans
 was paid off in the second quarter of fiscal 2001. In September 2001, the credit
 facility was further amended to provide for more favorable interest rates on the
 remaining term loan. This loan was paid off in January 2002.

As a result
 of the paydowns of the term loans, as of February 2, 2002 the maximum availability
 under the facility was $80.0 million, with amounts available for letters of credit
 up to $20 million. Availability under the credit facility is limited by reference
 to a borrowing base calculation, based upon eligible inventory and accounts receivable.
 The amount available under the credit facility is typically much less than the $80.0
 million stated maximum limit of the facility (as of February 2, 2002 the total borrowing
 base available was approximately $30 million). The agreement contains restrictive
 covenants including annual capital expenditure limits, minimum inventory levels,
 limitations on store openings and closings, and prohibitions on dividends. As of
 February 2, 2002, we had no loans outstanding, and $13.3 million in outstanding
 letters of credit. Interest is paid monthly at the banks reference rate or
 LIBOR plus a margin. The agreement expires on June 30, 2003.

In connection
 with an amendment to our line of credit in September 2000, we issued putable warrants
 for the purchase of 550,000 shares of our common stock, subject to anti-dilution
 protections at $3.75 per share. In connection with the amendment of the credit facility
 in March 2001, 200,000 of the 550,000 warrants were repriced to $2.00 per share.
 The fair value of the warrants is calculated each quarter using the Black-Scholes
 model. The following assumptions were used in our calculation as of February 2,
 2002: expected life of 20 months, stock volatility considered to be 50%, risk free
 interest rate of 2.28%, and no dividends during the expected term. For fiscal 2001,
 the mark-to-market revaluation of the warrants resulted in a charge of approximately
 $2.7 million against earnings. The warrants expire on September 27, 2005. As of
 February 2, 2002 warrants for the purchase of approximately 405,000 shares of common
 stock remained outstanding. During the first quarter of fiscal 2002, all of the
 remaining warrants were exercised.

While we currently believe that our cash
 flow from operations, proceeds received from our various equity financings in fiscal
 2001 and funds available under our credit facility will satisfy our capital requirements
 for at least the next 12 months, adverse developments

18



---



##### 



concerning our sales performance
 or the availability of credit under our credit facility due to covenant limitations
 or other factors could limit the overall availability of funds to us. Moreover,
 we may not have successfully anticipated our future capital needs and, should the
 need arise, additional sources of financing may not be available or, if available,
 may not be on terms favorable to us or our stockholders. For more information, please
 see the section Factors That May Affect Our Future Operating Results,
 above, in particular the sections We are dependent on external funding sources
 which may not make available to us sufficient funds when we need them, Because
 our business requires a substantial level of liquidity, we are dependent upon a
 credit facility with numerous restrictive covenants that limit our flexibility
 and We may be unable to raise additional funds that we will need to remain
 competitive.

Contractual Commitments:

The following table summarizes significant
 contractual obligations of the Company as of February 2, 2002:



|                                   | AMOUNT OF COMMITMENT EXPIRATION PERIOD
|---------------------------------- | --------------------------------------
|                                   |                                       
|                                   | TOTAL                                 
|                                   |                                       
|CONTRACTUAL OBLIGATIONS            |                                       
|Long-term debt                     | $                                     
|Operating leases                   |                                       
|Capital leases                     |                                       
|Other long-term obligations        |                                       
|                                   |                                       
|Total contractual cash obligations | $                                     
|                                   |                                       



|                             | AMOUNT OF COMMITMENT EXPIRATION PERIOD
|---------------------------- | --------------------------------------
|                             |                                       
|OTHER COMMERCIAL COMMITMENTS | TOTAL                                 
|                             |                                       
|Revolving credit facility    | $                                     
|Standby letters of credit    |                                       
|Trade letters of credit      |                                       
|                             |                                       
|Total commercial commitments | $                                     
|                             |                                       

Revolving Credit Facility: As of February
 2, 2002, the Company had no amounts outstanding under its revolving credit facility

CRITICAL ACCOUNTING POLICIES

Our discussion
 and analysis of our financial condition and results of operations are based upon
 our consolidated financial statements, which have been prepared in accordance with
 accounting principles generally accepted in the United States. The preparation of
 these financial statements requires us to make estimates and judgments that affect
 the reported amounts of assets, liabilities, revenues and expenses, and related
 disclosure of contingent assets and liabilities. On an on-going basis, we evaluate
 our estimates, including those related to product returns, bad debts, inventories,
 goodwill, taxes on income, financing operations, contingencies and litigation. We
 base our estimates on historical experience and on various other assumptions that
 are believed to be reasonable under the circumstances, the results of which form
 the basis for making judgments about the carrying values of assets and liabilities
 that are not readily apparent from other sources. Actual results may differ from
 these estimates under different assumptions or conditions.

Our management
 believes the following critical accounting policies affect their more significant
 judgments and estimates used in the preparation of our consolidated financial statements:

Inventory  Our merchandise inventory
 is carried at the lower of cost or market with cost determined on a weighted average
 cost method. In connection with our merchandise repositioning, we recorded a charge
 of $5.3 million to write down discontinued merchandise at year-end to its estimated
 net realizable value, bringing our total lower of cost or market reserve to $6.5
 million. If actual market conditions are less favorable than those projected by
 our management, or if liquidation of the inventory is more difficult than anticipated,
 additional inventory write-downs may be required.

Long-lived Asset Impairment  We record
 a long-lived asset impairment charge when events or changes in circumstances indicate
 that the carrying amount of a long-lived asset may not be recoverable based on estimated
 future cash flows. In the course of performing this analysis, we determined that
 a long-lived asset impairment charge of $10.2 million was required for eight under-performing
 stores. The impairment charge was calculated as the difference between the net book
 value of the stores long-lived assets

19



---



##### 



and the projected present value of stores
 cash flows over the remaining life of the lease. Should actual results differ
 materially from projected results for these or other locations, additional impairment
 charges may be required in the future.

Goodwill  We had goodwill in the amount
 of $4.6 million at February 2, 2002. As required by generally accepted accounting
 principles, we performed an impairment test of goodwill which resulted in no impairment
 being identified. However, the process of evaluating goodwill involves making certain
 judgements and estimates in regards to company strategies and future cash flows.
 To the extent additional information arises or our strategies change, it is possible
 that our conclusion regarding goodwill impairment could change and result in an
 impairment charge.

Self-insurance costs  We record estimated
 liabilities for certain self-insured workers compensation programs. Should
 a greater amount of claims occur compared to what was estimated or the costs of
 the medical profession increase beyond what were anticipated, reserves recorded
 may not be sufficient and additional charges may be required.

Income Taxes  We account for income
 taxes under Statement of Financial Standards No. 109 (SFAS 109) Accounting
 for Income Taxes. Accordingly, we record a valuation allowance to reduce our deferred
 tax assets to the amount that is more likely than not to be realized. An analysis
 of projected taxable income and the corresponding utilization of these tax assets
 indicated that a valuation allowance of $7.0 million was appropriate. While future
 taxable income and ongoing prudent and feasible tax planning were considered in
 determining the amount of the valuation allowance, this allowance is subject to
 adjustment in the future. Specifically, in the event we were to determine that we
 would be able to realize our deferred tax assets in the future in excess of their
 net recorded amounts, an adjustment to the deferred tax assets would increase income
 in the period such determination was made. Likewise, should we determine that we
 would not be able to realize all or part of our net deferred tax assets in the future,
 an adjustment to the deferred tax assets would be charged to income in the period
 such determination was made. Additionally, SFAS 109 does not allow us to contemplate
 changes in tax laws or rates in our analysis of the utilization of our deferred
 tax assets. We believe that the economic stimulus bill that was enacted on March
 9, 2002 may have a positive impact on our analysis of our deferred tax assets, resulting
 in additional deferred tax assets becoming more likely than not to be realized in
 the first quarter of fiscal 2002.

The above
 listing is not intended to be a comprehensive list of all of our accounting policies.
 In many cases, the accounting treatment of a particular transaction is specifically
 dictated by generally accepted accounting principles, with no need for managements
 judgement in their application. There are also areas in which managements
 judgement in selecting any available alternative would not produce a materially
 different result. See our audited consolidated financial statements and notes thereto
 which begin on page 23 of this annual report, which contain accounting policies
 and other disclosures required by generally accepted accounting principles.

RECENT ACCOUNTING DEVELOPMENTS:

In the spring
 of 2002, we implemented the U.S. Securities and Exchange Commissions Staff
 Accounting Bulletin No. 101, Revenue Recognition in Financial Statements
 (SAB 101) effective January 30, 2000, which resulted in a change in
 revenue recognition for furniture sales. Previously, revenue for sales of furniture
 delivered to the customer was recognized when the furniture was shipped to the customer.
 Upon implementation of SAB 101, our revenue now reflects the recognition of revenue
 on furniture sales at the time of customer receipt. The cumulative effect of the
 implementation of SAB 101 resulted in a charge to income of $819,000 (net of income
 taxes of $570,000), or $0.05 per basic and diluted share for the fiscal year ended
 January 30, 2000.

Effective
 February 4, 2001, we adopted Statement of Financial Accounting Standards No. 133
 (SFAS No. 133), Accounting for Derivative Instruments and Hedging Activities,
 as amended by SFAS No. 138, Accounting for Certain Derivative Instruments and Certain
 Hedging Activities, which establishes accounting and reporting standards for derivative
 instruments, including certain derivative instruments embedded in other contracts,
 and for hedging activities. SFAS No. 133, as amended, requires the recognition of
 all derivative instruments as either assets or liabilities in the statement of financial
 position measured at fair value. The adoption of this standard had no material effect
 on our financial condition or results of operations.

In June 2001,
 the Financial Accounting Standards Board issued Statement of Financial Accounting
 Standards No. 141 (SFAS No.141), Business Combinations (effective July
 1, 2001) and Statement of Financial Accounting Standards No. 142 (SFAS No.
 142), Goodwill and Other Intangible Assets (effective for the Company on February
 3, 2002). SFAS No. 141 prohibits pooling-of-interests accounting for acquisitions.
 SFAS No. 142 specifies that goodwill and certain intangible assets will no longer
 be amortized but instead will be subject to periodic impairment testing. In accordance
 with the adoption of SFAS No. 142, as of February 3, 2002, we stopped amortizing
 goodwill. Goodwill was $4.6 million and $4.8 million as of February 2, 2002 and
 February 3, 2001,

20



---



##### 



respectively. Goodwill amortization was $0.2 million in each of
 fiscal years 2001, 2000 and 1999. In accordance with SFAS 142, we will test goodwill
 for impairment under the new fair value approach.

In October
 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting
 Standards No. 144, (SFAS No. 144), Accounting for the Impairment or
 Disposal of Long-Lived Assets. This statement supercedes Statement of Financial
 Accounting Standards No. 121 (SFAS No. 121), Accounting for the Impairment
 of Long-Lived Assets and for Long-Lived Assets to be Disposed Of, and the accounting
 and reporting provisions of APB Opinion No. 30, Reporting the Results of Operations  Reporting
 the Effects of Disposal of a Segment of a Business and Extraordinary,
 Unusual and Infrequently Occurring Events and Transactions, for the disposal of
 a segment of a business. SFAS No. 144 became effective for the Company on February
 3, 2002. The adoption of this standard is not expected to have a material effect
 on our financial condition or results of operations.

RELATED PARTY TRANSACTIONS

Stephen Gordon
 is Chairman of our Board of Directors. We lease our store in Eureka, California,
 from Mr. and Mrs. Gordon and a partnership of which Mr. Gordon is a partner. Pursuant
 to the written lease, we pay rent annually to Mr. and Mrs. Gordon and the partnership
 for use of the store. The aggregate lease payments paid to Mr. and Mrs. Gordon and
 the partnership were $65,657, 65,657 and 64,222 for the fiscal years ended February
 2, 2002, February 3, 2001 and January 29, 2000. The lease term expires on May 31,
 2004 and there are no renewal options. We believe that the lease arrangement with
 Mr. and Mrs. Gordon and a partnership of which Mr. Gordon is a partner was made
 on terms no less favorable to us than could have been obtained from unaffiliated
 third parties.

In connection
 with the Series A and B preferred stock financing completed in March 2001, Mr. Gary
 Friedman, our Chief Executive Officer, purchased 455 shares of the Series A preferred
 stock and 545 shares of the Series B preferred stock for an aggregate purchase price
 of $1 million. In addition, as part of Mr. Friedmans compensation package,
 we sold Mr. Friedman 571,429 shares of common stock at $1.75 per share and Mr. Friedman
 exercised his option to purchase 1.2 million shares of common stock at $1.75 per
 share for an aggregate sales price of approximately $3.1 million. In connection
 with this sale of preferred and common stock to Mr. Friedman, we also made a loan
 to Mr. Friedman in the amount of $2.05 million. All of the loan proceeds were used
 by Mr. Friedman to purchase a portion of this stock. The loan is a full recourse
 loan and is secured by shares of the common stock and preferred stock purchased
 by Mr. Friedman. This loan is evidenced by a note, dated March 22, 2001. Pursuant
 to the terms of the note, the interest rate on the outstanding principal amount
 of the loan is 8.5% per annum, payable on the first, second and third anniversaries
 of the date of the note. The principal is due on March 22, 2004 but the due date
 may be accelerated due to a number of factors, including, failure to make payments
 due under the note, expiration of the six-months period following the date Mr. Friedman
 ceases to be an employee of our company as a result of termination by us for cause,
 or 90 days after the closing of an acquisition of our company.

All transactions
 with officers, directors and principal stockholders and their affiliates, including
 the loan arrangement with Mr. Friedman, were approved, and all future such transactions
 will continue to be, approved by a majority of our board of directors, including
 a majority of the independent and disinterested directors of our board, and will
 be on terms no less favorable to us than could be obtained from unaffiliated third
 parties.




RESTATEMENT

In
the course of our continuing efforts to upgrade accounting systems
and personnel, we identified accounting errors concerning our
accounts payable and inventory balances as of February 2, 2002. The
errors, which resulted from the incorrect processing of certain
specific transactions, were primarily related to the recording of duplicate payments
to vendors and also to unrecorded amounts related to inventory
freight costs. The primary effect of correcting these identified
accounting errors was to decrease accounts payable and accrued
liabilities, originally reported as $34.9 million, to $34.1 million
and to increase merchandise inventories, originally reported as
$62.1 million, to $62.6 million, in each case as of the end of the
fiscal year ended February 2, 2002. Accordingly, the correction
of these identified accounting errors resulted in reducing the
reported net loss available to common stockholders from
$36.7 million, or $1.57 per share, to $35.8 million,
or $1.53 per share, for the fiscal year ended February 2, 2002.
Note 13 to the consolidated financial statements in Item 8
of this Part II summarizes the significant effects of our
restatement of the consolidated financial statements as of and for
the year ended February 2, 2002 to reflect the corrections for
these identified accounting errors.




CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING
 STATEMENTS

This annual
 report on Form 10-K/A contains forward-looking statements, within the
 meaning of the Private Securities Litigation Reform Act of 1995, that involve known
 and unknown risks. Such forward-looking statements include statements as to the
 results of strategic initiatives, our working capital and capital expenditure needs,
 the impact of competition and other statements containing words such as believes,
 anticipates, estimates, expects, may,
 intends, and words of similar import or statements of our managements
 opinion. These forward-looking statements and assumptions involve known and
 unknown risks, uncertainties and other factors that may cause our actual results,
 market performance or achievements to differ materially from any future results,
 performance or achievements expressed or implied by such forward-looking statements.
 Important factors that could cause such differences include, but are not limited
 to, changes in economic or business conditions in general, changes in product supply,
 fluctuations in comparable store sales, limitations resulting from restrictive covenants
 in our credit facility, failure of our management to anticipate changes in consumer
 trends, loss of key vendors, changes in the competitive environment in which we
 operate, changes in our management information needs, changes in management, failure
 to raise additional funds when required, changes in customer needs and expectations,
 governmental actions and consequences stemming from terrorist activities in or related
 to the United States. We undertake no obligation to update any forward-looking statements
 in order to reflect events or circumstances that may arise after the date of this
 annual report.

21



---



##### 



QUARTERLY RESULTS OF OPERATIONS






|                                             | 2001                                          
|-------------------------------------------- | ----------------------------------------------
|                                             |                                               
|                                             | FIRST                                         
|                                             | QUARTER                                       
|                                             |                                               
|                                             |                                               
|                                             | (dollars in thousands, except
 per share data)
|Statements of Consolidated
 Operations Data: |                                               
|Net sales(1)                                 | $                                             
|Gross profit                                 |                                               
|As a % of net sales                          |                                               
|Income (loss) from operations                |                                               
|Comparable store sales change                |                                               
|Net loss                                     |                                               
|Earnings (loss) per common share:            |                                               
|Basic(2)                                     | $                                             
|Diluted(3)                                   | $                                             
|                                             |                                               

|                                                                                                               | 2000                                   
|-------------------------------------------------------------------------------------------------------------- | ---------------------------------------
|                                                                                                               |                                        
|                                                                                                               | FIRST                                  
|                                                                                                               | QUARTER                                
|                                                                                                               |                                        
|                                                                                                               | (dollars in thousands, per
 share data)
|Statements of Consolidated
 Operations Data:                                                                   |                                        
|Net sales(1)                                                                                                   | $                                      
|Gross profit                                                                                                   |                                        
|As a % of net sales                                                                                            |                                        
|Income (loss) from operations                                                                                  |                                        
|Comparable store sales change                                                                                  |                                        
|Earnings (loss) before cumulative
 effect of change in accounting principle                                    |                                        
|Net
earnings (loss)                                                                                            |                                        
|Earnings (loss) per
 common share before cumulative effect of change in accounting
principle per common share: |                                        
|Basic(2)                                                                                                       | $                                      
|Diluted(3)                                                                                                     | $                                      
|Earnings (loss) per
 common share:                                                                             |                                        
|Basic(2)                                                                                                       | $                                      
|Diluted(3)                                                                                                     | $                                      
|                                                                                                               |                                        






|(1) | Net sales amounts include shipping fees in
 accordance with EITF 00-10, Accounting for Shipping and Handling Fees and Costs.                                                                                                                                                                                                                                                                                                                                                                                         
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) | Basic earnings per share is calculated for
 interim periods, including the effect of stock options exercised in prior interim periods. Basic earnings per
 share for the fiscal year is calculated using weighted shares outstanding based on the date stock options were
 exercised. Therefore, basic earnings per share for the cumulative four quarters may not equal fiscal year basic
 earnings per share.                                                                                                      
|   
|(3) | Diluted earnings per share for the fiscal
 year and for quarters with net earnings are computed based on weighted average common stock outstanding, convertible
 preferred stock and common stock equivalents (stock options and warrants). Net loss per share for quarters with net
 losses is computed based solely on weighted average common shares
outstanding. Therefore, the diluted earnings (loss) per share
 for each quarter may not equal the diluted earnings (loss) per share for the full fiscal year.
|   
|(4) | See
Note 13 to the consolidated financial statements.                                                                                                                                                                                                                                                                                                                                                                                                                                                                

ITEM 7A.   QUANTITATIVE AND
 QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

The interest payable on our credit
 facility is based on variable interest rates and is, therefore, affected by changes in market interest rates. If interest
 rates on existing variable rate debt rose no more than 10% from the banks reference rate, our results of operations and
 cash flows would not be materially affected. In addition, we have fixed and variable income investments consisting of cash
 equivalents and short-term investments, which are also affected by changes in market interest rates.

We do enter into a significant amount of
 purchase obligations outside of the United States which, to date, have been settled mostly in U.S. dollars and, therefore,
 we have only minimal exposure at present to foreign currency exchange risks. Historically, we have not hedged our 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 purchases outside of the United States will be made in currencies other than the U.S. dollar. Consequently, fluctuations
 in the rates of exchange between the U.S. dollar and other currencies may subject us to foreign currency exchange risks in
 the future.

22



---



##### 



ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

23



---



##### 



INDEPENDENT AUDITORS REPORT

To the Board of Directors and StockholdersRestoration
 Hardware, Inc.Corte Madera, California

We have audited the accompanying
 consolidated balance sheets of Restoration Hardware, Inc. and its subsidiaries as of February 2, 2002 and February
 3, 2001, and the related consolidated statements of operations, redeemable convertible preferred stock and
stockholders equity and cash flows for each of the three fiscal years in the period ended February 2, 2002.
 These financial statements are the responsibility of the Companys management. Our responsibility is to express
 an opinion on these financial statements based on our audits.

We conducted our audits in accordance
 with auditing standards generally accepted in the United States of America. Those standards require that we plan and
 perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.
 An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.
 An audit also includes assessing the accounting principles used and significant estimates made by management as well as
 evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for
 our opinion.

In our opinion, such consolidated
 financial statements present fairly, in all material respects, the financial position of Restoration Hardware, Inc.
 and its subsidiaries as of February 2, 2002 and February 3, 2001, and the results of their operations and their cash
 flows for each of the three fiscal years in the period ended February 2, 2002 in conformity with accounting principles
 generally accepted in the United States of America.

As
discussed in Note 13, the accompanying consolidated financial
statements as of and for the year ended February 2, 2002 have
been restated.




/s/ DELOITTE & TOUCHE LLPSan Francisco, California
April 23, 2002 (September 13, 2002 as to Note 1 and December 23, 2002 as to the effects of the restatement
 discussed in Note 13)

24



---



##### 



RESTORATION HARDWARE, INC.CONSOLIDATED
 BALANCE SHEETS(Dollars in thousands)






|                                                                                                                                                                                                                                                                |   | FEBRUARY 2,              |   |  |   | FEBRUARY 3, |  
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | - | ------------------------ | - |  | - | ----------- | -
|                                                                                                                                                                                                                                                                |   | 2002                     |   |  |   | 2001        |  
|                                                                                                                                                                                                                                                                |   |                          |  
|                                                                                                                                                                                                                                                                |   | As Restated(See Note 13) |   |  |   |             |  
|ASSETS                                                                                                                                                                                                                                                          |   |                          |   |  |   |             |  
|Current assets                                                                                                                                                                                                                                                  |   |                          |   |  |   |             |  
|Cash and cash equivalents                                                                                                                                                                                                                                       | $ | 22,285                   |   |  | $ | 2,610       |  
|Accounts receivable                                                                                                                                                                                                                                             |   | 3,278                    |   |  |   | 8,069       |  
|Merchandise inventories                                                                                                                                                                                                                                         |   | 62,609                   |   |  |   | 85,067      |  
|Prepaid expense and other                                                                                                                                                                                                                                       |   | 13,800                   |   |  |   | 8,975       |  
|                                                                                                                                                                                                                                                                |   |                          |   |  |   |             |  
|Total current assets                                                                                                                                                                                                                                            |   | 101,972                  |   |  |   | 104,721     |  
|Property and equipment, net                                                                                                                                                                                                                                     |   | 87,934                   |   |  |   | 117,186     |  
|Goodwill                                                                                                                                                                                                                                                        |   | 4,560                    |   |  |   | 4,776       |  
|Other assets                                                                                                                                                                                                                                                    |   | 12,276                   |   |  |   | 7,188       |  
|                                                                                                                                                                                                                                                                |   |                          |   |  |   |             |  
|Total assets                                                                                                                                                                                                                                                    | $ | 206,742                  |   |  | $ | 233,871     |  
|                                                                                                                                                                                                                                                                |   |                          |   |  |   |             |  
|LIABILITIES, REDEEMABLE
 CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS EQUITY                                                                                                                                                                                   
|Current liabilities                                                                                                                                                                                                                                             |   |                          |   |  |   |             |  
|Accounts payable and accrued
 expenses                                                                                                                                                                                                                          | $ | 34,065                   |   |  | $ | 43,321      |  
|Revolving line of credit and short
 term debt                                                                                                                                                                                                                   |   |                         |   |  |   | 5,730       |  
|Current portion of deferred lease
 incentives                                                                                                                                                                                                                   |   | 4,507                    |   |  |   | 4,575       |  
|Deferred revenue                                                                                                                                                                                                                                                |   | 2,855                    |   |  |   | 6,398       |  
|Other current liabilities                                                                                                                                                                                                                                       |   | 9,183                    |   |  |   | 8,501       |  
|                                                                                                                                                                                                                                                                |   |                          |   |  |   |             |  
|Total current liabilities                                                                                                                                                                                                                                       |   | 50,610                   |   |  |   | 68,525      |  
|Long-term debt                                                                                                                                                                                                                                                  |   |                         |   |  |   | 33,128      |  
|Long-term portion of deferred
 lease incentives                                                                                                                                                                                                                 |   | 37,101                   |   |  |   | 41,944      |  
|Deferred rent                                                                                                                                                                                                                                                   |   | 12,703                   |   |  |   | 10,787      |  
|Other long-term obligations                                                                                                                                                                                                                                     |   | 3,236                    |   |  |   | 612         |  
|                                                                                                                                                                                                                                                                |   |                          |   |  |   |             |  
|Total liabilities                                                                                                                                                                                                                                               |   | 103,650                  |   |  |   | 154,996     |  
|Series A redeemable convertible
 preferred stock, $.0001 par value, 28,037 shares designated on March 21, 2001, 14,320 shares issued and outstanding at
 February 2, 2002, aggregate liquidation preference and redemption value of $16,411 at February 2, 2002 |   | 14,106                   |   |  |   |            |  
|Common stock,
 $.0001 par value, 60,000,000 shares                                                                                                                                                                                                              |   |                          |   |  |   |             |  
|authorized, 28,827,883 and
 17,100,142 issued and outstanding, respectively                                                                                                                                                                                     |   | 144,162                  |   |  |   | 94,901      |  
|Stockholder loan                                                                                                                                                                                                                                                |   | (2,050                   | ) |  |   |            |  
|Unearned
compensation                                                                                                                                                                                                                                           |   | (1,103                   | ) |  |   |            |  
|Accumulated
other comprehensive loss                                                                                                                                                                                                                            |   | (159                     | ) |  |   | (4          | )
|Accumulated deficit                                                                                                                                                                                                                                             |   | (51,864                  | ) |  |   | (16,022     | )
|                                                                                                                                                                                                                                                                |   |                          |   |  |   |             |  
|Total stockholders equity                                                                                                                                                                                                                                      |   | 88,986                   |   |  |   | 78,875      |  
|                                                                                                                                                                                                                                                                |   |                          |   |  |   |             |  
|Total liabilities, redeemable
 convertible preferred stock and stockholders equity                                                                                                                                                                             | $ | 206,742                  |   |  | $ | 233,871     |  
|                                                                                                                                                                                                                                                                |   |                          |   |  |   |             |  




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

25



---



##### 



RESTORATION HARDWARE, INC.CONSOLIDATED STATEMENTS
 OF OPERATIONS(in thousands, except per share amounts)






|                                                                                | Fiscal Year Ended       
|------------------------------------------------------------------------------- | ------------------------
|                                                                                |                         
|                                                                                | February 2,             
|                                                                                | 2002                    
|                                                                                |                         
|                                                                                | As Restated(See Note 13)
|Net sales                                                                       | $                       
|Cost of sales and occupancy                                                     |                         
|                                                                                |                         
|Gross profit                                                                    |                         
|Selling, general and administrative                                             |                         
|                                                                                |                         
|Loss from operations                                                            |                         
|Interest expense                                                                |                         
|Interest income                                                                 |                         
|Change in fair value of warrants                                                |                         
|                                                                                |                         
|Pretax loss                                                                     |                         
|Income tax benefit                                                              |                         
|                                                                                |                         
|(Loss) before cumulative effect of
 change in accounting principle              |                         
|Cumulative effect of change in
 accounting principle, net of tax effect of $570 |                         
|                                                                                |                         
|Net loss                                                                        |                         
|Preferred shareholder return:                                                   |                         
|Dividends                                                                       |                         
|Beneficial conversion charges                                                   |                         
|                                                                                |                         
|(Loss) available to common
 stockholders                                        | $                       
|                                                                                |                         
|Earnings (Loss) per common
 share  basic and diluted:                          |                         
|Before
 cumulative effect of change in accounting principle                     | $                       
|Cumulative effect of change in
 accounting principle                            |                         
|Earnings (loss) per common share                                                |                         
|Weighted average shares
 outstanding, basic and diluted                         |                         

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




26



---



##### 



RESTORATION HARDWARE, INC.

CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE
PREFERRED STOCK AND STOCKHOLDERS EQUITY
(DOLLARS IN THOUSANDS)






|                                                     | Redeemable      |        |              |  |             |        |          |  |               |            |              |  |               |         |               |  |        |        |        |  |   |        |  
|---------------------------------------------------- | --------------- | ------ | ------------ |  | ----------- | ------ | -------- |  | ------------- | ---------- | ------------ |  | ------------- | ------- | ------------- |  | ------ | ------ | ------ |  | - | ------ | -
|                                                     | Convertible     |        |              |  |             |        |          |  | Accumulated   |            |              |  |               |         | Total        
|                                                     | Preferred Stock |        | Common Stock |  |             |        |          |  | Other         |            |              |  | Total         |         | Comprehensive
|                                                     |                 |        |              |  | Stockholder |        | Unearned |  | Comprehensive |            | Accumulated  |  | Stockholders |         | Income       
|(Dollars in thousands)                               | Shares          |        | Amount       |  | Shares      |        | Amount   |  | Loan          |            | Compensation |  | Income/(Loss) |         | Deficit       |  | Equity |        | (Loss)
|                                                     |                 |        |              |  |             |        |          |  |               |            |              |  |               |         |               |  |        |        |       
|BALANCE AT JANUARY 30, 1999                          |                 |       |              |  | $           |       |          |  |               | 16,246,260 |              |  | $             | 92,169  |               |  |        |       |        |  |   |       |  
|Issuance of common stock                             |                 |       |              |  |             |       |          |  |               | 655,078    |              |  |               | 2,149   |               |  |        |       |        |  |   |       |  
|Foreign currency translation adjustment              |                 |       |              |  |             |       |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   |       |  
|Net loss                                             |                 |       |              |  |             |       |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   |       |  
|                                                     |                 |        |              |  |             |        |          |  |               |            |              |  |               |         |               |  |        |        |        |  |   |        |  
|BALANCE AT JANUARY 29, 2000                          |                 |       |              |  |             |       |          |  |               | 16,901,338 |              |  |               | 94,318  |               |  |        |       |        |  |   |       |  
|                                                     |                 |        |              |  |             |        |          |  |               |            |              |  |               |         |               |  |        |        |        |  |   |        |  
|Issuance of common stock                             |                 |       |              |  |             |       |          |  |               | 198,804    |              |  |               | 583     |               |  |        |       |        |  |   |       |  
|Foreign currency translation adjustment              |                 |       |              |  |             |       |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   |       |  
|Net loss                                             |                 |        |              |  |             |       |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   |       |  
|                                                     |                 |        |              |  |             |        |          |  |               |            |              |  |               |         |               |  |        |        |        |  |   |        |  
|BALANCE AT FEBRUARY 3, 2001                          |                 |       |              |  |             |       |          |  |               | 17,100,142 |              |  |               | 94,901  |               |  |        |       |        |  |   |       |  
|Issuance of preferred stock - net                    |                 | 15,000 |              |  |             | 13,440 |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   |       |  
|Beneficial conversion feature                        |                 |       |              |  |             | (1,406 | )        |  |               |           |              |  |               | 1,406   |               |  |        |       |        |  |   |       |  
|Accretion of cumulative dividends of preferred stock |                 |       |              |  |             | 1,411  |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   |       |  
|Stock Compensation                                   |                 |       |              |  |             |       |          |  |               |           |              |  |               | 1,580   |               |  |        |       |        |  |   | (1,580 | )
|Amortization of unearned stock  compensation         |                 |       |              |  |             |       |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   | 477    |  
|Beneficial conversion charge                         |                 |        |              |  |             | 1,406  |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   |       |  
|Conversion of preferred stock to common stock        |                 | (680   | )            |  |             | (745   | )        |  |               | 340,000    |              |  |               | 745     |               |  |        |       |        |  |   |       |  
|Foreign currency translation adjustment              |                 |       |              |  |             |       |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   |       |  
|Net loss As Restated (See Note 13)                   |                 |       |              |  |             |       |          |  |               |           |              |  |               |        |               |  |        |       |        |  |   |       |  
|Issuance of common stock - net                       |                 |       |              |  |             |       |          |  |               | 11,387,741 |              |  |               | 45,530  |               |  |        | (2,050 | )      |  |   |       |  
|                                                     |                 |        |              |  |             |        |          |  |               |            |              |  |               |         |               |  |        |        |        |  |   |        |  
|BALANCE AT FEBRUARY 2, 2002                          |                 |        |              |  |             |        |          |  |               |            |              |  |               |         |               |  |        |        |        |  |   |        |  
|As Restated (See Note 13)                            |                 | 14,320 |              |  | $           | 14,106 |          |  |               | 28,827,883 |              |  | $             | 144,162 |               |  | $      | (2,050 | )      |  | $ | (1,103 | )
|                                                     |                 |        |              |  |             |        |          |  |               |            |              |  |               |         |               |  |        |        |        |  |   |        |  






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


27



---



##### 



RESTORATION HARDWARE, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS(DOLLARS IN THOUSANDS)






|                                                                                         | Fiscal Year Ended       
|---------------------------------------------------------------------------------------- | ------------------------
|                                                                                         |                         
|                                                                                         | FEBRUARY 2,2002         
|                                                                                         |                         
|                                                                                         | As Restated(See Note 13)
|Cash flows from operating activities:                                                    |                         
|Loss before cumulative effect of change in accounting principle                          | $                       
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |                         
|Change in fair value of warrants                                                         |                         
|Depreciation and amortization                                                            |                         
|Impairment of fixed assets                                                               |                         
|Other                                                                                    |                         
|Deferred income taxes                                                                    |                         
|Changes in assets and liabilities:                                                       |                         
|Accounts receivable                                                                      |                         
|Merchandise inventories                                                                  |                         
|Prepaid expenses and other assets                                                        |                         
|Accounts payable and accrued expenses                                                    |                         
|Tax payable                                                                              |                         
|Deferred revenue                                                                         |                         
|Other current liabilities                                                                |                         
|Deferred rent                                                                            |                         
|Deferred lease incentives and other long-term liabilities                                |                         
|                                                                                         |                         
|Net cash provided by operating activities                                                |                         
|                                                                                         |                         
|Cash flows from investing activities:                                                    |                         
|Proceeds from store closing agreements                                                   |                         
|Capital expenditures                                                                     |                         
|Purchase of The Michaels Furniture Co                                                    |                         
|                                                                                         |                         
|Net cash provided by (used in) investing activities                                      |                         
|                                                                                         |                         
|Cash flows from financing activities:                                                    |                         
|Net proceeds from private placement of preferred stock                                   |                         
|Net proceeds from private placements of common stock                                     |                         
|Borrowings (repayments) under revolving line of credit  net                             |                         
|Debt issuance costs                                                                      |                         
|Borrowings (repayments)  other debt                                                     |                         
|Issuance of common stock                                                                 |                         
|                                                                                         |                         
|Net cash provided by financing activities                                                |                         
|                                                                                         |                         
|Effects of foreign currency exchange rate translation on cash:                           |                         
|Net increase (decrease) in cash and cash equivalents                                     |                         
|Cash and cash equivalents:                                                               |                         
|Beginning of period                                                                      |                         
|                                                                                         |                         
|End of period                                                                            | $                       
|                                                                                         |                         
|Additional cash flow information:                                                        |                         
|Cash paid during the year for interest (net of amount capitalized)                       | $                       
|Cash (received) paid during the year for taxes                                           | $                       
|Non-cash transactions:                                                                   |                         
|Stockholder loan                                                                         | $                       
|Beneficial conversion feature  preferred stock                                          | $                       
|Beneficial conversion charge  preferred stock                                           | $                       
|Dividends attributable to preferred stock                                                | $                       




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

28



---



##### 



RESTORATION HARDWARE, INC.

NOTES TO CONSOLIDATED FINANCIAL
 STATEMENTS

(1) SUMMARY OF BUSINESS AND SIGNIFICANT
 ACCOUNTING POLICIES

Nature of Business

Restoration
 Hardware, Inc. and its subsidiaries (the Company), a Delaware corporation,
 is a specialty retailer of high-quality home furnishings, decorative accessories
 and hardware. These products are sold through retail locations, catalogs and the
 Internet. At February 2, 2002, the Company operated a total of 104 retail stores
 in 31 states, the District of Columbia and in Canada. The Company operates on a
 52  53 week fiscal year ending on the Saturday closest to January 31. The
 fiscal year ended February 3, 2001 included 53 weeks. All other years presented
 include 52 weeks.

Principles of Consolidation

The consolidated
 financial statements include the accounts of Restoration Hardware, Inc. and its
 subsidiaries. All inter-company balances and transactions are eliminated in consolidation.

Use of Accounting Estimates

The preparation
 of financial statements in conformity with generally accepted accounting principles
 requires management to make estimates and assumptions that affect the reported amounts
 of assets and liabilities and disclosures of contingent assets and liabilities at
 the date of the financial statements and the reported amounts of revenues and expenses
 during the reporting period. The Companys significant accounting estimates
 include lower of cost or market reserves on inventory, expected future cash flows
 in the review for impairment on long lived assets, the adequacy of self insurance
 reserves, and realization of deferred tax assets, including the potential need for
 valuation allowances on these tax assets. Actual results for these and other estimates
 could differ from those estimates.

Cash and Cash Equivalents

The Company
 considers all highly liquid investments with original maturities of three months
 of less to be cash equivalents.

Accounts Receivable

Accounts receivable
 consist primarily of receivables from our credit card processors for sales transactions
 and tenant improvement allowances from our landlords in connection with new leases.
 We have typically not provided an allowance for doubtful accounts for these receivables,
 as our bad debt experience has been insignificant.

Merchandise Inventories

Retail inventories
 are stated at the lower of cost (determined under the weighted average cost method)
 or market. Manufacturing inventories are stated at the lower of cost (first-in,
 first-out) or market. Cost includes certain buying and distribution costs, including
 merchant payroll and other costs related to the purchase of inventory, as well as
 payroll and other costs to process inventory at the Companys distribution
 centers. A provision, when necessary, has been made to reduce excess or obsolete
 inventory to its net realizable value. As of February 2, 2002, the Company had lower
 of cost or market reserves of $6.5 million, which included $5.3 million in reserves
 related to discontinued merchandise.

Prepaid Catalog Expenses

Prepaid catalog
 expenses consist of the cost to produce, print and distribute catalogs. Such costs
 are amortized over the expected sales volume of each catalog. Typically, over 90%
 of the cost of a catalog is amortized in the first four months. At February 2, 2002
 and February 3, 2001, the Company had $1,015,000 and $1,044,000, respectively, recorded
 as current assets.

29



---



##### 



Property and Equipment

Furniture,
 fixtures and equipment are stated at cost. Depreciation is calculated using the
 straight-line method over the estimated useful life of the asset, typically ranging
 from five to twelve years for equipment. The cost of leasehold improvements is amortized
 over the useful life of the asset or the applicable lease term, whichever is less.
 Computer hardware and software costs are included in fixtures and equipment and
 are amortized over estimated useful lives of three to five years. Fiscal 2001 depreciation
 expense includes a $2.0 million accelerated depreciation charge related to assets
 whose lives were shortened due to their anticipated elimination in connection with
 our spring 2002 remodel project.

Capitalization of Interest

The interest-carrying
 costs of capital assets under development or construction are capitalized based
 on the Companys weighted average borrowing rate. During the fiscal years,
 ended February 2, 2002, February 3, 2001 and January 29, 2000, $15,000, $195,000
 and $390,000, respectively, of interest was capitalized.

Goodwill

Goodwill represents
 the excess of the purchase price over the fair value of the net assets acquired
 in the purchase of The Michaels Furniture Company (Michaels). Goodwill
 is amortized on a straight-line basis over 25 years (see New Accounting Pronouncements ).

Capitalized Leases

Noncancellable
 leases which meet the criteria of capital leases are capitalized as assets and amortized
 over the lease term, using the interest method.

Impairment of Long-Lived Assets

The Companys
 policy is to review long-lived assets and certain identifiable intangibles,
 including goodwill, for impairment whenever events or changes in circumstances indicate
 that the carrying amount of an asset may not be recoverable based on estimated future
 cash flows calculated on a store by store basis. Based on the Companys reviews
 for the years ended February 3, 2001 and January 29, 2000 no adjustments were recognized
 to the carrying value of such assets. In the fiscal year ended February 2, 2002,
 the Company recorded a $10.2 million impairment charge on the long-lived assets
 of eight under-performing stores. The impairment charge was equal to the difference
 between the net asset value of long-lived assets and the present value of estimated
 future cash flows for these eight stores.

Store Closures

The Company
 continually reviews the operating performance of its stores and assesses its plans
 for certain store closures. For stores that are to be closed, the Company records
 a liability for future minimum lease payments and related ancillary costs from the
 date of closure to the end of the remaining lease term, net of estimated cost recoveries
 that may be achieved through favorable lease terminations. This liability is recorded
 at the time management commits to closing the store. The operating costs, including
 depreciation, of stores to be closed are expensed during the period they remain
 in use.

The Company
 closed three of its underperforming stores in fiscal 2001, for which it received
 cash proceeds from a third party who purchased the Companys lease rights.
 The cash proceeds received of $5.3 million approximated the net book value of the
 assets that were written off as a part of the store closures.

Accounts Payable

Accounts payable
 represents amounts owed to third parties at the end of the period. Accounts payable
 includes outstanding checks of approximately $13.7 million and $10.0 million at
 February 2, 2002 and February 3, 2001, respectively.

30



---



##### 



Self Insurance

The Company
 is self insured for workers compensation. The self-insurance liability is
 determined based on an independent third party actuarial report. The liability is
 based on claims filed and an estimate of claims incurred but not yet reported.

Deferred Rent and Deferred Lease Incentives

Certain of
 the Companys operating leases contain predetermined fixed escalations of the
 minimum rentals during the original term of the lease. For these leases, the Company
 recognizes the related rental expense on a straight-line basis over the life of
 the lease and records the difference between the amount charged to operations and
 amounts paid as deferred rent. As part of its lease agreements, the Company receives
 certain lease incentives. These allowances have been deferred and are amortized
 on a straight-line basis over the life of the lease as a reduction of rent expense.

Revenue Recognition

Retail Store
 Sales: Revenue is recognized at the point of sale for all purchases which are taken
 from the store by the customer at the time of purchase.

Non-Furniture  Direct-to-Customer
 (Catalog and Internet) Sales: Revenue is recognized upon
 shipment to the customer.

Furniture
 Sales: Furniture sales are recorded in either the direct-to-customer or retail segments
 depending upon where the sales transaction was originated. The majority of furniture
 sales are delivered to the customer. Revenue for these sales is recognized upon
 delivery of the furniture to the customer.

Shipping and
 Handling: Emerging Issues Task Force (EITF) Issue
No. 00-10, Accounting
 for Shipping and Handling Fees and Costs, requires that all amounts billed to a
 customer in a sale transaction related to shipping and handling, if any, should
 be classified as revenue. The Company records shipping and handling fees as net
 revenue in the sales channel segment (retail store or direct to customer) that originated
 the sales transaction. Shipping and handling fees included in revenues were $7.1
 million, $5.7 million and $4.0 million in fiscal 2001, 2000 and 1999, respectively.
 Costs of shipping and handling are included in cost of sales and occupancy.

Returns: The
 Company provides an allowance for sales returns based upon historical return rates.

Advertising Expense

Advertising
 costs are expensed as incurred. For the fiscal years ended February 2, 2002, February
 3, 2001, and January 29, 2000, advertising costs were approximately $16.1 million,
 $14.9 million, and $11.2 million, respectively.

Concentration of Credit Risk

Financial
 instruments, which potentially subject the Company to concentration of credit risk,
 consist principally of cash and cash equivalents. The Company places its cash with
 financial institutions. At times, such amounts may be in excess of FDIC insurance
 limits.

Taxes on Earnings




Statement
of Financial Accounting Standards (SFAS) No. 109,
 Accounting for Income Taxes, requires income taxes to be accounted for
 under an asset and liability approach that requires the recognition of deferred
 tax assets and liabilities for the expected future tax consequences of events that
 have been recognized in the Companys financial statements or tax returns.
 In estimating future tax consequences, the company generally considers all expected
 future events other than changes in the tax law or rates. For the year ended February
 2, 2002, a $7 million tax valuation allowance was recorded against the Companys
 deferred tax assets to reduce such assets to the amount that are more likely than
 not to be realized.




31



---



##### 



Stock-based Compensation

The Company
 accounts for stock-based awards to employees using the intrinsic value method in
 accordance with Accounting Principles Board (APB) No. 25, Accounting for Stock Issued to Employees. The disclosure
 requirements of SFAS
 No. 123, Accounting for Stock-Based Compensation, are set forth in Note 6.

Estimated Fair Value of Financial Instruments

The following
 disclosure is made in accordance with the requirements of SFAS No. 107, Disclosures
 about Fair Value of Financial Instruments. The carrying values of cash and cash
 equivalents, accounts receivable, accounts payable and borrowings under the revolving
 line of credit approximate their estimated fair values. Estimated fair value disclosures
 have been determined by the Company, using available market information and appropriate
 valuation methodologies. However, considerable judgment is required in interpreting
 market data to develop the estimates of fair value. Accordingly, the estimates presented
 herein are not necessarily indicative of the amounts that the Company could realize
 in a current market exchange. The use of different market assumptions and estimation
 methodologies may have a material effect on the estimated fair value amounts.

Earnings Per Share




SFAS
No. 128, Earnings Per Share
 (EPS), requires earnings per share to be computed and reported, under
 the treasury stock method, as both Basic EPS and Diluted EPS. Basic EPS is computed
 by dividing net income by the weighted average number of common shares outstanding
 for the period. Diluted EPS is computed by dividing net income by the weighted average
 number of common stock and dilutive common stock equivalents (stock options, convertible
 preferred stock and warrants) outstanding during the period. Diluted EPS reflects
 the potential dilution that could occur if options or warrants to issue common stock
 were exercised, or preferred stock was converted into common stock.
The potentially dilutive effects of certain common stock equivalents have been excluded
 from diluted earnings per share, because their inclusion would be anti-dilutive.
 Included here are only those options, warrants, and convertible
preferred stock for which the exercise price is
 less than the average share price for the respective year.






|                                                                                | February
 2, 2002 |  | February
 3, 2001 |  | January
 29, 2000
|------------------------------------------------------------------------------- | ----------------- |  | ----------------- |  | -----------------
|                                                                                |                   |  |                   |  |                  
|Shares of common stock subject to outstanding options                           | 573,867           |  | 395,440           |  | 837,053          
|Shares of
 common stock subject to outstanding warrants                         | 405,226           |  |                  |  |                 
|Shares of
 common stock reserved for conversion of the Series A preferred stock | 7,160,000         |  |                  |  |                 

The following
 is a reconciliation of the number of shares (denominator) used in the basic and
 diluted EPS computations (shares in thousands):






|                                         | 2001   |  | 2000      |       | 1999  
|---------------------------------------- | ------ |  | --------- | ----- | ------
|                                         |        |  |           |       |       
|                                         | Shares |  | Per Share |       | Shares
|                                         |        |  |           |       |       
|Basic earnings (loss) per common share   | 23,396 |  | $         | (1.53 | )     
|Effect of dilutive securities(1)         |       |  |           |      |       
|Diluted earnings (loss) per common share | 23,396 |  | $         | (1.53 | )     






(1) Potentially
 dilutive preferred stock, options and warrants were excluded because their inclusion
 would be anti-dilutive (their inclusion would decrease the loss per share)


Comprehensive Income

Comprehensive
 income (loss) consists of net income (loss) and other comprehensive income (loss)
 (primarily foreign currency translation adjustments). The components of comprehensive
 income (loss) are presented in the consolidated statements of changes in stockholders
 equity.

Foreign Currency Translation

In the preparation
 of consolidated financial statements, the assets and liabilities of the Companys
 subsidiary denominated in Canadian dollars are translated to US dollars at
 the rate of exchange in effect at the balance sheet date; income and expenses are
 translated at average rates of exchange prevailing during the year. The related
 translation adjustments are reflected in the other

32



---



##### 



comprehensive income section
 of the consolidated statements of stockholders equity. Almost all of the revenues
 of the Company are generated in US dollars. However, foreign currency gains and
 losses resulting from transactions denominated in foreign currencies, including
 inter-company transactions, are included in operations and have not been significant
 to date.

New Accounting Pronouncements

Effective
 February 4, 2001, we adopted SFAS No. 133,
 Accounting for Derivative Instruments and Hedging Activities, as
 amended by SFAS No. 138, Accounting for Certain Derivative Instruments
 and Certain Hedging Activities, which establishes accounting and reporting standards
 for derivative instruments, including certain derivative instruments embedded in
 other contracts, and for hedging activities. SFAS No. 133, as amended, requires
 the recognition of all derivative instruments as either assets or liabilities in
 the statement of financial position measured at fair value. The adoption of this
 standard had no material effect on our financial condition or results of operations.




In June 2001,
 the Financial Accounting Standards Board issued SFAS No. 141, Business Combinations (effective July 1, 2001), and SFAS No. 142, Goodwill and Other Intangible Assets (effective
 for the Company on February 3, 2002). SFAS No. 141 prohibits pooling-of-interests
 accounting for acquisitions. SFAS No. 142 specifies that goodwill and certain intangible
 assets will no longer be amortized but instead will be subject to periodic impairment
 testing. In accordance with the adoption of SFAS No. 142, as of February 3, 2002,
 the Company no longer amortizes goodwill. Goodwill was $4.6 million and $4.8 million
 as of February 2, 2002 and February 3, 2001, respectively. Goodwill amortization
 was $0.2 million in each of fiscal years 2001, 2000 and 1999. The adoption of this
 new accounting standard will result in the elimination of approximately $0.2 million
 of goodwill amortization each year. Instead, the Company will evaluate the fair
 value of goodwill versus the carrying amount on its balance sheet. The Company has
 not yet determined the impact the new approach to valuing goodwill will have on
 its financial position.




As required
 by SFAS No. 142, prior year results have not been restated to reflect the non-amortization
 provision. A reconciliation of net loss available to stockholders and loss per common
 share as if SFAS No. 142 had been adopted is presented below for the 2001, 2000
 and 1999 fiscal years:






|                                                   | 2001                                            |        | 2000 |   | 1999 
|-------------------------------------------------- | ----------------------------------------------- | ------ | ---- | - | -----
|                                                   |                                                 |        |      |   |      
|                                                   | (Dollars in thousands,except per share amounts)
|                                                   |                                                 |        |      |   |      
|Net loss available to common stockholders:         |                                                 |        |      |   |      
|Reported net loss available to common stockholders | $                                               | 35,842 |      | $ | 4,560
|Goodwill amortization, net of tax effect           |                                                 | 83     |      |   | 83   
|                                                   |                                                 |        |      |   |      
|Adjusted net loss available to common stockholders | $                                               | 35,759 |      | $ | 4,477
|Basic and diluted loss per common share:           |                                                 |        |      |   |      
|Reported loss per share                            | $                                               | 1.53   |      | $ | 0.27 
|Goodwill amortization, net of tax effect           |                                                 | 0.00   |      |   | 0.01 
|                                                   |                                                 |        |      |   |      
|Adjusted loss per common share                     | $                                               | 1.53   |      | $ | 0.26 







In October
 2001, the Financial Accounting Standards Board issued SFAS No.
144, Accounting for the Impairment or Disposal of Long-Lived Assets. This statement supercedes SFAS No. 121, Accounting
 for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
 Of, and the accounting and reporting provisions of APB Opinion No. 30, Reporting
 the Results of Operations  Reporting the Effects of Disposal of a Segment
 of a Business and Extraordinary, Unusual and Infrequently Occurring Events and Transactions,
 for the disposal of a segment of a business. SFAS No. 144 became effective
 for the Company on February 3, 2002. The adoption of this standard is not expected
 to have a material effect on the Companys financial position or results of
 operations.




33



---



##### 



Reclassifications

Certain prior
 year balance sheet amounts have been reclassified to conform with the fiscal year
 ended February 2, 2002 presentation.

(2) PROPERTY AND EQUIPMENT

Property and equipment consist of the following
 (in thousands):



|                                               | FEBRUARY 2, 2002 |         | FEBRUARY 3, 2001
|---------------------------------------------- | ---------------- | ------- | ----------------
|                                               |                  |         |                 
|Leasehold improvements                         | $                | 101,487 |                 
|Furniture, fixtures and equipment              |                  | 40,725  |                 
|Equipment under capital leases                 |                  | 1,035   |                 
|                                               |                  |         |                 
|Total                                          |                  | 143,247 |                 
|Less accumulated depreciation and amortization |                  | (55,313 | )               
|                                               |                  |         |                 
|Property and equipment, net                    | $                | 87,934  |                 
|                                               |                  |         |                 

(3) LEASES

The Company
 leases certain property consisting of retail stores, corporate offices, distribution
 centers and equipment. Leases expire at various dates through 2018. The retail stores,
 distribution centers and corporate office leases generally provide that the Company
 assumes the maintenance and all or a portion of the property tax obligations on
 the leased property. Most store leases also provide for minimum annual rentals,
 with provisions for additional rent based on a percentage of sales and for payment
 of certain expenses.

The aggregate future minimum rental payments
 under leases in effect at February 2, 2002 are as follows (in thousands):



|YEAR ENDING                                |  | CAPITALLEASES |      | OPERATINGLEASES |  | TOTAL
|------------------------------------------ |  | ------------- | ---- | --------------- |  | -----
|                                           |  |               |      |                 |  |      
|2003 (FY 2002)                             |  | $             | 278  |                 |  | $    
|2004                                       |  |               | 186  |                 |  |      
|2005                                       |  |               |     |                 |  |      
|2006                                       |  |               |     |                 |  |      
|2007                                       |  |               |     |                 |  |      
|Thereafter                                 |  |               |     |                 |  |      
|                                           |  |               |      |                 |  |      
|Minimum lease commitments                  |  | $             | 464  |                 |  | $    
|                                           |  |               |      |                 |  |      
|Less amount representing interest          |  |               | (47  | )               |  |      
|                                           |  |               |      |                 |  |      
|Present value of capital lease obligations |  |               | 417  |                 |  |      
|Less current portion                       |  |               | (243 | )               |  |      
|                                           |  |               |      |                 |  |      
|Long-term portion                          |  | $             | 174  |                 |  |      

Minimum and
 contingent rental expense, which is based upon certain factors such as sales volume,
 under operating leases, are as follows (in thousands):



|                          | FISCAL YEAR ENDED
|------------------------- | -----------------
|                          |                  
|                          | FEBRUARY 2, 2002 
|                          |                  
|Operating leases:         |                  
|Minimum rental expense    | $                
|Contingent rental expense |                  
|                          |                  
|Total                     | $                
|                          |                  

(4) REVOLVING LINE OF CREDIT AND DEBT

On March 21,
 2001, the Company amended its existing credit facility. The amendment reduced the
 overall commitment under the line of credit from $111 million to $89 million, increased
 the amounts available for letters of credit from $10 million to $20 million and
 eliminated the minimum earnings before interest, taxes, depreciation and amortization
 (EBITDA) requirement. Additionally, the borrowing base calculation was
 modified to provide the Company with more liquidity due to the pledge of additional
 collateral, and the interest rate was reduced by 0.25%, with possible additional
 reductions based on achievement of future EBITDA.

34



---



##### 



The amended
 credit facility included two high-interest term loans. The first of these term loans
 was paid off in the second quarter of fiscal 2001. In August of fiscal 2001, the
 credit facility was further amended to provide for more favorable interest rates
 on the remaining term loan. This loan was paid off in January 2002.

As a result
 of the paydowns of the term loans, as of February 2, 2002, maximum availability
 under the facility was $80.0 million, with amounts available for letters of credit
 up to $20 million. Availability under the credit facility is limited by reference
 to a borrowing base calculation, based upon eligible inventory and accounts receivable.
 The amount available under the credit facility is typically much less than the $80.0
 million stated maximum limit of the facility (as of February 2, 2002, the total
 borrowing base available was approximately $30.0 million). The agreement contains
 restrictive covenants, including annual capital expenditure limits, minimum inventory
 levels, limitations on store openings and closings and prohibitions on dividends.
 As of February 2, 2002, the Company had no loans outstanding, and $13.3 million
 in outstanding letters of credit. Interest is paid monthly at the banks reference
 rate or LIBOR plus a margin. As of February 2, 2002, the banks reference rate
 was 6.0% and the LIBOR plus margin rate was 5.3%. The agreement expires on June
 30, 2003.

In connection
 with an amendment to the Companys line of credit in September 2000, putable
 warrants were issued to purchase 550,000 shares of common stock, at an exercise
 price of $3.75 per share, subject to antidilution protection. The credit facility
 was amended in March of 2001 and the exercise price for 200,000 of the 550,000 warrants
 was decreased from $3.75 to $2.00 per share. The fair value of the warrants is calculated
 each quarter using the Black-Scholes model. The following assumptions were used
 in the Companys calculation as of February 2, 2002: expected life of 20 months,
 stock volatility considered to be 50%, risk free interest rate of 2.28%, and no
 dividends during the expected term. For the 2001 fiscal year, the revaluation of
 the warrants resulted in an expense of $2.7 million. The warrants expire on September
 27, 2005. As of February 2, 2002, warrants for the purchase of approximately 405,000
 shares of common stock were outstanding. During the first quarter of fiscal 2002,
 all remaining outstanding warrants were exercised.

(5) INCOME TAXES

The income tax expense (benefit) for the
 year ended February 2, 2002 consisted of (in thousands):






|                           | FISCAL YEAR ENDED
|-------------------------- | -----------------
|                           |                  
|                           | FEBRUARY 2,2002  
|                           |                  
|Current:                   |                  
|Federal                    | $                
|State                      |                  
|Foreign                    |                  
|                           |                  
|Total current payable      |                  
|                           |                  
|Deferred:                  |                  
|Federal                    | $                
|State                      |                  
|Foreign                    |                  
|                           |                  
|Total deferred             |                  
|                           |                  
|Provision for income taxes | $                
|                           |                  




35



---



##### 



Significant components of the Companys
 deferred tax assets and liabilities are as follows (in thousands):






|                                                     | FEBRUARY 2,2002 |        | FEBRUARY 3,2001 |  | JANUARY 29,2000
|---------------------------------------------------- | --------------- | ------ | --------------- |  | ---------------
|                                                     |                 |        |                 |  |                
|Current deferred tax asset (liability)               |                 |        |                 |  |                
|Accrued expense                                      | $               | 1,656  |                 |  | $              
|State tax benefit                                    |                 | (1,453 | )               |  |                
|Inventory                                            |                 | 3,485  |                 |  |                
|Deferred Revenue                                     |                 | 655    |                 |  |                
|Other                                                |                 | (615   | )               |  |                
|                                                     |                 |        |                 |  |                
|Net current deferred tax asset (liability)           |                 | 3,728  |                 |  |                
|                                                     |                 |        |                 |  |                
|Long-term deferred tax asset (liability):            |                 |        |                 |  |                
|Derivative warrant liability                         |                 | 1,121  |                 |  |                
|Deferred lease credits                               |                 | (758   | )               |  |                
|Property and equipment                               |                 | 8,833  |                 |  |                
|Net operating loss carryforwards                     |                 | 8,710  |                 |  |                
|AMT Credit                                           |                 | 441    |                 |  |                
|                                                     |                 |        |                 |  |                
|Net long-term deferred tax asset                     |                 | 18,347 |                 |  |                
|                                                     |                 |        |                 |  |                
|Total deferred tax assets before valuation allowance |                 | 22,075 |                 |  |                
|Valuation Allowance                                  |                 | (7,000 | )               |  |                
|                                                     |                 |        |                 |  |                
|Net deferred tax asset                               | $               | 15,075 |                 |  | $              
|                                                     |                 |        |                 |  |                




A reconciliation of the federal
 statutory tax rate to our effective state rate is as follows:






|                                               | FISCAL YEAR ENDED
|---------------------------------------------- | -----------------
|                                               |                  
|                                               | FEBRUARY 2,2002  
|                                               |                  
|Provision at statutory tax rate                | (34.0            
|State income taxes, net of federal tax benefit | (4.4             
|Other                                          | 0.0              
|Valuation allowance                            | 16.6             
|                                               |                  
|Total                                          | (21.8            
|                                               |                  







As of February
 2, 2002, the Company had federal, state and foreign net operating loss carryovers
 of approximately $18.3 million, $18.7 million and $950,000, respectively. These
 net operating loss carryovers will expire between 2006 and 2021. As of February
 2, 2002, the Company also had a federal alternative minimum tax credit of approximately
 $441,000. Using its best estimates, the Company has established a valuation allowance
 of $7.0 million at February 2, 2002, on certain of its federal and state deferred
 tax assets. The Company believes the remaining deferred tax assets are more likely
 than not to be realized. As is required by SFAS No. 109, the Company did not consider
 the impact of tax laws or changes in tax rates that had not been enacted by February
 2, 2002, including the economic stimulus bill that was enacted subsequent to year-end
 on March 9, 2002.




Internal Revenue
 Code Section 382 and similar state rules place a limitation on the amount of taxable
 income which can be offset by net operating loss carryforwards after a change in
 control (generally greater than 50% change in ownership). Due to these provisions,
 utilization of the net operating loss and tax credit carryforwards may be limited.

(6) REDEEMABLE CONVERTIBLE PREFERRED STOCK

On March 21,
 2001, the Company completed a sale of the preferred stock with aggregate proceeds
 to the Company of approximately $15 million. The initial sale on March 21, 2001
 included the sale of 6,820 shares of Series A and 8,180 shares of Series B, for
 $1,000 per share. The shares of Series B were converted on a one-for-one basis into
 shares of Series A preferred stock upon the approval of such conversion by the Companys
 stockholders on July 11, 2001. Each share of preferred stock has a par value
 of $.0001 per share.

Convertibility

The Series
 A is immediately convertible at the option of the holder into shares of the Companys
 common stock. The initial conversion formula is equal to the original issue
 price ($1,000) divided by $2.00 per share. Therefore, each share of Series A is
 initially convertible into 500 shares of common stock. The conversion price of the
 Series A is subject to certain adjustments for future

36



---



##### 



dilutive events. The Company
 may require conversion of the Series A, in whole or in part, by sending written
 notice of the request for conversion to holders of Series A at any time after March
 22, 2004, if the average closing price per share of the common stock exceeds three
 times the then-current conversion price of the Series A for the 20 trading days
 ending 3 business days preceding the date that the written request is sent. Upon
 the Companys notice of conversion, holders of Series A shall be deemed to
 have demanded registration of their shares of common stock received upon conversion
 of the Series A. If such holders subsequently choose not to include their shares
 in a registration statement, they may request redemption of their shares of Series
 A, in which case the Company must redeem the shares of Series A in accordance with
 the terms of the Certificate of Designation of the Series A and Series B (the Certificate
 of Designation). Any such redemption would be at a redemption price of $1,000
 plus all accrued and unpaid dividends. If the holders do not include their common
 stock in the registration statement, but also do not request redemption, their shares
 of Series A will automatically convert into common stock. The conversion price into
 common stock of $2.00 represents a discount to the fair market value of the common
 stock of $2.1875 at March 21, 2001, the date of completion of the preferred stock
 equity financing (herein referred to as a beneficial conversion feature).
 The beneficial conversion feature on the Series A of $639,375 was recorded as a
 return to the preferred stockholders on March 21, 2001 since the Series A were immediately
 convertible into common stock. The beneficial conversion feature on the Series B
 of $766,875 was initially being recorded as a return to the preferred stockholders
 over three years, the minimum period at which these stockholders could realize a
 return through the conversion to common stock. In the second quarter of fiscal 2001,
 upon the conversion of Series B into Series A, the unamortized balance of the beneficial
 conversion feature of approximately $707,000 was recorded as a return to the preferred
 stockholders as the shares became immediately convertible into common stock.

Redemption

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

Dividends

If the Companys
 Board of Directors declares a dividend, each share of Series A is entitled
 to dividends at the rate of $100 per share per annum. Such dividends are cumulative
 and deemed to have accrued from the original date of issuance of the Series A for
 purposes of the exercise of the Companys redemption rights and the redemption
 rights of the holders of Series A in connection with the Companys conversion
 rights described above and in the Certificate of Designation and the determining
 of the liquidation preferences of the holders of the Series A. Such dividends shall
 not be deemed to be cumulative and shall not be deemed to have so accrued upon any
 conversion of the Series A into common stock. The Company shall not pay or declare
 any dividend on any common stock or any of its other securities that are junior
 to the Series A during any fiscal year unless and until full dividends on the Series
 A are declared and paid for such fiscal year.

Voting

Holders of
 the Series A generally have the right to one vote for each share of common stock
 into which such Series A is convertible. Subject to the terms of the preferred stock
 purchase agreement entered into by and among the Company and the holders of Series
 A named therein and the Certificate of Designation, the holders of the Series A
 are entitled to elect two designees to the Board of Directors. At least one of the
 designees shall also be represented on all committees of the Board of Directors.
 In addition, the holders of Series A vote separately as a class in certain circumstances,
 including, without limitation, amendments to the Companys Second Amended and
 Restated Certificate of Incorporation, creation or issuance by the Company of any
 new class of securities having a preference senior to or on parity with the Series
 A, declaration or payment by the Company of any dividends or other distributions
 on the common stock, or the Company entering into certain transactions involving
 a merger, consolidation, or sale of all or substantially all of its assets.

Liquidation Preference

If the Company
 were dissolved or liquidated, voluntarily or involuntarily, the holders of the Series
 A would be entitled to receive, prior and in preference to any distribution of the
 Companys assets to the holders of any of its other equity securities, an amount
 equal to the greater of: (a) $1,000 per share (as adjusted for any stock splits,
 stock dividends and recapitalizations) plus accrued and unpaid dividends; or (b)
 the amount which such holder of the Series A would have received assuming all shares
 of Series A had been converted into common stock at the then applicable conversion
 rate immediately prior to any such dissolution or liquidation. If the

37



---



##### 



Company has
 insufficient assets and funds to distribute to the holders of Series A their full
 liquidation preference, then all of its assets and funds legally available for distribution
 shall be distributed pro rata among the holders of the Series A in proportion to
 the preferential amount each such holder is entitled to receive.

In addition,
 certain events, including, without limitation, a sale of all or substantially all
 of the Companys assets, or a change of control of the Company, may be designated
 by holders of Series A as a liquidation or dissolution, in which case, the above-described
 mechanisms for distribution of the Companys assets are applicable.

(7) STOCKHOLDERS EQUITY

In June 1998,
 the Company reincorporated in Delaware and adopted a Restated Certificate of Incorporation,
 Amended Bylaws and a Stockholder Rights Agreement. In October 2001, the Company
 amended its Restated Certificate of Incorporation to increase the number of authorized
 shares of the Company. The Restated Certificate of Incorporation, as amended, authorizes
 the Company to issue up to 60,000,000 shares of common stock, par value $.0001 per
 share, and 5,000,000 shares of preferred stock, par value $.0001 per share.

At February
 2, 2002, the Company has reserved the following shares of common stock for issuance
 in connection with:



|                              | Issuable upon |  |               |  |                
|----------------------------- | ------------- |  | ------------- |  | ---------------
|                              | conversion or |  |               |  |                
|                              | exercise of   |  | Available for |  | Total shares of
|                              | outstanding   |  | future sales  |  | common stock   
|                              | securities    |  | and grants    |  | reserved       
|                              |               |  |               |  |                
|Series A preferred stock      | 7,160,000     |  | 6,707,500     |  | 13,867,500     
|Stock warrants                | 405,226       |  |              |  | 405,226        
|Stock options                 | 3,836,778     |  | 2,454,491     |  | 6,291,269      
|Employee stock purchase plans |              |  | 172,367       |  | 172,367        
|Total                         | 11,402,004    |  | 9,334,358     |  | 20,736,362     

EQUITY TRANSACTIONS

On March 21,
 2001, the Company entered into a stock purchase agreement with its Chief Executive
 Officer, Gary G. Friedman in connection with his employment. Mr. Friedman purchased
 571,429 shares of common stock at $1.75 per share for a total purchase price of
 approximately $1 million. The difference between the fair market value of $2.1875
 per share on the closing date of the equity financing on March 21, 2001 and the
 purchase price of $1.75 per share resulted in a $250,000 charge that was expensed
 as compensation on that date.

Additionally,
 the Company granted Mr. Friedman an option to purchase 1,200,000 shares of common
 stock at $1.75 per share which he subsequently exercised. The terms of the option
 allow the Company to repurchase shares not fully vested at the time Mr. Friedman
 ceases, for any reason, to be an employee of the Company. The 1,200,000 shares vest
 and are no longer subject to the Companys repurchase option at the rate of
 33 1/3% upon completion of each year of service by Mr. Friedman to the Company.
 The difference between the fair market value of $2.1875 per share on the closing
 date of the equity financing and the purchase price of $1.75 results in a $525,000
 charge that will be expensed as compensation over the options thirty-six month
 vesting period. Furthermore, the Company granted Mr. Friedman an option to purchase
 200,000 shares of common stock at $6.00 per share. The 200,000 shares vest at the
 rate of 33-1/3% upon completion of each year of service by Mr. Friedman to the Company.

The aggregate
 purchase price for Mr. Friedmans purchase of the common stock was approximately
 $3,100,000, of which approximately $1,050,000 was paid in cash by Mr. Friedman and
 $2,050,000 was paid by Mr. Friedman in the form of a note, dated March 22, 2001,
 evidencing a loan from the Company to Mr. Friedman. Pursuant to the terms of the
 note, the interest rate on the outstanding principal amount of the loan in the original
 principal amount of $2,050,000 is 8.5% per annum, which interest is payable on the
 first, second and third anniversaries of the date of the note. The principal is
 due on March 22, 2004 but the due date may be accelerated due to a number of factors,
 including, Mr. Friedmans failure to make payments due under the note, expiration
 of the six-month period following the date Mr. Friedman ceases to be in the Companys
 employment as a result of termination for cause, or 90 days after the closing
 of an acquisition of the Company. The loan is a full recourse loan and is secured
 by shares of the common stock and preferred stock purchased by Mr. Friedman.

38



---



##### 



May financing  On May
 17, 2001, the Company completed a private placement sale with various
 institutional investors of 4,515,762 shares of common stock at $5.43 per share,
 resulting in aggregate net proceeds of approximately $24.5 million. As part of this
 private placement financing, the Company filed with the Securities and Exchange
 Commission on June 1, 2001, a registration statement on Form S-3 for the resale
 of the common stock acquired by these investors. The registration statement became
 effective on July 6, 2001.

November financing  On
 November 6, 2001, the Company completed a private placement sale with
 various institutional investors of 4,487,178 shares of our common stock at $3.90
 per share, resulting in aggregate net proceeds of approximately $17.5 million. As
 part of this private placement financing, the Company filed with the Securities
 and Exchange Commission on December 6, 2001, a registration statement on Form S-3
 for the resale of the common stock acquired by these investors.

STOCK OPTION GRANT AND COMMON STOCK PURCHASE

STOCK-BASED COMPENSATION PLANS

In April 1998,
 the Companys Board of Directors approved the 1998 Stock Incentive Plan (1998
 Plan), which serves as the successor to the Companys 1995 Stock Option
 Plan (the Predecessor Plan). The 1998 Plan is divided into five separate
 components: (i) the Discretionary Option Grant Program, (ii) the Stock Issuance
 Program, (iii) the Salary Investment Option Grant Program, (iv) the Automatic Option
 Grant Program and (v) the Director Fee Option Grant Program. The Discretionary Option
 Grant Program and Stock Issuance Program are administered by the Compensation Committee
 for Section 16 insiders and by a Secondary Committee of the Board of Directors for
 non-Section 16 insiders.

Under the
 1998 Plan, the Company originally authorized the Board of Directors to grant options
 of shares of common stock to key employees, directors, and consultants to purchase
 an aggregate of 3,287,662 shares of common stock. Such share reserve consists of
 (i) the number of shares available for issuance under the Predecessor Plan on June
 19, 1998, including the shares subject to outstanding options, and (ii) an additional
 increase of 980,000 shares. In addition, the number of shares of common stock reserved
 for issuance under the 1998 Plan will automatically be increased on the first trading
 day of each calendar year, beginning in calendar year 2000, by an amount equal to
 the lessor of (i) three percent of the total number of shares of common stock outstanding
 on the last trading day of the preceding calendar year or (ii) 966,202 shares. On
 January 2, 2002, January 2, 2001 and January 3, 2000, the Company added 853,670
 shares, 512,668 shares and 506,993 shares, respectively, to the 1998 Plan in accordance
 with the automatic increase provisions. Additionally, in July 2001, the Companys
 stockholders approved an increase of 1,000,000 shares of common stock under
 the 1998 Plan, as well as various other amendments to the 1998 Plan. In no event,
 however, may any one participant in the 1998 Plan receive option grants, separately
 exercisable stock appreciation rights or direct stock issuances for more than 1,000,000
 shares of common stock in the aggregate per calendar year.

For all options
 granted under the 1998 Plan, the vesting, exercise prices and other terms of the
 options are fixed by the Compensation Committee or Secondary Committee, as applicable.
 Options are granted at prices not less than the fair market value on the date of
 grant for incentive stock options and not less than 85% of the fair market value
 for non-statutory stock options. These options generally expire ten years from the
 date of grant and vest ratably over a three-year period. If any options are exercised
 before becoming vested, the holder can not sell or vote the shares until such shares
 have vested. If the holder leaves the Company before the options are fully vested,
 the Company has the right to repurchase unvested options at the employees
 original exercise price.

In May 2001,
 the Companys Board of Directors adopted a stock option program (the Program)
 outside of the Companys 1998 Plan pursuant to which options exercisable
 for up to 1,000,000 shares of common stock may be granted. Under the Program, the
 Board of Directors authorized a special purpose committee of the Board of Directors
 to administer the Program. The special purpose committee may make option grants
 to individuals as inducements to enter employment with the Company or, to the extent
 otherwise allowed under Nasdaq rules, as inducements to continue their employment
 with the Company, provided that in either case the terms of such grants are substantially
 similar to the terms of the stock option grants made pursuant to the 1998 Plan.
 Additionally, under the Program, options may be granted with an exercise price below
 the market price on The Nasdaq National Market on the date of grant, provided the
 special purpose committee first obtains approval of such grants from either the
 Board of Directors or the Compensation Committee. Vesting, exercise prices and other
 terms of the options are fixed by the special committee. Generally, options vest
 in one-third increments over a three-year period and have a term of not more than
 ten years from the grant date. The Board of Directors or the Compensation Committee
 may, in eithers sole discretion and at any time, restrict or withdraw from
 the special purpose committee, as to any particular matters or categories of matters,
 the authority to make any or particular option grants under the Program.

39



---



##### 



A summary
 of all employee option activity is set forth below:



|                                                                                    | NUMBER OFSHARES |            | WEIGHTEDAVERAGEEXERCISEPRICE
|----------------------------------------------------------------------------------- | --------------- | ---------- | ----------------------------
|                                                                                    |                 |            |                             
|Outstanding and exercisable, January 30, 1999                                       |                 | 2,254,001  |                             
|Granted with exercise price at fair value (weighted average fair value of $4.98)    |                 |            |                             
|Exercised                                                                           |                 | (561,337   | )                           
|Canceled                                                                            |                 | (282,992   | )                           
|                                                                                    |                 |            |                             
|Outstanding and exercisable, January 29, 2000                                       |                 | 2,409,798  |                             
|Granted with exercise price at fair value (weighted average fair value of $2.25)    |                 | 1,235,316  |                             
|Exercised                                                                           |                 | (78,252    | )                           
|Canceled                                                                            |                 | (623,902   | )                           
|                                                                                    |                 |            |                             
|Outstanding and exercisable, February 3, 2001                                       |                 | 2,942,960  |                             
|Granted with exercise price at fair value (weighted average fair value of $1.99)    |                 | 1,723,597  |                             
|Granted with exercise price above fair value (weighted average fair value of $0.06) |                 | 205,000    |                             
|Granted with exercise price below fair value (weighted average fair value of $1.57) |                 | 1,460,000  |                             
|Exercised                                                                           |                 | (1,612,076 | )                           
|Canceled                                                                            |                 | (882,703   | )                           
|                                                                                    |                 |            |                             
|Outstanding and exercisable, February 2, 2002                                       |                 | 3,836,778  |                             
|                                                                                    |                 |            |                             
|Vested at February 2, 2002                                                          |                 | 1,543,582  |                             
|                                                                                    |                 |            |                             
|Available for future grant at February 2, 2002                                      |                 | 2,454,491  |                             
|                                                                                    |                 |            |                             

Additional information regarding options
 outstanding as of February 2, 2002 is as follows:



|                |             |        |              |             |           |          | WEIGHTED  |        |          |          |  |           |          |   |      
|--------------- | ----------- | ------ | ------------ | ----------- | --------- | -------- | --------- | ------ | -------- | -------- |  | --------- | -------- | - | -----
|                |             |        |              |             |           |          | AVERAGE   |        | WEIGHTED |          |  |           | WEIGHTED
|                |             |        |              |             |           |          | REMAINING |        | AVERAGE  |          |  |           | AVERAGE 
|RANGE OF        |             | NUMBER |              | CONTRACTUAL |           | EXERCISE |           | NUMBER |          | EXERCISE
|EXERCISE PRICES | OUTSTANDING |        | LIFE (YEARS) |             | PRICE     |          | VESTED    |        | PRICE   
|                |             |        |              |             |           |          |           |        |          |         
|$               | 0.00        |       | 0.33         |             | 20,000    |          | 8.92      |        | $        | 0.32     |  | 20,000    |          | $ | 0.32 
|$               | 0.66        |       | 1.72         |             | 309,001   |          | 6.65      |        | $        | 1.30     |  | 209,438   |          | $ | 1.10 
|$               | 2.00        |       | 2.94         |             | 585,414   |          | 9.08      |        | $        | 2.36     |  | 107,297   |          | $ | 2.66 
|$               | 3.05        |       | 4.65         |             | 1,003,864 |          | 9.04      |        | $        | 4.25     |  | 139,167   |          | $ | 4.17 
|$               | 5.00        |       | 7.25         |             | 1,009,307 |          | 9.26      |        | $        | 5.87     |  | 270,654   |          | $ | 5.89 
|$               | 7.67        |       | 11.94        |             | 498,745   |          | 6.79      |        | $        | 10.42    |  | 409,846   |          | $ | 10.45
|$               | 12.38       |       | 14.50        |             | 53,456    |          | 7.28      |        | $        | 13.94    |  | 30,189    |          | $ | 14.50
|$               | 19.00       |       | 22.00        |             | 356,991   |          | 6.48      |        | $        | 19.86    |  | 356,991   |          | $ | 19.86
|                |             |        |              |             |           |          |           |        |          |          |  |           |          |   |      
|$               | 0.66        |       | $30.38       |             | 3,836,778 |          | 8.36      |        | $        | 6.52     |  | 1,543,582 |          | $ | 9.39 
|                |             |        |              |             |           |          |           |        |          |          |  |           |          |   |      

40



---



##### 



SFAS No. 123, Accounting for Stock-Based
Compensation requires the disclosure of pro forma net income had the
 Company adopted the fair value method as of the beginning of fiscal 1995. Under
 SFAS 123, the fair value of stock-based awards to employees is calculated through
 the use of option pricing models, even though such models were developed to estimate
 the fair value of freely traded, fully transferable options without vesting restrictions,
 which significantly differ from the Companys stock option awards. These models
 also require subjective assumptions, including future stock price volatility and
 expected time to exercise which greatly affect the calculated values. The Companys
 calculations were made using the Black-Scholes option pricing model with
 the following weighted average assumptions: expected life 54 months in all three
 years; stock volatility considered to be 50% in 2001, 21% in 2000, and 50% in 1999;
 risk free interest rates of 2.28% in 2001, 4.90% in 2000, and 6.50% in 1999, and
 no dividends during the expected term. The Companys calculations are based
 on a multiple option valuation approach and forfeitures are recognized as they occur.
 If the computed fair values of the awards had been amortized to expense over the
 vesting period of the awards, pro forma net income and per share amounts would have
 been as follows (dollars in thousands, except per share data):






|                                                   | FISCAL YEAR ENDED
|-------------------------------------------------- | -----------------
|                                                   |                  
|                                                   | FEBRUARY 2,2002  
|                                                   |                  
|Net income (loss) available to common stockholders |                  
|As reported                                        | $                
|Pro-forma                                          |                  
|Net Income (loss) per share:                       |                  
|Basic and diluted, as reported                     |                  
|Basic and diluted, proforma                        |                  




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 is designed to allow eligible
 employees, based on specified length of service requirements, of the Company and
 participating subsidiaries to purchase shares of common stock, at semi-annual intervals,
 through their periodic payroll deductions under the Purchase Plan. A reserve of
 475,000 shares of common stock has been established for this purpose. Individuals
 who are eligible employees may enter the Purchase Plan twice yearly and payroll
 deductions may not exceed 15% of total cash earnings. The purchase price per share
 will equal 85% of the lower of (i) the fair market value of the common stock on
 the participants entry date into the offering period or (ii) the fair market
 value on the semi-annual purchase date. During fiscal 2001, 2000 and 1999, employees
 purchased approximately 116,191 shares,89,856 shares and 96,592 shares, respectively,
 of the Companys common stock under the Purchase Plan at weighted average per-share
 prices of $1.33, $4.89 and $11.10, respectively. Through February 2, 2002, approximately
 302,639 shares had been issued under the Purchase Plan and 172,361 shares remained
 available for future issuance.

The Board
 of Directors may at any time alter, suspend or discontinue the Purchase Plan. However,
 certain amendments to the Purchase Plan may require stockholder approval.




(8) EMPLOYEE BENEFIT PLANS




The Company
 has a 401(k) plan for its employees who meet certain service and age requirements.
 Participants may contribute up to 15% of their salaries to a maximum of $10,000
 and qualify for favorable tax treatment under Section 401(k) of the Internal Revenue
 Code. In November 1997, the Company began matching 10% of the employees contribution
 up to a maximum of 4% of their base salary. The Company contributed $264,576, $221,977
 and $56,827 in the years ended February 2, 2002, February 3, 2001, and January 29,
 2000, respectively.




(9) OTHER RELATED PARTY TRANSACTIONS




The Company
 leases a store from the Chairman of the Board of Directors and his spouse and a
 partnership of which the Chairman is a partner. For the fiscal years ended February
 2, 2002, February 3, 2001, and January 29, 2001, rents of $65,657, $65,657, and
 $64,222 were paid in the aggregate to the Chairman and the partnership, respectively.
 The lease term expires on May 31, 2004 and there are no renewal options.

41



---



##### 



In connection
 with the preferred stock financing completed in March 2001, Mr. Friedman purchased
 455 shares of the Series A and 545 shares of the Series B preferred stock for an
 aggregate purchase price of $1 million. In addition, as part of Mr. Friedmans
 compensation package, we sold Mr. Friedman 571,429 shares of common stock at $1.75
 per share and Mr. Friedman exercised his option to purchase 1.2 million shares of
 common stock at $1.75 per share for an aggregate sales price of approximately $3.1
 million. In connection with this sale of preferred and common stock to Mr. Friedman,
 we also made a loan to Mr. Friedman in the amount of $2.05 million. All of the loan
 proceeds were used by Mr. Friedman to purchase a portion of this stock. The loan
 is a full recourse loan and is secured by shares of the common stock and preferred
 stock purchased by Mr. Friedman. This loan is evidenced by a note, dated March 22,
 2001. Pursuant to the terms of the note, the interest rate on the outstanding principal
 amount of the loan is 8.5% per annum, payable on the first, second and third anniversaries
 of the date of the note. The principal is due on March 22, 2004 but the due date
 may be accelerated due to a number of factors, including, failure to make payments
 due under the note, expiration of the six-month period following the date Mr. Friedman
 ceases to be an employee of the Company as a result of termination by the Company
 for cause, or 90 days after the closing of an acquisition of the Company.




(10) COMMITMENTS AND CONTINGENCIES




The Company
 is a party to various legal claims, actions and complaints. Although the ultimate
 resolution of legal proceedings cannot be predicted with certainty, management believes
 that disposition of these matters will not have a material adverse effect on the
 Companys consolidated financial statements.




(11) SEGMENT REPORTING




The Company
 classifies its business interests into three identifiable segments: retail, direct-to-customer
 and furniture manufacturing. The retail segment includes revenue and expense associated
 with the 104 retail locations. The direct to customer segment includes revenue and
 expenses associated with catalog and Internet sales. The furniture manufacturing
 segment includes all revenue and expense associated with our wholly-owned furniture
 manufacturer, The Michaels Furniture Co. The accounting policies of the segments
 are the same as those described in the summary of significant accounting policies
 (Note 1). The Company evaluates performance and allocates resources based on income
 from operations which excludes unallocated corporate general and administrative
 costs. Certain segment information, including segment assets, asset expenditures
 and related depreciation expense, is not presented as all assets of the Company
 are commingled and are not available by segment.

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






|                                    | FISCAL YEAR ENDED
|----------------------------------- | -----------------
|                                    |                  
|                                    | FEBRUARY 2,2002  
|                                    |                  
|Net sales                           |                  
|Retail                              | $                
|Direct-to-customer                  |                  
|Furniture manufacturing             |                  
|Intersegment furniture sales        |                  
|                                    |                  
|Consolidated net sales              | $                
|                                    |                  
|Income from operations              |                  
|Retail                              |                  
|Direct-to-customer                  |                  
|Furniture manufacturing             |                  
|Unallocated                         |                  
|Intersegment income from operations |                  
|                                    |                  
|Consolidated loss from operations   |                  
|                                    |                  







(12) ACQUISITION OF THE
MICHAELS FURNITURE COMPANY, INC.







On March 20,
 1998, the Company acquired 100% of the outstanding stock of The Michaels Furniture
 Company, Inc. (Michaels), a privately-owned manufacturer of wood furniture, from its sole shareholder
 and then-current President, Michael Vermillion. The Michaels acquisition was accounted
 for under the purchase method of accounting and all acquired assets and liabilities
 were recorded at their estimated fair market values.




42



---



##### 



Consideration
 given for the Michaels stock consisted of an initial cash payment of $5.0
 million at March 20, 1998, the date of the closing of the acquisition. Additionally,
 the Company was required to pay Mr. Vermillion contingent cash consideration based
 on a percentage of Michaels earnings before interest, taxes, depreciation
 and amortization (EBITDA). For the fiscal years ended February 3, 2001,
 January 29, 2000 and January 30,1999, EBITDA based payments of $80,000, $592,000
 and $647,000, respectively, were paid as additional purchase price to Mr. Vermillion.
 The period for additional consideration ended at February 3, 2001, and, as a result,
 no further consideration has been paid to Mr. Vermillion.

The Company
 leases the manufacturing operations buildings from Mr. Vermillion. For each of the
 years ended February 2, 2002, February 3, 2001 and January 29, 2000, rental payments
 of $346,560 were paid to Mr. Vermillion in each year.




(13) RESTATEMENT







Subsequent
 to the issuance of our consolidated financial statements for the
 year ended February 2, 2002, the Company identified accounting errors concerning
 our accounts payable and inventory balances as of February 2, 2002.
The errors, which resulted from the incorrect processing of certain
specific transactions, were primarily related to duplicate recording of payables
to vendors and to unrecorded amounts related to inventory freight costs. As
a result, the Company corrected for such identified errors and,
accordingly, the consolidated financial statements as of and for the year ended
 February 2, 2002 have been restated from the amounts previously reported. A summary
 of the significant effects of the restatement is as follows:









|                                                                                   | As of February 2, 2002     
|---------------------------------------------------------------------------------- | ---------------------------
|                                                                                   |                            
|(in thousands, except per share amounts)                                           | As Previously Report       
|                                                                                   |                            
|Merchandise inventories                                                            | $                          
|Total current assets                                                               |                            
|Other assets                                                                       |                            
|Total assets                                                                       |                            
|Accounts payable and accrued expenses                                              |                            
|Total current liabilities                                                          |                            
|Total liabilities                                                                  |                            
|Accumulated deficit                                                                |                            
|Total stockholders equity                                                         |                            
|Total liabilities, redeemable
convertible preferred stock and stockholders equity |                            
|                                                                                   |                            
|                                                                                   |                            
|                                                                                   | Year ended February 2, 2002
|                                                                                   |                            
|(in thousands, except per share amounts)                                           | As Previously Report       
|                                                                                   |                            
|Cost of sales and occupancy                                                        | $                          
|Gross profit                                                                       |                            
|Loss from operations                                                               |                            
|Loss before income taxes                                                           |                            
|Income tax benefit                                                                 |                            
|Loss before cumulative effect of change in accounting principle                    |                            
|Net loss                                                                           |                            
|Net loss available to common stockholders                                          |                            
|Loss per common share 
basic and diluted:                                         |                            
|Before cumulative effect of
change in accounting principle                         |                            
|Net loss                                                                           |                            
|                                                                                   |                            

|ITEM 9. | CHANGES IN
 AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
|------- | -------------------------------------------------------------------------------------

None.

43



---



##### 



PART III

Certain information
 required by Part III is omitted from this annual report in that we will have filed
 our definitive proxy statement pursuant to Regulation 14A no later than 120 days
 after the end of the fiscal year covered by this annual report and certain information
 is incorporated herein by reference.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS
 OF THE REGISTRANT

Information
 relating to our executive officers and directors will be set forth in the sections
 with the captions Executive Officers and Directors and Compliance
 with Section 16(a) of the Securities Exchange Act in our definitive proxy
 statement in connection with the annual meeting of stockholders to be held in July
 2002. This information is incorporated herein by reference.

ITEM 11. EXECUTIVE COMPENSATION AND OTHER
 INFORMATION

Information
 relating to executive compensation will be set forth in the section with the caption
 Executive Compensation and Other Information in our definitive proxy
 statement. This information is incorporated herein by reference.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
 OWNERS AND MANAGEMENT

Information
 relating to the security ownership of our common stock by our management and other
 beneficial owners will be set forth in the section with the caption Security
 Ownership of Certain Beneficial Owners and Management in our definitive proxy
 statement. This information is incorporated herein by reference.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED
 TRANSACTIONS

Information
 relating to certain relationships and related transactions between our company and
 directors, executive officers and stockholders owning greater than five percent
 of any class of voting securities will be set forth in the sections with the
 captions Employment Contracts, Termination of Employment and Change in Control
 Arrangements  and Certain Relationships and Related Transactions in our definitive
 proxy statement. This information is incorporated herein by reference.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULE
 AND REPORTS ON FORM 8-K

(a) The following
 are filed as a part of this annual report on Form 10-K.



1.   Index to
 Financial Statements


Consolidated Balance Sheet
Consolidated Statements of Operations
Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders Equity
Consolidated Statements of Cash Flows




2.   Financial
 Statement Schedule




Schedule II  Valuation
 and Qualifying Accounts




3.   Exhibits




The exhibits filed as part of
 this Form 10-K/A are listed in the Exhibit Index immediately preceding such exhibits, which Exhibit Index is
 incorporated herein by reference.


(b) Reports
 on Form 8-K:



(a) The Company filed an
 amendment to a Form 8-K on January 18, 2002, announcing that it had completed an equity financing in November
 2001 for an aggregate consideration to the Company of approximately $17.5 million.


44



---



##### 





(b) The Company filed a Form
 8-K on January 15, 2002, announcing the Companys holiday comparable store sales results.




(c) The Company filed
 a Form 8-K on November 21, 2001, announcing the Companys third quarter results.




(d) The Company filed a Form
 8-K on November 20, 2001, announcing the appointment of Kevin Shahan as the Companys new Chief Financial Officer.




(e) The Company filed a Form
 8-K on November 8, 2001, announcing the Companys third quarter sales results.




(f) The Company filed a Form
 8-K on November 7, 2001, announcing that it entered into a stock purchase agreement with a number
 of investors for the sale of its common stock for an aggregate consideration of approximately $17.5 million.




(g) The Company filed a Form
 8-K on November 6, 2001, announcing the incorporation by reference of the full text of the section
 titled Risk Factors that was included in the Companys Amendment No. 1 to its registration
 statement on Form S-3 (Registration No. 333-70624).


45



---



##### 



SIGNATURES




Pursuant to
 the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934,
 the registrant has duly caused this Amendment No. 2 to the annual report on Form
 10-K to be signed on its behalf by the undersigned, thereunto duly authorized, in
 the City of Corte Madera, State of California on this 23rd day of December, 2002.






| | RESTORATION
 HARDWARE, INC.
| | ---------------------------
| |                            
| | By:                        
| |                            
| |                            
| |                            
| |                            
| |                            
| |                            
| | Date: December
 23, 2002   




Pursuant to
 the requirements of the Securities Exchange Act of 1934, as amended, this Amendment
 No. 2 to the annual report on Form 10-K has been signed below by the following persons on behalf of
 the registrant and in the capacities and on the dates indicated.






|SIGNATURE            |  | TITLE                                                  |  | DATE             
|-------------------- |  | ------------------------------------------------------ |  | -----------------
|                     |  |                                                        |  |                  
|                     |  |                                                        |  |                  
|                     |  | Chairman                                               |  | December __, 2002
|                     |  |                                                        |  |                  
|Stephen J. Gordon    |  |                                                        |  |                  
|                     |  |                                                        |  |                  
|/s/ GARY G. FRIEDMAN |  | President, Chief Executive Officer and Director        |  | December 23, 2002
|                     |  |                                                        |  |                  
|Gary
G. Friedman     |  |                                                        |  |                  
|                     |  |                                                        |  |                  
|/s/ KEVIN W. SHAHAN  |  | Vice President, Chief Financial Officer
 and Secretary |  | December 23, 2002
|                     |  | (Principal Financial Officer)                          |  |                  
|Kevin W. Shahan      |  |                                                        |  |                  
|                     |  |                                                        |  |                  
|                     |  | Executive Vice President, Chief
 Operating Officer,    |  | December __, 2002
|                     |  | Assistant Secretary and Director                       |  |                  
|Thomas M. Bazzone    |  |                                                        |  |                  
|                     |  |                                                        |  |                  
|                     |  | Director                                               |  | December __, 2002
|                     |  |                                                        |  |                  
|Damon H. Ball        |  |                                                        |  |                  
|                     |  |                                                        |  |                  
|                     |  | Director                                               |  | December __, 2002
|                     |  |                                                        |  |                  
|Robert E. Camp       |  |                                                        |  |                  
|                     |  |                                                        |  |                  
|                     |  | Director                                               |  | December __, 2002
|                     |  |                                                        |  |                  
|Raymond C. Hemmig    |  |                                                        |  |                  
|                     |  |                                                        |  |                  
|                     |  | Director                                               |  | December __, 2002
|                     |  |                                                        |  |                  
|Glenn J. Krevlin     |  |                                                        |  |                  
|                     |  |                                                        |  |                  
|                     |  | Director                                               |  | December __, 2002
|                     |  |                                                        |  |                  
|Mark J. Schwartz     |  |                                                        |  |                  




46



---



##### 



RESTORATION HARDWARE,
 INC.

CERTIFICATION

I, Gary G. Friedman, certify that:






1. I have
 reviewed this annual report on Form 10-K/A of Restoration Hardware,
 Inc.;










2. Based on
 my knowledge, this annual report does not contain any untrue
 statement of a material fact or omit to state a material fact necessary to make
 the statements made, in light of the circumstances under which such statements were
 made, not misleading with respect to the period covered by this annual report; and










3. Based on
 my knowledge, the financial statements, and other financial information included
 in this annual report, fairly present in all material respects
 the financial condition, results of operations and cash flows of the registrant
 as of, and for, the periods presented in this annual report.












| | Date: December
 23, 2002
| | ------------------------
| |                         
| | By:                     
| |                         
| |                         

RESTORATION HARDWARE,
 INC.

CERTIFICATION

I, Kevin W. Shahan, certify that:






1. I have
 reviewed this annual report on Form 10-K/A of Restoration Hardware,
 Inc.;










2. Based on
 my knowledge, this annual report does not contain any untrue
 statement of a material fact or omit to state a material fact necessary to make
 the statements made, in light of the circumstances under which such statements were
 made, not misleading with respect to the period covered by this annual report; and










3. Based on
 my knowledge, the financial statements, and other financial information included
 in this annual report, fairly present in all material respects
 the financial condition, results of operations and cash flows of the registrant
 as of, and for, the periods presented in this annual report.










| | Date: December
 23, 2002
| | ------------------------
| |                         
| | By:                     
| |                         
| |                         

47



---



##### 



SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTSAS OF AND FOR THE FISCAL YEARS ENDED FEBRUARY
2, 2002, FEBRUARY 3, 2001 AND JANUARY 29, 2000(Dollars in Thousands)



|Column A                                          |  | Column B                       |       | Column C                             |  | Column D                |       | Column E  
|------------------------------------------------- |  | ------------------------------ | ----- | ------------------------------------ |  | ----------------------- | ----- | ----------
|                                                  |  |                                |       |                                      |  |                         |       |           
|Description                                       |  | Balances
 atBeginningof Period |       | AdditionsCharged toCosts andExpenses |  | Charged toOtherAccounts |       | Deductions
|                                                  |  |                                |       |                                      |  |                         |       |           
|AMOUNTS DEDUCTED FROM ASSETS TO WHICH THEY APPLY: |  |                                |       |                                      |  |                         |       |           
|Year ended January 29, 2000 Inventory reserves(1) |  | $                              | 130   |                                      |  | $                       | 4,115 |           
|Year ended February 3, 2001 Inventory reserves(1) |  |                                | 120   |                                      |  |                         | 4,149 |           
|Year ended February 2, 2002 Inventory reserves(1) |  |                                | 1,207 |                                      |  |                         | 9,425 |           



(1)  Amounts include reserves
 for shortages, damaged goods, and reductions in inventory to record inventory at its
 net realizable value.


48



---



##### 



EXHIBIT INDEX



|EXHIBIT NUMBER |       | DOCUMENT DESCRIPTION
|-------------- | ----- | --------------------
|               |       |                     
|               | 3.1   |                     
|               |       |                     
|               | 3.2   |                     
|               |       |                     
|               | 4.1   |                     
|               |       |                     
|               | 4.2   |                     
|               |       |                     
|               | 4.3   |                     
|               |       |                     
|               | 4.4   |                     
|               |       |                     
|               | 4.5   |                     
|               |       |                     
|               | 4.6   |                     
|               |       |                     
|               | 4.7   |                     
|               |       |                     
|               | 4.8   |                     
|               |       |                     
|+              | 10.1  |                     
|               |       |                     
|+              | 10.2  |                     
|               |       |                     
|+              | 10.3  |                     
|               |       |                     
|               | 10.4  |                     
|               |       |                     
|               | 10.5  |                     
|               |       |                     
|               | 10.6  |                     
|               |       |                     
|               | 10.7  |                     
|               |       |                     
|               | 10.8  |                     
|               |       |                     
|               | 10.9  |                     
|               |       |                     
|               | 10.10 |                     
|               |       |                     
|               | 10.11 |                     
|               |       |                     
|               | 10.12 |                     
|               |       |                     
|               | 10.13 |                     
|               |       |                     
|               | 10.14 |                     
|               |       |                     
|               | 10.15 |                     
|               |       |                     
|               | 10.16 |                     
|               |       |                     
|               | 10.17 |                     
|               |       |                     
|               | 10.18 |                     
|               |       |                     
|               | 10.19 |                     
|               |       |                     
|               | 10.20 |                     
|               |       |                     
|               | 10.30 |                     
|               |       |                     
|               | 10.31 |                     

49



---



##### 





|EXHIBIT NUMBER |       | DOCUMENT DESCRIPTION
|-------------- | ----- | --------------------
|               |       |                     
|               | 10.32 |                     
|               |       |                     
|               | 10.33 |                     
|               |       |                     
|               | 10.34 |                     
|               |       |                     
|               | 10.35 |                     
|               |       |                     
|               | 10.36 |                     
|               |       |                     
|               | 10.37 |                     
|               |       |                     
|               | 10.38 |                     
|               |       |                     
|               | 10.39 |                     
|               |       |                     
|               | 10.40 |                     
|               |       |                     
|               | 10.41 |                     
|               |       |                     
|               | 10.42 |                     
|               |       |                     
|               | 10.43 |                     
|               |       |                     
|+              | 10.44 |                     
|               |       |                     
|+              | 10.45 |                     
|               |       |                     
|               | 10.46 |                     
|               |       |                     
|*              | 10.47 |                     
|               |       |                     
|*              | 10.48 |                     
|               |       |                     
|*              | 10.49 |                     
|               |       |                     
|*              | 10.50 |                     
|               |       |                     
|               | 21    |                     
|               |       |                     
|**             | 23.1  |                     



---

|(1) | Incorporated by
 reference to the exhibit with the exhibit number 3.1 filed with the registrants Form
 8-K filed with the Securities and Exchange Commission on October 24, 2001.                                                             
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|    |                                                                                                                                                                                                                                                
|(2) | Incorporated by
 reference to the exhibit with the same number filed with the Companys Quarterly
 Report on Form 10-Q for the quarterly period ended October 31, 1998 filed with the Securities
 and Exchange Commission on December 15, 1998.
|    |                                                                                                                                                                                                                                                
|(3) | Incorporated by
 reference to the exhibit with the same number filed with the Companys Registration
 Statement on Form S-1 (File No. 333-51027) filed with the Securities and Exchange Commission
 on June 17, 1998.                          
|    |                                                                                                                                                                                                                                                
|(4) | Incorporated by
 reference to the exhibit with the same number filed with the Companys Report
 on Form 8-K filed with the Securities and Exchange Commission on April 2, 2001.                                                                
|    |                                                                                                                                                                                                                                                
|(5) | Incorporated by
 reference to the exhibit with the exhibit number 10.2 filed with the registrants
 Form 8-K filed with the Securities and Exchange Commission on May 23, 2001.                                                                
|    |                                                                                                                                                                                                                                                
|(6) | Incorporated by
 reference to the exhibit with the exhibit number 4.9 filed with the registrants
 Registration Statement on Form S-3 with the Securities and Exchange Commission on
 January 4, 2002.                                         

50



---



##### 





|(7)  | Incorporated by
 reference to the exhibit with the exhibit number 10.12 filed with the registrants
 Annual Report on Form 10-K for the year ended January 29, 2000 filed with the Securities
 and Exchange Commission on April 27, 2000.                   
|---- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|     |                                                                                                                                                                                                                                                             
|(8)  | Incorporated by
 reference to the exhibit with the exhibit number 10.12 filed with the registrants
 Annual Report on Form 10-K for the year ended January 29, 2000 filed with the Securities
 and Exchange Commission on April 27, 2000.                   
|     |                                                                                                                                                                                                                                                             
|(9)  | Incorporated by
 reference to the exhibit with the exhibit number 10.12 filed with the registrants
 Quarterly Report on Form 10-Q for the quarterly period ended October 28, 2000 filed
 with the Securities and Exchange Commission on December 12, 2000. 
|     |                                                                                                                                                                                                                                                             
|(10) | Incorporated by
 reference to the exhibit with the exhibit number 10.14 filed with the registrants
 Quarterly Report on Form 10-Q for the quarterly period ended October 28, 2000 filed with
 the Securities and Exchange Commission on December 12, 2000. 
|     |                                                                                                                                                                                                                                                             
|(11) | Incorporated by
 reference to the exhibit with the same number filed with the Companys Annual
 Report on Form 10-K for the year ended February 3, 2001 filed with the Securities and
 Exchange Commission on May 4, 2001.                                  
|     |                                                                                                                                                                                                                                                             
|(12) | Incorporated by
 reference to the exhibit with the exhibit number 10.1 filed with the registrants
 Form 8-K filed with the Securities and Exchange Commission on May 23, 2001.                                                                             
|     |                                                                                                                                                                                                                                                             
|(13) | Incorporated by
 reference to the exhibit with the exhibit number 10.2 filed with the registrants
 Quarterly Report on Form 10-Q for the quarterly period ended August 4, 2001, filed with
 the Securities and Exchange Commission on September 18, 2001.  
|     |                                                                                                                                                                                                                                                             
|(14) | Incorporated by
 reference to the exhibit with the exhibit number 10.18 filed with the registrants
 Quarterly Report on Form 10-Q for the quarterly period ended October 30, 1999, filed
 with the Securities and Exchange Commission on December 14, 1999.
|     |                                                                                                                                                                                                                                                             
|(15) | Incorporated by
 reference to the exhibit with the exhibit number 99.1 filed with the registrants
 registration statement on S-8 filed with the Securities and Exchange Commission on
 October 26, 2001.                                                   
|     |                                                                                                                                                                                                                                                             
|(16) | Incorporated by
 reference to the exhibit with the exhibit number 10.42 filed with the registrants
 Quarterly Report on Form 10-Q for the quarterly period ended November 3, 2001, filed
 with the Securities and Exchange Commission on December 18, 2001.
|     |                                                                                                                                                                                                                                                             
|(17) | Incorporated by
 reference to the exhibit with the exhibit number 10.1 filed with the registrants
 Form 8-K filed with the Securities and Exchange Commission on January 18, 2002.                                                                         
|     |                                                                                                                                                                                                                                                             
|+    | Management
 contract, compensatory plan or arrangement.                                                                                                                                                                                                     
|     |                                                                                                                                                                                                                                                             
|*    | Previously filed.                                                                                                                                                                                                                                           
|     |                                                                                                                                                                                                                                                             
|**   | Filed herewith.                                                                                                                                                                                                                                             

51