UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q/A

(MARK ONE)

[X]   QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES

EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED AUGUST 4, 2001

[   ]   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES

EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM ___________ TO_____________.

COMMISSION FILE NUMBER 333-51027

RESTORATION HARDWARE, INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE
(STATE OR OTHER JURISDICTION
OF INCORPORATION OR ORGANIZATION) 68-0140361
(I.R.S. EMPLOYER ID NO.)

15 KOCH ROAD, SUITE J, CORTE MADERA, CA 94925
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

REGISTRANT’S TELEPHONE NUMBER, INCLUDING AREA CODE (415) 924-1005

     Indicate by check [x] 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 requirement for the past 90 days [X] Yes [   ] No

     As of September 7, 2001, 23,808,594 shares of the registrant’s common stock were outstanding.

FORM 10-Q

FOR THE QUARTER ENDED AUGUST 4, 2001

INDEX

		PAGE
PART I. FINANCIAL INFORMATION
ITEM 1. Condensed Consolidated Financial Statements (unaudited)
	Balance Sheets as of August 4, 2001, February 3, 2001 and July 29, 2000		3
	Statements of Operations for the three and six months Ended August 4, 2001 and July 29, 2000		4
	Statements of Cash Flows for the six months ended August 4, 2001 and July 29, 2000		5
	Notes to Condensed Consolidated Financial Statements		6
ITEM 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			12
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk			28
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings			28
ITEM 2. Changes in Securities and Use of Proceeds
ITEM 4. Submission of Matters to a Vote of Security Holders			28
ITEM 6. Exhibits and Reports on Form 8-K			30
SIGNATURE PAGE			31
EXHIBIT INDEX			32

EXPLANATORY NOTE

This Form 10-Q/A to the Quarterly Report on Form 10-Q for the quarterly period ended August 4, 2001 is being filed to amend Part I, Item 2 (Management’s Discussion and Analysis of Financial Condition and Results of Operations), to change certain increases described therein expressed in terms of basis points to percentages.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands)
(Unaudited)

			August 4,			February 3,			July 29,
			2001			2001			2000
ASSETS
Current assets
	Cash and cash equivalents		$	2,603		$	2,610		$	2,408
	Accounts receivable			4,187			8,069			5,300
	Merchandise inventories			80,526			81,123			88,102
	Prepaid expense			8,879			7,954			8,532
	Tax benefit receivable			8,899			0			5,778
		Total current assets		105,094			99,756		$	110,120
	Property and equipment, net			105,388			117,186			114,216
	Goodwill			4,668			4,776			4,894
	Other long term assets			7,194			7,217			4,022
		Total assets	$	222,344		$	228,935		$	233,252
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable and accrued expenses		$	37,113		$	43,321		$	51,063
	Current portion of deferred lease incentives			4,530			4,575			4,030
	Revolving line of credit and short term debt			3			5,730			3
	Other current liabilities			7,573			8,494			5,371
		Total current liabilities		49,219			62,120			60,467
	Long-term debt			1,356			612			300
	Long-term line of credit			14,842			33,128			49,062
	Long-term portion of deferred lease incentives			39,371			41,944			38,418
	Deferred rent			11,784			10,787			9,485
		Total liabilities		116,572			148,591			157,732
Series A convertible preferred stock				14,170			0			0
Stockholders’ equity:
	Common stock, $.0001 par value; 40,000,000 shares authorized; 23,807,242, 17,100,142 and 17,027,332 issued and outstanding, respectively			124,366			94,901			94,697
	Shareholder loan			(2,050	)		0			0
	Accumulated deficit			(30,714	)		(14,557	)		(19,177	)
		Total stockholders’ equity		91,602			80,344			75,520
		Total liabilities, convertible preferred stock and stockholders’ equity		222,344		$	228,935		$	233,252

See Notes to Condensed Consolidated Financial Statements

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(Unaudited)

		Three Months Ended						Six Months Ended
		August 4,			July 29,			August 4,			July 29,
		2001			2000			2001			2000
Net sales		$	74,780		$	72,247		$	142,681		$	141,899
Cost of sales and occupancy			59,541			53,242			112,697			105,422
	Gross profit		15,239			19,005			29,984			36,477
Selling, general and administrative expenses			24,492			23,663			48,667			47,518
Loss from operations			(9,253	)		(4,658	)		(18,683	)		(11,041	)
Interest and other expense, net			(427	)		(1,135	)		(3,386	)		(2,030	)
	Loss before income taxes		(9,680	)		(5,793	)		(22,069	)		(13,071	)
Income tax benefit			3,487			2,376			7,947			5,358
	Net loss		(6,193	)		(3,417	)		(14,122	)		(7,713	)
Amounts allocable to convertible Preferred Stock			(1,122	)		0			(2,067	)		0
Loss available to common stockholders		$	(7,315	)	$	(3,417	)	$	(16,189	)	$	(7,713	)
Loss per share, basic and diluted			($0.31	)		($0.20	)		($0.80	)		($0.45	)
Weighted average shares basic and diluted			23,557			17,027			20,327			16,991

See Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(Unaudited)

				Six Months Ended
				August 4,			July 29,
				2001			2000
Cash flows from operating activities:
	Net loss			$	(14,122	)	$	(7,713	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Depreciation and amortization			8,831			7,179
		Change in fair value of warrant derivative			773			—
		Other			43			—
		Changes in assets and liabilities:
			Accounts receivable		3,881			1,252
			Merchandise inventories		(495	)		(2,201	)
			Prepaid expenses and other assets		(925	)		(889	)
			Accounts payable and accrued expenses		(6,206	)		5,678
			Taxes payable/receivable		(8,899	)		(6,556	)
			Other current liabilities		(1,109	)		(374	)
			Deferred rent		1,268			1,416
			Deferred lease incentives and other long-term liabilities		(1,728	)		721
			Net cash used in operating activities		(18,688	)		(1,487	)
Cash flows from investing activities:
	Proceeds from store closing agreements				5,325			—
	Capital expenditures				(991	)		(12,576	)
	Purchase of subsidiary				—			(91	)
	Foreign currency exchange gain (loss)				32			(24	)
			Net cash provided by (used in) investing activities		4,366			(12,691	)
Cash flows from financing activities:
	Net proceeds from private placement of preferred stock				13,511			—
	Net proceeds from private placement of common stock				24,357			—
	Borrowings/repayments under revolving line of credit — net				(17,719	)		11,615
	Debt issuance costs				(1,150	)		—
	Principal payments — capital lease obligations				(29	)		(50	)
	Borrowings (repayments) on long term debt, net				(6,000	)		15
	Issuance of common stock				1,345			379
			Net cash provided by financing activities		14,315			11,959
Net decrease in cash and cash equivalents					(7	)		(2,219	)
Cash and cash equivalents:
	Beginning of period				2,610			4,627
	End of period			$	2,603		$	2,408
	Non-cash transactions:
		Shareholder loan		$	2,050			—
		Amounts allocable to convertible preferred stock		$	1,122			—

     See Notes to Consolidated Financial Statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
THREE MONTHS ENDED AUGUST 4, 2001 AND JULY 29, 2000

1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business:

Restoration Hardware, Inc., a Delaware corporation, together with its subsidiaries, is a specialty retailer of high-quality home furnishings, decorative accessories and hardware. These products are sold through retail locations, catalogs and the Internet. As of August 4, 2001, we operated 104 retail stores in 31 states, the District of Columbia and Canada.

Basis of Presentation:

The accompanying interim condensed consolidated financial statements have been prepared from our records without audit and, in management’s opinion, include all adjustments (consisting of only normal recurring adjustments) necessary to present fairly the financial position at August 4, 2001, February 3, 2001 and July 29, 2000 results of operations for the three and six months ended August 4, 2001 and July 29, 2000, and cash flows for the six months ended August 4, 2001 and July 29, 2000. The balance sheet at February 3, 2001, as presented, has been derived from our audited financial statements for the year then ended. Certain reclassifications have been made to the 2000 presentation to conform to the 2001 presentation.

Our accounting policies are described in Note 1 to the audited consolidated financial statements for the year ended February 3, 2001. Certain information and disclosures normally included in annual financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted for purposes of the interim condensed consolidated financial statements. The interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements, including notes thereto, for the year ended February 3, 2001.

The results of operations for the three and six months presented herein are not necessarily indicative of the results to be expected for the full year.

2. RECENTLY ISSUED ACCOUNTING STANDARDS

Effective February 4, 2001, the Company adopted Statement of Financial Accounting Standards (“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.

In accordance with the provisions of SFAS No. 133, as amended, in the second quarter of fiscal 2001 we recorded a non-cash credit to interest expense of $700,000 to reflect the change in fair value through August 4, 2001 of the 550,000 putable warrants outstanding which were issued in conjunction with the September 2000 amendment of our credit facility, discussed below. For the first six months of fiscal 2001, the fair value adjustment was a non-cash charge to interest expense of $773,000. The fair value of the warrants will continue to be marked to market until the earlier of the date the warrants are converted into common stock, or the expiration of the warrants on September 27, 2005.

In June 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard (SFAS) No. 141, Business Combinations. SFAS No. 141 requires that all business combinations initiated after June 30, 2001 be accounted for under the purchase method and addresses the initial recognition and measurement of goodwill and other intangible assets acquired in a business combination. We do not expect the adoption of SFAS 141 to have an impact on the financial position, results of operations or cash flows of the Company.

In June 2001, the Financial Accounting Standards Board also issued Statement of Financial Accounting Standard (SFAS) No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 addresses the initial recognition and measurement of intangible assets acquired outside of a business combination and the accounting for goodwill and other intangible assets subsequent to their acquisition. SFAS No. 142 provides that intangible assets with finite useful lives be amortized and that goodwill and intangible assets with indefinite lives will not be amortized, but will rather be tested at least annually for impairment. We will adopt SFAS No. 142 for its fiscal year beginning February 3, 2002. Upon adoption of SFAS 142, we will stop our amortization of goodwill with a net carrying value of $4,560,000 at February 2, 2002 and annual amortization of $215,000 that resulted from business combinations initiated prior to the adoption of SFAS 141, Business Combinations. We will evaluate goodwill under the SFAS 142 transitional impairment test and have not yet determined whether or not there is an impairment loss. Any transitional impairment loss will be recognized as a change in accounting principle.

3. REVOLVING LINE OF CREDIT

During the second quarter of fiscal 2001, we permanently paid down Tranche C of our amended credit facility. As a result, our amended credit facility now provides for an overall commitment of $85.0 million, including up to $20.0 million for letters of credit. Maximum borrowings under the credit agreement are limited by reference to a borrowing base calculation, based upon eligible inventory and accounts receivable. Maximum borrowings under the credit facility are typically much less than the $85.0 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. The agreement contains restrictive covenants, including capital expenditure limits, and minimum availability requirements based on seasonality.

As of August 4, 2001 we believe we were in compliance with the covenants under the credit facility, and we had outstanding $14.8 million in loans (net of debt issuance costs of $2.9 million) and $8.6 million in outstanding letters of credit. The credit facility expires on June 30, 2003.

In September 2000, as part of an amendment to the then-existing credit facility, warrants to purchase 550,000 shares of Common Stock were issued to the lenders. The warrants contain a put feature which makes them subject to the rules of derivative accounting discussed above.

4. EARNINGS PER SHARE

Basic earnings per share is computed as net income available to common shareholders divided by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur from common shares to be issued through stock options, warrants and other convertible securities. The potential dilutive effects of 1,562,608 shares of common stock subject to outstanding stock options, 550,000 shares of common stock subject to outstanding warrants and 7,500,000 shares of common stock reserved for conversion of the Series A Preferred Stock are excluded from the diluted earnings per share calculation for the period ended August 4, 2001, and 498,938 shares of common stock subject to outstanding stock options are excluded from the diluted earnings per share for the period ended July 29, 2000, because their inclusion in net loss periods would be anti-dilutive to earnings per share.

5. SEGMENT REPORTING

We classify our business interests into three identifiable segments: retail, direct-to-customer and furniture. The retail segment includes revenue and expense associated with our retail locations. The direct-to-customer segment includes all revenue and expense associated with our catalog and e-commerce operations. The furniture segment includes all revenue and expense associated with The Michaels Furniture Company (“Michaels”).

We evaluate performance and allocate 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 our business segments is as follows (dollars in thousands):

			Second Quarter						Year-to-Date
			2001			2000			2001			2000
	Sales:
		Retail	$	68,051		$	68,136		$	129,623		$	132,878
		Direct-to-Customer		6,722			3,917			13,021			8,116
		Furniture		3,935			4,384			9,644			10,908
		Intersegment		(3,928	)		(4,190	)		(9,607	)		(10,003	)
Total sales			$	74,780		$	72,247		$	142,681		$	141,899

		Second Quarter						Year-to-Date
		2001			2000			2001			2000
Income/(Loss) from operations
	Retail	$	1,391		$	6,601		$	1,911		$	10,363
	Direct-to-customer		252			41			146			5
	Furniture		(362	)		(121	)		42			85
	Unallocated		(10,417	)		(11,176	)		(20,373	)		(21,430	)
	Intersegment loss from Operations		(117	)		(3	)		(408	)		(64	)
Consolidated loss from operations		$	(9,253	)	$	(4,658	)	$	(18,683	)	$	(11,041	)

6.      COMMON STOCK FINANCING

As of May 17, 2001, we issued 4,515,762 shares of our common stock at $5.43 per share in a private placement transaction, resulting in aggregate net proceeds of approximately $24.4 million. As part of this private placement financing, we 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. Additionally, we agreed to keep the registration statement effective until the sooner to occur of (A) the date on which all the shares of common stock included within the registration statement have been sold, (B) the date on which all of the investors, respectively, may sell within a three-month period under Rule 144 in compliance with any applicable volume limitations under Rule 144 of the Securities Act of 1933, as amended, all of the shares of common stock registered under such registration statement, or (C) May 17, 2003.

7. STORE CLOSINGS

During the first quarter of fiscal 2001, we signed agreements with a third party to cancel leases and close three of our under-performing locations. In April 2001, we received cash compensation of $4 million for the closing of our Soho, NY store. In May 2001 the two additional stores were closed and we received an additional $1.3 million. After recording costs associated with the closings, and the associated write-offs of property, equipment and other miscellaneous assets, the financial impact from these closings was not material.

8. PRIVATE PLACEMENT AND APPOINTMENT OF NEW CEO

In late March 2001, we entered into a sale of our preferred stock with net proceeds to us of approximately $13.5 million and appointed Mr. Gary Friedman as our new Chief Executive Officer. In addition, we sold Mr. Friedman 571,429 shares of our Common Stock at a price per share of $1.75 and Mr. Friedman exercised his option to purchase 1,200,000 shares of our common stock at a price of $1.75 per share for an aggregate sales price of approximately $3.1 million. Approximately $1.05 million was paid in cash by Mr. Friedman and $2.05 million was paid by Mr. Friedman in the form of a note.

CONVERTIBLE PREFERRED STOCK

Our Second Amended and Restated Certificate of Incorporation (the “Amended Certificate”) authorizes 5,000,000 shares of preferred stock (the “Preferred Stock”). In connection with the private placement transaction in March 2001, the Board of Directors designated, by resolution, 28,037 shares of the undesignated Preferred Stock as Series A Preferred Stock (“Series A”) and 21,217 shares of the undesignated Preferred Stock as Series B Preferred Stock (“Series B”). Each has a par value of $.0001 per share.

We entered into an Amended and Restated Series A and B Preferred Stock Purchase Agreement (the “Preferred Stock Purchase Agreement”) dated as of March 21, 2001 with several investors, including Mr. Friedman. Pursuant to the terms of the Preferred Stock Purchase Agreement, we issued 6,820 shares of Series A and 8,180 shares of Series B, each for $1,000 per share, for net proceeds to us of approximately $13.5 million after accounting for expenses relating to the transaction. Under the terms of the Certificate of Designation of the Series A and Series B (the “Certificate of Designation”), the Series B automatically converted on a one for one basis into Series A at such time as a majority of our stockholders approved the conversion. At the annual meeting of stockholders held on July 11, 2001, the conversion feature of the Series B was approved, and accordingly all 8,180 outstanding shares of Series B were converted into Series A. The unamortized difference between the fair market value of $2.1875 per share on the closing date of the transaction and the conversion price of $2.00 per share resulted in an allocation of the beneficial conversion feature of approximately $747,000 in the second quarter of fiscal 2001.

CONVERTIBLE PREFERRED STOCK SERIES A (“SERIES A”)

Convertibility

The Series A is immediately convertible at the option of the holder into shares of our common stock (“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 dilutive events. We may require conversion of the Series A, in whole or in part, by sending written notice of the conversion to holders of Series A at any time after March 22, 2004 if the average closing price per share of the Common Stock for the 20 trading days ending three business days preceding the date that the request is sent exceeds three times the then-current conversion price of the Series A. Upon our notice of conversion, holders of Series A shall be deemed to have demanded registration of their shares of Series A. If such holders subsequently choose not to include their shares in the registration statement, they may request redemption of their shares of Series A, in which case we must redeem the shares of Series A in accordance with the terms of the Certificate of

Designation. Any such redemption would be for a redemption price of $1,000 plus all accrued and unpaid dividends. If the holders do not participate in the registration, but also do not request redemption, their shares will automatically convert into Common Stock.

Redemption

We may redeem the Series A, in whole or in 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 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 our mandatory redemption rights and the redemption rights of the holders of Series A in connection with our mandatory 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. We shall not pay or declare any dividend on any Common Stock or any of our 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. Net loss to common shareholders for the first six months of 2001 includes accretion of approximately $660,000 for Series A dividends.

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 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 our Amended Certificate, our creation or issuance of any new class of securities having a preference senior to or on parity with the Series A, our declaration or payment of any dividends or other distributions on the Common Stock, or our entering into certain transactions involving a merger, consolidation, or sale of all or substantially all of our assets.

Liquidation Preference

If we 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 our assets to the holders of any of our 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 we have insufficient assets and funds to distribute to the holders of Series A their full liquidation preference, then all of our 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 our assets, or a change of control may, be designated by holders of Series A as a liquidation or dissolution, in which case, the above described mechanisms for distribution of our assets are applicable.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

THE THREE MONTHS (SECOND QUARTER) ENDED AUGUST 4, 2001 AS COMPARED TO THE THREE MONTHS (SECOND QUARTER) ENDED JULY 29, 2000 and THE SIX MONTHS (YEAR-TO-DATE) ENDED AUGUST 4, 2001 AS COMPARED TO THE SIX MONTHS (YEAR-TO-DATE) ENDED JULY 29, 2000

Net Sales

     Net sales consist of the following components:

		2nd Quarter 2001					2nd Quarter 2000					Year-to-Date 2001					Year-to-Date 2000
		Dollars		% Total			Dollars		% Total			Dollars		% Total			Dollars		% Total
Retail			68,051		91.0	%		68,136		94.3	%		129,623		90.9	%		132,878		93.7	%
Direct-to-Customer			6,722		9.0	%		3,917		5.4	%		13,021		9.1	%		8,116		5.7	%
Furniture			7		0.0	%		194		0.3	%		37		0.0	%		905		0.6	%
	Total Sales		74,780		100.0	%		72,247		100.0	%		142,681		100.0	%		141,899		100.0	%

Net sales for the second quarter of fiscal 2001 increased $2.5 million, or 3.5%, over net sales for the second quarter of fiscal 2000. The increase in net sales is principally due to improved performance in our direct-to-customer division offset by weak comparable store sales. Net sales amounts include shipping fees. As of

August 4, 2001, we operated 104 stores in 31 states, the District of Columbia and in Canada as compared to 98 stores as of July 29, 2000.

Year-to-date, sales for the first six months of fiscal 2001 increased $782,000 or 0.6% as compared to the same period of the prior year. As with the second quarter of fiscal 2001, improved performance in the direct-to-customer division was mostly offset by decreased comparable store sales.

Retail Sales

	Second Quarter			Second Quarter			Year-to-Date			Year-to-Date
	2001			2000			2001			2000
Retail sales		68,051			68,136			129,623			132,878
Retail growth percentage		-0.1	%		34.8	%		-2.5	%		24.1	%
Comparable store sales growth		-6.3	%		0.8	%		-11.4	%		-0.7	%
Number of stores at period end		104			98			104			98
Average selling sq. ft. per store		6,567			6,524			6,567			6,524
Store selling sq. ft. at period end		682,936			650,476			682,936			650,476

Retail sales in the second quarter of fiscal 2001 decreased 0.1% as compared to the same period of the prior year primarily due to a 6.3% decrease in comparable store sales. Comparable store sales are defined as sales from stores whose gross square footage 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 13th 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. As of August 4, 2001 94 stores were included in the comparable sales calculation.

Retail sales for the first six months of fiscal 2001 decreased 2.5% as compared to the same period of the prior year primarily as a result of weak comparable store sales. We opened one new store in the first six months of fiscal 2001 and closed 3 stores, as compared to 5 new store openings and no store closings in the first six months of fiscal 2000. We will not open any additional locations in fiscal 2001.

Direct-to-Customer

Direct-to-customer sales consist of catalog and e-commerce sales. Net direct-to-customer sales in the second quarter of fiscal 2001 increased $2.8 million or 71.6% as compared to the second quarter of fiscal 2000. Sales from our website

in the second quarter of fiscal 2001 were more than double the sales from our website for the same period of the prior year.

Circulation of our summer catalogs in the second quarter of fiscal 2001 increased 12.0% as compared to the same quarter of the prior year. In addition, we mailed 2.4 million Father’s Day gift guides, of which 2.1 million were mailed into retail trade areas. We believe this significantly limited decreases in our comparable stores sales in June, and suggests that our stated strategy of using catalogs to enhance our retail business may be successful in the future.

Direct-to-customer sales for the first six months of fiscal 2001 increased 60.4% as compared to the same period of fiscal 2000. Circulation of spring and summer catalogs, excluding catalogs mailed into retail trade areas, increased 44.9% as compared to the same period of the prior year.

Furniture Sales

Furniture sales consist of Michaels’ sales to external customers. Over the past 3 years, we have reduced Michaels’ external sales to third-party customers so as to be able to increase production capacity for our stores and direct-to-customer businesses.

COST OF GOODS SOLD AND OCCUPANCY

Cost of goods sold and occupancy expenses expressed as a percentage of net sales increased 5.9% to 79.6% in the second quarter of fiscal 2001 from 73.7% in the second quarter of fiscal 2000. The increase is principally attributable to the markdown activity associated with clearing unproductive inventories. As a result, year-over-year average store inventory decreased 16.7%. We believe this is a positive development for us and puts us in a better position to place new products in our stores throughout the balance of the year.

Year-to-date, cost of goods sold and occupancy expenses increased 4.7% to 79.0% from 74.3% in the same period of the previous year, primarily as a result of clearance activity associated with the repositioning of our business.

SELLING, GENERAL AND ADMINISTRATIVE

Selling, general and administrative expenses expressed as a percentage of net sales for the second quarter of fiscal 2001 were flat to the same period of the prior year, at 32.8%. For the first six months of fiscal 2001, selling, general and administrative expenses increased 0.6% to 34.1% of sales from 33.5% of sales for the same period of the previous year, primarily as a result of the decrease in comparable store sales during this period.

INTEREST AND OTHER EXPENSE, NET

Interest and other expense decreased $700,000, to $427,000 in the second quarter of fiscal 2001 from $1.1 million in the second quarter of fiscal 2000. Interest and other expense includes a non-cash credit of $700,000 related to a mark to market of the 550,000 warrants outstanding, as well as a non-cash charge of $400,000 for amortization of deferred financing costs.

Year-to-date, interest and other expense for the first six months of fiscal 2001 increased $1.4 million, to $3.4 million in fiscal 2001 from $2.0 million in fiscal 2000. The increase of $1.4 million includes a non-cash charge of $773,000 related to the mark to market of the outstanding warrants, as well as a non-cash charge of $704,000 for amortization of deferred financing costs.

INCOME TAXES

Our effective tax benefit rate was 36.0% in the second quarter of fiscal 2001, as compared to a tax benefit rate of 41.0% in the second quarter of fiscal 2000. 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.

LIQUIDITY AND CAPITAL RESOURCES

Net cash used in operating activities for the first six months of fiscal 2001 increased $17.2 million, to $18.7 million from $1.5 million for the first six months of fiscal 2000. The increase resulted primarily from an increased net loss and increased payments for accounts payable and other accrued expenses.

Net cash from investing activities for year-to-date fiscal 2001 increased $17.1 million, to a $4.4 million source of cash from a $12.7 million use of cash for year-to-date fiscal 2000. In the first quarter of fiscal 2001 we signed agreements with a third party to cancel leases and close three of our under-performing locations, for which we received $5.3 million. Capital expenditures for the first six months of fiscal 2001 decreased $11.6 million as compared to the same period of the prior year. During the current period, the Company opened one new store location in Santa Clara, CA. In the comparable period of the prior year, expenditures included five new stores and the Baltimore, MD facility.

Net cash provided by financing activities was $14.3 million for the first six months of fiscal 2001 as compared to $12.0 million for the first six months of fiscal 2000. In March of 2001 we completed a preferred stock financing, appointed a new Chief Executive Officer and amended our credit facility. For additional discussion of the rights, preferences and restrictions related to our preferred stock financing, refer to note 8 of the condensed consolidated financial statements. In May of 2001 we completed a common stock financing. For additional discussion of our

common stock financing, refer to note 6 of the condensed consolidated financial statements. Combined net proceeds from our preferred stock financing and common stock financing transactions were $37.9 million and were used to pay down our revolving line of credit and for other general corporate purposes. In the first six months of fiscal 2000, substantially all of the cash provided by financing activities was from borrowings under our line of credit facility.

Pursuant to our senior secured credit facility, as amended in March 2001, we have a line of credit of up to a maximum of $85.0 million with amounts available for letters of credit under the line up to a maximum of $20.0 million. The availability under the credit agreement is limited by reference to a borrowing base calculation, based upon eligible inventory and accounts receivable. Moreover, the amount available under the credit facility is typically much less than the $85.0 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. The agreement contains restrictive covenants, including capital expenditure limits. As of August 4, 2001 we believe we were in compliance with the covenants under the credit facility and we had outstanding $14.8 million in loans (net of debt issuance costs of $2.9 million) and $8.6 million in outstanding letters of credit. The credit facility expires on June 30, 2003.

In connection with an amendment to our credit facility in September 2000, we issued putable warrants for the purchase of 550,000 shares of our common stock at $3.75 per share. The warrants expire on September 27, 2005. The fair value of the warrants is calculated each quarter using the Black-Scholes model. For the second quarter of fiscal 2001, the revaluation of the warrants resulted in a non-cash credit to interest expense of $700,000.

We currently believe that the combination of the infusion of capital from the March 2001 preferred stock financing, the May 2001 common stock financing, cash flow from our operations and funds available under our credit facility will satisfy our expected working capital and capital expenditure requirements for at least the next 12 months. However, adverse developments 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.

FACTORS THAT MAY AFFECT FUTURE RESULTS

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. 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.

In addition, we make decisions regarding merchandise well in advance of the season in which it will be sold, particularly for the holiday selling season. We also 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 $4.4 million per year to approximately $14.1 million per year. As a result, if we misjudge the directions or trends in our market, we may significantly overstock unpopular products and understock popular ones while expending large amounts of our cash on advertising that generates little return on investment. All of these results 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 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 net sales decreased 1% in fiscal 2000, and increased 0.8% in fiscal 1999 and increased 12.3% in fiscal 1998. Comparable store sales decreased 6.3% for the second quarter of the fiscal year ending February 2, 2002. 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.

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 17% of our aggregate merchandise purchases in the fiscal year ended February 3, 2001. 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 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 would 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.

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 a $85.0 million credit facility, the amount available under this facility is typically much less than the $85.0 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 2001 common stock financing, 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 any increase in external funding required by these shortfalls may not be available to us.

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 include, among others, Fleet Capital Corporation. 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. The most recent amendment of our credit facility occurred in March 2001 in connection with our Series A and B preferred stock financing. The amended credit facility provided us with a line of credit of up to a maximum of $91.0 million, with amounts available for letters of credit under the line up to a maximum of $20.0 million. During the second quarter of fiscal 2001, we permanently paid down Tranche C of our amended credit facility. As a result, our amended credit facility now provides for an overall commitment of $85.0 million, including the $20.0 million for letters of credit. 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. Moreover, failure to comply with the terms of the credit facility would entitle the secured lenders to foreclose on our assets, including our accounts, 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.

We may be unable to raise additional funds that we will need to remain competitive.

We depend on a number of different financing sources to fund our continued operations, including third party financings and borrowings that may include debt, equity or other securities. 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 might 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.

We have increasing interest and other expense which 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 and other, which is net of interest income and includes amortization of debt issuance costs, and mark to market of warrant derivative interest expense on borrowings under our credit facility, increased $4.4 million to $5.8 million for the fiscal year ended February 3, 2001 from $1.4 million for the fiscal year ended January 29, 2000. For the fiscal year ended January 29, 2000, interest expense increased only $0.5 million to $1.4 million. The increase in interest expense in the past fiscal year resulted from both an increase in the average borrowings outstanding and an increase in the average interest rate. However, cash generated from our operations was not sufficient to cover operating expenses and capital expenditures. Consequently, we were required to make continuous borrowings under our credit facility during the fiscal year ended February 3, 2001. While our credit facility was amended in March 2001 to provide us with a more favorable interest rate, a substantial portion of our cash flow from operations must be used to pay our interest expense and will not be available for other business purposes. Interest expense continues to be a significant use of our available cash. Our ability to meet our debt and other obligations and to reduce our total debt 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.

During the fiscal year ended February 3, 2001, we purchased approximately 18% 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 2, 2002. 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 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 have a material adverse effect on our financial condition and results of operations in the future.

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

We may invest additional resources in the expansion of direct-to-customer business which could increase the risks associated with aspects of this business. While we out-source the fulfillment aspects of this segment, including telemarketing, customer service and distribution, to New Roads Corporation, increased efforts 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 cost increases associated with direct-to-customer business will not have an adverse effect on the profitability of our business.

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 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 is redefining and redirecting the focus of our stores, and implementing changes in the nature and types of many products we sell. If 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 items which prove popular could have a material adverse effect on our operating results.

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.

A material decline in sales and other adverse conditions resulting from our failure to accurately anticipate changes in merchandise trends and consumer demands may further require us to close under-performing stores. The closure of such stores would subject us to additional costs including but not limited to taking reserves on impaired assets, loss of goodwill and costs associated with outstanding lease obligations.

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

As our management team changes 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 who 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 product 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 demand and trends, and any downturn in the U.S. economy.

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.

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 new Chief Executive Officer, Mr. Gary G. Friedman. 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.

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

We believe that there currently is a general trend in the economy of weakening retail sales, and we further believe that we may continue to be hurt by this

trend. In particular, a weakening environment for retail sales could adversely affect consumer interest in our major product lines. Our comparable store net sales decreased 1% for the fiscal year ended February 3, 2001. Our second quarter sales for the fiscal year ending February 2, 2002 decreased 0.1% from the same period of the prior year. The success of our business depends to a significant extent upon the level of consumer spending, and 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. They also may 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 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.

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 suppliers or manufacturers by us or our competitors, proposed acquisitions by us or our competitors, financial results that fail to meet public market analyst 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, investors in our Series A preferred stock financing have been granted demand registration rights under an investor rights agreement pursuant to which they may make a demand on us at any time beginning September 17, 2001 to register in excess of 8 million shares of our common stock. Additionally, 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. 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 warrants, 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 certificate of incorporation and 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 certificate of incorporation and 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 some types of mergers, consolidations, acquisitions and similar transactions, and 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 our stockholders.

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 against United States targets, rumors or threats of war, actual conflicts involving the United States or its allies or military or trade disruptions impacting our domestic or foreign suppliers of merchandise, may impact our operations, including, among other things, causing delays or losses in the delivery of merchandise to us and decreased sales of the of the products we carry. More generally, 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.

SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995

This quarterly report on Form 10-Q 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 our plans to open additional stores, the results of strategic initiatives, the anticipated performance of new stores, 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 management’s opinion. These forward-looking statements and assumptions involve known and unknown risks, uncertainties and other factors that may cause the actual results, market performance or our 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 to anticipate changes in consumer trends, loss of key vendors, changes in the competitive environment in which we operate, competition for and the

availability of sites for new stores, 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 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 report.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

There are no material changes to our market risk as disclosed in our report on Form 10-K filed for the fiscal year ended February 3, 2001.

PART II. OTHER INFORMATION

ITEM 1. 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, and, while the results of the proceedings cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse effect on our consolidated financial position or results of operations.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.

CHANGES IN SECURITIES

At the annual meeting of stockholders held on July 11, 2001, our stockholders approved the conversion feature of our Series B preferred stock into Series A preferred stock and accordingly all outstanding shares of Series B preferred stock were converted automatically into Series A preferred stock. At the same meeting, our stockholders also approved the elimination of the limitation set forth in our Certificate of Designation of the Series A and Series B pursuant to which Series A preferred stock was convertible into no more than 3,410,000 shares of our common stock. Consequently, if all 15,000 shares of Series A preferred stock presently outstanding are converted into common stock at the present conversion rate of one share of Series A preferred stock to 500 shares of common stock, 7,500,000 shares of our common stock will be issuable as a result. In connection with our May 2001 common stock financing, we separately entered into a Consent and Waiver Regarding Additional Financing pursuant to which we agreed with holders of our outstanding preferred stock to accelerate the date by which we will effect a registration on Form S-3 (or its equivalent) for their benefit to the later of (i) such time as Form S-3 (or its equivalent) becomes available for use in a registered offering by us and (ii) October 1, 2001.

SALE OF UNREGISTERED SECURITIES

We entered into a Stock Purchase Agreement, dated as of May 17, 2001, with a number of accredited investors pursuant to which we received net proceeds in an aggregate amount of approximately $24.4 million in consideration for 4,515,762 shares of our common stock at a price of $5.43 per share. The transaction was led by a group of institutional investors including funds managed by Capital Research and Management Company and Fidelity Management and Research Company on behalf of funds and accounts managed by it. Other institutional investors included Baron Asset Management, Apex Capital, LLC and Buckingham RAF Partners, LP. Because each of the purchasers in this transaction met the definition of an accredited investor under Regulation D of the Securities Act of 1933, and because the sales of shares were made without general solicitation or advertising, the transaction was deemed to be exempt from registration under the Securities Act in reliance on Section 4(2) thereof.

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

(a)  The Company held its 2001 Annual Meeting of Stockholders on July 11, 2001.

(c)  As of the close of business on the record date, we had 19,279,567 shares of our common stock outstanding and entitled to vote on all proposals presented at the annual meeting, held by 134 stockholders of record. We had 6,820 shares of our Series A preferred stock outstanding and entitled to vote on all proposals presented at the annual meeting, held by 16 stockholders of record. The holders of our Series B preferred stock did not have any right to vote on any of the proposals at the annual meeting. Of these outstanding shares, 92.3% or 20,935,804 shares of common stock and Series A preferred stock (on an as-converted basis of 500 to 1) were represented at such meeting, in person or by proxy, which constituted a quorum. The matters voted upon at the Annual Meeting and the results of the voting as to each such matter are set forth below:

i. The following individuals were elected as our Class III directors to serve for a three-year term until the 2004 Annual Meeting of the stockholders or until their successors are duly elected and qualified:

	Votes For		Votes Withheld
Stephen J. Gordon		20,832,810		102,994
Gary G. Friedman		20,904,068		31,736

ii. Approval of an amendment and restatement of our 1998 stock incentive plan to increase the number of shares of our common stock authorized for issuance thereunder by one million shares, and, in accordance with Section 162(m) of the Internal Revenue Code, to limit the number of shares issuable under the plan to any individual participant to one million shares or, with respect to any new hire, one and a half million shares during such participant’s first year of employment.

For	Against		Abstain		Broker Non-Votes
13,804,587		2,235,347		18,146		4,877,724

iii(A).  Approval of the weighted-average antidilution feature of our Series A preferred stock and any issuance of our common stock as a result of the application of such antidilution feature.

For	Against		Abstain		Broker Non-Votes
15,957,390		71,886		28,804		4,877,724

iii(B).  Approval of the conversion features of our Series B preferred stock into Series A preferred stock and any issuance of our common stock as a result of the application of such conversion features. Upon obtaining such approval, each share of the Series B preferred stock was automatically converted into a share of the Series A preferred stock.

For	Against		Abstain		Broker Non-Votes
15,959,440		72,153		26,487		4,877,724

iv. The ratification of the appointment of Deloitte & Touche, LLP as our independent auditors for the fiscal year ending February 2, 2002.

For	Against		Abstain		Broker Non-Votes
20,905,654		18,050		12,100		0

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) Exhibits

      See attached exhibit index.

(b) Reports on Form 8-K

(ii)	On May 23, 2001, we filed a current report on Form 8-K dated May 17, 2001, reporting that we had completed a private placement of our common stock.
(iii)	On July 10, 2001 we filed a current report on Form 8-K, dated July 5, 2001, reporting that our Secretary, Chief Financial Officer, Executive Vice President and Chief Administrative Officer had resigned.
(iv)	On August 13, 2001, we filed a current report on Form 8-K, dated July 16, 2001, reporting the employment of Tom Bazzone as our Executive Vice President and Chief Operating Officer and the appointment of Mr. Bazzone as director of the company and reporting our second quarter results.
(v)	On August 22, 2001, we filed a current report on Form 8-K, dated the same date, reporting our second quarter results.

Signatures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this amendment to quarterly report on Form 10-Q to be signed on its behalf by the undersigned thereunto duly authorized.

	Restoration Hardware, Inc.
Date: January 4, 2002	By: /s/ GARY G. FRIEDMAN
	Gary G. Friedman President and Chief Executive Officer (Principal Executive Officer)

Date: January 4, 2002	By: /s/ KEVIN W. SHAHAN
	Kevin W. Shahan Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)

EXHIBIT INDEX

EXHIBIT NUMBER	DOCUMENT DESCRIPTIONS
3.1	Amended and Restated Certificate of Incorporation(1)
3.2	Bylaws, as amended to date(2)
4.1	Reference is made to Exhibit 3.1
4.2	Reference is made to Exhibit 3.2
4.3	Specimen Common Stock Certificate(1)
4.4	Specimen Series A Preferred Stock Certificate(3)
4.5	Specimen Series B Preferred Stock Certificate(3)
4.6	Certificate of Designation of Series A and Series B Preferred Stock(3)

EXHIBIT NUMBER	DOCUMENT DESCRIPTIONS
4.7	Amended and Restated Series A and B Preferred Stock Purchase Agreement dated as of March 21, 2001, by and among Restoration Hardware, Inc. and the investors named therein.(4)
4.8	Amended and Restated Investor Rights Agreement, dated as of March 21, 2001, by and among Restoration Hardware, Inc. and the investors named therein.(5)
4.9	Consent and Waiver Regarding Additional Financing.(6)
10.1	Stock Purchase Agreement, dated as of May 17, 2001, by and among Restoration Hardware, Inc. and certain investors named therein.(6)
*10.2	Offer Letter, dated June 26, 2001, from Restoration Hardware, Inc. to Tom Bazzone.

(1)	Incorporated by reference to the exhibit with the same number filed with the registrant’s Amendment No. 1 to the Registration Statement on Form S-1 (File No. 333-51027), filed with the Securities and Exchange Commission on June 2, 1998.
(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 Report on Form 8-K filed with the Securities and Exchange Commission on April 2, 2001.
(4)	Incorporated by reference to Exhibit 10.19 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on April 2, 2001.
(5)	Incorporated by reference to Exhibit 10.18 to the registrant’s Form 8-K filed with the Securities and Exchange Commission on April 2, 2001.
(6)	Incorporated by reference to the exhibit with the same number filed with the registrant’s Form 8-K filed with the Securities and Exchange Commission on May 23, 2001.
*	Previously filed.