Form 10-Q

10-Q 1 d10q.htm FORM 10-Q Form 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended October 29, 2005

¨	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: 000-24261

RESTORATION HARDWARE, INC.

(Exact name of registrant as specified in its charter)


DELAWARE		68-0140361
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)

15 KOCH ROAD, SUITE J, CORTE MADERA, CA		94925
(Address of principal executive offices)		(Zip Code)

(415) 924-1005

(Registrant’s telephone number, including area code)

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 requirement for the past 90 days.

Yes x No ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x No ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):

Yes ¨ No x

As of November 17, 2005, 37,727,029 shares of the registrant’s common stock, $0.0001 par value per share, were outstanding.

FORM 10-Q

FOR THE QUARTER ENDED OCTOBER 29, 2005

TABLE OF CONTENTS


PART I.	FINANCIAL INFORMATION	3

Item 1.	Interim Condensed Consolidated Financial Statements (Unaudited)	3

	Interim Condensed Consolidated Balance Sheets as of October 29, 2005, January 29, 2005, and October 30, 2004 (as restated)	3

	Interim Condensed Consolidated Statements of Operations for the third quarter and nine months ended October 29, 2005 and October 30, 2004 (as restated)	4

	Interim Condensed Consolidated Statements of Cash Flows for the nine months ended October 29, 2005 and October 30, 2004 (as restated)	5

	Notes to Interim Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	24

Item 4.	Controls and Procedures	24

PART II.	OTHER INFORMATION	25

Item 1.	Legal Proceedings	25

Item 6.	Exhibits	25

SIGNATURES		26

EXHIBIT INDEX		27

PART I. FINANCIAL INFORMATION

Item 1.

Interim Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

INTERIM CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except share data)

(Unaudited)


	October 29, 2005			January 29, 2005			October 30, 2004 (As restated- see Note 2)
ASSETS
Current assets:
Cash and cash equivalents	$	3,635		$	1,904		$	1,692
Accounts receivable		9,415			6,945			6,305
Merchandise inventories		164,138			144,185			157,457
Prepaid expense and other current assets		21,363			19,574			19,718

Total current assets		198,551			172,608			185,172
Property and equipment, net		90,157			81,886			82,701
Goodwill		4,560			4,560			4,560
Deferred tax assets, net		18,582			18,745			18,107
Other assets		7,237			1,464			7,794

Total assets	$	319,087		$	279,263		$	298,334

LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	66,126		$	63,920		$	65,949
Debt, current portion, net of issuance costs		—			33,819			64,206
Deferred revenue and customer deposits		11,778			8,130			7,446
Other current liabilities		13,092			14,948			12,247

Total current liabilities		90,996			120,817			149,848
Long-term debt, net of issuance costs		79,578			—			—
Deferred lease incentives		28,445			30,365			30,513
Deferred rent		20,064			20,321			20,440
Other long-term obligations		40			143			196

Total liabilities		219,123			171,646			200,997

Commitments and contingencies
Series A redeemable convertible preferred stock, $.0001 par value, 28,037 shares designated, 0, 8,473 and 8,473 shares issued and outstanding at October 29, 2005, January 29, 2005 and October 30, 2004 respectively		—			8,331			8,331

Stockholders’ equity:
Common stock, $.0001 par value; 60,000,000 shares authorized; 37,726,029, 33,084,223 and 33,025,509 issued and outstanding at October 29, 2005, January 29, 2005 and October 30, 2004 respectively		4			3			3
Additional paid-in capital		169,492			159,233			158,912
Unearned compensation		—			—			(22	)
Accumulated other comprehensive income		1,015			812			1,456
Accumulated deficit		(70,547	)		(60,762	)		(71,343	)

Total stockholders’ equity		99,964			99,286			89,006

Total liabilities, redeemable convertible preferred stock and stockholders’ equity	$	319,087		$	279,263		$	298,334

See Notes to Interim Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except share data)

(Unaudited)


	Third Quarter						First Nine Months
	Fiscal 2005			Fiscal 2004 (As restated – see Note 2)			Fiscal 2005			Fiscal 2004 (As restated – see Note 2)
Net revenue	$	128,402		$	118,165		$	390,648		$	337,965
Cost of revenue and occupancy		84,033			80,134			267,363			239,887

Gross profit		44,369			38,031			123,285			98,078

Selling, general and administrative expense		50,302			42,511			136,725			111,199

Loss from operations		(5,933	)		(4,480	)		(13,440	)		(13,121	)
Interest expense, net		(1,164	)		(737	)		(2,823	)		(1,673	)

Loss before income taxes		(7,097	)		(5,217	)		(16,263	)		(14,794	)
Income tax benefit		2,887			2,136			6,478			5,917

Net loss	$	(4,210	)	$	(3,081	)	$	(9,785	)	$	(8,877	)

Loss per share of common stock, basic and diluted	$	(0.11	)	$	(0.09	)	$	(0.28	)	$	(0.27	)

Weighted average shares outstanding, basic and diluted		37,648			33,017			34,673			32,904

See Notes to Interim Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

INTERIM CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)


	First Nine Months
	Fiscal 2005			Fiscal 2004 (As restated – see Note 2)
Cash flows from operating activities:
Net loss	$	(9,785	)	$	(8,877	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization		14,240			11,747
Changes in operating assets and liabilities:
Accounts receivable		(1,372	)		(560	)
Merchandise inventories		(19,953	)		(54,531	)
Prepaid expense, deferred tax and other assets		(6,918	)		(10,476	)
Accounts payable and accrued expenses		2,206			20,657
Deferred revenue and customer deposits		3,648			215
Other current liabilities		(1,856	)		809
Deferred rent		(257	)		216
Deferred lease incentives		(3,018	)		(3,486	)

Net cash used by operating activities		(23,065	)		(44,286	)
Cash flows from investing activities:
Capital expenditures		(22,036	)		(10,090	)

Net cash used by investing activities		(22,036	)		(10,090	)
Cash flows from financing activities:
Borrowings under line of credit, net		45,428			53,555
Repayments-other long-term obligations		(103	)		(156	)
Issuance of common stock		1,448			528

Net cash provided by financing activities		46,773			53,927
Effects of foreign currency exchange rate translation		59			138

Net increase (decrease) in cash and cash equivalents		1,731			(311	)
Cash and cash equivalents:
Beginning of period		1,904			2,003

End of period	$	3,635			1,692

Additional cash flow information:
Cash paid during the period for interest	$	2,044		$	1,332
Cash paid during the period for income taxes		624			593
Non-cash financing transactions:
Conversion of preferred stock to common stock	$	8,331		$	210
Tenant improvement allowance receivable		1,098			—

See Notes to Interim Condensed Consolidated Financial Statements.

NOTES TO INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business

Restoration Hardware, Inc., a Delaware corporation, and its subsidiaries (collectively, the “Company”) is a specialty retailer of high-quality home furnishings, functional and decorative hardware, bathware and bath fixtures and related merchandise that reflects its classic and authentic American point of view. These products are sold through retail locations, catalogs and the Internet. As of October 29, 2005, the Company operated 102 retail stores and five outlet stores in 30 states, the District of Columbia and Canada.

Basis of Presentation

The accompanying Interim Condensed Consolidated Financial Statements have been prepared from the Company’s records without audit and, in management’s opinion, include all adjustments (consisting of normal recurring adjustments) necessary to present fairly the financial position at October 29, 2005, January 29, 2005 and October 30, 2004, results of operations for the third quarters and nine months ended October 29, 2005 and October 30, 2004, respectively, and changes in cash flows for the nine months ended October 29, 2005 and October 30, 2004, respectively. The financial position at January 29, 2005, as presented, has been derived from the Company’s audited Consolidated Financial Statements for the fiscal year then ended. The Interim Condensed Consolidated Financial Statements for the prior interim periods have been restated. See Note 2 of the Interim Condensed Consolidated Financial Statements for additional information. The cumulative effect of this restatement was an increase in accumulated deficit of $3.9 million as of October 30, 2004 and an increase in pre-tax results of $62 thousand ($37 thousand, after tax) and $382 thousand ($229 thousand after tax) for the third quarter and nine months ended October 30, 2004, respectively.

Accounting policies followed by the Company are described in Note 1 to the audited Consolidated Financial Statements included in the Company’s Form 10-K, for the fiscal year ended January 29, 2005 (“fiscal 2004”). Certain information and disclosures normally included in the notes to annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America 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 the notes thereto, for fiscal 2004.

The results of operations for the third quarter and nine months ended October 29, 2005 presented in this Form 10-Q are not necessarily indicative of the results to be expected for the full year.

Stock-based Compensation

The Company accounts for stock-based employee compensation using the intrinsic value method in accordance with the provisions of Accounting Principals Board Opinion No. 25, “Accounting for Stock Issued to Employees.” The following table illustrates the effect on net loss and loss per share of common stock if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” to all stock-based employee compensation:


	Third Quarter						First Nine Months
(Dollars in thousands, except share data)	Fiscal 2005			Fiscal 2004 (As restated – see Note 2)			Fiscal 2005			Fiscal 2004 (As restated – see Note 2)
Net loss as reported	$	(4,210	)	$	(3,081	)	$	(9,785	)	$	(8,877	)
Add: Stock-based employee compensation expense for all options granted below fair market value included in reported net loss (net of tax)		—			23			—			127
Deduct: Compensation expense for all stock-based employee compensation (net of tax) calculated in accordance with the fair value method		(822	)		(968	)		(2,669	)		(2,549	)

Pro forma net loss	$	(5,032	)	$	(4,026	)	$	(12,454	)	$	(11,299	)

Loss per share of common stock:
Basic and diluted, as reported	$	(0.11	)	$	(0.09	)	$	(0.28	)	$	(0.27	)
Basic and diluted, pro forma	$	(0.13	)	$	(0.12	)	$	(0.36	)	$	(0.34	)

Comprehensive Loss

Comprehensive loss consists of net loss and foreign currency translation adjustments. The components of comprehensive loss for the third quarters and nine months ended October 29, 2005 and October 30, 2004 are as follows:


	Third Quarter						First Nine Months
(Dollars in thousands)	Fiscal 2005			Fiscal 2004 (As restated – see Note 2)			Fiscal 2005			Fiscal 2004 (As restated – see Note 2)
Components of comprehensive loss:
Net loss	$	(4,210	)	$	(3,081	)	$	(9,785	)	$	(8,877	)
Foreign currency translation adjustment		123			435			203			401

Total comprehensive loss	$	(4,087	)	$	(2,646	)	$	(9,582	)	$	(8,476	)

(2) RESTATEMENT OF INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

On February 7, 2005, the Office of the Chief Accountant of the Securities and Exchange Commission (“SEC”) issued a letter to the American Institute of Certified Public Accountants expressing its views regarding certain operating lease-related accounting issues and their treatment under accounting principles generally accepted in the United States of America (“GAAP”). In response to this letter, management reviewed its lease accounting and determined that the Company’s method of accounting for rent holidays was not in accordance with GAAP. As a result, the Company restated its accompanying Interim Condensed Consolidated Financial Statements as of and for the third quarter and the nine months ended October 30, 2004.

Historically, and consistent with industry practice, the Company has recognized the straight line rent expense for leases generally beginning on the store opening date, which had the effect of excluding the construction period of its stores (rent holiday) from the calculation of the period over which the Company expensed rent. The Company determined that the appropriate accounting treatment is to include the construction period in its calculation of straight line rent in accordance with Financial Accounting Standards Board (“FASB”) Technical Bulletin No. 85-3, “Accounting for Operating Leases with Scheduled Rent Increases.” The Company corrected its straight line rent accrual and deferred rent credits accordingly. The cumulative effect of this restatement was an increase in accumulated deficit of $3.3 million as of October 30, 2004 and an increase in pre-tax results of $62 thousand ($37 thousand, after tax) and $382 thousand ($229 thousand, after tax) for the third quarter and nine months ended October 30, 2004, respectively. Additionally, the Company corrected an error recorded in fiscal 2001 related to tax accounting; the correction had the effect of increasing the accumulated deficit and decreasing prepaid tax assets by $0.6 million as of October 30, 2004.

Following is a summary of the effects of the restatement on the Company’s Interim Condensed Consolidated Financial Statements as of and for the third quarter and nine months ended October 30, 2004 (in thousands except share data):


	Interim Condensed Consolidated Statement of Operations
(Dollars in thousands, except per share data)	As previously reported			Adjustments		As restated
*Third quarter ended October 30, 2004*
Cost of revenue and occupancy	$	80,196		(62	)	80,134
Gross profit		37,969		62		38,031
Loss from operations		(4,542	)	62		(4,480	)
Loss before income taxes		(5,279	)	62		(5,217	)
Income tax benefit		2,161		(25	)	2,136
Net loss		(3,118	)	37		(3,081	)
Net loss per share of common stock—basic and diluted	$	(0.09	)	0.00		(0.09	)

	Interim Condensed Consolidated Statement of Operations
(Dollars in thousands, except per share data)	As previously reported			Adjustments		As restated
*First nine months ended October 30, 2004*
Cost of revenue and occupancy	$	240,269		(382	)	239,887
Gross profit		97,696		382		98,078
Loss from operations		(13,503	)	382		(13,121	)
Loss before income taxes		(15,176	)	382		(14,794	)
Income tax benefit		6,070		(153	)	5,917
Net loss		(9,106	)	229		(8,877	)
Net loss per share of common stock—basic and diluted	$	(0.28	)	0.01		(0.27	)

	Interim Condensed Consolidated Balance Sheet
(Dollars in thousands)	As previously reported			Adjustments		As restated
*October 30, 2004*
Prepaid expense and other current assets	$	21,016		(1,298	)	19,718
Deferred tax assets, net		15,194		2,913		18,107
Other assets		7,947		(153	)	7,794
Deferred rent		15,053		5,387		20,440
Accumulated deficit		(67,403	)	(3,940	)	(71,343	)
Total stockholders’ equity	$	92,931		(3,925	)	89,006

3. LONG-TERM DEBT, NET

On July 29, 2005 the Company entered into an agreement (the “Amendment”) to amend its existing revolving credit facility. The Amendment increased the revolving loan commitment available to the Company under the facility from $100.0 million to $150.0 million and provided for an extension of the maturity date of the revolving loan from June 30, 2006 to June 30, 2009. In addition, the Amendment reduced the interest rate on base advances and provided for incremental advances with availability determined from the application of a higher advance rate on the Company’s borrowing base. Those incremental advances would be subject to higher interest rates. To the extent that borrowings are outstanding under the incremental advance provision, the Company would be required to maintain a minimum fixed charge coverage ratio. The Amendment also eliminated the lock box restriction except upon the occurrence of certain events, such as an event of default. Other elements of the revolving credit facility remain materially unchanged.

As of October 29, 2005, $79.6 million was outstanding under the facility, net of unamortized debt issuance costs of $1.0 million, and there was $10.5 million in letters of credit outstanding. As a result of the Amendment, the balance of $79.6 million at October 29, 2005 is considered a long-term liability rather than a current liability and has been classified accordingly. Borrowings made under the revolving credit facility are subject to interest at either the bank’s reference rate or LIBOR plus a margin. As of October 29, 2005, the bank’s reference rate was 6.75% and the LIBOR plus margin rate was 5.39%. The availability of credit at any given time under the revolving credit facility is limited by reference to a borrowing base formula based upon numerous factors, including the value of eligible inventory and eligible accounts receivable, and reserves established by the agent of the revolving credit facility. As a result of the borrowing base formula, the actual borrowing availability under the facility could be less than the stated amount of the facility reduced by the actual borrowings and outstanding letters of credit.

The revolving credit facility contains various restrictive covenants, including limitations on the ability to incur additional debt, acquisition of other businesses and payment of dividends and other distributions. The revolving credit facility does not contain any other significant financial or coverage ratio covenants unless the Company takes advantage of the incremental advance provision. If the Company does receive an advance under the incremental advance provision, the Company is required to maintain a fixed asset coverage ratio. The revolving credit facility also does not require that the Company repay all borrowings for a proscribed “clean-up” period each year.

4. INCOME TAXES

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 Consolidated Financial Statements or tax returns. In estimating future tax consequences, the Company generally takes into account all expected future events then known to it, other than changes in the tax law or rates, which are not permitted to be considered. Accordingly, the Company may record a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. The amount of valuation allowance would be based upon management’s best estimate of the recoverability of its deferred tax assets. While future taxable income and ongoing prudent and feasible tax planning are considered in determining the amount of the valuation allowance, this allowance is subject to adjustment in the future. Likewise, should the Company determine that it would not be able to realize all or part of its 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.

5. LOSS PER SHARE OF COMMON STOCK

Basic loss per share of common stock is computed by dividing net loss by the weighted average number of shares of common stock outstanding for the periods. Diluted loss per share of common stock is computed by dividing net loss by the weighted average number of common stock and potentially dilutive common stock equivalents outstanding during the period. Diluted loss per share of common stock reflects the potential dilution that could occur if options to issue common stock were exercised, or preferred stock previously outstanding had been converted into common stock. The following table details potential dilutive effects of the weighted average number of certain common stock equivalents that have been excluded from diluted loss per share of common stock, because their inclusion would be anti-dilutive, since the Company experienced a net loss in each of the third quarters and first nine months of fiscal 2005 and 2004, respectively:


	Third Quarter		First Nine Months
	Fiscal 2005	Fiscal 2004	Fiscal 2005	Fiscal 2004
Common stock issuable upon conversion of the Series A preferred stock	—	4,260,572	2,840,096	4,314,982
Common stock subject to outstanding stock options	904,026	597,109	863,690	631,949

Total	904,026	4,857,681	3,703,786	4,946,931

The above stock options represent only those stock options whose exercise prices are less than the average market price of the stock for the periods. In addition to the stock options included in the table above, there were an additional 3,955,642 and 4,754,306 for the third quarters of fiscal 2005 and 2004, respectively, and 3,988,461 and 4,143,719 stock options for the first nine months of fiscal 2005 and 2004, respectively, that were excluded from the table because the option exercise price for those stock options exceeded the average stock price for those periods. All outstanding shares of Series A preferred stock were converted effective July 30, 2005 into common stock. See Note 7 to the Interim Condensed Consolidated Financial Statements for additional information.

6. SEGMENT REPORTING

The Company classifies its business interests into two identifiable segments: retail and direct-to-customer. The retail segment includes all revenue and expenses associated with the Company’s retail locations. The direct-to-customer segment includes all revenue and expenses associated with catalog and Internet revenue. The Company also has a wholly owned furniture manufacturing company located in Sacramento, California, The Michaels Furniture Company, Inc. (“Michaels”). Michael’s revenue is recorded as either retail revenue or direct-to-customer revenue based on the channel in which the sale was initiated, and management decisions on resource allocation and performance assessment are made based on these two identifiable segments. The Company evaluates performance and allocates resources based on results from operations, which excludes certain unallocated costs. Certain segment information, including segment assets, asset expenditures and related depreciation expense, is not presented as all of the Company’s assets are commingled and are not available by segment.

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


	Third Quarter						First Nine Months
(Dollars in thousands)	Fiscal 2005			Fiscal 2004			Fiscal 2005			Fiscal 2004
Net Revenue:
Retail	$	92,256		$	89,747		$	278,832		$	259,094
Direct-to-customer		36,146			28,418			111,816			78,871

Consolidated net revenue	$	128,402		$	118,165		$	390,648		$	337,965


	Third Quarter						First Nine Months
	Fiscal 2005			Fiscal 2004 (As restated – see Note 2)			Fiscal 2005			Fiscal 2004 (As restated – see Note 2)
Income (loss) from operations:
Retail	$	7,617		$	8,211		$	23,286		$	21,308
Direct-to-customer		2,683			1,494			13,725			8,553
Unallocated		(16,233	)		(14,185	)		(50,451	)		(42,982	)

Consolidated loss from operations	$	(5,933	)	$	(4,480	)	$	(13,440	)	$	(13,121	)

7. CONVERSION OF SERIES A PREFERRED STOCK

As of July 30, 2005 the remaining holders of the Series A preferred stock elected to convert their shares of Series A preferred stock into common stock. Pursuant to the Company’s Certificate of Designation of Series A and Series B Preferred Stock, each share of Series A preferred stock was convertible into such number of shares of common stock as determined by dividing $1,000 by the conversion price, which was $1.9889 at the time of such conversion. As a result of the conversion, the 8,473 shares of Series A preferred stock outstanding on July 30, 2005 were converted into 4,260,144 shares of common stock.

8. NEW ACCOUNTING PRONOUNCEMENTS

In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “Inventory Costs,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). This statement is effective for the Company’s 2006 fiscal year. The Company believes the adoption of SFAS 151 will not have a significant impact on the overall results of operations or financial position.

In December 2004, the FASB issued SFAS No. 123(R) ”Share-Based Payment.” SFAS 123(R) requires the recognition of compensation expense relating to share-based payment transactions in consolidated financial statements. That expense will be measured based on the fair value of the equity or liability instruments issued as of the grant date, for the estimated number of awards that are expected to vest. SFAS 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. SFAS 123(R) replaces SFAS 123, “Accounting for Stock Based Compensation,” and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) is effective for interim periods that begin after December 15, 2005. The Company is allowed to select from three alternative transition methods, each having different reporting implications. The Company has not completed its evaluation to determine the impact of adopting SFAS 123(R).

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

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

Item 2.

Management’s Discussion And Analysis Of Financial Condition And Results Of Operations

OVERVIEW

Our Company, Restoration Hardware, Inc. (Nasdaq: RSTO), together with our subsidiaries, is a specialty retailer of high quality home furnishings, bath fixtures and bathware, functional and decorative hardware and related merchandise that reflects our classic and authentic American point of view. We commenced business in 1979 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. Our core merchandise offerings include premium textiles, bath fixtures and hardware, lighting, decorative accessories and furniture. We market our merchandise through retail locations, mail order catalogs and on the Internet 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. Over the next decade, we believe the fastest growing segment of the U.S. population will be 45 to 60 year olds. We believe that as these customers evolve, so will their purchasing needs and desires. We believe that our products can fulfill their aspirations to have homes designed with a high quality, classic and timeless style. Our plan is to fill the void in the marketplace above the current home lifestyle retailers, and below the interior design trade, by providing products targeted to 35 to 60 year olds and centered around our core businesses that reflect a predictable, high-quality promise to our customers.

We operate on a 52-53 week fiscal year ending on the Saturday closest to January 31st. Our current fiscal year is 52 weeks and ends on January 28, 2006 (“fiscal 2005”) and the prior fiscal year was 52 weeks and ended on January 29, 2005 (“fiscal 2004”).

The Interim Condensed Consolidated Financial Statements for the prior periods have been restated. See Note 2 of the Interim Condensed Consolidated Financial Statements for additional information. The disclosure and amounts included in this Management’s Discussion and Analysis of Financial Condition and Results of Operations reflect the effects of the restatement.

As of October 29, 2005, the Company operated 102 full-priced retail stores and five outlet stores in 30 states, the District of Columbia and Canada. In addition to our retail stores, we operate a direct-to-customer (“direct”) sales channel that includes both catalog and Internet. In the second quarter of fiscal 2005, we began the remodel of a majority of our stores. The remodeled stores enabled us to expand the merchandise offerings in certain core categories, particularly lighting and textiles, and present those offerings with more clarity and focus. The remodeling program required an investment of approximately $15.0 million of which approximately $14.3 million was paid in the first nine months of fiscal 2005 and has been reflected as capital expenditures in our Condensed Consolidated Statements of Cash Flow. The effort also required the removal of some existing store fixtures. The cost of accelerating the depreciation associated with those fixtures of $1.6 million was fully expensed in the second quarter and reflected in selling, general and administrative expense for the first nine months of fiscal 2005.

In the third quarter of fiscal 2005, we opened two new outlet stores which are located in Dawsonville, Georgia and San Marcos, Texas. We anticipate opening one new full price retail store and one additional outlet store in fiscal 2005, and we have no current plans to close any stores. On an ongoing basis we evaluate stores for closure based on underperformance. While we do not currently have any reserves established for store closures, we periodically make judgments about which stores we should close and which stores we should continue to operate. A material decline in sales and other adverse conditions resulting from our failure to accurately anticipate changes in merchandise trends and consumer demands may cause us to close additional under-performing stores.

The following table sets forth for the periods indicated the amount and percentage of net revenue represented by certain line items in our Condensed Consolidated Statements of Operations.


(Dollars in thousands, except per share data)	Third Quarter Fiscal 2005			% of Net Revenue		Third Quarter Fiscal 2004 (As restated- see Note 2)			% of Net Revenue		First Nine Months Fiscal 2005			% of Net Revenue		First Nine Months Fiscal 2004 (As restated- see Note 2			% of Net Revenue
Retail net revenue	$	92,256		71.8	%	$	89,747		76.0	%	$	278,832		71.4	%	$	259,094		76.7	%
Direct-to-customer net revenue		36,146		28.2			28,418		24.0			111,816		28.6			78,871		23.3

Net revenue		128,402		100.0			118,165		100.0			390,648		100.0			337,965		100.0
Cost of revenue and occupancy		84,033		65.4			80,134		67.8			267,363		68.4			239,887		71.0

Gross profit		44,369		34.6			38,031		32.2			123,285		31.6			98,078		29.0
Selling, general and administrative expense		50,302		39.2			42,511		36.0			136,725		35.0			111,199		32.9

Loss from operations		(5,933	)	(4.6	)		(4,480	)	(3.8	)		(13,440	)	(3.4	)		(13,121	)	(3.9	)
Interest expense, net		(1,164	)	(0.9	)		(737	)	(0.6	)		(2,823	)	(0.8	)		(1,673	)	(0.5	)

Loss before income taxes		(7,097	)	(5.5	)		(5,217	)	(4.4	)		(16,263	)	(4.2	)		(14,794	)	(4.4	)
Income tax benefit		2,887		2.2			2,136		1.8			6,478		1.7			5,917		1.8

Net loss	$	(4,210	)	(3.3	)	$	(3,081	)	(2.6	)	$	(9,785	)	(2.5	)	$	(8,877	)	(2.6	)

Loss per share of common stock — basic & diluted	$	(0.11	)			$	(0.09	)			$	(0.28	)			$	(0.27	)

Loss from operations increased 32% to $5.9 million for the third quarter of fiscal 2005 as compared to a loss from operations of $4.5 million for the third quarter of fiscal 2004. Net loss was $4.2 million ($0.11 per share) for the third quarter of fiscal 2005, compared to a net loss of $3.1 million ($0.09 per share) for the third quarter of fiscal 2004.

Loss from operations, which includes a pre-tax, non-cash charge of $1.6 million described above, increased 2% to $13.4 million for the first nine months of fiscal 2005 as compared to a loss from operations of $13.1 million for the first nine months of fiscal 2004. Net loss was $9.8 million ($0.28 per share) for the first nine months of fiscal 2005, compared to a net loss of $8.9 million ($0.27 per share) for the first nine months of fiscal 2004.

Third quarter net revenue was up 9% to $128.4 million, as compared to net revenue of $118.2 million in the third quarter last year. Direct-to-customer revenue was up 27% from the third quarter of fiscal 2004, but comparable store sales were down 2.1% from the prior year quarter. Comparable stores sales were impacted negatively by 3.6% due to a shift in timing for our furniture sales related to our new special order program that was implemented and promoted during the third quarter of fiscal 2005 through the Upholstered Furniture Event. As a result of the Event, an increase of approximately $3.2 million of orders were taken but not delivered, as these special order sales have longer production lead times. This creates a larger revenue deferral impact into the fourth quarter.

Our overall revenue expanded by 9% over the prior year quarter, even with the slight decrease in comparable store sales of 2.1%, and combined with the improvement in our gross margin of 240 basis points, we experienced a 17% growth in gross profit dollars. The expansion of our gross margin to 34.6% in the third quarter of fiscal 2005 from 32.2% in the third quarter of fiscal 2004 was attributable to continued improvements in our supply chain and distribution costs of 140 basis points and a 120 basis point improvement in product margin. The improvements were offset by a 20 basis point increase in occupancy costs as a percentage of net revenue. Selling, general and administrative expense for the third quarter increased $7.8 million and expressed as a percentage of revenue, was higher than the third quarter of fiscal 2004 by 320 basis points. The increase was driven by a combination of higher catalog circulation costs expressed as a percent of revenue of 140 basis points, an increase in other variable costs of 120 basis points, and increased direct-to-customer fulfillment costs as a percent of revenue of 60 basis points, reflecting the growth in the direct business. We believe that selling, general and administrative costs will continue to increase as a percentage of revenue in future quarters, in part due to higher catalog circulation costs which tend to rise at a higher rate than total revenue, reflecting the dynamic growth of our direct-to-customer business. As a result of the above, loss from operations increased 32% to $5.9 million for the third quarter of fiscal 2005 versus the prior year’s third quarter of $4.5 million.

Net revenue for the first nine months of fiscal 2005 was up 16% to $390.6 million, versus $338.0 million in the first nine months of fiscal 2004, with comparable store sales up 2.7% for the first nine months of fiscal 2005 and direct-to-customer revenue up 42% from the first nine months of fiscal 2004. The increase in revenue combined with expansion of our gross margin of 260 basis points, resulted in a 26% increase in gross profit dollars. The expansion of our gross margin to 31.6% in the first nine months of fiscal 2005 from 29.0% in the first nine months of fiscal 2004 was attributable to improvements in our supply chain and distribution costs of 120 basis points, leverage of our occupancy costs of 80 basis points and a 60 basis point improvement in product margins. Selling, general and administrative expense for the first nine months increased $25.5 million, including the $1.6 million remodeling non-cash charge referred to above, and expressed as a percentage of revenue, was higher than the first nine months of fiscal 2004 by 210 basis points. The increase was driven primarily by a combination of higher catalog circulation costs expressed as a percent of revenue of 120 basis points, increased direct-to-customer fulfillment costs of 70 basis points, and a 40 basis point increase for the non-cash charge associated with the store remodeling efforts, offset by a decrease in other variable costs of 20 basis points. Loss from operations including the pre-tax, non-cash charge of $1.6 million, increased 2% to a loss of $13.4 million for the first nine months of fiscal 2005 compared to an operating loss of $13.1 million in the first nine months of fiscal 2004.

Our business is highly seasonal, which reflects a general pattern in the retail industry wherein the highest sales and earnings occur during the holiday season. Historically, a significant portion of our sales are in the fourth fiscal quarter. In our peak holiday selling season, we incur significant additional expenses in connection with, among other things, the hiring of additional seasonal employees in our retail stores and the production and mailing of a higher volume of our catalogs.

REVENUE

Retail Net Revenue and Segment Results


	Third Quarter						First Nine Months
(Dollars in thousands)	Fiscal 2005			Fiscal 2004 (As restated-see Note 2)			Fiscal 2005			Fiscal 2004 (As restated-see Note 2)
Retail net revenue	$	92,256		$	89,747		$	278,832		$	259,094
Retail net revenue growth percentage		3	%		12	%		8	%		12	%
Comparable store sales (decline) growth		(2.1	)%		8.7	%		2.7	%		9.0	%
Income from retail operations	$	7,617		$	8,211		$	23,286		$	21,308
Income from retail operations – percent of net revenue		8.3	%		9.1	%		8.4	%		8.2	%
Number of stores at beginning of period		102			102			102			103
Number of stores opened		—			—			—			1
Number of stores closed		—			—			—			(2	)

Number of stores at end of period		102			102			102			102

Store selling square feet at end of period		676,520			673,910			676,520			673,910

Retail net revenue for the third quarter of fiscal 2005 increased by $2.5 million, or 3%, as compared to the third quarter of fiscal 2004 primarily due to revenue generated from outlet stores. Net revenue related to our outlets was $3.9 million for the third quarter of fiscal 2005. We did not have any outlet stores in the third quarter of fiscal 2004. Comparable store sales decreased by $1.9 million, or 2.1%. Comparable stores sales were impacted negatively by 3.6% due to a shift in timing for our furniture sales related to our new special order program that was implemented and promoted during the third quarter of fiscal 2005 through the Upholstered Furniture Event. As a result of such event, approximately $3.2 million of orders were taken but not delivered, as these special order sales have longer production lead times. This creates a larger revenue deferral impact into future periods.

Retail net revenue for the first nine months of fiscal 2005 increased by $19.7 million, or 8%, as compared to the first nine months of fiscal 2004 primarily due to increased warehouse sale events and new outlet stores. Net revenue related to our warehouse sales and outlet stores was $12.9 million for the first nine months of fiscal 2005, compared to $3.6 million in the first nine months of fiscal 2004. Additionally, retail revenue increased during the first nine months of fiscal 2005 due to a $6.9 million, or 2.7%, increase in comparable store sales. The increase in comparable store sales for the first nine months of fiscal 2005 was primarily driven by higher sales of our core product offerings. Warehouse sales revenue and outlet store revenue is included in retail revenue, but is excluded from our comparable store sales. Additionally, a previously opened store, although not open long enough to be included in the calculation of comparable store sales, contributed positively to the increase in revenue in the third quarter of fiscal 2005.

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 14th full month of operation. We believe that comparable store sales is a more useful indicator of store performance than the change in total net revenue, since comparable store sales excludes the effects of changes in the number of stores open. Warehouse sales and outlet revenue is included in retail revenue, but is excluded from our comparable store sales calculation.

During the second quarter we began the remodel of a majority of our stores in order to expand our merchandise offerings in certain core categories, particularly for lighting and textiles, and present these offerings with more clarity and focus. The remodeling program required an investment of approximately $15.0 million, of which approximately $14.3 million was paid in the second and third quarters of fiscal 2005, and required the removal of some existing store fixtures. As a result, income from operations for the first nine months of fiscal 2005 includes a $1.6 million non-cash charge reflecting the cost of these replaced store fixtures.

Income from operations for the retail segment decreased 7% to $7.6 million, or 8.3% of net retail revenue in the third quarter of fiscal 2005, from $8.2 million, or 9.1% of net retail revenue in the third quarter of fiscal 2004. This decrease was primarily due to an increase in selling, general and administrative expense, largely offset by improvements in gross margin. Selling, general and administrative expense for the segment increased by 180 basis points, due to an increase in store selling expenses and higher advertising costs. Gross margin improved 100 basis points from a combination of the following: supply chain and distribution cost savings of 160 basis points and an increase in product margin of 60 basis points, somewhat offset by an increase in store occupancy costs of 120 basis points as a percent of revenue. Product margins improved due to a shift away from lower margin discovery items to higher margin core offerings and included a negative impact of 110 basis points from sales in the outlet stores. Income from operations for the retail segment include the costs of retail stores results less the direct costs of the store field operations.

Income from operations for the retail segment, including the $1.6 million non-cash charge detailed above, increased 9% to $23.3 million, or 8.4% of net retail revenue in the first nine months of fiscal 2005 from $21.3 million, or 8.2% of net retail revenue in the first nine months of fiscal 2004. This increase was primarily due to improvements in gross margin, partially offset by increases in selling, general and administrative expense. Gross margin improved by 80 basis points from supply chain and distribution cost savings of 130 basis points, somewhat offset by a reduction in product margin of 50 basis points. Selling, general and administrative expense for the segment increased by 60 basis points, due to the impact of the non-cash charge associated with the store remodeling efforts.

Direct-to-Customer Net Revenue and Segment Results


	Third Quarter						First Nine Months
(Dollars in thousands)	Fiscal 2005			Fiscal 2004			Fiscal 2005			Fiscal 2004
Catalog revenue	$	19,216		$	15,505		$	59,970		$	44,081
Internet revenue		16,930			12,913			51,846			34,790

Total direct-to-customer net revenue	$	36,146		$	28,418		$	111,816		$	78,871

Income from direct-to-customer operations	$	2,683		$	1,494		$	13,725		$	8,553
Income from direct-to-customer operations – percent of direct-to-customer net revenue		7.4	%		5.3	%		12.3	%		10.8	%
Growth percentages:
Direct-to-customer net revenue		27	%		78	%		42	%		91	%
Number of catalogs mailed		—	%		—	%		10	%		15	%
Pages circulated		19	%		39	%		34	%		52	%

Direct-to-customer net revenue consists of both catalog and Internet sales. Direct-to-customer net revenue for the third quarter of fiscal 2005 increased $7.7 million, or 27%, as compared to the third quarter of fiscal 2004. Direct-to-customer net revenue for the first nine months of fiscal 2005 increased $32.9 million, or 42%, as compared to the first nine months of fiscal 2004. The higher sales in the third quarter of fiscal 2005 are primarily the result of a 19% increase in pages circulated compared to the third quarter of fiscal 2004. Catalog circulation and sales productivity per page remained flat to the prior year quarter. For the first nine months of fiscal 2005 circulation increased 10%, pages circulated increased 34% and sales productivity per page increased slightly. Catalog sales grew 24% in the third quarter of fiscal 2005 and 36% in the first nine months of fiscal 2005 to $19.2 million and $60.0 million, respectively. Internet sales grew 31% in the third quarter of fiscal 2005 and 49% in the first nine months of fiscal 2005 to $16.9 million and $51.8 million, respectively, as a result of our website marketing efforts coupled with growing customer familiarity with the Internet and strong customer response to our summer and fall product offerings.

Income from operations for the direct-to-customer segment was $2.7 million, or 7.4% of net direct revenue, in the third quarter of fiscal 2005 as compared to $1.5 million, or 5.3% of net direct revenue, in the same quarter of the prior fiscal year. This increase of $1.2 million, or 80%, represents a 210 basis point improvement and is primarily the result of a 310 basis point increase in gross margin due to an expansion in product margin of 200 basis points and savings in our supply chain and distribution costs of 110 basis points, offset by increases in selling, general and administrative expense from higher call center and fulfillment costs of 120 basis points. The increase in call center and fulfillment costs was offset slightly by leverage gained on other selling expenses of 20 basis points.

Income from operations for the direct-to-customer segment was $13.7 million, or 12.3% of net direct-to-customer revenue, in the first nine months of fiscal 2005 as compared to $8.6 million, or 10.8% of net direct revenue, in the first nine months of the prior fiscal year. This increase of $5.1 million, or 59%, represents a 150 basis point improvement and is primarily the result of a 300 basis point increase in gross margin due to improvements in product margin of 150 basis points and supply chain and distribution costs of 150 basis points. This is offset by a 150 basis point increase in selling, general and administrative expense from higher call center and fulfillment costs of 120 basis points and higher other variable costs of 30 basis points.

EXPENSES

Cost of Revenue and Occupancy Expense

Total cost of revenue and occupancy increased $3.9 million during the third quarter of fiscal 2005 to $84.0 million. As a percentage of net revenue these costs were reduced by 240 basis points to 65.4%, from 67.8% in the third quarter of fiscal 2004. This reduction was due to continued improvement in our supply chain and distribution costs of 140 basis points and an increase in product margins of 120 basis points, offset by a slight increase in occupancy cost as a percentage of revenue.

Total costs of revenue and occupancy increased $27.5 million to $267.3 million during the first nine months of fiscal 2005. For the first nine months of fiscal 2005, cost of revenue and occupancy expense expressed as a percentage of net revenue decreased 260 basis points to 68.4% from 71.0% for the first nine months of fiscal 2004. These improvements were achieved due to a 120 basis point improvement in our supply chain and distribution costs, the decrease of relatively fixed store occupancy costs by 80 basis points and improved product margins of 60 basis points.

Selling, General and Administrative Expense

Selling, general and administrative expense for the third quarter increased $7.8 million to $50.3 million and expressed as a percentage of revenue, was higher than the third quarter of fiscal 2004 by 320 basis points at 39.2% of net revenue compared to 36.0% in the same quarter last year. The increase in expense was driven by increased catalog circulation costs expressed as a percent of revenue of 140 basis points, increased other variable costs of 120 basis points and an increase in direct-to-customer fulfillment costs as a percent of revenue of 60 basis points reflecting the growth of the direct business.

Selling, general and administrative expense for the first nine months increased $25.5 million to $136.7 million, including the $1.6 million non-cash charge referred to previously, and expressed as a percentage of revenue, was higher than the first nine months of fiscal 2004 by 210 basis points at 35.0% of net revenue compared to 32.9% in the first nine months of last year. The increase in expense was driven by higher catalog circulation costs expressed as a percent of revenue of 120 basis points, increased-direct-to-customer fulfillment costs as a percent of revenue of 70 basis points and 40 basis points for the $1.6 million non-cash charge associated with remodeling efforts. These increases were slightly offset by an improvement in other variable costs as a percent of revenue of 20 basis points.

We expect that as the direct-to-customer channel revenue grows at a faster rate than retail revenue, the costs of catalog circulation will necessarily have the effect of increasing selling, general and administrative expense as a percentage of net revenue, as occurred for the third quarter and first nine months of fiscal 2005.

Interest Expense, Net

Interest expense, net includes interest on borrowings under our revolving credit facility and amortization of debt issuance costs. For the third quarter of fiscal 2005, interest expense, net was $1.1 million, an increase of $0.4 million as compared to $0.7 million for the third quarter of fiscal 2004. For the first nine months of fiscal 2005, interest expense, net was $2.8 million, an increase of $1.1 million as compared to $1.7 million for the first nine months of fiscal 2004. These increases were due to an increase in our average debt levels and slightly higher borrowing rates.

Income Tax Benefit

Our effective tax rate for the third quarter of fiscal 2005 and the first nine months of fiscal 2005 is consistent with fiscal 2004 and ranged between 40% and 41%.

LIQUIDITY AND CAPITAL RESOURCES

Operating Cash Flows

For the first nine months of fiscal 2005, net cash used by operating activities was $23.1 million compared to $44.3 million for the first nine months of fiscal 2004. Major drivers of cash flow used by operating activities are the effect of changes in inventory due to seasonal needs and sales growth requirements, prepaid expenses, deferred taxes, other assets and accounts payable and accrued expenses. Inventories generally build throughout the year from seasonally low year-end levels. The increase in merchandise inventories of $20.0 million in the first nine months of fiscal 2005 reflects this expected build in inventory in preparation for the fourth quarter holiday season. During the same nine month period in fiscal 2005, accounts payable and accrued expenses increased by $2.2 million, primarily reflecting the timing of payment for those receipts. The first nine months of fiscal 2004 also reflects the typical pattern of seasonal inventory increases of $54.5 million; while at the same time, increases in foreign sourced products resulted in an acceleration of the timing of payment for our goods and accordingly a more significant increase in accounts payable and accrued expenses of $20.7 million.

Investing Cash Flows

Net cash used by investing activities was $22.0 million for the first nine months of fiscal 2005, an increase of $11.9 million compared to $10.1 million for the first nine months of fiscal 2004. The cash used for investing activities for the first nine months of fiscal 2005 primarily related to the second quarter remodeling of a majority of our stores to expand our merchandise offerings as well as costs to build our new outlet stores. As previously stated, the remodeling program required an investment of approximately $15.0 million and as of October 29, 2005, approximately $14.3 million had been paid.

Financing Cash Flows

Net cash provided by financing activities was $46.8 million for the first nine months of fiscal 2005, compared to $53.9 million for the first nine months of fiscal 2004. Substantially all of the net cash provided by financing activities resulted from an increase in net borrowings under our revolving credit facility.

On July 29, 2005 the Company entered into an agreement (the “Amendment”) to amend its revolving credit facility. The Amendment increased the revolving loan commitment available to the Company under the facility from $100.0 million to $150.0 million and provided for an extension of the maturity date of the revolving loan from June 30, 2006 to June 30, 2009. In addition, the Amendment reduced the interest rate on base advances and provides for incremental advances with availability determined from the application of a higher advance rate on the Company’s borrowing base. Those incremental advances would be subject to higher interest rates. To the extent that borrowings are outstanding under the incremental advance provision, the Company would be required to maintain a minimum fixed charge coverage ratio. The Amendment also eliminated the lock box restriction except upon the occurrence of certain events, such as an event of default. Other elements of the revolving credit facility remain materially unchanged.

As of October 29, 2005, $79.6 million was outstanding under the line of credit, net of unamortized debt issuance costs of $1.0 million, and there was $10.5 million in letters of credit outstanding. As a result of the Amendment, the balance of $79.6 million at October 29, 2005 is considered a long-term liability rather than a current liability and has been classified accordingly. Borrowings made under the revolving credit facility are subject to interest at either the bank’s reference rate or LIBOR plus a margin. As of October 29, 2005, the bank’s reference rate was 6.75% and the LIBOR plus margin rate was 5.39%. The availability of credit at any given time under the revolving credit facility is limited by reference to a borrowing base formula based upon numerous factors, including the value of eligible inventory and eligible accounts receivable, and reserves established by the agent of the revolving credit facility. As a result of the borrowing base formula, the actual borrowing availability under the facility could be less than the stated amount of the facility reduced by the actual borrowings and outstanding letters of credit.

We currently believe that our cash flows from operations and funds available under our revolving credit facility will satisfy our expected working capital and capital requirements, for at least the next 12 months. However, the weakening of, or other adverse developments concerning our sales performance or adverse developments concerning the availability of credit under our revolving credit facility due to covenant limitations or other factors could limit the overall availability of funds to us. We may not have successfully anticipated our future capital needs or the timing of such needs and 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. However, should the need arise, additional sources of financing may not be available or, if available, may not be on terms favorable to our stockholders or us. 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. For more information, please see the section ”Factors That May Affect Our Future Operating Results,” below, in particular the sections “We are dependent on external funding sources, which may not make available to us sufficient funds when we need them,” and “Because our business requires a substantial level of liquidity, we are dependent upon a revolving credit facility with certain restrictive covenants that limit our flexibility.”

NEW ACCOUNTING PRONOUNCEMENTS

In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “Inventory Costs,” which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs and wasted material (spoilage). This statement is effective for our 2006 fiscal year. We believe the adoption of SFAS 151 will not have a significant impact on the overall results of operations or financial position.

In December 2004, the FASB issued SFAS No. 123(R) ”Share-Based Payment.” SFAS 123(R) requires the recognition of compensation expense relating to share-based payment transactions in consolidated financial statements. That expense will be measured based on the fair value of the equity or liability instruments issued as of the grant date, for the estimated number of awards that are expected to vest. SFAS 123(R) covers a wide range of share-based compensation arrangements including share options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. SFAS 123(R) replaces SFAS 123, “Accounting for Stock Based Compensation,” and supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees.” SFAS 123(R) is effective for interim periods that begin after December 15, 2005. We are allowed to select from three alternative transition methods, each having different reporting implications. We have not completed our evaluation to determine the impact of adopting SFAS 123(R).

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

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 revenue and the closing of underperforming stores.

Our success depends on our ability to anticipate and respond to changing merchandise trends and consumer demands in a timely manner. 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 potential sales revenue and 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. If this trend fails to continue to directly benefit us or if there is an overall decline in the trend, we could experience an adverse decline in 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 maintain a high level of quality control and service procedures or if we 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 addition, a material decline in sales and other adverse conditions resulting from our failure to accurately anticipate changes in merchandise trends and consumer demands could cause us to close additional underperforming stores. While we believe that we benefit in the long run financially by closing underperforming stores and reducing nonproductive costs, the closure of such stores would subject us to additional increased short-term 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 supply chain processes.

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 supply chain processes or to take full advantage of supply chain opportunities could result in loss of potential sales revenue, increased cost and have a material adverse effect on our operating results.

Because our revenue is 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 revenue and our gross profit 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 the fourth quarter, our business, financial condition and annual operating results may be materially adversely affected.

Increased catalog and other marketing expenditures without increased revenue may have a negative impact on our operating results.

Over the past several fiscal years, we have substantially increased the amount that we spend on catalog and other marketing costs, and we expect to continue to invest at these increased levels in the current fiscal year and in the future. As a result, if we misjudge the directions or trends in our market, we may expend large amounts of cash that generate little return on investment, which would have a negative effect 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, seasonality, remodelings 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 or investors, or if our operating results do not meet the guidance that we issue from time to time, the market price of our shares of common stock would likely decline.

Fluctuations in comparable store sales may cause our revenue 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 increased 2.7% in the first nine months of fiscal 2005. 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 revenue and operating results to vary from quarter to quarter, and an unanticipated decline in comparable store sales 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 revenue and significantly harm our operating results.

We make merchandise purchases from over 350 vendors. Our performance depends on our ability to purchase our merchandise in sufficient quantities at competitive prices. 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 our point-of-sale, merchandise management and warehouse management systems. We also rely on the same vendor for software support. A failure by this vendor to support our management information systems adequately in the future could have a material adverse effect on our business, results of operations and financial condition.

We routinely purchase products from new vendors from time to time, many of whom are located abroad. We cannot assure you that they will be reliable sources of our products. Moreover, a number of these manufacturers and suppliers are small and undercapitalized firms that 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 will be able, if necessary, to return products to these suppliers and manufacturers 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 a downturn in the U.S. or worldwide economy. Significant failures on the part of these suppliers or manufacturers could have a material adverse effect on our operating results.

In addition, many of these suppliers and manufacturers 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.

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

The distribution functions for our stores as well as all of our furniture orders 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 our 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. Separately, significant disruptions to the operations of the third party vendor who handles, among other things, the distribution and fulfillment functions for our direct-to-customer business on an outsourced basis could be expected to have similar negative consequences.

Labor activities could cause labor relations difficulties for us.

As of October 29, 2005, we had approximately 3,700 full and part time employees, and while we believe our relations with our employees are generally good, we cannot predict the effect that any future organizational activities will have on our business and operations. If we were to become subject to work stoppages, we could experience disruption in our operations and increases in our labor costs, either of which could materially adversely affect our business, financial condition or results of operations.

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

We have significantly relied and may rely in the future 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 $150.0 million revolving credit facility, the amount available under this facility could be less than the stated amount if there is a shortfall in the availability of eligible collateral to support the borrowing base and reserves as established by the terms of the revolving credit facility. We currently believe that our cash flow from operations and funds available under our revolving credit facility will satisfy our capital and operating requirements for at least the next 12 months. However, the weakening of, or other adverse developments concerning, our sales performance or adverse developments concerning the availability of credit under our revolving credit facility due to covenant limitations or other factors could limit the overall amount of funds available to us.

Our revolving credit facility contains a clause which allows our lenders to forego additional advances should they determine there has been a material adverse change in our operations, business, properties, assets, liabilities, condition or prospects or a condition or event that is reasonably likely to result in a material adverse change in our financial position or prospects reasonably likely to result in a material adverse effect on our business, condition (financial or otherwise), operations, performance or properties taken as a whole. However, our lenders have not notified us of any indication that a material adverse effect exists at October 29, 2005 or that a material adverse change has occurred. We believe that no material adverse change has occurred and we believe that we will continue to borrow on the line of credit to fund our operations over the term of the revolving credit facility. We do not anticipate any changes in our business practices that would result in any determination that there has been a material adverse effect in our operations, business, properties, assets, liabilities, condition or prospects. However, we cannot be certain that our lenders will not make such a determination in the future.

In particular, we may experience cash flow shortfalls in the future and we may require additional external funding beyond the amounts available under our revolving credit facility. 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 defer on taking other actions that otherwise may be important to our operations. Additionally, we may need to raise funds to take advantage of unanticipated opportunities. We also may need to raise funds to respond to changing business conditions or unanticipated competitive pressures. If we fail to raise sufficient additional 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 revolving credit facility with certain 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, advertising for the holiday buying season and other similar advance expenses. As described above, we currently have in place a revolving credit facility that provides for an overall commitment of $150.0 million. Over the past several years, we have entered into modifications, amendments and restatements of this revolving credit facility, primarily to address changes in the requirements applicable to us under the revolving credit facility documents, and, most recently, to increase the stated amount of commitment under the facility amongst other things.

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

We have drawn upon the revolving credit facility in the past and we expect to draw upon it in the future. As a result, failure to comply with the terms of the revolving credit facility would entitle the secured lenders to prevent us from further borrowing, and upon acceleration by the lenders, they would be entitled to begin foreclosure procedures against our assets, including accounts receivable, inventory, general intangibles, equipment, goods, and fixtures. The secured lenders would then be repaid from the proceeds of such foreclosure proceedings, using all available assets. Only after such repayment and the payment of any other secured and unsecured creditors would the holders of our capital stock receive any proceeds from the liquidation of our assets. Our ability to comply with the terms of the revolving credit facility may 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 in the past and could have in the future negative effects on our operations. An increase in the variable interest rate under our revolving credit facility, coupled with an increase in our outstanding debt, could result in material amounts otherwise available for other business purposes being used to pay for interest expense.

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. Many of these factors are beyond our control. In addition, we may need to incur additional indebtedness in the future. 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 needs or 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 third quarter of fiscal year 2005, we purchased approximately 60% of our merchandise directly from vendors located abroad. 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 of America. Our dependence on foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, risks of damage, destruction or confiscation of products while in transit to our distribution centers located in the United States of America, changes in import duties, tariffs and quotas, loss of “most favored nation” trading status by the United States of America in relation to a particular foreign country, work stoppages including without limitation as a result of events such as longshoremen strikes, transportation and other delays in shipments including without limitation as a result of heightened security screening and inspection processes or other port-of-entry limitations or restrictions in the United States of America, freight cost increases, economic uncertainties, including inflation, foreign government regulations, and political unrest and trade restrictions, including the United States of America retaliating against protectionist foreign trade practices. Furthermore, some or all of our foreign vendors’ operations may be adversely affected by political, financial or other instabilities that are particular to their home countries, including without limitation local acts of terrorism or economic, environmental or health and welfare-related crises, which may in turn result in limitations or temporary or permanent halts to their operations, restrictions on the transfer of goods or funds and/or other trade disruptions. 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 reduction or loss of our profit margin on such items.

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.

Rapid growth in our direct-to-customer business may not be sustained and may not generate a corresponding increase in profits to our business.

For the first nine months of fiscal year 2005, revenue through our direct-to-customer channel grew by 42% as compared to the same period in the prior fiscal year. 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 products. Although we intend to attempt to mitigate the impact of these increases by improving sales revenue and 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 outsource to a third party the fulfillment of our direct-to-customer division, including customer service and non-furniture distribution, 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, cause us to lose sales revenue and limit or counter recent growth in our direct-to-customer business.

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 Chairman, President and Chief Executive Officer, Gary 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. For instance, as previously disclosed, our Chief Financial Officer resigned effective September 9, 2005. We do not maintain any key man life insurance. The loss of the services of key management personnel, employee turnover in important areas of our business or our failure to attract additional qualified personnel or effectively handle management transitions could have a material adverse effect on our business, financial condition and results of operations.

Regulatory changes may increase our costs.

Changes in the laws, regulations and rules affecting public companies may increase our expenses in connection with our compliance with these new requirements. Compliance with these new requirements could also result in continued diversion of management’s time and attention, which could prove to be disruptive to normal business operations. Further, the impact of these laws, regulations and rules and activities in response to them could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors or as executive officers, which could harm our business.

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

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, rising oil prices, taxation and consumer confidence in future economic conditions. More generally, reduced consumer confidence and spending may result in reduced demand for discretionary items and luxury retail products, such as our products. Reduced consumer confidence and spending also may result in limitations on our ability to increase prices and 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 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, 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 the past, 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.

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.

Terrorist attacks, war, natural disasters and other catastrophic events may negatively impact all aspects of our operations, revenue, costs and stock price.

Threats of terrorist attacks in the United States of America, as well as future events occurring in response to or in connection with them, including, without limitation, future terrorist attacks or threats against United States of America targets, rumors or threats of war, actual conflicts involving the United States of America or its allies, including the on-going U.S. conflicts in Iraq and Afghanistan, further conflicts in the Middle East and in other developing countries, or military or trade disruptions affecting our domestic or foreign suppliers of merchandise, may impact our operations. Our operations also may be affected by natural disasters or other similar events, including floods, hurricanes, earthquakes or fires. The potential impact of any of these events 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 United States of America and worldwide financial markets and economies. Also, any of these events could result in economic recession in the United States of America or abroad. Any of these occurrences could have a significant impact on our operating results, revenue and costs and may result in the volatility of the future market 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 United States equity markets have from time to time experienced significant price and volume fluctuations that have particularly affected the market prices for the stocks of companies such as ours. These broad market fluctuations may materially adversely affect the market price of our common stock in the future. Variations in the market price of our common stock 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. 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 our guidance or 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 March 2001 preferred stock financing, we filed a registration statement on Form S-3 with the Securities and Exchange Commission to register approximately 6.4 million shares of our common stock issued, or to be issued, upon the conversion of our Series A preferred stock to some of our stockholders. The registration statement was declared effective by the Securities and Exchange Commission on October 31, 2002 and may remain effective under certain circumstances until as long as March 2009. 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.

Newly adopted accounting regulations that require companies to expense stock options will result in a decrease in our earnings and our stock price may decline.

The Financial Accounting Standards Board recently adopted regulations that will eliminate the Company’s ability to account for share-based compensation transactions using the intrinsic method and would require that such transactions be accounted for using a fair-value-based method and recognized as an expense in our Consolidated Statement of Operations. We will be required to expense stock options effective in periods beginning after January 28, 2006. Currently, we only disclose such expenses on a pro forma basis in the Notes to our Condensed Consolidated Financial Statements in accordance with accounting principles generally accepted in the United States of America. The Company is still evaluating the impact on our financial statements but the adoption of this new accounting regulation could have a significant impact on our results of operations and our stock price could decline accordingly.

We are subject to anti-takeover provisions and the terms and conditions of our preferred stock 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.

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. These provisions may create a potentially discouraging effect on, among other things, any third party’s interest in completing a merger, consolidation, acquisition or similar type of transaction with us. Consequently, the existence of these anti-takeover provisions may 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.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

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 without limitation statements relating to our future plans, statements relating to anticipated future costs and expenses, statements relating to anticipated future revenue growth, statements relating to revenue deferrals into future periods, statements relating to future availability under our revolving credit facility, statements relating to our working capital and capital expenditure needs, statements relating to the anticipated opening of new stores, and other statements containing words such as “believe,” “anticipate,” “expect,” “may,” “intend” 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, customer reactions to our current and anticipated merchandising and marketing programs and strategies, timely introduction and customer acceptance of our merchandise, positive customer reaction to our catalog and Internet offerings, revised product mix, prototype stores and core businesses, timely and effective sourcing of our merchandise from our foreign and domestic vendors and delivery of merchandise through our supply chain to our stores and customers, effective inventory and catalog management, actual achievement of cost savings and improvements to operating efficiencies, effective sales performance, the actual impact of key personnel of the Company on the development and execution of our strategies, changes in investor perceptions of the Company, fluctuations in comparable store sales, limitations resulting from restrictive covenants in our credit facility, changes in economic or business conditions in general, changes in political conditions in the United States and abroad in general, changes in product supply, changes in the competitive environment in which we operate, changes in our management information needs, changes in customer needs and expectations, governmental actions, and other factors described above in the section ”Factors That May Affect Our Future Operating Results.” 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 quarterly report on Form 10-Q.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk.

Our market risk disclosures set forth in Item 7A of our Annual Report on Form 10-K, for the year ended January 29, 2005, have not changed materially during the third quarter ended October 29, 2005.

Item 4.

Controls and Procedures.

As of October 29, 2005, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures. This evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer (“CEO”) and Acting Chief Financial Officer (“CFO”). Based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures as of October 29, 2005 were effective. There has been no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings.

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

Item 6.

Exhibits.

See attached exhibit index.

SIGNATURES

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


	Restoration Hardware, Inc.

Date: December 7, 2005

	By:	/s/ Gary G. Friedman
		Gary G. Friedman
		Chairman, President and
		Chief Executive Officer

	By:	/s/ Murray Jukes
		Murray Jukes
		Acting Chief Financial Officer and Vice President, Controller
		(Principal Financial Officer and Principal Accounting Officer)

EXHIBIT INDEX


EXHIBIT NO.		DOCUMENT DESCRIPTION
3.1		Second Amended and Restated Certificate of Incorporation, as amended (incorporated by reference to exhibit number 3.1 of the Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on October 24, 2001)

3.2		Amended and Restated Bylaws, as amended to date (incorporated by reference to exhibit number 3.2 of Form 10-Q for the quarterly period ended October 31, 1998 filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on December 15, 1998)

3.3		Certificate of Designation of Series A and Series B Preferred Stock (incorporated by reference to exhibit number 4.6 of Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on April 2, 2001)

31.1		Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer

31.2		Rule 13a-14(a)/15d-14(a) Certification of Acting Chief Financial Officer

32.1		Section 1350 Certification of Chief Executive Officer

32.2		Section 1350 Certification of Chief Financial Officer