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 July 29, 2006

¨ 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 requirements for the past 90 days.

Yes x    No ¨

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

Large accelerated filer ¨    Accelerated filer x    Non-accelerated filer ¨

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

As of September 1, 2006, 37,954,597 shares of the registrant’s common stock, $0.0001 par value per share, were outstanding.

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FORM 10-Q

FOR THE QUARTER ENDED JULY 29, 2006

TABLE OF CONTENTS

PART I.	FINANCIAL INFORMATION	3
Item 1.	Condensed Consolidated Financial Statements (Unaudited)	3
	Condensed Consolidated Balance Sheets as of July 29, 2006, January 28, 2006, and July 30, 2005	3
	Condensed Consolidated Statements of Operations for the second quarter and six months ended July 29, 2006 and July 30, 2005	4
	Condensed Consolidated Statements of Cash Flows for the six months ended July 29, 2006 and July 30, 2005	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	20
Item 4.	Controls and Procedures	20
PART II.	OTHER INFORMATION	21
Item 1.	Legal Proceedings	21
Item 1A.	Risk Factors	21
Item 4.	Submission of Matters to a Vote of Security Holders	29
Item 6.	Exhibits	30
SIGNATURES		31
EXHIBIT INDEX		32

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

(Unaudited)

	July 29, 2006			January 28, 2006			July 30, 2005
ASSETS
Current assets:
Cash and cash equivalents	$	1,084		$	1,990		$	1,820
Accounts receivable		9,028			5,884			6,579
Merchandise inventories		181,199			158,647			136,952
Prepaid expense and other current assets		17,351			9,590			21,852
Total current assets		208,662			176,111			167,203
Property and equipment, net		90,054			92,360			84,288
Goodwill		4,560			4,560			4,560
Deferred tax assets, net		—			—			18,824
Other assets		1,317			1,237			4,115
Total assets	$	304,593		$	274,268		$	278,990
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	70,321		$	62,818		$	58,583
Deferred revenue and customer deposits		12,415			8,304			7,719
Other current liabilities		16,814			17,506			12,471
Total current liabilities		99,550			88,628			78,773
Long-term debt, net of issuance costs		79,432			58,126			48,595
Deferred lease incentives		25,894			27,465			28,409
Deferred rent		20,029			19,866			20,076
Other long-term obligations		1,037			51			46
Total liabilities		225,942			194,136			175,899
Commitments and contingencies (Note 6)
Stockholders’ equity:
Common stock, $.0001 par value; 60,000,000 shares authorized; 37,943,048, 37,762,629 and 37,542,096 issued and outstanding at July 29, 2006, January 28, 2006 and July 30, 2005, respectively		4			4			3
Additional paid-in capital		172,263			169,187			168,533
Accumulated other comprehensive income		1,130			1,010			892
Accumulated deficit		(94,746	)		(90,069	)		(66,337	)
Total stockholders’ equity		78,651			80,132			103,091
Total liabilities and stockholders’ equity	$	304,593		$	274,268		$	278,990

See Notes to Condensed Consolidated Financial Statements.

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RESTORATION HARDWARE, INC

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share data)

(Unaudited)

	Second Quarter						First Six Months
	Fiscal 2006			Fiscal 2005			Fiscal 2006			Fiscal 2005
Net revenue	$	179,343		$	144,781		$	312,723		$	262,246
Cost of revenue and occupancy		120,098			101,507			208,593			183,330
Gross profit		59,245			43,274			104,130			78,916
Selling, general and administrative expense		57,138			46,437			105,491			86,423
Income (loss) from operations		2,107			(3,163	)		(1,361	)		(7,507	)
Interest expense, net		(1,739	)		(834	)		(3,163	)		(1,659	)
Income (loss) before income taxes		368			(3,997	)		(4,524	)		(9,166	)
Income tax (expense) benefit		(132	)		1,535			(153	)		3,591
Net income (loss)	$	236		$	(2,462	)	$	(4,677	)	$	(5,575	)
Income (loss) per share of common stock, basic and diluted	$	0.01		$	(0.07	)	$	(0.12	)	$	(0.17	)
Weighted average shares outstanding, basic		37,884			33,259			37,828			33,185
Weighted average shares outstanding, diluted		38,911			33,259			37,828			33,185

See Notes to Condensed Consolidated Financial Statements.

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RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

	Six Months Ended
	Fiscal 2006			Fiscal 2005
Cash flows from operating activities:
Net loss	$	(4,677	)	$	(5,575	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization		10,571			9,845
Stock-based compensation expense		2,175			—
Changes in operating assets and liabilities:
Accounts receivable		(3,144	)		366
Merchandise inventories		(22,552	)		7,233
Prepaid expense, deferred tax and other assets		(7,841	)		(4,765	)
Accounts payable and accrued expenses		7,174			(5,337	)
Deferred revenue and customer deposits		4,111			(411	)
Other current liabilities		(913	)		(2,477	)
Deferred rent		163			(245	)
Deferred lease incentives and other long-term obligations		(1,571	)		(1,956	)
Net cash used by operating activities		(16,504	)		(3,322	)
Cash flows from investing activities:
Capital expenditures		(6,553	)		(11,955	)
Net cash used by investing activities		(6,553	)		(11,955	)
Cash flows from financing activities:
Borrowings under line of credit, net		21,334			14,521
Debt issuance costs		(175	)		—
Repayments other long-term obligations		(9	)		(97	)
Issuance of common stock		902			726
Net cash provided by financing activities		22,052			15,150
Effects of foreign currency exchange rate translation		99			43
Net decrease in cash and cash equivalents		(906	)		(84	)
Cash and cash equivalents:
Beginning of period		1,990			1,904
End of period	$	1,084		$	1,820
Additional cash flow information:
Cash paid during the period for interest	$	2,776		$	1,183
Cash paid during the period for income taxes		610			455
Non-cash investing and financing transactions:
Conversion of preferred stock to common stock	$	—		$	8,331

See Notes to Condensed Consolidated Financial Statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.

1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business

Restoration Hardware, Inc., and subsidiaries, (the “Company,” “we,” or “our”) is a specialty retailer of hardware, bathware, furniture, lighting, textiles, accessories and related merchandise 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 and high quality merchandise. 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. Our plan is to fill the void in the marketplace above the current home lifestyle retailers, and below the interior design trade. As of July 29, 2006, the Company operated 103 retail stores and 8 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, which includes both Catalog and Internet, and a wholly-owned furniture manufacturer.

Basis of Presentation

The accompanying unaudited 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 Company’s financial position at July 29, 2006 and July 30, 2005 and the results of operations and changes in cash flows for the six months ended July 29, 2006 and July 30, 2005, respectively. The financial position at January 28, 2006, as presented, has been derived from the Company’s audited Consolidated Financial Statements for the fiscal year then ended.

The Company’s accounting policies are described in Note 1 to the audited Consolidated Financial Statements for the fiscal year ended January 28, 2006 (“fiscal 2005”) included in the Company’s Form 10-K. 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 these Condensed Consolidated Financial Statements. The Condensed Consolidated Financial Statements should be read in conjunction with the audited Consolidated Financial Statements, including the notes thereto, for fiscal 2005.

The results of operations for the second quarter and six months ended July 29, 2006 presented in this Form 10-Q are not necessarily indicative of the results to be expected for the full year.

Stock-based Compensation

Effective January 29, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 revised “Share-Based Payment”, (“SFAS 123R”), which establishes accounting for non-cash, stock-based awards exchanged for employee services. Accordingly, stock-based compensation cost is measured at grant date, based on the fair value of the award, and recognized over the requisite service period, which for the Company is generally the vesting period.

The Company adopted SFAS 123R using the modified prospective method, under which prior periods are not revised for comparative purposes. For all unvested options outstanding as of January 28, 2006, compensation expense previously measured but unrecognized, will be recognized in the statement of operations over the remaining service period based on the fair value at the original grant date. For equity-based compensation granted subsequent to January 28, 2006, compensation expense, based on the fair value on the date of grant, will be recognized in the statement of operations over the requisite service period.

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Consistent with the valuation method previously reflected only in pro forma disclosure as permitted by the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, prior to January 29, 2006, the Company used the Black-Scholes option pricing model to estimate the fair value of stock-based awards under SFAS 123R. The weighted-average estimated fair value of employee stock options granted during the second quarter and first six months ended July 29, 2006 was $4.14 and $3.99 per share respectively. The weighted-average estimated fair value of employee stock options granted during the second quarter and first six months ended July 30, 2005 was $3.05 and $2.97 per share respectively. The fair value of each stock option granted is estimated using the following assumptions:

	Second Quarter Ended		Six Months Ended
	Fiscal 2006	Fiscal 2005	Fiscal 2006	Fiscal 2005
Expected option life from grant date (in years)	4.5	4.5	4.5	4.5
Expected Volatility of stock	74%	52%	74%	52%
Risk-free interest rate	4.99% - 5.22%	4.40%	4.47% - 5.22%	4.40%
Expected Dividend yield	0%	0%	0%	0%

Expected option life: The Company’s expected option life represents the period that the Company’s stock-based awards are expected to be outstanding and was determined based on historical experience of similar awards, giving consideration to the contractual terms of the stock-based awards, vesting schedules and historical option exercise behavior and employee turnover.

Expected volatility of stock: The Company bases the expected volatility of its stock, used in the Black-Scholes valuation model, on daily changes in the Company’s historical common stock prices over a timeframe consistent with the expected life of the awards.

Risk free interest rate: The Company bases the risk-free interest rate on the U.S. Treasury yield curve rates in effect at the time of the grant using the term most consistent with the expected life of the award.

Expected Dividend yield: Dividend yields are estimated at zero as the Company historically has not paid dividends on common stock and does not anticipate paying any dividends in the future.

Estimated forfeitures: Forfeitures are estimated at the time of grant based on the Company’s historical forfeiture experience. For periods prior to 2006, the Company recognized forfeitures as they occurred.

In accordance with SFAS 123R, the company adjusts forfeiture estimates based on actual forfeiture experience for all awards with service conditions. The effect of forfeiture adjustments in the second quarter and the six months ended July 29, 2006 is insignificant.

For the second quarter ended July 29, 2006, the Company recorded $0.7 million for stock-based compensation under SFAS 123R, of which $0.5 million was recorded to selling, general and administrative expenses and $0.2 million was recorded to cost of revenue and occupancy. No tax benefits have been recorded due to the Company’s full valuation allowance position.

For the six months ended July 29, 2006, the Company recorded $1.6 million for stock-based compensation under SFAS 123R, of which $1.1 million was recorded to selling, general and administrative expenses and $0.5 million was recorded to cost of revenue and occupancy. No tax benefits have been recorded due to the Company’s full valuation allowance position.

Prior to January 29, 2006, the Company accounted for stock options according to the provisions of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, and therefore no related compensation expense was recorded for awards granted as it was believed that such awards had no intrinsic value.

The Company completed a voluntary review of its historical stock option practices that was overseen by the Audit Committee of the Board of Directors with the assistance of outside legal counsel. The Company determined that it used incorrect measurement dates with respect to the accounting for certain previously granted stock options, primarily during the years 2002 through 2004 as a result of lapses in documentation and deficiencies in option plan

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administration controls. Accordingly, the Company recorded a pretax cumulative charge of $0.6 million in the second quarter of fiscal 2006, $0.3 million in selling, general and administrative expenses and $0.3 million in cost of revenue and occupancy, related to certain grants dating back to fiscal 2002 based upon the Company’s determination that such grants had intrinsic value on the applicable measurement dates of the option grants.

Stock-Based Compensation Plans

In April 1998, the Company’s Board of Directors approved the 1998 Stock Incentive Plan (“the 1998 Plan”), which serves as the successor to the Company’s 1995 Stock Option Plan (“the Predecessor Plan”). The 1998 Plan is divided into five separate components: (i) the Discretionary Option Grant Program, (ii) the Stock Issuance Program, (iii) the Salary Investment Option Grant Program, (iv) the Automatic Option Grant Program and (v) the Director Fee Option Grant Program. The Discretionary Option Grant Program and Stock Issuance Program are administered by the Compensation Committee for Section 16 insiders and by a Secondary Committee of the Board of Directors for non-Section 16 insiders. The Director Fee Option Grant Program is not currently in use by the Company.

Under the 1998 Plan, the Company originally authorized the Board of Directors to grant options of shares of common stock to key employees, directors and consultants to purchase an aggregate of 3,287,662 shares of common stock. Such share reserve consists of (i) the number of shares available for issuance under the Predecessor Plan on June 19, 1998, including the shares subject to outstanding options, and (ii) an additional increase of 980,000 shares. In addition, the number of shares of common stock reserved for issuance under the 1998 Plan will automatically be increased on the first trading day of each calendar year, beginning in calendar year 2000, by an amount equal to the lesser of (i) three percent of the total number of shares of common stock outstanding on the last trading day of the preceding calendar year or (ii) 966,202 shares. On January 2, 2006, January 2, 2005 and January 2, 2004, the Company added 966,202 shares, 966,202 shares and 966,202 shares, respectively, to the 1998 Plan in accordance with the automatic increase provisions. Additionally, in July 2001, the Company’s stockholders approved an increase of 1,000,000 shares of common stock under the 1998 Plan, as well as various other amendments to the 1998 Plan. In no event, however, may any one participant in the 1998 Plan receive option grants, separately exercisable stock appreciation rights or direct stock issuances for more than 1,000,000 shares of common stock in the aggregate per calendar year.

For all options granted under the Discretionary Option Grant Program, the vesting, exercise prices and other terms of the options are fixed by the Compensation Committee or Secondary Committee, as applicable. The Discretionary Option Grant Program and the Automatic Option Grant Program provide for the grant of incentive stock options and non-statutory stock options at exercise prices not less than 100% of the fair market value on the date of grant. Under the Salary Investment Option Grant Program and the Director Fee Option Grant Program, the non-statutory stock options are granted at exercise prices not less than 33 ¹/3% of the fair market value on the date of grant. These options generally expire ten years from the date of grant and vest ratably either over a one-year period, three-year period or four-year period. The plan administrator shall have the discretion to grant options which are exercisable for unvested shares of common stock. If any such options are exercised before becoming vested, the holder cannot sell or transfer the shares received upon exercise until such shares have vested. If the holder leaves the Company before such shares are fully vested, the Company has the right to repurchase such unvested shares at the holder’s original exercise price.

In May 2001, the Company’s Board of Directors adopted a stock option program (the “Program”) outside of the Company’s 1998 Plan pursuant to which options exercisable for up to 1,000,000 shares of common stock may be granted. Under the Program, the Board of Directors authorized a special purpose committee of the Board of Directors to administer the Program. The special purpose committee was authorized to make non-statutory stock option grants to individuals as inducements to enter employment with the Company or, to the extent otherwise allowed under Nasdaq rules, as inducements to continue their employment with the Company, provided that in either case the terms of such grants were substantially similar to the terms of the stock option grants made pursuant to the 1998 Plan. However, the special purpose committee was not authorized to grant an option to acquire more than 50,000 shares to any one individual. Additionally, under the Program, options were allowed to be granted with an exercise price below the market price on The Nasdaq National Market on the date of grant, provided the special purpose committee first obtained approval of such grants from either the Board of Directors or the Compensation Committee. In no event was any option to have an exercise price less than $2.00 per share. Vesting, exercise prices and other terms of the options were fixed by the special committee. Generally, options vest in one-fourth increments

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over a four-year period and have a term of not more than ten years from the grant date. The Board of Directors or the Compensation Committee could, in either’s sole discretion and at any time, restrict or withdraw from the special purpose committee, as to any particular matters or categories of matters, the authority to make any or particular option grants under the Program. All options have contractual life of 10 years.

A summary of all employee option activity for the six months ended July 29, 2006 is set forth below:

Options	Shares		Weighted Average Exercise Price		Weighted Average Remaining Contractual Term	Aggregate Intrinsic Value
Outstanding at January 28, 2006	6,696,158		$	5.95
Granted	1,694,066			6.59
Exercised	(180,419	)		5.00
Forfeited	(349,420	)		5.32
Expired	(62,932	)		9.14
Outstanding at July 29, 2006	7,797,453		$	6.12	7.67	$	9,643,515
Vested and Exercisable	3,458,857		$	6.07	6.37	$	5,859,496

The weighted-average estimated fair value of employee stock options granted during the second quarter and six months ended July 29, 2006 was $4.14 and $3.99 per share, respectively. The weighted-average estimated fair value of employee stock options granted during the second quarter and six months ended July 30, 2005 was $3.05 and $2.97 per share, respectively. Total intrinsic value of options exercised during the second quarter ended July 29, 2006 and July 30, 2005 was $198,337 and $496,260, respectively. As of July 29, 2006, there was approximately $4.1 million of total unrecognized compensation cost. The cost is expected to be recognized over a weighted-average remaining period of 1.67 years.

The following table illustrates the effect on net loss and loss per share if we had applied the fair value provisions of SFAS 123 to share-based compensation for the periods prior to the adoption of SFAS 123R. The share-based compensation amounts presented below have been adjusted to reflect the expected calculation of compensation expense for the periods presented. While the Company correctly disclosed its expected option life from grant date of 4.5 years, the Company erroneously calculated compensation expense in fiscal 2005 based on a 7 year expected option life. The table presented below has been revised from the Company’s previous filing for the second quarter of fiscal 2005.

(Dollars in thousands, except per share data)	Second Quarter Ended Fiscal 2005			Six Months Ended Fiscal 2005
Net loss as reported	$	(2,462	)	$	(5,575	)
Add: Stock-based employee compensation expense for all options granted below fair market value included in reported net loss (net of tax)		—			—
Deduct: Compensation expense for all stock-based employee compensation (net of tax) calculated in accordance with the fair value method		(710	)		(1,332	)
Pro forma net loss	$	(3,172	)	$	(6,907	)
Loss per share of common stock:
Basic and diluted, as reported	$	(0.07	)	$	(0.17	)
Basic and diluted, pro forma	$	(0.10	)	$	(0.21	)

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Comprehensive Income (Loss)

Comprehensive income (loss) consists of net income (loss) and foreign currency translation adjustments. The components of comprehensive income (loss) for the second quarters and six months ended July 29, 2006 and July 30, 2005 are as follows:

	Second Quarter Ended						Six Months Ended
(Dollars in thousands)	Fiscal 2006			Fiscal 2005			Fiscal 2006			Fiscal 2005
Components of comprehensive income (loss):
Net income (loss)	$	236		$	(2,462	)	$	(4,677	)	$	(5,575	)
Foreign currency translation adjustment		(53	)		190			120			80
Total comprehensive income (loss)	$	183		$	(2,272	)	$	(4,557	)	$	(5,495	)

2. LONG-TERM DEBT, NET

On June 19, 2006, the Company entered into an agreement (“the Amendment”) to amend its existing revolving credit facility. The Amendment provides for an extension of the maturity date of the revolving credit facility from June 30, 2009 to June 30, 2011 and effects the substitution of Bank of America, N.A. as agent in place of Fleet Retail Group, LLC. The Amendment also includes a number of other changes to the existing facility, including with respect to the definition of EBITDA, to clarify that charges associated with the adoption of SFAS 123R will be eliminated in such calculation, the circumstances in which the fixed charge coverage ratio applies, and the applicable margin added to the interest rate under the facility as more fully described in the Amendment. Other elements of the existing facility remain materially unchanged.

As of July 29, 2006, $79.4 million was outstanding under the Company’s revolving credit facility, net of unamortized debt issuance costs of $0.9 million, and there was $11.0 million in letters of credit outstanding. 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 July 29, 2006, the bank’s reference rate was 8.25% and the LIBOR plus margin rate was 7.4%. Borrowings that are incremental advances under the revolving credit facility are subject to interest at the bank’s reference rate plus a margin or LIBOR plus a higher margin. The availability of credit at any given time under the revolving credit facility is limited by reference to a borrowing base formula (which includes an adjustment to the advance rate against eligible inventory and eligible accounts receivables for incremental advances as discussed below) 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. As of July 29, 2006, the Company had availability under the facility of $36.6 million.

The revolving credit facility contains various restrictive covenants, including limitations on the ability to make liens, make investments, sell assets, incur additional debt, merge, consolidate or acquire other businesses, pay dividends and other distributions, and enter into transactions with affiliates. 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 and availability under the revolving credit facility is less than 10%. If the Company does receive an advance under the incremental advance provision and if the remaining availability for additional borrowing under the facility is less than 10% of the applicable borrowing base for the line of credit at the time, the Company is required to maintain a fixed charge coverage ratio. The revolving credit facility also does not require that the Company repay all borrowings for a prescribed “clean-up” period each year.

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3. INCOME TAXES

SFAS 109, “Accounting for Income Taxes” (“SFAS 109”), 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, if needed the Company may record a valuation allowance to reduce net 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 the net deferred tax assets. While future taxable income and ongoing prudent and feasible tax planning are considered in determining the amount of the valuation allowance, the necessity for an allowance is subject to adjustment in the future. Specifically, in the event the Company were to determine that it would not be able to realize the net deferred tax assets in the future in excess of their net recorded amounts, an adjustment to the net deferred tax assets would decrease income in the period such determination was made. This allowance does not alter the Company’s ability to utilize the underlying tax net operating loss and credit carryforwards in the future, the utilization of which is limited to achieving future taxable income. Accordingly, the Company recorded a full valuation allowance against the net deferred tax assets during fiscal 2005. In the second quarter of fiscal 2006, the Company recorded a tax expense of $0.1 million.

4. EARNINGS (LOSS) PER SHARE OF COMMON STOCK

Basic earnings (loss) per share of common stock is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding for the periods. Diluted earnings (loss) per share of common stock is computed by dividing net income (loss) by the weighted average number of common stock and potentially dilutive common stock equivalents outstanding during the period. Diluted earnings (loss) per share of common stock reflects the potential dilution that could occur if options to issue common stock were exercised. The following table details potential dilutive effects of the weighted average number of certain common stock equivalents that have been included in the second quarter of fiscal 2006 diluted earnings per share but excluded from diluted loss per share for the second quarter of fiscal 2005 and the first six months of fiscal 2006 and 2005, respectively, because their inclusion would be anti-dilutive as the Company experienced a net loss in the second quarter of fiscal 2005 and first six months of fiscal 2006 and 2005, respectively:

	Second Quarter Ended		Six Months Ended
	Fiscal 2006	Fiscal 2005	Fiscal 2006	Fiscal 2005
Common stock issuable upon conversion of the Series A preferred stock	—	4,260,144	—	4,260,144
Common stock subject to outstanding stock options	1,026,953	1,197,259	841,031	927,947
Total	1,026,953	5,457,403	841,031	5,188,091

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 4,066,988 and 2,749,007 stock options for the second quarter of fiscal 2006 and 2005, respectively, and 4,121,158 and 3,758,366 stock options for the six months of fiscal 2006 and 2005, respectively, that were excluded from the table because the option exercise price for those stock options exceeded the average stock price for the period.

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5. 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. 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:

	Second Quarter Ended						Six Months Ended
(Dollars in thousands)	Fiscal 2006			Fiscal 2005			Fiscal 2006			Fiscal 2005
Net Revenue:
Retail	$	111,428		$	101,900		$	202,488		$	186,576
Direct-to-customer		67,915			42,881			110,235			75,670
Consolidated net revenue	$	179,343		$	144,781		$	312,723		$	262,246
	Second Quarter Ended						Six Months Ended
	Fiscal 2006			Fiscal 2005			Fiscal 2006			Fiscal 2005
Income (loss) from operations:
Retail	$	12,797		$	8,554		$	20,997		$	15,669
Direct-to-customer		13,482			6,442			20,987			11,042
Unallocated		(24,172	)		(18,159	)		(43,345	)		(34,218	)
Consolidated income (loss) from operations	$	2,107		$	(3,163	)	$	(1,361	)	$	(7,507	)

6. COMMITMENTS AND CONTINGENCIES

The Company is a party from time to time to various legal claims, actions and complaints. Although the ultimate resolution of legal proceedings cannot be predicted with certainty, the Company’s management currently believes that disposition of any such matters will not have a material adverse effect on the Company’s Condensed Consolidated Financial Statements.

7. NEW ACCOUNTING PRONOUNCEMENTS

In July 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes,” an Interpretation of SFAS 109. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken in a tax return. The Company must determine whether it is more likely than not that a tax position will be sustained upon examination based on the technical merits of the position. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently evaluating the impact of adopting FIN 48 on the Condensed Consolidated Financial Statements.

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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 bathware, hardware, lighting, furniture, textiles and accessories that reflect 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 and high quality merchandise. 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 53 weeks and ends on February 3, 2007 (“fiscal 2006”) and the prior fiscal year was 52 weeks and ended on January 28, 2006 (“fiscal 2005”).

As of July 29, 2006, we operated 103 stores and 8 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.

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

• In 2002, we began the transformation required to reposition our brand. This included new merchandise offerings, the adjustment of our overall product mix, and also the remodeling of our stores in order to best present the new merchandise. In addition, to drive sales in our direct channels, we expanded our product assortment of catalog and Internet only items.

• In 2003, we built on the prior year’s successful launch by further refining and expanding our core merchandise offerings, including the repositioning of our premium textiles, bath fixtures and hardware categories and enhancements in our lighting and furniture categories.

• We re-merchandised our furniture assortment in 2004 and revamped our accessories offering. We also redesigned our catalog in fiscal 2004 to improve the presentation of our core businesses and more clearly communicate the quality positioning of our offerings.

In 2005, we finalized the major changes in our assortment with a repositioning of our lighting and window categories. In addition, our efforts focused on three key priorities:

• Create dominant assortments in key categories. We reconfigured our stores to appropriately present our repositioned lighting and window treatment categories. These changes, in addition to the remodeling work done in 2002, allow us to project dominance in our key core categories: textiles, bath fixtures and hardware, lighting, and window treatments. Our catalog and Internet presentations also reflected this improved presentation.

• Maximize product margin opportunities. We target core categories that are high-margin businesses. The product and merchandising differentiation we offer our customers, and our sourcing strategies, supports this margin improvement strategy. Additionally, we believe we can further strengthen the overall business’s margin through the use of outlet stores to liquidate overstocked and discontinued goods. In 2005, we

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expanded our outlet strategy by opening five new outlet stores. We believe these stores will help us efficiently and cost-effectively manage our inventories, reducing the need for the less productive warehouse sales events that we have historically held.

• Strengthen the supply chain. In 2005, we made progress on improving our in-stock position in key categories. Additionally, we began work on upgrading the systems and processes for placing and fulfilling customer orders. In 2006, we are continuing this work with the implementation of store order terminals and the first phase of new warehouse systems.

The three primary priorities for 2005 have continued in 2006. In the first quarter, we launched our first category extension, the Restoration Hardware Outdoor Catalog. This is the first phase of our strategic efforts to extend the Restoration Hardware brand. We are pleased with the market’s acceptance of the Outdoor Catalog and will introduce our second category extension this holiday, the Restoration Hardware Gift Catalog. Supported by a unique assortment and fresh merchandising approach, the Gift Catalog, as well as a supporting web experience, will be an important addition to our holiday business.

In the third quarter of fiscal 2006, we plan to launch a new brand, Brocade Home. Brocade Home is a fashion home brand targeted at the broader value market with a unique and feminine point of view. The brand launches with a catalog this fall, and our plan is to develop a multi-channel retailing platform over the next several years. Brocade Home’s website is located at www.brocadehome.com.

During the first six months of fiscal 2006 we opened the last two of our eight outlet stores. We have no current plans to open additional stores or to close any stores in fiscal 2006. On an ongoing basis we evaluate stores for closure based on performance. 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.

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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 Statement of Operations.

(Dollars in thousands, except per share data)	Second Quarter Ended Fiscal 2006			% of Net Revenue		Second Quarter Ended Fiscal 2005			% of Net Revenue		Six Months Ended Fiscal 2006			% of Net Revenue		Six Months Ended Fiscal 2005			% of Net Revenue
Retail net revenue	$	111,428		62.1	%	$	101,900		70.4	%	$	202,488		64.7	%	$	186,576		71.1	%
Direct-to-customer net revenue		67,915		37.9			42,881		29.6			110,235		35.3			75,670		28.9
Net revenue		179,343		100.0			144,781		100.0			312,723		100.0			262,246		100.0
Cost of revenue and occupancy		120,098		67.0			101,507		70.1			208,593		66.7			183,330		69.9
Gross profit		59,245		33.0			43,274		29.9			104,130		33.3			78,916		30.1
Selling, general and administrative expense		57,138		31.8			46,437		32.1			105,491		33.7			86,423		33.0
Income (loss) from operations		2,107		1.2			(3,163	)	(2.2	)		(1,361	)	(0.4	)		(7,507	)	(2.9	)
Interest expense, net		(1,739	)	(1.0	)		(834	)	(0.6	)		(3,163	)	(1.0	)		(1,659	)	(0.6	)
Income (loss) before income taxes		368		0.2			(3,997	)	(2.8	)		(4,524	)	(1.4	)		(9,166	)	(3.5	)
Income tax (expense) benefit		(132	)	(0.1	)		1,535		1.1			(153	)	(0.1	)		3,591		1.4
Net income (loss)	$	236		0.1		$	(2,462	)	(1.7	)	$	(4,677	)	(1.5	)	$	(5,575	)	(2.1	)
Income (loss) per share of common stock—basic & diluted	$	0.01				$	(0.07	)			$	(0.12	)			$	(0.17	)

Income (Loss) from Operations and Net Income (Loss)

Income from operations improved to $2.1 million for the second quarter of fiscal 2006 as compared to a loss from operations of $3.2 million for the second quarter of fiscal 2005. Net income was $0.2 million ($0.01 per share) for the second quarter of fiscal 2006, compared to a net loss of $2.5 million ($0.07 per share) for the second quarter of fiscal 2005. The results for the second quarter of fiscal 2006 also included a $0.7 million non-cash charge associated with the expensing of stock options as required by SFAS 123R and did not include a federal income tax provision due to U.S. losses incurred for the year-to-date period and the valuation allowance against the company’s net deferred tax asset. In the second quarter of fiscal 2005, the net loss included a $1.5 million benefit.

During the second quarter of 2006, we also completed a voluntary review of our historical stock option practices that was overseen by the Audit Committee of our Board of Directors with the assistance of outside legal counsel. We determined that incorrect measurement dates were used with respect to the accounting for certain previously granted stock options, primarily during the years 2002 through 2004 as a result of lapses in documentation and deficiencies in option plan administration controls. The cumulative impact of the errors resulted in an additional non-cash compensation charge of $0.6 million, which has been taken in the second quarter of fiscal 2006. The cumulative charge was reported in the current period since the amount of the stock option compensation expense attributable to each of the previous periods was not material to any previously reported historical period and is not expected to be material to the current fiscal year.

Currently, we are assessing the impact, if any, of negative tax consequences that might arise for employees as a result of this matter. We may decide to compensate employees for any such negative tax consequences that have arisen. Any such compensation that we may elect to make to the employees for any negative tax effects would be recorded at the time that a decision is made as to this matter. The potential tax consequences may be affected by the issuance of final regulations related to Section 409A of the Internal Revenue Code expected to be issued by the Department of Treasury later this year.

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Loss from operations improved to $1.4 million for the first six months of fiscal 2006 as compared to a loss from operations of $7.5 million for the first six months of fiscal 2005. Net loss was $4.7 million ($0.12 per share) for the first six months of fiscal 2006, compared to a net loss of $5.6 million ($0.17 per share) for the first six months of fiscal 2005. The results for the first six months of fiscal 2006 included a $1.6 million non-cash charge associated with the expensing of stock options as required by SFAS 123R and the additional $0.6 million non-cash cumulative stock option charge described above. The results for the first six months of fiscal 2006 also did not include any federal income tax provision due to U.S. losses for the year-to-date period and the valuation allowance against the Company’s net deferred tax asset. In the first six months of fiscal 2005, the net loss included a $3.6 million tax benefit.

Net Revenue, Gross Profit and Selling, General & Administrative Expense

Second quarter net revenue was up 24% to $179.3 million on higher sales in retail and direct-to-customer segments. Comparable store sales increased 4.3% over the prior year quarter and direct-to-customer revenue was up 58%. Growth in the direct-to-customer channel was driven by the increased circulation from the launch of the Restoration Hardware Outdoor Catalog in the first and second quarters.

Our operating results improved by $5.3 million as compared to the prior year’s second quarter driven by higher sales and increase in our gross margins. Total cost of revenue and occupancy increased $18.6 million during the second quarter of fiscal 2006 to $120.1 million. As a percentage of net revenue these costs were reduced by 310 basis points to 67.0%, from 70.1% in the second quarter of fiscal 2005. The improvement in gross margin was driven by higher product margins of 280 basis points attributed to the recent strategic repositioning of our product mix and reduction in our occupancy costs as a percentage of net revenue. These amounts were partially offset by an increase in supply chain and distribution costs.

Selling, general and administrative expense for the second quarter increased $10.7 million but expressed as a percentage of revenue, was lower than the second quarter of fiscal 2005 by 30 basis points. The decrease in expense expressed as a percentage of revenue was driven primarily by a store fixture write-off that occurred last year and was associated with our store remodel effort, offset by a non-cash charge associated with the expensing of stock options as required by SFAS 123R, investments in our supply chain and Brocade Home initiatives and increased catalog costs as the mix of direct-to-customer revenue increased to 38% of the business from 30% last year.

For the first six months, net revenue was up 19% to $312.7 million on higher sales in the retail and direct-to-customer segments. Comparable store sales increased 4.1% from the prior year same quarter and direct-to-customer revenue was up 46% from the first six months of fiscal 2005. Growth in the direct-to-customer channel was driven by the increased circulation from the launch of the Restoration Hardware Outdoor Catalog in the first and second quarters.

Our operating results improved by $6.1 million as compared to the prior year’s first six months driven by higher sales and an increase in our gross margins. Total cost of revenue and occupancy increased $25.3 million during the first six months of fiscal 2006 to $208.6 million. As a percentage of net revenue these costs were reduced by 320 basis points to 66.7%, from 69.9% in the first six months of fiscal 2005. The improvement in gross margin was driven by higher product margins of 250 basis points attributed to the recent strategic repositioning of our product mix and a reduction of occupancy costs as a percentage of net revenue.

Selling, general and administrative expense for the first six months increased $19.1 million and expressed as a percentage of revenue, was higher than the second quarter of fiscal 2005 by 70 basis points. The increase was primarily driven by higher catalog circulation costs of 200 basis points, offset by a $1.6 million, non-cash charge associated with remodeling efforts in the prior year period. The increase in catalog circulation costs was driven by the higher direct-to-customer segment growth rate. Due to the expected growth of our direct-to-customer channel as a percentage of our total business mix, we believe that catalog circulation costs will continue to increase to support its growth, thus causing total company selling, general and administrative costs to continue deleveraging as a percentage of revenue in future quarters.

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 fiscal fourth

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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.

Retail Net Revenue and Segment Results

	Second Quarter Ended						Six Months Ended
(Dollars in thousands)	Fiscal 2006			Fiscal 2005			Fiscal 2006			Fiscal 2005
Retail net revenue	$	111,428		$	101,900		$	202,488		$	186,576
Retail net revenue growth percentage		9.4	%		10.0	%		8.5	%		10.0	%
Comparable store sales growth		4.3	%		5.6	%		4.1	%		5.3	%
Income from retail operations	$	12,797		$	8,554		$	20,997		$	15,669
Income from retail operations—percent of retail net revenue		11.5	%		8.4	%		10.4	%		8.4	%
Number of stores at beginning of period		103			102			103			102
Number of stores opened		—			—			—			—
Number of stores closed		—			—			—			—
Number of stores at end of period		103			102			103			102
Store selling square feet at end of period		686,649			676,520			686,323			676,520

Retail net revenue for the second quarter of fiscal 2006 increased by $9.5 million, or 9.4%, as compared to the second quarter of fiscal 2005. The increase is driven by a $4.1 million, or 4.3% increase in comparable store sales, a $3.3 million increase in revenue generated from outlet stores sales and a $1.3 million increase in warehouse sales over the same period last year. Outlet store and warehouse sales are included in retail revenue, but are excluded from comparable store sales. The growth in comparable store sales for the second quarter of fiscal 2006 was primarily driven by a 31% increase in average retail dollars per transaction combined with a decrease in total retail transactions of approximately 20% reflecting the changes in our merchandising strategy. In the second quarter of fiscal 2006 we had eight outlet stores versus three in the second quarter of fiscal 2005.

Retail net revenue for the first six months of fiscal 2006 increased by $15.9 million, or 8.5%, as compared to the first six months of fiscal 2005. The increase is primarily driven by a $7.4 million, or 4.1% increase in comparable store sales, as well as a $6.9 million increase in revenue generated from outlet stores. 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.

Income from operations for the retail segment increased to $12.8 million, or 11.5% of net retail revenue in the second quarter of fiscal 2006, from $8.6 million, or 8.4% of net retail revenue in the second quarter of fiscal 2005. Income from operations for the retail segment includes the costs of retail stores less the direct costs of the store field operations. The increase in income from operations was primarily due to higher sales coupled with improvements in selling, general and administrative expense. Gross margin improved 70 basis points due to an increase in product margin, partially offset by increases in store occupancy costs and supply chain and distribution cost as a percentage of revenue. Product margins improved due to the continued shift away from lower margin discovery items to higher margin core offerings highlighted by our recent store remodeling and repositioning efforts. Selling, general and administrative expense for the segment decreased by 240 basis points when expressed as a percentage of revenue, primarily due to the $1.6 million non-cash charge associated with remodeling efforts in the prior year period and lower payroll costs as a percentage of revenue.

Income from operations for the retail segment increased to $21.0 million, or 10.4% of net retail revenue in the first six months of fiscal 2006, from $15.7 million, or 8.4% of net retail revenue in the first six months of fiscal

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2005. Income from operations for the retail segment includes the costs of retail stores less the direct costs of the store field operations. The increase was primarily due to revenue growth combined with improvements in both gross margin and selling, general and administrative expense. Gross margin improved 90 basis points due to an increase in product margin, partially offset by increases in store occupancy costs and supply chain and distribution cost as a percentage of revenue. Product margins improved due to a shift away from lower margin discovery items to higher margin core offerings highlighted by our recent store remodeling and repositioning efforts. Selling, general and administrative expense for the segment decreased by 110 basis points when expressed as a percentage of revenue, primarily due to a $1.6 million non-cash charge to remove store fixtures as part of our remodel in the first six months of fiscal 2005 as well as lower payroll costs as a percentage of revenue.

Direct-to-Customer Net Revenue and Segment Results

	Second Quarter Ended						Six Months Ended
(Dollars in thousands)	Fiscal 2006			Fiscal 2005			Fiscal 2006			Fiscal 2005
Catalog revenue	$	34,926		$	22,674		$	56,836		$	40,754
Internet revenue		32,989			20,207			53,399			34,916
Total direct-to-customer net revenue	$	67,915		$	42,881		$	110,235		$	75,670
Income from direct-to-customer operations	$	13,482		$	6,442		$	20,987		$	11,042
Income from direct-to-customer operations—percent of direct-to-customer net revenue		19.9	%		15.0	%		19.0	%		14.6	%
Growth percentages:
Direct-to-customer net revenue		58	%		50	%		46	%		50	%
Number of catalogs mailed		67	%		14	%		44	%		16	%
Pages circulated		46	%		50	%		37	%		48	%

Direct-to-customer net revenue consists of both catalog and Internet sales. Direct-to-customer net revenue for the second quarter of fiscal 2006 increased $25.0 million, or 58%, as compared to the second quarter of fiscal 2005. The higher sales in the second quarter of fiscal 2006 are primarily the result of a 67% increase in the number of catalogs mailed as well as a 46% increase in pages circulated compared to the second quarter of fiscal 2005. Internet sales grew 63% in the second quarter to $33.0 million and catalog sales grew 54% in the second quarter to $34.9 million.

Direct-to-customer net revenue for the first six months of fiscal 2006 increased $34.6 million, or 46%, as compared to the first six months of fiscal 2005. For the first six months, the number of catalogs mailed increased by 44% with a 37% increase in pages circulated. Internet sales grew 53% in the first six months of fiscal 2006 to $53.4 million and catalog sales grew 39% in the first six months of fiscal 2006 to $56.8 million.

Revenue growth in the direct-to-customer channel was driven by the increase in circulation from the launch of the Restoration Hardware Outdoor Catalog in the first and second quarters. Internet sales grew in the second quarter and first six months of 2006 as a result of our website marketing efforts coupled with growing customer familiarity with the Internet and strong customer response to our spring, outdoor and summer offerings.

Income from operations for the direct-to-customer segment was $13.5 million, or 19.9% of net direct revenue, in the second quarter of fiscal 2006 as compared to $6.4 million, or 15.0% of net direct revenue, in the same quarter of the prior fiscal year. The increase of $7.0 million represents a 490 basis point improvement when expressed as a percentage of revenue, and is primarily the result of savings in our supply chain and distribution costs attributable to significant efficiencies in customer shipping and improvement of our product margin. Selling, general and administrative expenses leveraged by 50 basis points, primarily due to higher than expected revenue growth.

Income from operations for the direct-to-customer segment was $21.0 million, or 19.0% of net direct revenue, in the first six months of fiscal 2006 as compared to $11.0 million, or 14.6% of net direct revenue, in the first six months of the prior fiscal year. This increase of $9.9 million represents a 440 basis point improvement and is primarily the result of an improvement in supply chain and distribution costs of expansion in product margin. Selling, general and administrative expenses leveraged by 70 basis points, primarily due to higher than expected revenue growth.

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Interest Expense, Net

Interest expense, net includes interest on borrowings under our revolving credit facility and amortization of debt issuance costs. For the second quarter of fiscal 2006, interest expense, net was $1.7 million, an increase of $0.9 million as compared to $0.8 million for the second quarter of fiscal 2005. For the first six months of fiscal 2006, interest expense, net was $3.2 million, an increase of $1.5 million as compared to $1.7 million for the first six months of fiscal 2005. The increase in expense was due to higher average debt levels combined with increased borrowing rates.

Income Tax Expense (Benefit)

During the second quarter of fiscal 2006, the Company recorded income tax expense of $132 thousand compared to an income tax benefit of $1.5 million for the same period in the prior year. For the first six months of fiscal 2006, the Company recorded income tax expense of $153 thousand compared to an income tax benefit of $3.6 million for the first six months of fiscal 2005. The Company’s effective tax rate for the first six months of fiscal 2006 was a tax expense rate of 3% compared to a tax benefit rate of 39% for the comparable period in the prior year, primarily due to the full valuation allowance for deferred tax assets in the fourth quarter of fiscal 2005.

LIQUIDITY AND CAPITAL RESOURCES

Operating Cash Flows

For the first six months of fiscal 2006, net cash used by operating activities was $16.5 million compared to $3.3 million for the first six months of fiscal 2005. The majority of the increase is due to the effect of changes in inventory due to seasonal needs and planned sales growth requirements. The increase in cash usage associated with merchandise inventories of $22.6 million in the first six months of fiscal 2006 reflects targeted inventory investments in product categories where we believe we have opportunities to drive higher revenues through improving our in-stock positions in both our retail and direct-to-customer channels. Inventory was also impacted by the launch of our second category extension late in the first quarter, the Restoration Hardware Outdoor catalog. The increase in operating cash usage was partially offset by a $7.2 million increase in accounts payable and accrued expenses in support of increased sales and merchandise inventory.

Investing Cash Flows

Net cash used by investing activities was $6.6 million for the first six months of fiscal 2006, a decrease of $5.4 million compared to $12.0 million for the second quarter of fiscal 2005. The reduction in cash used for investing activities for the first six months of fiscal 2006 relates primarily to the store remodeling efforts that began in the second quarter of fiscal 2005. In fiscal 2005 we reconfigured our stores to appropriately present our repositioned lighting and window treatment categories.

Financing Cash Flows

Net cash provided by financing activities was $22.1 million for the first six months of fiscal 2006, compared to $15.2 million for the first six months of fiscal 2005. Substantially all of the net cash provided by financing activities resulted from an increase in net borrowings under our revolving credit facility.

As of July 29, 2006, $79.4 million was outstanding under our revolving credit facility, net of unamortized debt issuance costs of $0.9 million, and there was $11.0 million in letters of credit outstanding. 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 July 29, 2006, the bank’s reference rate was 8.25% and the LIBOR plus margin rate was 7.4%. Borrowings that are incremental advances under the revolving credit facility are subject to interest at the bank’s reference rate plus a margin or LIBOR plus a higher margin. The availability of credit at any given time under the revolving credit facility is limited by reference to a borrowing base formula (which includes an adjustment to the advance rate

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against eligible inventory and eligible accounts receivables for incremental advances as discussed below) 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 and the other terms and conditions of the credit facility, 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. As of July 29, 2006, we had availability under the facility of $36.6 million.

The revolving credit facility contains various restrictive covenants, including limitations on the ability to make liens, make investments, sell assets, incur additional debt, merge, consolidate or acquire other businesses, pay dividends and other distributions, and enter into transactions with affiliates. The revolving credit facility does not contain any other significant financial or coverage ratio covenants unless we take advantage of the incremental advance provision and availability under the revolving credit facility is less than 10%. If we do receive an advance under the incremental advance provision and if the remaining availability for additional borrowing under the facility is less than 10% of the applicable borrowing base for the line of credit at the time, we are required to maintain a fixed charge coverage. The revolving credit facility also does not require that we repay all borrowings for a prescribed “clean-up” period each year.

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 “Risk Factors,” , in particular the sections “We are dependent on external funding sources, including the terms of our revolving credit facility, 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.”

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 28, 2006, have not changed materially during the second quarter ended July 29, 2006.

Item 4. Controls and Procedures.

As of July 29, 2006, 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 Chief Financial Officer (“CFO”). Based on that evaluation, our CEO and CFO concluded that our disclosure controls and procedures as of July 29, 2006 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.

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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 1A. Risk Factors.

In addition to the other information in this Quarterly Report on Form 10-Q, the factors and risks listed below, among others, could affect our future performance and should be carefully considered in evaluating our outlook. There were no material changes in these risk factors from the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended January 28, 2006.

Our success depends upon consumer responses to our product offerings; if we fail to successfully anticipate changes in consumer trends or consumers otherwise do not respond to our product offerings, our results of operations may be adversely affected.

Our success depends on consumer responses to our product offerings and our ability to anticipate and respond to changing merchandise trends and consumer demands in a timely manner. If, for example, consumers do not respond to our product offering or we misjudge market trends, we may significantly overstock unpopular products and be forced to 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 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. At July 29, 2006, we did not expect, and therefore did not reserve for, any store closures.

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

Our product mix is increasingly dependent upon the efficiency of our supply chain infrastructure and order acceptance and fulfillment processes. Our in store customer sales have recently consisted of higher percentages of merchandise that must be shipped to the customer or is custom ordered as we have refined our product offerings. Such transactions put additional pressure on our order acceptance and fulfillment processes. An important part of our efforts to achieve efficiencies, cost reductions and sales growth is the identification and implementation of

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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, increase our costs 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 fiscal 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 fiscal 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, timing of delivery of orders, 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, the timing of delivery of orders and our ability to execute our business strategy efficiently. Our comparable store sales increased 4.3% in the second quarter 2006. 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.

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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 148 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 offerings 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 adequately support our management information systems 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, 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.

Operational difficulties in any of our distribution and order acceptance and fulfillment operations would materially affect our operating results.

A growing percentage of our business depends upon the successful operation of our distribution and order acceptance and fulfillment services either because the business is generated through our Catalog and Internet channels or because the customer’s purchase in the store must be completed through a shipment of product to the customer. 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. Operational difficulties such as a 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 could also 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 July 29, 2006, we had approximately 3,600 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

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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, including the terms of our revolving credit facility, which may not make available to us sufficient funds when we need them.

We have significantly relied and may rely in the 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 will be less than the stated amount (i) 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 and (ii) at times when we are not in compliance with the requirements of the fixed charge coverage ratio for us to access incremental advances under the credit facility when the remaining availability for additional borrowing under the facility is less than 10% of the applicable borrowing base for the line of credit at the time. 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 provides for incremental advances with availability determined from the application of a higher advance rate on eligible inventory and eligible accounts receivables. In order to obtain these incremental advances, we are required to maintain a minimum fixed charge coverage ratio if the remaining availability for additional borrowing under the facility is less than 10% of the applicable borrowing base for the line of credit at the time.

Our revolving credit facility also 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 July 29, 2006 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 subject to its terms and conditions of availability in order to fund our operations over the term of the revolving credit facility which expires in June 2011. 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.

We may experience cash flow shortfalls in the future and we may otherwise 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, mailings of catalogs and other advertising costs 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

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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.

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. In addition, the incremental advance portion of our revolving credit facility includes a fixed charge coverage ratio covenant that is expected to limit our ability to access incremental advances during certain months of the year.

Although we have been able to obtain incremental advances when needed to provide the capital required for our business to date, there may be times in the future when the terms and conditions of availability for our line of credit, including the restrictions applicable to the incremental advance provisions, would limit our ability to access working capital as and to the extent we require for the operation of our business, potentially having an adverse affect on our results of operation.

These covenants restrict numerous aspects of our business. The revolving credit facility also includes a borrowing base formula (which includes an adjustment to the advance rate against eligible inventory and eligible accounts receivable for incremental advances as described above) 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. 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 second quarter fiscal year 2006, we purchased approximately 69% 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

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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 of America 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 we 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 second quarter fiscal year 2006, revenue through our direct-to-customer channel grew by 58% as compared to 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

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at any time. 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 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 locations. 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 or our customers and decreased sales of the products we carry. Additionally, any of these events could cause consumer confidence and spending to

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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 of America 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. During fiscal 2005, the remaining holders of the Series A preferred stock elected to convert their shares of Series A preferred stock into common stock. Sale, or the availability for sale, of substantial amounts of common stock by our existing stockholders pursuant to an effective registration statement or under Rule 144, through the exercise of registration rights or the issuance of shares of common stock upon the exercise of stock options, or the conversion of our preferred stock, or the perception that such sales or issuances could occur, could adversely affect prevailing market prices for our common stock and could materially impair our future ability to raise capital through an offering of equity securities.

We are subject to anti-takeover provisions and other terms and conditions 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,

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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 “Risk Factors.” 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 4. Submission of Matters to a Vote of Security Holders.

We held our 2006 annual meeting of stockholders on July 19, 2006. The following proposals were voted on by our stockholders and the results of each proposal are as follows:

Proposal I:

The following individuals were elected by holders of our common stock, voting as a single class, as our Class II directors to serve for a three-year term until the 2009 annual meeting of stockholders or until their successors are duly elected and qualified:

	Votes For	Votes Withheld	Abstain	Broker Non-Votes
Robert E. Camp	32,636,731	0	906,715	0
M. Ann Rhoades	33,239,851	0	303,595	0

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Proposal II:

The ratification of the selection of Deloitte & Touche LLP as our registered independent public accountants for the fiscal year ending February 3, 2007:

Votes For	Votes Against	Abstain	Broker Non-Votes
32,092,331	19,456	1,431,659	0

Item 6. Exhibits.

See attached exhibit index.

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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: September 7, 2006
	By:	/s/ GARY G. FRIEDMAN
		Gary G. Friedman
		Chairman, President and
		Chief Executive Officer
		(Principal Executive Officer)

By:	/s/ CHRIS NEWMAN
	Chris Newman
	Chief Financial Officer
	(Principal Financial Officer)

By:	/s/ VIVIAN MACDONALD
	Vivian Macdonald
	Vice President, Corporate Controller
	(Principal Accounting Officer)

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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)
10.45	Employment Offer Letter, dated May 5, 2006, from Restoration Hardware, Inc. to Ken Dunaj
10.46	Employment Offer Letter, dated June 2, 2006, from Restoration Hardware, Inc. to Vivian Macdonald
10.47	Letter Agreement, dated June 5, 2006, between Restoration Hardware, Inc. and Bonnie McConnell-Orofino
31.1	Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
31.2	Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
32.1	Section 1350 Certification of Chief Executive Officer
32.2	Section 1350 Certification of Chief Financial Officer

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