Form 10-Q

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

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(MARK ONE)

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

For the quarterly period ended November 3, 2007

¨	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 November 28, 2007, 38,934,912 shares of the registrant’s common stock, $0.0001 par value per share, were outstanding.

RESTORATION HARDWARE, INC.

FORM 10-Q

FOR THE QUARTER ENDED NOVEMBER 3, 2007

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION		3

Item 1.	Condensed Consolidated Financial Statements (Unaudited)	3

	Condensed Consolidated Balance Sheets as of November 3, 2007, February 3, 2007 and October 28, 2006	3

	Condensed Consolidated Statements of Operations for the three and nine months ended November 3, 2007 and October 28, 2006	4

	Condensed Consolidated Statements of Cash Flows for the nine months ended November 3, 2007 and October 28, 2006	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	20

Item 4.	Controls and Procedures	21

PART II. OTHER INFORMATION		21

Item 1.	Legal Proceedings	21

Item 1A.	Risk Factors	21

Item 6.	Exhibits	31

SIGNATURES		32

EXHIBIT INDEX		33

PART I. FINANCIAL INFORMATION

Item 1.

Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)


	November 3, 2007			February 3, 2007			October 28, 2006
ASSETS
Current assets:
Cash and cash equivalents	$	1,746		$	1,461		$	1,639
Accounts receivable		8,535			7,164			12,068
Merchandise inventories		230,913			192,805			217,668
Prepaid expense and other current assets		19,636			18,984			20,327

Total current assets		260,830			220,414			251,702

Property and equipment, net		89,283			87,961			89,187
Goodwill		4,560			4,560			4,560
Deferred tax assets		2,025			1,911			376
Other assets		1,541			1,521			1,445

Total assets	$	358,239		$	316,367		$	347,270

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable and accrued expenses	$	83,287		$	79,340		$	81,935
Deferred revenue and customer deposits		13,063			9,556			12,910
Deferred tax liabilities		1,452			1,357			—
Other current liabilities		21,541			20,335			18,372

Total current liabilities		119,343			110,588			113,217
Long-term debt, net of issuance costs		131,317			68,384			110,941
Deferred lease incentives		20,007			23,515			24,717
Deferred rent		18,824			19,998			19,796
Other long-term obligations		10,460			1,774			1,002

Total liabilities		299,951			224,259			269,673

Commitments and contingencies (Note 6)
Stockholders’ equity:
Common stock, $.0001 par value; 60,000,000 shares authorized; 38,828,806, 38,740,288 and 38,698,544 issued and outstanding at November 3, 2007, February 3, 2007 and October 28, 2006, respectively		4			4			4
Additional paid-in capital		180,717			178,176			176,897
Accumulated other comprehensive income		2,161			745			1,150
Accumulated deficit		(124,594	)		(86,817	)		(100,454	)

Total stockholders’ equity		58,288			92,108			77,597

Total liabilities and stockholders’ equity	$	358,239		$	316,367		$	347,270

See accompanying Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share data)

(Unaudited)


	Three Months Ended						Nine Months Ended
	November 3, 2007			October 28, 2006			November 3, 2007			October 28, 2006
Net revenues	$	173,681		$	157,073		$	499,613		$	469,796
Cost of revenue and occupancy		115,615			103,232			336,055			311,825

Gross profit		58,066			53,841			163,558			157,971
Selling, general and administrative expense		70,950			57,545			193,856			163,036

Loss from operations		(12,884	)		(3,704	)		(30,298	)		(5,065	)
Interest expense, net		(2,409	)		(2,119	)		(6,644	)		(5,282	)

Loss before income taxes		(15,293	)		(5,823	)		(36,942	)		(10,347	)
Income tax benefit (expense)		105			115			73			(38	)

Net loss	$	(15,188	)	$	(5,708	)	$	(36,869	)	$	(10,385	)

Net loss per share, basic and diluted	$	(0.39	)	$	(0.15	)	$	(0.95	)	$	(0.27	)

Shares used in calculation of earnings per share:
Basic and diluted		38,826			38,311			38,794			37,989

See accompanying Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)


	Nine Months Ended
	November 3, 2007			October 28, 2006
Cash flows from operating activities:
Net loss	$	(36,869	)	$	(10,385	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation and amortization		16,715			15,956
Net loss on disposal of property and equipment		44			27
Stock-based compensation expense		2,204			3,053
Deferred income taxes		(187	)		(376	)
Changes in operating assets and liabilities:
Accounts receivable		(1,371	)		(6,184	)
Merchandise inventories		(38,108	)		(59,021	)
Prepaid expense and other current assets		(504	)		(10,945	)
Accounts payable and accrued expenses		3,564			18,255
Deferred revenue and customer deposits		3,507			4,606
Other current liabilities		2,096			878
Deferred rent		(1,174	)		(70	)
Deferred lease incentives and other long-term obligations		(3,620	)		(2,748	)

Net cash used by operating activities		(53,703	)		(46,954	)
Cash flows from investing activities:
Capital expenditures		(8,667	)		(10,861	)
Proceeds from sale of property and equipment		—			464

Net cash used by investing activities		(8,667	)		(10,397	)
Cash flows from financing activities:
Borrowings under line of credit, net		63,000			52,792
Debt issuance costs		(210	)		(175	)
Payments on capital leases		(1,272	)		(343	)
Issuance of common stock, net		337			4,658

Net cash provided by financing activities		61,855			56,932
Effects of foreign currency exchange rate translation		800			68

Net increase (decrease) in cash and cash equivalents		285			(351	)
Cash and cash equivalents:
Beginning of period		1,461			1,990

End of period	$	1,746		$	1,639

Additional cash flow information:
Cash paid during the period for interest	$	6,560		$	2,206
Cash paid during the period for income taxes		1,124			1,213
Non-cash investing and financing transactions:
Property and equipment acquired under capital leases	$	5,055		$	1,653
Construction in progress – leased facilities	$	3,544		$	—

See accompanying Notes to Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

1. NATURE OF BUSINESS AND BASIS OF PRESENTATION

Nature of Business

Restoration Hardware, Inc., a Delaware corporation (together with its subsidiaries collectively, the “Company”), is a specialty retailer of furniture, bathware, hardware, lighting, textiles, accessories and related merchandise. Through the Company’s subsidiary, The Michaels Furniture Company, Inc. (“Michaels”), the Company manufactures a line of high quality furniture for the home. These products are sold through retail locations, catalogs and the Internet. At November 3, 2007, the Company operated a total of 102 retail stores and 8 outlets stores in 30 states, the District of Columbia and in Canada.

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements have been prepared from the Company’s records without audit and, in management’s opinion, include all adjustments (consisting of normal recurring adjustments) necessary to present fairly the Company’s financial position at November 3, 2007 and October 28, 2006, the results of operations for the three and nine months ended November 3, 2007 and October 28, 2006, and changes in cash flows for the nine months ended November 3, 2007 and October 28, 2006, respectively. The condensed consolidated balance sheet at February 3, 2007, 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 February 3, 2007 (“fiscal 2006”) included in the Company’s Form 10-K. Certain information and disclosures normally included in the notes to annual consolidated 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 interim condensed consolidated financial statements. The interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements, including the notes thereto, for fiscal 2006. The Company’s current fiscal year ends on February 2, 2008 (“fiscal 2007”).

The results of operations for the three and nine months ended November 3, 2007 presented in this Form 10-Q are not necessarily indicative of the results to be expected for the full fiscal year.

Effective in fiscal 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of SFAS 109” (“FIN 48”). This interpretation prescribes a recognition threshold of more-likely-than-not and a measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. See Note 3, “Income Taxes,” for additional information regarding the Company’s adoption of FIN 48.

Stock-based Compensation

The Company follows the accounting provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123R “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. For the quarter ended November 3, 2007, the Company recorded $0.4 million for pre-tax stock-based compensation under SFAS 123R, of which $0.3 million was recorded to selling, general and administrative expenses and $0.1 million was recorded to cost of revenue and occupancy. During the third quarter of fiscal 2006, the Company recorded $0.9 million for pre-tax stock-based compensation, of which $0.7 million was recorded to selling, general and administrative expenses and $0.2 million was recorded to cost of revenue and occupancy. For the nine months ended November 3, 2007, the Company recorded $2.2 million for pre-tax stock-based compensation under SFAS 123R, of which $1.6 million was recorded to selling, general and administrative expenses and $0.6 million was recorded to cost of revenue and occupancy. During the nine months ended October 28, 2006, the Company recorded $2.5 million for stock-based compensation under SFAS 123R and $0.6 million of stock-based compensation related to the completion of 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. Of the $3.1 million in stock-based compensation for the nine months ended October 28, 2006, $2.1 million was recorded to selling, general and administrative expenses and $1.0 million was recorded to cost of revenue and occupancy.

During the third quarter of fiscal 2007, the Company granted 43,000 shares of employee stock options with a weighted average exercise price of $3.34 and an average grant date fair value of $1.62. During the third quarter of fiscal 2006, the

Company granted 0.3 million shares of employee stock options with a weighted average exercise price of $8.19 and an average grant date fair value of $4.87. For the nine months ended November 3, 2007, the Company granted 0.7 million shares of employee stock options with a weighted average exercise price of $5.84 and an average grant date fair value of $3.13 and granted 0.4 million shares of restricted stock units with an average market value at grant date value of $6.15. For the nine months ended October 28, 2006, the Company granted 2.0 million shares of employee stock options with a weighted average exercise price of $6.80 and an average grant date fair value of $4.11. As of November 3, 2007, unrecognized compensation cost under the Company’s stock option plans was $2.1 million for employee stock options and $0.6 million for restricted stock units. The unrecognized compensation cost is expected to be recognized over a weighted-average remaining vesting period of 1.46 years for employee stock options and 3.52 years for restricted stock units.

Stock-Based Compensation Plans

At the Company’s annual meeting of stockholders held on July 12, 2007, the stockholders approved the Company’s 2007 stock incentive plan (the “2007 Plan”). The 2007 Plan, which became effective immediately upon stockholder approval of the 2007 Plan, replaces the Company’s 1998 Stock Incentive Plan (the “1998 Plan”) and no further awards will be granted under the 1998 Plan. The purpose of the 2007 Plan is to retain key employees, consultants and directors of the Company having experience and ability, to attract new employees, consultants and directors whose services are considered valuable, to encourage the sense of proprietorship and to stimulate the active interest of such persons in the development and financial success of the Company. All of the Company’s directors, executive officers and employees are eligible to participate in the 2007 Plan. Awards under the 2007 Plan may be granted in the form of an option (incentive stock option or non-qualified stock option), stock appreciation right, restricted stock or restricted stock unit. The maximum aggregate number of shares which may be issued pursuant to all awards under the 2007 Plan is 2.4 million shares, plus approximately 1.9 million shares that remained available for grants of awards under the 1998 Plan as of the date the 2007 Plan was approved, plus any shares that would otherwise return to the 1998 Plan as a result of forfeiture, termination or expiration of awards previously granted under the 1998 Plan. Annual award grants are limited to one million shares on a per person basis. All grants of awards under the 2007 Plan have a maximum term of ten years, except incentive stock options issued to a stockholder owning more than 10% of the voting power of all classes of the Company’s stock, which have a maximum term of five years. The exercise price of an award shall not be less than 100% of the fair market value on the date of grant or not less than 110% of the fair market value on the date of grant for an incentive stock option granted to a 10% stockholder. Awards granted under the 2007 Plan shall be administered by the Company’s board of directors or by one or more committees designated by the board of directors. As of November 3, 2007, there were approximately 4.4 million shares available for future grant.

Lease Obligation

The Company entered into a lease agreement during the third quarter of 2007 pursuant to which the Company will lease a distribution facility in Ohio. The Company’s accounting for tenant improvements differs if a lease is accounted for under the provision of EITF 97-10, “The Effect of Lessee Involvement in Asset Construction” (“EITF 97-10”). The Company’s lease for this distribution facility has a cap on the construction allowance which places the Company at risk for cost overruns and causes the Company to be deemed, for accounting purposes only, the owner of the distribution facility during the construction period even though it is not the legal owner.

As of November 3, 2007, the Company has capitalized the estimated cost incurred to date of $3.5 million, which has been recorded as construction-in-progress. The related liability has been recorded as other long-term obligations on the accompanying balance sheet.

Once construction is complete, the Company considers the requirement under FASB No. 98, “Accounting for Leases: Sale-Leaseback Transactions Involving Real Estate, Sales-Type Leases of Real Estate, Definition of Lease Term, and Initial Direct Costs of Direct Financing Leases,” for sale-leaseback treatment. If the arrangement does not qualify for sale-leaseback treatment, the Company continues to amortize the financing obligation and depreciate the building over the lease term.

Comprehensive Loss

Comprehensive loss consists of net loss and foreign currency translation adjustments. The components of comprehensive loss for the three and nine months ended November 3, 2007 and October 28, 2006, respectively, are as follows:


	Three Months Ended						Nine Months Ended
	November 3, 2007			October 28, 2006			November 3, 2007			October 28, 2006
(Dollars in thousands)
Components of comprehensive loss:
Net loss	$	(15,188	)	$	(5,708	)	$	(36,869	)	$	(10,385	)
Foreign currency translation adjustment		715			20			1,416			140

Total comprehensive loss	$	(14,473	)	$	(5,688	)	$	(35,453	)	$	(10,245	)

2. LONG-TERM DEBT

On April 27, 2007, the Company entered into an agreement (the “Amendment”) to further amend its existing revolving credit facility. The Amendment provides for an extension of the maturity date of the revolving credit facility to June 30, 2012 and an increase in the amount of the revolving credit facility to $190 million. The Amendment further provides that the Company may increase the amount of the revolving credit facility by up to an additional $75 million provided that, among other things, no default under the facility then exists or would arise as a result of such increase. The Amendment also includes a number of other improvements to the existing facility, including (i) an increase in the loan-to-value limits under the facility, (ii) a decrease of the interest rate on certain loans and obligations under the facility, (iii) a lower minimum fixed charge coverage ratio for certain loans under the facility, and (iv) a change in the circumstances in which the fixed charge coverage ratio applies under the facility. Other terms and conditions of the existing revolving credit facility remain materially unchanged.

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 described 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 (as reduced by the actual borrowings and outstanding letters of credit under the facility). The revolving credit facility is secured by the Company’s assets, including accounts receivable, inventory, general intangibles, equipment, goods and fixtures.

As of November 3, 2007, $131.3 million was outstanding under the facility, net of unamortized debt issuance costs of $0.9 million, and there was $12.1 million in outstanding letters of credit. 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 November 3, 2007, the bank’s reference rate was 7.5% and the LIBOR plus margin rate was 5.92%. 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. As of November 3, 2007, availability under the facility was $48.6 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 or 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 remaining availability is less than $15 million, in which case 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. In addition, the revolving credit facility does not require a daily sweep lockbox arrangement except upon the occurrence of an event of default under the facility or in the event the remaining availability for additional borrowings under the facility is less than $15 million.

3. INCOME TAXES

In June 2006, the FASB issued FIN 48, which clarifies the criteria that an individual tax position must satisfy for some or all of the benefits of that position to be recognized in a company’s financial statements. FIN 48 prescribes a recognition threshold of more-likely-than-not, and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those tax positions to be recognized in the financial statements.

Effective February 4, 2007, the Company adopted the provisions of FIN 48. As a result of the implementation, the Company established a $2.2 million reserve for unrecognized tax benefits, inclusive of $0.3 million of related interest. This reserve is classified as a long-term liability and included in other long-term obligations on the Company’s interim condensed consolidated balance sheet at November 3, 2007. Upon adoption of FIN 48, the Company also recognized a reduction in retained earnings of $0.9 million and certain other deferred income tax assets and liabilities were recorded or reclassified.

Adjustments required upon adoption of FIN 48 to the United States related deferred tax asset accounts were offset by the United States related valuation allowance. Future changes to the Company’s assessment of the realizability of those

deferred tax assets will impact the effective tax rate. The total amount of unrecognized tax benefits as of the date of adoption was $2.2 million. Of this amount, $2.0 million represents the amount that would reduce the Company’s effective income tax rate if recognized in future periods.

The Company accounts for interest and penalties related to unrecognized tax benefits as a component of income tax expense.

The Company could be subject to United States and state tax examinations for years 2000 and forward. The Company may also be subject to audits in Canada for years 2001 and forward. There are no material United States or Canadian tax examinations currently in progress.

As of November 3, 2007, the total amount of unrecognized tax benefits was approximately $2.5 million. In addition, the Company has recorded $0.5 million of related interest. The Company anticipates an increase to the unrecognized tax benefits during the next twelve months applicable to foreign tax exposures. While the total increase cannot be estimated at this time, the change is not expected to be material to the fiscal 2007 consolidated financial statements.

4. NET LOSS PER SHARE OF COMMON STOCK

Basic net loss per share of common stock is computed by dividing net loss by the weighted average number of shares of common stock outstanding for the periods. Diluted net loss per share of common stock is computed by dividing net loss by the weighted average number of common stock and potentially dilutive common stock equivalents outstanding during the period. Diluted net loss per share of common stock reflects the potential dilution that could occur if options to issue common stock were exercised.

The potential dilutive effects of the weighted average number of certain common stock equivalents have been excluded from diluted net loss per share of common stock because their inclusion would be anti-dilutive. The amounts excluded for the third quarter of fiscal 2007 and 2006 was 0.2 million common stock equivalents and 1.2 million common stock equivalents, respectively. The amount of common stock equivalents excluded for the nine months ended November 3, 2007 and October 28, 2006 was 0.5 million and 1.0 million, respectively. These common stock equivalents only represent stock options whose exercise prices were less than the average market price of the stock during the respective periods and therefore were potentially dilutive.

There were an additional 5.9 million and 3.1 million stock options for the third quarter of fiscal 2007 and 2006, respectively, which were also excluded because the option exercise price for those stock options exceeded the average market price of the stock during the respective periods. For the nine months ended November 3, 2007 and October 28, 2006, 5.0 million and 3.8 million stock options were excluded because the option exercise price for those stock options exceeded the average market price of the stock during the respective periods.

5. SEGMENT REPORTING

Beginning in the second quarter of fiscal 2007, the Company consolidated all small package, direct-to-customer shipments into one distribution center. Previously, these shipments were fulfilled through three facilities: one direct-to-customer distribution center and two retail replenishment distribution centers. As part of the consolidation of small package direct-to-customer fulfillment into the direct-to-customer distribution center, certain revenues that had been recorded in the retail segment are now being recorded in the Direct-to-customer segment beginning in the second quarter of 2007. The shift in revenue reporting represented approximately 15 percentage points of the 24% decrease in Stores segment revenues and 27 percentage points of the 71% increase in Direct-to-customer segment revenues for the three months ended November 3, 2007 as compared to the three months ended October 28, 2006. For the nine months ended November 3, 2007 as compared to the nine months ended October 28, 2006, the shift represented 8 percentage points of the 17% decrease in Store segment revenues and 14 percentage points of the 49% increase in Direct-to-customer segment revenues. The revenue segment results for all periods presented reflect the method the Company now records revenues following the consolidation of all small package, direct-to-customer shipments into one distribution center.

Also, beginning in the second quarter of fiscal 2007, the Company revised its segment reporting to better represent how management evaluates each segment’s performance. In summary, the key elements of the segment reporting changes are as follows:

•

Stores—the name of the Retail segment has changed to Stores. The Stores segment includes retail stores, outlet stores and warehouse sale events.

•

Direct-to-Customer—the Direct-to-customer segment includes the catalog and Internet business (including Brocade Home), To the Trade sales division, Restoration Hardware Baby & Child and store orders fulfilled by the direct-to-customer distribution center.

•

To be consistent with the revenue shift, a proportionate amount of related costs is shifted from the Stores segment to the Direct-to-customer segment.

•

Unallocated—the unallocated category includes all distribution center, call center and headquarters costs.

•

Distribution center and other fulfillment costs have been eliminated from the operating segments to make external reporting consistent with how management evaluates the business. The distribution centers, call center and headquarters costs are considered support costs and are not included as part of segment profitability.

Segment revenues for all periods presented are based on the origin of distribution center fulfillment. The Company has restated previously reported comparable periods’ segment income (loss) from operations to reflect the changes in allocations of certain cost of revenues and selling, general and administrative expenses. Management decisions on resource allocation and performance assessment are made based on these two identifiable reportable 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 support our multi-channel retailing platform strategy.

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


	Three Months Ended						Nine Months Ended
	November 3, 2007			October 28, 2006			November 3, 2007			October 28, 2006
(Dollars in thousands)
Net revenue:
Stores	$	76,465		$	100,059		$	250,553		$	302,547
Direct-to-customer		97,216			57,014			249,060			167,249

Consolidated net revenue	$	173,681		$	157,073		$	499,613		$	469,796

Income (loss) from operations:
Stores	$	2,053		$	12,406		$	16,450		$	40,486
Direct-to-customer		17,477			9,895			48,812			33,275
Unallocated		(32,414	)		(26,005	)		(95,560	)		(78,826	)

Consolidated loss from operations	$	(12,884	)	$	(3,704	)	$	(30,298	)	$	(5,065	)

The income from Store and Direct-to-customer operations for the three and nine months ended October 28, 2006 have been adjusted to reflect the segment reporting change implemented during the second quarter of fiscal 2007.

(Loss) income from operations for the three and nine months ended October 28, 2006 have been adjusted to be consistent with the modified reportable segment structure. The adjustments for the third quarter of fiscal 2006 are as follows: (i) Stores income from operations has changed to $12.4 million from $7.4 million as previously reported, (ii) Direct-to-customer income from operations has changed to $9.9 million from $7.6 million as previously reported and (iii) Unallocated loss from operations has changed to $26.0 million from $18.7 million as previously reported. The adjustments for the nine months ended October 28, 2006 are as follows: (i) Stores income from operations has changed to $40.5 million from $28.4 million as previously reported, (ii) Direct-to-customer income from operations has changed to $33.3 million from $28.5 million as previously reported and (iii) Unallocated loss from operations has changed to $78.8 million from $62.0 million as previously reported.

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.

On November 28, 2007, a stockholder complaint was filed by Richard Hattan as a purported class action on behalf of all of the Company’s stockholders against the Company, each of the Company’s directors, Catterton Partners, Glenhill Capital LP, Vardon Capital Management LLC, Palo Alto Investors LLC and Reservoir Capital Management LLC in Superior Court of the State of California, County of Marin, Case No. CV 075563. The plaintiff alleges that he is an owner of the Company’s common stock. The complaint alleges, among other things, that the Company’s directors breached their fiduciary duties in connection with the proposed merger transaction between the Company and affiliates of Catterton Partners by approving a sale process that fails to maximize stockholder value. Among other things, the complaint seeks to enjoin the

Company, its directors and the other defendants from proceeding with or consummating the merger between the Company and certain affiliates of Catterton Partners. Based on the facts known to date, the Company believes that the claim asserted by the plaintiff is without merit and the Company intends to defend this suit vigorously.

7. NEW ACCOUNTING PRONOUNCEMENTS

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”), effective for fiscal years beginning after November 15, 2007. SFAS No. 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. The Company does not believe the adoption of SFAS No. 157 will have a material impact on the Company’s operating results or financial position.

In November 2007, the FASB reaffirmed its vote against a blanket deferral of SFAS No. 157. The FASB did vote affirmatively to defer the effective date of adoption of SFAS No. 157 for other non-financial assets and liabilities to fiscal years beginning after November 15, 2008. The Company is currently evaluating the impact that the deferral of the adoption of SFAS No. 157, but does not believe it will have a material impact on the Company’s operating results and financial position.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Liabilities” (“SFAS No. 159”), effective for fiscal years beginning after November 15, 2007. SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value. If the fair value option is elected, unrealized gains and losses will be recognized in earnings at each subsequent reporting date. The Company does not believe the adoption of SFAS No. 159 will have a material impact on the Company’s operating results or financial position.

8. SUBSEQUENT EVENT

On November 8, 2007, the Company entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Home Holdings, LLC, a Delaware limited liability company (“Parent”), and Home Merger Sub, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Merger Sub”). Parent and Merger Sub are affiliates of Catterton Partners. Pursuant to the terms of the Merger Agreement, Merger Sub will merge with and into the Company, with the Company as the surviving corporation of the merger (the “Merger”). In the Merger, each share of common stock of the Company will be cancelled and converted into the right to receive $6.70 per share in cash (the “Merger Consideration”). A committee of independent directors is engaged in a solicitation process under the terms of the Merger Agreement pursuant to which it solicited proposals for a competing transaction from third parties from November 8, 2007 through December 13, 2007. On December 10, 2007, the Company announced that it had entered into a confidentiality agreement with Sears Holdings Corporation (“Sears”) which allows Sears to have access to non-public information regarding the Company. Negotiations with “excluded parties” (as such term is defined in the Merger Agreement) may continue beyond December 13.

Bank Waiver

In connection with the Merger Agreement, the Company and The Michaels Furniture Company, Inc. entered into a waiver (the “Waiver”) with Bank of America, N.A., The CIT Group/Business Credit, Inc. and Wells Fargo Retail Finance, LLC (collectively, the “Lenders”), dated as of November 8, 2007, pursuant to which the Lenders waived any event of default under that certain Eighth Amended and Restated Loan and Security Agreement among the Company, The Michaels Furniture Company, Inc. and the Lenders, dated as of June 19, 2006 (the “Credit Agreement”), that would otherwise arise due to a change of control of the Company resulting from the Merger. In addition, the Waiver amended the definition of “Change in Control” in the Credit Agreement to exclude certain transactions with Catterton Partners.

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

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 regarding the impact of investments and cost savings initiatives on future growth and results of operations, statements relating to future availability under our revolving credit facility, statements relating to our working capital and capital expenditure needs, statements relating to operational efficiencies and cost reductions, statements relating to the market environment for home furnishings retailers 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 the following: the impact on the Company of the merger and related solicitation process; the impact of the Company of the uncertainty relating to the pending merger or the possibility of another transaction involving the Company, including potential difficulties in employee retention, disruption in current plans or operations and diversion of management’s attention from ongoing business operations; the likelihood of closing the merger transaction with Catterton Partners or a similar transaction; 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; changes in product supply; 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; changes in economic or business conditions in general; fluctuations in sales; limitations resulting from restrictive covenants in our revolving credit facility; consumer responses to our product offerings and changes in consumer trends; loss of key vendors; changes in the competitive environment in which we operate; changes in our management information needs; changes in management; failure to raise additional funds when required; changes in customer needs and expectations; governmental actions; and other factors described below in Part II, Item 1A “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.

OVERVIEW

Our Company, Restoration Hardware, Inc. (Nasdaq: RSTO), together with our subsidiaries, is a specialty retailer of high quality bathware, hardware, lighting, furniture, textiles, accessories and gifts that reflect our classic and authentic American point of view. 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 also believe that our products can fulfill their aspirations to have homes designed with a high quality, classic and timeless style. Our positioning fills the void in the marketplace above the current home lifestyle retailers, and below the interior design trade, by providing products targeted to 35 to 60 year olds and centered around our core businesses that reflect a predictable, high-quality promise to our customers.

We operate on a 52-53 week fiscal year ending on the Saturday closest to January 31st. Our current fiscal year is 52 weeks and ends on February 2, 2008 (“fiscal 2007”) and the prior fiscal year was 53 weeks and ended on February 3, 2007 (“fiscal 2006”).

As of November 3, 2007, we operated 102 retail stores and 8 outlet stores in 30 states, the District of Columbia and in Canada. In addition to our retail and outlet stores, we operate a Direct-to-customer (“direct”) sales channel that includes both catalog and Internet.

Over the past several years, we have invested heavily in repositioning our brands and remodeling our stores, including:

In 2002 and 2003, we began our repositioning efforts with the launch of new merchandising strategy and the remodeling of our stores. We made key changes to our assortment including refinements in premium textiles, bath fixtures and hardware, lighting and furniture.

In 2004, we re-merchandised our furniture assortment and revamped our accessories offering. In addition, we redesigned our catalog to improve the presentation of our core businesses and more clearly communicate the quality positioning of our product offerings. We also introduced our first outlet store. Our outlet store strategy is designed to enable us to more effectively liquidate overstocked, discontinued and damaged merchandise.

In 2005, we remodeled the majority of our existing stores. The remodeled stores enabled us to expand our merchandise offerings in certain core categories, particularly lighting and textiles, and to present those offerings with more clarity and focus. We also opened one retail store and five outlet stores.

In 2006, we continued to grow our direct-to-customer business with the addition of two category extensions, the Restoration Hardware Outdoor Catalog and the Restoration Hardware Gift Catalog. In addition, we opened two outlet stores, and launched 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. This brand was launched with a catalog and a subsequent web site; 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. In 2006 we also began a multi-year program of investing in systems and infrastructure targeted at strengthening our supply chain. Included in these investments are new order management and warehouse management programs, redesigned distribution networks and facilities, and other systems, process and infrastructure changes. We believe these investments will improve our customers’ experiences while leveraging our operation costs as a percentage of our sales. In addition, we have strengthened our Company by hiring several new key employees as part of our management team.

During the first nine months of fiscal 2007, we introduced our third category extension, the Restoration Hardware Bed & Bath catalog, reflecting our efforts to extend our leadership position in this strategically important category. Additionally, we launched Restoration Hardware Trade, a direct sales division targeting home and hospitality developers. Each of these new initiatives has continued to grow in size as the year progresses.

The macro economic environment in the home furnishings and home building sectors, as well as the weakening consuming spending and traffic levels, continued to challenge our business during the first nine months of fiscal 2007, particularly higher ticket durable categories. Our financial performance has been affected as a result of the current downtrend in these sectors. We expect continued pressure on our results of operations during such time as these business conditions persist.

In response to current market conditions, we have undertaken a variety of cost cutting and other initiatives. Nevertheless, these efforts may not be sufficient to overcome the adverse impact on our financial results caused by the weakness of market conditions.

We also are focused on a number of growth initiatives and business process improvements that we expect to yield longer-term contribution to the growth of our business and our financial results, including the following:

•

We completed the retrofitting of our East Coast furniture distribution centers in the first quarter of this year. We installed new narrow aisle racking, which will greatly improve space utilization and improve productivity.

•

We consolidated our small package direct-to-customer fulfillment from three distribution centers into one centralized distribution center in the second quarter of fiscal 2007. This consolidation of order fulfillment is intended to improve our in-stock availability, turn of inventory and inbound & outbound freight costs. This consolidation of small package direct-to-customer operations resulted in a shift in reporting of certain shelf stock orders originating from our retail stores. See Note 5, “Segment Reporting,” of the Condensed Consolidated Financial Statements for further description of this segment reporting change.

•

We have implemented cost reduction strategies to lower expenses over the balance of the year, including the renegotiation of key components of our catalog production costs and the reorganization of our headquarters that resulted in the elimination of approximately 100 positions, of which approximately 40% were filled positions.

•

We installed a new warehouse management system in one of our furniture distribution centers to improve order integrity, tracking and productivity, and plan to install this system in other furniture distribution centers later this fiscal year.

•

We are re-engineering our home delivered furniture network, with the goal of reducing returns and damages.

•

We are investing in sourcing and production management in order to reduce our cost of goods in some of our core merchandise categories.

•

We are developing an integrated, multi-channel order management system in order to provide greater order integrity.

•

We will open a new distribution center in the summer of 2008. This new facility will be used primarily for the fulfillment of our small package direct-to-customer business and the replenishment of our East Coast retail stores.

Recent Developments

On November 8, 2007, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Home Holdings, LLC, a Delaware limited liability company (“Parent”), and Home Merger Sub, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Merger Sub”). Parent and Merger Sub are affiliates of Catterton Partners. Pursuant to the terms of the Merger Agreement, Merger Sub will merge with and into the Company, with the Company as the surviving corporation of the merger (the “Merger”). In the Merger, each share of our common stock will be cancelled and converted into the right to receive $6.70 per share in cash. A committee of independent directors is engaged in a solicitation process under the terms of the Merger Agreement pursuant to which it solicited proposals for a competing transaction from third parties from November 8, 2007 through December 13, 2007. On December 10, 2007, we announced that we had entered into a confidentiality agreement with Sears Holdings Corporation (“Sears”) which allows Sears to have access to non-public information regarding the Company. Negotiations with “excluded parties” (as such term is defined in the Merger Agreement may continue beyond December 13. We have expensed approximately $1.4 million in costs through the third quarter of 2007 in connection with the transaction.

For additional and more detailed information regarding the Merger Agreement, please refer to the Form 8-K we filed with the Securities and Exchange Commission on November 8, 2007. Please also refer to the risk factors included in Part II, Item 1A “Risk Factors” of this Form 10-Q under the heading “Risks Relating to the Pending Merger.”

Results of Operations

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


	Three Months Ended										Nine Months Ended
	November 3, 2007			% of Net Rev.		October 28, 2006			% of Net Rev.		November 3, 2007			% of Net Rev.		October 28, 2006			% of Net Rev.
	(Dollars in thousands, except per share data)										(Dollars in thousands, except per share data)
Net revenues	$	173,681		100.0	%	$	157,073		100.0	%	$	499,613		100.0	%	$	469,796		100.0	%
Cost of revenue and occupancy		115,615		66.6			103,232		65.7			336,055		67.3			311,825		66.4

Gross profit		58,066		33.4			53,841		34.3			163,558		32.7			157,971		33.6
Selling, general and administrative expense		70,950		40.8			57,545		36.7			193,856		38.8			163,036		34.7

Loss from operations		(12,884	)	(7.4	)		(3,704	)	(2.4	)		(30,298	)	(6.1	)		(5,065	)	(1.1	)
Interest expense, net		(2,409	)	(1.4	)		(2,119	)	(1.3	)		(6,644	)	(1.3	)		(5,282	)	(1.1	)

Loss before income taxes		(15,293	)	(8.8	)		(5,823	)	(3.7	)		(36,942	)	(7.4	)		(10,347	)	(2.2	)
Income tax (expense) benefit		105		0.1			115		0.1			73		(0.0	)		(38	)	(0.0	)

Net loss	$	(15,188	)	(8.7	)	$	(5,708	)	(3.6	)	$	(36,869	)	(7.4	)	$	(10,385	)	(2.2	)

Loss per share of common stock— basic and diluted	$	(0.39	)			$	(0.15	)			$	(0.95	)			$	(0.27	)

Third Quarter of Fiscal 2007 vs. Third Quarter of Fiscal 2006

Net revenues increased by $16.6 million, or 11%, to $173.7 million in the third quarter of fiscal 2007 compared to the third quarter of fiscal 2006. Our revenue growth during the third quarter of fiscal 2007 was driven by continued growth in our Direct-to-customer business but continued to be impacted by the challenging home furnishings environment and by the weakness in the home building sector.

Cost of revenue and occupancy expense increased by $12.4 million, or 12%, to $115.6 million, in the third quarter of fiscal 2007. Cost of revenue and occupancy expense expressed as a percentage of net revenue increased by 90 basis points to 66.6% in the third quarter of fiscal 2007, from 65.7% in the third quarter of fiscal 2006. The 90 basis point increase in these costs, expressed as a percentage of net revenues, was primarily due to 210 basis point decrease in product margin as a result of a higher mix of promotional selling during the third quarter of fiscal 2007 and 160 basis point increase in supply chain costs. These amounts were offset by a higher growth rate in the Direct-to-customer segment, which carries a lower cost of revenue and occupancy expense than that of the Stores segment.

Selling, general and administrative expenses increased by $13.4 million, to $71.0 million, in the third quarter of fiscal 2007. Expressed as a percentage of net revenue, selling, general, and administrative expense increased to 40.8% for the third quarter of fiscal 2007 compared to 36.7% for the third quarter of fiscal 2006. The 410 basis point increase in these costs, expressed as a percentage of net revenues, was primarily due to a 260 basis point increase in advertising costs resulting from increased circulation of our catalogs. Total catalog circulation and circulated pages increased by 54% and 26%, respectively, compared to the same period in the prior fiscal year. The remaining increase was related to costs for investments in our growth initiatives, expenses related to the finalization of a Merger Agreement with certain affiliates of Catterton Partners of $1.4 million, and severance costs associated with layoffs at the Company’s corporate headquarters of $0.4 million.

The third quarter of fiscal 2007 reflected a combination of factors that affected our financial performance. We went from a loss from operations of $3.7 million in the third quarter of fiscal 2006 to a loss of $12.9 million in the third quarter of fiscal 2007. This result was principally caused by the ongoing softness across our business due to the challenging home furnishings environment and the effects from the slowdown in the home building industry. Accordingly, we had a higher mix of promotional selling during the third quarter of fiscal 2007 as compared to the third quarter of fiscal 2006. In addition, during the third quarter of fiscal 2007, we continued with our multi-year program of investing in systems and infrastructure targeted at strengthening our supply chain processes and we continued to make investments in Brocade Home and Restoration Hardware Baby & Child.

Interest expense, net includes interest on borrowings under our revolving credit facility and amortization of debt issuance costs. Interest expense, net increased from $2.1 million in the third quarter of fiscal 2006 to $2.4 million in the third quarter of fiscal 2007. This increase resulted from higher average debt balances, to support current working capital requirements, including increased merchandise inventory during the third quarter of fiscal 2007, offset slightly by lower average interest rates.

Our third quarter of fiscal 2007 income tax benefit was $105,000 on pre-tax loss of $15.3 million. This compares to income tax benefit of $115,000 on a pre-tax loss of $5.8 million, recorded in the third quarter of fiscal 2006. The income tax benefit in our third quarter of fiscal 2007 was primarily due to taxes related to our wholly-owned Canadian subsidiary and interest on unrecognized tax benefits.

First nine months of Fiscal 2007 vs. First nine months of Fiscal 2006

Net revenues increased by $29.8 million, or 6%, to $499.6 million in the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006. Our revenue growth during the first nine months of fiscal 2007 was driven by continued growth in our Direct-to-customer business, but continued to be impacted by the current challenging home furnishings environment and by the weakness in the home building sector.

Cost of revenue and occupancy expense increased by $24.2 million, or 8%, to $336.1 million, in the first nine months of fiscal 2007. Cost of revenue and occupancy expense expressed as a percentage of net revenue increased by 90 basis points in these costs, expressed as a percentage of net revenues, to 67.3% in the first nine months of fiscal 2007 from 66.4% in the first nine months of fiscal 2006. The 90 basis point increase in these costs, expressed as a percentage of net revenues, was primarily due to 110 basis point decrease in product margin as a result of a higher mix of promotional selling during the period.

Selling, general and administrative expenses increased by $30.8 million, or 19%, to $193.9 million, in the first nine months of fiscal 2007. Expressed as a percentage of net revenue, selling, general and administrative expenses increased to 38.8% for the first nine months of fiscal 2007 compared to 34.7% for the first nine months of fiscal 2006. The 410 basis point increase in these costs, expressed as a percentage of net revenues, was primarily due to a 220 basis points increase related to higher advertising costs resulting from increased circulation from our catalogs. Total catalog circulation and circulated pages increased by 37% and 27%, respectively, compared to the same period in the prior fiscal year. The remaining increase was related to investments in our growth initiatives, expenses related to the finalization of a Merger Agreement with certain affiliates of Catterton Partners of $1.4 million, and severance costs associated with layoffs at the Company’s corporate headquarters of $0.4 million.

The first nine months of fiscal 2007 reflected a combination of factors that affected our financial performance. We experienced a substantial increase in loss from operations, increasing from a loss of $5.1 million in the first nine months of fiscal 2006 to a loss of $30.3 million in the first nine months of fiscal 2007. This result was principally caused by the ongoing softness across our business due to the challenging home furnishings environment and the effects from the slowdown in the home building industry. We continued to invest in our business despite these challenging times. During the first nine months

of fiscal 2007 we continued with our multi-year program of investing in systems and infrastructure targeted at strengthening our supply chain processes. We also introduced a new category extension during the first nine months of fiscal 2007, Restoration Hardware Bed & Bath Catalog, and continued to make investments in Brocade Home, Restoration Hardware Trade and Restoration Hardware Baby & Child.

Interest expense, net includes interest on borrowings under our revolving credit facility and amortization of debt issuance costs. Interest expense, net increased from $5.3 million in the first nine months of fiscal 2006 to $6.6 million in the first nine months of fiscal 2007. This increase resulted from higher average debt levels to support current working capital requirements, including increased merchandise inventory during the first nine months of fiscal 2007.

We recognized an income tax benefit of $73,000, on pre-tax loss of $36.9 million, during the first nine months of fiscal 2007. This compares to income tax expense of $38,000, on a pre-tax loss of $10.3 million, recorded in the first nine months of fiscal 2006. The income tax benefit in our first nine months of fiscal 2007 was primarily due to taxes related to our wholly-owned Canadian subsidiary and interest on unrecognized tax benefits.

Segment Change

Beginning in the second quarter of fiscal 2007, we consolidated all small package, direct-to-customer shipments into one distribution center. Previously, these shipments were fulfilled through three facilities: one direct-to-customer distribution center and two retail replenishment distribution centers. As part of the consolidation of small package direct-to-customer fulfillment into the direct-to-customer distribution center, certain revenues that had been recorded in the retail segment are now being recorded in the Direct-to-customer segment beginning in the second quarter of 2007. The shift in revenue reporting represented approximately 15 percentage points of the 24% decrease in Stores segment revenues and 27 percentage points of the 71% increase in Direct-to-customer segment revenues for the three months ended November 3, 2007 as compared to the three months ended October 28, 2006. For the nine months ended November 3, 2007 as compared to the nine months ended October 28, 2006, the shift represented 8 percentage points of the 17% decrease in store segment revenues and 14 percentage points of the 49% increase in Direct-to-customer segment revenues. The revenue segment results for all periods presented reflect the method we now record revenues following the consolidation of all small package, direct-to-customer shipments into one distribution center.

Also, beginning in the second quarter of fiscal 2007, we revised our segment reporting to better represent how management evaluates each segment’s performance. In summary, the key elements of the segment reporting changes are as follows:

•

Stores—the name of the Retail segment has changed to Stores. The Stores segment includes retail stores, outlet stores and warehouse sale events.

•

To be consistent with the revenue shift, a proportionate amount of related costs is shifted from the Stores segment to the Direct-to-customer segment.

•

Unallocated—the unallocated category includes all distribution center, call center and headquarters costs.

•

Segment revenues for all periods presented are based on the origin of distribution center fulfillment. We have restated previously reported comparables periods’ segment income (loss) from operations to reflect the changes in allocations of certain cost of revenues and selling, general and administrative expenses.

Revenue and Segment Results

Stores Segment Results


	Three Months Ended						Nine Months Ended
	November 3, 2007			October 28, 2006			November 3, 2007			October 28, 2006
(Dollars in thousands)
Stores net revenue	$	76,465		$	100,059		$	250,553		$	302,547
Stores net revenue growth percentage		(23.6	)%		8.0	%		(17.2	)%		9.0	%
Income from Stores operations	$	2,053		$	12,406		$	16,450		$	40,486
Income from Stores operations-percent of Stores net revenue		2.7	%		12.4	%		6.6	%		13.4	%
Number of stores at beginning of period		102			103			103			103
Number of stores opened		—			—			—			—
Number of stores closed		—			—			(1	)		—

Number of stores at year-end		102			103			102			103

Store selling square feet at end of period		682,737			687,625			682,737			687,625
Number of outlet stores at end of period		8			8			8			8

The income from store operations for the three and nine months ended October 28, 2006 have been adjusted to reflect a change in the allocation of revenues and expenses between segments implemented beginning with the second quarter of fiscal 2007. See Note 5, “Segment Reporting,” of the Condensed Consolidated Financial Statements for further description of this segment reporting change.

Third Quarter of Fiscal 2007 vs. Third Quarter of Fiscal 2006

Stores net revenue for the third quarter of fiscal 2007 decreased by $23.6 million, or 24%, as compared to the third quarter of fiscal 2006. Our Stores segment net revenue decline was affected by a shift in revenue reporting from the Stores to the Direct-to-customer segment due to the consolidation of small package direct-to-customer shipments and changes in our assortment and marketing strategies. The challenging home furnishings and home building environment also contributed to the decline in revenue in the Stores segment.

The shift in revenue related to the consolidation of small package direct-to-customer shipments represented approximately 15 percentage points of the 24% decrease in Stores segment revenues for the three months ended November 3, 2007 as compared to the three months ended October 28, 2006.

Our Stores segment experienced a decline in its operating results, decreasing to income from operations of $2.1 million, or 2.7% of Stores net revenue, during the third quarter of fiscal 2007 compared to income from operations of $12.4 million, or 12.4% of Stores net revenue, in the same period of the prior fiscal year. This decline, representing a 970 basis point decrease in the Stores segment operating results for the third quarter of fiscal 2007, resulted from a 570 basis point decrease in gross margin and from a 400 basis point increase in selling, general and administrative expenses. The 570 basis point decrease in gross margin was primarily due to a decline in the product margin due to higher mix of promotional selling and an increased penetration of outlet business because of the shift of revenue to our Direct-to-customer segment. The 400 basis point increase in selling, general and administrative expenses was primarily due to the increase in store employment, store utility costs and store advertising costs as a percentage of Stores net revenue, all factors of which were driven by lower sales and the shift in reporting of sales from Stores to Direct-to-customer.

First nine months of Fiscal 2007 vs. First nine months of Fiscal 2006

Stores net revenue for the first half of fiscal 2007 decreased by $52.0 million, or 17%, as compared to the first nine months of fiscal 2006. Our Stores segment net revenue decline was affected by the overall slowdown in the home furnishings and home building sectors, by the changes in our assortment and marketing strategies, and by the shift in revenue reporting from the Stores to the Direct-to-customer segment due to the consolidation of small package direct-to-customer shipments in the second quarter of fiscal 2007.

The shift in revenue related to the consolidation of small package direct-to-customer shipments represented approximately 8 percentage points of the 17% decrease in Stores segment revenues for the nine months ended November 3, 2007 as compared to the nine months ended October 28, 2006.

Our Stores segment experienced a decline in its operating results, decreasing to income from operations of $16.5 million, or 6.6% of Stores net revenue, during the first nine months of fiscal 2007 compared to income from operations of $40.5 million, or 13.4% of Stores net revenue, in the same period of the prior fiscal year. This decline, representing a 680 basis point decrease in the Stores segment operating results for the first nine months of fiscal 2007, resulted from a 440 basis

point decrease in gross margin and from a 240 basis point increase in selling, general and administrative expenses. The 440 basis point decrease in gross margin was primarily due to a decline in the product margin due to higher mix of promotional selling. The 240 basis point increase in selling, general and administrative expenses was primarily due to an increase in store employment costs and store utility costs as a percentage of sales, all factors of which were driven by the shift in reporting of sales from Stores to Direct-to-customer and lower sales volume during the first nine months of fiscal 2007 compared to the same period in the prior fiscal year.

Direct-to-Customer Segment Results


	Three Months Ended						Nine Months Ended
	November 3, 2007			October 28, 2006			November 3, 2007			October 28, 2006
(Dollars in thousands)
Direct-to-customer net revenue	$	97,216		$	57,014		$	249,060		$	167,249
Direct-to-customer net revenue growth percentage		70.5	%		58.0	%		48.9	%		50.0	%
Income from Direct-to-customer operations	$	17,477		$	9,895		$	48,812		$	33,275
Income from Direct-to-customer operations—percent of Direct-to-customer net revenue		18.0	%		17.4	%		19.6	%		19.9	%
Growth percentages:
Number of catalog books mailed		54	%		15	%		37	%		36	%
Pages circulated		26	%		8	%		27	%		23	%

The income from Direct-to-customer operations for the three and nine months ended October 28, 2006 have been adjusted to reflect a change in the allocation of revenues and expenses between segments implemented beginning with the second quarter of fiscal 2007. See Note 5, “Segment Reporting,” of the Condensed Consolidated Financial Statements for further description of this segment reporting change.

Third Quarter of Fiscal 2007 vs. Third Quarter of Fiscal 2006

Direct-to-customer net revenue for the third quarter of fiscal 2007 increased $40.2 million, or 71%, as compared to the third quarter of fiscal 2006. Direct-to-customer net revenue consists of both catalog and Internet sales. The continued growth in our Direct-to-customer segment resulted from an overall increase in the total number of catalogs circulated along with increased page count in the Restoration Hardware Home and the Restoration Hardware Outdoor catalogs, and from the shift in revenue reporting from the Stores to the Direct-to-customer segment as a result of the consolidation of small package direct-to-customer shipments. Growth in this segment also reflects our strategy of leveraging our catalogs and the Internet to size our assortment to market potential, resulting in a planned shift of business from the Stores segment to the Direct-to-customer segment. The total number of catalogs mailed and pages circulated increased by 54% and 26%, respectively, from the third quarter of fiscal 2006 to the current fiscal quarter. At the same time, the growth experienced during the third quarter of fiscal 2007 was negatively impacted by the challenging home furnishings and home building environment.

The shift in revenue related to the consolidation of small package direct-to-customer shipments represented approximately 27 percentage points of the 71% increase in Direct-to-customer segment revenues for the three months ended November 3, 2007 as compared to the three months ended October 28, 2006.

Income from operations for our Direct-to-customer segment increased to $17.5 million, or 18.0% of Direct-to-customer net revenue, during the third quarter of fiscal 2007 compared to income from operations of $9.9 million, or 17.4% of Direct-to-customer net revenue, in the same quarter of the prior fiscal year. This $7.6 million increase represented a 60 basis point increase in operating income for our Direct-to-customer operating segment expressed as a percentage of Direct-to-customer net revenue. This improvement resulted from a 140 basis point decrease in gross margin, offset by a 200 basis point decrease in selling, general and administrative expenses. The 140 basis point decrease in gross margin resulted from the higher costs associated with the revenue shifted from the Stores to the Direct-to-customer segment, due to the consolidation of small package direct-to-customer shipments, which were offset in part by a favorable shipping expense leverage. The 200 basis point decrease in selling, general and administrative expenses was primarily due to a decrease in advertising expenses as a percentage of sales, partially offset by higher employment costs.

First nine months of Fiscal 2007 vs. First nine months of Fiscal 2006

Direct-to-customer net revenue for the first nine months of fiscal 2007 increased by $81.8 million, or 49%, as compared to the first nine months of fiscal 2006. The growth in our Direct-to-customer segment was caused by an overall increase in the total number of catalogs circulated along with increased page count in the Restoration Hardware Home and the Restoration Hardware Outdoor catalogs. Continued growth in the Direct-to-customer segment reflects our strategy of

leveraging our catalogs and the Internet to size our assortment to market potential, which results in a planned shift of business from Stores to Direct-to-customer. The total number of catalogs mailed and pages circulated increased by 37% and 27%, respectively, from the first nine months of fiscal 2006 to the first half of this fiscal year. At the same time, growth was impacted by the shift in revenue reporting from the Stores to the Direct-to-customer segment as a result of the consolidation of small package direct-to-customer shipments offset by the challenging home furnishings and home building environment.

The shift in revenue related to the consolidation of small package direct-to-customer shipments represented approximately 14 percentage points of the 49% increase in Direct-to-customer segment revenues for the nine months ended November 3, 2007 as compared to the nine months ended October 28, 2006.

Income from operations for our Direct-to-customer segment increased to $48.8 million, or 19.6% of Direct-to-customer net revenue, during the first nine months of fiscal 2007 compared to income from operations of $33.3 million, or 19.9% of Direct-to-customer net revenue, during the same period in the prior fiscal year. This increase of $15.5 million, represented an 30 basis point decrease, expressed as a percentage of net revenues, resulting from a 50 basis point decrease in gross margin offset by a 20 basis point decrease in selling, general and administrative expenses. The 50 basis point decrease in gross margin resulted from costs associated with the shift in revenues from the Stores segment, partially offset by a decrease in supply chain costs.

LIQUIDITY AND CAPITAL RESOURCES


	Nine Months Ended
	November 3, 2007			October 28, 2006
	(Dollars in thousands)
Net cash used by operating activities	$	(53,703	)	$	(46,954	)
Net cash used by investing activities		(8,667	)		(10,397	)
Net cash provided by financing activities		61,855			56,932
Effects of foreign currency exchange rate translation		800			68

Net increase (decrease) in cash and cash equivalents	$	285		$	(351	)

Operating Cash Flows

For the first nine months of fiscal 2007, net cash used by operating activities was $53.7 million compared to net cash used by operating activities of $47.0 million in the first nine months of fiscal 2006. The increased use of cash of $6.7 million was primarily a result of an increase in net loss of $26.5 million offset by the decrease in use of cash for purchase of merchandise inventories of $20.9 million related to our seasonal purchases for the 2007 holiday season. We also experienced a decrease in cash provided by accounts payable and accrued expenses activities compared to the same period of the prior fiscal year offset by a decrease in net cash used by prepaid expenses and other current assets. The decrease in cash provided by accounts payable and accrued expenses is primarily related to the timing of payments. The decrease in net cash used by prepaid expenses and other current assets is primarily related to prepaid catalog costs and prepaid rent.

Investing Cash Flows

Net cash used by investing activities declined to $8.7 million for the first nine months of fiscal 2007 from $10.4 million for the first nine months of fiscal 2006. The change is primarily related to a reduction in capital expenditures incurred during the respective periods.

Financing Cash Flows

Net cash provided by financing activities increased from $56.9 million in the first nine months of fiscal 2006 to $61.9 million in the first nine months of fiscal 2007. This increase primarily resulted from a $10.2 million increase in net borrowings received under our revolving credit facility during the first nine months of fiscal 2007 compared to the first nine months of fiscal 2006, partially offset by a $0.9 million increase in payments on capital leases and a $4.3 million decrease in proceeds from issuance of common stock. The $10.2 million increase in net borrowings under our revolving credit facility was utilized to support our current working capital requirements, including increased merchandise inventory.

On April 27, 2007, we entered into an agreement (the “Amendment”) to further amend our existing revolving credit facility. The Amendment provides for an extension of the maturity date of our revolving credit facility to June 30, 2012 and increases the amount of our revolving credit facility to $190 million. The Amendment further provides that we may increase the amount of the revolving credit facility by up to an additional $75 million provided that, among other things, no default

under the facility then exists or would arise as a result of such increase. In addition, the Amendment includes a number of other improvements to the existing facility, including (i) an increase in the loan-to-value limits under the facility, (ii) a decrease of the interest rate on certain loans and obligations under the facility, (iii) a lower minimum fixed charge coverage ratio for certain loans under the facility, and (iv) a change in the circumstances in which the fixed charge coverage ratio applies under the facility. Other terms and conditions of the existing revolving credit facility remain materially unchanged.

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 described 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 (as reduced by the actual borrowings and outstanding letters of credit under the facility). The revolving credit facility is secured by our assets, including accounts receivable, inventory, general intangibles, equipment, goods and fixtures.

As of November 3, 2007, $131.3 million was outstanding under the facility, net of unamortized debt issuance costs of $0.9 million, and there was $12.1 million in outstanding letters of credit. 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 November 3, 2007, the bank’s reference rate was 7.50% and the LIBOR plus margin rate was 5.92%. 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. As of November 3, 2007, availability under the facility was $48.6 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 or 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 remaining availability is less than $15 million, in which case the Company is required to maintain a fixed charge coverage ratio. The revolving credit facility also does not require that we repay all borrowings for a prescribed “clean-up” period each year. In addition, the revolving credit facility does not require a daily sweep lockbox arrangement except upon the occurrence of an event of default under the facility or in the event the remaining availability for additional borrowings under the facility is less than $15 million.

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 through fiscal year 2008. 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 the borrowing base formula, covenant limitations or other factors could limit the overall availability of funds to us.

We also 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 complete planned improvements or other operations. For example, we plan to open a new leased distribution facility in the summer of 2008 in West Jefferson, Ohio. However, there may be unforeseen construction, scheduling, engineering, environmental, cost or other problems with the construction of the new facility, which could require additional capital from us that we have not currently anticipated. If we fail to raise sufficient funds, we may be required to delay or abandon some of our planned future expenditures or aspects of our current operations.

We 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 not be able to adequately respond to changing business condition or competitive pressures.

For more information, please refer to the risk factors included in Part II, Item 1A “Risk Factors” of this Form 10-Q entitled “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,” “Because our business requires a substantial level of liquidity, we are dependent upon a revolving credit facility with certain terms that limit our flexibility,” and “Operational difficulties in any of our distribution and order acceptance and fulfillment operations would materially affect our operating results.”

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 February 3, 2007, have not changed materially for the third quarter ended November 3, 2007.

Item 4.

Controls and Procedures.

As of November 3, 2007, 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 November 3, 2007 were effective. There has been no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected or is reasonably likely to materially affect our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings.

We also are involved from time to time in other legal proceedings, including litigation arising in the ordinary course of our business. At the present time, we do not believe that any of these other 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.

Risks Relating to the Pending Merger

The merger process could adversely affect our business.

On November 8, 2007, we entered into a definitive agreement to be acquired by certain affiliates of Catterton Partners for $6.70 per share in cash. The process relating to the merger could cause disruptions in our business, which could have an adverse effect on our financial results. Among other things, uncertainty as to whether a transaction will be completed with Catterton Partners or another acquiring party may cause current and prospective employees to become uncertain about their future roles with the company after the completion of the merger process. This uncertainty could adversely affect our ability to retain employees and our relationships with vendors. Further, the attention of management may be directed toward the completion of a transaction and diverted from day-to-day operations.

The failure to complete the merger could adversely affect our business.

There is no assurance that the merger agreement with Catterton Partners or any other transaction will occur. If the proposed merger or similar transaction is not completed, the share price of our common stock may change to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. In addition, under circumstances defined in the merger agreement, we may be required to pay a termination fee of up to $10,680,000 and reimburse reasonable out-of-pocket fees and expenses incurred with respect to the transactions contemplated by the merger agreement if the merger agreement is terminated. Further, a failed transaction may result in negative publicity and/or a negative impression of us in the investment community.

While the merger agreement is in effect, we are subject to restrictions on our business activities.

While the merger agreement is in effect, we are subject to significant restrictions on our business activities and must generally operate our business in the ordinary course (subject to certain exceptions or the consent of Parent), including that we will not: (i) other than pursuant to the Company’s existing revolving credit facility, incur, create, assume or otherwise become liable for, or repay or prepay, any indebtedness, or amend, modify or refinance the terms of any indebtedness or make any loans, advances or capital contributions to, or investments in, any other person, other than the Company or any of its subsidiaries, (ii) modify, amend, terminate or waive any rights under any material contract in any material respect other than in the ordinary course of business consistent with past practice, (iii) acquire any assets other than purchases of inventory and other assets in the ordinary course of business not having a value in excess of $1,000,000 individually or $5,000,000 in the aggregate, (iv) open or close, or commit to open or close, any store locations, (v) enter into any new line of business outside of our existing businesses, or (vi) pay, discharge, waive, settle or satisfy any claim, liability or obligation, other than in the ordinary course of business or any claim, liability or obligation not in excess of $100,000 individually or $250,000 in the aggregate. These restrictions on our business activities could have a material adverse effect on our future results of operations or financial condition.

We are subject to litigation related to the pending merger.

On November 28, 2007, a stockholder complaint was filed by Richard Hattan as a purported class action on behalf of all of the Company’s stockholders against the Company, each of the Company’s directors, Catterton Partners, Glenhill Capital LP, Vardon Capital Management LLC, Palo Alto Investors LLC and Reservoir Capital Management LLC in Superior Court of the State of California in the County of Marin, Case No. CV 075563. The plaintiff alleges that he is an owner of the Company’s common stock. The complaint alleges, among other things, that the Company’s directors breached their fiduciary duties in connection with the proposed merger transaction between the Company and affiliates of Catterton Partners by approving a sale process that fails to maximize stockholder value. Among other things, the complaint seeks to enjoin the Company, its directors and the other defendants from proceeding with or consummating the merger between the Company and certain affiliates of Catterton Partners. Additional lawsuits pertaining to the merger could be filed in the future.

Any conclusion of this litigation in a manner adverse to the Company could have a material adverse effect on the Company’s business, results of operations, financial condition and cash flows. In addition, the cost to the Company of defending the litigation, even if resolved in the Company’s favor, could be substantial. Such litigation could also substantially divert the attention of the Company’s management and the Company’s resources in general.

Risks Relating to the Company and its 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, particularly in the home furnishings sector which in turn is highly dependent on the housing sector. 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, the macro climate for the retail home furnishings sector, general business conditions, the level of consumer debt, interest rates, rising oil prices, taxation, housing prices, new construction and other activity in the housing sector and consumer confidence in future economic conditions. In particular, the recent reduction in the availability of credit and the recent activity in the housing sector, including the slowing housing turnover, the slowing home-price appreciation, and the depreciation of home prices in some areas, could limit consumers’ discretionary spending or affect their confidence level and lead to reduced spending on home furnishings or home improvement projects. 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 or sustain 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. In addition, as a result of any such adverse economic conditions, we may be required to launch additional cost-cutting initiatives to reduce operating costs, and these initiatives may not be successful in reducing costs significantly or may impair our ability to operate effectively.

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. We have recently introduced a number of new products through new brand initiatives including our new brand Brocade Home as well as our Restoration Hardware Outdoor Catalog, our Restoration Hardware Gift Catalog and our Restoration Hardware Bed & Bath Catalog and we recently

announced plans to introduce Restoration Hardware Baby & Child. We also recently introduced Restoration Hardware Trade. There can be no assurance that any of these new brands or divisions will grow or be successful or achieve the results we expect. We also may not be successful in integrating these new brands and divisions into our existing operations. In addition, if consumers do not respond to our product offerings 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 and market 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 November 3, 2007, we 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 improvements to our planning, logistical and distribution infrastructure and our supply chain, including merchandise ordering, transportation and receipt processing. We will continue to make investments in improvements to this part of our business. Our success in implementing these initiatives may affect our financial performance both in the short term and the longer term. We may experience cost overruns in implementing our investment initiatives or operational disruptions that result from changes in our systems, facilities or processes. If we are not successful in our efforts to improve our planning and supply chain processes in order to take full advantage of supply chain opportunities, we may experience a material adverse effect on our operating results through, among other things, loss of customer sales or increases in our costs.

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.

We must manage our merchandise in stock and inventory levels to track customer preferences and demand. We order merchandise based on our best projection of consumer tastes and anticipated demand in the future, but we cannot guarantee that our projections of consumer tastes and the demand for our merchandise will be accurate. It is critical to our success that we stock our product offerings in appropriate quantities. If demand for one or more products outstrips our available supply, we may have large backorders and cancellations and our operating results may be adversely affected. On the other hand, if one or more products do not achieve projected sales levels, we may have surplus or un-saleable inventory that would force us to take significant inventory markdowns, which could adversely affect our operating results.

In addition, much of our inventory is sourced from vendors located outside the United States. Thus, we usually must order merchandise, and enter into contracts for the purchase and manufacture of such merchandise, months in advance of the applicable selling season and frequently before trends and market factors are known. The extended lead times for many of our purchases may make it more difficult for us to respond rapidly to new or changing trends or market factors. Our vendors may also not have the capacity to handle our demands.

Further, the seasonal nature of the specialty home products business requires us to carry a significant amount of inventory prior to peak selling season. The general pattern associated with the retail industry is one of peak sales and earnings during the holiday season. Our business also includes product offerings that are of a seasonal nature such as our outdoor products which are highly dependent upon the outdoor selling season. In anticipation of increased sales activity for seasonal

goods including holiday sales during the fourth quarter, we incur significant additional expenses both prior to and during the seasonal selling period. As a result, we accumulate inventory in advance of the seasonal selling period and are vulnerable to demand and pricing shifts and to misjudgments in the selection and timing of merchandise purchases. If we do not accurately predict our customers’ preferences and market and other trends, our inventory levels will not be appropriate and our business and operating results may be negatively impacted.

We may be unable to achieve, or may be delayed in achieving, our cost-cutting initiatives, which may adversely affect our results of operations and cash flows.

We have recently launched a number of cost-cutting initiatives, including the reorganization of our headquarters that resulted in the elimination of a number of positions. These initiatives are designed to improve operating efficiencies and reduce operating costs. Although we anticipate a substantial amount of annual cost savings associated with these cost-cutting initiatives, we may not be able to achieve the cost savings we expect or these initiatives may impair our ability to operate effectively. If we are unable to achieve, or have any unexpected delays in achieving, additional cost savings, our results of operations and cash flows may be 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, the weather, 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.

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 hundreds of 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.

Our business depends upon the successful operation of our distribution and order acceptance and fulfillment services. 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. These interruptions could result from disruptions or delays in our telecommunications systems, the Internet or at our distribution centers that are caused by telephone or power outages, computer viruses, security breaches, natural disasters, adverse weather conditions or union organizing activity. 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.

In addition, we plan to open a new distribution facility in the summer of 2008 in West Jefferson, Ohio. The new distribution facility will service all of our small package direct-to-customer operations, as well as our small package retail store distributions to the Eastern and Central regions of the country. We have entered into a lease agreement with Duke Realty Limited Partnership pursuant to which we will lease the new distribution facility from Duke Realty, and Duke Reality will construct the new distribution facility. However, there may be unforeseen construction, scheduling, engineering, environmental, cost or other problems with the construction of the new facility that could cause the completion date to differ significantly from initial expectations. Any significant delay in the completion of the new distribution facility could have a material adverse effect on our business, financial condition and results of operations. We also may experience other operational disruptions as a result of the new distribution facility, including telecommunications system problems, disruptions in transitioning fulfillment orders to the new distribution facility and problems or increased expenses associated with operating the new facility, any of which could have a material adverse effect on our business, financial condition and results of operations.

Labor activities could cause labor relations difficulties for us.

As of November 3, 2007, we had approximately 4,000 full and part-time employees, and while we believe our relations with our employees are generally good, we cannot predict the effect that any future organizational activities will have on our business and operations. If we were to become subject to work stoppages, we could experience disruption in our operations and increases in our labor costs, either of which could materially adversely affect our business, financial condition or results of operations.

We are dependent on external funding sources, 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 $190.0 million revolving credit facility (which may be increased by up to an additional $75 million provided that, among other things, no default under the facility then exists or would arise as a result of such increase), the amount available under this facility may 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 $15 million.

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 the borrowing base formula, 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 $15 million.

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. Our lenders have not notified us of any indication that a material adverse effect exists at November 3, 2007 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 2012. 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 terms 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 $190.0 million (which may be increased by an additional $75 million in certain circumstances). Over the past several years, we have entered into modifications, amendments and restatements of this revolving credit facility, primarily to address changes in the requirements applicable to us under the revolving credit facility documents.

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.

We purchased more than half of our merchandise directly from vendors located abroad. As an importer, our future success will depend in large measure upon our ability to maintain our existing foreign supplier relationships and to develop new ones. While we rely on our long-term relationships with our foreign vendors, we have no long-term contracts with them. Additionally, many of our imported products are subject to existing duties, tariffs and quotas that may limit the quantity of some types of goods which we may import into the United States of America. Our dependence on foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, risks of damage, destruction or confiscation of products while in transit to our distribution centers located in the United States of America, changes in import duties, tariffs and quotas, loss of “most favored nation” trading status by the United States of America in relation to a particular foreign country, work stoppages including without limitation as a result of events such as longshoremen strikes, transportation and other delays in shipments including without limitation as a result of heightened security screening and inspection processes or other port-of-entry limitations or restrictions in the United States of America, freight cost increases, economic uncertainties, including inflation, foreign government regulations, and political unrest and trade restrictions, including the United States of America retaliating against protectionist foreign trade practices. Furthermore, some or all of our foreign vendors’ operations may be adversely affected by political, financial or other instabilities that are particular to their home countries, including without limitation local acts of terrorism or economic, environmental or health and welfare-related crises, which may in turn result in limitations or temporary or permanent halts to their operations, restrictions on the transfer of goods or funds and/or other trade disruptions. If any of these or other factors were to render the conduct of business in particular countries undesirable or impractical, our financial condition and results of operations could be materially adversely affected.

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

In addition, although we continue to improve our global compliance program, there remains a risk that one of more of our foreign vendors will not adhere to our global compliance standards such as fair labor standards and the prohibition on child labor. Non-governmental organizations might attempt to create an unfavorable impression of our sourcing practices or the practices of some of our vendors that could harm our image. If either of these occurs, we could lose customer goodwill and favorable brand recognition, which could negatively affect our business and operation results.

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 third quarter fiscal year 2007, revenue through our direct-to-customer channel grew by 71% as compared to the third quarter of 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 currently outsource the fulfillment of our direct-to-customer division to third parties, the third parties may not have the capacity to accommodate our growth. This lack of capacity may result in delayed customer orders and deficiencies in customer service, both of which may adversely affect our reputation, cause us to lose sales revenue and limit or counter recent growth in our direct-to-customer business.

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

The success of our business will continue to depend upon our key personnel, including our Chairman, President, and Chief Executive Officer, Gary Friedman. Competition for qualified employees and personnel in the retail industry is intense. The process of locating personnel with the combination of skills and attributes required to carry out our goals is often lengthy. Our success depends to a significant degree upon our ability to attract, retain and motivate qualified management, marketing and sales personnel, in particular store managers, and upon the continued contributions of these people. We cannot assure you that we will be successful in attracting and retaining qualified executives and personnel. In addition, our employees may voluntarily terminate their employment with us at any time. 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.

We are exposed to potential risks from legislation requiring companies to evaluate controls under Section 404 of the Sarbanes-Oxley Act of 2002.

We have evaluated and tested our internal controls in order to allow management to report on, and our registered independent public accounting firm to attest to, our internal controls, as required by Section 404 of the Sarbanes-Oxley Act of 2002. We have incurred, and expect to continue to incur, significant expenses and a diversion of management’s time to meet the requirements of Section 404. If we are not able to continue to meet the requirements of section 404 in a timely manner or with adequate compliance, we would be required to disclose material weaknesses if they develop or are uncovered and we may be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission or the Nasdaq Stock Market. Any such action could negatively impact the perception of us in the financial market and our business. In addition, our internal controls may not prevent or detect all errors and fraud. A control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable assurance that the objectives of the control system will be met.

We face an extremely competitive specialty retail business market.

The retail market is highly competitive. Our specialty retail stores, mail order catalogs and e-commerce websites compete with other retail stores, including large department stores, discount stores, other specialty retailers offering home centered assortments, other mail order catalogs and other e-commerce websites. Our product offerings also compete with a variety of national, regional and local retailers. The substantial sales growth in the direct-to-customer industry within the last decade has encouraged the entry of many new competitors and an increase in competition from established companies. 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 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 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. We have previously raised financing through sales of our securities including sales of our common stock. 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 for resale 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. We may also sell additional securities in order to raise financing. The sale, or the availability for sale, of substantial amounts of common stock by us in new offerings or by our existing stockholders whether in a securities offering, in market transactions, 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.

Changes to accounting rules or regulations may adversely affect our results of operations.

Changes to existing accounting rules or regulations may impact our future results of operations. For example, on December 16, 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Share-Based Payment” (“SFAS 123R”), which required that beginning in fiscal 2006 we measure compensation costs for all stock-based compensation at fair value and record compensation expense equal to that value over the requisite service period. The adoption of SFAS 123R resulted in the recording of $3.4 million of pre-tax stock-based compensation expense in fiscal 2006. We believe SFAS 123R will continue to materially adversely impact our earnings. In addition, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of SFAS 109” (FIN 48), in July 2006. 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. However, our adoption of FIN 48 on February 4, 2007 did not have a material effect on our results of operations or financial position.

Other new accounting rules or regulations and varying interpretations of existing accounting rules or regulations have occurred and may occur in the future. A change in accounting rules or regulations may even affect our reporting of transactions completed before the change is effective. Future changes to accounting rules or regulations or the questioning of current accounting practices, may adversely affect our results of operations.

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, 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.

We face the risk of inventory shrinkage.

We are subject to the risk of inventory loss and theft. We have experienced inventory shrinkage in the past, and we cannot assure you that incidences of inventory loss and theft will decrease in the future or that the security measures we have taken in the past will effectively address the problem of inventory theft. If we were to experience higher rates of inventory shrinkage or incur increased security costs to combat inventory theft, our financial condition could be affected adversely.

We must successfully manage our Internet business.

The success of our Internet business depends, in part, on factors over which we have limited control. In addition to changing consumer preferences and buying trends relating to Internet usage, we are vulnerable to certain additional risks and uncertainties associated with the Internet, including changes in required technology interfaces, website downtime and other technical failures, costs and technical issues as we upgrade our website software, computer viruses, changes in applicable federal and state regulation, security breaches, and consumer privacy concerns. Our failure to successfully respond to these risks and uncertainties might adversely affect the sales in our Internet business, as well as damage our reputation and brands.

We may be exposed to risks and costs associated with credit card fraud and identity theft that could cause us to incur unexpected expenditures and loss of revenue.

A substantial portion of our customer orders are placed through our website. In order for the online commerce market to function and develop successfully, we and other market participants must be able to transmit confidential information, including credit card information, securely over public networks. Third parties may have the technology or know-how to breach the security of customer transaction data. Any breach could cause consumers to lose confidence in the security of our website and choose not to purchase from us. Although we take the security of our systems very seriously, we cannot guarantee that our security measures will effectively prohibit others from obtaining improper access to our information and information of our customers. If a person is able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt our operations. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation, any of which could adversely affect our business.

In addition, states and the federal government are increasingly enacting laws and regulations to protect consumers against identity theft. We collect personal information from consumers in the course of doing business. These laws will likely increase the costs of doing business and, if we fail to implement appropriate safeguards or we fail to detect and provide prompt notice of unauthorized access as required by some of the new laws, we could be subject to potential claims for damages and other remedies. If we were required to pay any significant amount of money in satisfaction of claims under these laws, or if we were forced to cease our business operations for any length of time as a result of our inability to comply fully with any such law, our business, operating results and financial condition could be adversely affected.

Item 6.

Exhibits.

See attached exhibit index.

SIGNATURES

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


	Restoration Hardware, Inc.
Date: December 13, 2007

	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)

EXHIBIT INDEX


EXHIBIT NO.		DOCUMENT DESCRIPTION

2.1		Agreement and Plan of Merger, dated November 8, 2007, by and among Restoration Hardware, Inc., Home Holdings, LLC and Home Merger Sub, Inc. (incorporated by reference to exhibit number 2.1 of the Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on November 8, 2007).

10.1		Lease Agreement entered into on August 7, 2007 between Restoration Hardware, Inc. and Duke Realty Limited Partnership, effective as of August 3, 2007 (Confidential treatment has been requested for certain portions of this exhibit. The copy filed as an exhibit to this Form 10-Q omits the information subject to the confidential treatment request.)

10.2		First Amendment dated as of August 27, 2007, to Lease Agreement dated as of August 7, 2007, by and between Duke Realty Limited Partnership and Restoration Hardware, Inc.

10.3		Letter Agreement between Restoration Hardware, Inc., The Michaels Furniture Company, Inc., Bank of America, N.A., The CIT Group/Business Credit, Inc. and Wells Fargo Retail Finance, LLC dated as of November 8, 2007.

10.4*		Restoration Hardware, Inc. Change in Control Severance Plan (incorporated by reference to exhibit number 10.1 of the Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on November 8, 2007).

10.5*		Restoration Hardware, Inc. Change in Control Retention Plan (incorporated by reference to exhibit number 10.2 of the Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on November 8, 2007).

10.6*		Amendment No. 1 to Offer Letter between Restoration Hardware, Inc., and Chris Newman dated November 15, 2007 (incorporated by reference to exhibit number 10.1 of the Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on November 16, 2007).

10.7*		Amendment No. 1 to Offer Letter between Restoration Hardware, Inc., and Ken Dunaj dated November 15, 2007 (incorporated by reference to exhibit number 10.2 of the Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on November 16, 2007).

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

*	Indicates a management contract or compensatory plan or arrangement.

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