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Restoration Hardware 10-Q 2007
Form 10-Q
Table of Contents

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 May 5, 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 May 25, 2007, 38,781,927 shares of the registrant’s common stock, $0.0001 par value per share, were outstanding.

 



Table of Contents

RESTORATION HARDWARE, INC.

FORM 10-Q

FOR THE QUARTER ENDED MAY 5, 2007

TABLE OF CONTENTS

 

PART I.

   FINANCIAL INFORMATION    3

Item 1.

  

Condensed Consolidated Financial Statements (Unaudited)

   3
  

Condensed Consolidated Balance Sheets as of May 5, 2007, February 3, 2007 and April 29, 2006

   3
  

Condensed Consolidated Statements of Operations for the first quarter ended May 5, 2007 and April 29, 2006

   4
  

Condensed Consolidated Statements of Cash Flows for the first quarter ended May 5, 2007 and April 29, 2006

   5
  

Notes to Condensed Consolidated Financial Statements

   6

Item 2.

  

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

   10

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   17

Item 4.

  

Controls and Procedures

   17

PART II.

  

OTHER INFORMATION

   17

Item 1.

  

Legal Proceedings

   17

Item 1A.

  

Risk Factors

   17

Item 6.

  

Exhibits

   25

SIGNATURES

   26

EXHIBIT INDEX

   27

 

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Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Condensed Consolidated Financial Statements.

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in thousands)

(Unaudited)

 

     May 5, 2007     February 3,
2007
    April 29,
2006
 

ASSETS

      

Current assets:

      

Cash and cash equivalents

   $ 1,196     $ 1,461     $ 2,260  

Accounts receivable

     8,535       7,164       9,175  

Merchandise inventories

     215,483       192,805       194,628  

Prepaid expense and other current assets

     24,367       18,984       17,633  
                        

Total current assets

     249,581       220,414       223,696  

Property and equipment, net

     89,537       87,961       91,449  

Goodwill

     4,560       4,560       4,560  

Deferred tax assets

     1,939       1,911       —    

Other assets

     1,531       1,521       1,343  
                        

Total assets

   $ 347,148     $ 316,367     $ 321,048  
                        

LIABILITIES AND STOCKHOLDERS’ EQUITY

      

Current liabilities:

      

Accounts payable and accrued expenses

   $ 63,097     $ 79,340     $ 77,626  

Deferred revenue and customer deposits

     14,111       9,556       14,178  

Deferred tax liabilities

     1,351       1,357       —    

Other current liabilities

     20,312       20,335       17,197  
                        

Total current liabilities

     98,871       110,588       109,001  

Long-term debt, net of issuance costs

     121,763       68,384       88,065  

Deferred lease incentives

     22,318       23,515       26,667  

Deferred rent

     19,588       19,998       20,160  

Other long-term obligations

     5,781       1,774       660  
                        

Total liabilities

     268,321       224,259       244,553  
                        

Commitments and contingencies (Note 6)

      

Stockholders’ equity:

      

Common stock

     4       4       4  

Additional paid-in capital

     179,117       178,176       170,290  

Accumulated other comprehensive income

     1,176       745       1,183  

Accumulated deficit

     (101,470 )     (86,817 )     (94,982 )
                        

Total stockholders’ equity

     78,827       92,108       76,495  
                        

Total liabilities and stockholders’ equity

   $ 347,148     $ 316,367     $ 321,048  
                        

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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Table of Contents

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share data)

(Unaudited)

 

     First Quarter Ended  
     May 5,
2007
    April 29,
2006
 

Net revenues

   $ 142,112     $ 133,380  

Cost of revenue and occupancy

     97,638       88,495  
                

Gross profit

     44,474       44,885  

Selling, general and administrative expense

     56,397       48,353  
                

Loss from operations

     (11,923 )     (3,468 )

Interest expense, net

     (1,999 )     (1,424 )
                

Loss before income taxes

     (13,922 )     (4,892 )

Income tax benefit (expense)

     164       (21 )
                

Net loss

   $ (13,758 )   $ (4,913 )
                

Net loss per share, basic and diluted

   $ (0.35 )   $ (0.13 )
                

Shares used in computing basic and diluted net loss per share

     38,757       37,773  

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

     First Quarter Ended  
     May 5, 2007     April 29, 2006  

Cash flows from operating activities:

    

Net loss

   $ (13,758 )   $ (4,913 )

Adjustments to reconcile net loss to net cash used by operating activities:

    

Depreciation and amortization

     5,061       5,148  

Stock-based compensation expense

     807       907  

Deferred income taxes

     (34 )     —    

Changes in operating assets and liabilities:

    

Accounts receivable

     (1,371 )     (3,086 )

Merchandise inventories

     (22,678 )     (35,980 )

Prepaid expense and other current assets

     (5,393 )     (8,149 )

Accounts payable and accrued expenses

     (16,215 )     14,857  

Deferred revenue and customer deposits

     4,555       5,874  

Other current liabilities

     302       (680 )

Deferred rent

     (410 )     294  

Deferred lease incentives and other long-term obligations

     (1,303 )     (1,003 )
                

Net cash used by operating activities

     (50,437 )     (26,731 )

Cash flows from investing activities:

    

Capital expenditures

     (3,264 )     (3,151 )
                

Net cash used by investing activities

     (3,264 )     (3,151 )

Cash flows from financing activities:

    

Borrowings under line of credit, net

     53,332       29,864  

Payments on capital leases and other long-term obligations

     (293 )     (10 )

Issuance of common stock, net

     134       197  
                

Net cash provided by financing activities

     53,173       30,051  

Effects of foreign currency exchange rate translation

     263       101  
                

Net (decrease) increase in cash and cash equivalents

     (265 )     270  

Cash and cash equivalents:

    

Beginning of period

     1,461       1,990  
                

End of period

   $ 1,196     $ 2,260  
                

Additional cash flow information:

    

Cash paid during the period for interest

   $ 1,378     $ 879  

Cash paid during the period for income taxes

     233       49  

Non-cash investing and financing transactions:

    

Property and equipment acquired under capital leases

   $ 2,569     $ 938  

Tenant improvement allowance receivable

     —         205  

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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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 May 5, 2007, the Company operated a total of 103 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 May 5, 2007 and April 29, 2006, and the results of operations and changes in cash flows for the first quarters ended May 5, 2007 and April 29, 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 condensed consolidated financial statements. The condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements, including the notes thereto, for fiscal 2006. The Company’s current fiscal year ends on February 2, 2008 (“fiscal 2007”).

The results of operations for the first quarter ended May 5, 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 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 May 5, 2007, the Company recorded $0.8 million for pre-tax stock-based compensation under SFAS 123R, of which $0.6 million was recorded to selling, general and administrative expenses and $0.2 million was recorded to cost of revenue and occupancy. During the first quarter of fiscal 2006, the company recorded $0.9 million for pre-tax stock-based compensation, of which $0.6 million was recorded to selling, general and administrative expenses and $0.3 million was recorded to cost of revenue and occupancy.

During the first quarter of fiscal 2007, the Company granted 0.5 million shares of employee stock options with a weighted average exercise price of $6.47 and an average grant date fair value of $3.52 and granted 0.3 million shares of restricted stock units with an average grant date fair value of $6.56. During the first quarter of fiscal 2006, the Company granted 0.4 million shares of employee stock options with a weighted average exercise price of $5.76 and an average grant date fair value of $3.49. As of May 5, 2007, unrecognized compensation cost under the Company’s stock option plans was $3.0 million for employee stock options and $0.5 million for restricted stock units. The unrecognized compensation cost is expected to be recognized over a weighted-average remaining vesting period of 1.47 years for employee stock options and 3.94 years for restricted stock units.

 

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Stock-Based Compensation Plans

In April 1998, the Company’s Board of Directors approved the 1998 Stock Incentive Plan (“1998 Plan”), which serves as the successor to the Company’s 1995 Stock Option Plan (“the Predecessor Plan”). The 1998 Plan is divided into six separate components: (i) the Discretionary Option Grant Program, (ii) the Stock Issuance Program, (iii) the Salary Investment Option Grant Program, (iv) the Automatic Option Grant Program, (v) the Director Fee Option Grant Program, and (vi) the Restricted Stock Unit Program. The Discretionary Option Grant Program and Stock Issuance Program are administered by the Compensation Committee. The Compensation Committee has the sole and exclusive authority to make grants to executive officers. The Compensation Committee also has concurrent authority under the Discretionary Option Grant Program with a Secondary Committee of the Board of Directors. The Secondary Committee has discretionary authority to make grants to eligible individuals other than executive officers pursuant to guidelines issued from time to time by the Board of Directors. Neither the Salary Investment Option Grant Program nor the Director Fee Option Grant Program is currently in use by the Company.

Comprehensive Loss

Comprehensive loss consists of net loss and foreign currency translation adjustments. The components of comprehensive loss for the quarters ended May 5, 2007 and April 29, 2006, respectively, are as follows:

 

     First Quarter Ended  
     May 5, 2007     April 29, 2006  
     (Dollars in thousands)  

Components of comprehensive loss:

    

Net loss

   $ (13,758 )   $ (4,913 )

Foreign currency translation adjustment

     (431 )     (173 )
                

Total comprehensive loss

   $ (14,189 )   $ (5,086 )
                

2. LONG-TERM DEBT, NET

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 from June 30, 2011 to June 30, 2012 and an increase in the amount of the revolving credit facility from $150 million 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 May 5, 2007, $121.8 million was outstanding under the facility, net of unamortized debt issuance costs of $0.8 million, and there was $10.0 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 May 5, 2007, the bank’s reference rate was 8.25% and the LIBOR plus margin rate was 6.32%. 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 May 5, 2007, availability under the facility was $32.7 million.

 

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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 $15.0 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 Financial Accounting Standards Board (“FASB”) issued FIN 48. This statement 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 May 5, 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 is $2.2 million. Of this amount, $1.9 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. As of the date of adoption, the Company had $0.3 million of interest accrued associated with unrecognized tax benefits.

The Company could be subject to United States and state tax examinations for years 2000 and forward by virtue of net operating loss carryforwards from those years. The Company may also be subject to audits in Canada for years 2001 and forward. There are no United States or Canadian tax examinations currently in progress.

As of May 5, 2007, the total amount of unrecognized tax benefits was approximately $2.2 million. The Company anticipates an increase to the unrecognized tax benefits during fiscal 2007 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 first quarter of fiscal 2007 and 2006 was 0.8 million common stock equivalents and 0.7 million common stock equivalents, 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 3.3 million and 4.5 million stock options for the first quarter of fiscal 2007 and 2006, respectively, that were also excluded because the option exercise price for those stock options exceeded the average market price of the stock during the respective periods.

 

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5. SEGMENT REPORTING

The Company classifies its business interests into two identifiable segments: retail and direct-to-customer. The retail segment includes all revenue and expenses associated with the Company’s store and outlet locations. The direct-to-customer segment includes all revenue and expenses associated with catalog and Internet revenue, including Brocade Home. Revenue related to Michaels, the Company’s furniture manufacturing company, is recorded as either retail or direct-to-customer revenue based on the channel in which the sale was initiated. Management decisions on resource allocation and performance assessment are made based on these two identifiable segments. The Company evaluates performance and allocates resources based on results from operations, which excludes certain unallocated costs. Certain segment information, including segment assets, asset expenditures and related depreciation expense, is not presented as all of the Company’s assets are commingled and are not available by segment.

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

 

     First Quarter Ended  
     May 5, 2007     April 29, 2006  
     (Dollars in thousands)  

Net Revenue:

    

Retail

   $ 83,524     $ 91,060  

Direct-to-customer

     58,588       42,320  
                

Consolidated net revenue

   $ 142,112     $ 133,380  
                

Income (loss) from operations:

    

Retail

   $ (979 )   $ 6,346  

Direct-to-customer

     10,000       6,724  

Unallocated

     (20,944 )     (16,538 )
                

Consolidated loss from operations

   $ (11,923 )   $ (3,468 )
                

Income (loss) from operations for the first quarter of fiscal 2006 has been adjusted to be consistent with the allocation methodology used in the first quarter of fiscal 2007. The adjustments are as follows: (i) retail income from operation for the first quarter of fiscal 2006 has changed to $6.3 million from $8.2 million as previously reported, (ii) direct-to-customer income from operations has changed to $6.7 million from $7.5 million as previously reported and (iii) unallocated loss from operations has changed to $16.5 million from $19.2 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.

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 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.

 

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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, 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 comparable store 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 May 5, 2007, we operated 103 retail stores and 8 outlet stores in 30 states, the District of Columbia and in Canada. In addition to our retail stores, we operate a direct-to-customer (“direct”) sales channel that includes both catalog and Internet.

Over the past several years, we have 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.

 

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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 has been launched with a catalog, and our plan is to develop a multi-channel retailing platform over the next several years. Brocade Home’s website is located a 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.

In the first quarter of fiscal 2007, we introduced our third category extension, the premier edition of 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.

The macro economic environment in the home furnishings sector continued to be challenging during the first quarter of fiscal 2007 and our financial performance was affected by the current downtrend in this sector. We also experienced below plan sales in April, primarily in our outdoor and seasonal businesses with a majority concentrated in the Eastern region of the country. We believe this was due to the fact that the second mailing of our Outdoor catalog dropped on April 5th during adverse weather conditions on the East coast.

In addition, our inventory levels increased during the first quarter as a result of, among other factors, the slowdown in our anticipated level of sales. We are focused on a number of initiatives to improve our operations in fiscal 2007 and have a number of cost cutting efforts and growth initiatives in place over the next several quarters which are designed to respond to the current market conditions as well as to improve some parts of our business operations, 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 are consolidating our small package direct-to-customer operations from three distribution centers into one centralized distribution center, which will improve our in-stock availability, turn of inventory and inbound & outbound freight costs.

 

   

We are installing a new warehouse management system in our furniture distribution centers to improve order integrity, tracking and productivity.

 

   

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.

As we look forward to the balance of the fiscal year, we are excited about our long-term growth plans as we pursue our multi-channel, multi-brand strategy. We will continue to build on the new Restoration Hardware Bed & Bath catalog and our new Restoration Hardware Trade direct sales division. We also will continue to grow our new brand, Brocade Home, and we are excited about the expected launch of our new Restoration Hardware Kids catalog.

 

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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.

 

     First Quarter Ended  
     May 5, 2007     % of Net
Revenue
    April 29, 2006     % of Net
Revenue
 
     (Dollars in thousands, except per share data)  

Retail net revenue

   $ 83,524     58.8  %   $ 91,060     68.3  %

Direct-to-customer net revenue

     58,588     41.2       42,320     31.7  
                            

Net revenue

     142,112     100.0       133,380     100.0  

Cost of revenue and occupancy

     97,638     68.7       88,495     66.3  
                            

Gross profit

     44,474     31.3       44,885     33.7  

Selling, general and administrative expense

     56,397     39.7       48,353     36.3  
                            

Loss from operations

     (11,923 )   (8.4 )     (3,468 )   (2.6 )

Interest expense, net

     (1,999 )   (1.4 )     (1,424 )   (1.1 )
                            

Loss before income taxes

     (13,922 )   (9.8 )     (4,892 )   (3.7 )

Income tax (expense) benefit

     164     0.1       (21 )   (0.0 )
                            

Net Loss

   $ (13,758 )   (9.7 )   $ (4,913 )   (3.7 )
                            

Net loss per share of common stock—basic & diluted

   $ (0.35 )     $ (0.13 )  
                    

Net revenues increased by $8.7 million, or 7%, to $142.1 million in the first quarter of fiscal 2007 compared to the first quarter of fiscal 2006. This increase resulted from a $16.3 million, or 38%, increase in revenues in our direct-to-customer segment offset by a $7.5 million, or 8%, decrease in our retail segment. Our strong growth in the direct-to-customer segment was primarily driven by increased page count and the redesign of our Restoration Hardware Home Catalog and by increased circulation and page count for our Restoration Hardware Outdoor Catalog. The $7.5 million decline in net revenues in our retail segment was caused by changes in customer purchase habits migrating to our direct channel as a result of the larger product assortment in our catalogs, thus enhancing our direct channel sales. Additionally, we were impacted by the adverse weather conditions experienced during the first quarter of fiscal 2007, particularly in the Eastern regions of the U.S, and by the current challenging home furnishings environment.

Cost of revenue and occupancy expense increased by $9.1 million, to $97.6 million, in the first quarter of fiscal 2007. Cost of revenue and occupancy expense expressed as a percentage of net revenue increased by 240 basis points to 68.7% in the first quarter of fiscal 2007, from 66.3% in the first quarter of fiscal 2006. This result was primarily driven from lower product margins due to a greater mix of promotional selling during the first quarter of fiscal 2007 and by the retrofit of our distribution centers.

Selling, general and administrative expenses increased by $8.0 million, to $56.4 million, in the first quarter of fiscal 2007. Expressed as a percentage of net revenue, selling, general, and administrative expense increased to 39.7% for the first quarter of fiscal 2007 compared to 36.3% for the first quarter of fiscal 2006. The 340 basis point increase in these costs, expressed as a percentage of net revenues, was primarily due to a 210 basis point increase in advertising costs associated with the increased circulation from our catalogs which drove increased direct channel sales. Total catalog circulation and circulated pages increased by 41% and 42%, respectively, compared to the same period in the prior fiscal year. With the growth in revenue in the direct business, our selling, general and administrative costs increased relative to overall revenue since we have a higher selling, general and administrative rate for our direct business as compared to our retail business. During the first quarter of fiscal 2007, we also incurred costs in our direct-to-customer segment to support our growth initiatives.

The first quarter 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 $3.5 million in the first quarter of fiscal 2006 to a loss of $11.9 million in the first quarter of fiscal 2007. This result was due to two primary factors. First, April sales were below our projected plan. The shortfall occurred primarily in our outdoor and seasonal businesses with the majority concentrated in the Eastern region of the U.S. This was predominantly due to our second Outdoor catalog mailing having dropped on April 5th during adverse weather conditions in the East. Also, we experienced ongoing softness across our business due to the challenging home furnishings environment and the effects from the slowdown in the home building

 

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industry. Second, during the first quarter of fiscal 2007 we continued with our multi-year program of investing in systems and infrastructure targeted at strengthening our supply chain processes. In addition, we introduced a new category extension during the first quarter of fiscal 2007, Restoration Hardware Bed & Bath Catalog, and continue to make investments in Brocade Home, Restoration Hardware Kids and our Trade initiative. These investments also had an impact upon our results for the first quarter of fiscal 2007.

Interest expense, net includes interest on borrowings under our revolving credit facility and amortization of debt issuance costs. Interest expense, net increased from $1.4 million in the first quarter of fiscal 2006 to $2.0 million in the first quarter of fiscal 2007. This increase resulted from higher average interest rates during the first quarter of fiscal 2007 combined with higher average debt levels to support current working capital requirements, including increased merchandise inventory.

Our first quarter fiscal 2007 income tax benefit was $0.2 million on pre-tax loss of $13.9 million. This compares to income tax expense of $21,000 recorded in the first quarter of fiscal 2006. The income tax benefit in our first quarter of fiscal 2007 was primarily due to a tax adjustment related to our wholly-owned Canadian subsidiary.

Revenue and Segment Results

Retail Segment Results

 

     First Quarter Ended  
     May 5, 2007     April 29, 2006  
     (Dollars in thousands)  

Retail net revenue

   $ 83,524     $ 91,060  

Retail net revenue growth percentage

     -8 %     8 %

(Loss) income from retail operations

   $ (979 )   $ 6,346  

(Loss) income from retail operations—percent of retail net revenue

     -1 %     7 %

Number of retail stores at beginning of period

     103       103  

Number of retail stores opened

     —         —    

Number of retail stores closed

     —         —    
                

Number of retail stores at year-end

     103       103  
                

Retail store selling square feet at end of period

     688,710       685,672  

Number of outlet stores at end of period

     8       7  

See Note 5, “Segment Reporting,” of the Condensed Consolidated Financial Statements regarding certain allocation changes made to income from retail operations for the first quarter of fiscal 2006.

Retail net revenue for the first quarter of fiscal 2007 decreased by $7.5 million, or 8%, as compared to the first quarter of fiscal 2006. Our retail segment net revenue decline was affected by our strategy to offer a larger product assortment in our catalogs, contributing to a shift in revenues from our retail stores to our direct channels. The retail segment net revenue was also impacted by the challenging home furnishings environment, by the overall slowdown in the home building industry, and by the adverse weather conditions experienced in the Eastern regions of the U.S.

Our retail segment experienced a decline in its operating results, decreasing to a loss from operations of $1.0 million, or 1% of retail net revenue, during the first quarter of fiscal 2007 compared to income from operations of $6.3 million, or 7% of retail net revenue, in the same period of the prior fiscal year. This significant decline, representing an 810 basis point decrease in the retail segment operating results for the first quarter of fiscal 2007, resulted from a 590 basis point decrease in gross margin and by a 220 basis point increase in selling, general and administrative expenses. The 590 basis point decrease in gross margin was primarily due to a decrease in product margin of 280 basis points (including the impact of higher outlet sales), and by an increase in store occupancy costs of 220 basis points. The 220 basis point increase in selling, general and administrative expenses was primarily due to an increase in store employment and advertising costs, all factors of which were driven by lower sales volume during the first quarter of fiscal 2007. Income from operations for the retail segment includes the costs of retail stores less the direct costs of the store field operations.

 

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Direct-to-Customer Segment Results

 

     First Quarter Ended  
     May 5, 2007     April 29, 2006  
     (Dollars in thousands)  

Direct-to-customer net revenue

   $ 58,588     $ 42,320  

Direct-to-customer net revenue growth percentage

     38 %     29 %

Income from direct-to-customer operations

   $ 10,000     $ 6,724  

Income from direct-to-customer operations—percent of direct-to-customer net revenue

     17 %     16 %

Growth percentages:

    

Number of catalog books mailed

     41 %     25 %

Pages circulated

     42 %     19 %

See Note 5, “Segment Reporting,” of the Condensed Consolidated Financial Statements regarding certain allocation changes made to income from direct-to-customer operations for the first quarter of fiscal 2006.

Direct-to-customer net revenue for the first quarter of fiscal 2007 increased $16.3 million, or 38.4%, as compared to the first quarter 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. 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 shift of business from retail to direct. At the same time, growth was impacted by the challenging home furnishings environment and by the adverse weather conditions experienced in the Eastern regions of the U.S. The total number of catalogs mailed and pages circulated increased by 41% and 42%, respectively, from the first quarter of fiscal 2006 to the current fiscal quarter. Direct-to-customer net revenue consists of both catalog and Internet sales.

Income from operations for our direct-to-customer segment increased by $3.3 million, or 17%, during the first quarter of fiscal 2007 compared to 16% in the same quarter of fiscal 2006. This increase of $3.3 million, represented a 110 basis point improvement which primarily resulted from a 240 basis point increase in gross margin, offset in part by a 130 basis point increase in selling, general and administrative expenses. The 240 basis point increase in gross margin resulted from shipping expense leverage. The 130 basis point increase in selling, general and administrative expense was primarily due to a general increase in employment-related costs and advertising costs resulting from higher page count and catalog book circulations. Increased investments supported our third category extension, Restoration Hardware Bed & Bath Catalog, and continued investment in Brocade Home and Restoration Hardware Kids. Income from operations for the direct-to-customer segment reflects the results associated with catalog and Internet sales, less direct management costs.

 

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LIQUIDITY AND CAPITAL RESOURCES

 

     First Quarter Ended  
     May 5, 2007     April 29, 2006  
     (Dollars in thousands)  

Net cash used by operating activities

   $ (50,437 )   $ (26,731 )

Net cash used by investing activities

     (3,264 )     (3,151 )

Net cash provided by financing activities

     53,173       30,051  

Effects of foreign currency exchange rate translation

     263       101  
                

Net (decrease) increase in cash and cash equivalents

   $ (265 )   $ 270  
                

Operating Cash Flows

For the first quarter of fiscal 2007, net cash used by operating activities was $50.4 million compared to net cash used by operating activities of $26.7 million in the first quarter of fiscal 2006. The increased use of cash of $23.7 million was primarily a result of an increase in net loss of $8.8 million, a decrease in accounts payable and accrued expenses compared to an increase in the same period of the prior fiscal year, offset by a lower increase in merchandise inventories. The increase in the use of cash related to accounts payable and accrued expenses primarily related to a lower outstanding check balance due to the timing of our quarter end, which ended on May 5th in the first quarter of fiscal 2007 compared to April 28th in the first quarter of fiscal 2006, and the timing of payments to our merchandise vendors. The higher use of cash related to merchandise inventories in the first quarter of fiscal 2006 primarily related to the launch of our first category extension of the Restoration Hardware Outdoor catalog late in the first quarter of fiscal 2006.

Investing Cash Flows

Net cash used by investing activities remained relatively consistent at $3.3 million for the first quarter of fiscal 2007, compared to $3.2 million for the first quarter of fiscal 2006 and related to capital expenditures incurred during the quarters.

Financing Cash Flows

Net cash provided by financing activities increased from $30.1 million in the first quarter of fiscal 2006 to $53.2 million in the first quarter of fiscal 2007. This increase primarily resulted from a $23.5 million increase in net borrowings received under our revolving credit facility, net of debt issuance costs during the first quarter of fiscal 2007 compared to the first quarter of fiscal 2006, partially offset by a $0.3 million increase in payments on capital leases and other long-term obligations. The $23.5 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 from June 30, 2011 to June 30, 2012 and increases the amount of our revolving credit facility from $150 million 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 May 5, 2007, $121.8 million was outstanding under the facility, net of unamortized debt issuance costs of $0.8 million, and there was $10.0 million in outstanding letters of credit. Borrowings made under the revolving credit facility are

 

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subject to interest at either the bank’s reference rate or LIBOR plus a margin. As of May 5, 2007, the bank’s reference rate was 8.25% and the LIBOR plus margin rate was 6.32%. 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 May 5, 2007, availability under the facility was $32.7 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 $15.0 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 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 availability of funds to us. We may not have successfully anticipated our future capital needs or the timing of such needs and we may need to raise additional funds in order to take advantage of unanticipated opportunities. We also may need to raise additional funds to respond to changing business conditions or unanticipated competitive pressures. However, should the need arise, additional sources of financing may not be available or, if available, may not be on terms favorable to our stockholders or us. If we fail to raise sufficient funds, we may be required to delay or abandon some of our planned future expenditures or aspects of our current operations. For more information, please 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” and “Because our business requires a substantial level of liquidity, we are dependent upon a revolving credit facility with certain terms that limit our flexibility.”

Contractual Commitments

The following table summarizes our significant contractual cash obligations and other commercial commitments as of May 5, 2007:

 

     Payments Due By Period
     Total    Fiscal 2007   

Fiscal 2008

through 2009

  

Fiscal 2010

through 2011

   Thereafter
     (Dollars in thousands)

Operating leases (1)

   $ 245,028    $ 36,903    $ 86,260    $ 60,427    $ 61,438

Capital leases

     7,017      1,550      3,752      1,614      101

Line of credit (2)

     122,545      —        —        —        122,545

Interest (3)

     26,330      6,682      12,234      7,414      —  

Standby letters of credit

     9,721      9,721      —        —        —  

Trade letters of credit

     287      287      —        —        —  

Purchase obligations for inventory (4)

     84,516      84,516      —        —        —  
                                  

Total

   $ 495,444    $ 139,659    $ 102,246    $ 69,455    $ 184,084
                                  

(1) Operating lease contractual commitments exclude insurance, real estate taxes, and repair and maintenance expenses related to those operating leases.
(2) The costs reflect our long-term debt, gross of debt issuance costs of $0.8 million.
(3) Interest payments in the future periods have been reflected based on average debt levels during fiscal 2006 and the first quarter of fiscal 2007 and interest levels at the end of the first quarter of fiscal 2007 and reflects the June 2012 maturity date of the line of credit.
(4) Represents estimated commitments at the end of the first quarter of fiscal 2007 to purchase inventory in the normal course of business to meet operating requirements.

 

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(5) Effective in fiscal 2007, we adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an Interpretation of SFAS 109” (“FIN 48”). Pursuant to the guidelines of FIN 48, a $2.2 million reserve for unrecognized tax benefits, inclusive of $0.3 million of related interest, was established and included in other long-term obligations on our condensed consolidated balance sheet at May 5, 2007. These obligations are excluded from the schedule above as the timing of payments cannot be reasonably estimated.

 

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 first quarter ended May 5, 2007.

 

Item 4. Controls and Procedures.

As of May 5, 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 May 5, 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.

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

 

Item 1A. Risk Factors.

In addition to the other information in this Quarterly Report on Form 10-Q, the factors and risks listed below, among others, could affect our future performance and should be carefully considered in evaluating our outlook. There were no material changes in these risk factors from the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended February 3, 2007.

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. 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.

 

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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 May 5, 2007, we did not expect, and therefore did not reserve for, any store closures.

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

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

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.

 

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

We make merchandise purchases from over 600 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.

Labor activities could cause labor relations difficulties for us.

As of May 5, 2007, we had approximately 3,900 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.

 

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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 May 5, 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.

 

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These covenants restrict numerous aspects of our business. The revolving credit facility also includes a borrowing base formula (which includes an adjustment to the advance rate against eligible inventory and eligible accounts receivable for incremental advances as described above) to address the availability of credit at any given time based upon numerous factors, including the value of eligible inventory and eligible accounts receivable, in each case, subject to the overall aggregate cap on borrowings. Consequently, for purposes of the borrowing base formula, the value of eligible inventory and eligible accounts receivable may limit our ability to borrow under the revolving credit facility.

We have drawn upon the revolving credit facility in the past and we expect to draw upon it in the future. Failure to comply with the terms of the revolving credit facility would entitle the secured lenders to prevent us from further borrowing, and upon acceleration by the lenders, they would be entitled to begin foreclosure procedures against our assets, including accounts receivable, inventory, general intangibles, equipment, goods, and fixtures. The secured lenders would then be repaid from the proceeds of such foreclosure proceedings, using all available assets. Only after such repayment and the payment of any other secured and unsecured creditors would the holders of our capital stock receive any proceeds from the liquidation of our assets. Our ability to comply with the terms of the revolving credit facility may be affected by events beyond our control.

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

High levels of interest and other expense have had in the past, and could have in the future, negative effects on our operations. An increase in the variable interest rate under our revolving credit facility, coupled with an increase in our outstanding debt, could result in material amounts otherwise available for other business purposes being used to pay for interest expense.

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

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

During the first quarter of fiscal 2007, we purchased approximately 73% 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.

 

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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 first quarter fiscal year 2007, revenue through our direct-to-customer channel grew by 38% as compared to the first 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.

 

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

The success of our business depends to a significant extent upon the level of consumer spending. A number of economic conditions affect the level of consumer spending on merchandise that we offer, including, among other things, the general state of the economy, 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 activity and consumer confidence in future economic conditions. More generally, reduced consumer confidence and spending may result in reduced demand for discretionary items and luxury retail products, such as our products. Reduced consumer confidence and spending also may result in limitations on our ability to increase prices and may require increased levels of selling and promotional expenses. Adverse economic conditions and any related decrease in consumer demand for discretionary items such as those offered by us could have a material adverse effect on our business, results of operations and financial condition.

We face an extremely competitive specialty retail business market.

The retail market is highly competitive. 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.

 

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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.

 

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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.

 

Item 6. Exhibits.

See attached exhibit index.

 

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SIGNATURES

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

 

  Restoration Hardware, Inc.
Date: June 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)

 

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EXHIBIT INDEX

 

EXHIBIT NO.

  

DOCUMENT DESCRIPTION

*10.1

   Form of Restricted Stock Unit Agreement under the Restoration Hardware, Inc. 1998 Stock Incentive Plan, as amended and restated (incorporated by reference to exhibit number 10.1 of Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on April 11, 2007)

*10.2

   Restoration Hardware, Inc. 1998 Stock Incentive Plan, as Amended and Restated on April 9, 2007

*10.3

   Summary of Compensation of Named Executive Officers for Fiscal Year 2006

*10.4

   First Amendment to Eighth Amended and Restated Loan and Security Agreement dated as of April 27, 2007 among 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. (incorporated by reference to exhibit number 10.1 of Form 8-K filed by Restoration Hardware, Inc. with the Securities and Exchange Commission on May 3, 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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