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Restoration Hardware 10-Q 2008

Documents found in this filing:

  1. 10-Q
  2. Ex-31.1
  3. Ex-31.2
  4. Ex-32.1
  5. Ex-32.2
  6. Ex-32.2
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 3, 2008

 

¨ 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, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  ¨    Accelerated filer  x
Non-accelerated filer  ¨  (Do not check if a smaller reporting company)    Smaller reporting company  ¨

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

As of May 21, 2008, 38,969,600 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 3, 2008

TABLE OF CONTENTS

 

PART I.

  

FINANCIAL INFORMATION

   3

Item 1.

  

Condensed Consolidated Financial Statements (Unaudited)

   3
  

Condensed Consolidated Balance Sheets as of May 3, 2008, February 2, 2008 and May 5, 2007 (as restated)

   3
  

Condensed Consolidated Statements of Operations for the three months ended May 3, 2008 and May 5, 2007 (as restated)

   4
  

Condensed Consolidated Statements of Cash Flows for the three months ended May 3, 2008 and May 5, 2007 (as restated)

   5
  

Notes to Condensed Consolidated Financial Statements

   6

Item 2.

  

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

   13

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   19

Item 4.

  

Controls and Procedures

   20

PART II.

  

OTHER INFORMATION

   20

Item 1.

  

Legal Proceedings

   20

Item 1A.

  

Risk Factors

   21

Item 6.

  

Exhibits

   33

SIGNATURES

   34

EXHIBIT INDEX

   35

 

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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 3, 2008     February 2, 2008     May 5, 2007  
                 (as restated)  

ASSETS

      

Current assets:

      

Cash and cash equivalents

   $ 2,053     $ 1,229     $ 1,196  

Accounts receivable

     11,766       8,399       8,535  

Merchandise inventories

     230,727       200,386       216,250  

Prepaid expense and other current assets

     18,232       18,500       24,367  
                        

Total current assets

     262,778       228,514       250,348  

Property and equipment, net

     124,410       110,271       89,537  

Goodwill

     —         —         4,560  

Deferred tax assets

     2,262       2,311       1,939  

Other assets

     1,424       1,450       1,531  
                        

Total assets

   $ 390,874     $ 342,546     $ 347,915  
                        

LIABILITIES AND STOCKHOLDERS’ EQUITY

      

Current liabilities:

      

Accounts payable and accrued expenses

   $ 90,433     $ 88,303     $ 63,097  

Deferred revenue and customer deposits

     13,428       12,845       14,111  

Deferred tax liabilities

     1,698       1,697       1,351  

Other current liabilities

     23,434       23,159       20,312  
                        

Total current liabilities

     128,993       126,004       98,871  
                        

Line of credit, net of issuance costs

     127,725       78,367       121,763  

Convertible promissory notes, net of issuance costs

     25,042       25,010       —    

Deferred lease incentives

     18,130       19,067       22,318  

Asset construction-related liabilities

     41,069       24,110       —    

Deferred rent

     17,802       18,290       19,588  

Other long-term obligations

     7,506       7,868       5,781  
                        

Total liabilities

     366,267       298,716       268,321  

Commitments and contingencies (Note 7)

      

Stockholders’ equity:

      

Common stock

     4       4       4  

Additional paid-in capital

     182,368       181,712       179,117  

Accumulated other comprehensive income

     1,667       1,776       1,176  

Accumulated deficit

     (159,432 )     (139,662 )     (100,703 )
                        

Total stockholders’ equity

     24,607       48,830       79,594  
                        

Total liabilities and stockholders’ equity

   $ 390,874     $ 342,546     $ 347,915  
                        

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)

 

     Three Months Ended  
     May 3, 2008     May 5, 2007  
           (as restated)  

Net revenues

   $ 144,738     $ 142,112  

Cost of revenue and occupancy

     104,602       96,871  
                

Gross profit

     40,136       45,241  

Selling, general and administrative expense

     57,806       56,397  
                

Loss from operations

     (17,670 )     (11,156 )

Interest expense, net

     (1,933 )     (1,999 )
                

Loss before income taxes

     (19,603 )     (13,155 )

Income tax benefit (expense)

     (167 )     164  
                

Net loss

   $ (19,770 )   $ (12,991 )
                

Net loss per share, basic and diluted

   $ (0.51 )   $ (0.34 )
                

Shares used in calculation of earnings per share:

    

Basic and diluted

     38,969       38,757  

See accompanying Notes to Condensed Consolidated Financial Statements.

 

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Table of Contents

RESTORATION HARDWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

     Three Months Ended  
     May 3, 2008     May 5, 2007  
           (as restated)  

Cash flows from operating activities:

    

Net loss

   $ (19,770 )   $ (12,991 )

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

    

Depreciation and amortization

     6,130       5,061  

Stock-based compensation expense

     653       807  

Deferred income taxes

     63       (34 )

Changes in operating assets and liabilities:

    

Accounts receivable

     (3,367 )     (1,371 )

Merchandise inventories

     (30,341 )     (23,445 )

Prepaid expense and other current assets

     180       (5,393 )

Accounts payable and accrued expenses

     1,490       (16,215 )

Deferred revenue and customer deposits

     158       4,555  

Other current liabilities

     583       302  

Deferred rent

     (488 )     (410 )

Deferred lease incentives and other long-term obligations

     (937 )     (1,303 )
                

Net cash used by operating activities

     (45,646 )     (50,437 )

Cash flows from investing activities:

    

Capital expenditures

     (2,167 )     (3,264 )

Proceeds from sale of property and equipment

     —      
                

Net cash used by investing activities

     (2,167 )     (3,264 )

Cash flows from financing activities:

    

Borrowings under line of credit

     198,421       201,463  

Repayments under line of credit

     (149,111 )     (148,131 )

Payments on capital leases and other long-term obligations

     (608 )     (293 )

Issuance of common stock

     3       134  
                

Net cash provided by financing activities

     48,705       53,173  

Effects of foreign currency exchange rate translation

     (68 )     263  
                

Net increase (decrease) in cash and cash equivalents

     824       (265 )

Cash and cash equivalents:

    

Beginning of period

     1,229       1,461  
                

End of period

   $ 2,053     $ 1,196  
                

Additional cash flow information:

    

Cash paid during the period for interest

   $ 1,021     $ 1,378  

Cash paid during the period for income taxes

     14       233  

Non-cash investing and financing transactions:

    

Property and equipment acquired under capital leases

   $ 322     $ 2,569  

Construction in progress – leased facilities

     16,959       —    

Property and equipment additions in accounts payable

     790       595  

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 3, 2008, the Company operated a total of 101 retail stores and ten 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 3, 2008 and May 5, 2007 (as restated), the results of operations for the three months ended May 3, 2008 and May 5, 2007 (as restated), and changes in cash flows for the three months ended May 3, 2008 and May 5, 2007 (as restated), respectively. The condensed consolidated balance sheet at February 2, 2008, 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 2, 2008 (“fiscal 2007”) included in the Company’s Form 10-K. Certain information and disclosures normally included in the notes to annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted for purposes of these interim condensed consolidated financial statements. The interim condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements, including the notes thereto, for fiscal 2007. The Company’s current fiscal year ends on January 31, 2009 (“fiscal 2008”).

The results of operations for the three months ended May 3, 2008 presented in this Form 10-Q are not necessarily indicative of the results to be expected for the full fiscal year.

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 3, 2008, the Company recorded $0.7 million for pre-tax stock-based compensation under SFAS 123R, of which $0.5 million was recorded to selling, general and administrative expenses and $0.2 million was recorded to cost of revenue and occupancy. During the first three months of fiscal 2007, the Company recorded $0.8 million for pre-tax stock-based compensation, 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 three months of fiscal 2008, the Company did not grant any shares of employee stock options or restricted stock units. During the first three months 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. As of May 3, 2008, unrecognized compensation cost under the Company’s stock option plans was $1.2 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 1.2 years for employee stock options and 3.0 years for restricted stock units.

 

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Tenant Improvement Allowance

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

As of May 3, 2008, the Company has capitalized the estimated cost incurred to date of $41.1 million, which has been recorded as construction-in-progress. The related liability has been recorded as asset construction-related liabilities on the accompanying balance sheet.

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

Comprehensive Loss

Comprehensive loss consists of net loss and foreign currency translation adjustments. The components of comprehensive loss for the three months ended May 3, 2008 and May 5, 2007, respectively, are as follows:

 

     Three Months Ended  
     May 3, 2008     May 5, 2007  
(Dollars in thousands)          (as restated)  

Components of comprehensive loss:

    

Net loss

   $ (19,770 )   $ (12,991 )

Foreign currency translation adjustment

     109       (431 )
                

Total comprehensive loss

   $ (19,661 )   $ (13,422 )
                

Reclassification

The Company historically presented borrowings under the line of credit as a net balance on the consolidated statements of cash flows. To be consistent with the current year presentation, the Company has adjusted prior year amounts to reflect borrowings and repayments of the line of credit separately.

2. LINE OF CREDIT

On April 27, 2007, the Company entered into an agreement (the “Amendment”) to further amend its existing revolving credit facility. The Amendment provides for an extension of the maturity date of the revolving credit facility to June 30, 2012 and an increase in the amount of the revolving credit facility to $190 million. The Amendment further provides that the Company may increase the amount of the revolving credit facility by up to an additional $75 million, but such is subject to a number of terms and conditions, including agreement of lenders to participate in the increased loan commitments under the facility and the availability of sufficient borrowing base collateral to support increased loan amounts. 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.

 

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As of May 3, 2008, $127.7 million was outstanding under the facility, net of unamortized debt issuance costs of $0.8 million, and there was $9.6 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 3, 2008, the bank’s reference rate was 5.00% and the LIBOR plus margin rate was 3.72%. 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 3, 2008, availability under the facility was $35.0 million.

The revolving credit facility contains various restrictive covenants, including limitations on the ability to make liens, make investments, sell assets, incur additional debt, merge, consolidate or acquire other businesses, pay dividends or other distributions, and enter into transactions with affiliates. The revolving credit facility does not contain any other significant financial or coverage ratio covenants unless the remaining availability is less than $15 million, in which case the Company is required to maintain a fixed charge coverage ratio. The revolving credit facility also does not require that the Company repay all borrowings for a prescribed “clean-up” period each year. In addition, the revolving credit facility does not require a daily sweep lockbox arrangement except upon the occurrence of an event of default under the facility or in the event the remaining availability for additional borrowings under the facility is less than $15 million.

3. CONVERTIBLE PROMISSORY NOTES

On January 24, 2008, the Company entered into a First Amendment to the Agreement and Plan of Merger, dated as of November 8, 2007, with affiliates of Catterton Partners (see Note 9—“Merger Agreement” for additional information). In connection with the Amendment, the Company received $25.0 million from funds of Catterton Partners in exchange for the issuance of subordinated unsecured promissory notes in the principal amount of $25.0 million. Concurrently with the issuance of the unsecured promissory notes, the Company entered into (i) a letter agreement with Catterton Management Company, LLC with respect to the payment of an arrangement fee of $0.6 million for the extension of credit and (ii) letter agreements providing that the Notes shall be exchanged for an equity interest in Parent upon the closing of the merger contemplated in the Merger Agreement.

The promissory notes have an interest rate of 8% per annum through December 31, 2008 and 15% per annum beginning January 1, 2009 through maturity. The maturity date of the arrangement fee is July 2008 and the maturity date of the notes is December 2012. The notes may be exchanged for common equity securities upon a change of control resulting in an acquisition of the Company by affiliates of Catterton Partners. If there is a change of control with any party other than the affiliates of Catterton Partners, the notes are due and payable immediately at 100% of the principal amount plus all interest accrued.

As of May 3, 2008, the convertible promissory notes balance was $25.0 million, net of unamortized debt issuance costs of $0.6 million.

4. INCOME TAXES

As of May 3, 2008, the total amount of unrecognized tax benefits was approximately $2.5 million. In addition, the Company has recorded $0.6 million of related interest. The Company anticipates an increase to the unrecognized tax benefits during the next twelve months applicable to interest on foreign tax exposures. The change is not expected to be material to the fiscal 2008 consolidated financial statements.

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

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

5. 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.

 

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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 2008 and 2007 was 0.3 million common stock equivalents and 0.8 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 5.3 million and 3.3 million stock options for the first quarter of fiscal 2008 and 2007, respectively, which were also excluded because the option exercise price for those stock options exceeded the average market price of the stock during the respective periods.

6. SEGMENT REPORTING

Beginning in the second quarter of fiscal 2007, the Company consolidated all small package, direct-to-customer shipments into one distribution center. Previously, these shipments were fulfilled through three facilities: one direct-to-customer distribution center and two retail replenishment distribution centers. As part of the consolidation of small package direct-to-customer fulfillment into the direct-to-customer distribution center, revenues that had been recorded in the Stores segment are now being recorded in the Direct-to-customer segment beginning in the second quarter of 2007. The shift in revenue reporting represented approximately 18 percentage points of the 30% decrease in Stores segment revenues and 26 percentage points of the 47% increase in Direct-to-customer segment revenues for the three months ended May 3, 2008 as compared to the three months ended May 5, 2007.

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

The Company classified its business into two reportable segments:

 

   

Stores—the Stores segment includes retail stores, outlet stores and warehouse sale events.

 

   

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

The unallocated category includes all distribution centers, call center and headquarters costs. Distribution center, call center and headquarters costs are considered support costs and are not included as part of segment profitability.

No adjustment to prior period segment revenues were required as revenues for all periods presented are based on the origin of distribution center fulfillment. The Company has restated previously reported comparable periods’ segment income (loss) from operations to reflect the changes in allocations of certain cost of revenues and selling, general and administrative expenses. Management decisions on resource allocation and performance assessment are made based on these two identifiable reportable segments. The Company evaluates performance and allocates resources based on results from operations, which excludes certain unallocated costs. Certain segment information, including segment assets, asset expenditures and related depreciation expense, is not presented as all of the Company’s assets support our multi-channel retailing platform strategy.

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

 

     Three Months Ended  
     May 3, 2008     May 5, 2007  
(Dollars in thousands)          (as restated)  

Net revenue:

    

Stores

   $ 58,742     $ 83,524  

Direct-to-customer

     85,996       58,588  
                

Consolidated net revenue

   $ 144,738     $ 142,112  
                

Loss from operations:

    

Stores

   $ (3,611 )   $ 5,337  

Direct-to-customer

     20,221       12,028  

Unallocated

     (36,380 )     (28,521 )
                

Consolidated loss from operations

   $ (19,770 )   $ (11,156 )
                

 

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The income from Store and Direct-to-customer operations for the three months ended May 5, 2007 have been adjusted to reflect the segment reporting change implemented during the second quarter of fiscal 2007.

Income (loss) from operations for the three months ended May 5, 2007 have been adjusted to be consistent with the modified reportable segment structure. The adjustments for the first quarter of fiscal 2007 are as follows: (i) Stores income (loss) from operations has changed to $5.3 million income from operations from $1.0 million loss from operations as previously reported, (ii) Direct-to-customer income from operations has changed to $12.0 million from $10.0 million as previously reported and (iii) Unallocated loss from operations has changed to $28.5 million from $20.2 million as restated.

7. COMMITMENTS AND CONTINGENCIES

Two stockholder complaints have been filed as purported class actions on behalf of the public stockholders of the Company. The first was filed on November 28, 2007 by Richard Hattan against the Company, each of the Company’s directors, Catterton Partners, Glenhill Capital LP, Vardon Capital Management LLC, Palo Alto Investors LLC and Reservoir Capital Management LLC in Superior Court of the State of California, County of Marin, Case No. CV 075563. Plaintiff amended his complaint on March 7, 2008. The plaintiff alleges that he is an owner of the Company’s common stock. The amended complaint alleges, among other things, that the Company’s directors breached their fiduciary duties in connection with the proposed Merger by pursuing a process for the sale of the Company that was not reasonably likely to maximize stockholder value. In particular, the amended complaint alleges that the directors did not deal appropriately with Sears. The amended complaint also alleges that the Company’s disclosures with respect to the transaction were inadequate or incomplete, rendering the disclosures materially misleading. The amended complaint alleges that the remaining defendants aided and abetted the alleged breaches of fiduciary duties. The complaint seeks, among other things, to enjoin the Company, its directors and the other defendants from proceeding with or consummating the Merger and an injunction changing or supplementing the disclosures made by the Company. Discovery has been proceeding in the case. On May 21, 2008, the plaintiff filed a motion seeking a preliminary injunction to delay the vote and prohibit the closing of the Merger. The motion is expected to be heard on June 11, 2008. The absence of an injunction prohibiting the consummation of the Merger is a condition to the closing of the Merger.

The second stockholder complaint was filed on March 26, 2008 by Randall Reimer against the Company, each of the Company’s directors, Parent, Merger Sub, and Catterton Partners in the Court of Chancery of the State of Delaware. The plaintiff amended the complaint on May 6, 2008. The plaintiff alleges that he is an owner of the Company’s common stock. The amended complaint alleges essentially the same claims as the amended complaint in Hattan v. Restoration Hardware, including the alleged failure to pursue a process reasonably likely to maximize shareholder value and allegedly misleading omissions in the Company’s disclosures regarding the Merger. Similar to the Hattan complaint, the Reimer complaint alleges that the directors have therefore breached their fiduciary duties and that the remaining defendants have aided and abetted the alleged breaches. The complaint seeks essentially the same remedies as the suit in California, including an injunction to prevent the Merger or rescission of the Merger, if it is consummated. The absence of an injunction prohibiting the consummation of the Merger is a condition to the closing of the Merger. The defendants have moved to stay this proceeding in light of the lawsuit in California. Both complaints are publicly available.

Based on the facts known to date, the Company believes that the claims asserted by the plaintiffs in both actions are without merit and intends to defend this suit vigorously.

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, management of the Company currently believes that disposition of any such matters will not have a material adverse effect on the Company’s consolidated financial statements.

8. 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 FASB did defer the effective date of adoption of SFAS No. 157 for other non-financial assets and liabilities to fiscal years beginning after November 15, 2008. SFAS No. 157 for financial assets and liabilities was effective for the Company on February 3, 2008. The adoption of SFAS No. 157 did not have an impact on the Company’s operating results or financial position.

 

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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 elect 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. SFAS No. 159 was effective for the Company on February 3, 2008. The adoption of SFAS No. 159 did not have an impact on the Company’s operating results and financial position.

In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFAS 141(R)”). SFAS 141(R) will significantly change the accounting for business combinations. Under SFAS 141(R), an acquiring entity will be required to recognize all the assets acquired and liabilities assumed in a transaction at the acquisition date fair value with limited exceptions. SFAS 141(R) will change the accounting treatment for certain specific acquisition-related items, including expensing acquisition-related costs as incurred, valuing noncontrolling interests (minority interests) at fair value at the acquisition date, and expensing restructuring costs associated with an acquired business. SFAS 141(R) applies prospectively to business combinations for which the acquisition date is on or after the first fiscal period beginning on or after December 15, 2008, except for adjustments to a previously acquired entity’s deferred tax assets and uncertain tax position balances occurring outside the measurement period, which are recorded as a component of income tax expense in the period of adjustment, rather than goodwill. Early adoption is not permitted. Generally, the effect of SFAS 141(R) will depend on future acquisitions and, as such, we do not currently expect the adoption of this Statement to have a material impact on the Company’s operating results or financial position.

In March 2008, the FASB issued SFAS No. 161, “Disclosures About Derivative Instruments and Hedging Activities” (“SFAS No. 161”). SFAS 161 enhances disclosures for derivative instruments and hedging activities, including: (i) the manner in which a company uses derivative instruments; (ii) the manner in which derivative instruments and related hedged items are accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” and (iii) the effect of derivative instruments and related hedged items on a company’s financial position. SFAS No. 161 is effective for financial statements issued for fiscal years beginning after November 15, 2008 and interim periods within those fiscal years. As SFAS No. 161 relates specifically to disclosures, this standard will have no impact on our operating results or financial position.

9. MERGER AGREEMENT

The Company entered into an Agreement and Plan of Merger, dated November 8, 2007, with Home Holdings, LLC, a Delaware limited liability company (“Parent”), and Home Merger Sub, Inc., a Delaware corporation and a wholly owned subsidiary of Parent (“Merger Sub”), as amended by the First Amendment thereto dated January 24, 2008 (collectively, the “Amended Merger Agreement”). Parent and Merger Sub are affiliates of Catterton Partners. Pursuant to the terms of the Amended Merger Agreement, Merger Sub will merge with and into the Company, with the Company as the surviving corporation of the merger (the “Merger”). The purchase price is $4.50 per share in cash. In connection with the Amended Merger Agreement, Catterton Partners provided a $25 million subordinated convertible promissory note to the Company for working capital purposes. The independent committee of the Board of Directors engaged in a solicitation process under the terms of the Amended Merger Agreement pursuant to which it solicited proposals for a competing transaction from third parties. The “go shop” process under the Amended Merger Agreement expired on February 28, 2008, and the independent committee unanimously determined that no party qualified as an “excluded party” under the terms of the Amended Merger Agreement. The special meeting of stockholders of the Company to consider the vote on the proposal to adopt the Amended Merger Agreement is scheduled to be held on June 12, 2008.

The Company expensed approximately $2.1 million in costs during the first quarter of fiscal 2008 in connection with the transaction.

10. RESTATEMENT

As discussed in the Company’s annual report on Form 10-K, for the fiscal year ended February 2, 2008, the Company’s management determined that an estimate related to the calculation of indirect costs capitalized into inventory was not identified and corrected in a timely manner as a result of a material weakness in the Company’s internal controls over financial reporting. The accounts affected were capitalized indirect costs which are included in merchandise inventories and cost of revenue and occupancy. The Company determined that the incorrectly reported amounts identified

 

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were not material individually in any particular quarter, but the Company concluded that such amounts in the aggregate required adjustment to the Company’s previously reported unaudited interim consolidated financial statements for fiscal 2007. The Company has restated its unaudited quarterly financial information for the first three months ended May 5, 2007 in order to accurately reflect the amount of these costs.

The effect of the restatement on the Company’s financial statements for the first three months of fiscal 2007 is presented in the following tables:

 

     As of May 5, 2007  
(Dollars in thousands)    As previously
reported
    As restated  

Merchandise inventories

   $ 215,483     $ 216,250  

Total current assets

     249,581       250,348  

Total assets

     347,148       347,915  

Accumulated deficit

     (101,470 )     (100,703 )

Total stockholders’ equity

     78,827       79,594  

Total liabilities and stockholders’ equity

     347,148       347,915  
     Three Months Ended May 5, 2007  
(Dollars in thousands, except per share amounts)    As previously
reported
    As restated  

Cost of revenue and occupancy

   $ 97,638     $ 96,871  

Gross profit

     44,474       45,241  

Loss from operations

     (11,923 )     (11,156 )

Loss before income taxes

     (13,922 )     (13,155 )

Net loss

     (13,758 )     (12,991 )

Net loss per share, basic and diluted

   $ (0.35 )   $ (0.34 )
     Three Months Ended May 5, 2007  
(Dollars in thousands)    As previously
reported
    As restated  

Cash flows from operating activities:

    

Net loss

   $ (13,758 )   $ (12,991 )

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

    

Changes in operating assets and liabilities:

    

Merchandise inventories

     (22,678 )     (23,445 )

 

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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 the following: the impact on the Company of the uncertainty relating to the pending merger with affiliates of Catterton Partners, including potential difficulties in employee retention, disruption in current plans or operations and diversion of management’s attention from ongoing business operations; the likelihood of closing the merger transaction with Catterton Partners or a similar transaction; customer reactions to our current and anticipated merchandising and marketing programs and strategies; timely introduction and customer acceptance of our merchandise; positive customer reaction to our catalog and Internet offerings, revised product mix, prototype stores and core businesses; timely and effective sourcing of our merchandise from our foreign and domestic vendors and delivery of merchandise through our supply chain to our stores and customers; changes in product supply; effective inventory and catalog management; actual achievement of cost savings and improvements to operating efficiencies; effective sales performance; the actual impact of key personnel of the Company on the development and execution of our strategies; changes in investor perceptions of the Company; changes in economic or business conditions in general; fluctuations in sales; limitations resulting from restrictive covenants in our revolving credit facility; consumer responses to our product offerings and changes in consumer trends; loss of key vendors; changes in the competitive environment in which we operate; changes in our management information needs; changes in management; failure to raise additional funds when required; changes in customer needs and expectations; governmental actions; and other factors described below in Part II, Item 1A “Risk Factors.” We undertake no obligation to update any forward-looking statements in order to reflect events or circumstances that may arise after the date of this quarterly report on Form 10-Q.

OVERVIEW

Our Company, Restoration Hardware, Inc. (Nasdaq: RSTO), together with our subsidiaries, is a specialty retailer of high quality bathware, hardware, lighting, furniture, textiles, accessories and gifts that reflect our classic and authentic American point of view. We market our merchandise through retail locations, mail order catalogs and on the Internet at www.restorationhardware.com.

Our merchandise strategy and our stores’ architectural style create a unique and attractive selling environment designed to appeal to an affluent, well-educated, 35 to 60 year old customer. Over the next decade, we believe one of the fastest growing segments in 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 January 31, 2009 (“fiscal 2008”). The prior fiscal year was also 52 weeks and ended on February 2, 2008 (“fiscal 2007”).

As of May 3, 2008, we operated 101 retail stores and ten outlet stores in 30 states, the District of Columbia and in Canada. In addition to our retail and outlet stores, we operate a Direct-to-customer (“direct”) sales channel that includes both catalog and Internet.

 

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

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. 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 2007, we introduced our third category extension, the Restoration Hardware Bed & Bath catalog, reflecting our effort 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. In 2007, we also continued our multi-year program of investing in systems and infrastructure to strengthen our supply chain. We completed a number of projects leading to increased productivity including, the retrofit of our furniture distribution centers in order to improve space utilization and productivity, consolidation of our small package Direct-to-customer fulfillment and installation of a new warehouse management system for our furniture distribution centers.

During the first quarter of fiscal 2008, we opened one outlet store and continued our multi-year program of investing in systems and infrastructure to strengthen our supply chain. We have focused on a number of initiatives, including the following:

 

   

Launch Restoration Hardware Baby & Child in the spring of 2008.

 

   

Continue to develop an integrated, multi-channel order management system in order to provide greater order integrity. We anticipate implementing the new system in the summer of 2008.

 

   

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

 

   

Open our 11th outlet store by the end of the summer of 2008.

We believe our assortment and enhanced operational effectiveness will provide us with a strong foundation for future revenue growth, margin expansion and operational efficiencies.

The macro economic environment in the home furnishings and home building sectors, as well as the weakening consuming spending and traffic levels, continued to challenge our business during the first three months of fiscal 2008. Our financial performance has been affected as a result of the current downtrend in these sectors. We expect continued pressure on our results of operations during such time as these business conditions persist. In response to current market conditions, we have undertaken a variety of cost cutting and other initiatives, including further lowering our catalog costs, reducing headcount and putting new sourcing initiatives in place. Nevertheless, these efforts may not be sufficient to overcome the adverse impact on our financial results caused by the weakness of market conditions. Although we have implemented and expect to continue to implement new brand and catalog initiatives, some of these initiatives may not be successful and some of these initiatives may not be continued or expanded depending upon customer response.

Amended Merger Agreement

Pursuant to the terms of the Amended Merger Agreement, Merger Sub will merge with and into the Company, with the Company as the surviving corporation of the Merger. The independent committee of the Board of Directors engaged in a solicitation process under the terms of the Amended Merger Agreement pursuant to which it solicited proposals for a competing transaction from third parties. The “go shop” process under the Amended Merger Agreement expired on February 28, 2008, and the independent committee unanimously determined that no party qualified as an “excluded party” under the terms of the Amended Merger Agreement. The special meeting of stockholders of the Company to consider the vote on the proposal to adopt the Amended Merger Agreement is scheduled to be held on June 12, 2008.

 

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We expensed approximately $2.1 million in costs during the first quarter of fiscal 2008 in connection with the transaction.

For additional and more detailed information regarding the Amended Merger Agreement, please refer to the definitive proxy statement we filed with the Securities and Exchange Commission on May 9, 2008. Please also refer to the risk factors included in Part II, Item 1A “Risk Factors” of this Form 10-Q under the heading “Risks Relating to the Pending Merger.”

Results of Operations

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

 

     Three Months Ended  
     May 3,
2008
    % of Net
Rev.
    May 5,
2007
(as restated)
    % of Net
Rev.
 
     (Dollars in thousands, except per share data)  

Net revenues

   $ 144,738     100.0 %   $ 142,112     100.0 %

Cost of revenue and occupancy

     104,602     72.3       96,871     68.2  
                            

Gross profit

     40,136     27.7       45,241     31.8  

Selling, general and administrative expense

     57,806     39.9       56,397     39.7  
                            

Loss from operations

     (17,670 )   (12.2 )     (11,156 )   (7.9 )

Interest expense, net

     (1,933 )   (1.3 )     (1,999 )   (1.4 )
                            

Loss before income taxes

     (19,603 )   (13.5 )     (13,155 )   (9.3 )

Income tax (expense) benefit

     (167 )   (0.1 )     164     0.1  
                            

Net loss

   $ (19,770 )   (13.6 )   $ (12,991 )   (9.2 )
                            

Loss per share of common stock—basic and diluted

   $ (0.51 )     $ (0.34 )  
                    

We experienced a loss from operations of $17.7 million in the first three months of fiscal 2008, which was an increase in net loss of $6.5 million, from $11.2 million loss from operations for the first three months of fiscal 2007. $3.3 million of the increased loss was driven by transaction-related fees of $2.1 million and severance costs of $1.2 million. The remaining increase was driven by lower gross profit because of weakening consumer spending and traffic levels. The increase in loss from operations was comprised of an increase of $1.4 million in selling, general and administrative expenses and a decrease of gross profit of $5.1 million. The net loss for the first three months of fiscal 2008 was $19.8 million or $0.51 per share on a diluted net loss per share basis, as compared to $13.0 million net loss for the first three months of fiscal 2007 or $0.34 per share on a diluted net loss per share basis.

Net revenues increased by $2.6 million, or 2%, to $144.7 million for the first three months of fiscal 2008 compared to the first three months of fiscal 2007. Our revenue growth during the first three months of fiscal 2008 was driven by continued growth in our Direct-to-customer business. Our growth in the Direct-to-customer segment was primarily driven by the consolidation of our small package, Direct-to-customer shipments and the associated shift in revenue reporting. Overall revenue growth was impacted by a challenging home furnishings environment and weakness in the home building sector.

Cost of revenue and occupancy expense increased by $7.7 million, or 8%, to $104.6 million, for the first three months of fiscal 2008. Cost of revenue and occupancy expense expressed as a percentage of net revenue increased by 410 basis points to 72.3% in the first three months of fiscal 2008, from 68.2% for the first three months of fiscal 2007. The 410 basis point increase in costs, expressed as a percentage of net revenues, was primarily due to a 280 basis point decrease in product margin as a result of a higher mix of promotional selling during the first three months of fiscal 2008 and an 80 basis point increase in supply chain costs.

Selling, general and administrative expenses increased by $1.4 million, to $57.8 million, for the first three months of fiscal 2008. Expressed as a percentage of net revenue, selling, general, and administrative expense increased to 39.9% for the first three months of fiscal 2008 compared to 39.7% for the first three months of fiscal 2007. The 20 basis point increase in these costs, expressed as a percentage of net revenues, was primarily due to $2.1 million of transaction costs related to the merger with certain affiliates of Catterton Partners and $1.2 million of severance costs related to our headcount reduction during the first quarter of fiscal 2008. Together, these costs drove approximately 230 basis points of selling, general and administrative expense deleverage. These amounts were offset by a decrease in advertising costs resulting from decreased circulation of our catalogs and number of pages circulated. Total catalog circulation and circulated pages decreased by 23% and 10%, respectively, compared to the same period in the prior fiscal year.

 

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Interest expense, net includes interest related to our line of credit, interest on our convertible promissory notes and amortization of debt issuance costs. Interest expense, net decreased from $2.0 million for the first three months of fiscal 2007 to $1.9 million for the first three months of fiscal 2008. This decrease resulted from lower average interest rates.

We recognized $167 thousand of income tax expense in the first three months of fiscal 2008. The tax recorded in the first three months of fiscal 2008 was attributable to taxes related to our wholly-owned Canadian subsidiary and interest on unrecognized tax benefits. This compares to income tax benefit of $164 thousand on a pre-tax loss of $13.2 million, recorded in the first three months of fiscal 2007. This benefit was primarily due to a tax adjustment related to our wholly-owned Canadian subsidiary. As of May 3, 2008, the total amount of unrecognized tax benefits was $2.5 million. In addition, we have recorded $0.6 million of related interest.

Segment Results

Beginning in the second quarter of fiscal 2007, we consolidated all small package, Direct-to-customer shipments into one distribution center. Previously, these shipments were fulfilled through three facilities: one Direct-to-customer distribution center and two retail replenishment distribution centers. As part of the consolidation of small package Direct-to-customer fulfillment into the Direct-to-customer distribution center, certain revenues that had been recorded in the retail segment are now being recorded in the Direct-to-customer segment beginning in the second quarter of 2007. The shift in revenue reporting represented approximately 18 percentage points of the 30% decrease in Stores segment revenues and 26 percentage points of the 47% increase in Direct-to-customer segment revenues for the three months ended May 3, 2008 as compared to the three months ended May 5, 2007.

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

We classify our business into two reportable segments:

 

   

Stores—the Stores segment includes retail stores, outlet stores and warehouse sale events.

 

   

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

No adjustment to prior period segment revenues were required as revenues for all periods presented are based on the origin of distribution center fulfillment. We have restated previously reported comparable periods’ segment income (loss) from operations to reflect the changes in allocations of certain cost of revenues and selling, general and administrative expenses.

Stores Segment Results

 

     Three Months Ended  
(Dollars in thousands)    May 3, 2008     May 5, 2007  

Stores net revenue

   $ 58,742     $ 83,524  

Stores net revenue growth percentage

     (30 )%     (8 )%

Income (Loss) from Stores operations

   $ (3,611 )   $ 5,337  

Income (Loss) from Stores operations-percent of Stores net revenue

     (6.2 )%     6.4 %

Number of stores at beginning of period

     102       103  

Number of stores opened

     —         —    

Number of stores closed

     (1 )     —    
                

Number of stores at year-end

     101       103  
                

Store selling square feet at end of period

     675,191       688,710  

Number of outlet stores at end of period

     10       8  

 

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The income from store operations for the three months ended May 5, 2007 have been adjusted to reflect a change in the allocation of revenues and expenses between segments implemented beginning with the second quarter of fiscal 2007. See Note 6, “Segment Reporting,” of the Condensed Consolidated Financial Statements for further description of this segment reporting change.

Stores net revenue for the first three months of fiscal 2008 decreased by $24.8 million, or 30%, as compared to the first three months of fiscal 2007. Our Stores segment net revenue decline was affected by a shift in revenue reporting from the Stores to the Direct-to-customer segment due to the consolidation of small package direct-to-customer shipments and changes in our assortment and marketing strategies. The challenging home furnishings and home building environment also contributed to the decline in revenue in the Stores segment.

The shift in revenue related to the consolidation of small package direct-to-customer shipments represented approximately 18 percentage points of the 30% decrease in Stores segment revenues for the three months ended May 3, 2008 as compared to the three months ended May 5, 2007.

Our Stores segment experienced a decline in its operating results, decreasing to a loss from operations of $3.6 million, or -6.2% of Stores net revenue, during the first three months of fiscal 2008 compared to income from operations of $5.3 million, or 6.4% of Stores net revenue, in the same period of the prior fiscal year. This decline, representing a 1,260 basis point decrease in the Stores segment operating results for the first three months of fiscal 2008, resulted from a 760 basis point decrease in gross margin and a 500 basis point increase in selling, general and administrative expenses. The 760 basis point decrease in gross margin was primarily due to a 490 basis point of deleverage in store occupancy costs and a 330 basis point decline in product margin due to a higher mix of promotional selling and an increased penetration of outlet business because of the shift of revenue to our Direct-to-customer segment. The 500 basis point increase in selling, general and administrative expenses was primarily due to the increase in store employment and store utility costs as a percentage of Stores net revenue which were driven by lower sales and the shift in reporting of sales from Stores to Direct-to-customer.

Direct-to-Customer Segment Results

 

     Three Months Ended  
(Dollars in thousands)    May 3, 2008     May 5, 2007  

Direct-to-customer net revenue

   $ 85,996     $ 58,588  

Direct-to-customer net revenue growth percentage

     47 %     38 %

Income from Direct-to-customer operations

   $ 20,211     $ 12,028  

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

     23.5 %     20.5 %

Growth percentages:

    

Number of catalog books mailed

     (23 )%     41 %

Number of pages circulated

     (10 )%     42 %

The income from Direct-to-customer operations for the three months ended May 5, 2007 have been adjusted to reflect a change in the allocation of revenues and expenses between segments implemented beginning with the second quarter of fiscal 2007. See Note 6, “Segment Reporting,” of the Condensed Consolidated Financial Statements for further description of this segment reporting change.

Direct-to-customer net revenue for the first three months of fiscal 2008 increased $27.4 million, or 47%, as compared to the first three months of fiscal 2007. Direct-to-customer net revenue consists of both catalog and Internet sales. The continued growth in our Direct-to-customer segment resulted from the shift in revenue reporting from the Stores to the Direct-to-customer segment as a result of the consolidation of small package direct-to-customer shipments. The total number of catalogs mailed and pages circulated decreased by 23% and 10%, respectively, from the first three months of fiscal 2007 to the current fiscal quarter in a planned effort to reduce catalog costs and leverage our catalog and the Internet to size our assortment to market potential. At the same time, the growth experienced during the first three months of fiscal 2008 was negatively impacted by the challenging home furnishings and home building environment.

The shift in revenue related to the consolidation of small package direct-to-customer shipments represented approximately 26 percentage points of the 47% increase in Direct-to-customer segment revenues for the three months ended May 3, 2008 as compared to the three months ended May 5, 2007.

 

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Income from operations for our Direct-to-customer segment increased to $20.2 million, or 23.5% of Direct-to-customer net revenue, during the first three months of fiscal 2008 compared to income from operations of $12.0 million, or 20.5% of Direct-to-customer net revenue, in the same quarter of the prior fiscal year. This $8.2 million increase represented a 300 basis point increase in operating income for our Direct-to-customer operating segment expressed as a percentage of Direct-to-customer net revenue. This improvement resulted from a 790 basis point decrease in gross margin, offset by a 1,090 basis point decrease in selling, general and administrative expenses. The 790 basis point decrease in gross margin resulted from the higher mix of promotional selling and higher costs associated with the revenue shifted from the Stores to the Direct-to-customer segment, due to the consolidation of small package direct-to-customer shipments. The 1,090 basis point decrease in selling, general and administrative expenses was primarily due to a decrease in advertising expenses as a percentage of sales.

LIQUIDITY AND CAPITAL RESOURCES

 

     Three Months Ended  
     May 3, 2008     May 5, 2007  
(Dollars in thousands)          (as restated)  

Net cash used by operating activities

   $ (45,646 )   $ (50,437 )

Net cash used by investing activities

     (2,167 )     (3,264 )

Net cash provided by financing activities

     48,705       53,173  

Effects of foreign currency exchange rate translation

     (68 )     263  
                

Net increase (decrease) in cash and cash equivalents

   $ 824     $ (265 )
                

Operating Cash Flows

For the first three months of fiscal 2008, net cash used by operating activities was $45.6 million compared to net cash used by operating activities of $50.4 million in the first three months of fiscal 2007. The decrease in net cash used by operating activities of $4.8 million was a result of a decrease in use of cash by operating activities related to accounts payable and accrued expenses of $17.7 million and prepaid expense and other current assets of $5.6 million. These amounts were offset by an increase in net cash used by operating activities related to net loss of $6.8 million, merchandise inventories of $6.9 million and deferred revenue and customer deposits of $4.4 million.

Investing Cash Flows

Net cash used by investing activities declined to $2.2 million for the first three months of fiscal 2008 from $3.3 million for the first three months of fiscal 2007. The change is related to a reduction in capital expenditures incurred during the respective periods.

Financing Cash Flows

Net cash provided by financing activities decreased from $53.2 million in the first three months of fiscal 2007 to $48.7 million in the first three months of fiscal 2008. This decrease primarily resulted from a $4.0 million decrease in net borrowings received under our revolving credit facility and a $0.3 million increase in payments on capital leases during the first three months of fiscal 2008 compared to the first three months of fiscal 2007.

Revolving Credit Facility

As of May 3, 2008, $127.7 million was outstanding under the facility, net of unamortized debt issuance costs of $0.8 million, and there was $9.6 million in outstanding letters of credit. As of May 3, 2008, the bank’s reference rate was 5.00% and the LIBOR plus margin rate was 3.72%. Borrowings that are incremental advances under the revolving credit facility are subject to interest at the bank’s reference rate plus a margin or LIBOR plus a higher margin. The availability of credit at any given time under the revolving credit facility is limited by reference to a borrowing base formula (which includes an adjustment to the advance rate against eligible inventory and eligible accounts receivables for incremental advances as described above) based upon numerous factors, including the value of eligible inventory and eligible accounts receivable, and reserves established by the agent of the revolving credit facility. As a result of the borrowing base formula, the actual borrowing availability under the facility could be less than the stated amount of the facility reduced by the actual borrowings and outstanding letters of credit. As of May 3, 2008, availability under the facility was $35.0 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 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.

Convertible Promissory Notes

On January 24, 2008, we entered into a First Amendment to the Agreement and Plan of Merger (“First Amendment”), dated as of November 8, 2007 with affiliates of Catterton Partners. In connection with the First Amendment, we received $25.0 million from funds of Catterton Partners in exchange for the issuance of unsecured promissory notes in the principal amount of $25.0 million. Concurrently with the issuance of the unsecured promissory notes, we entered into (i) a letter agreement with Catterton Management Company, LLC with respect to the payment of an arrangement fee of $0.6 million for the extension of credit and (ii) letter agreements providing that the Notes shall be exchanged for an equity interest in Parent upon the closing of the merger contemplated in the Merger Agreement.

The promissory notes have an interest rate of 8% per annum through December 31, 2008 and 15% per annum beginning January 1, 2009 through maturity. The maturity date of the arrangement fee is July 2008 and the maturity date of the notes is December 2012. The notes may be exchanged for common equity securities upon a change of control resulting in an acquisition of the Company by affiliates of Catterton Partners. If there is a change of control with any party other than the affiliates of Catterton Partners, the notes are due and payable immediately at 100% of the principal amount plus all interest accrued. As of May 3, 2008, the convertible promissory notes balance was $25.0 million, net of unamortized debt issuance costs of $0.6 million.

We currently believe that our cash flows from operations and funds available under our revolving credit facility and the convertible promissory notes will satisfy our expected working capital and capital requirements for the foreseeable future. However, the weakening of, or other adverse developments concerning, our sales performance or adverse developments concerning the availability of credit under our revolving credit facility due to covenant limitations or other factors could limit the overall availability of funds to us. We may not have successfully anticipated our future capital needs or the timing of such needs and we may need to raise additional funds in order to complete planned improvements or other operations. For example, we plan to open a new leased distribution facility in the summer of 2008 in West Jefferson, Ohio. However, there may be unforeseen construction, scheduling, engineering, environmental, cost or other problems with the construction of the new facility, which could require additional capital from us that we have not currently anticipated. If we fail to raise sufficient funds, we may be required to delay or abandon some of our planned future expenditures or aspects of our current operations.

We also may need to raise additional funds to respond to changing business conditions or unanticipated competitive pressures. However, should the need arise, additional sources of financing may not be available or, if available, may not be on terms favorable to our stockholders or us. If we fail to raise sufficient funds, we may 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,” 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.”

 

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 2, 2008, have not changed materially for the three months ended May 3, 2008.

 

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Item 4. Controls and Procedures.

Disclosure Controls and Procedures

As of May 3, 2008, 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 and the material weakness described below, our CEO and CFO concluded that our disclosure controls and procedures were not effective as of May 3, 2008.

As of May 3, 2008, management concluded that we did not maintain effective disclosure controls and procedures over financial reporting primarily because we identified a material weakness in the operation of controls for monitoring and oversight over the preparation of a significant accounting estimate. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis.

As a result of the material weakness, an estimate related to the calculation of indirect costs capitalized into inventory was not identified and corrected in a timely manner. Specifically, we did not have strong monitoring and review procedures over the review of the assumptions and calculations related to indirect costs capitalized and recorded as part of the inventory balance on a quarterly basis to determine whether the methodology should be updated to reflect current business activity. The accounts affected were capitalized indirect costs which are included in merchandise inventories and cost of revenue and occupancy. As a result of this material weakness, we incorrectly reported the amount of indirect costs capitalized into inventory for the first three quarters of fiscal year 2007.

We believe that the incorrectly reported amounts identified were not material individually in any particular quarter, but we concluded that such amounts in the aggregate required adjustment to the Company’s unaudited quarterly financial statements for fiscal year 2007. Accordingly, we have restated our quarterly 2007 financial results in this Form 10-Q in order to accurately reflect the amount of these costs.

Changes in Internal Control over Financial Reporting

During the first quarter of fiscal 2008, we implemented changes to enhance our controls relating to the calculations of indirect costs capitalized into inventory to reduce the likelihood that a misstatement of our financial statements that is more than inconsequential could occur. Specifically, we enhanced controls and procedures to review the estimate of capitalization of indirect costs into inventory, we enhanced controls over the review of complex accounts to ensure that assumptions remain compliant with existing guidance and current business process and that calculations and related underlying data are based on approved assumptions, and we enhanced additional controls over the review of our significant accounting procedures.

Except as described above, there has been no change in our internal control over financial reporting that occurred during the three months ended May 3, 2008 that has materially affected or is reasonable likely to materially affect our internal control over financial reporting.

Despite the existence of the material weakness, management believes that the financial statements included in this report fairly present, in all material respects, our financial position, results of operations and cash flows for the periods presented.

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings.

Two stockholder complaints have been filed as purported class actions on behalf of the public stockholders of the Company. The first was filed on November 28, 2007 by Richard Hattan against the Company, each of the Company’s directors, Catterton Partners, Glenhill Capital LP, Vardon Capital Management LLC, Palo Alto Investors LLC and Reservoir Capital Management LLC in Superior Court of the State of California, County of Marin, Case No. CV 075563. Plaintiff amended his complaint on March 7, 2008. The plaintiff alleges that he is an owner of the Company’s common stock. The amended complaint alleges, among other things, that the Company’s directors breached their fiduciary duties in connection with the proposed Merger by pursuing a process for the sale of the Company that was not reasonably likely to maximize stockholder value. In particular, the amended complaint alleges that the directors did not deal appropriately with Sears. The amended complaint also alleges that the Company’s disclosures with respect to the transaction were inadequate or incomplete, rendering the disclosures materially misleading. The amended complaint alleges that the remaining

 

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defendants aided and abetted the alleged breaches of fiduciary duties. The complaint seeks, among other things, to enjoin the Company, its directors and the other defendants from proceeding with or consummating the Merger and an injunction changing or supplementing the disclosures made by the Company. The absence of an injunction prohibiting the consummation of the Merger is a condition to the closing of the Merger. Discovery has been proceeding in the case. On May 21, 2008, the plaintiff filed a motion seeking a preliminary injunction to delay the vote and prohibit the closing of the Merger. The motion is expected to be heard on June 11, 2008.

The second stockholder complaint was filed on March 26, 2008 by Randall Reimer against the Company, each of the Company’s directors, Parent, Merger Sub, and Catterton Partners in the Court of Chancery of the State of Delaware. The plaintiff amended his complaint on May 6, 2008. The plaintiff alleges that he is an owner of the Company’s common stock. The amended complaint alleges essentially the same claims as the amended complaint in Hattan v. Restoration Hardware, including the alleged failure to pursue a process reasonably likely to maximize shareholder value and allegedly misleading omissions in the Company’s disclosures regarding the Merger. Similar to the Hattan complaint, the Reimer complaint alleges that the directors have therefore breached their fiduciary duties and that the remaining defendants have aided and abetted the alleged breaches. The complaint seeks essentially the same remedies as the suit in California, including an injunction to prevent the Merger or rescission of the Merger, if it is consummated. The absence of an injunction prohibiting the consummation of the Merger is a condition to the closing of the Merger. The defendants have moved to stay this proceeding in light of the lawsuit in California. Both complaints are publicly available.

Based on the facts known to date, we believe that the claims asserted by the plaintiffs in both actions are without merit and intend to defend this suit vigorously.

We also are involved from time to time in other legal proceedings, including litigation arising in the ordinary course of our business. At the present time, we do not believe that any of these other legal proceedings will have a material adverse effect on our business, financial condition or results of operations. However, we cannot assure you that the results of any proceeding will be in our favor. Moreover, due to the uncertainties inherent in any legal proceeding, we cannot accurately predict the ultimate outcome of any proceeding and may incur substantial costs to defend the proceeding, irrespective of the merits. An unfavorable outcome of any legal proceeding could have an adverse impact on our business, financial condition, and results of operations.

 

Item 1A. Risk Factors.

In addition to the other information in this Quarterly Report on Form 10-Q, the factors and risks listed below, among others, could affect our future performance and should be carefully considered in evaluating our outlook.

Risks Relating to the Pending Merger

The merger process could adversely affect our business.

We have entered into the Amended Merger Agreement with Catterton Partners which provides that all of our outstanding shares of common stock, other than those exchanged by certain participating stockholders, will be acquired for a price per share equal to $4.50 in cash. The process relating to the Merger could cause disruptions in our business, which could have an adverse effect on our financial results. Among other things, uncertainty as to whether a transaction will be completed with Catterton Partners may affect our ability to recruit prospective employees or to retain and motivate existing employees. We believe we have already lost some employees due to this circumstance and our success will depend on our ability to replace such employees. Similarly, Sears previously indicated in public filings that it may be interested in acquiring the Company, but did not vigorously pursue a transaction in negotiations with the independent committee of the Company’s board of directors or through a separate “qualified tender offer” as defined in the confidentiality agreement entered into between Sears and the Company. The independent committee determined that Sears’ last proposal, delivered on February 28, 2008, was not a “superior proposal” under the terms of the Amended Merger Agreement. Uncertainty as to the Company’s future could adversely affect our business, our relationship with creditors and our relationship with vendors. Further, the attention of management will be directed at least in part toward the completion of a transaction and thus diverted in part from day-to-day operations.

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

There is no assurance that the Merger pursuant to the Amended Merger Agreement with Catterton Partners will occur by the June 30, 2008 deadline set forth in the Amended Merger Agreement or that any other transaction will occur. For example, an injunction could be granted in either of the two pending stockholder lawsuits against the Company (as described elsewhere in this Form 10-Q) preventing the proposed Merger from closing, or the requisite number of holders of our common stock may not approve of the proposed Merger at the special meeting of our stockholders. In addition, even if all of the conditions to closing the Merger are met, the terms of the Amended Merger Agreement permit

 

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Catterton Partners to elect in its discretion not to proceed with the transaction for any reason, including actions of third parties such as Sears or actions of the participants in the Merger who have agreed to rollover their shares or make an investment in the Company in connection with the Merger. Similarly, although the lenders under our credit facility have consented to the terms of the proposed Merger and the transaction with Catterton Partners is not subject to any condition that Catterton Partners obtain financing for the transaction, Catterton Partners could elect in its discretion not to proceed with the transaction if the lenders under the credit facility determined for any reason to take adverse actions with respect to our credit facility, such as reducing the amount available under the facility. In the event Catterton Partners does not elect to close the transaction solely at its option when the other conditions to closing have been fulfilled, Catterton Partners would be required to pay us a reverse break-up fee in the amount of $10,680,000 and reimburse us for certain of our other costs, but our recourse against Catterton Partners for its failure to move forward with the transaction would otherwise be limited.

If the proposed Merger or similar transaction is not completed, the share price of our common stock will likely fall to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. The Company is limited in its ability to require the closure of the Merger by the terms of the Amended Merger Agreement and the Amended Merger Agreement further limits the damages that the buyer must pay in case of a breach. In addition, under circumstances defined in the Amended Merger Agreement, we may be required to pay a termination fee of up to $7,103,000 and reimburse reasonable out-of-pocket fees and expenses incurred with respect to the transactions contemplated by the Amended Merger Agreement if the Amended Merger Agreement is terminated. Further, a failed transaction may result in negative publicity and/or a negative impression of us in the investment community and may affect our relationship with employees, vendors, creditors and other partners in the business community.

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

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

We are subject to litigation related to the pending merger.

We are actively defending two stockholder lawsuits filed in California and Delaware related to the Amended Merger Agreement. In the California action, the plaintiff alleges, among other things, that the Company’s directors breached their fiduciary duties in connection with the proposed Merger by pursuing a process for the sale of the Company that was not reasonably likely to maximize stockholder value. In particular, the complaint alleges that the directors did not deal appropriately with Sears. The complaint also alleges that the Company’s disclosures with respect to the transaction were inadequate or incomplete, rendering the disclosures materially misleading. The complaint seeks, among other things, to enjoin the Company, its directors and the other defendants from proceeding with or consummating the Merger and an injunction changing or supplementing the disclosures made by the Company. Discovery has been proceeding in the case. On May 21, 2008, the plaintiff filed a motion seeking a preliminary injunction to delay the vote and prohibit the closing of the Merger. The motion is expected to be heard on June 11, 2008. The absence of an injunction prohibiting the consummation of the Merger is a condition to the closing of the Merger. In the Delaware action, the complaint was filed against the Company, each of the Company’s directors, Parent, Merger Sub, and Catterton Partners. The Delaware complaint alleges essentially the same claims and seeks the same remedies as the California action, including an injunction to prevent the Merger or rescission of the Merger, if it is consummated.

While the Company believes that the claims made in this litigation are without merit and intends to defend such claims vigorously, there can be no assurance that the Company will prevail in its defense. Further, it is possible that additional claims beyond those that have already been filed will be brought by the current plaintiffs or by others in an effort to enjoin the proposed Merger or seek monetary relief from the Company. An unfavorable resolution of any such litigation surrounding the proposed Merger could delay or prevent the consummation of the proposed Merger. In addition, the cost to the Company of defending the litigation, even if resolved in the Company’s favor, could be substantial. Such litigation could also substantially divert the attention of the Company’s management and the Company’s resources in general.

 

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Risks Relating to the Company and its Business

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

The success of our business depends to a significant extent upon the level of consumer spending, particularly in the home furnishings sector which in turn is highly dependent on the housing sector. A number of economic conditions affect the level of consumer spending on merchandise that we offer, including, among other things, the general state of the economy, the macro climate for the retail home furnishings sector, general business conditions, the level of consumer debt, interest rates, rising oil prices, taxation, housing prices, new construction and other activity in the housing sector and consumer confidence in future economic conditions. Both the retail sector and the housing sector of the economy have been performing poorly in recent quarters and into the spring of 2008. In particular, the recent reduction in the availability of credit and the recent activity in the housing sector, including the slowing housing turnover, the slowing home-price appreciation, and the depreciation of home prices in some areas, may continue to limit consumers’ discretionary spending or affect their confidence level and lead to continued reduced spending on home furnishings or home improvement projects. These factors have had, and may continue to have, an adverse impact on our business and results, and these factors may make it difficult for us to accurately predict our operating and financial results for future periods.

More generally, reduced consumer confidence and spending may result in a continued reduction in demand for discretionary items and luxury retail products, such as our products. Reduced consumer confidence and spending also may result in limitations on our ability to increase or sustain prices and may require increased levels of selling and promotional expenses. Adverse economic conditions and any related decrease in consumer demand for discretionary items such as those offered by us could have a material adverse effect on our business, results of operations and financial condition. In addition, as a result of any such adverse economic conditions, we may be required to launch additional cost-cutting initiatives to reduce operating costs, and these initiatives may not be successful in reducing costs significantly or may impair our ability to operate effectively.

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

Our success depends on consumer responses to our product offerings and our ability to anticipate and respond to changing merchandise trends and consumer demands in a timely manner. We have recently introduced a number of new products through new brand initiatives including Brocade Home as well as our Restoration Hardware Outdoor Catalog, our Restoration Hardware Gift Catalog and our Restoration Hardware Bed & Bath Catalog and we recently announced plans to introduce Restoration Hardware Baby & Child. We also recently introduced Restoration Hardware Trade. There can be no assurance that any of these new brands or divisions will grow or be successful or achieve the results we expect. We also may not be successful in integrating these new brands and divisions into our existing operations. In addition, if consumers do not respond to our product offerings or we misjudge market trends, we may significantly overstock unpopular products and be forced to take significant inventory markdowns, which would have a negative impact on our operating results. Conversely, shortages of popular items could result in loss of potential sales revenue and have a material adverse effect on our operating results.

We believe there is a lifestyle trend toward increased interest in home renovation and interior decorating, and we further believe we are benefiting from such a trend. If this trend fails to continue to directly benefit us or if there is an overall decline in the trend, we could experience an adverse decline in consumer interest in our major product lines. Moreover, our products must appeal to a broad range of consumers whose preferences cannot always be predicted with certainty and may change between sales seasons. If we misjudge either the market for our merchandise or our customers’ purchasing habits, we may experience a material decline in sales or be required to sell inventory at reduced margins. We could also suffer a loss of customer goodwill if we do not maintain a high level of quality control and service procedures or if we otherwise fail to ensure satisfactory quality of our products. These outcomes may have a material adverse effect on our business, operating results and financial condition.

 

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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 or close or curtail underperforming brands or divisions. 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 3, 2008 we did not reserve for any store closures.

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

Our product mix is increasingly dependent upon the efficiency of our supply chain infrastructure and order acceptance and fulfillment processes. Our in store customer sales have recently consisted of higher percentages of merchandise that must be shipped to the customer or is custom ordered as we have refined our product offerings. Such transactions put additional pressure on our order acceptance and fulfillment processes. An important part of our efforts to achieve efficiencies, cost reductions and sales growth is the identification and implementation of improvements to our planning, logistical and distribution infrastructure and our supply chain, including merchandise ordering, transportation and receipt processing. We will continue to make investments in improvements to this part of our business. Our success in implementing these initiatives may affect our financial performance both in the short term and the longer term. We may experience cost overruns in implementing our investment initiatives or operational disruptions that result from changes in our systems, facilities or processes. If we are not successful in our efforts to improve our planning and supply chain processes in order to take full advantage of supply chain opportunities, we may experience a material adverse effect on our operating results through, among other things, loss of customer sales or increases in our costs.

Significant deviations from projected demand for products in our inventory during a selling season could have a material adverse effect on our financial condition and results of operations.

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

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

Further, the seasonal nature of the specialty home products business requires us to carry a significant amount of inventory prior to peak selling season. The general pattern associated with the retail industry is one of peak sales and earnings during the holiday season. Our business also includes product offerings that are of a seasonal nature such as our outdoor products which are highly dependent upon the outdoor selling season. In anticipation of increased sales activity for seasonal goods including holiday sales during the fourth quarter, we incur significant additional expenses both prior to and during the seasonal selling period. As a result, we accumulate inventory in advance of the seasonal selling period and are vulnerable to demand and pricing shifts and to misjudgments in the selection and timing of merchandise purchases. If we do not accurately predict our customers’ preferences and market and other trends, our inventory levels will not be appropriate and our business and operating results may be negatively impacted.

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

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

 

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

Over the past several fiscal years, we have substantially increased the amount that we spend on catalog and other marketing costs, and we expect to continue to invest at these increased levels in the current fiscal year and in the future. As a result, if we misjudge the directions or trends in our market, we may expend large amounts of cash that generate little return on investment, which would have a negative effect on our operating results.

Our quarterly results fluctuate due to a variety of factors and are not a meaningful indicator of future performance.

Our quarterly results have fluctuated in the past and may fluctuate significantly in the future, depending upon a variety of factors, including, among other things, the mix of products sold, the timing and level of markdowns, promotional events, store openings, closings, the weather, remodelings or relocations, shifts in the timing of holidays, timing of catalog releases or sales, timing of delivery of orders, competitive factors and general economic conditions. Accordingly, our profits or losses may fluctuate. Moreover, in response to competitive pressures, we may take certain pricing or marketing actions that could have a material adverse effect on our business, financial condition and results of operations. Therefore, we believe that period-to-period comparisons of our operating results are not necessarily meaningful and cannot be relied upon as indicators of future performance. If our operating results in any future period fall below the expectations of securities analysts or investors, or if our operating results do not meet the guidance that we issue from time to time, the market price of our shares of common stock would likely decline.

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

We make merchandise purchases from hundreds of vendors. Our performance depends on our ability to purchase our merchandise in sufficient quantities at competitive prices. Our smaller vendors generally have limited resources, production capacities and operating histories, and some of our vendors have limited the distribution of their merchandise in the past. We have no long-term purchase contracts or other contractual assurances of continued supply, pricing or access to new products, and any vendor or distributor could discontinue selling to us at any time. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future, or be able to develop relationships with new vendors to expand our offerings or replace discontinued vendors. Our inability to acquire suitable merchandise in the future or the loss of one or more key vendors and our failure to replace any one or more of them may have a material adverse effect on our business, results of operations and financial condition.

In addition, a single vendor supports our point-of-sale, merchandise management and warehouse management systems. We also rely on the same vendor for software support. A failure by this vendor to adequately support our management information systems in the future could have a material adverse effect on our business, results of operations and financial condition.

We routinely purchase products from new vendors, many of whom are located abroad. We cannot assure you that they will be reliable sources of our products. Moreover, a number of these manufacturers and suppliers are small and undercapitalized firms that produce limited numbers of items. Given their limited resources, these firms might be susceptible to production difficulties, quality control issues and problems in delivering agreedupon 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, recent weaknesses in the dollar may have an impact on the cost of merchandise that we source from abroad, such as by increasing our suppliers’ cost of business and ultimately our cost of goods sold and our selling, general and administrative expenses.

Further, 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.

 

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

Our business depends upon the successful operation of our distribution and order acceptance and fulfillment services. The distribution functions for our stores as well as all of our furniture orders are currently handled from our facilities in Hayward and Tracy, California and Baltimore, Maryland. Operational difficulties such as a significant interruption in the operation of any of these facilities may delay shipment of merchandise to our stores and our customers, damage our reputation or otherwise have a material adverse effect on our financial condition and results of operations. These interruptions could result from disruptions or delays in our telecommunications systems, the Internet or at our distribution centers that are caused by telephone or power outages, computer viruses, security breaches, natural disasters, adverse weather conditions or union organizing activity. Moreover, a failure to successfully coordinate the operations of these facilities could also have a material adverse effect on our financial condition and results of operations. Separately, significant disruptions to the operations of the third party vendor who handles, among other things, the distribution and fulfillment functions for our direct-to-customer business on an outsourced basis could be expected to have similar negative consequences.

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

Labor activities could cause labor relations difficulties for us.

As of May 3, 2008, we had approximately 3,500 full and part-time employees, and while we believe our relations with our employees are generally good, we cannot predict the effect that any future organizational activities will have on our business and operations. If we were to become subject to work stoppages, we could experience disruption in our operations and increases in our labor costs, either of which could materially adversely affect our business, financial condition or results of operations.

We are dependent on external funding sources, including the terms of our revolving credit facility, which may not make available to us sufficient funds when we need them.

We have significantly relied and may rely in the future on external funding sources to finance our operations and growth. Any reduction in cash flow from operations could increase our external funding requirements to levels above those currently available to us. We currently have in place a $190.0 million revolving credit facility (which may be increased by up to an additional $75 million, but such increase is subject to a number of terms and conditions, including agreement of lenders to participate in the increased loan commitments under the facility and the availability of sufficient borrowing base collateral to support increased loan amounts), and we received a $25.0 million loan from certain funds of Catterton Partners in connection with the amendment to the original merger agreement entered into on January 24, 2008.

However, the credit facility involves three separate lenders and therefore is dependent on their continued advancement of funds to the Company. Various factors may impact these lenders’ continued willingness to provide funds to the Company, including (i) their financial strength and ability to perform under the facility, particularly in light of the currently tight lending conditions in the U.S., (ii) the Company’s continuing compliance with the terms of the facility, and (iii) the amount of availability under the facility, which depends on whether (a) 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 (the terms of which provide for valuation appraisals from time to time which may affect the amount of eligible collateral including inventory) and (b) we are 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.

 

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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 the foreseeable future. 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. We do not currently meet such minimum fixed charge coverage ratio.

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 3, 2008 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, but such increase is subject to a number of terms and conditions, including agreement of lenders to participate in the increased loan commitments under the facility and the availability of sufficient borrowing base collateral to support increased loan amounts). Over the past several years, we have entered into modifications, amendments and restatements of this revolving credit facility, primarily to address changes in the requirements applicable to us under the revolving credit facility documents.

Covenants in the revolving credit facility include, among others, ones that limit our ability to incur additional debt, make liens, make investments, consolidate, merge or acquire other businesses, sell assets, pay dividends or other distributions, and enter into transactions with affiliates. In addition, the incremental advance portion of our revolving credit facility includes a fixed charge coverage ratio covenant that is expected to limit our ability to access incremental advances during certain months of the year. Although we have been able to obtain incremental advances when needed to provide the capital required for our business to date, there may be times in the future when the terms and conditions of availability for our line of credit, including the restrictions applicable to the incremental advance provisions, would limit our ability to access working capital as and to the extent we require for the operation of our business, potentially having an adverse affect on our results of operation.

These covenants restrict numerous aspects of our business. The revolving credit facility also includes a borrowing base formula (which includes an adjustment to the advance rate against eligible inventory and eligible accounts receivable for incremental advances as described above) to address the availability of credit at any given time based upon numerous

 

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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 and such value in turn depends on the outcome of valuation appraisals from time to time.

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.

Our business is highly dependent on the purchase of merchandise inventory directly from vendors located abroad. For example, in fiscal 2007, we purchased more than half of our merchandise directly from vendors located abroad. As an importer, our future success will depend in large measure upon our ability to maintain our existing foreign supplier relationships and to develop new ones. While we rely on our long-term relationships with our foreign vendors, we have no long-term contracts with them. Additionally, many of our imported products are subject to existing duties, tariffs and quotas that may limit the quantity of some types of goods which we may import into the United States of America. Our dependence on foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, risks of damage, destruction or confiscation of products while in transit to our distribution centers located in the United States of America, changes in import duties, tariffs and quotas, loss of “most favored nation” trading status by the United States of America in relation to a particular foreign country, work stoppages including without limitation as a result of events such as longshoremen strikes, transportation and other delays in shipments including without limitation as a result of heightened security screening and inspection processes or other port-of-entry limitations or restrictions in the United States of America, freight cost increases, economic uncertainties, including inflation, foreign government regulations, and political unrest and trade restrictions, including the United States of America retaliating against protectionist foreign trade practices. Furthermore, some or all of our foreign vendors’ operations may be adversely affected by political, financial or other instabilities that are particular to their home countries, including without limitation local acts of terrorism or economic, environmental or health and welfare-related crises, which may in turn result in limitations or temporary or permanent halts to their operations, restrictions on the transfer of goods or funds and/or other trade disruptions. If any of these or other factors were to render the conduct of business in particular countries undesirable or impractical, our financial condition and results of operations could be materially adversely affected.

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

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

 

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Fluctuations in foreign currency could have an adverse impact on our business.

We purchase a substantial portion of our inventory from foreign suppliers who source their raw materials in currencies other than the U.S. dollar. We have not historically hedged our currency risk and we do not currently anticipate doing so in the future. Recent weakness in the dollar as well as other factors such as increases in transportation costs may have an impact on the cost of merchandise that we source from abroad, such as by increasing the prices that we must pay to purchase and transport merchandise from our overseas suppliers which may in turn increase our cost of goods sold and our selling, general and administrative expenses. If we are unable to pass such cost increases on to our customers or the higher cost of the products results in decreased consumption, our gross margins, and ultimately earnings, would decrease.

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

Our direct-to-customer business generally continues to grow. For example, in fiscal year 2007, revenue through our direct-to-customer channel grew by 44% as compared to the prior fiscal year. Increased activity in our direct-to-customer business could result in material changes in our operating costs, including increased merchandise inventory costs and costs for paper and postage associated with the distribution and shipping of catalogs and products. Although we intend to attempt to mitigate the impact of these increases by improving sales revenue and efficiencies, we cannot assure you that we will succeed in mitigating expenses with increased efficiency or that cost increases associated with our direct-to-customer business will not have an adverse effect on the profitability of our business. Additionally, while we currently outsource to a third party the fulfillment of our direct-to-customer division, including customer service and non-furniture distribution, the third party may not have the capacity to accommodate our growth. This lack of capacity may result in delayed customer orders and deficiencies in customer service, both of which may adversely affect our reputation, cause us to lose sales revenue and limit or counter recent growth in our direct-to-customer business.

If we lose key personnel or are unable to hire additional qualified personnel, our business may be harmed.

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.

In addition, we have implemented several reductions in force recently as a result of the challenging home furnishings environment. These past reductions in force and any additional reductions in force we undertake may adversely impact employee morale and impair our ability to attract and retain highly qualified personnel. 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.

 

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We face an extremely competitive specialty retail business market.

The retail market is highly competitive. Our specialty retail stores, mail order catalogs and e-commerce websites compete with other retail stores, including large department stores, discount stores, other specialty retailers offering home centered assortments, other mail order catalogs and other e-commerce websites. Our product offerings also compete with a variety of national, regional and local retailers. The substantial sales growth in the direct-to-customer industry within the last decade has encouraged the entry of many new competitors and an increase in competition from established companies. We compete with these and other retailers for customers, suitable retail locations, suppliers, qualified employees and management personnel. Many of our competitors have significantly greater financial, marketing and other resources. Moreover, increased competition may result, and has resulted in the past, in potential or actual litigation between us and our competitors relating to such activities as competitive sales and hiring practices, exclusive relationships with key suppliers and manufacturers and other matters. As a result, increased competition may adversely affect our future financial performance, and we cannot assure you that we will be able to compete successfully in the future.

We believe that our ability to compete successfully is determined by several factors, including, among other things, the breadth and quality of our product selection, effective merchandise presentation, customer service, pricing and store locations. Although we believe that we are able to compete favorably on the basis of these factors, we may not ultimately succeed in competing with other retailers in our market.

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

Threats of terrorist attacks in the United States of America, as well as future events occurring in response to or in connection with them, including, without limitation, future terrorist attacks or threats against United States of America targets, rumors or threats of war, actual conflicts involving the United States of America or its allies, including the on-going U.S. conflicts in Iraq and Afghanistan, further conflicts in the Middle East and in other developing countries, or military or trade disruptions affecting our domestic or foreign suppliers of merchandise, may impact our operations. Our operations also may be affected by natural disasters or other similar events, including floods, hurricanes, earthquakes, or fires. The potential impact of any of these events to our operations includes, among other things, delays or losses in the delivery of merchandise to us or our customers and decreased sales of the products we carry. Additionally, any of these events could cause consumer confidence and spending to decrease or result in increased volatility in the United States of America and worldwide financial markets and economies. Also, any of these events could result in economic recession in the United States of America or abroad. Any of these occurrences could have a significant impact on our operating results, revenue and costs and may result in the volatility of the future market price of our common stock.

Our common stock price may be volatile.

The market price of our common stock has fluctuated significantly in the past, and is likely to continue to be highly volatile. In addition, the trading volume in our common stock has fluctuated, and significant price variations can occur as a result. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future. In addition, the United States of America equity markets have from time to time experienced significant price and volume fluctuations that have particularly affected the market prices for the stocks of companies such as ours. These broad market fluctuations may materially adversely affect the market price of our common stock in the future. Variations in the market price of our common stock may be the result of changes in the trading characteristics that prevail in the market for our common stock, including low trading volumes, trading volume fluctuations and other similar factors that are particularly common among highly volatile securities. Variations also may be the result of changes in our business, operations or prospects, announcements or activities by our competitors, entering into new contractual relationships with key suppliers or manufacturers by us or our competitors, proposed acquisitions by us or our competitors, financial results that fail to meet our guidance or public market analysts’ expectations, changes in stock market analysts’ recommendations regarding us, other retail companies or the retail industry in general, and domestic and international market and economic conditions.

Future sales of our common stock could adversely affect our stock price and our ability to raise funds in new equity offerings.

We cannot predict the effect, if any, that future sales of shares of our common stock or the availability for future sale of shares of our common stock or securities convertible into or exercisable for our common stock will have on the market price of our common stock prevailing from time to time. We have previously raised financing through sales of our securities including sales of our common stock. In connection with our March 2001 preferred stock financing, we filed a registration statement on Form S-3 with the Securities and Exchange Commission to register for resale approximately 6.4 million shares of our common stock issued, or to be issued, upon the conversion of our Series A preferred stock to some of our stockholders. The registration statement was declared effective by the Securities and Exchange Commission on October 31, 2002

 

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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.

Material weakness or deficiencies in our internal control over financial reporting could lead to errors in our financial statements and a lack of investor confidence in us and a resulting decline in our stock price.

Management concluded that as of February 2, 2008, we had not maintained effective internal control over financial reporting because of a material weakness in the operation of controls for monitoring and oversight over the preparation of a significant accounting estimate. A material weakness led us to incorrectly report the amount of indirect costs capitalized into inventory for the first three quarters of fiscal year 2007. As a result, we restated our financial statements for the first three quarters of fiscal 2007. In addition, management has concluded that as May 3, 2008, we had not maintained effective disclosure controls and procedures as a result of the same material weakness in the operation of controls for monitoring and oversight over the preparation of a significant accounting estimate.

Although, as disclosed in Part I, Item 4 in this Quarterly Report on Form 10-Q, we are adopting measures to remediate the material weakness related to the operation of controls for monitoring and oversight over the preparing of a significant estimate, there can be no assurance that our remedial efforts will be effective, nor can there be any assurances that additional material weaknesses will not be identified in the future. We will continue to incur significant expense and management burdens associated with these remediation efforts. Any failure to remedy a material weakness or other deficiency in our internal controls, or any additional errors in our financial reporting, whether or not resulting from a failure to remedy our identified material weakness that resulted in the current restatement, or other identified deficiencies, would have a material adverse effect on our business and results of operations and could have a substantial adverse impact on the trading price of our common stock.

Further, the existence of a material weakness in our internal control over financial reporting or other deficiency could lead third parties to question the reliability and accuracy of our reported financial information. Any such lack of confidence in the financial information that we provide could result in a material adverse effect on our business, results of operations and/or a decline in our stock price.

 

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We are subject to anti-takeover provisions and other terms and conditions that could delay or prevent an acquisition and could adversely affect the price of our common stock.

Our Second Amended and Restated Certificate of Incorporation, as amended, and Amended and Restated Bylaws, certain provisions of Delaware law and the Certificate of Designation governing the rights, preferences and privileges of our preferred stock may make it difficult in some respects to cause a change in control of our Company and replace incumbent management. For example, our Second Amended and Restated Certificate of Incorporation, as amended, and Amended and Restated Bylaws provide for a classified board of directors. With a classified board of directors, at least two annual meetings of stockholders, instead of one, will generally be required to effect a change in the majority of the board. As a result, a provision relating to a classified board may discourage proxy contests for the election of directors or purchases of a substantial block of our common stock because its provisions could operate to prevent obtaining control of the board in a relatively short period of time.

In addition our board of directors has the authority to fix the rights and preferences of, and to issue shares of, our preferred stock, which may have the effect of delaying or preventing a change in control of our Company without action by holders of our common stock. These provisions may create a potentially discouraging effect on, among other things, any third party’s interest in completing a merger, consolidation, acquisition or similar type of transaction with us. Consequently, the existence of these anti-takeover provisions may collectively have a negative impact on the price of our common stock, may discourage third-party bidders from making a bid for our Company or may reduce any premiums paid to our stockholders for their common stock.

We face the risk of inventory shrinkage.

We are subject to the risk of inventory loss and theft, including from both failure to properly track inventory as well as specific instances of fraud or theft. We have experienced these losses in the past, including in recent periods. We cannot assure you that incidences of inventory loss and theft will decrease in the future or that the security measures we have taken in the past will effectively address the problem of inventory theft. If we were to experience higher rates of inventory shrinkage or incur increased security costs to combat inventory theft, our financial condition could be affected adversely.

We must successfully manage our Internet business.

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

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

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

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

 

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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 3, 2008     By:   /s/ GARY G. FRIEDMAN
       

Gary G. Friedman

Chairman, President and Chief 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

  

DOCUMENT DESCRIPTION

31.1    Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
31.2    Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
32.1    Section 1350 Certification of Chief Executive Officer
32.2    Section 1350 Certification of Chief Financial Officer

 

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