WILLIAMS SONOMA INC - Quarter Report: 2009 November (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended November 1, 2009.

or

For the transition period from                      to                     

Commission File Number: 001-14077

WILLIAMS-SONOMA, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (415) 421-7900

(Former name, former address and former fiscal year, if changed since last report)

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   ü   No       

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes        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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

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

As of November 29, 2009, 106,174,005 shares of the registrant’s Common Stock were outstanding.

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WILLIAMS-SONOMA, INC.

REPORT ON FORM 10-Q

FOR THE QUARTER ENDED NOVEMBER 1, 2009

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PART I. FINANCIAL INFORMATION

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ITEM 1. FINANCIAL STATEMENTS

WILLIAMS-SONOMA, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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WILLIAMS-SONOMA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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WILLIAMS-SONOMA, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

See Notes to Condensed Consolidated Financial Statements.

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WILLIAMS-SONOMA, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Thirty-Nine Weeks Ended November 1, 2009 and November 2, 2008

(Unaudited)

NOTE A. FINANCIAL STATEMENTS - BASIS OF PRESENTATION

These financial statements include Williams-Sonoma, Inc. and its wholly owned subsidiaries (“we,” “us” or “our”). The condensed consolidated balance sheets as of November 1, 2009 and November 2, 2008, the condensed consolidated statements of operations for the thirteen and thirty-nine weeks then ended and the condensed consolidated statements of cash flows for the thirty-nine weeks then ended have been prepared by us, without audit. In our opinion, the financial statements include all adjustments (which include only normal recurring adjustments) necessary to present fairly the financial position at the balance sheet dates and the results of operations for the thirteen and thirty-nine weeks then ended. Significant intercompany transactions and accounts have been eliminated. The balance sheet as of February 1, 2009, presented herein, has been derived from our audited balance sheet included in our Annual Report on Form 10-K for the fiscal year ended February 1, 2009.

The results of operations for the thirteen and thirty-nine weeks ended November 1, 2009 are not necessarily indicative of the operating results of the full year.

Certain information and footnote disclosures normally included in the annual financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the fiscal year ended February 1, 2009.

Subsequent events were evaluated through December 11, 2009, the date these condensed consolidated financial statements were issued.

NOTE B. ACCOUNTING POLICIES

Recent Accounting Pronouncements

In June 2009, the Financial Accounting Standards Board (“FASB”) approved the “FASB Accounting Standards Codification,” (“ASC”), as the single source of authoritative US generally accepted accounting principles (“GAAP”) for all non-governmental entities. The ASC changes the referencing and organization of accounting guidance and is effective for periods ending after September 15, 2009. Beginning with the third quarter of fiscal 2009, our financial statements refer to specific ASC US GAAP standards.

On February 2, 2009, we adopted ASC 820 “Fair Value Measurements and Disclosures” (formerly Statement of Financial Accounting Standards (“SFAS”) No. 157, Fair Value Measurements). ASC 820 establishes a standard definition for fair value, provides a framework under GAAP for measuring fair value and expands disclosure requirements for fair value measurements. We do not have significant financial assets and liabilities or nonfinancial assets and liabilities recognized or disclosed at fair value and, as such, the adoption of this ASC did not have a material impact on our consolidated financial position, results of operations or cash flows.

In June 2009, ASC 810-10 Consolidation, (formerly SFAS No. 167, “Amendments to FASB Interpretation No. 46(R))” was issued. This ASC revises the consolidation guidance for variable interest entities and will become effective for us on February 1, 2010. We are currently evaluating the impact this ASC will have on our consolidated financial statements.

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NOTE C. STOCK-BASED COMPENSATION

Equity Award Programs

Our Amended and Restated 2001 Long-Term Incentive Plan (the “Plan”) provides for grants of incentive stock options, nonqualified stock options, stock-settled stock appreciation rights (collectively, “option awards”), restricted stock awards, restricted stock units, deferred stock awards (collectively, “stock awards”) and dividend equivalents up to an aggregate of 15,959,903 shares. Awards may be granted under the Plan to officers, employees and non-employee Board members of the company or any parent or subsidiary. Annual grants are limited to 1,000,000 shares covered by option awards and 400,000 shares covered by stock awards on a per person basis. All grants of option awards made under the Plan have a maximum term of ten years, except incentive stock options that may be issued to 10% shareholders, which have a maximum term of five years. The exercise price of these option awards is not less than 100% of the closing price of our stock on the day prior to the grant date or not less than 110% of such closing price for an incentive stock option granted to a 10% shareholder. Option awards granted to employees generally vest over a period of four to five years. Stock awards granted to employees generally vest over a period of three to five years for service based awards. Certain option and stock awards contain vesting acceleration clauses in the event of a merger or similar corporate event. Option and stock awards granted to non-employee Board members generally vest in one year. Non-employee Board members automatically receive stock awards on the date of their initial election to the Board and annually thereafter on the date of the annual meeting of shareholders (so long as they continue to serve as a non-employee Board member). Shares issued as a result of award exercises will be funded with the issuance of new shares.

Stock-Based Compensation Expense

We account for stock-based compensation arrangements in accordance with ASC 718-10, Stock Compensation (formerly SFAS No. 123R, “Share-Based Payment”), which requires us to measure and record compensation expense in our consolidated financial statements for all employee stock-based awards using a fair value method.

During the thirteen and thirty-nine weeks ended November 1, 2009, we recognized total stock-based compensation expense, as a component of selling, general and administrative expenses, of $5,462,000 and $14,152,000, respectively. During the thirteen and thirty-nine weeks ended November 2, 2008, we recognized a net stock-based compensation benefit of $7,147,000 and a net stock-based compensation expense of $6,031,000, as a component of selling, general and administrative expenses, respectively, both of which included an approximate $11,023,000 reversal of compensation expense related to performance-based stock awards.

Equity Award Exchange Program

In response to the significant decline in our stock price, on June 11, 2008, our shareholders approved an offer for our eligible employees to exchange certain outstanding option awards for restricted stock units. This offer commenced on March 16, 2009 and closed on April 10, 2009, at which time, 2,979,735 outstanding option awards were exchanged for 842,019 restricted stock units. Participants exchanged their eligible option awards for restricted stock units of an approximate equal fair value and, as such, no incremental compensation expense was recognized as a result of the exchange. The remaining unamortized compensation expense associated with the newly issued restricted stock units of approximately $19,199,000 as of April 10, 2009 is being recognized on a straight-line basis over the vesting periods of the awards of approximately 3 years.

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Stock Options

The following table summarizes our stock option activity during the thirty-nine weeks ended November 1, 2009:

¹ As a result of the equity award exchange program, a total of 1,134,620 options were canceled during the first quarter of fiscal 2009 in exchange for the issuance of restricted stock units.

Stock-Settled Stock Appreciation Rights

The following table summarizes our stock-settled stock appreciation rights activity during the thirty-nine weeks ended November 1, 2009:

¹ As a result of the equity award exchange program, a total of 1,845,115 stock-settled stock appreciation rights were canceled during the first quarter of fiscal 2009 in exchange for the issuance of restricted stock units.

Restricted Stock Units

The following table summarizes our restricted stock unit activity during the thirty-nine weeks ended November 1, 2009:

¹ As a result of the equity award exchange program, a total of 842,019 restricted stock units were granted during the first quarter of fiscal 2009.

² A total of 24,771 restricted stock units vested on May 22, 2009, however, the release of the awards was deferred based on election by the holders.

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NOTE D. BORROWING ARRANGEMENTS

Credit Facility

We have a credit facility that provides for a $300,000,000 unsecured revolving line of credit that may be used for loans or letters of credit. Prior to April 4, 2011, we may, upon notice to the lenders, request an increase in the credit facility of up to $200,000,000, to provide for a total of $500,000,000 of unsecured revolving credit. The revolving line of credit facility contains certain financial covenants, including a maximum leverage ratio (funded debt adjusted for lease and rent expense to earnings before interest, income tax, depreciation, amortization and rent expense “EBITDAR”), a minimum fixed charge coverage ratio (calculated as EBITDAR to total fixed charges), and covenants limiting our ability to repurchase shares of stock or increase our dividend, in addition to covenants limiting our ability to dispose of assets, make acquisitions, be acquired (if a default would result from the acquisition), incur indebtedness, grant liens and make investments. The credit facility also contains events of default that include, among others, non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations and warranties, bankruptcy and insolvency events, material judgments, cross defaults to material indebtedness and events constituting a change of control. The occurrence of an event of default will increase the applicable rate of interest by 2.0% and could result in the acceleration of our obligations under the credit facility and an obligation of any or all of our subsidiaries that have guaranteed our credit facility to pay the full amount of our obligations under the credit facility. As of November 1, 2009, we were in compliance with our financial covenants under the credit facility and based on our current projections, expect to be in compliance throughout fiscal 2009. The credit facility matures on October 4, 2011, at which time all outstanding borrowings must be repaid and all outstanding letters of credit must be cash collateralized.

We may elect interest rates calculated at (i) Bank of America’s prime rate (or, if greater, the average rate on overnight federal funds plus one-half of one percent, or a rate based on LIBOR plus one percent) plus a margin based on our leverage ratio, or (ii) LIBOR plus a margin based on our leverage ratio. As of November 1, 2009 and November 2, 2008, no amount was outstanding under the credit facility. However, as of November 1, 2009, $40,291,000 in issued but undrawn standby letters of credit was outstanding under the credit facility. The standby letters of credit were issued to secure the liabilities associated with workers’ compensation, other insurance programs and certain debt transactions.

Letter of Credit Facilities

On September 4, 2009, we renewed four of our unsecured commercial letter of credit reimbursement facilities, each of which matures on September 3, 2010. Due to significant reductions in inventory purchases and an overall reduction in the number of vendors who require the use of our letter of credit facilities, we decreased the aggregate credit available under these facilities from $155,000,000 to $125,000,000. The letter of credit facilities contain covenants and provide for events of default that are consistent with our unsecured revolving line of credit. Interest on unreimbursed amounts under the letter of credit facilities accrues at the lender’s prime rate (or if greater, the average rate on overnight federal funds plus one-half of one percent) plus 2.0%. As of November 1, 2009, an aggregate of $31,784,000 was outstanding under the letter of credit facilities. Such letters of credit represent only a future commitment to fund inventory purchases to which we had not taken legal title as of November 1, 2009. The latest expiration possible for any future letters of credit issued under the facilities is now January 31, 2011.

Long Term Debt

As of November 1, 2009, we had $23,686,000 of long term debt obligations (consisting primarily of our Mississippi industrial development bonds and the bond-related debt associated with our Memphis-based distribution facilities), the majority of which accrue interest based on variable rates. On December 7, 2009, in an effort to reduce interest and other debt related costs and due to our significant cash balances on hand, the remaining outstanding balance on our Mississippi industrial development bonds of $13,150,000 was repaid, without penalty.

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As of November 1, 2009, the carrying value of our long term debt approximates fair value.

NOTE E. COMPREHENSIVE INCOME (LOSS)

Comprehensive income for the thirteen and thirty-nine weeks ended November 1, 2009 and November 2, 2008 was as follows:

NOTE F. EARNINGS (LOSS) PER SHARE

Basic earnings (loss) per share is computed as net earnings (loss) divided by the weighted average number of common shares outstanding for the period. Diluted earnings (loss) per share is computed as net earnings (loss) divided by the weighted average number of common shares outstanding for the period plus common stock equivalents consisting of shares subject to stock-based awards with exercise prices less than or equal to the average market price of our common stock for the period, to the extent their inclusion would be dilutive.

The following is a reconciliation of net earnings (loss) and the number of shares used in the basic and diluted earnings (loss) per share computations:

¹ Due to the net loss recognized for the thirteen weeks ended November 2, 2008 and the thirty-nine weeks ended November 1, 2009, all stock-based awards were excluded from the calculation of diluted earnings (loss) per share as their inclusion would be anti-dilutive.

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Stock-based awards of 2,419,000 and 9,972,000 for the thirteen weeks ended and 10,312,000 and 6,450,000 for the thirty-nine weeks ended November 1, 2009 and November 2, 2008, respectively, were not included in the computation of diluted earnings (loss) per share, as their inclusion would be anti-dilutive.

NOTE G. LEGAL PROCEEDINGS

We are involved in lawsuits, claims and proceedings incident to the ordinary course of our business. These disputes are not currently material. Litigation is inherently unpredictable. Any claims against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. The results of these lawsuits, claims and proceedings cannot be predicted with certainty. However, we believe that the ultimate resolution of these current matters will not have a material adverse effect on our consolidated financial statements taken as a whole.

NOTE H. ASSET IMPAIRMENT AND LEASE TERMINATION CHARGES

We review the carrying value of all long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable. If a long-lived asset is found to be impaired, the amount recognized for impairment is equal to the difference between the net carrying value and the asset’s fair value. Long-lived assets are measured at fair value on a nonrecurring basis using Level 3 inputs as defined in the fair value hierarchy. The fair value is estimated based upon future cash flows (discounted at a rate that is commensurate with the risk and approximates our weighted average cost of capital). In addition, for any store or facility closures where a lease obligation still exists, we record the estimated future liability associated with the rental obligation on the date the store or facility is closed. Most store and facility closures, however, occur upon the lease expiration. Should store profitability and general economic, market or business conditions continue to decline, we may be required to record additional impairment charges and/or lease termination charges.

During the thirteen and thirty-nine weeks ended November 1, 2009, we recorded expense of approximately $12,156,000 and $25,529,000, respectively, associated with asset impairment and early lease termination charges for underperforming retail stores, of which $11,036,000 and $24,250,000, respectively, are recorded within selling, general and administrative expenses, the remainder of which is recorded within cost of goods sold. In addition, during the thirteen and thirty-nine weeks ended November 1, 2009, we incurred charges of approximately $6,245,000 and $7,580,000, respectively, related to the exit of excess distribution capacity, of which $5,665,000 and $5,981,000, respectively, are recorded in selling, general, and administrative expenses and the remainder of which is recorded within cost of goods sold.

During the thirteen and thirty-nine weeks ended November 2, 2008, we recorded expense of approximately $12,280,000 and $14,350,000, respectively, within selling, general and administrative expenses associated with asset impairment charges for underperforming retail stores. During the thirty-nine weeks ended November 2, 2008, we also recorded a benefit of approximately $9,350,000 within selling, general and administrative expenses related to an incentive payment received from a landlord to compensate us for terminating a store lease prior to its expiration.

NOTE I. SEGMENT REPORTING

We have two reportable segments, retail and direct-to-customer. The retail segment has five merchandising concepts which sell products for the home (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Williams-Sonoma Home). The five retail merchandising concepts are operating segments, which have been aggregated into one reportable segment, retail. The direct-to-customer segment has six merchandising concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, PBteen, West Elm and Williams-Sonoma Home) and sells similar products through our seven direct mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids,

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Pottery Barn Bed and Bath, PBteen, West Elm and Williams-Sonoma Home) and six e-commerce websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com, westelm.com and wshome.com). Management’s expectation is that the overall economics of each of our major concepts within each reportable segment will be similar over time.

These reportable segments are strategic business units that offer similar home-centered products. They are managed separately because the business units utilize two distinct distribution and marketing strategies. Our operating segments are aggregated at the channel level for reporting purposes due to the fact that our brands are interdependent for economies of scale and we do not maintain fully allocated income statements at the brand level. As a result, material financial decisions related to the brands are made at the channel level. Furthermore, it is not practicable for us to report revenue by product group.

We use earnings before unallocated corporate overhead, interest and taxes to evaluate segment profitability. Unallocated costs before income taxes include corporate employee-related costs, occupancy expenses (including depreciation expense), administrative costs and third-party service costs, primarily in our corporate systems, corporate facilities and other administrative departments. Unallocated assets include the net book value of corporate facilities and related information systems, deferred income taxes, other corporate long-lived assets and corporate cash and cash equivalents.

Income tax information by segment has not been included as taxes are calculated at a company-wide level and are not allocated to each segment.

Segment Information

¹ Includes net revenues in the retail channel of approximately $19.7 million and $18.0 million for the thirteen weeks ended November 1, 2009 and November 2, 2008, respectively, and $49.9 million and $56.4 million for the thirty-nine weeks ended November 1, 2009 and November 2, 2008, respectively, related to our foreign operations.

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² Includes expenses in the retail channel of approximately $12.2 million and $12.3 million for the thirteen weeks ended November 1, 2009 and November 2, 2008, respectively, and $25.5 million and $14.4 million for the thirty-nine weeks ended November 1, 2009 and November 2, 2008, respectively, related to asset impairment and early lease termination charges for underperforming retail stores.

³ Unallocated costs before income taxes include $6.2 million and $7.6 million for the thirteen and thirty-nine weeks ended November 1, 2009, respectively, related to exiting excess distribution capacity.

⁴ Unallocated costs before income taxes include a benefit of approximately $11.0 million related to the reversal of expense associated with certain performance-based stock awards.

⁵ Includes $29.7 million and $29.4 million of long-term assets as of November 1, 2009 and November 2, 2008, respectively, related to our foreign operations.

⁶ Includes a benefit in the retail channel of approximately $9.4 million related to an incentive payment received from a landlord to compensate us for terminating a store lease prior to its expiration, partially offset by accelerated depreciation of $1.1 million related to the early termination of this lease, as well as a benefit in unallocated costs of $16.0 million related to a gain on the sale of a corporate aircraft.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, as well as assumptions that, if they do not fully materialize or prove incorrect, could cause our business and results of operations to differ materially from those expressed or implied by such forward-looking statements. Such forward-looking statements include: projections of earnings, revenues or financial items, statements regarding the impact of accounting changes; statements regarding our expected effective tax rate; statements of the plans, strategies and objectives of management for future operations; statements related to the future performance of our brands; statements related to macroeconomic and retail trends; statements related to an expected improvement in West Elm’s revenues in the fourth quarter; statements related to assessing the long-term strategy for the Williams-Sonoma Home brand; statements related to the benefits of our transportation, quality returns and inventory management initiatives; statements related to eliminating excess distribution capacity and excess office space; statements related to seeing a revenue decline in fiscal 2009 as compared to fiscal 2008; statements related to opening franchised stores internationally; statements related to future store profitability and fluctuations in comparable store sales; statements related to impairment and lease termination charges; statements related to our initiatives for the remainder of the year and the ability of these initiatives to improve our operating margins over time, continue to strengthen our balance sheet and improve the positioning of our brands; statements related to the adequacy and use of our available cash; statements related to the future payment of a dividend; statements related to compliance with our bank covenants; statements related to our projected capital expenditures; and statements of belief and statements of assumptions underlying any of the foregoing. You can identify these and other forward-looking statements by the use of words such as “may,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “intends,” “potential,” “continue,” or the negative of such terms, or other comparable terminology.

The risks, uncertainties and assumptions referred to above that could cause our results to differ materially from the results expressed or implied by such forward-looking statements include those discussed under the heading “Risk Factors” in this document and the risks, uncertainties and assumptions discussed from time to time in our other public filings and public announcements. All forward-looking statements included in this document are based on information available to us as of the date hereof, and we assume no obligation to update these forward-looking statements.

OVERVIEW

We are a specialty retailer of products for the home. The retail segment of our business sells our products through our five retail store concepts (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, West Elm and Williams-Sonoma Home). The direct-to-customer segment of our business sells similar products through our seven direct-mail

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catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed and Bath, PBteen, West Elm and Williams-Sonoma Home) and six e-commerce websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com, westelm.com and wshome.com). Based on net revenues in fiscal 2008, retail net revenues accounted for 58.4% of our business and direct-to-customer net revenues accounted for 41.6% of our business. Based on their contribution to our net revenues in fiscal 2008, the core brands in both the retail and direct-to-customer channels are: Pottery Barn, which sells casual home furnishings; Williams-Sonoma, which sells cooking and entertaining essentials; and Pottery Barn Kids, which sells stylish children’s furnishings.

The following discussion and analysis of our financial condition, results of operations, and liquidity and capital resources for the thirteen weeks ended November 1, 2009 (“third quarter of fiscal 2009”), as compared to the thirteen weeks ended November 2, 2008 (“third quarter of fiscal 2008”) and the thirty-nine weeks ended November 1, 2009 (“year-to-date 2009”), as compared to the thirty-nine weeks ended November 2, 2008 (“year-to-date 2008”), should be read in conjunction with our condensed consolidated financial statements and the notes thereto.

All explanations of changes in operational results are discussed in order of their magnitude.

Third Quarter of Fiscal 2009 Financial Results

While the home furnishings sector remained under pressure in the third quarter of fiscal 2009, we saw our business trends improve. Throughout the quarter, we saw a strengthening consumer response to both our merchandising and marketing strategies, and progressively better sales and margins. We also saw ongoing financial and operational benefits from our cost containment and inventory management initiatives, and an improvement in cash flow, whereby we ended the quarter with $228,744,000 in cash.

Our diluted earnings per share in the third quarter of fiscal 2009 was $0.07 (including a $0.06 per diluted share charge for asset impairment and early lease termination costs associated with underperforming retail stores and a $0.03 per diluted share charge associated with the exit of excess distribution capacity) compared to a diluted loss per share of $0.10 (including a $0.07 per diluted share charge from asset impairment costs, partially offset by a $0.06 per diluted share benefit associated with the reversal of performance-based stock compensation expense) in the third quarter of fiscal 2008.

Net revenues in the third quarter of fiscal 2009 decreased by $22,755,000, or 3.0%, compared to the third quarter of fiscal 2008, despite a 2.2% year-over-year increase in retail leased square footage, including four net new stores, and a comparable store sales increase of 1.7%. This decrease was driven by declining revenues in all brands primarily due to the continued negative impact of the general economic environment during the third quarter of fiscal 2009. Additionally, our catalog and page circulation decreased 18.1% and 20.6%, respectively (including the impact of our catalog circulation optimization strategy).

Retail net revenues in the third quarter of fiscal 2009 increased $3,900,000, or 0.9%, compared to the third quarter of fiscal 2008. This increase was driven by a 1.7% increase in comparable stores sales and a 2.2% year-over-year increase in retail leased square footage, including four net new stores. The Pottery Barn and West Elm brands had year-over-year revenue increases, while net revenues in the Pottery Barn Kids, Williams-Sonoma and Williams-Sonoma Home brands declined during the quarter.

Direct-to-customer net revenues in the third quarter of fiscal 2009 decreased $26,655,000, or 8.1%, compared to the third quarter of fiscal 2008. All brands had declining net revenues during the quarter, led primarily by Pottery Barn, West Elm, Pottery Barn Kids and Williams-Sonoma Home due to the continued negative impact of the general economic environment and a decrease in catalog and page circulation of 18.1% and 20.6%, respectively (including the impact of our catalog circulation optimization strategy). In addition, net revenues generated in our Internet business decreased 7.0% to $230,112,000 for the third quarter of fiscal 2009 compared to $247,463,000 for the third quarter of fiscal 2008.

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In our core brands, net revenues in the third quarter of fiscal 2009 decreased by 2.1% compared to the third quarter of fiscal 2008, primarily driven by a decrease in Pottery Barn Kids, Williams-Sonoma and Pottery Barn. Sales trends, however, improved in every brand and we are encouraged by these results as they correlate with the rollout of our revitalization initiatives and affirm our merchandising and marketing strategies.

In the Pottery Barn Kids brand, net revenues declined 5.0% and comparable store sales declined 3.1% during the third quarter of fiscal 2009. These results were an improvement in trend and the strongest validation we have had of the customer’s acceptance of our new merchandising strategies. Consumer response to our entry price points, classic assortment and in-store selling and marketing programs was positive, driving both better sales and stronger selling margins. In the Williams-Sonoma brand, we continued to see the same economic resilience we have seen all year. While net revenues and comparable store sales declined 1.8% and 2.1%, respectively, selling margins began to rebound to historical levels. Strong merchandising, tight inventories, and a focus on exclusive product offerings drove these results within the brand. In the Pottery Barn brand, although net revenues in the third quarter decreased 0.9% (driven by a decrease in the direct-to-customer channel, despite positive demand), comparable store sales increased 7.6%. These continue to demonstrate a sustaining trend of net revenue improvement on both a one-year and two-year basis, and affirm the effectiveness of our strategies to drive customers to the Pottery Barn brand.

In our emerging brands (West Elm, PBteen and Williams-Sonoma Home) net revenues decreased 7.7%. In West Elm, net revenues declined during the third quarter of fiscal 2009, partially due to the residual impact from a low in-stock position in furniture. These issues are now resolved, however, and we are optimistic that we will continue to see an improvement in West Elm’s net revenues in the fourth quarter since more than half of the brand’s business is driven by furniture. In PBteen, although net revenues declined during the third quarter of fiscal 2009, the brand remains the best performing brand in the company on both a one-year and two-year basis.

In Williams-Sonoma Home, revenue and margin trends did not improve during the quarter. As such, our concerns about the luxury home furnishings market have escalated and we are critically assessing the positioning of the brand going forward. In the meantime, we are implementing inventory management, catalog circulation, and merchandising strategies that will optimize cash flow while maintaining flexibility as we contemplate a longer term strategy for the brand. At the end of the third quarter, net assets in the brand, including inventory, were approximately $25,000,000, and we have long term real estate lease commitments on 11 stores.

Third Quarter of Fiscal 2009 Operational Results

In supply chain, we continued to see both customer service and financial benefits from our ongoing transportation and quality returns initiatives. During the quarter, we completed the coastal consolidation of our large cube inventory and are now shipping together orders that historically were delivered in multiple shipments. We also consolidated six third-party furniture delivery hubs into one company-operated hub in Columbus, Ohio. Both of these initiatives are driving a significantly improved customer experience and increased gross margin dollars. In addition, we began to see the benefits of our inventory management initiatives, including strategically balancing inventory levels with full-price selling and margin objectives, partnering with our vendors to reduce product costs, renegotiating our ocean freight and furniture delivery contracts and expanding our upholstered furniture operations. As a result, as of the end of the third quarter of fiscal 2009, merchandise inventory had decreased $149,555,000 to $545,042,000 from the third quarter of fiscal 2008.

We also continue to make progress on our occupancy cost reduction initiatives by increasing planned fiscal 2009 permanent store closures from 16 to 20 and eliminating 1,200,000 square feet of excess distribution capacity in the third quarter. By the end of fiscal 2009, we also plan to eliminate 80,000 square feet of excess office space.

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Fiscal 2009

As we look forward to the balance of the year, based on the sales and margin trends that we are seeing today, particularly in our core brands, we now expect to see a net revenue decline of 9% to 11% for fiscal 2009 as compared to fiscal 2008. We will also continue to expand on the initiatives that have driven our success including: capturing market share through innovative merchandising and a greater emphasis on opening price points; delivering superior customer service; continuing our catalog circulation optimization strategy; driving efficiencies in our worldwide supply chain; and maximizing profitability and cash flow. We believe that all of these initiatives will allow us to incrementally improve our operating margins over time, continue to strengthen our balance sheet and position our brands to emerge stronger when the economy improves.

Finally, in fiscal 2009, we expect to continue our quarterly cash dividend of $0.12 per diluted share for an indicated annual cash dividend of $0.48 per diluted share, or approximately $51,000,000, subject to capital availability.

Results of Operations

NET REVENUES

Net revenues consist of retail sales and direct-to-customer sales, both of which include shipping fees. Retail sales include sales of merchandise to customers at our retail stores and shipping fees on retail products shipped to our customers’ homes. Direct-to-customer sales include sales of merchandise to customers through our catalogs and the Internet and shipping fees. Shipping fees consist of revenue received from customers for delivery of merchandise to their homes. Revenues are presented net of sales returns and other discounts.

The following table summarizes our net revenues for the third quarter of fiscal 2009 and fiscal 2008, and year-to-date 2009 and 2008:

Net revenues in the third quarter of fiscal 2009 decreased by $22,755,000, or 3.0%, compared to the third quarter of fiscal 2008, despite a 2.2% year-over-year increase in retail leased square footage, including four net new stores, and a comparable store sales increase of 1.7%. This decrease was driven by declining revenues in all brands primarily due to the continued negative impact of the general economic environment during the third quarter of fiscal 2009. Additionally, our catalog and page circulation decreased 18.1% and 20.6%, respectively (including the impact of our catalog circulation optimization strategy).

Net revenues for year-to-date 2009 decreased by $340,431,000, or 14.5%, compared to year-to-date 2008, despite a 2.2% year-over-year increase in retail leased square footage, including four net new stores. This decrease was driven by declining revenues in all brands primarily due to the continued negative impact of the general economic environment during year-to-date 2009, which resulted in a comparable store sales decrease of 11.6%. Additionally, our catalog and page circulation decreased 18.0% and 22.8%, respectively (including the impact of our catalog circulation optimization strategy).

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RETAIL REVENUES AND OTHER DATA

¹ Remodeled stores are defined as those stores temporarily closed and subsequently reopened during the period due to square footage expansion, store modification or relocation.

Retail net revenues in the third quarter of fiscal 2009 increased $3,900,000, or 0.9%, compared to the third quarter of fiscal 2008. This increase was driven by a 1.7% increase in comparable stores sales and a 2.2% year-over-year increase in retail leased square footage, including four net new stores. The Pottery Barn and West Elm brands had year-over-year revenue increases, while net revenues in the Pottery Barn Kids, Williams-Sonoma and Williams-Sonoma Home brands declined during the quarter.

Retail net revenues for year-to-date 2009 decreased $135,272,000, or 10.2%, compared to year-to-date 2008. All brands had declining net revenues during the year led by Pottery Barn, Williams-Sonoma and Pottery Barn Kids. This decrease was driven by the continued negative impact of the general economic environment which resulted in a comparable store sales decrease of 11.6%.

Comparable Store Sales

Comparable stores are defined as those stores in which gross square footage did not change by more than 20% in the previous 12 months and which have been open for at least 12 consecutive months without closure for seven or more consecutive days. By measuring the year-over-year sales of merchandise in the stores that have a history of being open for a full comparable 12 months or more, we can better gauge how the core store base is performing since it excludes new store openings, store remodelings and expansions. Comparable stores exclude new retail concepts until such time as we believe that comparable store results in those concepts are of sufficient size to evaluate the performance of the retail strategy. Therefore, in both fiscal 2009 and fiscal 2008, West Elm and Williams-Sonoma Home were excluded.

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Percentages represent changes in comparable store sales compared to the same period in the prior year.

Various factors affect comparable store sales, including the overall economic and general retail sales environment as well as current local and global economic conditions, each of which were significant factors in our comparable store sales results in fiscal 2009. Additional factors have affected our comparable store sales results in the past and may continue to affect them in the future, such as the number, size and location of stores we open, close, remodel or expand in any period, consumer preferences and buying trends, changes in sales mix between distribution channels, our ability to efficiently source and distribute products, changes in our merchandise mix, competition (including competitive promotional activity and discount retailers), the timing of our releases of new merchandise and promotional events, the success of marketing programs, the cannibalization of existing store sales by our new stores, changes in catalog circulation and in our direct-to-customer business and fluctuations in foreign exchange rates. Among other things, weather conditions can affect comparable store sales because inclement weather can alter consumer behavior or require us to close certain stores temporarily and thus reduce store traffic. Even if stores are not closed, many customers may decide to avoid going to stores in bad weather. These factors have caused our comparable store sales to fluctuate significantly in the past on an annual, quarterly and monthly basis and, as a result, we expect that comparable store sales will continue to fluctuate in the future.

DIRECT-TO-CUSTOMER REVENUES

¹Approximately 60% of our company-wide non-gift registry Internet revenues are driven by customers who recently received a catalog and approximately 40% are incremental to the direct-to-customer channel.

Direct-to-customer net revenues in the third quarter of fiscal 2009 decreased $26,655,000, or 8.1%, compared to the third quarter of fiscal 2008. All brands had declining net revenues during the quarter, led primarily by Pottery Barn, West Elm, Pottery Barn Kids and Williams-Sonoma Home due to the continued negative impact of the general economic environment and a decrease in catalog and page circulation of 18.1% and 20.6%, respectively (including the impact of our catalog circulation optimization strategy). In addition, net revenues generated in our Internet business decreased 7.0% to $230,112,000 for the third quarter of fiscal 2009 compared to $247,463,000 for the third quarter of fiscal 2008.

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Direct-to-customer net revenues for year-to-date 2009 decreased $205,159,000, or 19.9%, compared to year-to-date 2008. All brands had declining net revenues during the quarter, led primarily by Pottery Barn, Pottery Barn Kids, West Elm and PBteen due to the continued negative impact of the general economic environment and a decrease in catalog and page circulation of 18.0% and 22.8%, respectively (including the impact of our catalog circulation optimization strategy). In addition, net revenues generated in our Internet business decreased 17.1% to $633,829,000 for year-to-date 2009 compared to $764,114,000 for year-to-date 2008.

COST OF GOODS SOLD

Cost of goods sold includes cost of goods, occupancy expenses and shipping costs. Cost of goods consists of cost of merchandise, inbound freight expenses, freight-to-store expenses and other inventory related costs such as shrinkage, damages and replacements. Occupancy expenses consist of rent, depreciation and other occupancy costs, including common area maintenance and utilities. Shipping costs consist of third party delivery services and shipping materials.

Our classification of expenses in cost of goods sold may not be comparable to other public companies, as we do not include non-occupancy related costs associated with our distribution network in cost of goods sold. These costs, which include distribution network employment, third party warehouse management, and other distribution-related administrative expenses, are recorded in selling, general and administrative expenses.

Within our reportable segments, the direct-to-customer channel does not incur freight-to-store or store occupancy expenses, and typically operates with lower markdowns and inventory shrinkage than the retail channel. However, the direct-to-customer channel incurs higher customer shipping, damage and replacement costs than the retail channel.

Third Quarter of Fiscal 2009 vs. Third Quarter of Fiscal 2008

Cost of goods sold decreased by $35,127,000, or 6.9%, in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. Cost of goods sold as a percentage of net revenues decreased to 65.3% in the third quarter of fiscal 2009 from 68.0% in the third quarter of fiscal 2008. This decrease as a percentage of net revenues was primarily driven by a decrease in cost of merchandise (including the benefit from reduced markdowns), reduced freight costs, favorable replacements and damages expense and occupancy expense reductions, partially offset by charges associated with the early lease termination of underperforming retail stores and exiting excess distribution capacity.

In the retail channel, cost of goods sold as a percentage of net revenues decreased 470 basis points in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. This decrease as a percentage of net revenues was primarily driven by a decrease in cost of merchandise (including the benefit from reduced markdowns) and occupancy expense reductions, partially offset by charges associated with the early lease termination of underperforming retail stores.

In the direct-to-customer channel, cost of goods sold as a percentage of net revenues decreased 180 basis points in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. This decrease as a percentage of net revenues was primarily driven by reduced freight costs and favorable replacements and damages expense.

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Year-to-Date 2009 vs. Year-to-Date 2008

Cost of goods sold for year-to-date 2009 decreased by $197,041,000, or 12.6%, compared to year-to-date 2008. However, cost of goods sold as a percentage of net revenues increased to 67.6% for year-to-date 2009 from 66.2% for year-to-date 2008. This increase as a percentage of net revenues was primarily driven by the deleverage of fixed occupancy expenses due to declining sales, partially offset by reduced freight costs and favorable replacements and damages expense.

In the retail channel, cost of goods sold as a percentage of net revenues increased 10 basis points for year-to-date 2009 compared to year-to-date 2008. This increase as a percentage of net revenues primarily resulted from the deleverage of fixed occupancy expenses due to declining sales, partially offset by a decrease in cost of merchandise (including the benefit from reduced markdowns).

In the direct-to-customer channel, cost of goods sold as a percentage of net revenues increased 50 basis points for year-to-date 2009 compared to year-to-date 2008. This increase as a percentage of net revenues primarily resulted from an increase in cost of merchandise (including the impact of increased markdowns) and the deleverage of fixed occupancy expenses resulting from declining sales, partially offset by reduced freight costs and favorable replacements and damages expense.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses consist of non-occupancy related costs associated with our retail stores, distribution warehouses, customer care centers, supply chain operations (buying, receiving and inspection) and corporate administrative functions. These costs include employment, advertising, third party credit card processing and other general expenses.

We experience differing employment and advertising costs as a percentage of net revenues within the retail and direct-to-customer channels due to their distinct distribution and marketing strategies. Store employment costs represent a greater percentage of retail net revenues than employment costs as a percentage of net revenues within the direct-to-customer channel. However, catalog advertising expenses are greater within the direct-to-customer channel than the retail channel.

Third Quarter of Fiscal 2009 vs. Third Quarter of Fiscal 2008

Selling, general and administrative expenses decreased by $16,462,000, or 6.3%, in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. Selling, general and administrative expenses as a percentage of net revenues decreased to 33.4% in the third quarter of fiscal 2009 from 34.6% in the third quarter of fiscal 2008. This decrease as a percentage of net revenues was primarily driven by reductions in employment, total advertising and other general expenses reflecting the effect of our infrastructure cost reduction program, catalog circulation optimization strategy and continuing cost containment initiatives. This decrease as a percentage of net revenues was partially offset by an approximate $11,023,000 benefit associated with the reversal of performance-based stock compensation expense in the third quarter of fiscal 2008 that did not recur in fiscal 2009 and charges associated with exiting excess distribution capacity of $5,665,000 in the third quarter of fiscal 2009.

In the retail channel, selling, general and administrative expenses as a percentage of net revenues decreased 420 basis points in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. This was primarily

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driven by reductions in employment and other general expenses reflecting the effect of our infrastructure cost reduction program and continuing cost containment initiatives.

In the direct-to-customer channel, selling, general and administrative expenses as a percentage of net revenues decreased 220 basis points in the third quarter of fiscal 2009 compared to the third quarter of fiscal 2008. This decrease as a percentage of net revenues was primarily driven by reductions in total advertising and employment reflecting the effect of our catalog circulation optimization strategy and infrastructure cost reduction program.

Year-to-Date 2009 vs. Year-to-Date 2008

Selling, general and administrative expenses for year-to-date 2009 decreased by $101,113,000, or 13.1%, compared to year-to-date 2008. However, selling, general and administrative expenses as a percentage of net revenues increased to 33.4% for year-to-date 2009 from 32.8% for year-to-date 2008. This increase as a percentage of net revenues was primarily driven by a benefit of approximately $16,000,000 related to a gain on the sale of a corporate aircraft, an approximate $11,023,000 benefit associated with the reversal of performance-based stock compensation expense, and a benefit of approximately $9,350,000 related to an incentive payment received from a landlord to compensate us for terminating a store lease prior to its expiration recorded in fiscal 2008, none of which recurred in fiscal 2009. This increase was further driven by asset impairment and early lease termination charges of $24,250,000 for underperforming retail stores for year-to-date 2009 compared to $14,350,000 for year-to-date 2008 and charges associated with exiting distribution capacity of $5,981,000 for year-to-date 2009. This increase as a percentage of net revenues was partially offset by reductions in total advertising, employment and other general expenses, reflecting the effect of our catalog circulation optimization strategy, infrastructure cost reduction program and continuing cost containment initiatives.

In the retail channel, selling, general and administrative expenses as a percentage of net revenues decreased 30 basis points for year-to-date 2009 compared to year-to-date 2008. This decrease as a percentage of net revenues was primarily driven by reductions in employment costs and other general expenses reflecting the effect of our infrastructure cost reduction program and continuing cost containment initiatives. This decrease was partially offset by higher asset impairment and early lease termination charges for underperforming retail stores for year-to-date 2009 compared to year-to-date 2008 and an early lease termination benefit received from a landlord in fiscal 2008 that did not recur in fiscal 2009.

In the direct-to-customer channel, selling, general and administrative expenses as a percentage of net revenues decreased 140 basis points for year-to-date 2009 compared to year-to-date 2008. This decrease as a percentage of net revenues was primarily driven by reductions in total advertising and employment, reflecting the effect of our catalog circulation optimization strategy and infrastructure cost reduction program.

INCOME TAXES

Our effective rate was a benefit of 46.0% for year-to-date 2009 versus an expense of 21.6% for year-to-date 2008. Our effective tax rate for year-to-date 2009 was primarily the result of our year-to-date net loss in addition to certain favorable income tax resolutions during fiscal 2009.

We expect our effective tax rate to be in the range of 35.0% to 40.0% in fiscal 2009. Throughout the year, we expect that there could be ongoing variability in our quarterly tax rates as taxable events occur and exposures are re-evaluated.

LIQUIDITY AND CAPITAL RESOURCES

As of November 1, 2009, we held $228,744,000 in cash and cash equivalent funds. As is consistent with our industry, our cash balances are seasonal in nature, with the fourth quarter historically representing a significantly higher level of cash than other periods. This cash balance, however, is the highest cash balance at the end of the third quarter in our history.

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Throughout the fiscal year, we utilize our cash balances to build our inventory levels in preparation for our fourth quarter holiday sales. In fiscal 2009, we plan to use our cash resources to fund our inventory and inventory related purchases, catalog advertising and marketing initiatives, purchases of property and equipment and dividend payments. On December 7, 2009, we also repaid the remaining outstanding balance on our Mississippi industrial development bonds in the amount of $13,150,000, without penalty. In addition to the current cash balances on-hand, as of November 1, 2009, we have a credit facility that provides for a $300,000,000 unsecured revolving line of credit that may be used for loans or letters of credit. Prior to April 4, 2011, we may, upon notice to the lenders, request an increase in the credit facility of up to $200,000,000 to provide for a total of $500,000,000 of unsecured revolving credit. As of November 1, 2009 and November 2, 2008, no amount was outstanding under this credit facility and we do not expect to need to access the line of credit at any time during the remainder of fiscal 2009. However, as of November 1, 2009, $40,291,000 in issued but undrawn standby letters of credit was outstanding under this credit facility. Additionally, as of November 1, 2009, we had four unsecured letter of credit reimbursement facilities for a total of $125,000,000. As of November 1, 2009, an aggregate of $31,784,000 was outstanding under these letter of credit facilities, which represent only a future commitment to fund inventory purchases to which we had not taken legal title as of November 1, 2009. We believe our cash on-hand, in addition to our available credit facilities, will provide adequate liquidity for our business operations over the next 12 months. Further, we are currently in compliance with all of our bank covenants and expect to remain in compliance throughout fiscal 2009.

For year-to-date 2009, net cash provided by operating activities was $165,585,000 compared to net cash provided by operating activities of $54,320,000 for year-to-date 2008. Net cash provided by operating activities for year-to-date 2009 was primarily attributable to a decrease in merchandise inventories due to our continued inventory reduction initiatives, an increase in deferred lease incentives and an increase in accounts payable due to the timing of expenditures. Net cash provided by operating activities for year-to-date 2009 increased compared to year-to-date 2008 primarily due to a decrease in income taxes paid in fiscal 2009 resulting from a reduction in our pre-tax income, as well as a reduction in merchandise inventories.

For year-to-date 2009, net cash used in investing activities was $49,535,000 compared to net cash used in investing activities of $110,974,000 for year-to-date 2008. For year-to-date 2009, purchases of property and equipment were $50,391,000, comprised of $27,561,000 for stores, $18,732,000 for systems development projects (including e-commerce websites) and $4,098,000 for distribution, facility infrastructure and other projects. Net cash used in investing activities for year-to-date 2009 decreased compared to year-to-date 2008 primarily due to a reduction in purchases of property and equipment resulting from a decrease in the number of new and remodeled stores we opened and expect to open during fiscal 2009 and an overall reduction in all other capital expenditures, as well as proceeds received from the sale of a corporate aircraft during fiscal 2008, which did not recur in fiscal 2009.

For fiscal 2009, we anticipate investing $85,000,000 to $90,000,000 in the purchase of property and equipment, primarily for the construction of 9 new stores and 8 remodeled or expanded stores, systems development projects (including e-commerce websites) and distribution, facility infrastructure and other projects.

For year-to-date 2009, net cash used in financing activities was $36,369,000 compared to net cash used in financing activities of $37,601,000 for year-to-date 2008. Net cash used in financing activities for year-to-date 2009 and year-to-date 2008 was primarily attributable to the payment of dividends.

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Dividend Policy

Our quarterly cash dividend is $0.12 per common share. The indicated annual cash dividend, subject to capital availability, is $0.48 per common share, or approximately $51,000,000 in fiscal 2009. Our quarterly cash dividend may be limited or terminated at any time.

Critical Accounting Policies

Management’s Discussion and Analysis of Financial Condition and Results of Operations is based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures of contingent assets and liabilities. The estimates and assumptions are evaluated on an ongoing basis and are based on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results may differ significantly from these estimates. During the third quarter of fiscal 2009, there have been no significant changes to the policies discussed in our Annual Report on Form 10-K for the year ended February 1, 2009.

Impact of Inflation

The impact of inflation on results of operations was not significant for year-to-date 2009 or year-to-date 2008.

Seasonality

Our business is subject to substantial seasonal variations in demand. Historically, a significant portion of our revenues and net earnings have been realized during the period from October through December, and levels of net revenues and net earnings have generally been significantly lower during the period from January through September. We believe this is the general pattern associated with the retail and direct-to-customer industries. In anticipation of our peak season, we hire a substantial number of additional temporary employees in our retail stores, call centers and distribution centers, and incur significant fixed catalog production and mailing costs.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risks, which include significant deterioration of the U.S. and foreign markets, changes in U.S. interest rates, foreign currency exchange rates, including any devaluation of the U.S. dollar, and the effects of uncertain economic forces which may affect the prices we pay our vendors in the foreign countries in which we do business. We do not engage in financial transactions for trading or speculative purposes.

Interest Rate Risk

As of November 1, 2009, we had three debt instruments with variable interest rates which subject us to risks associated with changes in interest rates (the interest payable on our credit facility, our Mississippi industrial development bond and the bond-related debt associated with one of our Memphis-based distribution facilities). As of November 1, 2009, the total outstanding principal balance on these instruments was $13,575,000 (with a weighted average interest rate of approximately 1.6%). If interest rates on these existing variable rate debt instruments rose 16 basis points (an approximate 10% increase in the associated variable rates as of November 1, 2009), our results from operations and cash flows would not be materially affected. On December 7, 2009, in an effort to reduce interest and other debt related costs and due to our significant cash balances on hand, the remaining outstanding balance on our Mississippi industrial development bonds of $13,150,000 was repaid, without penalty.

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In addition, we have fixed and variable income investments consisting of short-term investments classified as cash and cash equivalents, which are also affected by changes in market interest rates. As of November 1, 2009, our investments, made solely in U.S. Treasury bills and money market and municipal funds are stated at cost and approximate their fair values. An increase in interest rates of 10% would have an immaterial effect on the value of these investments. Declines in interest rates, however, have and would in the future decrease the income derived from these investments.

Foreign Currency Risks

We purchase a significant amount of inventory from vendors outside of the U.S. in transactions that are denominated in U.S. dollars, however, only approximately 3% of our international purchase transactions are in currencies other than the U.S. dollar, primarily the euro. Any currency risks related to these international purchase transactions were not significant to us during year-to-date 2009 and year-to-date 2008. Since we pay for the majority of our international purchases in U.S. dollars, however, a decline in the U.S. dollar relative to other foreign currencies would subject us to risks associated with increased purchasing costs from our vendors in their effort to offset any lost profits associated with any currency devaluation. We cannot predict with certainty the effect these increased costs may have on our financial statements or results of operations.

In addition, as of November 1, 2009, we have 17 retail stores in Canada and limited sourcing operations in both Europe and Asia, each of which expose us to market risk associated with foreign currency exchange rate fluctuations. Although these exchange rate fluctuations have not been material to us in the past, we may enter into foreign currency contracts in the future to minimize any currency remeasurement risk associated with the intercompany assets and liabilities of our subsidiaries. We did not enter into any foreign currency contracts during year-to-date 2009 or year-to-date 2008.

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

As of November 1, 2009, an evaluation was performed by management, with the participation of our Chief Executive Officer (“CEO”) and our Executive Vice President, Chief Operating and Chief Financial Officer (“CFO”), of the effectiveness of our disclosure controls and procedures. Based on that evaluation, our management, including our CEO and CFO, concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Securities Exchange Act of 1934 is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely discussions regarding required disclosures, and that such information is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC.

Changes in Internal Control Over Financial Reporting

There was no change in our internal control over financial reporting that occurred during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Information required by this Item is contained in Note G to our Condensed Consolidated Financial Statements within Part I of this Form 10-Q.

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ITEM 1A. RISK FACTORS

A description of the risks and uncertainties associated with our business is set forth below. You should carefully consider such risks and uncertainties, together with the other information contained in this report and in our other public filings. If any of such risks and uncertainties actually occurs, our business, financial condition or operating results could differ materially from the plans, projections and other forward-looking statements included in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report and in our other public filings. In addition, if any of the following risks and uncertainties, or if any other risks and uncertainties, actually occurs, our business, financial condition or operating results could be harmed substantially, which could cause the market price of our stock to decline, perhaps significantly.

The changes in general economic conditions over the past year, and the resulting impact on consumer confidence and consumer spending, could continue to adversely impact our results of operations.

Our financial performance is subject to changes in general economic conditions and the impact of such economic conditions on levels of consumer confidence and consumer spending. Over the past year, consumer confidence and consumer spending have deteriorated significantly, and could remain depressed for an extended period of time. Consumer purchases of discretionary items, including our merchandise, generally decline during periods where disposable income is adversely affected, unemployment rates increase or there is economic uncertainty. The current economic environment could cause our vendors to go out of business or our banks to discontinue lending us or our vendors money, or it could cause us to undergo additional restructurings, any of which would adversely impact our business and operating results.

We are unable to control many of the factors affecting consumer spending, and declines in consumer spending on home furnishings in general could reduce demand for our products.

Our business depends on consumer demand for our products and, consequently, is sensitive to a number of factors that influence consumer spending, including general economic conditions, disposable consumer income, fuel prices, recession and fears of recession, unemployment, war and fears of war, inclement weather, availability of consumer credit, consumer debt levels, conditions in the housing market, interest rates, sales tax rates and rate increases, inflation, consumer confidence in future economic conditions and political conditions, and consumer perceptions of personal well-being and security. In particular, the current economic downturn has led to decreased discretionary spending, which has adversely impacted our business. In addition, a decrease in home purchases has led and may continue to lead to significantly decreased consumer spending on home products. These factors have affected our various brands and channels differently. Adverse changes in factors affecting discretionary consumer spending have reduced and may continue to further reduce consumer demand for our products, thus reducing our sales and harming our business and operating results.

If we are unable to identify and analyze factors affecting our business, anticipate changing consumer preferences and buying trends, and manage our inventory commensurate with customer demand, our sales levels and profit margin may decline.

Our success depends, in large part, upon our ability to identify and analyze factors affecting our business and to anticipate and respond in a timely manner to changing merchandise trends and customer demands. For example, in the specialty home products business, style and color trends are constantly evolving. Consumer preferences cannot be predicted with certainty and may change between selling seasons. Changes in customer preferences and buying trends may also affect our brands differently. We must be able to stay current with preferences and trends in our brands and address the customer tastes for each of our target customer demographics. We must also be able to identify and adjust the customer offerings in our brands to cater to customer demands. For example, a change in customer preferences for children’s room furnishings may not correlate to a similar change in buying trends for other home furnishings. If we misjudge either the market for our merchandise or our customers’

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purchasing habits, our sales may decline significantly, and we may be required to mark down certain products to sell the resulting excess inventory or to sell such inventory through our outlet stores or other liquidation channels at prices which are significantly lower than our retail prices, either of which would negatively impact our business and operating results.

In addition, we must manage our inventory effectively and commensurate with customer demand. 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, up to twelve months in advance of the applicable selling season and frequently before trends are known. The extended lead times for many of our purchases may make it difficult for us to respond rapidly to new or changing trends. Our vendors also may not have the capacity to handle our demands or may go out of business in times of economic crisis. In addition, the seasonal nature of the specialty home products business requires us to carry a significant amount of inventory prior to peak selling season. As a result, we 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 acceptance levels of our products, our inventory levels will not be appropriate, and our business and operating results may be negatively impacted.

Our sales may be negatively impacted by increasing competition from companies with brands or products similar to ours.

The specialty retail and direct-to-customer business is highly competitive. Our specialty retail stores, direct mail catalogs and e-commerce websites compete with other retail stores, other direct mail catalogs and other e-commerce websites that market lines of merchandise similar to ours. We compete with national, regional and local businesses utilizing a similar retail store strategy, as well as traditional furniture stores, department stores and specialty stores. 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. In addition, the decline in the global economic environment has led to increased competition from discount retailers selling similar products at reduced prices. The competitive challenges facing us include:

In light of the many competitive challenges facing us, we may not be able to compete successfully. Increased competition could reduce our sales and harm our operating results and business.

We depend on key domestic and foreign agents and vendors for timely and effective sourcing of our merchandise, and we may not be able to acquire products in sufficient quantities and at acceptable prices to meet our needs which would impact our operations and financial results.

Our performance depends, in part, on our ability to purchase our merchandise in sufficient quantities at competitive prices. We purchase our merchandise from numerous foreign and domestic manufacturers and importers. We have no contractual assurances of continued supply, pricing or access to new products, and any vendor could change the terms upon which it sells to us, discontinue selling to us, or go out of business at any time. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future. Better than expected sales demand may also lead to customer backorders and lower in-stock positions of our merchandise.

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Any inability to acquire suitable merchandise on acceptable terms or the loss of one or more of our key agents or vendors could have a negative effect on our business and operating results because we would be missing products that we felt were important to our assortment, unless and until alternative supply arrangements are secured. We may not be able to develop relationships with new agents or vendors, and products from alternative sources, if any, may be of a lesser quality and/or more expensive than those we currently purchase.

In addition, we are subject to certain risks, including availability of raw materials, labor disputes, union organizing activities, vendor financial liquidity, inclement weather, natural disasters, and general economic and political conditions that could limit our vendors’ ability to provide us with quality merchandise on a timely basis and at prices that are commercially acceptable. For these or other reasons, one or more of our vendors might not adhere to our quality control standards, and we might not identify the deficiency before merchandise ships to our stores or customers. In addition, our vendors may have difficulty adjusting to our changing demands and growing business. Our vendors’ failure to manufacture or import quality merchandise in a timely and effective manner could damage our reputation and brands, and could lead to an increase in customer litigation against us and an attendant increase in our routine litigation costs. Further, any merchandise that we receive, even if it meets our quality standards, could become subject to a recall, which could damage our reputation and brands, and harm our business. Recently enacted legislation has given the U.S. Consumer Product Safety Commission increased regulatory and enforcement power, particularly with regard to children’s safety. As a result, companies like ours are recalling more products and incurring recall-related expenses. For example, during fiscal 2009, we have incurred a year-to-date pre-tax charge of $1,545,000 from voluntary product recalls.

Our dependence on foreign vendors and our increased overseas operations subject us to a variety of risks and uncertainties that could impact our operations and financial results.

In fiscal 2008, we sourced our products from vendors in 42 countries outside of the United States. Approximately 59% of our merchandise purchases were foreign-sourced, predominantly from Asia. Our dependence on foreign vendors means that we may be affected by changes in the value of the U.S. dollar relative to other foreign currencies, as well as increases in the cost of living in the vendors’ local countries due to the economic slowdown. For example, any upward valuation in the Chinese yuan, the euro, or any other foreign currency against the U.S. dollar may result in higher costs to us for those goods. In addition, an increase in the cost of living in the foreign countries in which our vendors operate may result in an increase in our costs or in our vendors going out of business. In fiscal 2009, although approximately 97% of our foreign purchases of merchandise are negotiated and paid for in U.S. dollars, declines in foreign currencies and currency exchange rates might negatively affect the profitability and business prospects of one or more of our foreign vendors. This, in turn, might cause such foreign vendors to demand higher prices for merchandise in their effort to offset any lost profits associated with any currency devaluation, delay merchandise shipments to us, or discontinue selling to us, any of which could ultimately reduce our sales or increase our costs.

We are also subject to other risks and uncertainties associated with changing economic and political conditions in foreign countries. These risks and uncertainties include import duties and quotas, compliance with anti-dumping regulations, work stoppages, economic uncertainties and adverse economic conditions (including inflation and recession), foreign government regulations, employment matters, wars and fears of war, political unrest, natural disasters and other trade restrictions. We cannot predict whether any of the countries in which our products are currently manufactured or may be manufactured in the future will be subject to trade restrictions imposed by the U.S. or foreign governments or the likelihood, type or effect of any such restrictions. Any event causing a disruption or delay of imports from foreign vendors, including the imposition of additional import restrictions, restrictions on the transfer of funds and/or increased tariffs or quotas, or both, could increase the cost or reduce the supply of merchandise available to us and adversely affect our business, financial condition and operating results. Furthermore, some or all of our foreign vendors’ operations may be adversely affected by political and

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financial instability resulting in the disruption of trade from exporting countries, restrictions on the transfer of funds and/or other trade disruptions. In addition, an economic downturn in or failure of foreign markets may result in financial instabilities for our foreign vendors, which may cause our foreign vendors to decrease production, discontinue selling to us, or to cease operations altogether. Our overseas operations in Europe and Asia could also be affected by changing economic and political conditions in foreign countries, any of which could have a negative effect on our business, financial condition and operating results.

In addition, although we continue to improve our global compliance program, there remains a risk that one or 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 operating results.

As we continue to expand our overseas operations, we are subject to certain U.S. laws, including the Foreign Corrupt Practices Act, in addition to the laws of the foreign countries in which we operate. We must ensure that the employees in our overseas operations comply with these laws. If any of our overseas operations, or our employees or agents, violates such laws, we could become subject to sanctions or other penalties that could negatively affect our business and operating results.

A number of factors that affect our ability to successfully open new stores or close existing stores are beyond our control, and these factors may harm our ability to expand or retract our retail operations and harm our ability to increase our sales and profits.

In each of the past three fiscal years, the majority of our net revenues have been generated by our retail stores. Our ability to open additional stores or close existing stores successfully will depend upon a number of factors, including:

Many of these factors are beyond our control. For example, for the purpose of identifying suitable store locations, we rely, in part, on demographic surveys regarding location of consumers in our target market segments. While we believe that the surveys and other relevant information are helpful indicators of suitable store locations, we recognize that these information sources cannot predict future consumer preferences and buying trends with complete accuracy. In addition, changes in demographics, in the types of merchandise that we sell and in the pricing of our products may reduce the number of suitable store locations. Further, time frames for lease negotiations and store development vary from location to location and can be subject to unforeseen delays. Construction and other delays in store openings could have a negative impact on our business and operating results. We may not be able to open new stores or, if opened, operate those stores profitably. Additionally, in these economic times, we may not be able to renegotiate the terms of our current leases or close our underperforming stores, both of which could negatively impact our operating results.

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Our business and operating results may be harmed if we are unable to timely and effectively deliver merchandise to our stores and customers.

The success of our business depends on our ability to timely and effectively deliver merchandise to our stores and customers. We cannot control all of the various factors that might affect our fulfillment rates in direct-to-customer sales and timely and effective merchandise delivery to our stores. We rely upon third party carriers for our merchandise shipments and reliable data regarding the timing of those shipments, including shipments to our customers and to and from all of our stores. In addition, we are heavily dependent upon two carriers for the delivery of our merchandise to our customers. Accordingly, we are subject to the risks, including labor disputes, union organizing activity, inclement weather, natural disasters, the closure of their offices or a reduction in operational hours due to an economic slowdown and possible acts of terrorism associated with such carriers’ ability to provide delivery services to meet our shipping needs. Failure to deliver merchandise in a timely and effective manner could damage our reputation and brands. In addition, fuel costs have been volatile and airline and other transportation companies struggle to operate profitably, which could lead to increased fulfillment expenses. Any fulfillment costs could negatively affect our business and operating results by increasing our transportation costs and decreasing the efficiency of our shipments.

Our failure to successfully manage our order-taking and fulfillment operations could have a negative impact on our business and operating results.

Our direct-to-customer business depends on our ability to maintain efficient and uninterrupted order-taking and fulfillment operations in our call centers and on our e-commerce websites. Disruptions or slowdowns in these areas could result from disruptions in telephone service or power outages, inadequate system capacity, system issues, computer viruses, security breaches, human error, changes in programming, union organizing activity, disruptions in our third party labor contracts, natural disasters or adverse weather conditions. Industries that are particularly seasonal, such as the home furnishings business, face a higher risk of harm from operational disruptions during peak sales seasons. These problems could result in a reduction in sales as well as increased selling, general and administrative expenses.

In addition, we face the risk that we cannot hire enough qualified employees to support our direct-to-customer operations, or that there will be a disruption in the labor we hire from our third party providers, especially during our peak season. The need to operate with fewer employees could negatively impact our customer service levels and our operations.

Our facilities and systems, as well as those of our vendors, are vulnerable to natural disasters and other unexpected events, any of which could result in an interruption in our business and harm our operating results.

Our retail stores, corporate offices, distribution centers, infrastructure projects and direct-to-customer operations, as well as the operations of vendors from which we receive goods and services, are vulnerable to damage from earthquakes, tornadoes, hurricanes, fires, floods, power losses, telecommunications failures, hardware and software failures, computer viruses and similar events. If any of these events result in damage to our facilities or systems, or those of our vendors, we may experience interruptions in our business until the damage is repaired, resulting in the potential loss of customers and revenues. In addition, we may incur costs in repairing any damage beyond our applicable insurance coverage.

Declines in our comparable store sales may harm our operating results and cause a decline in the market price of our common stock.

Various factors affect comparable store sales, including the number, size and location of stores we open, close, remodel or expand in any period, the overall economic and general retail sales environment, consumer preferences and buying trends, changes in sales mix among distribution channels, our ability to efficiently source and distribute products, changes in our merchandise mix, competition (including competitive promotional

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activity and discount retailers), current local and global economic conditions, the timing of our releases of new merchandise and promotional events, the success of marketing programs, the cannibalization of existing store sales by our new stores, changes in catalog circulation and in our direct-to-customer business and fluctuations in foreign exchange rates. Among other things, weather conditions can affect comparable store sales because inclement weather can alter consumer behavior or require us to close certain stores temporarily and thus reduce store traffic. Even if stores are not closed, many customers may decide to avoid going to stores in bad weather. These factors have caused and may continue to cause our comparable store sales results to differ materially from prior periods and from earnings guidance we have provided. For example, the overall economic and general retail sales environment, as well as current local and global economic conditions, has caused a significant decline in our comparable store sales results.

Our comparable store sales have fluctuated significantly in the past on an annual, quarterly and monthly basis, and we expect that comparable store sales will continue to fluctuate in the future. Past comparable store sales are no indication of future results. Comparable store sales have decreased in the past and may continue to decrease for fiscal 2009. Our ability to improve our comparable store sales results depends, in large part, on maintaining and improving our forecasting of customer demand and buying trends, selecting effective marketing techniques, providing an appropriate mix of merchandise for our broad and diverse customer base and using effective pricing strategies. Any failure to meet the comparable store sales expectations of investors and securities analysts in one or more future periods could significantly reduce the market price of our common stock.

Our failure to successfully manage the costs and performance of our catalog mailings might have a negative impact on our business.

Catalog mailings are an important component of our business. Postal rate increases, paper costs, printing costs and other catalog distribution costs affect the cost of our catalog mailings. We rely on discounts from the basic postal rate structure, which could be changed or discontinued at any time. Our paper costs have fluctuated significantly during the past three fiscal years and may continue to fluctuate in the future. Future increases in postal rates, paper costs or printing costs would have a negative impact on our operating results to the extent that we are unable to offset such increases by raising prices or by implementing more efficient printing, mailing, delivery and order fulfillment systems. In addition, if the performance of our catalogs declines, if we misjudge the correlation between our catalog circulation and net sales, or if our catalog circulation optimization strategy overall is not successful, our results of operations could be negatively impacted.

We have historically experienced fluctuations in customer response to our catalogs. Customer response to our catalogs is substantially dependent on merchandise assortment, merchandise availability and creative presentation, as well as the selection of customers to whom the catalogs are mailed, changes in mailing strategies, the sizing and timing of delivery of the catalogs as well as the general retail sales environment and current domestic and global economic conditions. In addition, environmental organizations and other consumer advocacy groups may attempt to create an unfavorable impression of our paper use in catalogs and our distribution of catalogs generally, which may have a negative effect on our sales and our reputation. In addition, we depend upon external vendors to print our catalogs. The failure to effectively produce or distribute our catalogs could affect the timing of catalog delivery. The timing of catalog delivery has been and can be affected by postal service delays. Any delays in the timing of catalog delivery could cause customers to forego or defer purchases.

If we are unable to effectively manage our Internet business, our reputation and operating results may be harmed.

Our Internet business has been our fastest growing channel over the last several years and continues to be a significant part of our sales success. The success of our Internet business depends, in part, on factors over which we have limited control. We must successfully respond to changing consumer preferences and buying trends relating to Internet usage. We are also vulnerable to certain additional risks and uncertainties associated with the

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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. In addition, we must keep up to date with competitive technology trends, including the use of improved technology, creative user interfaces and other Internet marketing tools, which may increase costs and which may not succeed in increasing sales or attracting customers. 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.

Our failure to successfully anticipate merchandise returns might have a negative impact on our business.

We record a reserve for merchandise returns based on historical return trends together with current product sales performance in each reporting period. If actual returns are greater than those projected by management, additional sales returns might be recorded in the future. Actual merchandise returns may exceed our reserves. In addition, to the extent that returned merchandise is damaged, we often do not receive full retail value from the resale or liquidation of the merchandise. Further, the introduction of new merchandise, changes in merchandise mix, changes in consumer confidence, or other competitive and general economic conditions may cause actual returns to exceed merchandise return reserves. In particular, the current adverse economic conditions have resulted and may continue to result in increased merchandise returns. Any significant increase in merchandise returns that exceeds our reserves could harm our business and operating results.

If we are unable to manage successfully the complexities associated with a multi-channel and multi-brand business, we may suffer declines in our existing business and our ability to attract new business.

During the past several years, with the launch and expansion of our Internet business, new brands and brand extensions, our overall business has become substantially more complex. The changes in our business have forced us to develop new expertise and face new challenges, risks and uncertainties. For example, we face the risk that our Internet business might cannibalize a significant portion of our retail and catalog businesses, and we face the risk of increased catalog circulation cannibalizing our retail sales. While we recognize that our Internet sales cannot be entirely incremental to sales through our retail and catalog channels, we seek to attract as many new customers as possible to our e-commerce websites. We continually analyze the business results of our three channels and the relationships among the channels in an effort to find opportunities to build incremental sales.

If we are unable to introduce new brands and brand extensions successfully, or to reposition existing brands, we may not be able to grow our business.

We have in the past and may in the future introduce new brands and brand extensions, or reposition existing brands. Our newest brands – West Elm, PBteen and Williams-Sonoma Home – and any other new brands, however, may not be successful growth vehicles. Further, if we devote time and resources to new brands, brand extensions or brand repositioning, and those businesses are not as successful as we planned, then we risk damaging our overall business results. Alternatively, if our new brands, brand extensions or repositioned brands prove to be very successful, we risk hurting our other existing brands through the potential migration of existing brand customers to the new businesses. In addition, we may not be able to introduce new brands and brand extensions, or to reposition brands, in a manner that improves our overall business and operating results. For example, our concerns over the Williams-Sonoma Home brand have escalated and we are critically evaluating the positioning of the brand going forward. In the meantime, we are implementing inventory management, catalog circulation and merchandising strategies that will optimize cash flow while maintaining flexibility as we contemplate a longer term strategy for the brand.

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Our inability to obtain commercial insurance at acceptable prices or our failure to adequately reserve for self-insured exposures might increase our expenses and have a negative impact on our business.

We believe that commercial insurance coverage is prudent in certain areas of our business for risk management. Insurance costs may increase substantially in the future and may be affected by natural catastrophes, fear of terrorism, financial irregularities and other fraud at publicly-traded companies, intervention by the government and a decrease in the number of insurance carriers. In addition, the carriers with which we hold our policies, including AIG, may go out of business, or may be otherwise unable to fulfill their contractual obligations. In addition, for certain types or levels of risk, such as risks associated with earthquakes, hurricanes or terrorist attacks, we may determine that we cannot obtain commercial insurance at acceptable prices, if at all. Therefore, we may choose to forego or limit our purchase of relevant commercial insurance, choosing instead to self-insure one or more types or levels of risks. We are primarily self-insured for workers’ compensation, employee health benefits and product and general liability claims. If we suffer a substantial loss that is not covered by commercial insurance or our self-insurance reserves, the loss and attendant expenses could harm our business and operating results. In addition, exposures exist for which no insurance may be available and for which we have not reserved.

Our inability or failure to protect our intellectual property would have a negative impact on our brands, goodwill and operating results.

Our trademarks, service marks, copyrights, trade dress rights, trade secrets, domain names and other intellectual property are valuable assets that are critical to our success. The unauthorized reproduction or other misappropriation of our intellectual property could diminish the value of our brands or goodwill and cause a decline in our sales. Protection of our intellectual property and maintenance of distinct branding are particularly important as they distinguish our products and services from our competitors who may sell similar products and services. We may not be able to adequately protect our intellectual property. In addition, the costs of defending our intellectual property may adversely affect our operating results.

We may be subject to legal proceedings that could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources.

We are involved in lawsuits, claims and proceedings incident to the ordinary course of our business. Litigation is inherently unpredictable. Any claims against us, whether meritorious or not, could be time consuming, result in costly litigation, require significant amounts of management time and result in the diversion of significant operational resources. There are an increasing number of cases being filed against companies generally, including a growing number of business method patent infringement lawsuits. There has also been a rise in lawsuits against companies like us that collect personal information from customers. In addition, there has been an increase in lawsuits alleging violations of California labor laws against companies with large numbers of California-based employees, especially retailers. The cost of defending claims against us or the ultimate resolution of such claims may harm our business and operating results. In addition, the significant deterioration in the global financial markets can create a more litigious environment and therefore subjects us to increased exposure to shareholder lawsuits.

Our operating results may be harmed by unsuccessful management of our employment, occupancy and other operating costs, and the operation and growth of our business may be harmed if we are unable to attract qualified personnel.

To be successful, we need to manage our operating costs and continue to look for opportunities to reduce costs. We recognize that we may need to increase the number of our employees, especially during peak sales seasons, and incur other expenses to support new brands and brand extensions, as well as the opening of new stores and direct-to-customer growth of our existing brands. Alternatively, if we are unable to make substantial adjustments to our cost structure during times of uncertainty, such as this current economic environment, we may incur

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unnecessary expenses, we may have too few resources to properly run our business, or our business and operating results may be negatively impacted. From time to time, we may also experience union organizing activity in currently non-union facilities. Union organizing activity may result in work slowdowns or stoppages and higher labor costs. In addition, there appears to be a growing number of wage-and-hour lawsuits against retail companies, especially in California.

We contract with various agencies to provide us with qualified personnel for our workforce. Any negative publicity regarding these agencies, such as in connection with immigration issues or employment practices, could damage our reputation, disrupt our ability to obtain needed labor or result in financial harm to our business, including the potential loss of business-related financial incentives in the jurisdictions where we operate.

Although we strive to secure long-term contracts with our service providers and other vendors and to otherwise limit our financial commitment to them, we may not be able to avoid unexpected operating cost increases in the future. Further, we incur substantial costs to warehouse and distribute our inventory. Significant increases in our inventory levels may result in increased warehousing and distribution costs in addition to potential increases in costs associated with inventory that is lost, damaged or aged. Higher than expected costs, particularly if coupled with lower than expected sales, would negatively impact our business and operating results. In addition, in times of economic uncertainty, these long-term contracts may make it difficult to quickly reduce our fixed operating costs, which could negatively impact our business and operating results.

We are undertaking certain systems changes that might disrupt our business operations.

Our success depends, in part, on our ability to source and distribute merchandise efficiently through appropriate systems and procedures. We are in the process of substantially modifying our information technology systems which involve updating or replacing legacy systems with successor systems during the course of several years. There are inherent risks associated with replacing our core systems, including supply chain and merchandising systems disruptions that could affect our ability to get the correct products into the appropriate stores and delivered to customers. We may not successfully launch these new systems, or the launch of such systems may result in disruptions to our business operations. In addition, changes to any of our software implementation strategies could result in the impairment of software-related assets. We are also subject to the risks associated with the ability of our vendors to provide information technology solutions to meet our needs. Any disruptions could negatively impact our business and operating results.

We outsource certain aspects of our business to third party vendors and are in the process of in sourcing certain business functions from third party vendors, both of which subject us to risks, including disruptions in our business and increased costs.

We outsource certain aspects of our business to third party vendors that subject us to risks of disruptions in our business as well as increased costs. For example, we utilize outside vendors for such things as payroll processing and various distribution center services. Accordingly, we are subject to the risks associated with their ability to successfully provide the necessary services to meet our needs. If our vendors are unable to adequately protect our data and information is lost, our ability to deliver our services is interrupted, or our vendors’ fees are higher than expected, then our business and operating results may be negatively impacted.

In addition, we are in the process of in sourcing certain aspects of our business, including the management of certain infrastructure technology, furniture manufacturing, furniture delivery to our customers and the management of our international vendors, each of which were previously outsourced to third party providers. This may cause disruptions in our business and result in increased cost to us. In addition, if we are unable to perform these functions better than, or at least as well as, our third party providers, our business may be harmed.

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Our efforts to expand internationally through franchising arrangements may not be successful and could impair the value of our brands.

We have entered into a franchise agreement with an unaffiliated franchisee to operate stores in the Middle East. Under this agreement, a third party will operate stores that sell goods purchased from us under our brand names. We have no prior experience operating through these types of third party arrangements, and this arrangement may not be successful. The administration of this relationship may divert management attention and require more resources than we expect. While we expect that this will be a small part of our business in the near future, if successful, we plan to continue to increase the number of stores and countries in which these franchises operate as part of our efforts to expand internationally. The effect of these arrangements on our business and results of operations is uncertain and will depend upon various factors, including the demand for our products in new markets internationally. In addition, certain aspects of these arrangements are not directly in our control, such as the ability of this third party to meet their projections regarding store openings and sales. Moreover, while the agreement we have entered into may provide us with certain termination rights, to the extent that this third party does not operate its stores in a manner consistent with our requirements regarding our brand identities and customer experience standards, the value of our brands could be impaired. In addition, in connection with this new franchise agreements we are implementing certain new processes that will subject us to additional regulations and laws, such as U.S. export regulations. Failure to comply with these regulations or laws could have an adverse effect on our results of operations.

If our operating and financial performance in any given period does not meet the extensive guidance that we have provided to the public, our stock price may decline.

We provide extensive public guidance on our expected operating and financial results for future periods. Although we believe that this guidance provides investors and analysts with a better understanding of management’s expectations for the future and is useful to our shareholders and potential shareholders, such guidance is comprised of forward-looking statements subject to the risks and uncertainties described in this report and in our other public filings and public statements. Our actual results may not always be in line with or exceed the guidance we have provided, especially in times of great economic uncertainty. In the past, when we have reduced our previously provided guidance, the market price of our common stock has declined. If, in the future, our operating or financial results for a particular period do not meet our guidance or the expectations of investment analysts or if we reduce our guidance for future periods, the market price of our common stock may decline as well.

A variety of factors, including seasonality and the economic downturn, may cause our quarterly operating results to fluctuate, leading to volatility in our stock price.

Our quarterly results have fluctuated in the past and may fluctuate in the future, depending upon a variety of factors, including shifts in the timing of holiday selling seasons, including Valentine’s Day, Easter, Halloween, Thanksgiving and Christmas as well as changes in economic conditions. A significant portion of our revenues and net earnings has typically been realized during the period from October through December each year, however we realized significantly lower-than-expected revenues and net earnings during the October through December selling season of fiscal 2008 due to the economic downturn, which affected our business and operating results. In anticipation of increased holiday sales activity, we incur certain significant incremental expenses prior to and during peak selling seasons, particularly October through December, including fixed catalog production and mailing costs and the costs associated with hiring a substantial number of temporary employees to supplement our existing workforce.

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We may require external funding sources for operating funds, which may cost more than we expect, or not be available at the levels we require and, as a consequence, our expenses and operating results could be negatively affected.

We regularly review and evaluate our liquidity and capital needs. We currently believe that our available cash, cash equivalents, cash flow from operations and cash available under our existing credit facilities will be sufficient to finance our operations and expected capital requirements for at least the next 12 months. However, we might experience periods during which we encounter additional cash needs during the course of our fiscal year, and we might need additional external funding to support our operations. Although we were able to amend our line of credit facility during fiscal 2008 on acceptable terms, in the event we require additional liquidity from our lenders, such funds may not be available to us or may not be available to us on acceptable terms. For example, in the event we were to breach any of our financial covenants, our banks would not be required to provide us with additional funding, or they may require us to renegotiate our existing credit facility on less acceptable terms. In addition, we may not be able to renew our letters of credit that we use to help pay our suppliers on terms that are acceptable to us, or at all, as the availability of letter of credit facilities may continue to be limited. Further, the providers of such credit may reallocate the available credit to other borrowers. If we are unable to access credit at the levels we require, or the cost of credit is greater than expected, it could adversely affect our operating results.

Disruptions in the financial markets may adversely affect our liquidity and capital resources and our business.

Disruptions in global financial markets and banking systems have made credit and capital markets more difficult for companies to access, even for some companies with established revolving or other credit facilities. We have access to capital through our revolving line of credit facility. Each financial institution which is part of the syndicate for our revolving line of credit facility is responsible for providing a portion of the loans to be made under the facility. If any participant or group of participants with a significant portion of the commitments in our revolving line of credit facility fails to satisfy its obligations to extend credit under the facility and we are unable to find a replacement for such participant or group of participants on a timely basis (if at all), our liquidity may be adversely affected and our business could be materially adversely affected.

If we are unable to pay quarterly dividends at intended levels, our reputation and stock price may be harmed.

Our current quarterly cash dividend is $0.12 per common share. The dividend program requires the use of a significant portion of our cash earnings. As a result, we may not retain a sufficient amount of cash to fund our operations or finance future growth opportunities, new product development initiatives and unanticipated capital expenditures. Our Board of Directors may, at its discretion, decrease the intended level of dividends or entirely discontinue the payment of dividends at any time. Our ability to pay dividends will depend on our ability to generate sufficient cash flows from operations in the future. This ability may be subject to certain economic, financial, competitive and other factors that are beyond our control. Any failure to pay dividends after we have announced our intention to do so may negatively impact our reputation and investor confidence in us and negatively impact our stock price.

If we fail to maintain proper and effective internal controls, our ability to produce accurate and timely financial statements could be impaired and investors’ views of us could be harmed.

We have evaluated and tested our internal controls in order to allow management to report on, and our registered independent public accounting firm to attest to, our internal controls, as required by Section 404 of the Sarbanes-Oxley Act of 2002. We have incurred, and expect to continue to incur, significant expenses and a diversion of management’s time to meet the requirements of Section 404. If we are not able to continue to meet the requirements of Section 404 in a timely manner or with adequate compliance, we would be required to disclose material weaknesses if they develop or are uncovered and we may be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission or the New York Stock Exchange. Any

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such action could negatively impact our business and the perception of us in the financial markets. In addition, our internal controls may not prevent or detect all errors and fraud. A control system, no matter how well designed and operated, is based upon certain assumptions and can provide only reasonable assurance that the objectives of the control system will be met.

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

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

Changes to estimates related to our property and equipment, including information technology systems, or operating results that are lower than our current estimates at certain store locations, may cause us to incur impairment charges.

We make certain estimates and projections in connection with impairment analyses for certain of our store locations and other property and equipment, including information technology systems. These impairment analyses require that we review for impairment all stores for which current or projected cash flows from operations are either negative or nominal, or the construction costs are significantly in excess of the amount originally expected. An impairment charge is required when the carrying value of the asset exceeds the undiscounted future cash flows over the remaining life of the lease. These calculations require us to make a number of estimates and projections of future results, often up to 20 years into the future. If these estimates or projections change or prove incorrect, we may be, and have been, required to record impairment charges on certain store locations and other property and equipment, including information technology systems. These impairment charges have been significant in the past and may be in the future and, as a result of these charges, our operating results have been and may be adversely affected. For example, during fiscal 2008 and year-to-date 2009, we recorded impairment charges of $33,995,000 and $21,537,000, respectively, related to underperforming retail stores.

If we do not properly account for our unredeemed gift certificates, gift cards and merchandise credits, our operating results will be harmed.

We maintain a liability for unredeemed gift cards, gift certificates and merchandise credits until the earlier of redemption, escheatment or four years. After four years, the remaining unredeemed gift cards, gift certificate or merchandise credit liability is relieved and recorded within selling, general and administrative expenses. In the event that our historical redemption patterns change in the future, we might change the minimum time period for maintaining a liability for unredeemed gift certificates on our balance sheets, which would affect our financial position or operating results. Further, in the event that a state or states were to require that the unredeemed amounts should have been escheated to that state or states, our business and operating results would be harmed.

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 significant portion of our customer orders are placed through our website or through our customer care centers. In addition, a significant portion of sales made through our retail channel require the collection of certain customer data, such as credit card information. In order for our sales channel to function and develop successfully, we and other parties involved in processing customer transactions must be able to transmit confidential information, including credit card information, securely over public networks. Third parties may have the technology or knowledge to breach the security of customer transaction data. Although we take the security of our systems and the privacy of our customers’ confidential information seriously, we cannot guarantee

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that our security measures will effectively prevent others from obtaining unauthorized access to our information and our customers’ information. Any person who circumvents our security measures could destroy or steal valuable information or disrupt our operations. Any security breach could cause consumers to lose confidence in the security of our website or stores and choose not to purchase from us. Any security breach could also expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation, any of which could harm 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 to detect and provide prompt notice of unauthorized access as required by some of these new laws, we could be subject to potential claims for damages and other remedies, which could harm our business.

Fluctuations in our tax obligations and effective tax rate may result in volatility of our operating results and stock price.

We are subject to income taxes in many U.S. and certain foreign jurisdictions. We record tax expense based on our estimates of future payments, which include reserves for estimates of probable settlements of foreign and domestic tax audits. At any one time, many tax years are subject to audit by various taxing jurisdictions. The results of these audits and negotiations with taxing authorities may affect the ultimate settlement of these issues. As a result, we expect that throughout the year there could be on-going variability in our quarterly tax rates as taxable events occur and exposures are evaluated. Further, our effective tax rate in a given financial statement period may be materially impacted by changes in the mix and level of earnings or by changes to existing accounting rules or regulations.

If we fail to attract and retain key personnel, our business and operating results may be harmed.

Our future success depends to a significant degree on the skills, experience and efforts of key personnel in our senior management, whose vision for our company, knowledge of our business and expertise would be difficult to replace. If any of our key employees leaves, is seriously injured or is unable to work, and we are unable to find a qualified replacement, we may be unable to execute our business strategy.

In addition, our main offices are located in the San Francisco Bay Area, where competition for personnel with retail and technology skills can be intense. If we fail to identify, attract, retain and motivate these skilled personnel, especially in this challenging economic environment, our business may be harmed. Further, in the event we need to hire additional personnel, we may experience difficulties in attracting and successfully hiring such individuals due to competition for highly skilled personnel as well as the significantly higher cost of living expenses in our market.

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ITEM 6. EXHIBITS

(a) Exhibits

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SIGNATURE

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.

Date: December 11, 2009

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