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

BUSINESS

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, Hold Everything and West Elm). The direct-to-customer segment of our business sells similar products through our eight direct-mail catalogs (Williams-Sonoma, Pottery Barn, Pottery Barn Kids, Pottery Barn Bed + Bath, PBteen, Hold Everything, West Elm and Williams-Sonoma Home) and five e-commerce websites (williams-sonoma.com, potterybarn.com, potterybarnkids.com, pbteen.com and westelm.com). Based on net revenues in fiscal 2003, retail net revenues accounted for 58.9% of our business and direct-to-customer net revenues accounted for 41.1% of our business. Based on their contribution to our net revenues in fiscal 2003, the core brands in both retail and direct-to-customer are: Pottery Barn, which sells contemporary tableware and home furnishings; Williams-Sonoma, which sells cookware essentials; and Pottery Barn Kids, which sells stylish children’s furnishings. The following discussion and analysis of financial condition, results of operations, liquidity and capital resources should be read in conjunction with our condensed consolidated financial statements and the notes thereto.

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, without limitation, projections of earnings, revenues or financial items, statements of the plans, strategies and objectives of management for future operations, statements related to the future performance of our brands, statements related to stronger merchandising, improved sourcing and enhanced retail execution in the Williams-Sonoma brand, statements related to our plans to increase retail leased square footage, statements related to increasing and expanding catalog circulation and increasing catalog page counts, statements related to introducing new core and seasonal merchandise assortments, statements related to enhancing product quality, statements related to reducing our customer backorders and improving our in-stock positions in key furniture programs, statements related to implementing new marketing initiatives and expanding on-line and electronic direct marketing initiatives, statements related to making investments in our emerging brands, statements related to increasing our interactions with our teen customers and broadening our assortment of teenage home-centered gifts, statements related to our plans to open new retail stores, statements related to launching new websites, statements regarding future comparable store sales, statements related to the use of our available cash, statements related to our projected capital expenditures, statements related to the timing of the replenishment of our inventory levels, statements related to our stock repurchase program, 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, but are not limited to, those discussed under the heading “Risk Factors” in this document and the risks,

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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

In the third quarter of 2004 versus the third quarter of 2003, on revenue growth of 14.2%, we increased our diluted earnings per share by 20.0%, to $0.24 per share and our pre-tax operating margin by 30 basis points, despite a difficult retail environment and a challenging performance in the Williams-Sonoma brand. A strong consumer response to our merchandising initiatives in the Pottery Barn brand, with particularly strong growth in furniture, growth in our Internet channel, and continuing benefits from successful overhead cost containment initiatives drove these results.

During the third quarter of 2004, net revenues increased 14.2% from the third quarter of 2003, primarily driven by increases in the Pottery Barn, Pottery Barn Kids and PBteen brands. A positive consumer response to both our core and seasonal product offerings, with particularly strong growth in furniture, drove the Pottery Barn businesses.

In our retail channel, net revenues increased 11.6% from the third quarter of 2003, due to an increase in store leased square footage of 10.2% and a comparable store sales increase of 3.1%, which was driven primarily by increases in the Pottery Barn and Pottery Barn Kids brands. The comparable store sales increase was partially impacted by Williams-Sonoma which had a challenging quarter, primarily in the tabletop, cookware and outdoor categories. We believe the challenges we faced in Williams-Sonoma in the third quarter of 2004 will be overcome in future quarters with stronger merchandising, improved sourcing, and enhanced retail execution.

In our direct-to-customer channel, net revenues increased 17.5% in the third quarter of 2004 versus the third quarter of 2003. This increase was primarily driven by incremental sales generated in the Pottery Barn, PBteen, West Elm and Pottery Barn Kids brands resulting from increased catalog circulation and the continued success of our e-commerce initiatives.

In the third quarter of 2004, we launched Williams-Sonoma Home, our newest brand. This new premium brand, offering classic home furnishings and decorative accessories, extends the Williams-Sonoma lifestyle beyond the kitchen into every room of the home. During the quarter, we circulated approximately 5,600,000 catalogs and were pleased with the consumer response. From a merchandising perspective, we saw strong performance in textiles, furniture, lighting, and decorative accessories. Especially promising was the success of the customer upholstered furniture assortment that was targeted against the void in the market between the high-end designer and contemporary home furnishings.

Operationally, in the third quarter, we finalized the start-up of our new 781,000 square foot East Coast furniture distribution center in Cranbury, New Jersey. The new center has allowed us to improve our service levels to our East Coast customers and has made it operationally efficient for us to bring a large percentage of our furniture containers through East Coast ports, avoiding the congestion on the West Coast.

As we look forward to the fourth quarter, we are continuing to focus on our strategic initiatives. In our core brands (Williams-Sonoma, Pottery Barn and Pottery Barn Kids), consistent with our strategic

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effort to drive top-line sales growth, we are increasing retail leased square footage and catalog circulation, introducing new core and seasonal merchandise assortments, continuing to enhance product quality with a particular focus on furniture, focusing on reducing our customer backorders and improving our in-stock positions in key furniture programs and implementing new marketing initiatives that will continue to expand the reach of our brands.

During the fourth quarter of 2004, we will be making investments in our emerging brands (PBteen, West Elm, Hold Everything and Williams-Sonoma Home). In PBteen, we will continue to increase page counts per catalog, expand our on-line marketing initiatives, increase our interactions with our teen customers through contests, print media and entertainment related promotions and broaden our assortment of teenage home-centered gifts. In West Elm, we will open our third prototype store and will continue to expand our on-line search and electronic direct marketing initiatives. In Hold Everything, we plan to launch our first e-commerce website and open three new prototype stores. In Williams-Sonoma Home, we will continue to expand catalog circulation, focus on identifying customers in the underserved premium market segment, and expand our e-mail marketing initiatives to grow our customer database and attract new customers to the interactive e-catalog.

NET REVENUES

Net revenues consist of retail sales, direct-to-customer sales and shipping fees. Retail sales include sales of merchandise to customers at our retail stores, direct-to-customer sales include sales of merchandise to customers through catalogs and the Internet, and shipping fees consist of revenue received from customers for delivery of merchandise.

The following table summarizes our net revenues for the thirteen weeks ended October 31, 2004 (“Third Quarter of 2004”) and November 2, 2003 (“Third Quarter of 2003”) and the thirty-nine weeks ended October 31, 2004 (“Year-to-Date 2004”) and November 2, 2003 (“Year-to-Date 2003”).

Net revenues for the Third Quarter of 2004 increased by $89,937,000, or 14.2%, over net revenues for the Third Quarter of 2003. This was primarily due to a year-over-year increase in store leased square footage of 10.2%, driven by 36 new store openings and the remodeling and expansion of an additional 24 stores, a comparable store sales increase of 3.1%, increased catalog circulation of 10.3%, and the strong momentum from our Internet growth initiatives. This increase was partially offset by the temporary closure of 23 stores and the permanent closure of 11 stores since the Third Quarter of 2003.

Net revenues for Year-to-Date 2004 increased by $303,204,000, or 17.3%, over net revenues for Year-to-Date 2003. This was primarily due to a year-over-year increase in store leased square footage of 10.2%, driven by 36 new store openings and the remodeling and expansion of an additional 24 stores, a comparable store sales increase of 4.9%, increased catalog circulation of 19.4%, and the strong momentum from our Internet growth initiatives. This increase was partially offset by the temporary closure of 23 stores and the permanent closure of 11 stores since the Third Quarter of 2003.

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

Retail revenues for the Third Quarter of 2004 increased by $40,981,000, or 11.6%, over the Third Quarter of 2003, primarily driven by a year-over-year increase in store leased square footage of 10.2%, including 36 new store openings and the remodeling and expansion of an additional 24 stores, and a comparable store sales increase of 3.1%, despite a difficult retail environment and a challenging performance in the Williams-Sonoma brand. This increase was partially offset by the temporary closure of 23 stores and the permanent closure of 11 stores since the Third Quarter of 2003. Net sales generated in the Pottery Barn and Pottery Barn Kids brands were the primary contributors to the year-over-year sales increase, partially offset by lower sales in the Hold Everything brand due to a year-over-year reduction in Hold Everything retail stores from 12 stores to 7 stores.

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Retail revenues for Year-to-Date 2004 increased $133,162,000, or 13.4%, over Year-to-Date 2003, primarily due to 36 new store openings and the remodeling and expansion of an additional 24 stores, and a comparable store sales increase of 4.9%. This increase was partially offset by the temporary closure of 23 stores and the permanent closure of 11 stores since the Third Quarter of 2003. Net sales generated in the Pottery Barn, Pottery Barn Kids, and Williams-Sonoma brands were the primary contributors to the year-over-year sales increase, partially offset by lower sales in the Hold Everything brand due to the year-over-year reduction in Hold Everything retail stores from 12 stores to 7 stores.

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 store expansions and closings. Percentages represent changes in comparable store sales versus the same period in the prior year.

The Third Quarter of 2004 comparable store sales increase in Pottery Barn of 5.7% from the Third Quarter of 2003 was primarily driven by a positive consumer response to the overall merchandise assortments, particularly furniture.

The Third Quarter of 2004 comparable store sales increase in Pottery Barn Kids of 5.6% from the Third Quarter of 2003 was primarily driven by a strong performance in both single-store and multi-store markets, successful in-store marketing programs and new merchandise assortments, particularly furniture.

The Third Quarter of 2004 comparable store sales decrease in Williams-Sonoma of 4.2% from the Third Quarter of 2003 was primarily driven by the underperformance in the tabletop, cookware and outdoor categories as well as the decision not to repeat last year’s deeply promotional tabletop transition, which was responsible for a portion of the brand’s comparable store sales increase in the Third Quarter of 2003.

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Direct-to-customer revenues (including catalog and Internet) in the Third Quarter of 2004 increased by $48,956,000, or 17.5%, over the Third Quarter of 2003. This increase was primarily driven by net sales generated in the Pottery Barn, PBteen, West Elm and Pottery Barn Kids brands resulting from increased catalog circulation and the positive response to our on-line marketing initiatives.

Direct-to-customer revenues for Year-to-Date 2004 increased $170,042,000, or 22.5%, over Year-to-Date 2003. This increase was primarily driven by net sales generated in the Pottery Barn, PBteen, Pottery Barn Kids and West Elm brands, resulting from increased catalog circulation and the positive response to our on-line marketing initiatives.

Internet sales in the Third Quarter of 2004 increased by $35,917,000, or 43.6%, over the Third Quarter of 2003 and contributed 42.0% of total direct-to-customer sales in the Third Quarter of 2004 versus 34.4% in the Third Quarter of 2003. Internet sales for Year-to-Date 2004 increased by $112,921,000, or 53.3%, over Year-to-Date 2003 and contributed 41.1% of total direct-to-customer sales in Year-to-Date 2004 versus 32.9% in Year-to-Date 2003. Although the amount of Internet sales that are incremental to our direct-to-customer channel cannot be identified precisely, we estimate that approximately 40% of our company-wide non-gift registry Internet sales are incremental to the direct-to-customer channel and approximately 60% are catalog-driven sales.

Cost of goods and occupancy expenses in the Third Quarter of 2004 increased by $49,633,000, or 14.2%, over the Third Quarter of 2003. As a percentage of net revenues, cost of goods and occupancy expenses remained unchanged for the Third Quarter of 2004 from the Third Quarter of 2003. Although

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the rate as a percentage of net revenues remained unchanged, there were offsetting contributing factors. As a percentage of net revenues, cost of goods sold and occupancy expenses increased from the Third Quarter of 2003 due to a higher percentage of total company net revenues in the Third Quarter of 2004 being driven by furniture, which generates a higher average cost of good sold. This increase was offset by a reduction in markdowns from the Third Quarter of 2003 due to a deeply promotional tabletop transition in 2003 and a rate reduction in occupancy expenses. The rate reduction in occupancy expenses resulted from a greater percentage of total Company net revenues being generated in the direct-to-customer channel, which does not incur store related occupancy expenses, in addition to the overall leverage of fixed occupancy expenses that resulted from strong revenue growth during the quarter.

Cost of goods and occupancy expenses for Year-to-Date 2004 increased by $161,692,000, or 16.4%, over Year-to-Date 2003. As a percentage of net revenues, cost of goods and occupancy expenses decreased 50 basis points for Year-to-Date 2004 from Year-to-Date 2003. This percentage decrease was primarily driven by a rate reduction in occupancy expenses, partially offset by the cost of replacing and liquidating damaged merchandise that was returned from customers. The rate reduction in occupancy expenses resulted from a greater percentage of total Company net revenues being generated in the direct-to-customer channel, which does not incur store-related occupancy expenses, in addition to the overall leverage of fixed occupancy expenses that resulted from strong revenue growth during the year.

Shipping costs consist of third-party delivery services and shipping materials. Shipping costs in the Third Quarter of 2004 increased by $7,861,000, or 23.6%, versus the Third Quarter of 2003. This increase was directly related to a higher number of direct-to-customer shipments associated with the increase in direct-to-customer sales. Shipping costs as a percentage of shipping fees were 83.8% in the Third Quarter of 2004 versus 79.0% in the Third Quarter of 2003, primarily driven by an increase in furniture sales and a corresponding increase in furniture shipments, which generate lower shipping margins than the Company average.

Shipping costs for Year-to-Date 2004 increased by $23,551,000, or 25.1%, from Year-to-Date 2003 due to a higher number of direct-to-customer shipments associated with the increase in direct-to-customer sales. Shipping costs as a percentage of shipping fees were 83.2% for Year-to-Date 2004 versus 80.7% for Year-To-Date 2003, primarily driven by an increase in furniture sales and a corresponding increase in furniture shipments, which generate lower shipping margins than the Company average.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES

Selling, general and administrative expenses increased $24,953,000, or 11.9%, to $235,018,000 in the Third Quarter of 2004 from $210,065,000 in the Third Quarter of 2003. Selling, general and administrative expenses expressed as a percentage of net revenues decreased to 32.5% in the Third Quarter of 2004 from 33.2% in the Third Quarter of 2003. This 70 basis point decrease as a percentage of net revenues was primarily driven by rate reductions in employment and advertising expenses. The employment rate decrease was primarily driven by year-over-year sales leverage in corporate employment and employee benefit expenses. The advertising rate reduction was primarily driven by a greater percentage of total Company net revenues in the Third Quarter of 2004 being generated in the e-commerce channel, which incurs advertising expenses at a lower rate than the Company average.

For Year-to-Date 2004, selling, general and administrative expenses increased $81,055,000, or 14.0%, to $660,189,000 from $579,134,000 for Year-to-Date 2003. Selling, general and administrative

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expenses expressed as a percentage of net revenues decreased by 90 basis points to 32.2% for Year-to-Date 2004 from 33.1% for Year-to-Date 2003. This decrease as a percentage of net revenues was primarily driven by rate reductions in employment expenses resulting from year-over-year sales leverage in corporate employment and store labor as well as an overall rate reduction in employee benefit expenses, partially offset by an increase in other general expenses.

INTEREST EXPENSE (INCOME) – NET

Interest expense, net of capitalized interest, was $53,000 in the Third Quarter of 2004 compared to interest income of $116,000 in the Third Quarter of 2003. For Year-to-Date 2004, net interest expense was $339,000 compared to net interest income of $562,000 for Year-to-Date 2003. The increase in interest expense in the Third Quarter of 2004 and for Year-to-Date 2004 was primarily due to additional interest expense of $376,000 and $1,155,000, respectively, associated with the consolidation of our Memphis-based distribution facilities. Prior to the adoption of FIN 46R, this expense would have been classified as occupancy expense. This increase in interest expense was partially offset by an increase in interest income resulting from an increase in our cash balances from the prior year.

INCOME TAXES

Our effective tax rate was 38.3% for Year-to-Date 2004 and 38.5% for Year-to-Date 2003. We expect our effective tax rate to remain at approximately 38.3% for fiscal 2004.

LIQUIDITY AND CAPITAL RESOURCES

As of October 31, 2004, we held $88,783,000 in cash and cash equivalents. As is consistent with our industry, a significant portion of our revenues and net earnings are realized during the period from October through December, and levels of net revenues and net earnings are generally significantly lower during the period from January through September. As a result, we utilize our cash throughout the year to fund the on-going operations of the business, such as our inventory and inventory-related purchases, catalog advertising and marketing initiatives and to support current store development and infrastructure strategies. We utilize the additional cash during the third quarter to build our inventory levels in preparation for our fourth quarter holiday sales. In addition to the current cash balances on-hand, we have a $200,000,000 credit facility available as of October 31, 2004. We have not borrowed against this facility in Year-to-Date 2004. We believe our cash on-hand, in addition to our available credit facilities, will provide adequate liquidity and capital for our business operations and growth opportunities during the next twelve months.

For Year-to-Date 2004, net cash provided by operating activities was $53,737,000 as compared to net cash used in operating activities of $43,420,000 in Year-to-Date 2003. Net cash provided by operating activities for Year-to-Date 2004 was primarily attributable to net earnings, excluding depreciation and amortization expense, an increase in accounts payable driven by higher freight payables and the timing of expenditures, an increase in deferred rent and lease incentives due to retail store openings and an increase in customer deposits due to the continued growth in our unredeemed gift certificates and gift card liabilities. This cash increase was partially offset by an increase in merchandise inventories in preparation for our fourth quarter holiday sales. Although merchandise inventories increased 6.6% from the prior year, this was lower than our expectations due to lower than planned in-stock positions on key furniture collections resulting from better than expected sales demand, and the ongoing success of our newly implemented inventory initiatives. We expect to fully replenish our inventory levels by the end of the first quarter of 2005. Additionally, this cash increase was partially offset by the payment

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of income taxes, an increase in prepaid catalog expenses due to the timing of expenditures for our catalogs and an increase in catalog circulation, and an increase in accounts receivable due to the timing of third party credit card receipts.

For Year-to-Date 2004, net cash used in investing activities was $144,828,000 as compared to $131,852,000 for Year-to-Date 2003. Year-to-Date 2004 purchases of property and equipment included approximately $75,254,000 for stores, $39,198,000 for systems development projects (including e-commerce websites) and $30,376,000 for distribution and facility infrastructure projects.

Year-to-Date 2003 purchases of property and equipment of $131,852,000 included approximately $85,850,000 for stores, $40,871,000 for systems development projects (including e-commerce websites) and $5,131,000 for distribution and facility infrastructure projects.

In fiscal 2004, we anticipate investing $180,000,000 to $190,000,000 in the purchase of property and equipment, primarily for the construction of 43 new stores and the remodeling of 17 stores, systems development projects (including e-commerce websites), and distribution and facility infrastructure projects.

For Year-to-Date 2004, net cash provided by financing activities was $15,694,000, as compared to $23,159,000 for Year-to-Date 2003, comprised primarily of proceeds from the exercise of stock options and the issuance of bonds associated with the Mississippi Debt Transaction, partially offset by cash used to repurchase common stock and the repayment of capital lease and long-term debt obligations .

For Year-to-Date 2003, cash provided by financing activities was $23,159,000, comprised primarily of proceeds from the exercise of stock options, partially offset by the repayment of capital lease and long-term debt obligations .

Stock Repurchase Program

In May 2004, the Board of Directors authorized a stock repurchase program to acquire up to 2,500,000 shares of our outstanding common stock in the open market. During the second quarter of 2004, we repurchased and retired 255,500 shares of our common stock under the program at a total cost of approximately $7,915,000, a weighted average cost of $30.98 per share. No additional shares were repurchased during the Third Quarter of 2004. At October 31, 2004, the remaining authorized amount of stock eligible for repurchase was 2,244,500 shares. Stock repurchases under this program may be made through open market and privately negotiated transactions at times and in such amounts as management deems appropriate. The timing and actual number of shares repurchased will depend on a variety of factors including price, corporate and regulatory requirements and other market conditions. The stock repurchase program does not have an expiration date and may be limited or terminated at any time without prior notice. Subsequent to October 31, 2004, we repurchased and retired 849,300 shares of our common stock under the program at a total cost of approximately $31,069,000, a weighted average cost of $36.58 per share.

Impact of Inflation

The impact of inflation on results of operations was not significant for Year-to-Date 2004 or Year-to-Date 2003.

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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, and we expect this to continue going forward. In anticipation of our peak season, we hire a substantial number of additional employees in our retail stores and direct-to-customer processing and distribution areas, and incur significant fixed catalog production and mailing costs.

Critical Accounting Policies

“Management’s Discussion and Analysis of Financial Condition and Results of Operations” is based on our 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 on-going 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. As of October 31, 2004, there have been no significant changes to our critical accounting policies as disclosed in our Annual Report on Form 10-K for the year ended February 1, 2004.

RISK FACTORS

The following information describes certain significant risks and uncertainties inherent in our business. You should carefully consider such risks and uncertainties, together with the other information contained in this report, our Annual Report on Form 10-K for the fiscal year ended February 1, 2004 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 disclosed 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.

We must successfully anticipate changing consumer preferences and buying trends, and manage our inventory commensurate with customer demand.

Our success depends upon our ability to anticipate and respond in a timely manner to changing merchandise trends and customer demands. Consumer preferences cannot be predicted with certainty and may change between sales seasons. Changes in customer preferences and buying trends may also affect our brands differently. If we misjudge either the market for our merchandise or our customers’ 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, each of which would harm our business and operating results.

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In addition, we must manage our inventory effectively and commensurate with customer demand. Much of our inventory is sourced from vendors located outside the U.S. Thus, we usually must order merchandise, and enter into contracts for the purchase and manufacture of such merchandise, well 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. 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 business depends, in part, on factors affecting consumer spending that are out of our control.

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, recession and fears of recession, war and fears of war, inclement weather, consumer debt, interest rates, sales tax rates and rate increases, consumer confidence in future economic conditions and political conditions, and consumer perceptions of personal well-being and security generally. These factors may also affect our various brands and channels differently. Adverse changes in factors affecting discretionary consumer spending could reduce consumer demand for our products, thus reducing our sales and harming our business and operating results.

We face intense 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, mail order catalogs and e-commerce websites compete with other retail stores, other mail order 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.

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 harm our sales, operating results and business.

We depend on key domestic and foreign vendors for timely and effective sourcing of our merchandise, and we are subject to various risks and uncertainties that might affect our vendors’ ability to produce quality merchandise.

Our performance depends on our ability to purchase our merchandise in sufficient quantities at competitive prices. We purchase our merchandise from numerous foreign and domestic manufacturers

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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 they sell to us or discontinue selling to us at any time. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future. Better than expected sales demand may also lead to customer backorders and lower in-stock positions of our products.

Any inability to acquire suitable merchandise on acceptable terms or the loss of one or more key 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 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 a price that is 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.

Our dependence on foreign vendors subjects us to a variety of risks and uncertainties.

In fiscal 2003, we sourced our products from manufacturers in 41 countries outside of the United States. Approximately 61% of our merchandise purchases were foreign-sourced, primarily from Asia and Europe. Our dependence on foreign vendors means that we may be affected by declines in the relative value of the U.S. dollar to other foreign currencies. Although substantially all 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, 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, concerns over anti-dumping, work stoppages, economic uncertainties (including inflation), foreign government regulations, wars and fears of war, political unrest 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, against home-centered items 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 financial instability resulting in the disruption of trade from exporting countries, restrictions on the transfer of funds and/or other trade disruptions.

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In addition, although we are in the process of implementing an enhanced 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.

The growth of our sales and profits depends, in large part, on our ability to successfully open new stores.

In each of the past three fiscal years, our retail stores have generated approximately 59% of our net revenues. During 2004 we opened 43 new and 17 remodeled retail stores as part of our growth strategy. The growth of our sales and profits depend, in large part, on our ability to successfully open new stores.

Our ability to open additional 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 demographics 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 the 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.

We must 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. Accordingly, we are subject to the risks, including labor disputes such as the west coast port strike of 2002, union organizing activity, inclement weather, natural disasters, 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 increased

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substantially and airline companies struggle to operate profitably, which could lead to increased fulfillment expenses. The increased fulfillment costs could negatively affect our business and operating results by increasing our transportation costs and, therefore, 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.

The operation of our direct-to-customer business depends on our ability to maintain the efficient and uninterrupted operation of our order-taking and fulfillment operations and our e-commerce websites. Disruptions or slowdowns in these areas could result from disruptions in telephone service or power outages, inadequate system capacity, security breaches, human error, union organizing activity, natural disasters or adverse weather conditions. 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, especially during our peak season, to support our direct-to-customer operations, due to war or other circumstances that reduce the relevant workforce. 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, and any of these events could result in an interruption in our business.

Our 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, fire, floods, power loss, telecommunications failures, and similar events. If any of these events results 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.

We experience fluctuations in our comparable store sales.

Our success depends, in part, upon our ability to increase sales at our existing stores. Various factors affect comparable store sales, including the number of stores we open, close and expand in any period, the general retail sales environment, changes in sales mix between distribution channels, our ability to efficiently source and distribute products, changes in our merchandise mix, competition, current economic conditions, the timing of our releases of new merchandise and promotional events, the success of marketing programs, and the cannibalization of existing store sales by new stores. Among other things, weather conditions can affect comparable store sales, because inclement weather can 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 may cause our comparable store sales results to differ materially from prior periods and from earnings guidance we have provided.

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. Our comparable store sales increases for fiscal years 2003, 2002 and 2001 were 4.0%, 2.7% and 1.7%, respectively. Past comparable store sales are no indication of future results, and comparable store sales may decrease in the future. Our ability to maintain and improve our comparable store sales results depends in large part on maintaining and improving our forecasting of customer demand and buying

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trends, selecting effective marketing techniques, providing an appropriate mix of merchandise for our broad and diverse customer base and using more effective pricing strategies. Any failure to meet the comparable store sales expectations of investors and security 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.

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, such as discounts for bulk mailings and sorting by zip code and carrier routes. Our cost of paper has fluctuated significantly during the past three fiscal years, and our paper costs may increase in the future. Although we have entered into long-term contracts for catalog paper and catalog printing, these contracts offer no assurance that our catalog production costs will not substantially increase following expiration of the contracts. Future increases in postal rates or paper or printing costs would have a negative impact on our operating results to the extent that we are unable to pass such increases on directly to customers or offset such increases by raising prices or by implementing more efficient printing, mailing, delivery and order fulfillment systems.

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 sizing and timing of delivery of the catalogs. In addition, environmental organizations may attempt to create an unfavorable impression of our paper use in catalogs. The failure to effectively produce or distribute our catalogs could affect the timing of catalog delivery, which could cause customers to forego or defer purchases.

We must successfully manage our Internet business.

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

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 may 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. Any significant increase in merchandise returns that exceeds our reserves could harm our business and operating results.

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We must successfully manage the complexities associated with a multi-channel and multi-brand business.

During the past few years, with the launch and expansion of our Internet business, new brands and brand expansions, 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. 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. However, as our Internet business grows and as we add e-commerce websites for more of our concepts, these increased Internet sales may cannibalize a portion of our retail and catalog businesses.

We may not be able to introduce new brands and brand extensions that improve our business.

We have recently introduced three new brands – West Elm, PBteen and Williams-Sonoma Home and may introduce new brands and brand extensions in the future. If we devote time and resources to new brands and brand extensions, and those businesses are not as successful as we planned, then we risk damaging our overall business results. Alternatively, if our new brands and brand extensions prove to be very successful, we risk hurting our existing brands through the potential migration of existing brand customers to the new businesses. We may not be able to introduce new brands and brand extensions that improve our overall business and operating results.

Our inability to obtain commercial insurance at acceptable prices might have a negative impact on our business.

Insurance costs continue to be volatile, affected by natural catastrophes, fear of terrorism and financial irregularities and other fraud at publicly-traded companies. We believe that commercial insurance coverage is prudent for risk management and insurance costs may increase substantially in the future. In addition, for certain types or levels of risk, such as risks associated with earthquakes or terrorist attacks, we might determine that we cannot obtain commercial insurance at acceptable prices. Therefore, we might choose to forego or limit our purchase of relevant commercial insurance, choosing instead to self-insure one or more types or levels of risks. If we suffer a substantial loss that is not covered by commercial insurance, the loss and attendant expenses could harm our business and operating results.

Our inability or failure to protect our intellectual property would have a negative impact on our business.

Our trademarks, service marks, copyrights, patents, 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. 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 have been sued and may be named in additional lawsuits in a growing number of industry-wide patent litigation cases relating to the Internet.

There appears to be a growing number of patent infringement lawsuits instituted against companies such as ours that have an Internet business. The plaintiff in each case claims to hold a patent that

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covers certain website technology, which is allegedly infringed by the operation of the defendants’ e-commerce websites. We are currently a defendant in one such patent infringement case and anticipate being named in others in the future, as part of an industry-wide trend. Even in cases where a plaintiff’s claim lacks merit, the defense costs in a patent infringement case can be high. Additional patent infringement claims may be brought against us, and the cost of defending such claims or the ultimate resolution of such claims may harm our business and operating results.

We need to manage our employment, occupancy and other operating costs.

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 in 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. 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. In addition, there appears to be a growing number of wage and hour lawsuits against retail companies, especially in California.

From time to time we may also experience union organizing activity in currently non-union distribution facilities, stores and direct-to-customer operations. Union organizing activity may result in work slowdowns or stoppages and higher labor costs, which would harm our business and operating results. 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. Higher than expected costs, particularly if coupled with lower than expected sales, would negatively impact our business and operating results.

We are planning certain systems changes that might disrupt our supply chain operations.

Our success depends 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 supporting the product pipeline, including design, sourcing, merchandise planning, forecasting and purchase order, inventory, distribution, transportation and price management. Modifications will 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 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 may result in supply chain and merchandising systems disruptions. Any such disruptions could harm our business and operating results.

We are implementing changes to our data center information technology infrastructure that might disrupt our business.

We have engaged IBM to host and manage certain aspects of our data center information technology infrastructure. Accordingly, we are subject to the risks associated with IBM’s ability to provide information technology services to meet our needs. Our operations will depend significantly upon IBM’s ability to make our servers, software applications and websites available and to protect our data from damage or interruption from human error, computer viruses, intentional acts of vandalism, labor disputes, natural disasters and similar events. If IBM is unable to adequately protect our data and information is lost or our ability to deliver our services is interrupted, then our business may be harmed.

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While we believe that we currently have adequate internal control procedures in place, we are still exposed to potential risks from recent legislation requiring companies to evaluate controls under Section 404 of the Sarbanes-Oxley Act of 2002.

We are evaluating our internal control systems 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. We are performing the system and process evaluation and testing required in an effort to comply with the management certification and auditor attestation requirements of Section 404. As a result, we are incurring additional expenses and a diversion of management’s time. While we anticipate being able to fully implement the requirements relating to internal control procedures and all other aspects of Section 404 in a timely fashion, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of these actions on our operations since there is no precedent available by which to measure compliance adequacy. If we are not able to implement the requirements of Section 404 in a timely manner or with adequate compliance, we might be subject to sanctions or investigation by regulatory authorities, such as the Securities and Exchange Commission or the New York Stock Exchange. Any such action could adversely affect our financial results and the market price of our common stock.

Our operating and financial performance in any given period might not meet the extensive guidance that we have provided to the public.

We provide extensive public guidance on our expected operating and financial results for future periods. Although we believe that this guidance fosters confidence among investors and analysts, 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 guidance may not always be accurate. 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 could decline.

Our quarterly results of operations might fluctuate due to a variety of factors, including seasonality.

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, and the strategic importance of fourth quarter results. A significant portion of our revenues and net earnings have been realized during the period from October through December. In anticipation of increased holiday sales activity, we incur certain significant incremental expenses, including the hiring of a substantial number of temporary employees to supplement our existing workforce. If, for any reason, we were to realize significantly lower-than-expected revenues or net earnings during the October through December selling season, our business and results of operations would be materially adversely affected.

We may require external funding sources for operating funds.

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 twelve months. However, as we continue to grow, we might experience peak periods for our cash needs during the course of our fiscal year, and we might need additional external funding to support our operations. Although we believe we would have access to additional debt and/or capital market funding if needed, such funds may not be available to us on acceptable terms. If the cost of such funds is greater than expected, it could adversely affect our expenses and our operating results.

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