UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM 10-Q

(Mark One)

xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 29, 2008April 4, 2009

OR

 

¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                toto                

Commission File Number: 000-50807

DESIGN WITHIN REACH, INC.

(Exact name of registrant as specified in its charter)

 

Delaware 94-3314374

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

225 Bush Street, 20th Floor, San Francisco, CA 94104
(Address of principal executive offices) (Zip Code)

(415) 676-6500

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x  Yes    ¨  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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act) (Check one).

Large accelerated filer  ¨            Accelerated filer  x¨

Non-accelerated filer  ¨x (do not check if smaller reporting company)         Smaller reporting company  ¨

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

The number of outstanding shares of the registrant’s common stock, par value $0.001 per share, as of May 2, 200811, 2009 was 14,460,087.14,489,001.

 

 

 


DESIGN WITHIN REACH, INC.

FORM 10-Q — QUARTERLY REPORT

FOR THE QUARTERLY PERIOD ENDED MARCH 29, 2008APRIL 4, 2009

TABLE OF CONTENTS

 

   Page No

PART I – FINANCIAL INFORMATION

  

Item 1

  

Financial Statements

  1
  

Condensed Balance Sheets (unaudited) as of April 4, 2009, January 3, 2009 and March 29, 2008 December 29, 2007 and March 31, 2007

  1
  

Condensed Statements of Operations (unaudited) for the thirteen week periods ended April 4, 2009 and March 29, 2008 and March 31, 2007

  2
  

Condensed Statements of Cash Flows (unaudited) for the thirteen week periods ended April 4, 2009 and March 29, 2008 and March 31, 2007

  3
  

Notes to the Condensed Financial Statements (unaudited)

  4

Item 2

  

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

  1112

Item 3

  

Quantitative and Qualitative Disclosures about Market Risk

  21

Item 4

  

Controls and Procedures

  22

PART II – OTHER INFORMATION

  

Item 1

  

Legal Proceedings

  2524

Item 1A

  

Risk Factors

  2524

Item 2

  

Unregistered Sales of Equity Securities and Use of Proceeds

  25

Item 3

  

Defaults Upon Senior Securities

  25

Item 4

  

Submission of Matters to a Vote of Security Holders

  25

Item 5

  

Other Information

  25

Item 6

  

Exhibits

  26

SIGNATURES

  27


PART I—I - FINANCIAL INFORMATION

Item 1.   Financial Statements

Design Within Reach, Inc.

Condensed Balance Sheets

(Unaudited)

(amounts in thousands, except per share data)

 

  March 29,
2008
 December 29,
2007
 March 31,
2007
         April 4,      
2009
      January 3,    
2009
      March 29,    
2008

ASSETS

          

Current assets

          

Cash and cash equivalents

  $6,496  $5,651  $5,423    $3,099    $8,684    $6,496 

Restricted cash

   2,000    —    — 

Accounts receivable (less allowance for doubtful accounts of $159, $164, and $267, respectively)

   1,500    1,459    1,755 

Inventory

   41,217   37,820   40,889    30,085    36,596    41,217 

Accounts receivable (less allowance for doubtful accounts of $267, $264 and $289, respectively)

   2,194   1,176   2,635 

Prepaid catalog costs

   1,423   2,101   1,382    183    708    1,423 

Deferred income taxes

   1,251   1,251   2,078    —    —    1,251 

Other current assets

   2,992   1,986   2,587    3,462    3,978    3,431 
                   

Total current assets

   55,573   49,985   54,994    40,329    51,425    55,573 

Property and equipment, net

   22,929   23,302   23,875    22,522    23,702    22,929 

Deferred income taxes, net

   8,182   8,182   8,083    —    —    8,182 

Other non-current assets

   965   955   974    1,012    1,025    965 
                   

Total assets

  $87,649  $82,424  $87,926    $63,863    $76,152    $87,649 
                   

LIABILITIES AND STOCKHOLDERS’ EQUITY

          

Current liabilities

          

Accounts payable

  $15,305  $14,442  $20,079    $13,595    $16,978    $15,305 

Accrued expenses

   5,271   4,500   5,821    4,568    4,455    5,271 

Accrued compensation

   2,079   2,765   1,696    2,184    1,945    2,079 

Deferred revenue

   1,980   325   4,246    1,637    1,162    1,980 

Customer deposits and other liabilities

   3,310   3,397   2,441    3,435    3,191    3,310 

Borrowings under loan agreement

   2,534   —     2,587    9,683    13,949    2,534 

Long-term debt, current portion

   351   346   341    317    254    351 
                   

Total current liabilities

   30,830   25,775   37,211    35,419    41,934    30,830 

Deferred rent and lease incentives

   6,139   5,976   5,762    6,377    6,373    6,139 

Long-term debt, net of current portion

   224   321   498    206    223    224 
                   

Total liabilities

   37,193   32,072   43,471    42,002    48,530    37,193 
                   

Commitments and Contingencies

   —     —     —      —    —    — 

Stockholders’ equity

          

Preferred stock – $0.001 par value; 10,000 shares authorized; no shares issued and outstanding

   —     —     —      —    —    — 

Common stock – $0.001 par value; authorized 30,000 shares; issued and outstanding, 14,455, 14,455 and 14,418 shares

   14   14   14 

Common stock – $0.001 par value; authorized 30,000 shares; issued and outstanding, 14,489, 14,480 and 14,455 shares

   14    14    14 

Additional paid-in capital

   59,611   59,146   57,450    60,697    60,585    59,611 

Accumulated other comprehensive income

   334   73   —      —    (111)   334 

Accumulated deficit

   (9,503)  (8,881)  (13,009)   (38,850)   (32,866)   (9,503)
                   

Total stockholders’ equity

   50,456   50,352   44,455    21,861    27,622    50,456 
                   

Total liabilities and stockholders’ equity

  $87,649  $82,424  $87,926    $63,863    $76,152    $87,649 
                   

The accompanying notes are an integral part of these financial statements.

Design Within Reach, Inc.

Condensed Statements of Operations

(Unaudited)

(amounts in thousands, except per share data)

 

  Thirteen weeks ended   Thirteen weeks ended
  March 29,
2008
 March 31,
2007
       April 4, 2009          March 29, 2008    

Net sales

  $46,914  $43,848    $34,076    $46,914 

Cost of sales

   24,738   25,503    19,746    24,738 
             

Gross margin

   22,176   18,345    14,330    22,176 

Selling, general and administrative expenses

   23,359   22,244    20,203    23,359 
             

Loss from operations

   (1,183)  (3,899)   (5,873)   (1,183)

Interest income

   57   110    —    57 

Interest expense

   (48)  (38)   (114)   (48)

Other income (expense), net

   (144)  22       (144)
             

Loss before income tax benefit

   (1,318)  (3,805)   (5,984)   (1,318)

Income tax benefit

   (696)  —      —    (696)
             

Net loss

  $(622) $(3,805)   $(5,984)   $(622)
             

Net loss per share:

       

Basic

  $(0.04) $(0.26)   $(0.41)   $(0.04)

Diluted

  $(0.04) $(0.26)   $(0.41)   $(0.04)

Weighted average shares used in calculation of net loss per share:

       

Basic

   14,455   14,418    14,488    14,455 

Diluted

   14,455   14,418    14,488    14,455 

The accompanying notes are an integral part of these financial statements.

Design Within Reach, Inc.

Condensed Statements of Cash Flows

(Unaudited)

(amounts in thousands)

 

  Thirteen weeks ended   Thirteen weeks ended
  March 29,
2008
 March 31,
2007
       April 4, 2009          March 29, 2008    

Cash flows from operating activities:

       

Net loss

  $(622) $(3,805)   $(5,984)   $(622)

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

       

Depreciation and amortization

   1,480   2,000    1,560    1,480 

Stock-based compensation

   465   601    107    465 

Loss on the sale/disposal of long-lived assets

   —     1 

Impairment of long-lived assets

   73    — 

Provision for doubtful accounts

   3   (26)   (5)   

Changes in assets and liabilities:

       

Accounts receivable

   (36)   (1,212)

Inventory

   (3,397)  (7,040)   6,511    (3,397)

Accounts receivable

   (1,021)  (95)

Prepaid catalog costs

   678   (336)   525    678 

Other assets

   (764)  (246)   520    (573)

Accounts payable

   790   2,916    (2,913)   790 

Accrued expenses

   942   1,480    (81)   942 

Accrued compensation

   (686)  (749)   239    (686)

Deferred revenue

   1,655   2,663    475    1,655 

Customer deposits and other liabilities

   (87)  99    355    (87)

Deferred rent and lease incentives

   163   182       163 
             

Net cash used in operating activities

   (401)  (2,355)

Net cash provided by (used in) operating activities

   1,350    (401)
             

Cash flows from investing activities:

       

Purchase of property and equipment

   (1,196)  (1,338)   (720)   (1,196)
             

Net cash used in investing activities

   (1,196)  (1,338)   (720)   (1,196)
             

Cash flows from financing activities:

       

Net borrowings under loan agreement

   2,534   2,587 

Proceeds from issuance of common stock, net of expenses

      — 

Net borrowings (repayments) under loan agreement

   (4,266)   2,534 

Restricted cash

   (2,000)   — 

Repayments of long-term obligations

   (92)  (266)   (207)   (92) 

Borrowings on notes payable

   253    — 
             

Net cash provided by financing activities

   2,442   2,321 

Net cash provided by (used in) financing activities

   (6,215)   2,442 
             

Net increase (decrease) in cash and cash equivalents

   845   (1,372)   (5,585)   845 

Cash and cash equivalents at beginning of period

   5,651   6,795    8,684    5,651 
             

Cash and cash equivalents at end of the period

  $6,496  $5,423    $3,099    $6,496 
             

Supplemental disclosure of cash flow information:

       

Cash paid during the period for:

       

Income taxes paid

  $16  $4    $24    $16 

Interest paid

  $53  $15    $116    $53 

Non-cash investing and financing activities:

       

Gain on fair value of derivatives

  $209  $—   

Gain (loss) on fair value of derivatives

   $—    $209 

The accompanying notes are an integral part of these financial statements.

Design Within Reach, Inc.

Notes to the Condensed Financial Statements

(Unaudited)

Note 1 –

1.Description of Company and Summary of Significant Accounting Policies

Organization and Business Activity

Design Within Reach, Inc. (the “Company”) was incorporated in California in November 1998 and reincorporated in Delaware in March 2004. The Company is an integrated retailer of distinctive modern design products. The Company markets and sells its products to both residential and commercial customers through three integrated sales points consisting of studios, website and phone. The Company sells its products directly to customers principally throughout the United States. The Company opened its firstStates and it has one international studio in Canada in the first quarter 2008.Canada.

The Company operates on a 52- or 53-week fiscal year, which ends on the Saturday closest to December 31. Each fiscal year consists of four 13-week quarters, with an extra week added onto the fourth quarter every four to six years. The Company’s 2007 fiscal year ended on December 29, 20072009 and the 2008 fiscal year willyears end on January 2, 2010 and January 3, 2009.2009, respectively. Fiscal year 2007 consisted2009 consists of 52 weeks and fiscal year 2008 consistsconsisted of 53 weeks.

Basis of Presentation and Quarterly informationInformation (unaudited)

The accompanying unaudited interim condensed financial statements as of and for the thirteen weeks ended April 4, 2009 and March 29, 2008 and March 31, 2007 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. The accompanying balance sheet as of December 29, 2007January 3, 2009 was derived from audited statements within the Company’s Annual Report on Form 10-K for the year ended December 29, 2007.January 3, 2009. Accordingly, the accompanying unaudited interim financial statements do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“U.S.US GAAP”) for complete financial statements and should be read in conjunction with the audited financial statements and related notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 29, 2007.January 3, 2009. The accompanying unaudited interim financial statements reflect all adjustments that are, in the opinion of management, necessary for a fair statement of results for the interim periods presented. The results of operations for the thirteen weeks ended March 29,first quarters 2009 and 2008 and March 31, 2007 are not necessarily indicative of the results to be expected for any future period or the full fiscal year.

The accompanying unaudited interim condensed financial statements were prepared according to US GAAP, which contemplate continuation of the Company as a going concern. However, the economic downturn has adversely impacted the Company’s operations, resulting in lower sales and higher losses than expected during 2008 and the first quarter 2009. In response to lower sales following the economic downturn and resulting losses from operations in 2008, the Company undertook several initiatives to lower its expenses to better match the forecasted reduction in revenues and improve liquidity in the fourth quarter 2008 and the first quarter 2009. The Company restructured certain real estate lease contracts, reduced marketing and catalog expenses primarily by reducing the number of planned catalog mailings and the number of pages per catalog, delayed implementation of a new ERP system, renegotiated certain support contracts related to software maintenance and telecommunications, and lowered outside contractor fees as well as headcount in all areas of the Company. The Company reduced expenses by approximately $3 million in the first quarter 2009 and expects reduced expenses of approximately $15 million in the remainder of 2009 from the prior comparable periods in 2008. The Company also reduced inventory levels significantly from year-end 2008 levels to generate additional liquidity. As a result, the Company was able to generate cash from operating activities during the first quarter 2009. However, if the Company fails to generate sales and margins at levels currently forecasted or does not obtain additional debt or equity financing, it is unlikely that the Company could continue as a going concern. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts and classification of liabilities that might be necessary should the Company be unable to continue in existence.

Design Within Reach, Inc.

Notes to the Condensed Financial Statements (unaudited) – (continued)

Segment Reporting

The Company’s business is conducted in a single operating segment. The Company’s chief operating decision maker is the Chief Executive Officer who reviews a single set of financial data that encompasses the Company’s entire operations for purposes of making operating decisions and assessing performance.

Reclassifications

Three itemsAccounts receivable consists of amounts due from major credit card companies that are generally collected within one to five days after a customer’s credit card is charged, receivables due within 30 days of the invoice date from commercial customers and commissions receivable. Amounts receivable from vendors in prior periods have been reclassified to conform to thethis presentation for the current reporting period. On the condensed balance sheets as of January 3, 2009 and March 29, 2008, vendor receivables that were originally included in accounts receivable of approximately $303,000 and $439,000, respectively, were reclassified to other current assets. In addition, related to this reclassification, on the condensed statement of cash flows for the thirteen weeks ended March 31, 2007, the first reclassification relates29, 2008, $191,000 was reclassified from accounts receivable to breaking out the provision for doubtful accounts originally included in the change in accounts receivable; and the second reclassification relates to breaking out the changes in accrued compensation originally included in changes in accrued expenses. On the condensed balance sheet as of March 31, 2007, the third reclassification relates to moving the estimated write-down for expected damaged returned inventory from inventory reserves to reserve for expected product returns in other current liabilities.assets. These reclassifications did not have an impact on the Company’s results of operations or cash flows used in operating activities.

Use of Estimates

The preparation of financial statements in conformity with US GAAP requires management of the Company to make estimates and assumptions affecting the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenues and expenses during the reporting period. Actual results could differ from those estimates and such differences could affect the results of operations reported in future periods.

Restricted Cash

On March 18, 2009, the Company entered into the first amendment to its loan agreement and a securities account availability agreement with Wells Fargo Retail Finance, LLC (“Wells Fargo”), in which Wells Fargo increased the amount of advances otherwise available to the Company by $1,000,000 in exchange for the Company’s granting Wells Fargo collateral rights to a deposit account of the Company with a balance of $4,678,000. Wells Fargo will permit the Company to withdraw amounts from this account in excess of $2,000,000 so long as no default or event of default has occurred. Accordingly, the Company classified $2,000,000 of cash to restricted cash.

Inventory

Inventory consists of finished goods purchased from third-party manufacturers and estimated inbound freight costs. Inventory on hand is carried at the lower of cost or market. Cost is determined using the average cost method. The Company writes down inventory below cost to the estimated market value when necessary, based upon assumptions about future demand and market conditions. As of April 4, 2009, January 3, 2009 and March 29, 2008, inventories were $30,085,000, $36,596,000 and $41,217,000, respectively, net of write-downs of $1,813,000, $1,844,000 and $2,522,000, respectively.

Total inventory includes inventory-in-transit that consists primarily of finished goods purchased from third-party manufacturers that are in-transit from the vendor to the Company when terms are FOB shipping point and estimated inbound freight costs. Inventory-in-transit also includes those goods that are in-transit from the Company to its customers. Inventory-in-transit is carried at cost. Inventory-in-transit was $2,526,000, $3,203,000 and $5,418,000, as of April 4, 2009, January 3, 2009 and March 29, 2008, respectively.

Design Within Reach, Inc.

Notes to the Condensed Financial Statements (unaudited) – (continued)

Revenue Recognition

Significant management judgments and estimates must be made and used in connection with determining net sales recognized in any accounting period. The Company recognizes revenue on the date on which it estimates that the product has been received by the customer and retains title to items and bears the risk of loss of shipments until delivery on shipments fromto its warehouse.customers. The Company recognizes shipping and handling fees charged to customers in net sales at the time products are estimated to have been received by customers. The Company takes title to itemsrecognizes drop shipped by vendors at the time of shipment andship sales on a gross basis in accordance with Emerging Issues Task Force (“EITF”) 99-19,Reporting Revenue Gross as a Principal versus Net as an Agent, because it bears the risk of loss until delivery to customers. The Company uses third-party freight carrier information to estimate standard delivery times to various locations throughout the United States and Canada. The Company records as deferred revenue the dollar amount of all shipments for a particular day, if based upon the Company’s estimated delivery time, such shipments, on average, are expected to be delivered after the end of the reporting period. As of April 4, 2009, January 3, 2009 and March 29, 2008, December 29, 2007 and March 31, 2007, deferred revenue was approximately$1,637,000, $1,162,000 and $1,980,000, $325,000 and $4,246,000, respectively, and related deferred cost of sales was approximately$890,000, $572,000 and $1,024,000, $173,000 and $2,251,000, respectively.

Sales are recorded net of expected product returns by customers. The Company analyzes historical returns, current economic trends, and changes in customer demand and acceptance of products when evaluating the adequacy of the sales returns and other allowances in any accounting period. The returns allowance is recorded as a reduction to net sales for the estimated retail value of the projected product returns and as a reduction in cost of sales for the corresponding cost amount, less any reserve for estimated scrap. The reserves for estimated product returns were $532,000, $573,000 and $674,000 as of April 4, 2009, January 3, 2009 and March 29, 2008, respectively.

Various governmental authorities directly impose taxes on sales including sales, use, value added and some excise taxes. The Company excludes such taxes from net sales. The Company accounts for gift cards by recognizing a liability at the time a gift card is sold, and recognizing revenue at the time the gift card is redeemed for merchandise. Promotion gift cards, issued as part of a sales transaction, are recorded as a reduction in sales for the value of the gift card.

InventoryShipping and Handling Costs

Inventory consistsShipping costs, which include inbound and outbound freight costs, are included in cost of finished goods purchased from third-party manufacturers. Inventory on hand is carried at an averagesales. The Company records costs of shipping products to customers in cost that approximates a first-in first-out method and is carriedof sales at the lowertime products are estimated to have been received by customers. Handling costs, which include fulfillment center expenses, call center expenses, and credit card fees, are included in selling, general and administrative expenses. Handling costs were approximately $1,742,000 and $2,471,000 in the first quarters 2009 and 2008, respectively.

Advertising Costs

The cost of cost or market. Asprint media advertising, other than direct response catalogs, is expensed upon publication. Direct response catalog costs are recorded as prepaid catalog costs and consist of third-party costs, including paper, printing, postage, name acquisition and mailing costs. In accordance with Statements of Position of the Accounting Standards Division No. 93-7,Reporting on Advertising Costs(“SOP 93-7”), advertising costs must be expensed as incurred unless the advertising elicits sales to customers. In order to conclude that advertising elicits sales to customers who could be shown to have responded specifically to the advertising, there must be a means of documenting that response, including a record that can identify the name of the customer and the advertising that elicited the direct response.

In the first nine months of 2008, prepaid catalog costs were amortized over their expected period of future benefit of approximately four months in accordance with SOP 93-7, based upon weighted-average historical revenues attributed to previously issued catalogs. Prepaid catalog costs were $1,423,000 as of March 29, 2008, December 29, 2007which included $1,092,000 of unamortized costs for catalogs previously distributed and March 31, 2007, inventories$331,000 of costs for catalogs waiting to be distributed. In the fourth quarter 2008 and the first quarter 2009, prepaid catalog costs were $41,217,000, $37,820,000expensed upon publication since the Company no longer adequately tracked the required information required by SOP 93-7. Prepaid catalog costs for catalogs waiting to be distributed were $183,000 and $40,889,000, respectively,$708,000 as of April 4, 2009 and January 3, 2009, respectively.

Design Within Reach, Inc.

Notes to the Condensed Financial Statements (unaudited) – (continued)

The Company accounts for consideration received from its vendors for co-operative advertising as a reduction of selling, general and administrative expense. Co-operative advertising amounts earned by the Company were $40,000 and $306,000 in the first quarters 2009 and 2008, respectively. Advertising and promotion expenses, including catalog expense, net of write-downs of $2,522,000, $2,166,000co-operative advertising, were $2,630,000 and $2,591,000,$3,283,000 in the first quarters 2009 and 2008, respectively.

Total inventory includes inventory-in-transit that consists of finished goods purchasedApart from third-party manufacturers that are in-transitamounts received from the vendor tovendors for co-operative advertising, the Company when terms are FOB shipping point. Inventory-in-transit also includes those goods that are in-transitdoes not typically receive allowances or credits from vendors. In the case of a few select vendors, the Company to its customers. Inventory-in-transit is carried at cost.receives a small discount of approximately 2% for prompt payment of invoices. These discounts were recorded as a reduction of cost of sales of $4,000 and $104,000 in the first quarters 2009 and 2008, respectively.

Income Taxes

Income taxes are computed using the asset and liability method under FAS No. 109, “Accounting for Income Taxes” (“FAS 109”). Deferred income tax assets and liabilities are determined based on the differences between the financial reporting and tax bases of assets and liabilities and are measured using the currently enacted tax rates and laws currently in effect.

Design Within Reach, Inc.

Notes to the Condensed Financial Statements (unaudited) – (continued) The Company estimates a valuation allowance on its deferred tax assets if it is more likely than not that they will not be realized.

Net Loss per Share

Basic loss per share is calculated by dividing the Company’s net loss available to the Company’s common stockholders for the period by the number of weighted average common shares outstanding for the period. Diluted income per share includes the effects of dilutive instruments, such as stock options, and uses the average share price for the period in determining the number of incremental shares that are added to the weighted average number of shares outstanding. Options to purchase approximately 2,191,0002,416,000 and 2,084,0002,191,000 shares of common stock that were outstanding as of April 4, 2009 and March 29, 2008, and March 31, 2007, respectively, have been excluded from the calculation of diluted loss per share because inclusion of such shares would be anti-dilutive.

Comprehensive Income (Loss)Loss

Comprehensive loss consists of net loss, unrealized mark-to-market gain (loss) on open derivatives, unamortized gain (loss) on settled derivatives and unrealized gain (loss) on available-for-sale securities, if any. The following table presents comprehensive loss for the thirteen weeks ended March 29, 2008first quarters 2009 and March 31, 2007:2008:

 

  Thirteen weeks ended   Thirteen weeks ended
  March 29,
2008
 March 31,
2007
       April 4, 2009          March 29, 2008    
(amounts in thousands)  (unaudited)   (unaudited)

Net loss

  $(622) $(3,805)   $(5,984)   $(622)

Other comprehensive income:

       

Net gain on foreign currency cash flow hedges

   261   —      111    261 
             

Comprehensive loss

  $(361) $(3,805)   $(5,873)   $(361)
             

Design Within Reach, Inc.

Notes to the Condensed Financial Statements (unaudited) – (continued)

Derivative and Hedging Activities

The Company applies FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted, for derivative instruments and requires that all derivatives be recorded at fair value on its balance sheet, including embedded derivatives.

The Company’s operations are exposed to global market risks, including the effect of changes in foreign currency exchange rates. To mitigate its foreign currency exchange rate risk, the Company purchasespurchased foreign currency contracts to pay for merchandise purchases based on forecasted demand.demand in 2008. The objective of the Company’s foreign exchange risk management program is to manage the financial and operational exposure arising from these risks by offsetting gains and losses on the underlying exposures with gains and losses on currency contract derivatives used to hedge those exposures. The Company maintains comprehensive hedge documentation that defines the hedging objectives, practices, procedures and accounting treatment. The Company’s hedging program and derivative positions and strategy arewere reviewed on a regular basis by management. Derivatives used to manage financial exposures for foreign exchange risks generally matured within one year. The Company discontinued its hedging activities during the fourth quarter 2008 resulting in no open contracts as of April 4, 2009 and January 3, 2009.

The Company applies FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”), as amended and interpreted, for derivative instruments and requires that all derivatives be recorded at fair value on its balance sheet, including embedded derivatives. In March 2008, the Financial Accounting Standards Board (“FASB”) issued Statement 161, “Disclosures about Derivative Instruments and Hedging Activities” (“FAS 161”), to expand the disclosure framework in FAS 133. The new Statement requires companies with derivative instruments to disclose information about how and why the company uses derivative instruments; how the company accounts for derivative instruments and related hedged items under FAS 133; and how derivative instruments and related hedged items affect the company’s financial position, financial performance, and cash flows. The expanded disclosure guidance also requires a company to provide information about its strategies and objectives for using derivative instruments; disclose credit-risk-related contingent features in derivative agreements and information about counterparty credit risk; and present the fair value of derivative instruments and related gains or losses in a tabular format. The Company adopted FAS 161 as of the required effective date of January 4, 2009 and will apply its provisions prospectively by providing the additional disclosures in its financial statements for any hedging activity the Company enters into in the future. Additional disclosures required by FAS 161 have not been provided for prior periods. Periods in years after initial adoption will include comparative disclosures, as allowed by FAS 161.

The Company records derivatives related to cash flow hedges for foreign currency at fair value on its balance sheet, including embedded derivatives. The Company implemented a new hedging strategy in the first quarter 2007 to mitigate the impact of foreign currency fluctuations on inventory purchases. Foreign currency contracts entered into during January 2007 through April 2007 were not designated as cash flow hedge contracts. The Company accounted for non-hedge foreign currency contracts on a monthly basis by recognizing the net cash settlement gain or loss in other income (expense) and adjusting the carrying amount of open contracts to fair value by recognizing any corresponding gain or loss in other income (expense). In the second quarter 2007, the Company developed a hedging strategy and policies and procedures that met the criteria for cash flow hedge accounting. Foreign currency contracts entered into from May 2007 through March 2008 were designated as cash flow hedge contracts and were accounted for on a monthly basis by recognizing the net cash settlement gain or loss in other comprehensive income (loss) and adjusting the carrying amount of open designated contracts to fair value by recognizing any corresponding gain or loss in other comprehensive income (loss) and recognizing the net cash settlement gain or loss in other comprehensive income (loss). NetSubsequently, these net cash settlement gains or losses are recognized in cost of sales as the underlying hedged inventory is sold in each reporting period. In the statements of cash flows, net cash settlement gain or loss is included in operating cash flows as changes in other assets, and as customer deposits and other liabilities. The following table presents designated hedge contract activity for the first quarters 2009 and 2008:

   Thirteen weeks ended
(amounts in thousands)      April 4, 2009          March 29, 2008    

Increase in carrying amount to fair value of open designated hedge contracts

   $—    $209 

Amount of gain recognized in other comprehensive income upon settlement of designated hedge contracts

   —    111 

Amount of (gain) loss reclassified to cost of sales from accumulated other comprehensive income (loss)

   111    (59)
        

Other comprehensive income -

    

Net gain on foreign currency cash flow hedges

   $111    $261 
        

Design Within Reach, Inc.

Notes to the Condensed Financial Statements (unaudited) – (continued)

Management evaluates hedges for effectiveness, and for derivatives that are deemed ineffective, the ineffective portion is reported through earnings. The fair market value of the hedged exposure is presumed to be the market value of the hedge instrument when critical terms match. The Company did not record any amounts for ineffectiveness in the thirteen weeks ended March 29, 2008first quarters 2009 and March 31, 2007.

Derivatives used to manage financial exposures for foreign exchange risks generally mature within one year and contracts held by the Company as of March 29, 2008 mature from April 2008 to July 2008. As of March 29, 2008, open hedge contracts were revalued to their fair value of approximately $260,000. Approximately $74,000 in accumulated other comprehensive income as of March 29, 2008 is expected to be recognized in cost of sales in the second quarter 2008. The Company did not have any foreign currency contracts outstanding as of March 31, 2007 that met the criteria for cash flow hedge accounting or any amounts recorded to other comprehensive income in the thirteen weeks ended March 31, 2007.

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires management of the Company to make estimates and assumptions affecting the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, as well as revenues and expenses during the reporting period. The Company’s significant accounting estimates include estimates of dates on which product has been received by the customer used in determining when to recognize revenue, estimates of market value used in calculating inventory reserves to reflect inventory carried at a lower of cost or market, estimates of uncollectible accounts receivable, estimates of fair value used in calculating the value of stock-based compensation, estimates of expected future cash flows and useful lives used in the review for impairment of long-lived assets, estimates of the Company’s ability to realize its deferred tax assets which are also used to establish whether valuation allowances are needed on those assets, estimates of projected net taxable income and deductible expenses to calculate the income tax benefit for interim financial reporting periods, estimates of freight costs used to calculate accrued liabilities, estimates of returns used to calculate sales returns reserves, estimates for determining inventory-in-transit, estimates for the amortization of prepaid catalog costs, estimates for calculating certain accrued liabilities and estimates related to the recognition of hedging gains and losses in cost of sales. Actual results could differ from those estimates and such differences could affect the results of operations reported in future periods.

Recent Accounting Pronouncements

In September 2006,April 2009, the Financial Accounting Standards BoardFASB issued FAS Staff Position No. 157-4, “Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly (“FASB”FSP 157-4”) issuedto provide additional guidance on estimating fair value when the volume and level of activity for an asset or liability have significantly decreased. FSP 157-4 also includes guidance on identifying circumstances that indicate a transaction is not orderly. FSP 157-4 emphasizes that, regardless of whether the volume and level of activity for an asset or liability have decreased significantly and regardless of which valuation technique was used, the objective of a fair value measurement under FASB Statement No. 157,Fair Value Measurements (“FAS 157”). This statement clarifies, remains the definition of fair value andsame, which is to estimate the methods usedprice that would be received to measure fair value, andsell an asset or transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. FSP 157-4 also requires expanded financial statement disclosures about fair value measurementsdisclosures. FSP 157-4 is effective for assetsinterim and liabilities.annual periods ending after June 15, 2009. The Company adoptedintends to adopt FSP 157-4 effective the second quarter 2009 and apply its provisions of FAS 157 on December 30, 2007, the first day of theprospectively. The Company’s fiscal year 2008, related to financial assets and liabilities are typically measured using Level 1 inputs and other assets and liabilities carried at fair value onas a recurring basis. Theresult, the Company does not believe that the adoption of FAS 157 did notFSP 157-4 will have a materialsignificant effect on the Company’sits financial condition or results of operations. The provisions of FAS 157 related to other nonfinancial assets and liabilities will be effective for the Company on January 4, 2009, the first day of the Company’s fiscal year 2009. The Company is currently evaluating the impact that these additional FAS 157 provisions will have on the Company’s financial statements. See Note 4 for further discussion.

Design Within Reach, Inc.

Notes to the Condensed Financial Statements (unaudited) – (continued)

In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities—Including an Amendment of FASB Statement No. 115(“FAS 159”). This standard permits an entity to choose to measure many financial instruments and certain other items at fair value. Most of the provisions in FAS 159 are elective; however, the amendment to FAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, applies to all entities with available-for-sale and trading securities. The fair value option established by FAS 159 permits all entities to choose to measure eligible items at fair value at specified election dates. A business entity will report unrealized gains and losses on items for which the fair value option has been elected in earnings (or another performance indicator if the business entity does not report earnings) at each subsequent reporting date. The fair value option: (a) may be applied instrument by instrument, with a few exceptions, such as investments otherwise accounted for by the equity method; (b) is irrevocable (unless a new election date occurs); and (c) is applied only to entire instruments and not to portions of instruments. FAS 159 is effective at the beginning of the first fiscal year beginning after November 15, 2007. The Company has decided not to adopt FAS 159.

In December 2007, the SEC issued Staff Accounting Bulletin No. 110 (“SAB 110”). SAB 110 amends and replaces Question 6 of Section D.2 of Topic 14,Share-Based Payment, of the Staff Accounting Bulletin series. Question 6 of Section D.2 of Topic 14 expresses the views of the staff regarding the use of the “simplified” method in developing an estimate of the expected term of “plain vanilla” share options and allows usage of the “simplified” method for share option grants prior to December 31, 2007. SAB 110 allows public companies which do not have historically sufficient experience to provide a reasonable estimate to continue to use the “simplified” method for estimating the expected term of “plain vanilla” share option grants after December 31, 2007. The Company adopted SAB 110 on December 30, 2007, the first day of the Company’s fiscal year 2008. The Company will continue to use the “simplified” method until it has enough historical experience to provide a reasonable estimate of expected term in accordance with SAB 110.

In December 2007,April 2009, the FASB issued FAS Staff Position No. 141 (revised 2007),107-1 and APB 28-1, “Business CombinationsInterim Disclosures about Fair Value of Financial Instruments (“FSP FAS 141(R)”107-1 and APB 28-1”), which replaces FAS No. 141,Business Combinations. FAS 141(R) retains the underlying concepts of FAS 141 in that all business combinations are still required to be accounted for atrequire, on an interim basis, disclosures about the fair value under the acquisition method of accounting butfinancial instruments for public entities. FSP FAS 141(R) changed the method of applying the acquisition method in a number of significant aspects. Acquisition costs will generally be expensed as incurred; noncontrolling interests will be valued at fair value at the acquisition date; in-process research107-1 and development will be recorded at fair value as an indefinite-lived intangible asset at the acquisition date; restructuring costs associated with a business combination will generally be expensed subsequent to the acquisition date; and changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense. FAS 141(R)APB 28-1 is effective on a prospective basis for all business combinations for which the acquisition date is on orinterim and annual periods ending after the beginning of the first annual period subsequent to DecemberJune 15, 2008.2009. The Company is currently evaluating this new statementintends to adopt FSP FAS 107-1 and APB 28-1 effective the second quarter 2009. The Company anticipates that this statement will not have a significant impact on the reporting of its results of operations.

2.Fair Value of Financial Instruments

Effective December 30, 2007, the Company adopted SFAS No. 157,Fair Value Measurements(“SFAS 157”). In December 2007,February 2008, the FASB issued FASFSP No. 160,157-2,Noncontrolling Interests in Consolidated Financial Statements—an amendmentEffective Date of ARBFASB Statement No. 51157. This statement is, which provides a one-year deferral of the effective date of SFAS 157 for fiscal yearsnon-financial assets and interim periods withinnon-financial liabilities, except for those fiscal years, beginning onthat are recognized or after December 15, 2008. This statement requires the recognition of a noncontrolling interest (minority interest) as equitydisclosed in the consolidated financial statements at fair value at least annually. SFAS 157 defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles and enhances disclosures about fair value measurements. Fair value is defined under SFAS 157 as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under SFAS 157 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes how to measure fair value based on a three-level hierarchy of inputs, of which the first two are considered observable and the last unobservable.

Level 1 — Quoted prices in active markets for identical assets or liabilities.

Level 2 — Inputs other than Level 1 that are observable, either directly or indirectly, such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be recorded separate fromcorroborated by observable market data for substantially the parent’s equity. The amountfull term of net income attributablethe assets or liabilities.

Level 3 — Unobservable inputs that are supported by little or no market activity and that are significant to the noncontrolling interest will be included in consolidated net income on the facefair value of the income statement.assets or liabilities.

We implemented FSP No. 157-2 for non-financial assets and non-financial liabilities on January 4, 2009. The Company is currently evaluating this new statement and anticipates thatadoption of this statement willdid not have a significantmaterial impact on the reporting of itsCompany’s results of operations.operations or financial condition.

Design Within Reach, Inc.

Notes to the Condensed Financial Statements (unaudited) – (continued)

In March 2008, the FASB issued FAS No. 161,Disclosures

The following table presents information about Derivative Instrumentsassets and Hedging Activities(“FAS 161”), which changes the disclosure requirements for derivative instruments and hedging activities. FAS 161 is intendedliabilities required to enhance the current disclosure framework in FAS 133,Accounting for Derivative Instruments and Hedging Activities. FAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The Company is currently evaluating this new statement andbe carried at fair value on a recurring basis as FAS 161 relates specifically to disclosures, this standard will have no impact on the Company’s financial condition or results of operations.April 4, 2009:

Note 2 – Income Taxes

(amounts in thousands)      Fair Value at  
April 4, 2009
          Level 1                  Level 2                  Level 3        

Cash equivalents

   $2,905    $2,905    $—    $— 

Restricted cash

   2,000    2,000    —    — 

The Company recorded a tax benefit of approximately $696,000 calculated atprimarily applies the projected annual effective tax rate of 52.8% in the first quarter 2008. The difference between the statutory rate of 39.5% and effective tax rate is primarily due to projected stock-based compensation expense related to incentive stock options not being deductiblemarket approach for tax purposes. No income tax benefit was recognized in the first quarter 2007 because it was uncertain whether the tax benefit of the year-to-date pre-tax loss would be realized during fiscal year 2007.recurring fair value measurements.

Note 3 – Notes Payable and Bank Credit Facility

3.Loan Agreement and Long-term Debt

On February 2, 2007, the Company entered into a Loan, Guaranty and Security Agreement (the “Loan Agreement”) with Wells Fargo Retail Finance, LLC (the “Loan Agreement”) which replaced the previous loan with (“Wells Fargo HSBC Trade Bank, N.A.Fargo”). The Loan Agreement expires on February 2, 2012 and provides for an initial overall credit line up to $20,000,000, which may be increased to $25,000,000 at the Company’s option provided the Company is not in default on the Loan Agreement. The Loan Agreement consists of a revolving credit line and letters of credit up to $5,000,000. The amount the Company may borrow at any time under the Loan Agreement is based upon a percentage of eligible inventory and accounts receivable less certain reserves. Borrowings are secured by the right, title and interest to all of the Company’s personal property, including cash, accounts receivable, inventory, equipment, fixtures, general intangibles and intellectual property and inventory.property. The Loan Agreement contains various restrictive covenants, including minimum availability, which is the amount the Company may borrow under the Loan Agreement, less certain outstanding obligations, plus certain cash and cash equivalents,restrictions on payment of dividends, limitations on indebtedness, limitations on subordinated indebtedness and limitations on the amount of capital expenditures the Company may incur in any fiscal year. The Company is currently in compliance with all of these restrictive covenants.

In the fourth quarter 2008 and the first quarter 2009, bank-commissioned appraisals determined that the net liquidation value of the Company’s inventories had declined due to general market conditions and, as a result, Wells Fargo reduced the Company’s advance rates, which constricted the availability of borrowings under the line of credit. The availability of borrowings would decrease if subsequent appraisals determine that the net liquidation value of the Company’s inventories have decreased.

Wells Fargo increased discretionary reserves by $1,500,000 in the first quarter 2009. On March 18, 2009, the Company entered into a first amendment to the Loan Agreement and a securities account availability agreement with Wells Fargo in which Wells Fargo increased the amount of advances otherwise available to the Company by $1,000,000 in exchange for the Company’s granting Wells Fargo collateral rights to a deposit account of the Company with a balance of $4,678,000. Wells Fargo will permit the Company to withdraw amounts from this account in excess of $2,000,000 so long as no default or event of default has occurred. Accordingly, the Company classified $2,000,000 of cash to restricted cash. In addition, Wells Fargo rescinded its decision to require additional discretionary reserves of $1,500,000. On April 14, 2009, the Company withdrew $1,000,000 from this account for working capital purposes.

Interest on borrowings will be either at Wells Fargo’s prime rate, or LIBOR plus 1.25% to 1.75% based upon average availability, and the unused credit line fee is 0.25%0.3%. In the event of default, the Company’s interest rates will be increased by two percentage points. The interest rate on outstanding borrowings at March 29, 2008April 4, 2009 was 5.25%3.25%. As of March 29, 2008,April 4, 2009, the Company had outstanding borrowings of $2,534,000$9,683,000 under the revolving credit line and $1,073,000$1,318,000 in outstanding letters of credit. Approximately $16,393,000 wasAdvances of $3,836,000 were available for advances under the revolving credit line as of March 29, 2008.April 4, 2009.

In June 2006,January 2009, the Company financed the second and third years of a portionthree year software license fee of its new information technology projectapproximately $253,000 per year with a three-year promissory note of approximately $1,000,000 with an interest rate of approximately 2.0%. In accordance with Accounting Principals Board No. 21Interest on Receivables and Payables (“APB 21”), the Company discounted this note to its fair value. The discounted portion of approximately $58,000 is being amortized as interest expense over the life of the note using the effective interest method.note. As of March 29, 2008,April 4, 2009, the Company’s outstanding borrowings under this and other notes were approximately $469,000$261,000 with interest rates ranging from 2% to 6.75%. Future maturities of notes payable are approximately $241,000 for the remainder of 2008 and $228,000 for11% maturing in 2009.

Design Within Reach, Inc.

Notes to the Condensed Financial Statements (unaudited) – (continued)

Note

4.Commitments

As of April 4, – Fair Value Measurements2009, inventory purchase obligations related to open purchase orders were approximately $7,920,000, commitments for furniture, fixtures, and leasehold improvements related to studios were approximately $387,000, and commitments to maintain and enhance various information technology systems and website were approximately $1,316,000.

5.Income Taxes

No income tax benefit was recognized in the first quarter 2009 because recent general economic events have indicated that more likely than not the tax benefit of the year-to-date pre-tax loss would not be realized. In accordance with FAS 157, a fair value measurement is determined based on the assumptions that a market participant would use in pricing an asset or liability. FAS 157 also established a three-tiered hierarchy that draws a distinction between market participant assumptions based on (i) observable inputs such as quoted prices in active markets (Level 1), (ii) inputs other than quoted prices in active markets that are observable either directly or indirectly (Level 2) and (iii) unobservable inputs that requirefirst quarter 2008, the Company to use present value and other valuation techniques inrecorded a tax benefit of $696,000 calculated at the determinationprojected annual effective tax rate of fair value (Level 3)52.8%. The following table presents information about assetsdifference between the statutory rate of 39.5% and liabilities requiredeffective tax rate was primarily due to be carried at fair value on a recurring basis as of March 29, 2008 (amounts in thousands):projected stock-based compensation expense related to incentive stock options not being deductible for tax purposes.

 

Description

  Fair Value at
March 29,
2008
  Level 1  Level 2  Level 3

Outstanding Forward Contracts

  $260  $—    $260  $—  

The Company primarily applies the market approach for recurring fair value measurements.

Note 5 – Related Party Transactions

6.Related Party Transactions

The Company rents studio space from an affiliate of the former Chairman of the Company’s Board of Directors. Rent expense, applicable to this space was approximately $40,000 for each of the thirteen weeks ended March 29, 2008first quarters 2009 and March 31, 2007.2008.

Note 6 – Commitments

7.Subsequent Events

As of March 29, 2008, inventory purchase obligationsThe Company closed its Southlake, Texas and Tigard, Oregon studios during the second quarter 2009. Accordingly, leasehold improvements related to open purchase ordersthe Southlake, Texas studio were approximately $16,416,000, commitmentsdeemed impaired as of April 4, 2009. An impairment charge of $73,000 was included in selling, general and administrative expenses in the first quarter 2009 that reduced net property and equipment. The Company incurred an impairment charge related to new studios were approximately $344,000 forthe leasehold improvements and $240,000 for fixtures, and commitments for various information technology systems and website maintenance were approximately $920,000.

Caution on Forward-Looking Statements

Any statements in this report and the information incorporated herein by reference about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. You can identify these forward-looking statements by the use of words or phrases such as “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should” or “would.” We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions described in our Annual Report on Form 10-K for the year ended December 29, 2007.Tigard, Oregon studio in 2008.

Although we believeIn accordance with FASB Statement No. 146,Accounting for Costs Associated with Exit or Disposal Activities(“FAS 146”), a liability for costs that will continue to be incurred under the expectations reflectedlease agreement for the remaining term without economic benefit to the Company shall be recognized and measured at the lease’s fair value at the cease-use date. The Company will record additional charges in our forward-looking statements are reasonable, we cannot guaranteethe second quarter 2009 for future results, events, levels of activity, performance or achievement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, unless required by law.lease payments at the cease-use date in accordance with FAS 146.

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

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of OperationsForward-Looking Statements

The following discussion containsAny statements in this report and the information incorporated herein by reference about our expectations, beliefs, plans, objectives, assumptions or future events or performance are not historical facts and are forward-looking statements. You can identify these forward-looking statements which involve risks and uncertainties. Our actual results could differ materially from those anticipated inby the use of words or phrases such as “believe,” “may,” “could,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “seek,” “plan,” “expect,” “should,” or “would.” We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our financial condition, results of operations, business strategy and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions described in Part I, Item 1A. “Risk Factors” and elsewhere in this report.

Although we believe that the expectations reflected in our forward-looking statements are reasonable, we cannot guarantee future results, events, levels of activity, performance or achievement. We undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of various factors, including those set forth under the caption “Risk Factors” in our Annual Report on Form 10-K for the year ended December 29, 2007. new information, future events or otherwise, unless required by law.

The interim financial statements and this Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the financial statements and notes thereto for the fiscal year ended December 29, 2007January 3, 2009 and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report on Form 10-K for the fiscal year ended December 29, 2007January 3, 2009 filed with the Securities and Exchange Commission on March 12, 2008.April 1, 2009.

Overview

We are a retailer of distinctive modern design products to both residential and commercial customers. Our clients purchase through three integrated sales points.points, consisting of our studios, website and phone. We have developed a national presence in modern design furnishings and a brand recognized for design excellence among our customers and the design community. In the process we have created a business model that enables us to provide products to our customers in a more convenient, efficient and economical manner than was previously available to them. Our policy of maintaining core products in stock represents a departure from the approach taken by many other modern design furnishings retailers.

In fiscal year 2007, we introduced an extended lead-time program, allowing our clients to personalize their product to meet their unique needs. In addition, we launched an expanded offering in accessories in the fourth quarter 2007, which we call “Tools for Living.” We believe this new product line will increase our presence in providing modern design solutions for our customers. This category currently features approximately 200 new products, ranging in price from under $20 to over $2,000. The products all share good design, functionality and a modern aesthetic.

Each Tools for Living product is unique in how it solves a problem or makes something more comfortable or easier to use. We view this as an opportunity to offer our existing customers a solution to their everyday problems, as well as providing an introduction to DWR for new clients. If Tools for Living achieves a sufficient level of market acceptance, we will continue to grow the product line and explore other design-driven opportunities. Our relationships with both internationally recognized and emerging designers continue to grow and allow us to offer our customers an array of innovative and often hard-to-find merchandise.

We expanded our offerings in accessories called “DWR:Tools for Living.” In this category we feature approximately 700 products, ranging in price from under $10 to over $2,000. The products all share good design and functionality. Each DWR:Tools for Living product is unique in how it solves a problem or makes something more comfortable or easier to use.

Our business strategy is based upon the premise that integrated sales points improve customer convenience, reinforce brand awareness, enhance customer knowledge of our products and produce operational benefits that ultimately improve market penetration and returns on capital. We believe most traditional retailers initially established their presence with one sales point and subsequently added additional sales points, thereby making integration across sales points more difficult.

We have experienced significant growth in customershad 66 studios, two DWR:Tools for Living stores and sales since our founding in 1998. We began selling products through the phone and online in the second half of 1999, and we opened our first studio in November 2000. We base our decisions on where to open new studios by categorizing markets into “tiers” based on household population statistics and supporting sales data collected from our other sales points. Our experience indicates that studio openings significantly improve our overall market penetration rates in the markets in which they are located. In addition, we have seen our online sales increase in markets where we have studios compared to markets where we do not have studios.

In recent years, we have continued to increase sales as our studio base grows. Studios have increased in number from one at the end of 2000 to 68 studios and one outletthree outlets operating in 25 states, the District of Columbia and Canada as of March 29, 2008. DuringApril 4, 2009. We opened one new outlet during the first quarter 2008, we opened two new studios. During the remainder of 2008, we plan to relocate one studio in2009. We closed our Southlake, Texas and Tigard, Oregon studios during the second quarter 2008 and open two Tools for Living stores in the third quarter 2008.

On April 1, 2008, we re-launched our website on a new and improved platform.2009. We believe that the enhancementsnumber of available locations is currently limited to our web capabilities will provide us with future growth opportunities. Overall, our objectives for 2008 are66 studios and three outlets, and we may need to continue to strengthen our expense controls and, most importantly, begin to realize the benefits of our merchandise re-sourcing efforts.close underperforming studios.

All of our sales points, other than our new DWR:Tools for Living stores, utilize a single common inventory held at our Hebron, Kentucky fulfillment center. Because we don’t offer a “cash and carry” option in our studios, we are able to more fully utilize selling space and avoid the operational issues that often arise with stock balancing and store replenishment. We currently source our products primarily in the U.S.United States and Europe. In the thirteen weeks ended March 29, 2008,first quarter 2009, we purchased approximately 34%36% of our product inventories from manufacturers in foreign countries, with 24%20% of our product inventory purchases being paid for in Euros. To mitigate our foreign currency exchange risk, we purchased foreign currency contracts to pay for merchandise purchases. As fiscal year 2008 progresses, weWe expect to have an increasing amount of products being sourced from factories outside of Europe. We plan to increase our efforts to develop products internally and include more exclusive items in our mix, and in doing so, source products infrom other parts of the world including Latin America and Asia where product costs are generally lower. Our product development team has worked diligently to find qualified factories in North America, Asia and elsewhere that can provide us with the quality our clients expect but free us from the impact of fluctuations in the price of the Euro. By the end of 2008,2009, we believe we can achieve significant product margin improvements from these efforts. We believe that within fivefour years we may have less than 20% of our product coming from European factories.

Recent market and economic conditions have been unprecedented and challenging with tighter credit conditions, slower growth, and increased market uncertainty and instability in both U.S. and international capital and credit markets. These conditions, combined with declining business and consumer confidence and increased unemployment have recently contributed to volatility of unprecedented levels. The purchase of our products by customers is discretionary, and therefore highly dependent upon the level of consumer spending, particularly among affluent customers. Accordingly, sales of our products have been and may continue to be adversely affected by the current unfavorable market and economic conditions. As a result, we may be required to take significant additional markdowns in response to the lower levels of demand for our products.

In response to lower sales following the economic downturn and resulting losses from operations in 2008, we undertook several initiatives to lower our expenses to better match the forecasted reduction in revenues and improve liquidity in the fourth quarter 2008 and the first quarter 2009. We have restructured certain real estate lease contracts, reduced marketing and catalog expenses primarily by reducing the number of planned catalog mailings and the number of pages per catalog, delayed implementation of a new ERP system, renegotiated certain support contracts related to software maintenance and telecommunications, and lowered outside contractor fees as well as headcount in all areas of the Company. We reduced expenses by approximately $3 million in the first quarter 2009 and expect reduced expenses of approximately $15 million in the remainder of 2009 from the prior comparable periods in 2008. We also reduced inventory levels significantly from year-end 2008 levels to generate additional liquidity.

While we have generated sufficient liquidity to sustain operations with significant operating losses to date, if we fail to generate sales and margins at levels currently forecasted or do not obtain additional debt or equity financing, it is unlikely that we will be able to maintain sufficient liquidity to continue as a going concern.

In February 2009, we announced the engagement of Thomas Weisel Partners LLC, an investment banking firm, to assist in the review of strategic alternatives, including advice related to an unsolicited offer we recently received. In the review process, an independent committee of the board will consider a full range of possible alternatives, including, among other things, a possible sale, merger, strategic partnership or refinancing. We currently have no commitments or agreements with respect to any particular transaction, and there can be no assurance that our review of strategic alternatives will result in any transaction.

Basis of Presentation

We operate on a 52- or 53-week fiscal year, which ends on the Saturday closest to December 31. Each fiscal year consists of four 13-week quarters, with an extra week added onto the fourth quarter every four to six years. Our 2009 and 2008 fiscal years end on January 2, 2010 and January 3, 2009, respectively. Fiscal year 2009 consists of 52 weeks and fiscal year 2008 consisted of 53 weeks.

Results of Operations

Comparison of the thirteen weeks ended March 29, 2008April 4, 2009 (First Quarter 2008)2009) to the thirteen weeks ended March 31, 200729, 2008 (First Quarter 2007)2008)

Net Sales.Sales

Net sales consist of studio sales, online sales, phone sales, other sales and shipping and handling fees, net of actual and estimated returns by customers. Studio sales consist of sales of merchandise to customers from orders placed at our studios and sales at our DWR:Tools for Living stores, online sales consist of sales of merchandise from orders placed through our website, phone sales consist of sales of merchandise through the toll-free numbers associated with our printed catalogs, and other sales consist of warehouse sales and outlet sales. Warehouse sales consist of periodic clearance sales at our fulfillment center of product samples and products that customers have returned.returned product from our customers. Outlet sales consist of sales at our outletoutlets of product samples, returned productsproduct from our customers and to a lesser degree full price products.product. Shipping and handling fees consist of amounts we charge customers for the delivery of merchandise.

 

  Thirteen weeks ended   Thirteen weeks ended
(amounts in thousands)  March 29,
2008
  % of Net
Sales
 March 31,
2007
  % of Net
Sales
 Change % Change 

(amounts in thousands,

except percentages)

      April 4,    
2009
  % of
Net
    Sales    
      March 29,    
2008
  % of
Net
    Sales    
      Change      %
    Change    

Studio sales

  $31,314  66.7% $28,488  65.0% $2,826  9.9%   $23,468   68.9%    $31,314   66.7%    $(7,846)  (25.1)% 

Online sales

   6,327  13.5%  6,792  15.5%  (465) (6.8)%   5,206   15.3%    6,327   13.5%    (1,121)  (17.7)% 

Phone sales

   4,298  9.2%  4,197  9.6%  101  2.4%   2,365   6.9%    4,298   9.2%    (1,933)  (45.0)% 

Other sales

   1,420  3.0%  1,208  2.8%  212  17.5%   1,701   5.0%    1,420   3.0%    281   19.8 % 

Shipping and handling fees

   3,555  7.6%  3,163  7.1%  392  12.4%   1,336   3.9%    3,555   7.6%    (2,219)  (62.4)% 
                                  

Net sales

  $46,914  100.0% $43,848  100.0% $3,066  7.0%   $34,076   100.0%    $46,914   100.0%    $(12,838)  (27.4)% 
                                  

Net sales increased $3,066,000,decreased $12,838,000, or 7.0%27.4%, to $34,076,000 in the first quarter 2009 from $46,914,000 in the first quarter 2008 from $43,848,000 in the first quarter 2007.2008. The increasedecrease in the combined net sales of our three sales points (studio, online and phone) is related in part, to a 5% decrease in the number of units of merchandise shipped, a decrease in prices due to an increase in promotional discounts and a change in product mix to a relative higher volume of lower priced DWR:Tools for Living merchandise. The average revenue per unit retail sales price dueof product sold decreased by 23%. All of these factors are attributed to price increases and product mix.the impact of the unfavorable economy. Studio sales increased $2,826,000,decreased $7,846,000, or 9.9%25.1%, in the first quarter 20082009 compared to the first quarter 2007. This increase is partially attributed to the incremental sales of approximately $734,000 generated from two new studios opened in fiscal year 2007 which did not operate during the entire first quarter 2007 and two new studios opened in the first quarter 2008. We had 66 studios, two DWR:Tools for Living stores and three outlets open at the end of the first quarter 2009 compared to 68 studios and one outlet open at the end of the first quarter 2008 compared to 64 studios and one outlet open at the end of the first quarter 2007.2008. Online sales decreased $465,000,$1,121,000, or 6.8%17.7%, and phone sales increased $101,000,decreased $1,933,000, or 2.4%45.0%, in the first quarter 20082009 compared to the first quarter 2007.2008.

Other sales increased $212,000,$281,000, or 17.5%19.8%, in the first quarter 20082009 compared to the first quarter 2007.2008. This increase is primarily related to an increase of approximately $389,000$192,000 in sales generated from our outlets including our newly opened Palm Springs outlet, partially offset by a decrease inand an increase from warehouse sales of approximately $189,000.$82,000. Shipping and handling fees for delivery of merchandise increased $392,000,decreased $2,219,000, or 12.4%62.4%, in the first quarter 20082009 compared to the first quarter 2007, partially attributed2008, primarily attributable to the increaseddecrease in product sales.sales and an increase in the amount of promotional free shipping.

Cost of Sales.

Cost of sales decreased by $765,000,$4,992,000, or 3.0%20.2%, to $19,746,000 in the first quarter 2009 from $24,738,000 in the first quarter 2008 from $25,503,0002008. The decrease in cost of sales is attributable to the first quarter 2007.decrease in net sales. Cost of sales as a percentage of net sales decreased 5.5increased 5.2 percentage points to 57.9% in the first quarter 2009 from 52.7% in the first quarter 2008, from 58.2%primarily attributable to increased promotional sales discounts and negative margins on shipping because of promotional free shipping. The shipping margin was negative in the first quarter 2007. Of2009 compared to a positive shipping margin in the 5.5 percentage points decrease infirst quarter 2008. We expect cost of sales as a percentage of net sales 4.9 percentage points were attributed to product-related margin improvements and 0.6 percentage points were attributed to shipping margin improvementsincrease in the firstsecond quarter 2008of 2009 compared to 2008 as we utilize more promotional sales discounts and free shipping than the firstsecond quarter 2007. The shipping margin was positive in the first quarter 2008 compared to a negative shipping margin in the first quarter 2007.of 2008.

Selling, General and Administrative Expenses(“SG&A”).

Selling, general and administrative expenses consist of studio, marketing, corporate and fulfillment center costs. Studio costs includinginclude salaries and studio occupancy costs. Marketing costs include consumer and online advertising expenses, and costs associated with publishing our catalogscatalogs. Corporate costs include salaries, occupancy costs, computer systems and maintainingweb-site related costs and professional fees, among others. Fulfillment center costs include salaries, occupancy costs and charges for shipping merchandise from our website, and corporate and fulfillment center costs, including salariesto studios, DWR:Tools for Living stores, outlet and occupancy costs, among others.warehouse sales events. Our gross margins may not be comparable to those of other companies because some other companies include all of the costs related to their distribution network in cost of sales, and others,while other companies, including us, may exclude a portion of themthose costs from gross margin, including them instead in other line items, such as selling, general and administrative expenses.

 

  Thirteen weeks ended   Thirteen weeks ended
(amounts in thousands)  March 29,
2008
  % of Net
Sales
 March 31,
2007
  % of Net
Sales
 Change % Change 

(amounts in thousands,

except percentages)

  April 4,
    2009    
  % of
Net
    Sales    
  March 29,
    2008    
  % of
Net
    Sales    
      Change      %
    Change    

Salaries and benefits

  $9,360  20.0% $9,234  21.1% $126  1.4%   $7,603   22.3%    $9,360   20.0%    $(1,757)  (18.8)% 

Occupancy and related expense

   6,363  13.6%  6,485  14.8%  (122) (1.9)%   6,735   19.8%    6,363   13.6%    372   5.8 % 

Catalog, advertising and promotion

   3,283  7.0%  1,856  4.2%  1,427  76.9%   2,630   7.7%    3,283   7.0%    (653)  (19.9)% 

Other expense

   3,319  7.1%  2,762  6.3%  557  20.2%

Professional, accounting, legal and SOX

   1,034  2.2%  1,907  4.3%  (873) (45.8)%

Other expenses

   2,542   7.5%    3,319   7.1%    (777)  (23.4)% 

Professional - legal, consulting, SOX

   693   2.0%    1,034   2.2%    (341)  (33.0)% 
                                

Total SG&A

  $23,359  49.8% $22,244  50.7% $1,115  5.0%   $20,203   59.3%    $23,359   49.8%    $(3,156)  (13.5)% 
                                

SG&A expenses increaseddecreased by $1,115,000,$3,156,000, or 5.0%13.5%, to $20,203,000 in the first quarter 2009 from $23,359,000 in the first quarter 2008 from $22,244,000 in the first quarter 2007.2008. As a percentage of net sales, SG&A expenses decreasedincreased to 59.3% in the first quarter 2009 from 49.8% in the first quarter 2008, attributable to the decreased net sales. The decreases in SG&A are described below. In response to lower sales following the economic downturn and resulting losses from 50.7%operations in 2008, we undertook several initiatives to lower our expenses to better match the forecasted reduction in revenues and improve liquidity in the fourth quarter 2008 and the first quarter 2009. We have restructured certain real estate lease contracts, reduced marketing and catalog expenses primarily by reducing the number of planned catalog mailings and the number of pages per catalog, delayed implementation of a new ERP system, renegotiated certain support contracts related to software maintenance and telecommunications, and lowered outside contractor fees as well as headcount in all areas of the Company. We reduced expenses by approximately $3 million in the first quarter 2007, attributed to2009 and expect reduced expenses of approximately $15 million in the increased net sales. The increasesremainder of 2009 from the prior comparable periods in SG&A are primarily due to the following:2008.

Salaries and benefits expense increased $126,000,decreased $1,757,000, or 1.4%18.8%, to $7,603,000 in the first quarter 2009 from $9,360,000 in the first quarter 2008 from $9,234,000 in the first quarter 2007.2008. This increasedecrease is primarily related to a $142,000 increase$720,000 decrease in salary and contract labor expenses and a $153,000 increase$215,000 decrease in health care benefits and payroll taxes that are primarily attributable to the reduction in work force implemented in January 2009. In addition, the decrease is related to a $472,000 decrease in commission and bonus expenses, which is primarily attributable to the decrease in net sales and a $359,000 decrease in stock-based compensation expense. The decrease in stock-based compensation expense is partially the result of cancelled stock options due to the reduction in part,work force and the lower valuation of recently issued stock options due to the lower price of our common stock. Incremental salaries and benefits expense related to one new outlet opened in the increase in net sales. Of these amounts, approximately $153,000 is related tofirst quarter 2009, including pre-opening expenses, two new DWR:Tools for Living stores opened in the third and fourth quarters 2008 and two studios opened in fiscal year 2007the first quarter 2008, which did not operate during the entire first quarter 20072008, was approximately $221,000. Salaries and two new studios openedbenefits expense is expected to decrease in the remainder of 2009 due to headcount reductions implemented in January 2009 with a planned reduction from the prior comparable period in 2008 of approximately $4,000,000.

Occupancy and related expense increased $372,000, or 5.8%, to $6,735,000 in the first quarter 2009 compared to $6,363,000 in the first quarter 2008. This increase was partially offset by a $135,000 decrease in stock-based compensation expense. Salaries and benefits expense is expected to increase due to benefit cost increases, increased commissions related to planneda $294,000 increase in rent and operating expenses for new or relocated sales increases, if any, and headcount increases fromlocations including one new studios not operating in the prior comparable period. We may increase or decrease headcount depending on operating requirements and cost considerations that would affect salaries and benefits expense.

Occupancy and related expense decreased $122,000, or 1.9%, to $6,363,000outlet opened in the first quarter 2009, two new DWR:Tools for Living stores opened in the third and fourth quarters 2008 compared to $6,485,000and two studios opened in the first quarter 2007. This decrease is primarily due to a $520,000 decrease in depreciation expense, of which $450,000 was related to our information technology system, which was fully depreciated in the first quarter 2007. This decrease was partially offset by a $397,000 increase in rent and related operating expenses of which $194,000 is associated with two new studios opened in fiscal year 20072008, which did not operate during the entire first quarter 20072008. In addition, we relocated one studio with increased rent and two new studios openedoperating expenses in the firstsecond quarter 2008. The occupancy and related expense increase is also due to an $81,000 increase in depreciation expense. Occupancy and related expense is expected to increase within 2009 from 2008 as the openingresult of new studios. In addition, we anticipate increasesthe recently opened outlet and two DWR:Tools for Living stores and one relocated studio opened in depreciation expense as our enhanced website became operational on April 1, 2008 and other new information technology systems become operational throughout 2008.

Catalog, advertising and promotion expense increased approximately $1,427,000, or 76.9%, to $3,283,000 in the first quarter 2008 from $1,856,000 in the first quarter 2007. This increase is primarily due to a $1,239,000 increase in catalog expense and a $157,000 increase in media advertising expense. Direct response catalog costs are capitalized as prepaid catalog costs and are amortized over their expected period of future benefit of approximately four months. Of the increase in catalog amortization expense, $874,000 is attributed to the number and timing of catalogs distributed prior to year end and $345,000 is attributed to the timing and higher costs of our annual catalog. The annual catalog was distributed in January 2008 compared to March 2007 and the costs were higher because we mailed approximately 507,000 catalogs in the first quarter 2008 compared to approximately 219,000 in the first quarter 2007. We expect higher catalog expense throughout 2008 compared to 2007.

 

Catalog, advertising and promotion expense decreased $653,000, or 19.9%, to $2,630,000 in the first quarter 2009 from $3,283,000 in the first quarter 2008. This decrease is due to a $300,000 decrease in catalog expense and a $236,000 decrease in media advertising expense. Direct response catalog costs were recorded as prepaid catalog costs, and during the first nine months of 2008 were amortized over their expected period of future benefit of approximately four months. In accordance with Statements of Position of the Accounting Standards Division No. 93-7,Reporting on Advertising Costs(“SOP 93-7”), advertising costs must be expensed unless the advertising elicits sales to customers. During the fourth quarter 2008, we no longer adequately tracked the required information required by SOP 93-7. Consequently, catalog costs were expensed as the catalogs were distributed in the fourth quarter 2008 and first quarter 2009. The cost of catalogs distributed in the first quarter 2009 decreased by approximately $280,000 from the cost of catalogs distributed in the first quarter 2008. The number of catalogs we distributed in the first quarter 2009 increased by 16% from 2008. However, the increased costs from higher circulation was offset by a 38% decrease in the total number of pages of all catalogs distributed in the first quarter 2009 from 2008. In addition, we distributed a relatively more expensive annual catalog in the first quarter 2008 without a comparable catalog in the first quarter 2009. We plan to reduce overall spending on catalogs and advertising in the remainder of 2009 from the prior comparable period in 2008 by approximately $8,000,000 based on our initiative to lower our expenses including reduced advertising and fewer planned catalog mailings and fewer pages.

Other expense increased $557,000, or 20.2%, to $3,319,000 in the first quarter 2008 compared to $2,762,000 in the first quarter 2007. The increase is primarily due to a $147,000 increase in the cost of distributing sample merchandise to our studios, a $125,000 increase in sales-related merchant fees, a $105,000 increase in uncollectible credit card billings, and a $95,000 increase in travel-related expenses.

Other expense decreased $777,000, or 23.4%, to $2,542,000 in the first quarter 2009 compared to $3,319,000 in the first quarter 2008. The decrease is primarily due to a $348,000 decrease in merchant fees, a $256,000 decrease in supplies and the cost of distributing merchandise to our warehouse sales events, studios, and new DWR:Tools for Living stores, a $182,000 decrease in travel-related expense, a $114,000 decrease in bad debt expense, and a $104,000 decrease in telephone and telecommunication expense. This decrease was partially offset by an increase of $181,000 in software and website-related expenses and charges of $73,000 for impairment of leasehold improvements due to closing of our Southlake, Texas studio in the second quarter 2009. We also closed our Tigard, Oregon studio during the second quarter 2009. We incurred impairment charges related to the leasehold improvements for the Tigard, Oregon studio in 2008. In accordance with Financial Accounting Standards Board Statement No. 146,Accounting for Costs Associated with Exit or Disposal Activities(“FAS 146”), a liability for costs that will continue to be incurred under the lease agreement for the remaining term without economic benefit to the Company must be recognized and measured at the lease’s fair value at the cease-use date. We will record additional charges in the second quarter 2009 for future lease payments at the cease-use date in accordance with FAS 146. Excluding any impairment charges, we plan to reduce overall spending in other SG&A expenses in the remainder of 2009 from the prior comparable period in 2008 by approximately $3,000,000 based on our initiative to lower our expenses including reduced travel-related expense, information technology expenses and costs of distributing merchandise to our warehouse sales events, studios, and DWR:Tools for Living stores.

 

Professional, accounting, legal and SOX expense decreased $873,000,$341,000, or 45.8%33.0%, to $693,000 in the first quarter 2009 compared to $1,034,000 in the first quarter 2008 compared to $1,907,000 in the first quarter 2007.2008. The decrease is primarily due to a $906,000$363,000 decrease in accounting and consulting fees directly related to SEC reporting and SOX compliance, partially offset by a $46,000 increase in legal expense.Sarbanes-Oxley Act of 2002 compliance.

Interest Income.and Other Income and ExpensesInterest

We had no significant interest income decreased $53,000in the first quarter 2009 compared to interest income of $57,000 in the first quarter 2008 due to significantly less invested capital and lower interest rates. In the first quarter 2009, excess cash balances were used to pay down borrowings under our loan agreement compared to $110,000being swept into an interest bearing investment account in the first quarter 2007, primarily due2008. Interest expense increased $66,000 to lower interest rates and less amount of invested capital$114,000 in the first quarter 20082009 compared to the first quarter 2007.

Interest Expense.Interest expense increased $10,000 to $48,000 in the first quarter 2008 comparedprimarily due to $38,000increased borrowings under our loan agreement. We had no significant other income (expense) in the first quarter 2007.

Other Income (Expense), Net.2009. Other expense of $144,000 in the first quarter 2008 primarily consists of foreign currency exchange losses related to the value of the dollar decreasing approximately 7% relative to the Euro. We have certain liabilities from merchandise purchases denominated principally in Euros that result in charges to other expense when the value of the dollar decreases. Such charges are not offset against gains from designated hedge contracts in which corresponding gains are recognized in other comprehensive income.

Income Taxes. We

No income tax benefit was recognized in the first quarter 2009 because it was uncertain whether the tax benefit of the year-to-date pre-tax loss would be realized. In the first quarter 2008, we recorded a tax benefit of approximately $696,000 calculated at the projected annual effective tax rate of 52.8% in the first quarter 2008.. The difference between the statutory rate of 39.5% and effective tax rate iswas primarily due to projected stock-based compensation expense related to incentive stock options not being deductible for tax purposes. No income tax benefit was recognized in the first quarter 2007 because it was uncertain whether the tax benefit of the year-to-date pre-tax loss would be realized during fiscal year 2007.

Liquidity and Capital Resources

As of March 29, 2008,Cash and cash equivalents

Cash and cash equivalents were approximately $6,496,000. $3,099,000 and $6,496,000 as of April 4, 2009 and March 29, 2008, respectively.

Working capital

Working capital was $24,743,000$4,910,000 and $17,783,000$24,743,000 as of April 4, 2009 and March 29, 2008, respectively. The decrease in working capital is primarily the result of significant operating losses incurred in the second quarter 2008 through the fourth quarter 2008 and March 31, 2007, respectively.the first quarter 2009. Specific component changes in working capital were increased borrowings of $7,149,000 under the loan agreement and decreased inventory of $11,132,000.

Cash Flows.flows

Net cash provided by (used in):

 

  Thirteen weeks ended   Thirteen weeks ended

(amounts in thousands)

  March 29,
2008
 March 31,
2007
       April 4, 2009          March 29, 2008    

Operating activities

  $(401) $(2,355)   $1,350    $(401)

Investing activities

   (1,196)  (1,338)   (720)   (1,196)

Financing activities

   2,442   2,321    (6,215)   2,442 

Net Cash UsedProvided by (Used in) Operating Activities

Net cash provided by operating activities of $1,350,000 in Operating Activities.the first quarter 2009 was primarily attributable to a reduction of inventory of $6,511,000 that was offset by the loss from operations of $5,984,000. Net cash used in operating activities wasof $401,000 in the first quarter 2008 compared to $2,355,000 in the first quarter 2007. The improvement in cash flow was primarily attributedattributable to a lowerthe net loss from operations in the first quarter 2008 resulting from increased revenues and improved gross margins from the first quarter 2007.2008.

Net Cash Used in Investing Activities.Activities

Cash used in investing activities was for the purchase of property and equipment related to our new outlet and studios, and information technology systems in the amounts of $1,196,000$720,000 and $1,338,000$1,196,000 in the first quarter 20082009 and 2007,2008, respectively. We opened one new outlet in the first quarter 2009 and two new studios in the first quarter 2008 and one studio in the first quarter 2007.2008.

For the remainder of fiscal year 2008,2009, we anticipate that our investment in property and equipment is planned betweenwill be approximately $7,500,000 and $8,500,000$500,000, primarily to implement new information technology systems, relocate one studio open two Tools for Living stores and remodel selected studios.in the second quarter 2009. We plan to finance these investments in fiscal year 2008this investment from our existing cash balances, our anticipated cash flows from operations and borrowings under our revolving line of credit facility.

Net Cash Provided by (Used in) Financing Activities.Activities

Net cash used in financing activities in the first quarter 2009 was primarily comprised of repayment of borrowings under our loan agreement of $4,266,000, the restriction of $2,000,000 of cash related to our loan agreement and repayment of long-term obligations of $207,000. Net cash provided by financing activities was comprised of borrowings on our bank credit facility in the amounts of $2,534,000 and $2,587,000 in the first quarter 2008 was primarily comprised of borrowings of $2,534,000 under our loan agreement.

Cash Availability and 2007, respectively. Net cash used in financing activities was for the repayment of long-term obligations of $92,000 and $266,000 in the first quarter 2008 and 2007, respectively.Liquidity

As of March 29, 2008,April 4, 2009, we had available approximately $22,889,000$6,935,000 in working capital resources for our future cash needs as follows:

 

approximately $6,496,000$3,099,000 in cash and cash equivalents; and

 

approximately $16,393,000$3,836,000 in availability under our working capital line of credit.

In response to lower sales following the economic downturn and resulting losses from operations in 2008, we undertook several initiatives to lower our expenses to better match the forecasted reduction in revenues and improve liquidity in the fourth quarter 2008 and the first quarter 2009. We have restructured certain real estate lease contracts, reduced marketing and catalog expenses primarily by reducing the number of planned catalog mailings and the number of pages per catalog, delayed implementation of a new ERP system, renegotiated certain support contracts related to software maintenance and telecommunications, and lowered outside contractor fees as well as headcount in all areas of the Company. We reduced expenses by approximately $3 million in the first quarter 2009 and expect reduced expenses of approximately $15 million in the remainder of 2009 from the prior comparable periods in 2008. We also reduced inventory levels significantly from year-end 2008 levels to generate additional liquidity. However, if we fail to generate sales and margins at levels currently forecasted or do not obtain additional debt or equity financing, it is unlikely that we will be able to maintain sufficient liquidity to continue as a going concern.

As a result of the challenging market and economic conditions, concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. In addition, many vendors in our industry have begun to provide less favorable payment terms. Continued turbulence in the United States and international markets and economies may adversely affect the liquidity and financial condition of our lenders, vendors and our access to credit from our lenders and vendors. If these market conditions continue, they may limit our ability, and the ability of our lenders and vendors to timely replace maturing liabilities, and access the capital markets to meet liquidity needs, resulting in an adverse effects on our liquidity, financial condition and results of operations.

In the United States, recent market and economic conditions have been unprecedented and challenging with tighter credit conditions, and more frequent and lower reappraisals of inventories on which advance rates under our credit line are determined. In addition, large financial institutions have declared bankruptcy or are under government conservatorship. There can be no assurance that access to our working capital line of credit will not be impacted by adverse conditions in the financial markets.

We are currently in compliance with all of our debt covenants. If Wells Fargo increases reserves or reduces the advance rate due on our credit line by a material amount and we are unable to reduce outstanding borrowings to the reduced level of availability, or an event of default occurs, there can be no assurance that Wells Fargo will not demand repayment of the line of credit or take assets secured by our borrowing.

Commitments and Contractual Obligations

On February 2, 2007, we entered into a Loan, Guaranty and Security Agreement, or the Loan Agreement, with Wells Fargo Retail Finance, LLC, or the Loan Agreement, which replaced the previous loan with Wells Fargo HSBC Trade Bank, N.A.Fargo. The Loan Agreement expires on February 2, 2012 and provides for an initial overall credit line up to $20,000,000 which may be increased to $25,000,000 at our option, provided we are not in default on the Loan Agreement. The Loan Agreement consists of a revolving credit line and letters of credit up to $5,000,000. The amount we may borrow at any time under the Loan Agreement is based upon a percentage of eligible inventory and accounts receivable less certain reserves. Advance rates under the credit line are, in part, determined by third party appraisals of the net liquidation value of our inventories. Borrowings are secured by the right, title and interest to all of our personal property, including cash, accounts receivable, inventory, equipment, fixtures, general intangibles and intellectual property and inventory.property. The Loan Agreement contains various restrictive covenants, including minimum availability, which is the amount we may borrow under the Loan Agreement, less certain outstanding obligations, plus certain cash and cash equivalents,restrictions on payment of dividends, limitations on indebtedness, limitations on subordinated indebtedness and limitations on the amount of capital expenditures we may incur in any fiscal year. We are currently in compliance with all of these restrictive covenants.

In the fourth quarter 2008 and the first quarter 2009, bank-commissioned appraisals determined that the net liquidation value of our inventories had declined due to general market conditions and, as a result, Wells Fargo reduced our advance rates, which constricted the availability of borrowings under the line of credit. The availability of borrowings would decrease if subsequent appraisals determine that the net liquidation value of our inventories has decreased.

Wells Fargo increased discretionary reserves by $1,500,000 in the first quarter 2009. On March 18, 2009, we entered into a first amendment to the Loan Agreement and a securities account availability agreement with Wells Fargo in which Wells Fargo increased the amount of advances otherwise available to us by $1,000,000 in exchange for our granting Wells Fargo collateral rights on a deposit account with a balance of approximately $4,678,000. Wells Fargo will permit us to withdraw amounts from this account in excess of $2,000,000 so long as no default or event of default has occurred. Accordingly, we classified $2,000,000 of cash to restricted cash. In addition, Wells Fargo rescinded its decision to require additional discretionary reserves of $1,500,000. On April 14, 2009, we withdrew $1,000,000 from this account for working capital purposes. If Wells Fargo increases reserves or reduces the advance rate due on our credit line by a material amount and we are unable to reduce outstanding borrowings to the reduced level of availability, or an event of default occurs, there can be no assurance that Wells Fargo will not demand repayment of the line of credit or take assets secured by our borrowing.

Interest on borrowings will be either at Wells Fargo’s prime rate, or LIBOR plus 1.25% to 1.75% based upon average availability, and the unused credit line fee is 0.25%0.3%. In the event of default, our interest rates would increaseare increased by two percentage points. The interest rate on outstanding borrowings at March 29, 2008 was 5.25%. As of March 29, 2008,April 4, 2009, we had outstanding borrowings of $2,534,000$9,683,000 under the revolving credit line and $1,073,000$1,318,000 in outstanding letters of credit. Approximately $16,393,000$3,836,000 was available for advances under the revolving credit line as of March 29, 2008.April 4, 2009.

We have various other notes payable, which consist primarily of unsecured equipment financing loans. In June 2006,January 2009, we financed the second and third years of a portionthree year software license fee of our new information technology projectapproximately $253,000 per year with a three-year promissory note of approximately $1,000,000 with an interest rate of approximately 2.0%. In accordance with APB Opinion No. 21 “Interest on Receivables and Payables,” or APB 21, we discounted this note to its fair value. The discounted portion of approximately $58,000 is being amortized as interest expense over the life of the note using the effective interest method.note. As of March 29, 2008,April 4, 2009, outstanding borrowings under thesethis and other notes were $469,000$261,000 with interest rates ranging from 2% to 6.75%. These notes mature11% maturing in 2009.

We entered into equipment leases during fiscal yearyears 2008 and 2007 with remaining capitalized lease obligation payments of $138,000$287,000 including interest and principal as of March 29, 2008.April 4, 2009.

As of March 29, 2008,April 4, 2009, inventory purchase obligations related to open purchase orders were approximately $16,416,000,$7,920,000, commitments for furniture, fixtures, and leasehold improvements related to new studios were approximately $344,000$387,000, and commitments for leasehold improvementssoftware licenses, software maintenance, hosting, and $240,000 for fixtures, and commitmentsdevelopment services for various information technology systems and website maintenance were approximately $920,000.$1,316,000.

Critical Accounting Estimates

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States, or U.S.US GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, sales and expenses. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. Our critical accounting policies and estimates are set forth below.

We operateSee the Annual Report on a 52- or 53-week fiscal year, which ends onForm 10-K for the Saturday closest to December 31. Each fiscal year consists of four 13-week quarters, with an extra week added onto the fourth quarter every four to six years. Our 2007 fiscal year ended on December 29, 2007 and the 2008 fiscal year will end on January 3, 2009. Fiscal year 2007 consisted of 52 weeks2009, in the Notes to Financial Statements and fiscal year 2008 consists of 53 weeks.Critical Accounting Estimates section for critical accounting estimates except as modified below.

Revenue Recognition.Recognition

We recognize revenue on the date on which we estimate that the product has been received by the customer. Wecustomer and retain title to items and bear the risk of loss of shipments until delivery on shipments fromto our warehouse.customers. We recognize shipping and handling fees charged to customers in net sales at the time products are estimated to have been received by customers. We take title to items drop shipped by vendors at the time of shipment and bear the risk of loss until delivery to customers. We use third-party freight carrier information to estimate standard delivery times to various locations throughout the United States.States and Canada. We record as deferred revenue the dollar amount of all shipments for a particular day, if based upon our estimated delivery time, such shipments, on average, are expected to be delivered after the end of the reporting period. As of April 4, 2009, January 3, 2009 and March 29, 2008, December 29, 2007 and March 31, 2007, deferred revenue was approximately$1,637,000, $1,162,000 and $1,980,000, $325,000 and $4,246,000, respectively, and related deferred cost of sales was approximately$890,000, $572,000 and $1,024,000, $173,000 and $2,251,000, respectively.

Sales are recorded net of expected product returns by customers. Significant management judgments and estimates must be made and used in connection with determining net sales recognized in any accounting period. Our management must make estimates of potential future product returns related to current period revenue. We analyze historical returns, current economic trends, and changes in customer demand and acceptance of products when evaluating the adequacy of the sales returns and other allowances in any accounting period. The returns allowance is recorded as a reduction to net sales for the estimated retail value of the projected product returns and as a reduction in cost of sales for the corresponding cost amount, less any reserve for estimated scrap. The reserves for estimated product returns were approximately$532,000, $573,000 and $674,000 $654,000 and $578,000 as of April 4, 2009, January 3, 2009 and March 29, 2008, December 29, 2007 and March 31, 2007, respectively.

Various governmental authorities directly impose taxes on sales including sales, use, value added and some excise taxes. We exclude such taxes from net sales. We account for gift cards by recognizing a liability at the time a gift card is sold and recognizing revenue at the time the gift card is redeemed for merchandise.

Inventory. Inventory consists primarily of finished goods purchased from third-party manufacturers and estimated inbound freight costs. Inventory on hand is carried at an average cost which approximates a first-in first-out method and is carried at the lower of cost or market. We write down inventory below cost to the estimated market value when necessary, based upon assumptions about future demand and market conditions. If actual market conditions or demand for our products are less favorable than projected by management, additional inventory write-downs may be required. Although our actual inventory write-downs historically have not differed materially from estimated inventory write-downs, in the future, actual inventory write-downs may differ materially from our reserves. As a result, our operating results and financial condition could be adversely affected. As of March 29, 2008, December 29, 2007 and March 31, 2007, we had inventory of approximately $41,217,000, $37,820,000 and $40,889,000, respectively, net of write-downs of approximately $2,522,000, $2,166,000 and $2,591,000, respectively.

Inventory-in-transit. We record inventory-in-transit based upon purchase order amounts, shipping terms and estimated lead times from our vendors to our freight forwarders. Actual amounts shipped could differ from our estimates due to transit times as well as partial shipments due to shortages or backorders. Inventory-in-transit was approximately $5,418,000, $5,306,000 and $8,072,000 as of March 29, 2008, December 29, 2007 and March 31, 2007, respectively.

Accrued freight. We estimate inbound freight costs based upon an analysis and review of our historical freight costs. These costs may vary due to the actual weight and size of the product shipped as well as added fuel surcharges. Accrued inbound freight costs for unbilled freight on received inventory was approximately $456,000, $329,000 and $880,000 as of March 29, 2008, December 29, 2007 and March 31, 2007, respectively.

Impairment of Long-Lived Assets. We evaluate the recoverability of our long-lived assets in accordance with FAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,”or FAS 144. Long-lived assets are reviewed for possible impairment whenever events or circumstances indicate that the carrying amount of such assets may not be recoverable. If such review indicates that the carrying amount of long-lived assets is not recoverable, the carrying amount of such assets is reduced to fair value. Management considers the following circumstances and events to assess the recoverability of carrying amounts: 1) a significant adverse change in the extent or manner in which long-lived assets are being used or in their physical condition, 2) an accumulation of costs significantly in excess of the amount originally expected for the acquisition or construction of a long-lived asset, 3) a current-period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset, and 4) a current expectation that, more likely than not, the long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. Decisions to close a studio or facility also can result in accelerated depreciation over the revised useful life. When we close a location that is under a long-term lease, we record a charge for the fair value of the liability associated with that lease at the cease-use date. The fair value of such liability is calculated based on the present value of the remaining lease rental payments due under the lease, reduced by the present value of estimated rental payments that could be reasonably obtained by us for subleasing the property to a third party. The estimate of future cash flows is based on our experience, knowledge and typically third-party advice or market data. However, these estimates can be affected by factors such as future studio profitability, real estate demand and economic conditions that can be difficult to predict. If the undiscounted future cash flows from the long-lived assets are less than the carrying value, a loss is recognized equal to the difference between the carrying value and the fair value of the assets.

Advertising Costs. Direct response catalog costs consist of third-party costs, including paper, printing, postage, name acquisition and mailing costs. Such costs are capitalized as prepaid catalog costs and are amortized over their expected period of future benefit. Such amortization is based upon weighted-average historical revenues attributed to previously issued catalogs. Based on historical data we have collected, we have estimated that catalogs have a period of expected future benefit of approximately four months. The period of expected future benefit of our catalogs could decrease if we were to publish new catalogs more frequently in each year, or could increase if we published them less frequently. Prepaid catalog costs are evaluated for realizability at the end of each reporting period by comparing the carrying amount associated with each catalog to the estimated probable remaining future net benefit associated with that catalog. If the carrying amount is in excess of the estimated probable remaining future net benefit of the catalog, the excess is expensed in the reporting period. We account for consideration received from our vendors for co-operative advertising as a reduction of selling, general and administrative expense. Co-operative advertising amounts received from such vendors were approximately $306,000 and $205,000 in the thirteen weeks ended March 29, 2008 and March 31, 2007, respectively. Apart from amounts received from vendors for cooperative advertising, we do not typically receive allowances or credits from vendors. In the case of a few select vendors, we receive a small discount of approximately 2% for prompt payment of invoices. These discounts were recorded as a reduction of cost of sales and totaled approximately $104,000 and $25,000 in the thirteen weeks ended March 29, 2008 and March 31, 2007, respectively.

Stock-Based Compensation. In the first quarter of 2006, we adopted the modified prospective method for valuing stock options we grant in accordance with FAS 123R. Under FAS 123R, we recognized approximately $465,000 and $601,000 of compensation expense related to stock options and employee stock purchases in the thirteen weeks ended March 29, 2008 and March 31, 2007, respectively. Stock based compensation expense is classified in selling, general and administrative expenses. We calculate the value of each employee stock option, estimated on the date of grant, using the Black-Scholes model. The following assumptions are used in the model: (1) a volatility rate using historical stock prices of the Company, (2) a risk-free interest rate based upon the closing rates on the date of grant for U.S. treasury notes that have a life which approximates the expected life of the option, (3) a dividend yield based on historical and expected dividend payouts, (4) an expected life of employee stock options based on the simplified method allowed by the SEC’s Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management Staff Accounting Bulletin 110 and (5) a forfeiture rate based on historical data. We estimate forfeitures at the time of grant and revise, if necessary, in subsequent periods if actual forfeitures differ from those estimates. Prior to adopting FAS 123R, we recorded deferred stock-based compensation charges in the amount by which the exercise prices of certain options were less than the fair value of our common stock at the date of grant under the intrinsic value method of accounting as defined by the provisions of APB 25.

Accounting for Income Taxes. We will need to generate future taxable income of approximately $2,100,000 and $11,400,000, respectively, to realize federal and state net operating losses. We record an estimated valuation allowance on our deferred tax assets if it is more likely than not that they will not be realized. Significant management judgment is required in determining our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. The Company has California Enterprise Zone credits of $417,000 that may be used for an indefinite period of time. A valuation allowance must be provided when it is more likely than not that a deferred tax asset will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. The Company considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning strategies in making this assessment. Accordingly, the California Enterprise Zone credits have been reduced by $417,000 for amounts not expected to be fully utilized.

Derivative and Hedging Activities. We record derivatives related to cash flow hedges for foreign currency at fair value on our balance sheet, including embedded derivatives. We implemented a new hedging strategy in the first quarter 2007 to mitigate the impact of foreign currency fluctuations on inventory purchases. Foreign currency contracts entered into from January to April of fiscal year 2007 were not designated as cash flow hedge contracts. We accounted for non-hedge foreign currency contracts on a monthly basis by recognizing the net cash settlement gain or loss in other income (expense) and adjusting the carrying amount of open contracts to fair value by recognizing any corresponding gain or loss in other income (expense). In the second quarter 2007, we developed a hedging strategy and policies and procedures that met the criteria for cash flow hedge accounting. Foreign currency contracts entered into from May 2007 through March 2008 were designated as cash flow hedge contracts and were accounted for on a monthly basis by recognizing the net cash settlement gain or loss in other comprehensive income (loss) and adjusting the carrying amount of open designated contracts to market by recognizing any corresponding gain or loss in other comprehensive income (loss). Net cash settlement gain or loss was recognized in cost of sales as the underlying hedged inventory is sold in each reporting period. Our derivative positions were used only to manage identified exposures.

We evaluate hedges for effectiveness, and for derivatives that were deemed ineffective, the ineffective portion was reported through earnings. We did not record any amounts for ineffectiveness in the thirteen weeks ended March 29, 2008 and March 31, 2007.

Item 3.Quantitative and Qualitative Disclosures About Market Risk

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Exchange Risk

In the thirteen weeks ended March 29, 2008,first quarter 2009, we generated more than 99%98% of our net sales in U.S. dollars, but we purchased approximately 34%36% of our product inventories from manufacturers in foreign countries with 24%20% of our product inventory purchases being paid for in Euros. Increases and decreases in the U.S. dollar relative to the Euro result in fluctuations in the cost to us of merchandise sourced from Europe. As a result of such currency fluctuations, we have experienced and may continue to experience fluctuations in our operating results on an annual and a quarterly basis going forward. Specifically, as the value of the U.S. dollar declines relative to the Euro, ourthe effective cost of supplies offor our product increases. As a result, declines in the value of the U.S. dollar relative to the Euro and other foreign currencies would increase our cost of sales and decrease our gross margin. Although

In the first quarter 2009, the value of the dollar increased approximately 4% relative to the Euro. We purchased foreign currency forward contracts to hedge our hedging strategy described below may mitigate thisforeign currency risk in the short-term, currency fluctuations infirst quarter 2008 through the long term will not be mitigated by hedging because we do not hedge our currency risks beyond a year.

third quarter 2008. In the thirteen weeks ended March 29, 2008, the value of the dollar decreasedincreased approximately 7%5% relative to the Euro.Euro resulting in losses on some of those contracts and, as a result, we discontinued purchasing hedge contracts at the end of 2008. We implemented a new hedging strategydo not hold any foreign currency forward contracts as of April 4, 2009. A hypothetical 1% increase or decrease in the first quarter 2007Euro exchange rate with the dollar on January 4, 2009 would result in a change to mitigate the impact of foreign currency fluctuations on inventory purchases. Foreign currency contracts entered into from January 2007 to April 2007 were not designated as cash flow hedge contracts. We accounted for non-hedge foreign currency contracts on a monthly basis by recognizing the net cash settlement gain or loss in other income (expense) and adjusting the carrying amount of open contracts to fair value by recognizing any corresponding gain or loss in other income (expense). In the second quarter 2007, we developed a hedging strategy and policies and procedures that met the criteria for cash flow hedge accounting. Foreign currency contracts entered into from May 2007 through March 2008 were designated as cash flow hedge contracts and were accounted for on a monthly basis by recognizing the net cash settlement gain or loss in other comprehensive income (loss) and adjusting the carrying amount of open designated contracts to market by recognizing any corresponding gain or loss in other comprehensive income (loss). Net cash settlement gain or loss was recognized in cost of sales as the underlying hedgedof approximately $68,000 on an annualized basis if our product inventory is soldpurchases being paid for in each reporting period. Our derivative positions were used only to manage identified exposures. If our hedging strategy does not help reduce fluctuations in our cost of goods and mitigate the impact of the strengthening of the Euro relative to the U.S. dollar, we will continue to have difficulties in accurately predicting our costs of sales and our cost of sales may increase, adversely impacting our gross margin.Euros remained constant throughout 2009.

Interest Rate Risk

We have interest payable on our revolving line of credit. Amounts borrowed under this line of credit bear interest at an annual rate equal to the lender’s prime lending rate or LIBOR plus 1.25% to 1.75% based upon average availability. The extent of this risk is not quantifiable or predictable because of the variability of future interest rates and the future financing requirements. As of March 29, 2008,April 4, 2009, we had $2,534,000$9,683,000 of outstanding borrowings under the revolving credit line at an interest rate of 5.25%3.25%. A hypothetical increase or decrease in interest rates by one percentage point on January 3, 2009 would result in changes to our interest expenses of approximately $28,000 in the first quarter 2009 and approximately $101,000 on an annualized if our outstanding loan balance remained constant throughout 2009.

Item 4.Controls and Procedures

Item 4. Controls and Procedures

(a) Evaluation of Disclosure Controls and Procedures

(a)        Disclosure Controls and Procedures

Management, including our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, evaluated the effectiveness of our disclosure controls and procedures, as of the end of the period covered by this report, in accordance with Rules 13a-15(b) and 15d-15(b) of the Exchange Act. Based on that evaluation, our CEO and CFO concluded that control deficiencies which constituted material weaknesses at December 29, 2007the end of fiscal year 2008, as discussed in subsection (b) below, continued to exist in our internal control over financial reporting as of the end of the period covered by this report. As a result of these material weaknesses, our CEO and CFO concluded that our disclosure controls and procedures were not effective as of the end of the period covered by this report at the reasonable assurance level. In light of the material weaknesses described below, we performed additional analyses and other post-closing procedures to determine that our financial statements included in this report were prepared in accordance with U.S.US GAAP. Accordingly, management believes that the financial statements included in this report fairly present in all material respects our financial condition, results of operations and cash flows for the periods presented.

The certifications of our principal executive officer and principal financial officer required in accordance with Section 302 of the Sarbanes-Oxley Act of 2002 are attached as exhibits to this Quarterly Report on Form 10-Q. The disclosures set forth in this Item 4 contain information concerning the evaluation of our disclosure controls and procedures, internal control over financial reporting and changes in internal control over financial reporting referred to in those certifications. Those certifications should be read in conjunction with this Item 4 for a more complete understanding of the matters covered by the certifications.

(b) Management’s Report on Internal Control Overover Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over our financial reporting for the Company.reporting. Internal control over financial reporting refers to the process designed by, or under the supervision of, our CEO and CFO, and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S.US GAAP, and includes those policies and procedures that:

1) pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;

1)pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets;

2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. GAAP, and that our receipts and expenditures are being made only in accordance with the authorization of our management and directors; and

2)provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with US GAAP, and that our receipts and expenditures are being made only in accordance with the authorization of our management and directors; and

3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

3)provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of our internal control over financial reporting as of the end of the period covered by this report. In making this assessment, management used the framework set forth in the report entitled Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, or COSO. The COSO framework summarizes each of the components of a company’s internal control system, including (i) the control environment, (ii) risk assessment, (iii) control activities, (iv) information and communication, and (v) monitoring.

Material Weaknesses and Remediation Initiatives

A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the company’s annual or interim financial statements will not be prevented or detected on a timely basis. Management identifiedOur management has discussed the following material weaknesses during itsand other deficiencies with our Audit Committee and performed significant additional substantive review as described below where it identified material weaknesses to gain assurance that the financial statements as included herein are fairly stated in all material respects. During our assessment of our internal control over financial reporting as of the end of the period covered by this report.report, management identified the following material weaknesses:

Control Activities

We had an entity level material weakness related to ineffective controls over the initiation, authorization, review, documentation and recording of the financial impact of material contracts. Specifically, we do not have a contract tracking system for material contracts entered into other than for purchase orders related to inventory commitments. This material weakness could impact selling, general and administrative expenses and capital expenditures.

As remediation initiative we have developed a process to review material contracts for appropriate financial statement treatment and disclosure and are in the process of implementing it. Specifically, in the first quarter 2009 we have reviewed material contracts related to new real estate leases, real estate lease amendments, and website and information systems to adequately account for their financial impact.

Monitoring

We had an entity level material weakness related to insufficient oversight procedures performed by management of the company’sour internal controls. We did not maintain processes to verify that internal controls over financial reporting and regulatory filings were performed correctly or in a timely and consistent basis.

As a result of this conclusion, management performed significant additional substantive review of those areas described above where it identified material weaknesses to gain assurance that the financial statements as included herein are fairly stated in all material respects.

(c) Management’s Remediation Initiatives

We continue to evaluate the deficiencies that have been identified in 2007. We continue to remediate the remaining deficiencies.

To facilitate some of the improvementsremediation initiative in the internal control environment,first quarter 2009, we continue to implement a new ERP system. This new ERP system should replace the majority of our existing legacy systems. We expect the new system to allow the Company to leverage more automated controls which will help remediate some of the deficiencies.

Our management has discussed the material weaknesses described abovecontinued self testing and other deficiencies with our Audit Committee. In an effort to remediate the identified material weaknesses and other deficiencies, we have initiated and/or taken action to remediate material weaknesses related to the following areas:

Control Activities

We are continuing to develop a process to emphasize the importance of internal controls and verify that allevaluation by process owners arethat was initiated in 2008. When a deficiency was discovered, we followed up with the parties involved with performance of internal controls. We continue to provide training to all process owners onand monitored corrective action and confirmed the appropriate requirements to documentcontrol has been corrected and perform internal control procedures.

updated.

We are continuing to develop a process whereby, on a periodic basis, process owners will perform self-assessment testing and report results to management. Periodic independent testing also will be performed to evaluate the adequacy of design and effectiveness of internal control procedures.

We plan to develop a process to review material contracts for appropriate financial statement treatment and disclosure.

Monitoring

We plan to implement formal policies and procedures over performance of internal controls, including monitoring functions. We anticipate performing a top-down risk-based approach to identify those accounts, financial statement assertions, business processes and locations which have a higher likelihood of resulting in a material misstatement to our financial statements and to accordingly adjust the nature, timing and extent of control monitoring efforts.

An internal resource will be tasked to monitor compliance with internal control requirements, including the performance of self-testing by process owners.

(d) Changes in Internal Control over Financial Reporting

(b)        Changes in Internal Control over Financial Reporting

Other than these implementations, the improvements in our control environment overduring the last three monthsfirst quarter 2009 and the internal control implementation currently underway as discussed above, there have been no changes in our internal control over financial reporting during our fiscalthe first quarter ended March 29, 20082009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II - OTHER INFORMATION

Item 1. Legal Proceedings

Item 1.Legal Proceedings

None.

Item 1A.Risk Factors

Item 1A. Risk Factors

There are no material changesIn addition to the Risk Factorsother information set forth in this report, you should carefully consider the factors described underbelow, as well as those discussed in Part I, Item 1A, “Risk Factors,”Factors” in our Annual Report on Form 10-K for the fiscal year ended December 29, 2007. Please refer to that section for disclosures regardingJanuary 3, 2009, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks and uncertainties relatingfacing us. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business.business, financial condition and/or operating results.

Our business depends, in part, on factors affecting consumer spending that are not within our control and if current sales and margin trends are below our forecast, we may not be able to generate enough liquidity to sustain significant ongoing operating losses and continue operating as a going concern.

Our business depends on consumer demand for our products and, consequently, is sensitive to a number of factors that influence consumer spending. The recent downturn in the housing market, the turmoil in the credit markets, the decrease in consumer confidence and uncertainties in general economic conditions including the current recession, have adversely affected our sales. In addition, fewer customers are shopping at our studios, our website or through the catalog. Net sales decreased $12,838,000, or 27.4%, in the first quarter 2009 from the first quarter 2008. The decrease in the combined net sales of our three sales points (studio, online and phone) is related to a decrease in the number of units of merchandise shipped by 5%, a decrease in prices due to an increase in promotional discounts and a change in product mix to a relative higher volume of lower priced DWR:Tools for Living merchandise. The average revenue per unit of product sold decreased by 23%. All of these factors are attributed to the impact of the unfavorable economy.

In response to lower sales following the economic downturn and resulting losses from operations in 2008, we undertook several initiatives to lower our expenses to better match the forecasted reduction in revenues and improve liquidity in the fourth quarter 2008 and the first quarter 2009. We have restructured certain real estate lease contracts, reduced marketing and catalog expenses primarily by reducing the number of planned catalog mailings and the number of pages per catalog, delayed implementation of a new ERP system, renegotiated certain support contracts related to software maintenance and telecommunications, and lowered outside contractor fees as well as headcount in all areas of the Company. We reduced expenses by approximately $3 million in the first quarter 2009 and expect reduced expenses of approximately $15 million in the remainder of 2009 from the prior comparable periods in 2008. We also reduced inventory levels significantly from year-end 2008 levels to generate additional liquidity. However, if we fail to generate sales and margins at levels currently forecasted or do not obtain additional debt or equity financing, it is unlikely that we will be able to maintain sufficient liquidity to continue as a going concern.

Wells Fargo may demand repayment of the line of credit or take assets secured by our borrowing.

We are currently in compliance with all of our debt covenants. If Wells Fargo increases reserves or reduces the advance rate due on our credit line by a material amount and we are unable to reduce outstanding borrowings to the reduced level of availability, or an event of default occurs, there can be no assurance that Wells Fargo will not demand repayment of the line of credit or take assets secured by our borrowing.

Our process of exploring strategic alternatives may not be successful.

In February 2009, we announced the engagement of Thomas Weisel Partners LLC, an investment banking firm, to assist in the review of strategic alternatives, including advice related to an unsolicited offer we recently received. In the review process, an independent committee of the board has been and will continue to consider a full range of possible alternatives, including, among other things, a possible sale, merger, strategic partnership or refinancing. We currently have no commitments or agreements with respect to any particular transaction, and there can be no assurance that our review of strategic alternatives will result in any transaction.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Item 2.Unregistered Sales of Equity Securities and Use of Proceeds

None.

Item 3. Defaults Upon Senior Securities.

Item 3.Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders.

Item 4.Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

Item 5.Other Information

None.

Item 6. Exhibits

Item 6.Exhibits

 

Exhibit

Number

 

Exhibit Title

3.01(1) Amended and Restated Certificate of Incorporation
3.02(2) Amended and Restated Bylaws
3.03(3)4.01(3) Certificate of Designations for Series A Junior Participating Preferred Stock of Design Within Reach, Inc.
4.01(3)4.02(3) Form of Specimen Common Stock Certificate
4.02(3)4.03(3) Rights Agreement, dated as of May 23, 2006, among Design Within Reach, Inc. and American Stock Transfer and Trust Company, N.A., as Rights Agent, including the form of Certificate of Designations of the Series A Junior Participating Preferred Stock of Design Within Reach, Inc. as Exhibit A, the form of Right Certificate as Exhibit B and the Summary of Rights to Purchase Preferred Shares as Exhibit C
4.03(4)4.04(4) First Amendment dated December 13, 2007 to Rights Agreement dated May 23, 2006 between Design Within Reach, Inc. and American Stock Transfer and Trust Company
10.1(5)4.05(5) EmploymentSecond Amendment dated February 12, 2009 to Rights Agreement dated March 31, 2008May 23, 2006 between Design Within Reach, Inc. and Ray BrunnerAmerican Stock Transfer and Trust Company
4.05(6)Third Amendment dated April 30, 2009 to Rights Agreement dated May 23, 2006 between Design Within Reach, Inc. and American Stock Transfer and Trust Company
10.1(7)First Amendment to Loan Guaranty and Security Agreement among Design Within Reach, Inc., the Lenders thereto and Wells Fargo Retail, Finance, LLC, as Administrative Agent, dated as of March 18, 2009
31.1 Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934
31.2 Certification of Chief Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated under the Securities Exchange Act of 1934
32* Certifications of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

(1)

Incorporated by reference to the Registration Statement on Form S-1 (No. 333-113903) filed on March 24, 2004, as amended.

(2)

Incorporated by reference to Amendment No. 2 to Registration Statement on Form S-1 (No. 333-113903) filed on June 1, 2004, as amended.

(3)

Incorporated by reference to Design Within Reach’s Current Report on Form 8-K filed on May 25, 2006.

(4)

Incorporated by reference to Design Within Reach’s Current Report on Form 8-K filed on December 14, 2007.

(5)

Incorporated by reference to Design Within Reach’s Current Report on Form 8-K filed on April 2, 2008.February 13, 2009.

(6)

Incorporated by reference to Design Within Reach’s Current Report on Form 8-K filed on May 1, 2009.

(7)

Incorporated by reference to Design Within Reach’s Current Report on Form 8-K filed on March 23, 2009.

*These certifications are being furnished solely to accompany this quarterly report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of Design Within Reach, Inc., whether made before or after the date hereof, regardless of any general incorporation language in such filing.

SIGNATURES

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

 

Dated: May 8, 200818, 2009 DESIGN WITHIN REACH, INC.

/s/ John D. Hellmann

 John D. Hellmann/s/ Theodore R. Upland III
Theodore R. Upland III
 Vice President, Chief Financial Officer and Secretary
 (AuthorizedPrincipal Financial Officer and Principal FinancialDuly Authorized Officer)

 

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