UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

FORM 10-Q

(Mark One)

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

For the quarterly period ended July 1, 2006

OR

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

For the transition period from              to             

Commission File Number: 000-50807

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.    ¨  Yes    x  No

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (Check one).

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨

The number of outstanding shares of the registrant’s common stock, par value $0.001 per share, as of December 30, 2006 was 14,417,654.

DESIGN WITHIN REACH, INC.

FORM 10-Q — QUARTERLY REPORT

FOR THE QUARTERLY PERIOD ENDED JULY 1, 2006

TABLE OF CONTENTS

		Page No
PART I – FINANCIAL INFORMATION
Item 1	Financial Statements	3
	Condensed Balance Sheets (unaudited) as of July 1, 2006, December 31, 2005 and July 2, 2005	3
	Condensed Statements of Operations (unaudited) for the thirteen and twenty-six week periods ended July 1, 2006 and July 2, 2005	4
	Condensed Statements of Cash Flows (unaudited) for the twenty-six week periods ended July 1, 2006 and July 2, 2005	5
	Notes to Unaudited Condensed Financial Statements	6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3	Quantitative and Qualitative Disclosures about Market Risk	22
Item 4	Controls and Procedures	23
PART II – OTHER INFORMATION
Item 1A	Risk Factors	28
Item 2	Unregistered Sales of Equity Securities and Use of Proceeds	39
Item 3	Defaults Upon Senior Securities	40
Item 4	Submission of Matters to a Vote of Security Holders	40
Item 5	Other Information	41
Item 6	Exhibits	42
SIGNATURES		43

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

Design Within Reach, Inc.

Condensed Balance Sheets

(Unaudited)

(amounts in thousands, except share data)

	July 1,			December 31,			July 2,
	2006			2005			2005
ASSETS
Current assets
Cash and cash equivalents	$	5,557		$	3,428		$	5,030
Investments		4,400			9,652			12,954
Inventory		37,568			31,239			24,116
Accounts receivable (less allowance for doubtful accounts of $277, $253 and $38, respectively)		2,187			1,568			1,864
Prepaid catalog costs		1,178			1,237			1,315
Deferred income taxes		2,112			2,569			5,910
Other current assets		3,947			4,125			5,755
Total current assets		56,949			53,818			56,944
Property and equipment, net		27,413			25,474			25,641
Deferred income taxes, net		10,301			7,365			1,201
Other non-current assets		908			676			533
Total assets	$	95,571		$	87,333		$	84,319
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable	$	20,065		$	18,056		$	12,351
Accrued expenses		9,574			5,414			6,591
Deferred revenue		2,804			1,690			1,657
Customer deposits and other liabilities		1,986			2,898			3,850
Bank credit facility		3,220			—			—
Notes payable, current portion		327			—			—
Capital lease obligation, current portion		74			114			112
Total current liabilities		38,050			28,172			24,561
Deferred rent and lease incentives		5,271			4,470			2,908
Notes payable, net of current portion		675			—			—
Capital lease obligation		—			22			83
Deferred income tax liabilities		1,127			1,127			1,249
Total liabilities	$	45,123		$	33,791		$	28,801
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, 14,353, 14,042 and 13,739 shares		14			14			14
Additional paid-in capital		56,353			55,756			54,348
Deferred compensation		—			(628	)		(1,151	)
Accumulated other comprehensive loss		(56	)		(789	)		(1,186	)
Accumulated earnings (deficit)		(5,863	)		(811	)		3,493
Total stockholders’ equity		50,448			53,542			55,518
Total liabilities and stockholders’ equity	$	95,571		$	87,333		$	84,319

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

3

Design Within Reach, Inc.

Condensed Statements of Operations

(Unaudited)

(amounts in thousands, except per share data))

	Thirteen weeks ended						Twenty-six weeks ended
	July 1, 2006			July 2, 2005			July 1, 2006			July 2, 2005
Net sales	$	48,960		$	41,926		$	83,930		$	77,391
Cost of sales		27,666			23,238			48,254			43,165
Gross margin		21,294			18,688			35,676			34,226
Selling, general and administrative expenses		22,749			16,612			43,769			30,817
Earnings (loss) from operations		(1,455	)		2,076			(8,093	)		3,409
Other income and (expenses):
Interest income		70			94			156			209
Interest expense		(71	)		(29	)		(120	)		(38	)
Other income		16			—			69			—
Total other income		15			65			105			171
Earnings (loss) before income taxes		(1,440	)		2,141			(7,988	)		3,580
Income tax expense (benefit)		(607	)		791			(2,936	)		1,345
Net earnings (loss)	$	(833	)	$	1,350		$	(5,052	)	$	2,235
Net earnings (loss) per share:
Basic	$	(0.06	)	$	0.10		$	(0.35	)	$	0.17
Diluted	$	(0.06	)	$	0.09		$	(0.35	)	$	0.15
Weighted average shares used in calculation of net earnings (loss) per share:
Basic		14,334			13,828			14,282			13,479
Diluted		14,334			14,800			14,282			14,753

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

4

Design Within Reach, Inc.

Condensed Statements of Cash Flows

(Unaudited)

(amounts in thousands)

	Twenty-six weeks ended
	July 1, 2006			July 2, 2005
Cash flows from operating activities:
Net earnings (loss)	$	(5,052	)	$	2,235
Adjustments to reconcile net income (loss) to net cash used in operating activities :
Depreciation and amortization		4,452			2,336
Stock-based compensation		999			534
Ineffectiveness loss of derivatives		69			—
Loss on the sale/disposal of long-lived assets		120			—
Changes in assets and liabilities::
Accounts receivable, net		(619	)		(520	)
Inventory		(5,429	)		(3,214	)
Prepaid catalog costs		59			547
Other assets		(33	)		(4,000	)
Accounts payable		2,009			(3,019	)
Accrued expenses		3,548			1,923
Deferred revenue		1,114			(357	)
Customer deposits and other liabilities		(571	)		517
Deferred rent and lease incentives		801			1,034
Deferred income taxes		(3,054	)		890
Net cash used in operating activities		(1,587	)		(1,094	)
Cash flows from investing activities:
Purchase of property & equipment		(5,914	)		(9,405	)
Proceeds from sales of property and equipment, net		14			—
Purchases of investments		(15,275	)		(8,700	)
Sales of investments		20,525			21,279
Net cash provided by (used in) investing activities		(650	)		3,174
Cash flows from financing activities:
Proceeds from issuance of common stock, net of expenses		226			1,932
Borrowing on bank credit facility		3,220			—
Borrowing from other financing facility		982			—
Repayments of long term obligations		(62	)		(57	)
Net cash provided by financing activities		4,366			1,875
Net increase in cash and cash equivalents		2,129			3,955
Cash and cash equivalents at beginning of period		3,428			1,075
Cash and cash equivalents at end of the period	$	5,557		$	5,030
Supplemental disclosure of cash flow information
Cash paid during the period for:
Income taxes	$	102		$	1,559
Interest	$	103		$	38
Non cash investing and financing activities:
Unrealized (loss) on investments	$	(2	)	$	(12	)

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

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Design Within Reach, Inc.

Notes to the Condensed Financial Statements

(Unaudited)

Note 1 – Summary of Significant Accounting Policies

Design Within Reach, Inc. (“DWR” or the “Company”) was incorporated in California in November 1998 and reincorporated in Delaware in March 2004. The Company is an integrated multi-channel provider of distinctive modern design furnishings and accessories. The Company markets and sells its products to both residential and commercial customers through three sales channels consisting of its catalog, studios, and website. The Company sells its products directly to customers throughout the United States.

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 five to six years. The Company’s 2005 fiscal year ended on December 31, 2005 and its 2006 fiscal year will end on December 30, 2006. Fiscal year 2005 consists of 52 weeks and fiscal year 2006 consists of 52 weeks.

Quarterly information (unaudited)

The accompanying unaudited condensed interim financial statements as of July 1, 2006 and July 2, 2005 and for the thirteen weeks and twenty-six weeks ended July 1, 2006 and July 2, 2005 have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“U.S. 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 31, 2005. 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 fiscal periods ended July 1, 2006 and July 2, 2005 are not necessarily indicative of the results to be expected for any future period or the full fiscal year.

In connection with the preparation of the accompanying financial statements, the Company determined that accrued inventory and cost of goods sold needed to be reduced by approximately $136,000 due to errors in prior periods. This amount is the cumulative adjustment for the periods from May 1, 2005 through July 1, 2006. When combined with the other unadjusted differences in the financial statements, the Company has concluded that the impact of this adjustment on both prior periods as well as the current reporting period is not material to the Company’s financial statements for the respective periods. As such, the Company has recorded this adjustment during the thirteen weeks ended July 1, 2006.

Certain reclassifications have been made to prior period financial statements to conform to the current year presentation. These reclassifications did not have an impact on the Company’s results of operations. The Company reclassified outstanding checks in excess of cash balances at December 31, 2005 from bank credit facility to accounts payable.

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.

Inventories

Inventory on hand consists primarily of finished goods purchased from third-party manufacturers. Inventory on hand is carried at a computed average cost which approximates a first-in first-out method and the lower of cost or market. As of July 1, 2006 and July 2, 2005, inventory was $37.6 million and $24.1 million, net of reserves of $2.6 million and $1.0 million, respectively. Inventory in transit, which is included in the inventory balance, consists of purchased goods from third-party manufacturers which are shipments in transit as of the respective reporting dates. Inventory in transit is carried at actual cost. As of July 1, 2006 and July 2, 2005, the Company recorded inventory in transit of $8.0 million and $2.7 million, respectively.

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Accounts Payable

Amounts included in accounts payable on the condensed balance sheets include approximately $4.7 million and $0.9 million, as of July 1, 2006 and July 2, 2005, respectively, representing outstanding checks in excess of the cash balances in the Company’s bank accounts with Wells Fargo Trade Bank, N.A.

Stock-based Compensation

Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123R, Share-Based Payment (“SFAS 123R”). SFAS 123R supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock issued to Employees (“APB 25”), for periods beginning in fiscal 2006. Under APB 25, the Company accounted for stock options under the intrinsic value method. Accordingly, the Company only recognized expense related to employee stock options granted at an exercise price below the fair value of the underlying stock on the grant date. The Company did not recognize any expense related to employee stock options granted at an exercise price equal to the fair value of the underlying stock on the grant date.

The Company adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Company’s fiscal year 2006. Under the modified prospective method, compensation expense recognized includes the estimated expense for stock options granted on and subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123R, and the estimated expense for the portion vesting in the period for options granted prior to, but not vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123. The Company’s condensed financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R. See “Note 2—Stock-based Compensation” for additional related disclosures.

Prior to adopting SFAS 123R, the Company recorded deferred stock-based compensation charges in the amount by which the exercise prices of certain options were less than the fair value of the Company’s common stock at the date of grant under the intrinsic value method of accounting as defined by the provisions of APB 25. The Company previously disclosed the fair value of its stock options under the provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation (“SFAS No. 123”). The Company accounted for stock-based employee compensation arrangements in accordance with the provisions of APB 25 and complied with the disclosure provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” and related interpretations. The Company accounted for equity instruments issued to non-employees in accordance with the provisions of SFAS No. 123 and related interpretations.

Comprehensive Income (Loss)

Comprehensive income (loss) for the thirteen and twenty-six weeks ended July 1, 2006 and July 2, 2005 was as follows:

	Thirteen weeks ended						Twenty-six weeks ended
	July 1, 2006			July 2, 2005			July 1, 2006			July 2, 2005
(in thousands)	(unaudited)						(unaudited)
Net earnings (loss)	$	(833	)	$	1,350		$	(5,052	)	$	2,235
Other comprehensive income (loss):
Unrealized loss on available for sale securities		—			8			(2	)		6
Change in activity related to derivatives		303			(763	)		735			(1,674	)
Comprehensive income (loss)	$	(530	)	$	595		$	(4,319	)	$	567

Earnings (Loss) per Share

Basic earnings (loss) per share is calculated by dividing the Company’s net earnings (loss) available to the Company’s common stockholders for the period by the number of weighted average common shares outstanding for the period. Diluted earnings 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 to be added to the weighted average number of shares outstanding. The following table summarizes the incremental shares from potentially dilutive securities, calculated using the treasury stock method at the end of each fiscal period:

7

	Thirteen weeks ended		Twenty-six weeks ended
	July 1, 2006	July 2, 2005	July 1, 2006	July 2, 2005
(in thousands)	(unaudited)		(unaudited)
Shares used to compute basic earnings (loss) per share	14,334	13,828	14,282	13,479
Add: Effect of dilutive options outstanding	—	972	—	1,274
Shares used to compute diluted earnings (loss) per share	14,334	14,800	14,282	14,753

For the thirteen and twenty-six weeks ended July 1, 2006, approximately 223,000 and 284,000 shares have been excluded from the calculation of diluted loss per share because inclusion of such shares would be anti-dilutive.

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. The Company’s significant accounting estimates include estimates of market value used in calculating inventory reserves to reflect inventory carried at the lower of cost or market, estimates of fair value used in calculating the value of stock-based compensation (including estimated volatility and terms) estimates of future forfeiture rates to determine net 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 freight costs used to calculate accrued liabilities and estimates of returns used to calculate sales return reserves. Actual results could differ from those estimates and such differences could affect the results of operations reported in future periods.

New Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (FIN 48). FIN 48 prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is assessing FIN 48 and has not determined the impact that the adoption of FIN 48 will have on its results of operations.

In October 2005, FASB issued FASB Staff Position (“FSP”) 13-1, “Accounting for Rental Costs Incurred during a Construction Period.” FSP 13-1 requires rental costs associated with ground or building operating leases that are incurred during a construction period be recognized as rental expense. FSP 13-1 became effective for the first reporting period beginning after December 15, 2005. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. This statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The adoption of SFAS 154 did not have an impact on the Company’s financial statements.

In June 2005, the Emerging Issues Task Force (“EITF”) reached consensus on EITF 05-6, “Determining the Amortization Period for Leasehold Improvements.” Under EITF 05-6, leasehold improvements placed in service significantly after and not contemplated at or near the beginning of the lease term, should be amortized over the lesser of the useful life of the assets or a term that includes renewals that are reasonably assured at the date the leasehold improvements are purchased. EITF 05-6 is effective for periods beginning after June 29, 2005. The adoption of EITF 05-6 did not have a material impact on the Company’s financial statements.

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140.” SFAS 155 permits fair value measurement for any hybrid financial instrument that

8

contains an embedded derivative that otherwise would require bifurcation. This statement is effective for all financial instruments acquired or issued after the beginning of an entity’s fiscal year that begins after September 15, 2006. The Company does not expect the adoption of SFAS 155 to have a material impact on the Company’s financial statements.

In September 2006, the FASB issued Statement 157, Fair Value Measurements, (FAS 157). This statement clarifies the definition of fair value, the methods used to measure fair value, and requires expanded financial statement disclosures about fair value measurements for assets and liabilities. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007. The new guidance will be effective for us January 1, 2008 and we are currently assessing the impact on our financial statements.

In September 2006, the SEC’s Office of the Chief Accountant and Divisions of Corporation Finance and Investment Management released Staff Accounting Bulletin No. 108 (SAB 108), which provides interpretive guidance on how registrants should quantify financial-statement misstatements. Currently, the two methods most commonly used by preparers and auditors to quantify misstatements are the “rollover” method (which focuses primarily on the income statement impact of misstatements) and the “iron curtain” method (which focuses primarily on the balance sheet impact of misstatements). Under SAB 108, registrants will be required to consider both the rollover and iron curtain methods (i.e., a dual approach) when evaluating the materiality of financial statement errors. Registrants will need to revisit their prior materiality assessments and consider them using both the rollover and iron curtain methods.

SAB 108 is effective for annual financial statements in the first fiscal year ending after November 15, 2006, therefore for us, the year ended December 30, 2006. The SAB provides transition accounting and disclosure guidance for situations in which a registrant concludes that a material error(s) existed in prior-period financial statements under the dual approach. Specifically, registrants will be permitted to restate prior period financial statements or recognize the cumulative effect of initially applying SAB 108 through an adjustment to beginning retained earnings in the year of adoption. We believe SAB 108 will not have a material impact on our annual financial statements.

Note 2 – Stock-based Compensation

Stock Options Plans

In 1999, the Company adopted the 1999 Stock Plan (the “1999 Plan”) which allows for the issuance of incentive stock options and nonstatutory stock options to purchase shares of the Company’s common stock. The Company has reserved a total of 3,100,000 shares for issuance under the 1999 Plan.

In 2004, the Company adopted the 2004 Equity Incentive Award Plan (the “2004 Plan” and together with the 1999 Plan, the “Plans”) which allows for the issuance of incentive stock options and nonstatutory stock options to purchase shares of the Company’s common stock. The Company has reserved a total of 2,100,000 shares for issuance under the 2004 Plan.

Options granted under the Plans are for periods not to exceed ten years, and must be issued at prices not less than 100% of the fair market value for incentive stock options and not less than 85% of fair market value for nonstatutory options. Stock options granted to stockholders who own greater than 10% of the outstanding stock must be issued at prices not less than 110% of the fair market value of the stock on the date of grant. Options granted under the Plans generally vest within three to four years. The Plans allow certain options to be exercised prior to the time such options are vested. All unvested shares are subject to repurchase at the exercise price paid for such shares, at the option of the Company.

Employee Stock Purchase Plan

In 2004, the Company adopted an Employee Stock Purchase Plan (the “ESPP”). The ESPP allows employees to purchase Company common stock at a 15% discount to the market price through payroll deductions at the beginning or end of the offering period, whichever is less. The ESPP operates through a series of concurrent twelve-month offering periods. Except for the first offering period, these offering periods generally start on the first trading day on or after May 1st and November 1st of each year and end, respectively, on the last trading day of the next October and April. The Company initially registered 300,000 shares of Common Stock for purchase under the ESPP. The reserve automatically increases on each December 31 during the term of the plan by an amount equal to the lesser of (1) 100,000 shares or (2) a lesser amount determined by the board of directors.

Accounting for Stock-based Compensation

Under SFAS 123R, the Company recognized approximately $511,000 of stock-based compensation expense related to stock options and employee stock purchases in the thirteen weeks ended July 1, 2006, and for the twenty-six weeks ended July 1, 2006, the Company recognized approximately $1.0 million. Stock-based compensation expense is included in Selling, General and Administrative Expenses. Prior to adoption of SFAS 123R, the Company recorded approximately $93,000 net of

9

tax and $188,000 net of tax, in amortized expenses for deferred stock-based compensation in accordance with APB 25 for the thirteen and twenty-six weeks ended July 2, 2005, respectively. Upon adoption of SFAS 123R in the first quarter, the remaining unamortized balance of $628,000 of deferred compensation was charged to additional paid-in capital.

The table below reflects net earnings and diluted net earnings per share had compensation expense been recognized in accordance with SFAS 123 for the thirteen and twenty-six weeks ended July 2, 2005 (in thousands except per share amounts):

	Thirteen weeks ended July 1, 2005 (unaudited)			Twenty-six weeks ended July 1, 2005 (unaudited)
Net income, as reported	$	1,350		$	2,235
Add: Stock-based compensation expense included in reported net income, net of related tax effects		93			188
Deduct: Total stock-based compensation expense determined under fair value-based method for all awards, net of related tax effects		(355	)		(619	)
Pro forma net income	$	1,088		$	1,804
Earnings per common share:
Basic - as reported (1)	$	0.10		$	0.17
Basic - pro forma	$	0.08		$	0.13
Diluted - as reported (1)	$	0.09		$	0.15
Diluted - pro forma	$	0.07		$	0.12

(1) Net earnings and net earnings per share prior to fiscal 2006 did not include stock-based compensation expense for employee stock options and employee stock purchases under SFAS 123 because the Company did not adopt the recognition provisions of SFAS 123R until January 1, 2006.

Upon adoption of SFAS 123R, the Company continues to calculate the fair value of each employee stock option, estimated on the date of grant, using the Black-Scholes model in accordance with SFAS 123R. The weighted-average estimated value of employee stock options granted during the thirteen weeks ended July 1, 2006 and July 2, 2005 was $3.05 per share and $5.96 per share, respectively. The weighted average estimated value of employee stock options granted during the twenty-six weeks ended July 1, 2006 and July 2, 2005 was $3.44 and $6.10 per share respectively. The following weighted-average assumptions were used in arriving at these estimated values:

	Thirteen weeks ended				Twenty-six weeks ended
	July 1, 2006		July 2, 2005		July 1, 2006		July 2, 2005
Risk-free interest rate	5.0	%	4	%	4.3-5.0	%	4	%
Expected volatility of common stock	57	%	35	%	58.4	%	35	%
Dividend yield	0	%	0	%	0	%	0	%
Expected life (years)	5.7		5.0		5.8		5.0

Due to the relatively short period since the Company’s initial public offering, the Company used a blended volatility rate using a combination of historical stock price and market-implied volatility for traded and quoted options on the equities for the group of retail companies for which exchange traded options are observed. Prior to the first quarter of fiscal 2006, the Company used a historical volatility rate in accordance with SFAS 123 for purposes of its pro forma information.

The risk-free interest rate assumption is based upon the average daily closing rates during the quarter for U.S. treasury notes that have a life which approximates the expected life of the option. The dividend yield assumption is based on the Company’s history and expectation of dividend payouts.

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The expected life of employee stock options is based on the simplified method of estimating expected life in accordance with SAB 107. Under the guidance of SAB 107, companies with “plain vanilla” options may use the simplified method to calculate the expected term. This method is available until December 31, 2007. The Company plans to make a refined estimate of expected term before that date.

Beginning the first quarter of 2006, the Company began using an estimated forfeiture rate of 11% based on historical data. The Company adjusted this rate in the second quarter of 2006 to 22%. Prior to 2006, the Company assumed a 0% forfeiture rate in its calculation of the SFAS 123 pro forma disclosure. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

Stock option activity for the twenty-six weeks ended July 1, 2006 was as follows:

	Number of Shares (in thousands)		Weighted Average Exercise Price Per Share		Weighted Average Remaining Contractual Term (years)	Aggregate intrinsic Value (in millions)
Options outstanding at January 1, 2006	1,717		$	7.98	7.9	$
Options granted	682			6.01
Options exercised	(308	)		0.59
Options terminated, cancelled or expired	(395	)		10.03
Options outstanding at July 1, 2006	1,696		$	8.05	8.5	$	2.2
Options exercisable at July 1, 2006	635		$	7.70	7.4	$	1.3

The aggregate intrinsic value at July 1, 2006 is based upon the closing stock price on the preceding day.

At July 1, 2006, a total of approximately 1,330,000 shares were available for future grants under the terms of the Plans.

At July 1, 2006, the Company had approximately $5.1 million of total unrecognized compensation expense, related to stock option plans grants that will be recognized over the remaining weighted average period of 2.4 years. Cash received from stock option exercises was approximately $18,000 and $203,000 during the thirteen weeks ended and twenty-six weeks ended July 1, 2006. The total intrinsic value of options exercised was approximately $120,000 and $1.9 million for the thirteen and twenty-six weeks ended July 1, 2006, respectively.

Note 3 – Income Taxes

In the twenty-six weeks ended July 1, 2006, the Company recorded a tax benefit of $2.9 million. The Company’s effective tax rate of 36.8% differs from the federal statutory tax rate of 34% due primarily to the impact of state taxes and permanent book-to-tax differences, which include tax-free interest income received from municipal bonds. The Company recently completed an Internal Revenue Service audit of its 2003 and 2004 income tax returns. As a result of that audit, the Company was assessed an additional $87,393 and $32,015 in income taxes for the fiscal years ending 2003 and 2004 respectively, due to certain timing differences. We have recorded these items in the current period as an increase of deferred tax assets.

Note 4 – Bank Credit Facility

As of July 1, 2006, the Company’s outstanding borrowings under its credit facility were $3.2 million. As of July 1, 2006, $1.4 million of stand-by letters of credit were outstanding and approximately $5.4 million were available for advance under the credit facility.

The Company entered into a secured revolving line of credit with Wells Fargo HSBC Trade Bank, N. A. as amended on December 23, 2005. This Agreement was further amended on July 17, 2006 (Amended Credit Agreement). The Amended Credit Agreement provides for an overall credit line up to a maximum of $10.0 million (including a sub-limit of $5.0 million for letters of credit) with a maturity date of November 30, 2007.

Borrowings under the Amended Credit Agreement are based upon a percentage of eligible inventory and accounts receivable and are secured by the Company’s inventory, accounts receivable, equipment, general intangibles and other rights to

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payments. The agreement prohibits the payment or declaration of any dividends or the redemption or repurchase of any shares of any class of the Company’s stock. The Amended Credit Agreement contains various restrictive and financial covenants including an $8.0 million limit on capital expenditures in any fiscal year and financial covenants related to net worth and net income. Interest on outstanding borrowings in the Amended Credit Agreement is calculated at the lender’s floating prime rate plus .25%. Interest is payable on the last day of each month. As of July 1, 2006, the interest rate on outstanding borrowings was 8.25%.

The financial covenants were revised in the Amended Credit Agreement, including covenants pertaining to the period ended July 1, 2006. The Company was in compliance with these financial covenants as of July 1, 2006. Since August 10, 2006, the Company has been out of compliance with certain SEC reporting requirements of its credit agreement as a result of not filing its Form 10-Q within 40 days of quarter end. The Company received a waiver of default on August 10, 2006 from Wells Fargo HSBC Trade Bank, N.A.. On January 10, 2007, the Company received an additional waiver.

Although the Company is currently in compliance with its loan covenants, if it does not remain in compliance it may be restricted from borrowings until the Company returns to compliance with the covenants or the Company obtains an additional waiver which may or may not be available to it.

Note 5 – Related Party Transactions

On June 22, 2006, the Company entered into an agreement, effective June 30, 2006, with Robert Forbes, Jr., the Company’s Founder and Director, which calls for Mr. Forbes to prepare a monthly Company newsletter. The Company will pay Mr. Forbes $100,000 a year for these services. In addition, Mr. Forbes has agreed to continue to serve as a member of the board of directors of the Company for at least six months from June 30, 2006, and the Company has agreed to pay Mr. Forbes $25,000 for his services as a member of the board of directors. The agreement terminates on June 30, 2007.

The Company rents studio space from an affiliate of a member of the Board of Directors pursuant to a lease dated February 9, 2004. Rent expense related to this space was $27,545 and $25,455 for the thirteen weeks ended July 1, 2006 and July 2, 2005, respectively, and $94,146 and $50,763 for the twenty-six weeks ended July 1, 2006 and July 2, 2005, respectively.

From 2002 through 2004, a former member of management served on the board of directors of an information systems vendor which supplied the Company with design, programming and development services for a computer system. During this time, the Company spent approximately $2.1 million with this vendor. The former member of management resigned from the board of directors of the vendor effective in April 2004. Cumulative amounts paid to the vendor from the inception of services through July 1, 2006 were approximately $5.1 million.

The Company made sales to certain members of its Board of Directors. These sales totaled approximately $1,066 and $24,800 for the thirteen weeks ended July 1, 2006 and July 2, 2005, respectively. These sales totaled approximately $5,461 and $28,700 for the twenty-six weeks ended July 1, 2006 and July 2, 2005, respectively. The Company also made sales to employees. These sales totaled approximately $249,000 and $196,900 for the thirteen weeks ended July 1, 2006 and July 2, 2005, respectively. These sales totaled approximately $526,000 and $335,100 for the twenty-six weeks ended July 1, 2006 and July 2, 2005, respectively.

Note 6 - Commitments

Operating lease obligations consist of office, studio, outlet and fulfillment center lease obligations. Capital lease obligation consists of an obligation for the lease of a phone system. Between December 31, 2005 and July 1, 2006, the Company has entered into operating lease commitments for new studios (including an outlet) increasing minimum lease obligations by $7.7 million.

Note 7 – Stockholder Rights Plan

On May 23, 2006, the Board of Directors of the Company adopted a Stockholder Rights Plan (the “Rights Plan”) designed to protect its stockholders in the event of a proposed takeover. The Rights Plan, which expires in 2016, will not prevent a takeover, but will encourage anyone seeking a takeover of the Company to negotiate with the Board of Directors first. The Rights Plan was not approved in response to any specific effort to acquire control of the Company. As part of the Rights Plan, the Board of Directors declared a dividend distribution of the right to purchase from the Company one one-thousandth (1/1000th) of a share of Series A Junior Participating Preferred Stock, par value $0.001 per share (the “Preferred Shares”), at a price of $50.00 per one one-thousandth (1/1000th) of a Preferred Share on each outstanding share of the Company’s common stock, subject to certain anti-dilution adjustments.

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Subject to some exceptions, the rights will be exercisable if a person or group acquires 15 percent or more of the Company’s common stock or announces a tender offer for 15 percent or more of the common stock. Because of the nature of the Preferred Shares’ dividend, liquidation and voting rights, the value of one one-thousandth of a Preferred Share purchasable upon exercise of each right should approximate the value of one share of common stock.

In the event of any merger, consolidation or other transaction in which shares of common stock are exchanged, each Preferred Share will be entitled to receive 1,000 times the amount received per share of common stock. Until the rights are exercised, the holders of the rights, as such, will have no rights as stockholders of the Company beyond those as an existing stockholder, including, without limitation, the right to vote or to receive dividends. If the Company is acquired in a merger, or another way that has not been approved by the Board of Directors, each right will entitle its holder to purchase a number of the acquiring company’s common shares having a market value at that time of twice the right’s exercise price. The dividend was payable to stockholders of record on June 2, 2006.

The rights may be redeemed in whole, but not in part, at a price of $0.01 per right (the “Redemption Price”) by the Board of Directors at any time prior to the time that the rights have become exercisable. The redemption of the rights may be made effective at such time, on such basis and with such conditions as the Board of Directors in its sole discretion may establish. Immediately upon any redemption of the rights, the right to exercise the rights will terminate and the only right of the holders of rights will be to receive the Redemption Price.

On May 25, 2006, the Company filed a Certificate of Designations setting forth the terms of the Preferred Shares with the Delaware Secretary of State.

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

The following discussion contains forward-looking statements, which involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth below under the caption “Risk Factors.” 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 31, 2005 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 31, 2005 filed with the Securities and Exchange Commission on April 14, 2006.

Overview

Design Within Reach is an integrated multi-channel provider of distinctive modern design furnishings and accessories. We market and sell our products to both residential and commercial customers through three integrated sales channels, consisting of our studios sales, online sales and phone sales. We offer approximately 850 products in various categories, including chairs, tables, workspace and outdoor furniture, lighting, floor coverings, beds and related accessories, bathroom fixtures, fans and other home and office accessories.

Our policy of having core products “in stock and ready to ship” is a significant departure from the approach taken by many other modern design furnishings retailers. Our business operates on the premise that multiple, integrated sales channels improve customer convenience, reinforce brand awareness, and enhance knowledge of our product, and our customers often use all of these channels in the course of making a purchase decision. While our studios are our primary sales vehicle, our website and catalog are focused marketing vehicles and tools for building brand awareness and educating the customer about our products and designers. The furniture buying process can be a lengthy one, especially in the luxury segment that DWR occupies. This often requires the customer to contact us multiple times before making a purchase. We believe the seamless connection among our studios, website and catalog help to facilitate this process. We believe the fact that many of our studio proprietors and sales executives are educated in design and have design related experience provides a better customer experience and helps to drive sales.

We have experienced significant growth in customers 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 channels. We opened the majority of our new studios in markets in our top two tiers during fiscal year 2006. Although most of our studios have been open less than three full years, 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

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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 2001 to 62 studios and one outlet operating in 21 states and the District of Columbia as of July 1, 2006. During the twenty-six weeks ended July 1, 2006, we opened six studios and one outlet. We opened one additional studio during the fourth quarter. We expect to open between three to five new studios in fiscal 2007, in major and smaller urban markets.

All of our sales channels 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. and Europe. In fiscal year 2005, we purchased approximately 39% of our product inventories from manufacturers in foreign countries, 35.4% of which was paid for in Euros. Although we put a hedging strategy in place to mitigate the impact of currency fluctuations during the fourth quarter of 2004, we have not been satisfied with the results of this strategy. The final hedge contract under this arrangement was settled in July 2006. Consequently, we are evaluating new hedging programs for execution upon the completion of our current hedging program and intend to make changes to it during fiscal year 2007. We also plan to increase our efforts to develop products internally and include more exclusive items in our mix, and in doing so, we will strive to source products in other parts of the world including Latin America and Asia where product costs are expected to be lower. However, we believe this will not begin to favorably impact our product margins until fiscal year 2008.

In May 2005, we converted our then existing information technology systems to new, custom-built systems supporting our product sourcing, merchandise planning, forecasting, inventory management, product distribution and transportation and price management. These information technology systems also are used to generate information for our financial reporting. We encountered problems with the conversion, due in large part to the absence of rigorous testing of the new systems prior to implementation. In particular, the new systems do not contain mechanisms to automatically identify and correct or reject erroneous or incomplete data. During the third quarter of fiscal year 2005, we hired a consulting firm to assess the inadequacies of the system. As a result of that review process, we plan to replace the existing system, as discussed below. Our existing system cost us approximately $5.1 million and the net book value was approximately $1.7 million as of July 1, 2006. We decided to accelerate depreciation of the system during the third quarter of fiscal year 2005 such that the IMARC system will be fully depreciated when the new system is implemented.

During the first quarter of 2006, we undertook a process to clearly define and document the requirements for the new system. During the second quarter of 2006, we finalized the high-level specifications for the new system, selected a software vendor, hired a consulting firm to assist with implementation, and began the process of customizing, configuring, testing and installing the new system. We currently expect to complete the installation of the new system in 2007.

On July 6, 2004, we completed our initial public offering of 4,715,000 shares of common stock at $12.00 per share. Of the shares offered, 3,000,000 were sold by us and 1,715,000 were sold by selling stockholders. We raised net proceeds of $31.8 million in our initial public offering, net of underwriting discounts and offering expenses. On March 15, 2005, we completed a public offering of 2,070,000 shares of common stock at $15.80 per share. Of the shares offered, 100,000 were offered by us and 1,970,000 were offered by selling stockholders. We raised net proceeds of $898,000 in this public offering, net of underwriting discounts and offering expenses.

Basis of Presentation

Net sales consist of studio sales, phone sales, online sales, other sales and shipping and handling fees, net of returns by customers. Studio sales consist of sales of merchandise to customers at our studios, phone sales consist of sales of merchandise through the toll-free numbers associated with our printed catalogs, online sales consist of sales of merchandise from orders placed through our website, and other sales consist of sales made by our business development executives, warehouse sales, and outlet sales. Warehouse sales consist of periodic clearance sales at various locations of product samples and products that customers have returned. Outlet sales consist of sales at our outlet of product samples and returned product from customers. Shipping and handling fees consist of amounts we charge customers for the delivery of merchandise. Cost of sales consists of the cost of the products we sell and inbound and outbound freight costs. Handling costs, including our fulfillment center expenses, are included in selling, general and administrative expenses.

Selling, general and administrative expenses consist of studio costs, including salaries and studio occupancy costs, costs associated with publishing our catalogs and maintaining our website, and corporate and fulfillment center costs, including salaries and occupancy costs, among others.

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 five to six years. Our 2005 fiscal year ended on December 31, 2005 and our 2006 fiscal year will end of December 30, 2006. Fiscal year 2005 consists of 52 weeks and fiscal year 2006 consists of 52 weeks.

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As initially disclosed in our August 18, 2006 press release, we were previously unable to complete the reconciliation of a difference between the accrued inventory sub-ledger and the general ledger necessary to provide for a timely filing of this Quarterly Report on Form 10-Q. The difference between the general ledger and the sub-ledger arose in connection with the implementation of our IMARC inventory and sales system in May 2005 and inadequate training of finance personnel with respect to changes in procedures necessitated by the change in systems. Since that time, we have performed extensive procedures to reconcile the account back to May 2005, and we recently completed the reconciliation. In connection with the preparation of the accompanying financial statements, we determined that accrued inventory and cost of goods sold needed to be reduced by approximately $136,000 due to errors in prior periods. This amount is the cumulative adjustment for the periods from May 1, 2005 through July 1, 2006. When combined with the other unadjusted differences in the financial statements, we have concluded that the impact of this adjustment on both prior periods as well as the current reporting period is not material to our financial statements for the respective periods. As such, we have recorded this adjustment during the thirteen weeks ended July 1, 2006.

Results of Operations

Comparison of the thirteen weeks ended July 1, 2006 (Second Quarter 2006) to the thirteen weeks ended July 2, 2005 (Second Quarter 2005)

Net Sales. Net sales increased $7.1 million, or 16.9%, to $49.0 million in the Second Quarter 2006, from $41.9 million in the Second Quarter 2005. Approximately $3.3 million of the increase in net sales is from sales generated from eleven studios opened from July 3, 2005 through July 1, 2006. Additional sales were generated from three warehouse sale events that occurred in the Second Quarter 2006 versus the one warehouse event in the Second Quarter 2005 and the free shipping promotion offered in the Second Quarter 2006. As a result, studio and warehouse sales increased $5.5 million or 23.6% and $2.2 million or 314.3%, respectively compared to the Second Quarter 2005. Online sales increased $1.0 million, or 14.5%, and phone sales decreased $1.4 million, or 21.5%, in the Second Quarter 2006 compared to the Second Quarter 2005. We had 62 studios and one outlet open at the end of the Second Quarter 2006 compared to 51 studios open at the end of the Second Quarter 2005. Shipping and handling fees received from customers for delivery of merchandise decreased $0.2 million, or 4.4%, to $4.3 million in the Second Quarter 2006 compared to $4.5 million in the Second Quarter 2005 primarily due to the free shipping promotions offered in June 2006.

	Thirteen weeks ended
(in millions)	July 1, 2006		% of Net Sales		July 2, 2005		% of Net Sales		Change			% Change
Studio sales	$	28.8	58.8	%	$	23.3	55.6	%	$	5.5		23.6	%
Online sales		7.9	16.1	%		6.9	16.5	%		1.0		14.5	%
Phone sales		5.1	10.4	%		6.5	15.5	%		(1.4	)	(21.5	)%
Other sales		2.9	5.9	%		0.7	1.7	%		2.2		314.3	%
Shipping and handling fees		4.3	8.8	%		4.5	10.7	%		(0.2	)	(4.4	)%
Net sales	$	49.0	100.0	%	$	41.9	100.0	%	$	7.1		16.9	%

Cost of Sales. Cost of sales increased by $4.4 million, or 19.4%, to $27.7 million in the Second Quarter 2006 from $23.2 million in the Second Quarter 2005. As a percentage of net sales, cost of sales increased to 56.5% in the Second Quarter 2006 from 55.4% in Second Quarter 2005. This increase is due primarily to the effect of the warehouse sale events at a significantly lower margin. Our hedging policy did not negatively affect cost of goods sold as greatly as in First Quarter 2006.

Selling, General and Administrative Expenses (“SG&A”). SG&A expenses increased by $6.1 million, or 36.7%, to $22.7 million in the Second Quarter 2006 from $16.6 million in the Second Quarter 2005. As a percentage of net sales, SG&A expenses increased to 46.4% in the Second Quarter 2006 from 39.6% in the Second Quarter 2005. These increases are primarily due to the following:

• Salaries and benefits increased partly due to stock-based compensation as well as salary expense related to the eleven new studios and one outlet opened from July 3, 2005 through July 1, 2006. In conjunction with the adoption of SFAS 123R, we recorded compensation expense in second quarter 2006 of approximately $511,000 related to stock options and employee stock purchases. In the Second Quarter 2005, we recorded approximately $149,000 in amortized deferred stock based compensation in accordance with APB 25.

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• Occupancy and related expense increased primarily due to depreciation of long-lived assets. Depreciation expense increased to approximately $2.3 million in the Second Quarter 2006 from approximately $1.3 million in the Second Quarter 2005. As a percentage of net sales, depreciation and amortization expenses increased to 4.7% of net sales in the Second Quarter 2006 from 3.1% of net sales in the Second Quarter 2005. Included in the increase is approximately $300,000 in additional depreciation expense related to our information technology systems due to our decision in the Fourth Quarter 2005 to shorten the expected life of the systems, which we plan to replace by early fiscal 2007. Additionally, depreciation expenses increased primarily as a result of significant increases in spending on capital assets associated with improvements in our network infrastructure and our new studio openings over the period reported.

• Other selling general and administrative expenses consist primarily of fulfillment and merchant fees which are directly related to sales volume as well as information systems and telecommunications, bank fees, and miscellaneous corporate expenses. Other expenses increased from $2.0 million in the Second Quarter 2005 to $3.0 million in the Second Quarter 2006 due to higher corporate expenses. During, the Second Quarter three warehouse sales were held in Chicago, IL, Hebron, KY and San Francisco, CA in order to sell scratch-and-dent inventories and overstocked merchandise. Expenses associated with these infrequent events increased other expenses in the Second Quarter 2006.

• Professional fees were approximately $900,000 for the thirteen weeks ended July 1, 2006 compared to approximately $200,000 for the same period last year, an increase of $700,000. This increase is primarily attributable to the increase in Sarbanes-Oxley compliance related fees, accounting, and legal fees.

The following table details SG&A expenses:

	Thirteen weeks ended
(in millions)	July 1, 2006		% of Net Sales		July 2, 2005		% of Net Sales		Change		% Change
Salaries and benefits	$	8.9	18.2	%	$	6.7	16.0	%	$	2.2	32.8	%
Occupancy and related expense		6.3	12.9	%		4.6	10.9	%		1.7	37.0	%
Catalog, advertising and promotion		3.6	7.3	%		3.1	7.4	%		0.5	16.1	%
Other SG&A expenses		3.0	6.1	%		2.0	4.8	%		1.0	50.0	%
Professional - legal, consulting, SOX		0.9	1.8	%		0.2	0.5	%		0.7	350.0	%
Total SG&A	$	22.7	46.3	%	$	16.6	39.6	%	$	6.1	36.7	%

Interest Income decreased to $70,000 in the Second Quarter 2006 compared to $94,000 in the Second Quarter 2005, primarily due to lower investment and cash balances in the Second Quarter 2006.

Interest Expense increased to approximately $71,000 in the Second Quarter 2006 compared to $29,000 in the Second Quarter 2005 primarily to a higher amount of short-term borrowings under our bank credit facility for working capital purposes and for capital expenditures associated with new studios in the Second Quarter 2006.

Income Taxes. We recorded an income tax benefit of approximately $600,000 in the Second Quarter 2006 compared with an income tax expense of approximately $791,000 in the Second Quarter 2005, due to a net loss in the Second Quarter 2006 compared to net earnings in the Second Quarter 2005. Our effective tax rate was 42.2% due to permanent book-to-tax differences, which include exercise of incentive stock options and tax-free interest income from municipal bonds. We recently completed an Internal Revenue Service audit of our 2003 and 2004 income tax returns. As a result of that audit, we were assessed an additional $87,393 and $32,015 in income taxes for the fiscal years ending 2003 and 2004 respectively, due to certain timing differences. We have recorded these items in the current period as an increase of deferred tax assets.

Net Earnings (Losses). As a result of the foregoing factors, a net loss of $833,000 was recorded in the Second Quarter of 2006 compared with net income of $1.4 million in the same period of 2005.

Comparison of the twenty-six weeks ended July 1, 2006 to July 2, 2005

Net Sales. Net sales increased $6.5 million, or 8.4%, to $83.9 million in the twenty-six weeks ended July 1, 2006, compared to $77.4 million in the twenty-six weeks ended July 2, 2005 primarily due to higher studio sales, three warehouse sales and increased promotional activities. Online and phone sales decreased $0.3 million, or 2.1%, and $2.5 million, or 20.8%, respectively, in the twenty-six weeks ended July 1, 2006 compared to the twenty-six weeks ended July 2, 2005 as customers increasingly moved from direct to studio channels. Studio sales increased $7.8 million, or 18.7%, to $49.6 million in the twenty-six weeks ended July 1, 2006 from $41.8 million in twenty-six weeks ended July 2, 2005. We had 62 studios and one

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outlet open at the end of July 1, 2006 compared to 51 studios open at the end of July 2, 2005. Shipping and handling fees received from customers for delivery of merchandise decreased $0.5 million, or 6.1%, to $7.7 million in the twenty-six weeks ended July 1, 2006 compared to $8.2 million in the twenty-six weeks ended July 2, 2005 primarily due to the free shipping event in June 2006.

	Twenty-six weeks ended
(in millions)	July 1, 2006		% of Net Sales		July 2, 2005		% of Net Sales		Change			% Change
Studio sales	$	49.6	59.1	%	$	41.8	54.0	%	$	7.8		18.7	%
Online sales		14.2	16.9	%		14.5	18.7	%		(0.3	)	(2.1	)%
Phone sales		9.5	11.3	%		12.0	15.5	%		(2.5	)	(20.8	)%
Other sales		2.9	3.5	%		0.9	1.2	%		2.0		222.2	%
Shipping and handling fees		7.7	9.2	%		8.2	10.6	%		(0.5	)	(6.1	)%
Net sales	$	83.9	100.0	%	$	77.4	100.0	%	$	6.5		8.4	%

Cost of Sales. Cost of sales increased $5.1 million, or 11.8%, to $48.3 million in the twenty-six weeks ended July 1, 2006 from $43.2 million in the twenty-six weeks ended July 2, 2005. As a percentage of net sales, cost of sales increased to 57.5% in the twenty-six weeks ended July 1, 2006 from 55.8% in twenty-six weeks ended July 2, 2005. This increase is due primarily to an ineffective hedging strategy and the effect of the warehouse sale events which were at a significantly lower margin as well as lower margin on freight revenue.

Selling, General and Administrative Expenses (“SG&A”). SG&A expenses increased $12.9 million, or 41.9%, to $43.7 million in the twenty-six weeks ended July 1, 2006 from $30.8 million in the twenty-six weeks ended July 2, 2005. As a percentage of net sales, SG&A expenses increased to 52.1% in the twenty-six weeks ended July 1, 2006 from 39.8% in the twenty-six weeks ended July 2, 2005. These increases are primarily due to the following:

• Included in salaries and benefits is stock-based compensation. In conjunction with the adoption of SFAS 123R on January 1, 2006, we recorded compensation expense of approximately $1.0 million related to stock options and employee stock purchases during the twenty-six weeks ended July 1, 2006. In the twenty-six weeks ended July 2, 2005, we recorded approximately $304,000 in amortized deferred stock based compensation in accordance with APB 25. In addition, the increase in salaries and benefits is related to the opening of eleven studios and one outlet from July 3, 2005 through July 1, 2006 and severance costs incurred during the twenty-six weeks ended July 1, 2006.

• Included in occupancy and related expense is depreciation of long-lived assets. Depreciation expense increased to approximately $4.5 million in the twenty-six weeks ended July 1, 2006 from approximately $2.3 million in the twenty-six weeks ended July 2, 2005. As a percentage of net sales, depreciation and amortization expenses increased to 5.4% of net sales in the twenty-six weeks ended July 1, 2006 from 3.0% of net sales in the twenty-six weeks ended July 2, 2005. Included in the increase is approximately $600,000 in additional depreciation expense related to our information technology systems due to our decision in the Fourth Quarter 2005 to shorten the expected life of the systems, which we plan to replace by early fiscal 2007. Additionally, depreciation expense increased as a result of significant increases in spending on capital assets associated with our new studio openings and improvements in our network infrastructure, such as investments in servers, desktop computers and related software licenses. The increase in occupancy and related expenses is also in part due to the increased occupancy costs associated with the eleven studios opened from July 3, 2005 through July 1, 2006.

• Other Selling, General and Administrative expenses consist primarily of fulfillment and merchant fees which are directly related to sales volume as well as information systems and telecommunications, bank fees, and miscellaneous corporate expenses. Other SG&A expenses increased $1.3 million from $4.0 million in the twenty-six weeks ended July 2, 2005 to $5.3 million in the twenty-six weeks ended July 1, 2006 due to higher corporate expenses. During the Second Quarter 2006, three warehouse sales were held in Chicago, IL, Hebron, KY and San Francisco, CA in order to sell scratch-and-dent inventories and overstocked merchandise. Expenses associated with these infrequent events increased Other SG&A expenses in the Second Quarter 2006.

• Professional fees increased approximately $2.4 million primarily due to increases in auditing fees and professional fees related to Sarbanes-Oxley (“SOX”) compliance.

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The following table details SG&A expenses:

	Twenty-six weeks ended
(in millions)	July 1, 2006		% of Net Sales		July 2, 2005		% of Net Sales		Change		% Change
Salaries and benefits	$	17.2	20.5	%	$	12.3	15.9	%	$	4.9	39.8	%
Occupancy and related expense		12.5	14.9	%		8.3	10.7	%		4.2	50.6	%
Catalog, advertising and promotion		5.7	6.8	%		5.6	7.2	%		0.1	1.8	%
Other SG&A expenses		5.3	6.3	%		4.0	5.2	%		1.3	32.5	%
Professional - legal, consulting, SOX		3.0	3.6	%		0.6	0.8	%		2.4	400.0	%
Total SG&A	$	43.7	52.1	%	$	30.8	39.8	%		12.9	41.9	%

Interest Income decreased to $156,000 in the twenty-six weeks ended July 1, 2006 from $209,000 in the twenty-six weeks ended July 2, 2005 primarily due to lower investment and cash balances in the twenty-six weeks ended July 1, 2006.

Interest Expense increased to approximately $120,000 in the twenty-six weeks ended July 1, 2006 compared to $38,000 in the twenty-six weeks ended July 2, 2005 primarily due to a higher amount of short-term borrowings under our bank credit facility for working capital purposes and for capital expenditures associated with new studios.

Other Income . In the twenty-six weeks ended July 1, 2006, we recorded other income of approximately $142,000 consisting primarily of the rental of customer lists, which was partially offset by losses incurred from foreign exchange transactions.

Income Taxes. We recorded an income tax benefit of approximately $2.9 million in the twenty-six weeks ended July 1, 2006 and income tax expense of approximately $1.3 million in the twenty-six weeks ended July 2, 2005. Our effective tax rate was 36.8% due to permanent book-to-tax differences, which include incentive stock options and tax-free interest income from municipal bonds.

Net Earnings (Losses). As a result of the foregoing factors, a net loss of $5.1 million was incurred in the twenty-six weeks ended July 1, 2006 compared with net income of $2.2 million in the twenty-six weeks ended July 2, 2005.

Liquidity and Capital Resources

Cash, cash equivalents and investments consist of cash, auction rate securities and municipal bonds. As of July 1, 2006, cash, cash equivalents and investments were approximately $10.0 million. Working capital was $18.9 million and $32.4 million at July 1, 2006 and July 2, 2005, respectively.

Cash Flows

The following table summarizes our cash flow activity for the period:

	Twenty-six weeks ended
	July 1, 2006			July 2, 2005
	(In thousands)
Operating activities	$	(1,587	)	$	(1,094	)
Investing activities		(650	)		3,174
Financing activities		4,366			1,875

Net cash used in operating activities remained relatively unchanged in the twenty-six weeks ended July 1, 2006 compared to the twenty-six weeks ended July 2, 2005. During the twenty-six weeks ended July 1, 2006, net cash used by operating activities was $1.6 million, primarily due to the increase in inventory and the change in deferred income taxes, partially offset by an increase in accounts payable and accrued expenses. The increase in inventory was in part due to the increase in inventory to support the growth in sales. The increase in accounts payable is in part related to the increase in inventory.

We used $650,000 in investing activities for the twenty-six weeks ended July 1, 2006 compared with net cash provided by investment activities of $3.2 million for the twenty-six weeks ended July 2, 2005. Capital expenditures during the twenty-six weeks ended July 1, 2006 were $5.9 million which were partially offset by the net sales of investments. The capital expenditures during the twenty-six weeks ended July 1, 2006 were primarily for property and equipment for the six stores

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and one outlet opened during the period and for capital expenditures related to the new information technology system to be implemented in 2007. Purchases of $9.4 million in the twenty-six weeks ended July 2, 2005 were primarily related to the property and equipment for our store expansion and the implementation of an information technology system. We opened six studios and one outlet during the twenty–six weeks ended July 1, 2006 compared to eighteen during the same period last year.

During twenty-six weeks ended July 1, 2006, we opened six new studios and one new outlet. We opened one studio in the fourth quarter of 2006. In fiscal year 2007, we anticipate that our commitments for capital investment will be for three new studios as well as a new information technology system and an upgrade to our website. We estimate that capital expenditures for fiscal 2007 will be approximately $8.5 million.

Net cash provided by financing activities in the twenty-six weeks ended July 1, 2006 was comprised of borrowings against our bank credit facility of $3.2 million, borrowings related to our new information technology system of approximately $1.0 million, and $226,000 in issuance of common stock pursuant to our equity incentive plans. On March 15, 2005, we completed a public offering of 2,070,000 shares of common stock at $15.80 per share. Of the shares offered, 100,000 were offered by us and 1,970,000 were offered by selling stockholders. We raised net proceeds of $898,000 in our second public offering, net of underwriting discounts and offering expenses.

For the remaining twenty-six weeks ending December 30, 2006, our capital requirements are primarily to fund the opening of both one new studio and expenditures related to the new information technology system.

As of July 1, 2006, we had available a total of approximately $15.4 million in unused capital resources, not including cash flows we expect to generate from operating activities, for our future cash needs as follows:

• approximately $10.0 million in cash and investments; and

• approximately $5.4 million in availability under our working capital line of credit.

Although we expect to continue incurring operating losses through the end of 2006, we expect that the borrowings available under our working capital facility, assuming continued compliance with the covenants under this facility, as well cash and investments will provide sufficient capital resources to carry on our business for the next twelve months.

Other than our working capital facility, we do not have any significant available credit, bank financing or other external sources of liquidity. We are exploring increasing our liquidity by obtaining an increased working capital facility from another lender. There is no assurance that we will be able to obtain an increased working capital facility. Our challenging financial circumstances may make the terms, conditions and cost of any available capital relatively unfavorable. If additional financing is not readily available, we may be forced to scale back our operations.

Commitments

We have entered into a secured revolving line of credit with Wells Fargo HSBC Trade Bank, N.A., which was amended on July 17, 2006 (the “Amended Credit Agreement”). The Amended Credit Agreement provides for an overall credit line up to a maximum of $10.0 million including a sub-limit of $5.0 million for letters of credit with a maturity date of November 30, 2007. The letters of credit are for $2.5 million each in an equipment line of credit for the importation of furniture and another to secure lease deposits for new retail space. The line of credit is subject to availability guidelines that specify the amount that can be borrowed under the facility at any given time to provide working capital and expires on November 30, 2007. Amounts borrowed under this line of credit bear interest at an annual rate equal to the lender’s prime lending rate plus .25%. Interest accrued on this line is payable on the last day of each month. As of July 1, 2006, the interest rate for the operating line of credit was 8.25%. Amounts borrowed under the Amended Credit Agreement are secured by our accounts receivable, inventory and equipment. The Amended Credit Agreement prohibits the payment or declaration of any dividends or the redemption or repurchase of any shares of any class of our stock. The Amended Credit Agreement contains various restrictive and financial covenants, including an $8.0 million limit on capital expenditures in any fiscal year and covenants tied to net worth and net income, including for the period ended July 1, 2006. As of July 1, 2006, $3.2 million of borrowings and $1.4 million of stand-by letters of credit were outstanding under this facility and approximately $5.4 million was available to be drawn from the operating line of credit.

We were in compliance with the financial covenants as amended on July 17, 2006 for the period ending July 1, 2006. Since August 10, 2006, we have been out of compliance with certain SEC reporting requirements of our credit agreement as a result of not filing our Form 10-Q within 40 days of quarter end. We received a waiver of default on August 10, 2006 from Wells Fargo HSBC Trade Bank, N.A.. On January 10, 2007, we received an additional waiver. Although we are currently in compliance with the financial covenants, if we do not remain in compliance with our loan covenants, we may be restricted from borrowings until we return to compliance with the covenants or we obtain an additional waiver which may or may not be available to us. We cannot provide assurances that any such covenant waivers or amendments will be obtained or that the lender will not require additional collateral, significant cash payments or additional incentives in connection with any such waivers or amendments.

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Critical Accounting Policies

Our financial statements have been prepared in accordance with 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 are set forth below.

Revenue Recognition. We recognize revenue on the date on which we estimate that the product has been received by the customer. We record as deferred revenue any sales made in the last week of the reporting period for which we estimate delivery in the following period. Those estimated amounts are recorded as deferred revenue. We also record any payments received prior to the date goods are shipped to the customer as customer deposits. We use our third-party freight carrier information to estimate standard delivery times to various locations throughout the U.S. Sales are recorded net of estimated 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 our products when evaluating the adequacy of the sales returns and other allowances in any accounting period. Although our actual returns historically have not differed materially from estimated returns, in the future, actual returns may differ materially from our reserves. As a result, our operating results and financial condition could be affected adversely. The reserve for estimated product returns was approximately $417,000 and $905,000 as of July 1, 2006 and July 2, 2005, respectively. We recognize net sales revenue for shipping and handling fees charged to customers at the time products are estimated to have been received by customers.

Shipping and Handling Costs. Shipping costs, which include inbound and outbound freight costs, are included in cost of sales. We record costs of shipping products to customers in our cost of sales at the time 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 $2.7 million and $1.9 million for the thirteen weeks ended July 1, 2006 and July 2, 2005, respectively. Handling costs were approximately $4.7 million and $3.8 million for the twenty-six weeks ended July 1, 2006 and July 2, 2005, respectively. Our gross margin calculation may not be comparable to that of other entities, which may allocate all shipping and handling costs to cost of sales, resulting in lower gross margin, or to operating expenses, resulting in higher gross margin.

Inventory. Inventory consists primarily of finished goods purchased from third-party manufacturers. Inventory on hand is carried at a computed average cost which approximates a first-in first-out method and the lower of cost or market. We write down inventory for estimated damage equal to the difference between the cost of inventory and the estimated market value 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 affected adversely. As of July 1, 2006 and July 2, 2005, inventory reserves amounted to approximately $2.6 million and $1.0 million, respectively.

Stock-Based Compensation. In the first quarter 2006, we adopted the modified prospective method for valuing stock options we grant in accordance with Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, or SFAS 123R. Under SFAS 123R, we recognized $511,000 of compensation expense related to stock options and employee stock purchases in the thirteen weeks ended July 1, 2006. For the twenty-six weeks ended July 1, 2006, we recognized approximately $1.0 million of compensation expense related to stock options and employee stock purchases. 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 blended volatility rate using a combination of historical stock price and market-implied volatility for traded and quoted options on the equities for the group of retail companies for which exchange traded options are observed, (2) a risk-free interest rate based upon the average daily closing rates during the quarter 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 SAB 107 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 SFAS 123R, we recorded deferred stock-based compensation

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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 Accounting Principles Board (“APB”) Statement No. 25.

Accounting for Stock Issued to Employees. In the thirteen and twenty-six weeks ended July 2, 2005, respectively, we recognized approximately $515,000 or $0.04 per share and $1,003,000 or $.07 per share, in deferred stock-based compensation expense. Upon adoption of SFAS 123R in the first quarter, the balance of $628,000 of deferred compensation was charged to additional paid-in capital. Prior to adopting SFAS 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 Accounting Principles Board (“APB”) Statement No. 25.

Accounting for Income Taxes. 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, including judgments regarding whether or not we will generate sufficient taxable income to realize our deferred tax assets.

Advertising Costs. Prepaid catalog costs consist of third-party costs, including paper, printing, postage, name acquisition and mailing costs, for all of our direct response catalogs. Such costs are capitalized as prepaid catalog costs and are amortized over their expected period of future benefit. Such amortization is based upon the ratio of actual sales to the total of actual and estimated future sales on an individual catalog basis. The period of expected future benefit is calculated based on our projections of when approximately 90% of sales generated by the catalog will be made. Based on data we have collected, we historically have estimated that catalogs have a period of expected future benefit of two to four months. The period of expected future benefit of our catalogs would decrease if we were to publish new catalogs more frequently in each year, or 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 $163,000 and $179,000 in the thirteen weeks ended July 1, 2006 and July 2, 2005, respectively. Co-operative advertising amounts received from such vendors were approximately $394,000 and $382,000 in the twenty-six weeks ended July 1, 2006 and July 2, 2005, respectively.

Impairment of Long-Lived Assets. Long-lived assets held and used by us are reviewed for impairment whenever events or changes in circumstances indicate the net book value may not be recoverable. 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 its 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, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. An impairment loss is recognized if the sum of the expected future cash flows from use of the asset is less than the net book value of the asset. The amount of the impairment loss will generally be measured as the difference between net book values of the assets and their estimated fair values. In fiscal year 2005, we shortened the estimated useful lives for certain computer systems having a net book value of approximately $3.2 million from three years to 18 months as a result of our plans to replace them in fiscal year 2007. The impact of this change is anticipated to be an expense of approximately $1.2 million, and $300,000, in fiscal years 2006 and 2007, respectively. These amounts will reduce net income or increase net losses. The net book value of these assets as of July 1, 2006 is approximately $1.7 million.

Derivative and Hedging Activities. We record derivatives, particularly cash flow hedges for foreign currency, at fair value on our balance sheet, including embedded derivatives. We account for foreign currency option contracts on a monthly basis by recognizing the net cash settlement gain or loss on the call or put option in accumulated other comprehensive income (loss) and adjusting the carrying amount of the contract to market by recognizing any corresponding gain or loss in cost of goods sold as the underlying inventory which was hedged is sold in each reporting period. Our derivative positions are used only to manage identified exposures. Management evaluates our hedges for effectiveness at the time they are designated as well as throughout the hedge period. With respect to any derivative that is deemed ineffective, the ineffective portion is reported through earnings. Management evaluates the ineffectiveness of outstanding contracts when it is probable that the original forecasted transaction will change. The effective portion of changes in the fair value of cash flow hedges is recorded in other comprehensive income (loss) and is recognized in cost of sales when the underlying inventory is sold. We recorded approximately $69,000 for ineffectiveness in the twenty-six weeks ended July 1, 2006. There were no amounts recorded for ineffectiveness in the twenty-six weeks ended July 2, 2005.

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Caution on Forward-Looking Statements

Any statements in this report 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.” Among the factors that could cause actual results to differ materially from those indicated in the forward-looking statements are risks and uncertainties inherent in our business including the following: our profitability may be impaired; if we fail to offer merchandise that our customers find attractive, the demand for our products may be limited; we do not have long-term vendor contracts and as a result we may not have continued or exclusive access to products that we sell; our business depends, in part, on factors affecting consumer spending that are not within our control; our business will be harmed if we are unable to implement our growth strategy successfully; the expansion of our studio operations could result in increased expenses with no guarantee of increased earnings; if we do not manage our inventory levels successfully, our operating results will be adversely affected; we depend on domestic and foreign vendors, some of which are our competitors, for timely and effective sourcing of our merchandise; declines in the value of the U.S. dollar relative to foreign currencies could adversely affect our operating results; and we face intense competition and if we are unable to compete effectively, we may not be able to maintain profitability and the discussions set forth below under the caption “Risk Factors” and other factors detailed in this Quarterly Report on Form 10-Q for the twenty-six weeks ended July 1, 2006.

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 new information, future events or otherwise, unless required by law.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Foreign Currency Risk

All of our sales and a portion of our expenses are denominated in U.S. dollars, and our assets and liabilities together with our cash holdings are predominantly denominated in U.S. dollars, but we purchased approximately 39% of our product inventories from manufacturers in Europe, 35.4% of which were paid for in Euros. In fiscal year 2005, the value of the dollar increased approximately 10% relative to the Euro. However, we did not benefit significantly from this strengthening of the dollar because we made most of our fiscal year 2005 inventory purchases in the first part of the year when the dollar was still weak relative to the Euro and because of the costs associated with hedging contracts we purchased at a time when the dollar was relatively weak. The fact that much of our inventory was purchased in the early part of the year when the dollar was still weak relative to the Euro reflected an increased cost to us of merchandise sourced from Europe. 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. To mitigate our exchange rate risk relating to the Euro, under our current hedging program, we typically purchase foreign currency option contracts with maturities of 12 months or less for purchases of merchandise based on forecasted demand at certain prices. However, we discontinued purchasing these foreign currency option contracts in August 2005. We account for these contracts on a monthly basis in recognizing the net cash settlement gain or loss on the call or put option in accumulated other comprehensive income (loss) and adjusting the carrying amount of the contract to market by recognizing any corresponding gain or loss in cost of goods sold in each reporting period. Additionally, outstanding contracts are evaluated quarterly for ineffectiveness by evaluating changes in forecasted foreign purchases. In the second quarter 2006, our actual demand was less than our forecasted demand, and the amount of Euros we hedged was greater than the amount we needed for purchases of inventory. We are evaluating our foreign currency hedging strategy going forward and will make changes to it in fiscal year 2007. As of July 1, 2006, we had one foreign currency option contract outstanding which settled at the end of July 2006. We are also working to diversify our mix of suppliers to reduce our dependence on Euro-denominated purchases. We plan to increase our efforts to develop products internally and include more exclusive items in our mix, and in doing so, we will strive to source products in other parts of the world, including Latin America and Asia where product costs are expected to be lower. However, we believe this will not begin to favorably impact our product margins until fiscal year 2008.

Future hedging transactions may or may not successfully mitigate losses caused by currency fluctuations. In addition to the direct effect of changes in exchange rates on cost of goods, changes in exchange rates also affect the volume of purchases or the foreign currency purchase price as vendors’ prices become more or less attractive. We expect to continue to experience the effect of exchange rate fluctuations on an annual and quarterly basis, and currency fluctuations could have a material adverse impact on our results of operations. Net activity on cash flow hedges reported in stockholders’ equity were approximately $303,000 and $(763,000) during the Second Quarters 2006 and 2005, respectively. The extent of this risk is not quantifiable or predictable because of the variability of the Euro and the forecasted demand of cost of goods.

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With respect to any derivative that is deemed ineffective through management’s evaluation, the ineffective portion is reported through earnings by recording foreign currency losses in other expenses. Management evaluates the ineffectiveness of outstanding contracts when it is probable that the original forecasted transaction will change. The effective portion of changes in the fair value of cash flow hedges is recorded in other comprehensive income (loss) and is recognized in cost of sales when the underlying inventory is sold. We recorded approximately $15,000 for ineffectiveness in the second quarter 2006 and included that amount in other income (expense). There were no amounts recorded for ineffectiveness in the second quarter 2005.

Interest Rate Risk

Our investments are classified as available-for-sale. Available-for-sale securities are reported at market value. We typically do not attempt to reduce or eliminate our market exposures on our investment securities because the majority of our investments are short-term. The fair value of our investment portfolio or related income would not be significantly impacted by either a 100 basis point increase or decrease in interest rates due mainly to the short-term nature of our investment portfolio.

In addition, we have interest payable on our operating line of credit. Amounts borrowed under this line of credit bear interest at an annual rate equal to the lender’s prime lending rate. 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 July 1, 2006, approximately $3.2 million borrowings were outstanding under this facility. Our interest expense would not increase or decrease materially for the thirteen and twenty-six weeks ended July 1, 2006 in the event of a 100 basis increase or decrease in interest rates.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain “disclosure controls and procedures,” as such term is defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934 (the “Exchange Act”), that are designed to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in United States Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our chief executive officer and chief financial officer, as appropriate, to allow timely decisions regarding required disclosure.

We carried out an evaluation, under the supervision and with the participation of management, including the chief executive officer and the chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(b) and 15d-15(b). Based upon, and as of the date of this evaluation, the chief executive officer and the chief financial officer concluded that our disclosure controls and procedures were not effective because of the material weaknesses discussed in our Annual Report on Form 10-K as filed on April 14, 2006 for the year ended December 31, 2005, including our failure to maintain effective controls over or related to the following:

• Entity level controls;

• Period-end financial reporting processes;

• Segregation of duties;

• Access to our systems, financial applications, and data;

• Preparation of account analyses, account summaries and account reconciliations;

• Documentation of accounting policies and procedures;

• Records retention;

• Inventory management and merchandise accounts payable;

• Non-merchandise accounts payable;

• Costing and valuation of inventory;

• Recording of, and accounting for, fixed assets;

• Taxes computed by third-party experts;

• Revenue recognition and accounts receivable;

• Payroll processing;

• Treasury functions; and

• Spreadsheets used in our financial reporting process.

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A material weakness in internal control over financial reporting is defined by the Public Company Accounting Oversight Board’s Audit Standard No. 2 as being a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements would not be prevented or detected. A significant deficiency is a control deficiency, or combination of control deficiencies, that adversely affects the company’s ability to initiate, authorize, record, process, or report external financial data reliably in accordance with generally accepted accounting principles such that there is more than a remote likelihood that a misstatement of the company’s annual or interim financial statements that is more than inconsequential will not be prevented or detected.

In light of the material weaknesses listed above and described more fully in our Annual Report on Form 10-K, we performed additional analysis and other post-closing procedures to ensure our consolidated financial statements are prepared in accordance U.S. 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. Nevertheless, it is reasonably possible that, if not remediated, the material weaknesses described above could result in a material misstatement of our financial statement accounts that might result in a material misstatement to a future annual or interim period.

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.

Changes in Internal Control Over Financial Reporting

There was no significant change in our internal control over financial reporting that occurred during the second quarter of 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. Our management has discussed the material weaknesses as previously disclosed in Item 9A in our Annual Report on Form 10-K for the year ended December 31, 2005 and other deficiencies with our audit committee. There has not been significant change in our progress to remediate control weaknesses reported during 2005 due to significant employee turnover. In the first half 2006, we experienced significant employee turnover in accounting/finance, inventory control and planning, human resources and executive management. We actively began searches and interviews for candidates to fill positions, particularly in accounting and finance. In June 2006, we filled the position for Vice President—Finance and Corporate Controller and in July 2006 we filled our Chief Financial Officer and Accounting Director positions. Several positions remain vacant and work continues to be performed by temporary contractors to meet basic business requirements. We continue to seek to hire additional personnel as needed to focus on our ongoing remediation initiatives and compliance efforts. In an effort to remediate the identified material weaknesses and other deficiencies, beginning in the third quarter of 2006, we intend to implement or are currently in the process of implementing remedial measures, including, but not limited to the following:

Inadequate controls over period-end financial reporting process

• We will continue to enhance and adhere to financial closing procedures, including the use of checklists, established schedules and other monitoring tools to ensure financial statements are accurate, complete and timely compiled.

• We have established and implemented a journal entry processing policy to ensure the proper segregation of duties and that review and approval activities occur for all transactions recorded in the general ledger.

• We plan to establish more robust benchmarks and monitoring activities to evaluate historical information used in reserve calculations.

• We plan to establish review and follow-up procedures prior to the approval of significant reserves.

• We plan to perform timely cash application activities and reconciliations.

• We plan to continue to enhance and adhere to financial closing procedures through the use of checklists and other monitoring tools to ensure that the necessary reconciliation activities are being performed and reviewed in a timely manner by management.

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Inadequate segregation of duties

• We plan to re-allocate and/or reassign duties of employees by providing clear job descriptions to enhance segregation of duties.

• We plan to restrict access to systems applications to eliminate incompatible duties and ensure employees’ access is limited to only those activities needed to perform designated job responsibilities.

Inadequate control over systems, financial applications and data access

• We will apply user access restrictions within critical systems and financial applications to prevent unauthorized access and/or establish monitoring mechanisms and procedures to properly detect unauthorized system access and provide follow up when needed to ensure adherence to the proper segregation of duties.

• At the end of the first quarter of 2006, we established and documented a corporate purchasing policy and approval matrix, which specifies the dollar limits for approval of various types of purchases and authorization of banking arrangements and treasury activities. At the same time, we also established a capitalization policy that specifies specific duties and authorizations for those employees specifically accounting for and handling fixed assets.

Account analyses, account summaries and account reconciliations

As we previously disclosed, we identified an unreconciled difference between our general ledger and our sub-ledger with respect to accrued inventory. The balance in accrued inventory at any point in time reflects inventory we have received but for which we have not yet received an invoice. The difference between the general ledger and the sub-ledger with respect to the accrued inventory account arose in connection with the implementation of our IMARC inventory and sales system in May 2005 and inadequate training of finance personnel with respect to changes in procedures necessitated by the change in systems. We performed extensive procedures to reconcile the accrued inventory account back to May 2005, and we recently completed this reconciliation.

We have undertaken steps to avoid further unreconciled differences between the general ledger and sub-ledger with respect to the accrued inventory account, including the following:

• We are striving to make sure all vendor invoices are entered into IMARC on a current basis in order to verify open items against vendor statements and resolve any issues.

• All transactions affecting the accrued inventory account are being reviewed to ensure they are correct and posting to the appropriate account.

• Improvements and controls in the IMARC system were put in place in the fourth quarter of 2006.

• Accounts payable training is ongoing and entry errors are being identified on a more current basis.

Documentation of account policies and procedures

• We plan to establish accounting policies and procedures to ensure finance and accounting staff are provided with adequate guidance for calculating and recording non-routine transactions and estimates related to significant balance sheet accounts. We will provide proper training in conjunction with the development and implementation of such policies.

Records retention

• We plan to establish a records retention policy which outlines the requirements and procedures for retaining the appropriate supporting documentation for financial transactions and plan to implement procedures designed to ensure compliance with the related policy.

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Inventory management and merchandise accounts payable

• We plan to establish and implement procedures to capture inventory receipt documentation to ensure the timely matching of purchase documents and recording of complete inventory amounts.

• We plan to establish a customer returns policy outlining the procedures for the issuance of customer refunds and credits and receipt of returned merchandise. Additionally, we plan to add system restrictions or other monitoring controls to ensure returns are authorized and that refunds and credits are issued only upon the receipt of returned products.

• We plan to establish formal accounts payable procedures designed to ensure proper comparisons of purchase orders, receiving documents and vendor invoices, timely recording of merchandise and invoices received, and accurate processing of vendor payments.

• We plan to establish and implement formal policies and procedures for handling stock adjustments to ensure that significant adjustments are properly reviewed and authorized by management and properly documented with adequate support and that adjustments are monitored by management for reasonableness.

• We have engaged a consultant to address and correct the inventory control issues in the system. This work was completed in the fourth quarter of 2006.

Non-merchandise accounts payable

• We will implement our corporate purchasing policy and approval matrix, established at the beginning of 2006, which specifies the dollar limits for approval of various types of purchases and required documentation to support transactions. Concurrently, we plan to establish an accounts payable policy and procedures to ensure consistent application of payable processing activities and to establish methodologies for consistently recording accrued liabilities and ensuring the proper cut-off of liabilities.

• We plan to establish an accounts payable policy setting forth formal accounts payable procedures designed to ensure a proper three-way matching of non-merchandise documents or adequate support to evidence amounts, approval and receipt. The policy will further dictate that all necessary review activities shall be performed prior to the approval of disbursements to ensure proper amounts are recorded and paid and that the corporate purchasing policy and approval matrix are being followed.

• The accounts payable policy also will specify formal accounts payable procedures for setting up and maintaining vendor data and related master files. The procedures will include required monitoring activities to ensure that changes made to vendor data are valid, accurate and complete.

Merchandise inventory costing and valuation procedures

• We plan to enhance system applications to ensure that automated processing of inventory transactions record receipts using the proper cost tables and the cost tables obtain real-time or current and accurate foreign currency rates. Additional enhancements will include revisions to existing account mapping of automated transactions and the establishment of new account mappings to ensure the proper general ledger accounts are recorded for batch-processed inventory transactions.

• We plan to establish and implement monitoring activities of product tables and master files in the system to ensure costs are accurate and complete and that changes made to the master files are properly authorized. We will make periodic comparisons of the differences between the estimated landing costs based on a point-to-point rate and the actual landing costs.

• We plan to establish formal accounts payable procedures designed to ensure proper comparisons of purchase orders, receiving documents and vendor invoices, the timely recordation of merchandise and invoices received, and accurate processing of vendor payments.

• We plan to establish procedures for updating and maintaining current inventory cost data to ensure accurate and complete product costs. Monitoring and review activities will be specifically assigned to improve our ability to detect on a timely basis any unauthorized and/or invalid changes made to product costs. The policies will require these activities to be performed on a regular, scheduled basis to ensure costs and freight amounts are current.

• We plan to establish and implement a journal entry processing policy to ensure the proper segregation of duties and to ensure that review and approval activities occur for all transactions recorded in the general ledger.

• We plan to continue the implementation of comprehensive account analyses, account summaries and reconciliations we started to remediate in the fourth quarter of fiscal year 2005.

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Recording of, and accounting for, fixed assets

• We plan to continue to implement the capitalization policy we established in the first quarter of 2006 by developing procedures for taking physical inventory of certain fixed assets; obtaining authorizations for purchases and the initiation of major construction projects; accounting for acquisitions, disposals, impairment, and depreciation; and monitoring budgets.

• We plan to review, and revise, if necessary, our methodologies for evaluating construction-in-progress and practices for accounting for and recording transactions on a regular basis.

Tax computations outsourced to third-party experts.

• We plan to establish review procedures designed to ensure the accuracy and completeness of financial information provided to third-party experts who compute tax amounts and to ensure the accuracy of tax amounts recorded in the general ledger.

Revenue recognition and accounts receivable

• We plan to establish review and follow up procedures prior to the approval of significant reserves.

• We plan to establish more robust benchmarks and monitoring activities to effectively evaluate historical information used in reserve calculations.

• We plan to perform timely cash application activities and reconciliations.

Payroll transactions

• We plan to implement the segregation of duties remediation action items noted above to ensure that payroll activities are not incompatibly performed.

Treasury functions

• We plan to establish monitoring activities over banking and investing activities.

• We plan to continue to follow and enhance financial closing procedures through the use of checklists and other monitoring tools to ensure that the necessary reconciliation activities are being performed and reviewed in a timely manner by management.

Spreadsheets used in the financial reporting process

• We plan to establish a spreadsheet control policy and implement the necessary procedures to comply with such policy.

While we believe that the remedial actions will ultimately result in correcting the material weaknesses in our internal controls, the exact timing of when the conditions will be corrected is dependent upon future events, which may or may not occur. We intend to remediate the majority of material weaknesses by hiring additional permanent employees with the necessary skills to carry out the plan. Contractors and temporary resources will be obtained on an as-needed basis to remediate areas which require a specific technical expertise or as time and resource constraints arise. Our SEC Compliance Manager will monitor the progress of remediation and may prescribe the necessary remedial actions to be taken as needed.

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PART II - OTHER INFORMATION

Item 1A. Risk Factors

The following information sets forth factors that could cause our actual results to differ materially from those contained in forward-looking statements we have made in this report, the information incorporated herein by reference and those we may make from time to time. The following Risk Factors do not reflect any material changes to the Risk Factors set forth in our Annual Report on Form 10-K for the fiscal year ended December 31, 2005 other than the update of the tenth risk factor to address concerns relating to our liquidity and capital resources to reflect our default (since waived) under our credit agreement, the revision of the fifteenth risk factor to address the impact on us of our adoption of SFAS No. 123R, and the revision of the twenty-sixth and twenty-seventh risk factors to update for recent changes in management.

Risks Relating to our Business

Our limited operating history makes evaluation of our business difficult.

We were originally incorporated in November 1998 and began selling products in July 1999. As an early stage company with limited operating history, we face risks and difficulties, such as challenges in accurate financial planning and forecasting as a result of limited historical data and the uncertainties resulting from having had a relatively limited time period in which to implement and evaluate our business strategies as compared to older companies with longer operating histories. These difficulties are particularly evident with respect to the evaluation and prediction of the operating results and expenses of our studios, as we opened our first studio in November 2000 and have expanded from one studio at the end of 2001 to 62 studios and one outlet as of July 1, 2006. Further, our limited operating history will make it difficult for investors and securities analysts who may choose to follow our common stock, if any, to evaluate our business, strategy and prospects. Our failure to address these risks and difficulties successfully would seriously harm our business.

If we fail to offer merchandise that our customers find attractive, the demand for our products may be limited.

In order for our business to be successful, our product offerings must be distinctive in design, useful to the customer, well made, affordable and generally not widely available from other retailers. We may not be successful in offering products that meet these requirements in the future. If our products become less popular with our customers, if other retailers, especially department stores or discount retailers, offer the same products or products similar to those we sell, or if demand generally for design products such as ours decreases or fails to grow, our sales may decline or we may be required to offer our products at lower prices. If customers buy fewer of our products or if we have to reduce our prices, our net sales will decline and our operating results would be adversely affected.

We believe that our future growth will be substantially dependent on increasing sales of existing core products, and maintaining or increasing our current gross margin rates. We may not be able to increase the growth of existing core and-new products or maintain or increase our gross margin rate in future periods. Failure to do so may adversely affect our business.

Moreover, in order to meet our strategic goals, we must successfully identify, obtain supplies of, and offer to our customers new, innovative and high quality design products on a continuous basis. These products must appeal to a wide range of residential and commercial customers whose preferences may change in the future. If we misjudge either the market for our products or our customers’ purchasing habits, we may be faced with significant excess inventories for some products and missed opportunities for products we chose not to stock. In addition, our sales may decline or we may be required to sell our products at lower prices. This would have a negative effect on our business.

The expansion of our studio operations could result in increased expenses with no guarantee of increased earnings.

We plan to open three to four new studios in fiscal year 2007. We anticipate the costs associated with opening these new studios will be approximately $1.6 million in fiscal year 2007. However, we may not be able to attain our target number of new studio openings, and any of the new studios that we open may not be profitable, either of which could have an adverse impact on our financial results. Our ability to expand by opening new studios will depend in part on the following factors:

• the availability of attractive studio locations;

• our ability to negotiate favorable lease terms;

• our ability to identify customer demand in different geographic areas;

• general economic conditions; and

• availability of sufficient funds for expansion.

Even though we plan to expand the number of geographic areas in which our studios are located, we expect that our studio operations will remain concentrated in limited geographic areas. This concentration could increase our exposure to

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fluctuating customer demand, adverse weather conditions, competition, distribution problems and poor economic conditions in these regions. In addition, our phone sales, online sales or existing studio sales in a specific region may decrease as a result of new studio openings in that region.

In order to continue our expansion of studios, we will need to hire additional management and staff for our corporate offices and employees for each new studio. We must also expand our management information systems and distribution systems to serve these new studios. If we are unable to hire necessary personnel or grow our existing systems, our expansion efforts may not succeed and our operating results may suffer.

Some of our expenses will increase with the opening of new studios, such as headcount and lease occupancy expenses. Moreover, as we increase inventory levels to provide studios with product samples and support the incremental sales generated from additional studios, our working capital needs will increase. We may not be able to manage this increased inventory without decreasing our earnings. If studio sales are inadequate to support these new costs, our earnings will decrease. In addition, if we were to close any studio, whether because a studio is unprofitable or otherwise, we likely would be unable to recover our investment in leasehold improvements and equipment at that studio and would be liable for remaining lease obligations.

We do not have long-term vendor contracts and as a result we may not have continued or exclusive access to products that we sell.

All of the products that we offer are manufactured by third-party suppliers. We do not typically enter into formal exclusive supply agreements for our products and, therefore, have no exclusive contractual rights to-market and sell them. Since we do not have arrangements with any vendor or distributor that would guarantee the availability or exclusivity of our products from year to year, we do not have a predictable or guaranteed supply of these products in the future. If we are unable to provide our customers with continued access to popular products, our net sales will decline and our operating results would be harmed.

Our business depends, in part, on factors affecting consumer spending that are not within our control.

Our business depends on consumer demand for our products and, consequently, is sensitive to a number of factors that influence consumer spending, including general economic conditions, disposable consumer income, recession and fears of recession, stock market volatility, war and fears of war, acts of terrorism, inclement weather, consumer debt, interest rates, sales tax rates and rate increases, inflation, consumer confidence in future economic conditions and political conditions, and consumer perceptions of personal well-being and security generally. Adverse changes in factors affecting discretionary consumer spending could reduce consumer demand for our products, thus reducing our net sales and adversely affecting our operating results.

Our business will be harmed if we are unable to implement our growth strategy successfully.

Our growth strategy primarily includes the following components:

• increase studio sales;

• increase online sales;

• increase marketing via print media;

• refine our product offerings;

• reduce our dependence on our catalog for marketing; and

• attract and retain qualified sales and merchandising personnel

Any failure on our part to implement any or all of our growth strategies successfully would likely have a material adverse effect on our financial condition.

We rely on our studio operations, which could have unpredictable results.

Our success depends in part on our ability to market, advertise and sell our products effectively through the Design Within Reach Studios. In the twenty-six weeks ended July 1, 2006, studio sales totaled $49.6 million, representing 59.1% of our total net sales during such period. We believe that the continued success of our studio operations depends on the following factors:

• our ability to continue to offer a merchandise mix that is attractive to our customers;

• our ability to add new customers in a cost-effective manner;

• our ability to develop key partnerships with young designers;

• the continuation of a robust new housing and loft conversion market in key urban areas; and

• the continuation of growth in demand in the commercial sectors.

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In addition our catalog remains our primary marketing vehicle. Catalog production and mailings entail substantial paper, postage, merchandise acquisition and human resource costs, including costs associated with catalog development and increased inventories. We incur nearly all of these costs prior to the mailing of each catalog. As a result, we are not able to adjust the costs incurred in connection with a particular mailing to reflect the actual performance of the catalog. Increases in costs of mailing, paper or printing would increase our costs and would adversely impact our earnings as we would be unable to pass such increases directly on to our customers or offset such increases by raising prices. If we were to experience a significant shortfall in anticipated sales from a particular mailing, and thereby not recover the costs associated with that mailing, our future results would be adversely affected. In addition, response rates to our mailings and, as a result, sales generated by each mailing, are affected by factors such as consumer preferences, economic conditions, the timing of catalog mailings, the product mix in a particular catalog, the timely delivery by the postal system of our catalog mailings and changes in our merchandise mix, several of which may be outside our control. Furthermore, we have historically experienced fluctuations in the response rates to our catalog mailings. Customer response to our catalogs is dependent on merchandise assortment, merchandise availability and creative presentation, as well as the size and timing of delivery of the catalogs. If we are unable to achieve adequate response rates, we could experience lower sales, significant markdowns or write-offs of inventory and lower margins, which would adversely affect our future operating results.

We have made and will continue to make certain systems changes that might disrupt our supply chain operations and delay our release of financial results.

Our success depends on our ability to source merchandise efficiently through appropriate systems and procedures. In May 2005, we converted our then -existing information technology system to a new, custom-built system supporting our product sourcing, merchandise planning, forecasting, inventory management, product distribution and transportation and price management. These information technology systems also are used to generate information for our financial reporting. We encountered problems with the conversion, due in large part to the absence of rigorous testing of the new systems prior to implementation. In particular, the new systems do not contain mechanisms to automatically identify and correct or reject erroneous or incomplete data. These system problems resulted in our being unable to complete our fiscal year 2005 audit and file our Annual Report on Form 10-K in a timely manner. During the third quarter of 2005, we hired a consulting firm to assess the inadequacies of the system. As a result of that review process, we have decided to replace our current system.

During the first quarter of 2006, we hired another consulting firm to clearly define and document the requirements for the new system. During the second quarter of 2006, we finalized the high-level specifications for the new system, selected a software vendor, hired a consulting firm to assist with implementation, and began the process of developing, testing and implementing the new system We have begun installation of the new system and will have the conversion completed in early 2007. There are inherent risks associated with replacing our core systems, including possible supply chain disruptions that could affect our ability to deliver products to our customers or delays in obtaining the information necessary for our financial reporting. We may not be able to successfully launch these new systems or launch them without supply chain disruptions or delays in releasing our financial results in the future. Any resulting supply chain disruptions could have a material adverse effect on our operating results. If we cannot produce timely and reliable financial reports, our business and financial condition could be harmed, investors could lose confidence in our reported financial information, the market price of our stock could decline significantly and we may be unable to obtain additional financing to operate and expand our business.

Management has identified material weaknesses in internal controls over financial reporting. Our failure to implement and maintain effective internal controls in our business could have a material adverse effect on our business, financial condition, results of operations and stock price.

As required by Securities and Exchange Commission Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of December 31, 2005. Based on that evaluation, our chief executive officer and chief financial officer concluded that control deficiencies which constituted material weaknesses existed in our internal control over financial reporting as of December 31, 2005. As a result of these material weaknesses, our Board of Directors concluded that our disclosure controls and procedures were not effective as of December 31, 2005 at the reasonable assurance level. A material weakness is a control deficiency, or combination of control deficiencies, that results in more than a remote likelihood that a material misstatement of the financial statements will not be prevented or detected. Management identified material weaknesses relating both to our control environment and our control activities.

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Management determined that we had material weaknesses in our control environment because as of December 31, 2005 we did not have (1) a sufficient controls and procedures in place or appropriate depth of experience for our accounting and finance departments to ensure the preparation of interim and annual financial statements in accordance with US GAAP, (2) robust risk assessment processes, including strategic plans, budgets and clearly defined and communicated goals and objectives, (3) adequate monitoring of our existing control activities over financial reporting, (4) the ability to produce financial statements and deliver information to decision makers in a timely manner, and (5) the ability to remediate previously communicated weaknesses. In addition, we placed heavy reliance on manual procedures and controls without quality control review and other monitoring controls in place to adequately identify and assess significant risks that may impact financial statements and related disclosures. These conditions were exacerbated by problems encountered with the major systems implementation and significant turnover of personnel in several key finance and accounting and information technology positions, including the chief financial officer, controller and chief information officer. These control deficiencies could result in material misstatements of the annual or interim financial statements that would not be prevented or detected.

Management also identified numerous material weaknesses in our control activities, including the following:

• We did not maintain effective controls over period-end financial reporting processes;

• We did not maintain adequate segregation of duties;

• We did not maintain effective controls over access to our systems, financial applications, and data;

• We had deficiencies relating to the preparation of account analyses, account summaries and account reconciliations;

• We had deficiencies relating to the documentation of accounting policies and procedures;

• We had deficiencies relating to records retention;

• We had deficiencies relating to inventory management and merchandise accounts payable;

• We had deficiencies relating to non-merchandise accounts payable;

• We did not maintain effective control over the costing and valuation of inventory;

• We had deficiencies relating to the recording of, and accounting for, fixed assets;

• We did not maintain effective controls over taxes computed by third-party experts;

• We did not maintain an effective controls related to the invoicing of customers with credit terms and the collection and application of payments and credits to accounts receivable;

• We did not maintain effective control over payroll processing;

• We identified deficiencies in our treasury functions which were considered material weaknesses; and

• We did not maintain effective control over spreadsheets used in our financial reporting process.

Any of these control deficiencies could result in material misstatements of the annual or interim financial statements that would not be prevented or detected. For more information about the material weaknesses identified by management, please see Part I, Item 4, “Controls and Procedures.”

In second quarter 2006 we began to take steps to strengthen our internal control processes to address the matters we have identified. These measures may not, however, completely eliminate the material weaknesses we identified, and we may have additional material weaknesses or significant deficiencies in our internal controls that we have not yet identified. The existence of one or more material weaknesses or significant deficiencies could result in material errors in our financial statements, and we may incur substantial costs and may be required to devote substantial resources to rectify any internal control deficiencies. If we fail to achieve and maintain the adequacy of our internal controls in accordance with applicable standards, we may be unable to conclude on an ongoing basis that we have effective internal controls over financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of 2002. If we cannot produce timely and reliable financial reports, our business and financial condition could be harmed, investors could lose confidence in our reported financial information, the market price of our stock could decline significantly and we may be unable to obtain additional financing to operate and expand our business.

We may need additional financing and may not be able to obtain additional financing on favorable terms or at all, which could increase our costs, limit our ability to grow and dilute the ownership interests of existing stockholders.

We generated a net loss of $5.1 million in the twenty-six weeks ended July 1, 2006 and used cash in operations of $1.6 million during this period. We expect to continue incurring operating losses during the remainder of fiscal year 2006. We currently have a credit agreement with Wells Fargo HSBC Trade Bank, N.A., as amended July 17, 2006, which provides up

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to a $10.0 million operating line of credit. As of July 1, 2006, we were in compliance with financial covenants under our amended credit agreement. Since August 10, 2006, we have been out of compliance with certain SEC reporting requirements of our credit agreement as a result of not filing our Form 10-Q within 40 days of quarter end. We received a waiver of default on August 10, 2006 from Wells Fargo HSBC Trade Bank, N.A.. On January 10, 2007, we received an additional waiver. Although we are currently in compliance with the financial covenants, if we do not remain in compliance with our loan covenants, we may be restricted from borrowings until we return to compliance with the covenants or we obtain an additional waiver which may or may not be available to us. We cannot provide assurances that any such covenant waivers or amendments will be obtained or that the lender will not require additional collateral, significant cash payments or additional incentives in connection with any such waivers or amendments.

Other than our working capital facility, we do not have any significant available credit, bank financing or other external sources of liquidity. We may need to raise additional capital in the future to fund our working capital requirements, open additional studios, to facilitate long-term expansion, to respond to competitive pressures or to respond to unanticipated financial requirements. The amount of financing that we will require for these efforts will vary depending on our financial results, our ability to generate cash from internal operations, and the number and speed at which we open additional studios. We are exploring potential public and private debt and equity financing alternatives, including the sale from time to time of debt and equity securities. There is no assurance that we will be able to raise the amount of debt or equity capital required to meet our objectives. Our challenging financial circumstances may make the terms, conditions and cost of any available capital relatively unfavorable. If additional debt or equity capital is not readily available, we will be forced to scale back, or fail to address opportunities for expansion or enhancement of, our operations.

We must manage our online business successfully or our business will be adversely affected.

Our success depends in part on our ability to market, advertise and sell our products through our website. In the 26 week period ended July 1, 2006, online sales totaled $14.2 million, representing 16.9% of our total net sales. The success of our online business depends, in part, on factors over which we have limited control. In addition to changing consumer preferences and buying trends relating to Internet usage, we are vulnerable to additional risks and uncertainties associated with the Internet. These risks include changes in required technology interfaces, website downtime or slowdowns and other technical failures or human errors, changes in applicable federal and state regulation, security breaches, and consumer privacy concerns. Our failure to respond successfully to these risks and uncertainties might adversely affect the sales through our online business, as well as damage our reputation and increase our selling, general and administrative expenses.

If we do not manage our inventory levels successfully, our operating results will be adversely affected.

We must maintain sufficient inventory levels to operate our business successfully. However, we also must guard against the risk of accumulating excess inventory as we seek to fulfill our “in stock and ready to ship” philosophy. Our success depends upon our ability to anticipate and respond to changing merchandise trends and customer demands in a timely manner. If we misjudge market trends, we may overstock unpopular products and be forced to take significant inventory markdowns, which would have a negative impact on our operating results. Conversely, shortages of popular items could result in loss of sales and have a material adverse effect on our operating results.

Consumer preferences may change between the time we order a product and the time it is available for sale. We base our product selection on our projections of consumer preferences in a future period, and our projections may not be accurate. As a result, we are vulnerable to consumer demands and trends, to misjudgments in the selection and timing of our merchandise purchases and fluctuations in the U.S. economy. Additionally, much of our inventory is sourced from vendors located outside the United States that often require lengthy advance notice of our requirements in order to be able to produce products in the quantities we request. This usually requires us to order merchandise, and enter into purchase order contracts for the purchase and manufacture of such merchandise, well in advance of the time such products will be offered for sale, which makes us vulnerable to changes in consumer demands and trends. If we do not accurately predict our customers’ preferences and acceptance levels of our products, our inventory levels will not be appropriate and our operating results may be negatively impacted.

We source many of our products from manufacturers and suppliers located in Europe, many of which close for vacation during the month of August each year. Accordingly, during September and in many cases for several weeks thereafter as manufacturing resumes and products are shipped to the United States, we are often unable to receive product shipments from these suppliers. As a result, we are required to make projections regarding customer demand for these products for the third and fourth quarters of each year and order sufficient product quantities for delivery in advance of the August shutdown. If we misjudge demand for any of these items, our inventory levels may be too high or low. If we have a shortage of a particular item affected by the August shutdown, we may not be able to procure additional quantities for some weeks or months, which could result in loss of sales and have a material adverse effect on our operating results.

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We depend on domestic and foreign vendors, some of which are our competitors, for timely and effective sourcing of our merchandise.

Our performance depends on our ability to purchase our merchandise in sufficient quantities at competitive prices. We purchase our merchandise from foreign and domestic designers, manufacturers and distributors. We have no long-term purchase contracts with any of our suppliers and, therefore, have no contractual assurances of continued supply, pricing or access to products, and any vendor could discontinue selling to us at any time. In the twenty-six period ended July 1, 2006, products supplied by our five largest vendors represented approximately 31.0% of our total purchases during this period.

Additionally, some of our suppliers, including Herman Miller, Inc., Vitra Inc. and Kartell US Inc., compete directly with us in both residential and commercial markets and may in the future choose not to supply products to us. In 26 six week period ended July 1, 2006, products supplied by Herman Miller, Inc., Vitra Inc. and Kartell US Inc. represented approximately 17.5% of our total purchases during this period. Additionally, some of our smaller vendors have limited resources, production capacities and operating histories, which means that they may not be able to timely produce sufficient quantities of certain products demanded by our customers. We may not be able to acquire desired merchandise in sufficient quantities on terms acceptable to us in the future. Any inability to acquire suitable merchandise or the loss of one or more key vendors could have a negative effect on our business and operating results because we would be missing products from our merchandise mix unless and until alternative supply arrangements are made. Moreover, we may not be able to develop relationships with new vendors, and products from alternative sources, if any, may be of a lesser quality or more expensive than those we currently purchase.

New accounting pronouncements may impact our future results of operations.

In twenty-six week period ended July 1, 2006, we adopted Statement of Financial Accounting Standards, or SFAS, No. 123R, “Share-Based Payment” issued by the Financial Accounting Standards Board, or FASB. SFAS No. 123R requires us to recognize share-based compensation as compensation expense in the statement of operations based on the fair values of such equity on the date of the grant, with the compensation expense recognized over the period in which the recipient is required to provide service in exchange for the equity award. In accordance with SFAS 123R, we adopted a fair value-based method for measuring the compensation expense related to share-based compensation. In the twenty-six weeks ended July 1, 2006, we recognized approximately $1.0 million in expense related to stock-based compensation under SFAS 123R. Future financial impact is difficult to predict because it will depend on levels of share-based payments granted in the future, assumptions used to determine fair value and forfeiture rates used to calculate the expense.

Intellectual property claims against us could be costly and could impair our business.

Third parties may assert claims against us alleging infringement, misappropriation or other violations of patent, trademark, trade dress, or other proprietary rights held by them, whether or not such claims have merit. Some of the products we offer, including some of our best selling items, are reproductions of designs that some of our competitors believe they have exclusive rights to manufacture and sell, and who may take action to seek to prevent us from selling those reproductions. Alternatively, such persons may seek to require us to enter into distribution relationships with them, thereby requiring us to sell their version of such products, at a significantly higher price than the reproduction that we offer, which may have a significant adverse impact on our sales volume, net sales and gross margin. During 2005, we discontinued selling reproductions of Barcelona merchandise currently being manufactured by Knoll, Inc. and agreed to carry the Barcelona merchandise instead. We were selling the reproductions, which we referred to as “Pavillion” merchandise, at substantially lower prices than the Barcelona merchandise. In addition, when marketing or selling our products, we may refer to or use product designations that are or may be trademarks of other people, who may allege that we have no right to use such marks or product designations and bring actions against us to prevent us from using them. If we are forced to defend against third-party infringement claims, whether they are with or without merit or are determined in our favor, we could face expensive and time-consuming litigation, which could divert management personnel, or result in product shipment delays. If an infringement claim is determined against us, we may be required to pay monetary damages or ongoing royalties, or to cease selling the infringing product, which may have a significant adverse impact on our sales volume and gross margins, especially if we are required to stop selling any of our best-selling items as a result of, or in connection with, such claim. Further, as a result of infringement claims either against us or against those who license rights to us, we may be required to enter into costly royalty, licensing or product distribution agreements. Such royalty, licensing or product distribution agreements may be unavailable on terms that are acceptable to us, or at all. If a third party successfully asserts an infringement claim against us and we are required to pay monetary damages or royalties or we are unable to obtain suitable non-infringing alternatives or license the infringed or similar intellectual property on reasonable terms on a timely basis, it could significantly harm our business. Moreover, any such litigation regarding infringement claims may result in adverse publicity which may harm our reputation.

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We are subject to various risks and uncertainties that might affect our ability to procure quality merchandise from our vendors.

Our performance depends on our ability to procure quality merchandise from our vendors. Our vendors are subject to certain risks, including availability of raw materials, labor disputes, union organizing activity, inclement weather, natural disasters, and general economic and political conditions that might limit their ability to provide us with quality merchandise on a timely basis. For these or other reasons, one or more of our vendors might not adhere to our quality control standards, and we might not identify the deficiency before merchandise ships to us or our customers. Our vendors’ failure to manufacture or import quality merchandise could reduce our net sales, damage our reputation and have an adverse effect on our financial condition.

A substantial portion of our sales during any given period of time may be generated by a particular product or line of products obtained from a small number of vendors, and if sales of those products or line of products decrease, our common stock price may be adversely affected.

In the twenty-six weeks ended July 1, 2006, our sales of products supplied by Herman Miller, Inc., the manufacturer of, among other items, the Aeron Chair, the Eames Lounge Chair and Ottoman, the Eames^® Aluminum Management Chair and the Noguchi Table, constituted approximately 11.0% of our total product sales. Sales of products supplied by our top five vendors constituted approximately 27.0% of our total product sales in twenty-six week period ended July 1, 2006. Although we have no formal supply agreements with any of these vendors, we believe that sales of products we obtain from these vendors will continue to constitute a substantial portion of our sales in the future. However, sales of products from these vendors may not continue to increase or may not continue at this level in the future. If sales of products from these vendors decrease, our net sales will decrease and the price of our common stock may be adversely affected.

Changes in the value of the U.S. dollar relative to foreign currencies and/or any failure by us to adopt and implement an effective hedging strategy could adversely affect our operating results.

During the twenty-six weeks ended July 1, 2006, we generated all of our net sales in U.S. dollars. However during the same period, we purchased approximately 51.7% of our product inventories from international vendors, with 35.4% of our total product inventory purchases being 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, our effective cost of supplies of 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 goods sold and decrease our gross margin.

In fiscal year 2005, the value of the dollar increased approximately 10% relative to the Euro. However, we did not benefit significantly from this strengthening of the dollar because we made most of our fiscal year 2005 inventory purchases in the first part of the year when the dollar was still weak relative to the Euro and because of the hedging contracts we purchased at a time when the dollar was relatively weak. Under our hedging strategy, we purchased foreign currency option contracts with maturities of 12 months or less to hedge our currency risk on anticipated purchases of merchandise based on our forecasted demand. We account for hedging contracts on a monthly basis by recognizing the net cash settlement gain or loss on the call or put option in accumulated other comprehensive income (loss) and adjusting the carrying amount of the contract to market by recognizing any corresponding gain or loss in cost of goods sold as the underlying inventory which was hedged is sold in each reporting period. However, when derivative positions exceed identified exposures, such contracts are considered “ineffective” and reported through earnings (loss). In the twenty-six week period ended July 1, 2006, our actual demand was less than our forecasted demand, and the amount of Euros we hedged was greater than the amount we needed for purchases of inventory. As a result, we recorded approximately $69,000 for ineffectiveness during the twenty-six week period ended July 1, 2006.

Although we are evaluating and plan to revise our hedging strategy, we will not be able to eliminate all fluctuations in our cost of goods caused by changes in currency exchange rates. If our revised hedging strategy does not help reduce fluctuations in our cost of goods and mitigate the impact of strengthening of the Euro relative to the U.S. dollar, we will continue to have difficulties in accurately predicting our costs of goods and our cost of goods may increase, adversely impacting our gross margin. In addition, if our forecasted demand exceeds actual demand, we may have expenses associated with hedging that are not associated with inventory purchases.

We rely on foreign sources of production, which subjects us to various risks.

We currently source a substantial portion of our products from foreign manufacturers located in Canada, Denmark, Germany, Italy, The Netherlands, Spain, and in other countries. As such, we are subject to other risks and uncertainties

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associated with changing economic and political conditions in foreign countries. These risks and uncertainties include import duties and quotas, work stoppages, economic uncertainties, including inflation, foreign government regulations, wars and fears of war, acts of terrorism, political unrest and trade restrictions. Additionally, countries in which our products are currently manufactured or may be manufactured in the future may become subject to trade restrictions imposed by the United States or foreign governments. Any event causing a disruption or delay of imports from foreign vendors, including the imposition of additional import restrictions, restrictions on the transfer of funds or increased tariffs or quotas could increase the cost or reduce the supply of merchandise available to us and adversely affect our operating results.

There is also a risk that one or more of our foreign vendors will not adhere to fair labor standards and may engage in child labor practices. If this happens, we could lose customer goodwill and favorable brand recognition, which could negatively affect our business.

If we fail to timely and effectively obtain shipments of product from our vendors and deliver merchandise to our customers, our operating results will be adversely affected.

We cannot control all of the various factors that might affect our timely and effective procurement of supplies of product from our vendors and delivery of merchandise to our customers. All products that we purchase, domestically or overseas, must be shipped to our fulfillment center in Hebron, Kentucky by third-party freight carriers, except for those products that are shipped directly to our customers from the manufacturer. Our dependence on foreign imports also makes us vulnerable to risks associated with products manufactured abroad, including, among other things, risks of damage, destruction or confiscation of products while in transit, work stoppages including as a result of events such as longshoremen strikes, transportation and other delays in shipments including as a result of heightened security screening and inspection processes or other port-of-entry limitations or restrictions in the United States, lack of freight availability and freight cost increases. In addition, if we experience a shortage of a popular item, we may be required to arrange for additional quantities of the item, if available, to be delivered to us through airfreight, which is significantly more expensive than standard shipping by sea. As a result, we may not be able to obtain sufficient freight capacity on a timely basis or at favorable shipping rates and, therefore, we may not be able to timely receive merchandise from our vendors or deliver our products to our customers.

We rely upon land-based carriers for merchandise shipments from U.S. ports to our facility in Hebron, Kentucky and from this facility to our customers. Accordingly, we are subject to the risks, including labor disputes, union organizing activity, inclement weather and increased fuel costs, associated with such carriers’ ability to provide delivery services to meet our inbound and outbound shipping needs. For example, recent increases in oil prices resulted in increases in our shipping expenses and we have not passed all of this increase on to our customers, which has adversely affected our shipping margins. Failure to procure and deliver merchandise either to us or to our customers in a timely, effective and economically viable manner could damage our reputation and adversely affect our business. In addition, any increase in fulfillment costs and expenses could adversely affect our future financial performance.

All of our fulfillment operations are located in our facility in Hebron, Kentucky, and any significant disruption of this center’s operations would hurt our ability to make timely delivery of our products.

We conduct all of our fulfillment operations from our facility in Hebron, Kentucky. Our fulfillment center houses all of our product inventory and is the location from which all of our products are shipped to customers, except for those products that are shipped directly to our customers from the manufacturer. A natural disaster or other catastrophic event, such as an earthquake, fire, flood, severe storm, break-in, terrorist attack or other comparable event would cause interruptions or delays in our business and loss of inventory and could render us unable to accept or fulfill customer orders in a timely manner, or at all. Further, we have no formal disaster recovery plan and our business interruption insurance may not adequately compensate us for losses that may occur. In the event that a fire, natural disaster or other catastrophic event were to destroy a significant part of our Hebron, Kentucky facility or interrupt our operations for any extended period of time, or if harsh weather conditions prevent us from delivering products in a timely manner, our net sales would be reduced and our operating results would be harmed.

Our computer and communications hardware and software systems are vulnerable to damage and interruption, which could harm our business.

Our ability to receive and fulfill orders successfully is critical to our success and largely depends upon the efficient and uninterrupted operation of our computer and communications hardware and software systems. Our primary computer systems and operations are located at our corporate headquarters in San Francisco, California and distribution center in Hebron, Kentucky and are vulnerable to damage or interruption from power outages, computer and telecommunications failures, computer viruses, security breaches, catastrophic events, and errors in usage by our employees and customers. Further, our website servers are located at the facilities of, and hosted by, a third-party service provider in Santa Clara, California. In the event that this service provider experiences any interruption in its operations or ceases operations for any reason or if we are

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unable to agree on satisfactory terms for a continued hosting relationship, we would be forced to enter into a relationship with another service provider or take over hosting responsibilities ourselves. In the event it became necessary to switch hosting facilities in the future, we may not be successful in finding an alternative service provider on acceptable terms or in hosting our website servers ourselves. Any significant interruption in the availability or functionality of our website or our sales processing, distribution or communications systems, for any reason, could seriously harm our business.

If we are unable to provide satisfactory customer service, we could lose customers and our reputation could be harmed.

Our ability to provide satisfactory levels of customer service depends, to a large degree, on the efficient and uninterrupted operation of our customer call center. Any material disruption or slowdown in our order processing systems resulting from labor disputes, telephone or Internet failures, power or service outages, natural disasters or other events could make it difficult or impossible to provide adequate customer service and support. Further, we may be unable to attract and retain adequate numbers of competent customer service representatives, who are essential in creating a favorable, interactive customer experience. In addition, e-mail and telephone call volumes in the future may exceed our present system’s capacities. If this occurs, we could experience delays in taking orders, responding to customer inquiries and addressing customer concerns, which would have an adverse effect on customer satisfaction and our reputation.

We also are dependent on third-party shipping companies for delivery of products to customers. If these companies do not deliver goods in a timely manner or damage products in transit, our customers may be unsatisfied. Because our success depends in large part on keeping our customers satisfied, any failure to provide high levels of customer service would likely impair our reputation and have an adverse effect on our future financial performance.

We face intense competition, and if we are unable to compete effectively, we may not be able to maintain profitability.

The specialty retail furnishings market is highly fragmented but highly competitive. We compete with other companies that market lines of merchandise similar to ours, such as large retailers with a national or multinational presence, regional operators with niche assortments and catalog and Internet companies. Many of our competitors are larger companies with greater financial resources than us. We expect that as demand for high quality design products grows, many new competitors will enter the market and competition from established companies will increase.

Moreover, increased competition may result in potential or actual litigation between us and our competitors relating to such activities as competitive sales practices, relationships with key suppliers and manufacturers and other matters. As a result, increased competition may adversely affect our future financial performance.

The competitive challenges facing us include:

• anticipating and quickly responding to changing consumer demands better than our competitors;

• maintaining favorable brand recognition and achieving customer perception of value;

• effectively marketing and competitively pricing our products to consumers in several diverse market segments; and

• offering products that are distinctive in design, useful to the customer, well made and affordable, in a manner that favorably distinguishes us from our competitors.

The U.S. retail industry, the specialty retail industry in particular, and the e-commerce sector are constantly evolving and have undergone significant changes over the past several years. Our ability to anticipate and successfully respond to continuing challenges is critical to our long-term growth, and we may not be successful in anticipating and responding to changes in the retail industry and e-commerce sector.

In light of the many competitive challenges facing us, we may not be able to compete successfully. Increased competition could adversely affect our future net sales.

We maintain a liberal merchandise return policy, which allows customers to return most merchandise and, as a result, excessive merchandise returns could harm our business.

We maintain a liberal merchandise return policy that allows customers to return most merchandise received from us if they are dissatisfied with those items. We make allowances for returns in our financial statements based on historical return rates. Actual merchandise returns may exceed our allowances for returns. In addition, because our allowances are based on historical return rates, the introduction of new products, the opening of new studios, the introduction of new catalogs, increased sales online, changes in our merchandise mix or other factors may cause actual returns to exceed return allowances. Any significant increase in merchandise returns that exceed our allowances could have a material adverse effect on our future operating results.

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Our senior management team has limited experience working together as a group, and may not be able to manage our business effectively. The loss of key personnel could have an adverse effect on our ability to execute our business strategy and on our business results.

We have had three different Chief Executive Officers since October 2005. In October 2005, our then President and Chief Executive Officer, Wayne Badovinus, resigned his employment from the Company. As a result, Tara Poseley, previously serving as Vice President—Merchandising, was promoted to the position. In May 2006, Ms. Poseley resigned her employment from the Company. In May 2006, Ray Brunner, who previously served as the Executive Vice President— Studio Operations and Real Estate, accepted the position as President and Chief Executive Officer. Other key personnel turnover in the last twelve months include our Chief Financial Officer (position subsequently filled), Vice President—Finance and Corporate Controller (position subsequently filled), Chief Information Officer, Vice President—Human Resources, Vice President—Inventory Planning and Executive Vice President—Merchandising and Marketing. As a result, our senior management team has limited experience working together as a group. This lack of shared experience could impact our senior management team’s ability to quickly and efficiently respond to problems and effectively manage our business.

Our success depends to a significant extent upon the efforts and abilities of our current senior management to execute our business plan.

In particular, we are dependent on the services of Ray Brunner, our President and Chief Executive Officer. We do not have a long-term employment agreement with Mr. Brunner. The loss of the services of Mr. Brunner, any of the other members of our senior management team, or of other key employees could have a material adverse effect on our ability to implement our business strategy and on our business results. Recent changes in our senior management have been and any future departures of key employees or other members of senior management may be disruptive to our business and may adversely affect our operations. Additionally, our future performance will depend upon our ability to attract and retain qualified management, merchandising and sales personnel. If members of our existing management team are not able to manage our company or our growth, or if we are unable to attract and retain additional qualified personnel as needed in the future, our business results will be negatively impacted.

We have grown quickly and if we fail to manage our growth, our business will suffer.

We have rapidly and significantly expanded our operations, and anticipate that further significant expansion will be required to address potential growth in our customer base and market opportunities. This expansion has placed, and is expected to continue to place, a significant strain on our management and operational resources. Additionally, we need to properly implement and maintain our financial and managerial controls, reporting systems and procedures, including disclosure controls and procedures and internal controls over financial reporting. Moreover, if we are presented with appropriate opportunities, we may in the future make investments in, or possibly acquire, assets or businesses that we believe are complementary to ours. Any such investment or acquisition may further strain our financial and managerial controls and reporting systems and procedures. These difficulties could disrupt our business, distract our management and employees and increase our costs. If we are unable to manage growth effectively or successfully integrate any assets or businesses that we may acquire, our future financial performance would be adversely affected.

If the protection of our trademarks and proprietary rights is inadequate, our brand and reputation could be impaired and we could lose customers.

We regard our copyrights, service marks, trademarks, trade dress, patents, trade secrets and other intellectual property as critical to our success. Our principal intellectual property rights include trademark registrations or applications for our name, “Design Within Reach,” our logo, and the acronym, “DWR,” among others; copyrights and trade dress rights in our catalogs, website and certain of our products, such as our commissioned designs, and packaging; rights to our domain name, www.dwr.com, and our databases and information management systems; and patent registrations or applications, and other proprietary rights, in certain product designs. We rely on trademark, copyright, patent, unfair competition and trade secret laws, and confidentiality agreements with our employees, consultants, suppliers and others, to protect our proprietary rights. Nevertheless, the steps we take to protect our proprietary rights may be inadequate. If we are unable to protect or preserve the value of our trademarks, copyrights, patents, trade secrets or other proprietary rights for any reason, our brand and reputation could be impaired and we could lose customers. In addition, the costs of defending our intellectual property may adversely affect our operating results.

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We may face product liability claims or product recalls that are costly and create adverse publicity.

The products we sell may from time to time contain defects which could subject us to product liability claims and product recalls. Any such product liability claim or product recall may result in adverse publicity regarding us and the products we sell, which may harm our reputation. If we are found liable under product liability claims, we could be required to pay substantial monetary damages. Further, even if we successfully defend ourselves against this type of claim, we could be forced to spend a substantial amount of money in litigation expenses, our management could be required to spend valuable time in the defense against these claims and our reputation could suffer, any of which could harm our business. In addition, although we maintain limited product liability insurance, if any successful product liability claim or product recall is not covered by or exceeds our insurance coverage, our financial condition would be harmed.

The security risks of online commerce, including credit card fraud, may discourage customers from purchasing products from us online.

For our online sales channel to continue to succeed, we and our customers must be able to transmit confidential information, including credit card information, securely over public networks. Third parties may have the technology or know-how to breach the security of customer transaction data. Any breach could cause customers to lose confidence in the security of our website and choose not to purchase from us. Although we take the security of our systems very seriously, our security measures may not effectively prohibit others from obtaining improper access to our information. If a person is able to circumvent our security measures, he or she could destroy or steal valuable information or disrupt our operations. Any security breach could expose us to risks of data loss, litigation and liability and could seriously disrupt our operations and harm our reputation.

We do not carry insurance against the risk of credit card fraud, so the failure to prevent fraudulent credit card transactions could adversely affect our operating results. In addition, we may in the future suffer losses as a result of orders placed with fraudulent credit card data even though the associated financial institution approved payment of the orders. Under current credit card practices, we may be liable for fraudulent credit card transactions because we do not obtain a cardholder’s signature when we sell our products by telephone or online. If we are unable to detect or control credit card fraud, our liability for these transactions could harm our financial condition.

Existing or future government regulation could harm our business.

We are subject to the same federal, state and local laws as other companies conducting business online, including consumer protection laws, user privacy laws and regulations prohibiting unfair and deceptive trade practices. In particular, under federal and state financial privacy laws and regulations, we must provide notice to our customers of our policies on sharing non-public information with third parties, must provide advance notice of any changes to our privacy policies and, with limited exceptions, must give consumers the right to prevent sharing of their non-public personal information with unaffiliated third parties. Further, the growth of online commerce could result in more stringent consumer protection laws that impose additional compliance burdens on us. Today there are an increasing number of laws specifically directed at the conduct of business on the Internet. Moreover, due to the increasing use of the Internet, many additional laws and regulations relating to the Internet are being debated at the state and federal levels. These laws and regulations could cover issues such as freedom of expression, pricing, user privacy, fraud, quality of products and services, taxation, advertising, intellectual property rights and information security. Applicability of existing laws to the Internet relating to issues such as property ownership, copyrights and other intellectual property issues, taxation, libel, obscenity and personal privacy could also harm our business. For example, U.S. and international laws regulate our ability to use customer information and to develop, buy and sell mailing lists. Many of these laws were adopted prior to the advent of the Internet, and do not contemplate or address the unique issues raised by the Internet. The applicability and reach of those laws that do reference the Internet, such as the Digital Millennium Copyright Act, are uncertain. The restrictions imposed by and costs of complying with current and possible future laws and regulations related to our business could harm our future operating results.

In addition, because our website is accessible over the Internet in multiple states and other countries, we may be subject to their laws and regulations or may be required to qualify to do business in those locations. Our failure to qualify in a state or country where we are required to do so could subject us to taxes and penalties and we could be subject to legal actions and liability in those jurisdictions. The restrictions or penalties imposed by, and costs of complying with, these laws and regulations could harm our business, operating results and financial condition. Our ability to enforce contracts and other obligations in states and countries in which we are not qualified to do business could be hampered, which could have a material adverse effect on our business. During fiscal year 2005 and through the 26 weeks ended July 1, 2006, we have been subject to sales and use tax audits by various states as well as a current Internal Revenue Service audit for fiscal year 2003. Although any adverse results for completed audits have not been material to us, there is a risk that federal, state and local jurisdictions may challenge the characterization of certain transactions and assess additional amounts, including interest and penalties. In the event that transactions are challenged by tax authorities, the review process would divert management attention and resources and we may incur substantial costs.

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Tax authorities in a number of states, as well as a Congressional advisory commission, are currently reviewing the appropriate tax treatment of companies engaged in online commerce, and new state tax regulations may subject us to additional state sales and income taxes, which could have an adverse effect on our cash flows and results of operations. Further, there is a possibility that we may be subject to significant fines or other payments for any past failures to comply with these requirements.

Laws or regulations relating to privacy and data protection may adversely affect the growth of our online business or our marketing efforts.

We are subject to increasing regulation relating to privacy and the use of personal user information. For example, we are subject to various telemarketing laws that regulate the manner in which we may solicit future customers. Such regulations, along with increased governmental or private enforcement, may increase the cost of growing our business. In addition, several states have proposed legislation that would limit the uses of personal, user information gathered online or require online services to establish privacy policies. The Federal Trade Commission has adopted regulations regarding the collection and use of personal identifying information obtained from children under 13 years of age. Bills proposed in Congress would extend online privacy protections to adults. Moreover, proposed legislation in the United States and existing laws in other countries require companies to establish procedures to notify users of privacy and security policies, obtain consent from users for collection and use of personal information, and/or provide users with the ability to access, correct and delete personal information stored by companies. These data protection regulations and enforcement efforts may restrict our ability to collect demographic and personal information from users, which could be costly or harm our marketing efforts. Further, any violation of privacy or data protection laws and regulations may subject us to fines, penalties and damages and may otherwise have material adverse effect on our financial condition.

The State of California recently enacted a law that requires any company that does business in California and possesses computerized data, in unencrypted form, containing certain personal information about California residents to provide prompt notice to such residents if that personal information was, or is reasonably believed to have been, obtained by an unauthorized person such as a computer hacker. The law defines personal information as an individual’s name together with one or more of that individual’s social security number, driver’s license number, California identification card number, credit card number, debit card number, or bank account information, including any necessary passwords or access codes. As our customers, including California residents, generally provide information to us that is covered by this definition of personal information in connection with their purchases via our website, our business will be affected by this new law. As a result, we will need to ensure that all computerized data containing the previously-described personal information is sufficiently encrypted or that we have implemented appropriate measures to detect unauthorized access to our data. These measures may not be sufficient to prevent unauthorized access to the previously described personal information. In the event of an unauthorized access, we are required to notify our California customers of any such access to the extent it involves their personal information. Such measures will likely increase the costs of doing business and, if we fail to detect and provide prompt notice of unauthorized access as required by the new law, we could be subject to potential claims for damages and other remedies available to California residents whose information was improperly accessed or, under certain circumstances, the State of California could seek to enjoin our online operations until appropriate corrective actions have been taken. While we intend to comply fully with this new law, we may not be successful in avoiding all potential liability or disruption of business resulting from this law. If we were required to pay any significant amount of money in satisfaction of claims under this new law, or any similar law enacted by another jurisdiction, or if we were forced to cease our business operations for any length of time as a result of our inability to comply fully with any such law, our operating results could be adversely affected. Further, complying with the applicable notice requirements in the event of a security breach could result in significant costs.

We may be subject to liability for the content that we publish.

As a publisher of catalogs and online content, we face potential liability for intellectual property infringement and other claims based on the information and other content contained in our catalogs and website. In the past, parties have brought these types of claims and sometimes successfully litigated them against online services. If we incur liability for our catalog or online content, our financial condition could be affected adversely.

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

Our initial public offering of common stock was effected through a Registration Statement on Form S-1 (File No. 333-113903) that was declared effective by the Securities and Exchange Commission on June 29, 2004. On July 6, 2004, 3,000,000 shares of our common stock were sold on our behalf at an initial public offering price of $12.00 per share, for an aggregate offering price of $36.0 million, and 1,715,000 shares of our common stock were sold on behalf of certain selling stockholders at an initial public offering price of $12.00 per share, for an aggregate offering price of $20.6 million. The initial public offering was managed by CIBC World Markets Corp., William Blair & Co., L.L.C. and SG Cowen & Co., LLC.

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We paid to the underwriters underwriting discounts and commissions totaling approximately $2.5 million in connection with the offering. In addition, we incurred additional expenses of $1.6 million in connection with the offering, which when added to the underwriting discounts and commissions paid by us, amounts to total expenses of $4.1 million. Thus, the net offering proceeds to us, after deducting underwriting discounts and commissions and offering expenses, were $31.8 million. No offering expenses were paid directly or indirectly to any of our directors or officers (or their associates) or persons owning ten percent or more of any class of our equity securities or to any other affiliates.

We intend to use the net proceeds from this offering as follows:

• to finance the opening of additional studios;

• to pay any and all of the indebtedness outstanding under our bank credit facility

• the remaining net proceeds for other general corporate purposes, including working capital.

Item 3. Defaults Upon Senior Securities.

On July 17, 2006, we entered into an Amended and Restated Credit Agreement (“Amended Credit Agreement”). The Amended Credit Agreement provides for an overall credit line up to a maximum of $10.0 million including a sub-limit of $5.0 million for letters of credit with a maturity date of November 30, 2007.

Borrowings under the Amended Credit Agreement are based upon a percentage of eligible inventory and accounts receivable and are secured by our inventory, accounts receivable, equipment, general intangibles and other rights to payments. The agreement prohibits the payment or declaration of any dividends or the redemption or repurchase of any shares of any class of our stock. The Amended Credit Agreement contains various restrictive and financial covenants including an $8.0 million limit on capital expenditures in any fiscal year and financial covenants related to net worth and net income. Interest on outstanding borrowings in the Amended Credit Agreement is calculated at the lender’s floating prime rate plus .25%. Interest is payable on the last day of each month. As of July 1, 2006, the interest rate on outstanding borrowings was 8.25%.

The financial covenants were revised in the Amended Credit Agreement, including covenants pertaining to the period ended July 1, 2006. We were in compliance with these financial covenants as of July 1^st, 2006. Since August 10, 2006, we have been out of compliance with certain SEC reporting requirements of our credit agreement as a result of not filing our Form 10-Q within 40 days of quarter end. We received a waiver of default on August 10, 2006 from Wells Fargo HSBC Trade Bank, N.A.. On January 10, 2007, we received an additional waiver.

Although we are currently in compliance with our loan covenants, if we do not remain in compliance we may be restricted from borrowings until we return to compliance with the covenants or we obtain an additional waiver which may or may not be available to us.

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

A. Our Annual Meeting of stockholders was held on June 22, 2006 (the “Annual Meeting”).

B. The following Class II Directors were elected at the Annual Meeting:

Name	Position	Term Expires
Robert Forbes, Jr.	Class II Director	2009
Terry Lee	Class II Director	2009

The following Class I and Class III Directors continue to serve their respective terms which expire on our annual meeting of stockholders in the years noted:

Name	Position	Term Expires
Ray Brunner	Class III Director	2007
William McDonagh	Class III Director	2007
Lawrence Wilkinson	Class III Director	2007
John Hansen	Class I Director	2008
Hilary Billings	Class I Director	2008

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C. At the Annual Meeting, stockholders voted on three matters: (i) the election of two Class II Directors for a term of three years expiring in 2009; (ii) the approval of the Amended and Restated 2004 Equity Incentive Plan, which among other things, provided for the reservation of an additional 900,000 shares of common stock for issuance thereunder, extended the term of the plan to 2016, and removed the provisions regarding automatic increases to the share reserve; and (iii) the ratification of the appointment of Grant Thornton LLP as our independent registered public accounting firm for the fiscal year ending December 30, 2006. The stockholders approved all three matters, and the voting results were as follows:

I. Election of two Class II Directors:

Robert Forbes, Jr.	For 12,845,334	Withheld 131,878
Terry Lee	For 12,839,774	Withheld 137,438

II. Approval of the Amended and Restated 2004 Equity Incentive Plan, which among other things, increased the number of shares of common stock reserved for issuance from 1,200,000 to 2,100,000, extended the term of the plan to 2016, and removed the provisions regarding automatic increases to the share reserve:

For 4,973,933 Against 362,276 Abstain 20,574 Broker Non-Vote 7,620,429

III. Ratification of the appointment of Grant Thornton LLP as our independent registered public accounting firm for the fiscal year ending December 30, 2006:

For 12,962,618 Against 600 Abstain 13,994

Item 5. Other Information

None.

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Item 6. Exhibits

Exhibit Number	Exhibit Title
3.01(1)	Amended and Restated Certificate of Incorporation
3.02(2)	Amended and Restated Bylaws
4.01(3)	Form of Specimen Common Stock Certificate
10.22	Amended and Restated Credit Agreement between Design Within Reach, Inc. and Wells Fargo HSBC Trade Bank, N.A. dated as of July 17, 2006.
10.23	Revolving Credit Loan Note between Design Within Reach, Inc. and Wells Fargo HSBC Trade Bank, N.A. dated as of July 17, 2006
10.24	Security Agreement for Equipment and Fixtures between Design Within Reach, Inc. and Wells Fargo HSBC Trade Bank, N.A. dated as of July 17, 2006.
10.25	Continuing Security Agreement between Design Within Reach, Inc. and Wells Fargo HSBC Trade Bank, N.A. dated as of July 17, 2006.
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 same-numbered exhibit (except where otherwise noted) to the Registration Statement on Form S-1 (No. 333-113903) filed on March 24, 2004, as amended.

(2) Incorporated by reference to the same-numbered exhibit (except where otherwise noted) 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 the same-numbered exhibit (except where otherwise noted) to Amendment No. 1 to Registration Statement on Form S-1 (No. 333-113903) filed on May 17, 2004, as amended.

 * 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.

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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: January 16, 2007

/s/ John D. Hellmann

John D. Hellmann

Chief Financial Officer and Secretary

(Duly authorized Officer and
Principal Financial Officer)

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