DESIGN WITHIN REACH INC (DWRI) - Description of business

Company Description
  We are 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 phone, studios and website. We believe we have developed a national presence in modern design furnishings and a brand recognized for design excellence among our customers and the design community. We believe that we have created a differentiated business model that enables us to provide products to our customers in a more convenient, efficient and economical manner. We strive to broaden the base of modern design consumers, who we believe have been underserved in the United States. This belief has been driven by direct consumer feedback gathered over the last six years and our rapid sales growth, which was a compounded annual growth rate of over 40.4% from 2002 through 2005. Our policy of having products “in stock and ready to ship” is a departure from the approach taken by many other modern design furnishings retailers, which we believe typically requires customers to wait weeks or months to receive their products. We have relationships with both internationally recognized and emerging designers, which allow us to offer our customers an array of innovative and often hard-to-find merchandise. Our differentiated business model, along with a dedicated management team, has enabled us to generate significant growth in customers and net sales over the last six years. We established our business strategy on the premise that multiple, integrated sales channels improve customer convenience, reinforce brand awareness, enhance customer knowledge of our products, and produce operational benefits that ultimately improve market penetration and returns on capital. We believe most traditional furnishings retailers initially established their presence with one sales channel and subsequently added additional channels, thereby making integration across sales channels more difficult. Seamless channel integration, meaning all of our products are available, and order processing, customer service assistance and product returns can be handled, through any of our three sales channels, is crucial to our success because a substantial portion of our customers purchase our products after having had contact with two or sometimes all three of our sales channels. All of our sales channels utilize a common inventory held at our centralized Hebron, Kentucky fulfillment center and share information technology systems. This integration further improves customer service by providing inventory information across all sales channels. Our merchandise offering is comprised of products that we believe share an aesthetic appeal and feature distinctive modern design elements, superior quality and authenticity. We offer over 850 products in numerous categories, including chairs, tables, workspace, outdoor furniture, lighting, floor coverings, beds, upholstery, accessories, and our children’s furniture. Across each of our sales channels, we display merchandise in an educational context by providing detailed information regarding the designer and key design and functional elements about each product. We obtain our merchandise from select designers and manufacturers both domestic and foreign that meet our stringent requirements for design, quality, packaging, and consistency of production and flow. We believe that our unique assortment of innovative and often hard-to-find products serves as a competitive advantage and provides our customers with a distinctive shopping experience. We believe our success requires the development and maintenance of a broad base of residential and commercial customers. Our customers include design professionals, consumers with an interest in modern design and commercial clients. We target educated consumers focused on quality of life and interested in self-enrichment. Historically, our residential customers have been almost as likely to be male as female, have spanned a wide range of ages and typically have had household incomes greater than $75,000. We sell to the following commercial customers, who we believe are representative of our commercial customer base in a number of different industries, including: architects and designers such as Art Design and SHW Group, Inc., restaurants such as BJ’s Restaurants, Inc. and Krispy Kreme Doughnuts Inc., institutions of higher education such as New York University and Rhode Island School of Design, retailers such as The Gap, Inc. and The Limited Brands, Inc. and service firms such as Fitch, Inc. and iSTAR Financial Inc. A significant percentage of our commercial sales are to ses with an interest in, or focus on, design, such as restaurants, salons and boutiques. We also seek to establish close, lasting relationships with notable and emerging designers and manufacturers. While modern design products have been widely popular in Europe for decades, we believe distribution channels in the United States have historically been limited principally to local boutiques and interior designers. This has restricted product availability and exposure in the United States, reducing opportunities for both designers and manufacturers. We believe we are providing European and American designers with broader, more efficient access to the U.S. modern design furnishings market. In that role, we have developed relationships with leading and emerging designers and manufacturers of design products, many of whom have sought us out as a platform for further exposure and distribution of their products. We began selling products through our catalog and online in the second half of 1999. We opened our first studio in November 2000. During the last three years, we have continued to increase sales across all distribution channels with particular growth in studio sales. We have increased the number of our studios from one at the end of 2001 to 56 as of December 31, 2005. We expect to open 10 to 15 new studios during each of fiscal years 2006 and 2007. As of December 31, 2005, we had signed leases for four additional studios, two of which were opened as of March 31, 2006 and the other two are scheduled to open in mid 2006. Modern Design Modern design is a twentieth century movement, the purpose of which is to utilize current technologies and production methods to create more useful products for a broad audience. The movement was driven by many important designers and architects, including Ludwig Mies van der Rohe, Charles and Ray Eames and Le Corbusier, among others, and has its origins within the German Bauhaus school in the 1920s and the post-World War II mid-century modernists. Modern design is concerned more with functionality than with appearance. As such, modern design is not a decorative style, but rather a discipline where a product’s form follows its function. A product achieves its value through utility and performance, and a well-designed product is one that performs its task especially well and elegantly. Characteristics of modern design furnishings are simplicity, originality, intelligent use of materials, quality, longevity and the avoidance of superfluous ornamentation or period styling. We offer products created by the classic authors of modern design, as well as products created by emerging designers, and strive in all aspects of our business to enhance appreciation of modern design. Industry Overview The residential and commercial furnishings market encompasses a variety of goods, including furniture, floor coverings, lighting and accessories. Sales in the U.S. home furnishings and bedding market were estimated at approximately $79.0 billion in 2005 and are projected to grow 4.2% annually to $94.0 billion by 2009, according to Retail Forward, a business information company specializing in industry analysis and forecasts. Sales in the U.S. office furnishings market were approximately $11.9 billion in 2005, growing 12.3% from $10.6 billion in 2004, according to BIFMA International, a not-for-profit trade association of furniture manufacturers and suppliers whose strategic area of focus includes, among other things, statistical data generation. The modern design furnishings market is a sub-sector of the residential and commercial furnishings market. We believe that the upscale segment of this market, in which we operate, will continue to benefit from several long-term trends, including an increasing interest in modern design, middle-market consumers’ willingness to trade up for premium products and favorable demographic trends. We believe the increased focus on design covers a wide range of products both within and beyond the traditional furnishings market, from home computers to kitchen appliances. Consumers’ expanding focus on design has been featured in several television programs, such as Bravo Network’s Queer Eye for the Straight Guy , which has featured some of our products, and The Learning Channel’s Trading Spaces , as well as in books and other publications, including Michael Silverstein’s book, Trading Up: The New American Luxury. According to the U.S. Department of Commerce, the disposable income of consumers has increased from 2000 through 2005. These consumers are driving increased sales of premium goods and services, which deliver higher quality, technical advantages and superior performance relative to conventional products. These premium products typically command higher prices and gross margins than traditional products. We believe that the household “cocooning” trend among consumers has also had a significant impact on our market. As more consumers retreat to their homes to spend time with family and friends, we believe that quality, home-related design products have become increasingly popular. We believe many consumers are interested in modern design products, but are not familiar with, or are hesitant to engage, the more traditional sales channels, such as interior designers or expensive boutiques. Businesses have also begun to place more emphasis on modern design. We believe that many manufacturers are turning to design as an important differentiator of their products. A November 2003 article in Fortune magazine highlighted organizational initiatives at several major corporations, which have created new positions for design professionals and promoted other design professionals, reflecting the growing importance of design in selling their products. We believe ses, which account for a significant portion of our commercial sales, historically have also had difficulties gaining access to modern design furnishings. We believe that the modern design furnishings industry has generally marketed and sold modern design products in a manner that effectively excludes ses as buyers. Factors that contribute to the exclusion of ses from the market for modern design products include: the imposition of minimum order requirements that often exceed such buyers’ requirements, limited physical presence of product sellers in smaller markets; and lack of interest from product distributors to sell to smaller buyers, among others. We believe this large segment of the commercial market has traditionally been underserved and will continue to be particularly receptive to our product offerings. We believe our business model makes design-oriented products available for convenient purchase to a broad array of residential and commercial consumers and provides enhanced consumer education and product information to our customers, helping us further expand and penetrate the market for modern design products. Business Strengths We believe our business strategy and strengths position us to be a leading provider of modern design furnishings in the United States. We believe that our business model is differentiated in several key respects from those of traditional retailers and serves as a competitive strength. We intend to increase market penetration through our strong brand authority, multiple and integrated sales channels, distinctive merchandising, strategic designer and manufacturer relationships, superior customer service and the efforts of our experienced management team. In addition, in fiscal year 2006, we plan to offer substantially fewer promotional discounts than in fiscal year 2005. We have reduced the number of promotions in an effort to improve our gross margins. Strong Brand Authority Since our founding, an integral part of our strategy has been to build the Design Within Reach brand both within the design community and among residential and commercial consumers. To build our brand, we have cultivated relationships with leading designers, highlighted designers and classic design products throughout our sales channels, and carefully sourced products that embody the principles of enduring design, performance and authenticity. Our publications have broad consumer reach. In fiscal year 2005, we distributed on average over 997,000 catalogs each month, and more than 370,000 people currently receive our bi-weekly electronic newsletter, “Design Notes.” We have also sponsored design conferences and other design education activities, such as studio events and design contests, which further increase public awareness of our brand. Recent examples include a studio event featuring Philippe Starck discussing his philosophy and the progression of design, a co-sponsorship of a smallest, coolest apartment design contest, a furniture design contest and exhibition which brought together over 500 people in support of Chicago area design talent and a lecture on textiles and the development of new designs. Through these activities, we believe that the Design Within Reach brand provides our products with authenticity among our customers and has become associated with design excellence both in the design community and with residential and commercial consumers with an interest in modern design. Multiple, Integrated Sales Channels We market and sell our products to both residential and commercial customers through three integrated sales channels, consisting of phone, studios and online. We believe our multi-channel strategy enhances our ability to access and serve our customers while improving operational efficiency. This strategy allows us to better serve customers who may prefer shopping for products in different formats, facilitates rapid and direct feedback as to customer needs and satisfaction, and provides broader exposure and reinforcement of the Design Within Reach brand. Customer service is further enhanced by providing superior convenience, by cost effectively communicating educational information about our products and design in general and by permitting customers to view our complete product selection. During the second half of fiscal year 2005, approximately 67% of online buyers had previously been mailed a catalog and chose to purchase at www.dwr.com , sometimes after visiting a studio or speaking with a customer service representative over the phone. Our studios enable us to provide the touch and feel of our merchandise to customers and provide a local presence for enhancing market penetration. Our website serves as an information source for both our studio and catalog customers, as well as for our own business development executives. We maintain consistent pricing across all of our sales channels for all of our customers. Our strategy also improves operational efficiency through the utilization of a common inventory and centralized information systems. Operating from a common inventory allows us to maintain a high proportion of our products in stock at all times and facilitates more efficient inventory turns. In fiscal year 2005, we had an initial fulfillment rate, meaning the product was in stock and ready to ship at the time of order, of approximately 80%, and we achieved 5.0 turns of our pickable inventory (defined as annual product cost of goods sold divided by average product inventory in our fulfillment center and available for sale to our customers, over the preceding thirteen months). In addition, our integrated channel strategy and common inventory enable us to centralize our management information systems. A centralized system also permits us to utilize experience and information from each channel to benefit the others. For example, we deploy customer data from our phone and online channels to identify promising markets and to increase the effectiveness of our studio site selection process. Distinctive Merchandising We seek to be a leader in identifying and selling products that are innovative and not widely available from other retailers. In fiscal year 2005, 32.7% of our net sales were derived from products for which we believe we were the sole supplier in the United States. While we do not have exclusivity agreements with our manufacturers, we believe we are the sole supplier of many products we carry. We take a selective approach to product sourcing, and new products must meet our stringent standards for design, quality and authenticity before they are selected for inclusion in our product assortment. We ensure that the price, look and feel of our products is consistent across all sales channels to provide a cohesive product image to our customers. A crucial element of our merchandising is the belief that each well-designed product should be presented as a stand-alone item, rather than as part of a prepackaged set. Therefore, we present and describe our products in a clear, concise and specific manner, including by providing line drawings for each product with its measurements. We complement our merchandise mix with authoritative educational content regarding the designers of our products and other design topics. We believe that our merchandising approach delivers large average order values, along with attractive gross margins and returns on capital. Strategic Designer, Manufacturer and Distributor Relationships We purchase merchandise from select domestic and foreign designers, manufacturers and distributors that meet our stringent requirements for design, quality, packaging, and consistency of production and flow. We currently source products from over 200 vendors, many of which are small, family-owned businesses. Although we do not have any formal written agreements with designers, manufacturers and distributors, we believe that we have developed strong informal business relationships with such entities. These relationships have developed over time principally because these designers, manufacturers and distributors have prospered along with our growth, which has fostered loyalty towards us by these entities. For example, we purchase products from our vendors frequently and in large volumes, and in many cases we are a vendor’s largest customer. As a result, we have been able to develop strong relationships with most of our vendors and approximately 32.7% of our net sales were derived from products for which we believe have become the de facto sole provider in the United States. In addition, we seek to strengthen our relationships with designers by highlighting the design community in our publications and on our website, as well as through our educational efforts across all sales channels. Our credibility and reputation with residential and commercial consumers for high quality, innovative modern design products is further enhanced by our relationships with larger, more prominent vendors from around the world, such as Herman Miller, Inc., Vitra Inc., Knoll, Inc., Cassina S.p.A. and Kartell US Inc. Developing and maintaining our relationships with these designers and manufacturers is a critical component of our strategy. Superior Customer Service Since inception, we have focused on providing what we believe to be superior customer service in each of our sales channels. Our policy of having products “in stock and ready to ship” is a departure from the approach taken by many other modern design furnishings retailers, which we believe typically requires customers to wait weeks or months to receive their products. In fiscal year 2005 we had an initial fulfillment rate, meaning the product was in stock and ready to ship at the time of order, of approximately 80%, and we shipped substantially all in stock product by the next business day after receiving the order. Our fulfillment center in Hebron, Kentucky is located within a two-day drive time for delivery for a majority of the U.S. population, which has enhanced our level of customer service. Other key elements of our customer service include: well-designed and attractive catalogs; knowledgeable sales personnel; our easy-to-use website for around-the-clock purchases; extensive product information; and insightful design-oriented commentary. Our sales personnel work in a coordinated fashion across all of our sales channels with the goal of providing a satisfying and educational experience to all customers. We typically hire our sales personnel from the design community, and we believe that their passion and knowledge enables them to interact effectively with design professionals and residential and commercial consumers in all channels. The turnover rate among our sales personnel has historically been low, which we believe results from our sales personnel seeing their position with us as a career opportunity. Experienced Management Team We were founded in 1998 by Robert Forbes, Jr., who continues to be our leading influence in modern design and our principal contact with the design community. Tara Poseley assumed the role of Chief Executive Officer in October 2005. Ms. Poseley succeeded Wayne Badovinus who had held the role since May of 2000. Ms. Poseley joined DWR in August 2004 from the Gap Inc., where she worked for 15 years. At Gap, she held various senior level positions within the various divisions, including General Manager of GapKids, Baby Gap, and Gap Body. Ms. Poseley has assembled an experienced management team whose members have on average approximately 20 years of experience with leading companies in the retail and consumer products industries. We intend to leverage our management team’s experience and acumen to execute our strategy effectively. Growth Strategy Our goal is to strengthen our position as a leading provider of modern design furnishings and accessories. We believe that as a truly integrated multi-channel business, we must measure ourselves by total market penetration, or sales across all of our channels. Accordingly, we focus on increasing the overall penetration of our target markets, rather than on increasing sales in a particular channel. This helps us avoid conflicts among channels, which often occurs in traditional retail models. We select our target markets based upon population statistics and our current sales in those markets. We intend to increase our market penetration nationwide and within selected markets by opening additional studios, expanding and refining our product offerings, increasing marketing within and across our sales channels and expanding market awareness and appreciation for design products. Open Additional Studios Our studios have become an integral part of our multi-channel strategy by providing customers with the ability to touch and feel our products and by bringing our philosophy and products to life. We believe that our studio concept has broad appeal, offers attractive financial returns and can potentially be implemented successfully in many additional markets across the United States. We opened our first studio in November 2000 and have expanded from one studio at the end of 2001 to 56 studios operating in 21 states and the District of Columbia at the end of fiscal year 2005. During fiscal year 2005, we opened 23 new studios, many of them in smaller urban markets. This was our first significant studio deployment outside major metropolitan areas. As of December 31, 2005, we did not have sufficient information to determine how quickly these locations would reach their normal run rate, or how they would ultimately compare with their counterparts in larger urban markets. We are currently monitoring and analyzing studio results in these areas, and have developed tailored advertising programs to drive awareness in these markets. We expect to open 10 to 15 new studios in each fiscal year of 2006 and 2007, both in major and smaller urban markets. In fiscal year 2006, we anticipate opening the majority of our projected new studios for the fiscal year during the first half of the year. As of December 31, 2005, we had signed leases for four additional studios, two of which were opened as of March 31, 2006 and the other two are scheduled to open in mid 2006. We generally seek to occupy street-front locations in moderate rent areas, which allows us to become visible and integrated in a neighborhood while obtaining attractive rental payments. We believe our studios have compelling unit-level economics. In fiscal year 2005, studios open the entire twelve months had an average annual sales volume of $2.5 million and an average annual studio operating margin of 19.3%. These studios had an average ten-month payback on an average initial investment of approximately $527,000, including net buildout and pre-opening expenses and the cost of product floor samples. We intend to use the additional studios to gain market share and to secure a strong competitive position in each market where our studios are located, with support from our other sales channels. Expand and Edit Product Offerings We believe there are substantial opportunities in the near-term to utilize our brand attributes of enduring design, quality and authenticity to expand our product offerings within existing categories and enter into new, complementary categories. We regularly evaluate and edit our merchandise assortment based upon product performance, compatibility and margin. In recent years, we introduced several new product categories, such as bedroom furnishings and mattresses, floor coverings and lighting. In fiscal year 2005, we launched children’s furniture and bedding products. We also intend to focus on and expand the number of product offerings for which we believe we are the sole supplier in the United States. We believe that any product that meets our standards for design attributes and quality is a candidate to be added to our product assortment, and in the future we may seek out opportunities to market products beyond residential and commercial furnishings and accessories. Increase Marketing Within and Across Our Sales Channels We believe that opportunities exist to expand net sales with marketing initiatives focused within and across each of our sales channels. In fiscal year 2006, we are testing larger catalog sizes and increased mailing frequency to our top customers and prospective customers to increase response to our catalog channel. At the same time, we have reduced total mailings to reduce costs and improve our response rates. Additionally, we believe that we can enhance marketing efficiency by promoting our studio locations and openings in our catalogs and on our website and by utilizing customer data obtained from our catalog and online channels to target future studio openings. Our studios contain computers for online access to www.dwr.com , and we encourage in-studio sales personnel to promote online usage and to distribute our catalogs. To enhance online sales, we intend to develop additional website functionality and to implement additional third-party marketing agreements, such as our existing agreements with selected search engines. Expand Market Awareness and Appreciation for Design Products We intend to expand our addressable market by continuing to use each of our sales channels to promote innovative design products and to educate consumers on the principles of modern design. We seek to educate consumers through our weekly electronic newsletter, catalogs and other special publications, such as our republication of the classic design book How to See , by George Nelson, and through periodic design seminars, conferences, studio events and design contests. For example, we recently completed our third annual online contest asking customers to create chairs made from the corks and wire cages of champagne bottles. In our third annual contest, we received over 650 entries and, following the contest, as of March 31, 2006, we are now conducting traveling exhibitions of 50 of the leading entries for display in our studios. We often host events featuring industry speakers and promote studios by hosting in-studio activities such as wine tastings for consumers and neighboring galleries. Additionally, in fiscal year 2006 we will be testing and evaluating additional marketing vehicles, such as magazine print ads and other direct mail alternatives to increase awareness of our brand. We believe that these activities will enhance consumers’ appreciation of modern design and expand the market for our products. Product Merchandising Our merchandising strategy is to offer well-designed products that are versatile and can be comfortably integrated with other furnishings. As such, we are selective in the products we offer and present our products as stand-alone items, rather than as part of a prepackaged set. The principles that guide our merchandising decisions are authorship, attention to detail, simplicity, quality of materials and authenticity. Our product offering includes a refined assortment of chairs and tables, workspace and outdoor furniture, lighting, floor coverings, bedroom furnishings and related accessories, bathroom fixtures, fans and other home and office accessories. We manage our merchandise offering utilizing six general product designations:     •   Design Icons . These are products recognized throughout the design community and by knowledgeable residential and commercial consumers as legitimate examples of historically significant designs. Offering design icons for sale is a crucial element of our merchandising strategy since they carry their own design authority, which we use to build our Design Within Reach brand. We anticipate that design icons will continue to be an important part of our product assortment. Examples of design icons that we offer include: Noguchi Table—Designed in 1944 by Isamu Noguchi for Herman Miller, Inc., this is a practical glass-top table for commercial or residential use in which two simple, smoothly shaped solid wood pieces interlock to form a tripod that supports a three-quarter inch slab of transparent glass. Arco Floor Lamp—Designed in 1962 by Achille Castiglioni and Pier Giacomo Castiglioni, this is a classic modern lighting design characterized by the dramatic arc of its stainless steel stem and the counterpoint provided by the substantial Carrara marble base. The lamp is designed to provide overhead lighting without ceiling suspension, and its light intensity makes it useful for reading, working or dining.     •   Commissioned Designs . These are products that we have commissioned and developed. We will leverage our strong relationships with world-class designers to design products exclusively for us. Going forward we intend to focus on and expand the number of internally developed products in our assortment. Examples of commissioned designs that we offer include: Flight Recliner—Designed in 2005 by Jeffrey Bernett. The Flight Recliner has none of the bulkiness of a traditional recliner. Mr. Bernett has created a lightly-scaled, comfortable recliner that is targeted for our urban customer. Theater Sofa Collection—Designed in 2001 by Ted Boerner. This modern sofa collection has minimalist appeal while at the same time does not compromise comfort. The Theater collection is targeted for both the residential and commercial customer.     •   Design Exclusives . These are products for which we believe we are the sole supplier in the United States. Design exclusives utilize the strength of the Design Within Reach brand to supplement their appeal to customers. Going forward we intend to focus on and expand the number of design exclusives that we market. We believe that we are developing the brand authority and marketing strength to introduce design exclusives, which may become recognized in the future as design icons. Examples of design exclusives that we offer include: Globus Chair—Designed in 1993 by Jesus Gasca, this is a sophisticated and practical dining chair designed for both commercial and residential use. The chair has a stainless steel frame and wood lacquer back and stacks up to five chairs high. Sussex Credenza—Designed in 2000 by Terence Woodgate and inspired by the shingled, angled roof of a Sussex cottage, this credenza features four louvered doors with dominant horizontal lines that mimic the credenza’s rectangular shape, oak veneer applied to all sides, compartments with adjustable shelves and a steel base that lends further aesthetic appeal and acts as a stable foundation.     •   Design Solutions . These are products that we believe provide superior results in solving customer problems in functionality, aesthetic appeal and, in many cases, economy. We believe that the Design Within Reach brand further strengthens the appeal of these products as intelligent answers for residential and commercial customers’ furniture needs. We believe that commercial customers find many of these products particularly attractive because of their problem-solving attributes. Products designated as design solutions generally remain in our merchandise assortment until another product offering a better solution becomes available. Examples of design solutions that we offer include: Coco Armchair—Designed in 2001 by Fratelli Tominaga, this is a lightweight and sturdy dining chair that is built for easy maneuvering. The chair is constructed from durable beechwood and features a continuous barrel backrest which doubles as an armrest and can be hung on a tabletop or stacked to open floor space for cleaning or storage. The chair’s seat is subtly contoured for comfort and a single piece of wood acts as the back leg and forms a portion of the backrest for maximum strength. Sliding Sofa—Designed in 2000 by Pietro Arosio for Tacchini, this is a sofa with clean lines and modern proportions that easily transforms into a two-person bed by sliding the base of the sofa out from the backrest. Its seat cushions and backrest provide the platform for both sitting and sleeping, and it also comes with two large feather-filled pillows. The upholstery is fully removable for cleaning, and the aluminum frame is fitted with two casters for easy mobility.     •   Performance Designs . These are products designed to serve distinctive functional roles in the application for which they are used. They tend to have a predictable demand curve and, unlike design icons, may cycle out of our assortment as customer interest diminishes. Products designated as performance design typically represent a significant percentage of the new products offered in our catalogs. Based upon consumer response or product sales performance, these products may evolve into other of our product designations, such as design solutions. Examples of performance designs that we offer include: Cubitec Shelving—Designed in 1998 by Doron Lachish, this is a modular shelving system consisting of lightweight polypropylene panels, which may be easily assembled into multiple configurations of cubes. Each kit contains eighteen panels to create six cubes, which can be attached vertically or horizontally. The shelving comes in a variety of colors and can be used in a wide-range of residential and commercial environments. Kyoto Chair—A clean-looking chair constructed with beechwood, with an unusual broad back. The Kyoto Chair is so named because it is a popular café chair in Japan.     •   Design Accessories . These are products that supplement our larger assortment and enhance the utility of larger products. We have found design accessories to be important in increasing customer response rates and broadening our customer base. Design accessories also present opportunities for us to introduce new design products, which may evolve into significant separate product lines. Examples of design accessories that we offer include: Nelson Ball Clock—Designed in the 1950’s by George Nelson, this is a thirteen-inch diameter circular clock, the circumference of which is comprised of twelve small balls each connected by a rod to the clock’s center. PH5 Pendant Lamp—Designed in the 1950’s by Poul Henningsen, this is a hanging ceiling lamp that has been widely used in Europe for decades. The lamp’s shade is comprised of layers of varying sizes and shapes that direct light both horizontally and vertically. The lamp is compact enough to allow multiple lamps to be hung in the same setting and can be used in both residential and commercial applications. We believe there are many product lines that can be developed in addition to residential and commercial furnishings and accessories, and we are constantly looking for ways to further leverage our brand recognition for design and quality. Our merchant and inventory planning teams meet weekly to review selling rates and make decisions regarding our merchandise assortment based on product performance. We manage over 850 active products and regularly review the bottom third of our assortment and discontinue unproductive items. This process allows us to introduce new items each year while maintaining our focus on product management and inventory turnover. For example, in 2005, our top 100 products represented 51% of our net sales. When we discontinue an item, the remaining inventory of that item is offered as a clearance item through our website. Sales Channels We established our business strategy on the premise that multiple, integrated sales channels improve customer convenience, reinforce brand awareness, enhance customer knowledge of our products, and produce operational benefits that ultimately improve market penetration and returns on capital. The objective of each of our sales channels is to maximize total market penetration. Phone Sales Our phone sales consist of sales of merchandise through the toll-free numbers associated with our printed catalogs. Our full-color catalog is mailed every month and serves as our primary brand building and marketing tool. By mailing our catalogs in large quantities in selected markets, we are able to reach a substantial audience, reduce the need for large expenditures on traditional advertising and marketing and generate additional sales across all of our channels. In fiscal year 2005, we distributed 12.0 million catalogs to existing and prospective customers compared to 11.3 million in fiscal year 2004. In fiscal year 2005, phone sales totaled $22.3 million compared to $25.5 million in 2004, a 12.3% decrease as more customers moved to the web and our studios. Our catalog reflects the values of the modern design community, with clean and simple graphic layouts and low-density and easily-readable typeface. Copy is simple, direct and informative. Line drawings and measurements complete the straightforward presentation of each product. The catalog also addresses product functionality, such as the ability to stack chairs, the durability of fabrics and ergonomic features. Additionally, our catalogs provide historical information about our products, many of which have rich design legacies, and generally feature the designers pictured with their products. This approach signals to the customer our respect for the design community, and we believe that it has been one of the most appreciated aspects of our catalog. In fiscal year 2005, our catalogs generally ranged from between 80 and 100 pages and contained between 350 and 400 products. Catalog circulation is focused on:     •   current buyers and catalog requestors;     •   interior designers and architects;     •   other professionals whose work involves design, such as graphic artists;     •   subscribers to design-focused magazines; and     •   purchasers of products from related consumer catalogs and retail stores We have introduced smaller catalogs as part of our circulation strategy. These smaller catalogs contain our most popular products as well as new items and are mailed to prospective customers in markets where we have studios and in other select markets. We believe this has enabled us to more cost-effectively reach new customers, improve our response rates and order sizes and lower our per customer acquisition costs across all of our sales channels. These smaller catalogs generally range from between 50 and 60 pages and contain between 200 and 240 products. In fiscal year 2006, we are testing larger catalog sizes and increased mailing frequency to our top customers and believe this will increase the response to our catalog among this customer segment. Studio Sales The role of our studios is to bring modern design to customers’ neighborhoods and allow them to experience our products first hand. In fiscal year 2005, studio net sales totaled $88.2 million, representing a 66.9% increase from fiscal year 2004. Our studios have increased from one at the end of fiscal year 2001 to 56 studios operating in 21 states and the District of Columbia at the end of fiscal year 2005. During fiscal year 2005, we opened 23 new studios, many of them in smaller urban markets. This was our first significant studio deployment outside major metropolitan areas. As of December 31, 2005, we did not have sufficient information to determine how quickly these locations would reach their normal run rate, or how they would ultimately compare with their counterparts in larger urban markets. We are currently monitoring and analyzing studio results in these areas, and have developed tailored advertising programs to drive awareness in these markets. We expect to open 10 to 15 new studios in each fiscal year of 2006 and 2007, both in major and smaller urban markets. In fiscal year 2006, we anticipate opening the majority of our projected new studios for the year during the first half of the year. As of December 31, 2005, we had signed leases for four additional studios, two of which were opened as of March 31, 2006 and the other two are scheduled to open in mid 2006. Like our catalog and website, our studios are designed to reinforce our multi-channel strategy. For example, during the second half of fiscal year 2005, approximately 50% of buyers in our studios had been mailed a catalog prior to making a purchase. The design of our studios is understated and reflects the clean, simple aesthetics established by the catalog. This allows us to highlight the design elements of our merchandise. Studio sizes range from approximately 1,200 to 18,000 square feet. We are targeting our future studios to be approximately 4,500 square feet on average. Most studios are located in buildings with architectural elements such as brick walls, hardwood floors, high ceilings or exposed beams, which we believe provide the appropriate atmosphere for our products. Since studios are often located in architecturally distinctive buildings, sometimes not originally intended for retail use, our floor plans may vary. However, all of our studios feature designer-oriented graphics and include our “chair-wall,” which showcases a variety of the chairs we offer on clean white display risers. Each studio’s selection of tables, lounges, lighting, shelving and other items are displayed throughout the remainder of the studio. Signage is understated but informative and is meant to reflect our design community approach. Since our studios only contain product samples and do not stock inventory for purchase, we are able to devote substantially all of our studio space to showcasing and selling products while also reducing product shrinkage, in-studio costs and the number of studio personnel. Customers are encouraged to touch the products and treat the studio as their own design hub, allowing them to learn about our products in a friendly and informal atmosphere. Computers with direct connections to www.dwr.com are available in our studios, and salespeople are trained to take customers to our website and instruct them in its use. We generally staff our studios with one manager, whom we refer to as a proprietor, and two to three sales associates. We select proprietors from the design community who bring a passion for, and knowledge base about, design. The studio proprietors are responsible for creating traffic in the studios through in-house design events, hiring and training sales associates, and ultimately leading the sales effort for their studio. Because our studios contain only product samples and do not stock inventory for purchase, we are able to staff our studios leanly and our studio personnel are able to focus on delivering a superior level of service and information to our customers. Both studio proprietors and sales associates work on an incentive-based compensation structure that includes salary, commission and bonus. We believe that our studio employees have the opportunity to earn higher compensation than traditional home furnishings retail employees. Target markets for studio openings are identified based partly on household population statistics, but also on supporting sales data collected from our other channels. Studios are located typically in moderate rent areas and usually occupy street-front space. In fiscal year 2005, studios open the entire twelve months had an average annual sales volume of $2.5 million and an average annual studio operating margin of 19.3%. Our average initial investment per studio opened during fiscal year 2005 was approximately $527,000, including net build-out and pre-opening expenses and the cost of product floor samples. Online Sales We created our website, www.dwr.com , to be a readily available resource for modern design furnishings and to support sales and customer service activities 24 hours a day. In fiscal year 2005, our online sales totaled $29.2 million, representing a 16.2% increase from fiscal year 2004. Our website is designed to be consistent with our catalog, with clean and simple layouts. We believe that other features such as zoom, product color changes, and printable product specifications, increase functionality and differentiate our website from those of our competitors. Online sales are an essential component of our multi-channel strategy. During the second half of fiscal year 2005, approximately 67% of online buyers had previously been mailed a catalog but chose to purchase at www.dwr.com , often after visiting a studio or speaking with a customer service representative over the phone. In addition to driving traffic to our website through our other sales channels, we have entered into marketing agreements with select agencies to manage multiple pay-per-click search engine campaigns to increase the number of qualified visits to our website. One additional feature that has developed into a central part of our strategy is a bi-weekly outgoing e-mail called “Design Notes.” This newsletter currently has a circulation of more than 370,000 and covers a wide range of design topics. The newsletter provides information about our products and also features general industry discussions on topics such as urban design, automobile design, mass transit systems and profiles of specific designers. With an average opt-out rate, meaning the number of requests from newsletter recipients that we discontinue sending them our newsletter as a percentage of total newsletters sent out, of 2% in fiscal year 2005, the newsletter is an important tool allowing us to make valuable contacts with design enthusiasts and potential customers. We have also used our website and “Design Notes” as testing grounds for new products, as they have proven to be effective media for receiving prompt customer feedback. Product Sourcing We continually seek to identify and introduce new products that meet our stringent design and quality standards. We provide designers and manufacturers with a forum through which they can significantly enhance the exposure and distribution of their products. We cultivate vendor relationships and host a biennial conference where we communicate openly with our vendor base regarding our expansion strategy and product requirements. We employ a specialized merchandising team that actively participates with manufacturers and designers in the design process for many new products. Our founder and our merchandising team travel regularly to European and domestic markets visiting trade shows, designers and manufacturers in search of innovative new product offerings. Once a product has been approved for inclusion in our product assortment, we negotiate with the product’s vendor to secure product supply. In an effort to ensure consistent product flow from our manufacturers, our inventory planning team supplies select vendors with a six-month rolling forecast of projected purchases. When determining which products to introduce, we estimate the potential sales, gross margin and returns on capital. We also assess whether a product has the potential to be available through mass merchant channels, which would dilute the uniqueness of the product. In fiscal year 2005 approximately 32.7% of our net sales were derived from products for which we believe we were the sole supplier in the United States. Going forward, we will seek to increase this percentage. We depend on select designers, manufacturers and distributors to develop and manufacture products for us. We do not have any contractual relationships with these suppliers. However, we represent the largest share of business for many of them. We currently conduct business with over 200 designers, manufacturers and distributors, over half of which are located outside the United States. In fiscal year 2005, our largest vendor, Herman Miller, Inc., supplied us with products representing 11.2% of our net sales, and products supplied by our five largest vendors represented approximately 29.1% of net sales. Customer Service We are committed to providing our customers with courteous, knowledgeable and prompt service across all our channels. We have customer service representatives located at our corporate headquarters in San Francisco, California. Our agents are available to take calls from 9:00 a.m. to 9:00 p.m. Eastern time, Monday through Friday, and 10:00 a.m. to 6:30 p.m. Eastern time on Saturday. Our customer service center is staffed with DWR representatives who are interested in design and knowledgeable about our products. Our customer service representatives handled, on average, approximately 15,000 customer contacts monthly in fiscal year 2005. Our representatives provide personal attention to customers who call toll free or send e-mails to request a catalog subscription, place an order or inquire about a product. Our customer service group also is responsible for resolving customer complaints. If a customer is not satisfied with one of our products, he or she can return it for repair, replacement or refund. We seek to hire and retain qualified sales and customer service representatives in both our customer service center and studio operations. As of December 31, 2005, approximately half of our studio personnel either had a degree in design or prior work experience as a design professional. Each new studio proprietor undergoes a thorough training program during which he or she is trained in all aspects of our business. Studio sales personnel are trained extensively prior to a new studio opening. This training focuses primarily on giving them a working knowledge of our products, augmenting their knowledge regarding featured designers and ensuring that they understand our high customer service standards. We have also developed ongoing programs conducted at each studio that are designed to keep each salesperson up-to-date on each new product offered. During January 2004, we launched a private label credit card program, which is administered by World Financial Network National Bank. We bear no credit risk in connection with this program. As of December 31, 2005, approximately 9,700 cards had been issued. Fulfillment Substantially, all product orders from each of our sales channels are fulfilled from our facility in Hebron, Kentucky of approximately 317,000 square feet, except in limited cases where the product is shipped directly to the customer from the manufacturer. We expect this facility to support our distribution capacity for our existing and future needs. We believe this facility has enhanced our level of customer service with order fulfillment occurring within a two day drive time for delivery for the majority of the U.S. population. Shipment of products from our fulfillment center to our customers is through third-party carriers. Our goal is to ship the majority of customer orders within 24 to 48 hours after the order is received. In fiscal year 2005, we had an initial fulfillment rate, meaning the product was in stock and ready to ship at the time of order, of approximately 80%, and we shipped substantially all in stock product by the next business day after receiving the order. Information Technology and Systems In May 2005, we converted our 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 this 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 the existing 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 expect to finalize the specifications for the new system, hire a consulting firm and begin the process of developing, testing and implementing the new system. We are currently targeting an early fiscal year 2007 installation of the new system. Our website is located at a third-party hosting facility in Santa Clara, California. The hardware configuration includes firewalls, scalable servers, and other network enhancing features. This configuration allowed us to maintain 99.8% availability and a 1.4 second average response time over broadband during fiscal year 2005. Competition The market for residential and commercial furnishings is fragmented with no single company holding a dominant market position. The market includes numerous smaller specialty retailers, as well as department stores, larger mass merchandisers and home furnishings stores, with department stores commanding a decreasing percentage of the furnishings industry compared to specialty retailers. In recent years, the industry has been characterized by consolidation, the withdrawal of certain retailers from the marketplace and a de-emphasis by traditional department stores on upscale merchandise, leaving fewer large competitors focused exclusively on this segment of the furnishings market. We face competition from several sources, including the following:     •   modern design companies selling solely through catalog and online, such as Oriac Design Corp. and Topdeq Corporation;     •   regional retailers specializing in modern design, such as Limn, The Magazine, Murray Moss and Slater/Marinoff & Co.;     •   national or multinational retailers such as Crate & Barrel, CB2 (a company owned by Euromarket Designs, Inc.), Ethan Allen Interiors, Inc., Home Decorators Collection, IKEA, Pottery Barn and West Elm (divisions of Williams-Sonoma, Inc.), Restoration Hardware, Inc. and Room & Board, Inc.; and     •   manufacturers whose products we sell, such as Cassina S.p.A., Herman Miller, Inc., Kartell US Inc., Knoll, Inc., Steelcase, Inc. and Vitra Inc., selling through other authorized dealerships. Many of our competitors are larger than us and have substantially greater financial, marketing and other resources than we do. However, many smaller specialty retailers may lack the financial resources, infrastructure and national brand identity necessary to compete effectively with us. The U.S. retail industry, along with the catalog and online commerce sectors are highly competitive, dynamic in nature and have undergone significant change over the past several years. Our ability to anticipate and respond successfully to these changes is critical to our long-term growth. If we are unable to maintain or increase our market share or compete effectively in the furnishings market, our business, financial condition and operating results would be adversely affected. We believe that the ability to compete successfully is determined by a variety of factors, including quality of product selection, effective product presentation, customer service and pricing. We believe that we compete favorably on the basis of these factors. Intellectual Property We believe that our trademarks, including our registered trademark, “Design Within Reach,” and the brand name recognition that we have developed are of significant value. We strive to preserve the quality of our brand name and protect all of our intellectual property rights, which include the copyrights in our catalogs, rights to our domain name, www.dwr.com , databases and information management systems, and licenses for software for our desktop computers, to ensure that the value of our proprietary rights is maintained. We attempt to protect our intellectual property rights on our commissioned designs, both in the United States and in foreign countries, through a combination of trademark, copyright and trade secret laws, as well as licensing agreements and third-party nondisclosure and assignment agreements. We rely on various intellectual property laws and contractual restrictions to protect our proprietary rights. These include trademark, copyright and trade secret laws and confidentiality, invention assignment and nondisclosure agreements with our employees, contractors and suppliers. Employees At December 31, 2005, we had 356 employees, of whom 303 were engaged in selling and administrative functions, and 53 were involved in sourcing or fulfillment functions. Available Information A copy of any of the materials we file with the SEC may be inspected without charge at the public reference room maintained by the SEC, located at 450 Fifth Street, N.W., Room 1200, Washington, DC 20549. Please call the SEC at 1-800-SEC-0330 for further information about the public reference room. The SEC also maintains an Internet website that contains reports, proxy and information statements and other information regarding registrants that file electronically with the SEC. The address of the site is www.sec.gov . We file periodic reports, proxy statements and other information with the SEC. Such periodic reports, proxy statements and other information are available for inspection and copying at the public reference room and website of the SEC referred to above. We maintain a website at www.dwr.com. You may access our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act with the SEC free or charge at our website as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. The reference to our web address does not constitute incorporation by reference of the information contained at or accessible through this site. 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. 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 56 studios as of December 31, 2005. 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 ou