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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the fiscal year ended January 31, 2005

OR

For the transition period from                     to                     

Commission File Number 0-15827

SHARPER IMAGE CORPORATION

(Exact name of registrant as specified in its charter)

Registrant’s telephone number including area code:

(415) 445-6000

Securities registered pursuant to Section 12(b) of the Act:

None

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, par value $.01

(Title of Class)

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

Indicate by check mark whether registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).    Yes  x    No  ¨

The aggregate market value of the voting common stock held by non-affiliates of the Registrant based on the reported last sale price for the common stock on the Nasdaq National Market on July 31, 2004, was $346,293,713.

As of April 11, 2005, 15,383,410 shares of the Registrant’s common stock were outstanding.

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DOCUMENTS INCORPORATED BY REFERENCE

Portions of the Registrant’s Proxy Statement for the 2005 Annual Meeting of Stockholders, presently scheduled to be held June 6, 2005, and filed within 120 days after the end of the fiscal year ended January 31, 2005, are incorporated by reference in Part III hereof.

FORWARD-LOOKING STATEMENTS

This Annual Report on Form 10-K and the documents incorporated herein by reference of Sharper Image Corporation (referred to as the “Company”, “The Sharper Image,” “it,” “we,” “our,” “ours,” and “us”) contain forward-looking statements within the meaning of federal securities laws that have been made pursuant to the provisions of the Private Securities Litigation Reform Act of 1995. Such forward-looking statements are based on current expectations, estimates and projections about the Company’s industry, management’s beliefs and certain assumptions made by the Company’s management. Words such as “anticipates,” “expects,” “intends,” “plans,” “believes,” “seeks,” “estimates,” or variations of such words and similar expressions, are intended to identify such forward-looking statements. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual results may differ materially from those expressed or forecasted in any such forward-looking statements. Such risks and uncertainties include those set forth herein under “Certain Additional Business Risk Factors” on pages 9 through 16 as well as those noted in the documents incorporated herein by reference. Unless required by law, the Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise. However, readers should carefully review the statements set forth in other reports or documents the Company files from time to time with the Securities and Exchange Commission, particularly the Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.

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SHARPER IMAGE CORPORATION

ANNUAL REPORT ON FORM 10-K

FISCAL YEAR ENDED JANUARY 31, 2005

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ITEM 1. BUSINESS

THE SHARPER IMAGE

Sharper Image Corporation (referred to as the “Company,” “The Sharper Image,” and “it”) is a leading specialty retailer of innovative, high quality products that are useful and entertaining and are designed to make life easier and more enjoyable. The Company offers a unique assortment of products in the electronics, recreation and fitness, personal care, houseware, travel, toy, gifts and other categories. The Sharper Image merchandising philosophy focuses principally on new and creative proprietary Sharper Image Design products and exclusive Sharper Image branded products and, to a lesser extent, on third party branded products. The Company designs and develops its Sharper Image Design products, while Sharper Image branded products are generally designed by the Company with third parties. The Company believes that its unique merchandising and creative marketing strategies have made The Sharper Image one of the most widely recognized retail brand names in the United States.

The Sharper Image was founded in 1977 by Richard J. Thalheimer, who currently serves as Chairman and Chief Executive Officer. The Company mailed its first catalog in 1979, began the expansion into store operations in 1981 and commenced online operations in 1994. The Sharper Image markets and sells merchandise primarily through four integrated sales channels: The Sharper Image stores, The Sharper Image catalog, which includes revenue from all direct marketing activities and television infomercials, the Internet and wholesale. The Company believes that this multichannel approach provides significant marketing, advertising, sales and operational synergies and provides its customers with enhanced shopping flexibility and superior customer service. Financial information related to each of these sales channels is disclosed in Note K to the financial statements. In addition to the Company’s primary business, the Company leverages its name and reputation through its Corporate Incentives and Rewards program and wholesale sales of Sharper Image brand products, which include Sharper Image Design and Sharper Image branded products.

THE SHARPER IMAGE STORES

The Company has three store formats: The Sharper Image stores, The Sharper Image Design stores and outlet stores. As of January 31, 2005, The Sharper Image operated 163 The Sharper Image stores, eight The Sharper Image Design stores and four outlet stores for a total of 175 stores in 37 states and the District of Columbia. The Sharper Image Stores generate the highest proportion of the Company sales, representing 57.2% of total revenues for the year ended January 31, 2005 (“fiscal 2004”) and 58.6% for the year ended January 31, 2004 (“fiscal 2003”). The Sharper Image stores present an interactive and entertaining selling environment that emphasizes the features and functionality of the Company’s innovative, fun and useful products and allows the customer to interact with and experience the product while shopping. The Company’s average store sales per square foot is consistently above industry averages, and during fiscal 2004 and 2003, it generated average sales of $618 and $676, respectively, per square foot. For stores opened for more than one year, the average sales per square foot in fiscal 2004 and fiscal 2003 were $665 and $710, respectively. During fiscal 2004, The Sharper Image opened 28 new stores and closed two stores. The Company plans to increase its number of stores by approximately 15% during fiscal 2005.

Each store is generally staffed with approximately 8 to 12 associates, including a manager, an assistant manager, a senior sales associate, sales associates and other support staff. A number of the Company’s high volume stores are staffed with 15 to 20 associates. The Company’s store managers have an average tenure of over five years. The Company’s store personnel are compensated primarily through commissions. In order to maintain a high customer service level, the Company’s sales associates undergo considerable training on the many new and often technically oriented products. The Company’s stores are operated according to standardized procedures to maintain high levels of customer service, merchandise display and pricing, product demonstration, inventory maintenance, personnel training, administration and security. The Sharper Image stores are designed by the Company’s visual design and creative staff at its headquarters in San Francisco, California.

The Sharper Image stores typically have 2,200 to 3,000 square feet of selling space and approximately 1,300 to 2,200 square feet of storage and administrative space. The typical cost of leasehold improvements,

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before landlord contributions, but including fixtures and equipment averages $500,000 to $650,000 per store. Initial inventory for a new The Sharper Image store generally costs approximately $200,000. The Sharper Image Design stores typically consist of between 1,200 to 2,000 square feet of selling space and feature higher margin Sharper Image Design and private label products, in addition to other top-selling merchandise. Outlet stores typically consist of between 2,100 to 3,200 square feet of selling space and are primarily used to sell slow-moving, discontinued and regular merchandise.

Over the past several years, The Sharper Image has been updating the look and appeal of its new retail stores and remodeling selected existing stores. The updated format presents an open, fresh and inviting environment designed to appeal to both men and women and to highlight the Company’s Sharper Image Design and Sharper Image branded products and attractive product packaging. The average cost of converting an existing store to the new format is similar to the cost of a new store build out, which ranges from $500,000 to $650,000, subject to leasehold allowances. The Company intends to continue to selectively remodel stores utilizing the new store format, which typically occurs at the time of the store’s natural lease renewal.

THE SHARPER IMAGE CATALOG AND DIRECT MARKETING

The Sharper Image direct marketing operations, including revenues generated directly from the Company’s award-winning, full-color monthly catalog, single product mailers, print ads and television infomercials, generated 17.2% of the Company’s total revenues in fiscal 2004 and 19.9% in fiscal 2003. The Sharper Image catalog is a full-color catalog that is mailed to an average of five to six million individuals each month, with an increase to six to eight million individuals during the Father’s Day and graduation months and an increase to nine to 16 million individuals during the holiday season. The Sharper Image catalog has been recognized for creative excellence by leading catalog industry trade groups. The catalog is currently the primary advertising vehicle for the Company’s retail stores and Internet business. During fiscal 2004 and 2003, the Company mailed approximately 98 million and 86 million The Sharper Image catalogs to over 19 million and 18 million households, respectively.

The Sharper Image catalog design uses dramatic visuals and problem-solving and benefit-oriented product descriptions. The catalog design features the most important products prominently. The number of items featured each month ranges between 200 and 250 products during the first three quarters of the year, increasing to more than 350 products during the holiday shopping season in the fourth quarter. The Sharper Image catalog is designed and produced by the Company’s in-house staff of writers and production artists. This enables the Company to maintain quality control and shorten the lead time needed to produce the catalog. During fiscal 2004, The Sharper Image catalog contained between 56 and 96 pages for non-peak months and between 72 and 140 pages for Father’s Day and the peak holiday shopping season.

The Sharper Image has developed a proprietary customer database of more than 19 million names, which it utilizes regularly. The Company collects customer names through its catalog and Internet order processing, as well as electronic point-of-sale registers in the retail stores. The names and associated sales information are merged daily into the Company’s customer master file. This daily merge process provides a constant source of current information to help assess the effectiveness of the catalog as a form of retail advertising, identify new customers that can be added to the Company’s in-house mailing list without using customer lists obtained from other catalogers, and identify the Company’s top purchasers. To further enhance the effectiveness of the Company’s catalog mailings to individuals in the customer database, the Company’s in-house staff utilizes statistical evaluation and selection techniques to determine which customer segments are likely to contribute the greatest revenue per mailing. The Company has established a data bank of top purchasers who receive preferred services, including invitations for special sales events and enhanced customer service.

During fiscal 2004 and 2003, the Company expanded its television infomercial presence by highlighting several popular Sharper Image Design and private label products on cable and national broadcast stations. The Company believes that this type of direct marketing initiative, combined with its Internet and print advertising will broaden the existing customer base and will also increase customer traffic and sales in retail store locations.

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During fiscal 2003, the Company increased its circulation of single product mailers, which highlights several Sharper Image Design proprietary and Sharper Image brand products by 26.1%. During fiscal 2004, the Company decreased circulation of single product mailers by 7.8%. The Company believes that the investment in this type of advertising will continue to increase brand awareness and broaden the existing customer base.

INTERNET OPERATIONS

The Sharper Image was an early entrant into Internet retailing. The Company has participated in online shopping since 1994, and has maintained its own Website at www.sharperimage.com since 1995. Revenues from the Company’s Internet operations, including auction sales, increased to $116.3 million in fiscal 2004 from $95.1 million in fiscal 2003. The Company’s Internet operations generated 15.3% and 14.7% of total revenues in fiscal 2004 and 2003, respectively. During fiscal 2004, revenues from the Company’s Internet operations, including auction sales, increased 22.3%, transactions increased 16.4% and average revenue per transaction increased 3.3%. The Company’s Internet operations benefit from The Sharper Image brand name, customer base, The Sharper Image catalogs and unique product offerings, as well as its multimedia approach to advertising. The Company believes that its Sharper Image Design and Sharper Image branded products are particularly well positioned to be marketed and sold over the Internet and that the Company’s Internet operations have enabled it to expand and diversify the Company’s existing customer base. Shoppers on the Company’s Website have the convenience of exchanging or returning products purchased through the Internet at the Company’s retail store locations. The Company sends out periodic email marketing campaigns to its list of Internet shoppers. These emails include sneak previews of newly released products and special offers that are intended to drive sales in all selling channels. The Company currently also offers international Websites where Internet shoppers are able to get local delivery of Sharper Image Design and Sharper Image branded products, which in some cases have been specifically adapted for use throughout Europe.

The Sharper Image’s goal is to make www.sharperimage.com a Website that provides the Company’s Internet customers with an interactive experience similar to The Sharper Image stores. The Company continues to update its Website by incorporating advanced technologies to improve its product presentations and make its Website increasingly customer friendly, while retaining its entertainment quality. The Company’s Website incorporates much of the look and feel of the new store design. It includes features such as dynamic browsing, inventory status, order tracking, Flash technology, gift guides by category and product, and catalog quick order. The Company continually evaluates, tests, and enhances the Website. Some of the changes made to the Company’s Internet operations during fiscal 2004 include new category pages, an easier checkout process for its Internet customers, enhanced site search functions, new video and audio for products, and redesign of the Company’s Spanish Website. The Company also strengthened and increased its server and software infrastructure of its Website. During fiscal 2003 the Company added an online gift registry and upgraded its customer service area. The Company also has enhanced its backend systems by updating its servers and programs to ensure the speed and efficiency of its Website. The Sharper Image plans to continue to allocate resources to its Internet operations by establishing additional strategic relationships with other Internet partners and continuing to enhance the technical capabilities and presentation of products on its Website.

In fiscal 2004 and 2003, the editors and readers of Internet Retailer Magazine honored www.sharperimage.com as one of the industry’s 50 best Websites.

The Company also has an established Internet auction site that allows customers to bid on and acquire a broad range of new, returned, repackaged and refurbished Sharper Image products for less than regular retail price. The Company’s products are also featured on eBay’s auction site, as well as on the Company’s eBay store. Most products purchased on the auction site have the same warranty that accompanies full- price products and customers also enjoy a thirty-day return privilege. The Company believes that bidders have an enhanced level of confidence in the Company’s operations since, unlike many other Internet auction sites, The Sharper Image is an established retailer with an inventory of well-known products under warranty with established return policies. The auction site not only offers consumers the enjoyment of bidding and winning products at less than retail price, it also provides the Company an opportunity to effectively manage its closeout products, while maintaining

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gross margin goals. In addition to the Company’s auction site, customers are able to purchase discontinued, clearance and refurbished products at lower than retail prices on the Sharper Image Outlet store Website.

The Company is pursuing additional steps to achieve continued growth of its Internet operations. These steps include technological improvements, dramatic visual presentations, development of international Websites in Europe and establishment of strategic Internet marketing arrangements. The Company has established relationships with Google, eBay, MSN Shopping, Linkshare, Amazon, Yahoo! Shopping, AOL and Catalog City.

OTHER OPERATIONS

In addition to the Company’s store, catalog and Internet operations, the Company also has a business-to-business operation, which includes wholesale operations and its Sharper Image Corporate Incentives and Rewards program. It also derives revenues from its customer list-rental program.

The business development department is the primary group responsible for wholesale marketing to other retailers, including fine department and specialty stores in the United States, as well as retailers in other countries. The Company has wholesale marketing arrangements with established retail chains such as Linens ‘n Things; Bed, Bath and Beyond; May Department Stores; and Federated Department Stores. This group’s sales increased by 116.5% and were $58.4 million in fiscal 2004, as compared to $27.0 million in fiscal 2003.

Under the Sharper Image Corporate Incentives and Reward program, the Company sells product, rewards cards, incentive and merchandise certificates to major corporations and not-for-profit entities, who in turn distribute them under their programs to increase their sales, or to motivate and reward their high-achieving employees and best customers. The Sharper Image stores, catalog and Internet Website are the primary means of offering, delivering and redeeming the incentives and gifts. The Company records revenues and expenses for its Sharper Image Reward Program through its retail stores, catalog and direct marketing, and Internet operations.

MERCHANDISING, SOURCING AND DEVELOPMENT

Merchandising

The Sharper Image is known for its varied product mix and a merchandising philosophy focusing on innovative, well-designed, high-quality products that are either developed by The Sharper Image, exclusive to The Sharper Image or in limited distribution. The Company’s merchandising strategy emphasizes products that are innovative and new-to-market. In recent years the Company has focused significant resources on the development and marketing of its Sharper Image Design and Sharper Image branded products. Sharper Image Design and Sharper Image branded products typically generate higher gross margins than other products, minimize direct price comparisons and, the Company believes, strengthens The Sharper Image brand as well as broadens its customer reach. The percentage of the Company’s total revenues attributable to Sharper Image Design and Sharper Image branded products was approximately 74% in fiscal 2004 and 73% for fiscal 2003. The Company believes that the increase in the percentage of revenues attributable to Sharper Image Design and Sharper Image branded products was due to the modification of certain third party branded products, making them exclusive to Sharper Image branded product offerings, and the introduction of the Professional Series^™ line of Ionic Breeze^® Silent Air Purifiers, and other Sharper Image Design proprietary products. The Company intends to continue to increase the Company’s Sharper Image Design and Sharper Image branded product offerings.

The Company offers products in the $20 to $550 price range to appeal to a wide customer base. The Company chooses each product separately and focuses its marketing efforts on each item’s unique attributes, features and benefits. This approach distinguishes the Company from other retailers who are oriented more to category or product classification. In product lines where the Company competes directly with other retailers, the Company generally chooses to sell the best available version of the product with the most advanced features. The Company adjusts its merchandise mix to reflect market trends and customer buying habits. New products are selected or developed and brought into the Company’s merchandise mix based on criteria such as anticipated popularity, gross margin, uniqueness, value, competitive alternatives, exclusivity, quality and vendor performance. As a result of such shifting emphasis among individual items, and depending on the customers’

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demand and the level of marketing and advertising programs, the mix of sales by category changes from time to time and the sales volume of individual or related products can be significant to any particular reporting period’s total sales. The effect of changes from year to year in the mix of sales by category can be to increase or decrease the merchandise gross margin rates since margins vary according to category of merchandise.

Sharper Image Design products are produced for the Company on a contract basis, substantially all by manufacturers in Asia, primarily China. The Company provides all product specifications to the contract manufacturers. Development lead-time is generally in the range of 12 to 18 months, although certain product introductions may require a shorter or longer lead-time.

The Sharper Image regularly generates information on merchandise orders and inventory that is reviewed by the Company’s buyers, its senior merchandising staff and top management. The Company averages new offerings of approximately 50 to 100 products during the peak selling season. The Sharper Image carefully considers which products will not be offered in future months based upon numerous factors including revenues generated, gross margins, the cost of catalog and store space devoted to each product, product availability and quality.

Product Sourcing

The process of finding new products involves the Company’s buyers who review voluminous product literature, travel extensively throughout the United States and Asia to attend trade shows and exhibitions and meet with manufacturers. The Company enjoys relationships with many major manufacturers who use The Sharper Image regularly to introduce their newest products in the United States.

The Sharper Image purchases merchandise from numerous foreign and domestic manufacturers and importers. The Company had a single supplier that provided approximately 28% of the Company’s net merchandise purchases in fiscal 2004 and 21% in fiscal 2003. In fiscal 2004 and 2003, substantially all of the products offered by the Company were manufactured in Asia, primarily China.

Product Development

The Company’s Sharper Image Design group has more than ten years of experience in designing and developing new products, as well as finding new product ideas from outside sources. The product development group meets regularly with the merchandising and sales staff to review new Sharper Image Design product opportunities, product quality and customer feedback. From these creative sessions, product ideas are put into design, development and production. Successful product introductions during the past three years include: Professional Series^™ Ionic Breeze^® Quadra^® Silent Air Purifier; Professional Series^™ Ionic Breeze GP^® Silent Air Purifier with ultraviolet germicidal protection; “Bright As Day!”^™ Daylight Spectrum Lamps; PowerTie^™ Motorized Tie Rack; World’s First Truly Silent & Efficient Watch Winder; Cordless Rechargeable Blower; Home Air Compressor & Inflator; Turbo-Clipper^™; Hot+Cold^™ Car Snack Box; Deluxe Spire^™ Feel-Good Fan^®; Turbo-Groomer^® 5.0; Automatic Eyeglass Cleaner; “CD” Shower Companion^®; Ultrasonic Jewelry Cleaner; Personal Entertainment Center^™; Big Screen Travel Clock; CD/Radio Alarm Clock with Sound Soother^® 20; “DVD” Power Tower^®; Hot+Cold^™ Mini Fridge; Ionic Breeze^® Personal Air Purifier; Ionic Breeze^® Quadra Silent Air Purifier; Ionic Conditioning^® Quiet Hair Dryer; “Now You Can Find It”^® Wireless Electronic Locator; Personal Cooling System^™ 3.0; Shower Companion^® AM/FM Stereo Radio; Sound Soother^® 20; and the Talking Travel Companion^®.

In addition, the Sharper Image emphasizes and works with vendors to develop Sharper Image branded products focusing on unique and innovative features that would distinguish the Company from its competitors. These Sharper Image products span the Company’s product areas of electronics, recreation and fitness, personal care, houseware, travel, toy and gifts. Manufacturers and inventors frequently approach the Company to launch technologically advanced products with distinctive, cutting edge features.

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CUSTOMER SERVICE

The Sharper Image is committed to providing its customers with courteous, knowledgeable and prompt service. The Company’s customer service and catalog sales groups at the corporate headquarters in San Francisco and at distribution centers in Little Rock, Arkansas and Richmond, Virginia provide personal attention to customers who call toll free or send emails to request a catalog subscription, place an order or inquire about a product. The Company’s customer service group is also responsible for resolving customer problems promptly and to the customer’s complete satisfaction. The Company also contracts with third party call centers for additional sales and customer service representative coverage. These third party call centers are subject to the same high-level expectations of customer service as the Company’s internal staff.

ORDER FULFILLMENT AND DISTRIBUTION

The Sharper Image owns an approximately 103,000 square foot fulfillment and distribution facility in Little Rock, Arkansas. The Sharper Image currently has leased facilities in Little Rock, Arkansas; Ontario, California; and Richmond, Virginia; totaling approximately 486,000 square feet for catalog, direct response, and Internet order and store fulfillment needs, returns processing and storage. The Company’s merchandise is generally delivered to its catalog and Internet customers and to The Sharper Image stores directly from its distribution facilities. Some products are shipped directly from the vendor to the customer or to the Company’s stores. The shipment of products directly from vendors to the stores and customers reduces the level of inventory required to be carried at the distribution center, freight costs and the lead-time required to receive the products. Each catalog order is received via remote terminal at the distribution facility after the order has been approved for shipment. The Company’s goal is to ship the majority of catalog and Internet orders within 24 - 48 hours after the order is received.

Maintaining sufficient inventory levels is critical to The Sharper Image’s business. The Company’s stores are equipped with electronic point-of-sale registers that communicate daily with the main computer system at corporate headquarters, transmitting sales, inventory and customer data, as well as receiving data from headquarters. The sales, inventory and customer data enable sales and corporate personnel to monitor sales by item on a daily basis, provide the information utilized by the automatic replenishment system (ARS) and merchandising personnel for inventory allocations, provide management with current inventory and merchandise information, and enable the Company’s in-house mailing list to be updated regularly with customer names and activity.

ADVERTISING

While the catalog remained The Sharper Image’s primary advertising vehicle during fiscal 2004 and 2003, the Company also broadened its customer base through increased multimedia advertising, including television infomercials, newspapers, magazines, email marketing programs, Internet advertising and marketing programs, and business-to-business trade publications. The Company increased its spending on television media infomercials as well as print and magazine advertising that highlighted selected Sharper Image Design and Sharper Image branded products. These increased advertising initiatives were utilized to realize the Company’s goal of acquiring new customers, which it believes will produce additional sales in the stores, catalog and Internet channels, and business-to-business sales in the current and future periods. The Company continually reevaluates its advertising strategies to improve the effectiveness of its advertising programs.

INFORMATION TECHNOLOGY

The Sharper Image maintains an integrated management information system for merchandising, point-of-sale, order fulfillment, distribution and financial reporting. The Company believes its system increases productivity by providing extensive merchandise information and inventory control. The Company continually evaluates and enhances its computer systems and information technology in order to provide additional and improved management and financial information. The Company has backup systems for its mainframe and servers located at its distribution center in Little Rock, Arkansas.

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ASSOCIATES

The Sharper Image places great importance on recruiting, training and providing the proper incentives for quality personnel. The Sharper Image seeks to hire and retain qualified sales and customer service representatives in its store, catalog and Internet operations and to thoroughly train them. Each new store manager undergoes an intense program during which the manager is trained in all aspects of the Company’s business. Sales personnel are trained during the first two weeks of employment, or during the weeks before a new store opens, and updated periodically with ongoing sales training sessions. Training for sales personnel focuses primarily on acquiring a working knowledge of the Company’s products, developing selling skills and obtaining an understanding of The Sharper Image’s high customer service standards. Each sales associate is trained to adhere to the Company’s philosophy of “taking ownership” of every customer service issue that may arise. The Company also has developed ongoing programs conducted at each store that are designed to keep sales personnel updated on all new product offerings.

As of January 31, 2005, The Sharper Image employed approximately 2,800 associates, approximately 55% of whom were full time. The Company also hires a significant number of seasonal employees during its peak holiday selling season. The Company considers its associate relations to be good.

COMPETITION

The Sharper Image operates in a highly competitive environment. The Company competes principally with a diverse mix of department stores, sporting goods stores, discount stores, specialty retailers and other catalog and Internet retailers that offer products similar to or the same as some of those the Company offers. Many of the Company’s competitors are larger companies with greater financial resources, a wider selection of merchandise and greater inventory availability. Larger retailers, such as department stores, offer a wider range of products and offer the convenience of one-stop shopping. Specialty retailers, such as electronics stores, may offer only a certain category of product but often offer a wider range of selection within a particular product category. Discount stores may offer analogous products at lower price points.

Since The Sharper Image offers a more limited range of products compared to its competitors, its ability to anticipate the preferences of its customers, to effectively market and distinguish The Sharper Image brand is critical. Although the Company attempts to market products not generally available elsewhere and have emphasized exclusive products in its merchandising strategy, some of the Company’s products or similar products can also be found in other retail stores, other catalogs or through the Internet. The Sharper Image offers competitive pricing when other retailers market certain products similar to the Company’s products at lower prices. In addition, a number of other companies have attempted to imitate the presentation and method of operation of the Company’s catalog and stores and its Sharper Image Design products. The Company’s ability to distinguish its products from similar products offered by its competitors is particularly important in order to maintain pricing and because of the ease with which customers can comparison shop on-line. A significant portion of the Company’s sales and net income are generated by its air purification line of products. The Company believes the success of this product line has and will continue to encourage other companies to imitate these products.

The Sharper Image competes principally on the basis of product exclusivity, selection, brand recognition, quality and price of its products, merchandise presentation in its catalog, its stores and on the Internet, its customer list and the quality of its customer service. The Company has continued in its commitment to additional resources to its internal product development group to create and produce Sharper Image Design products, and to its merchandising team to support a program to increase the number of Sharper Image brand products exclusively available from the Company. The Company believes that these Sharper Image Design and Sharper Image brand products provide it with a competitive advantage in its merchandising offering.

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INTELLECTUAL PROPERTY

The Sharper Image believes its registered service mark and trademark “The Sharper Image” and the brand name recognition that it has developed are of significant value. The Company actively protects its brand name and other intellectual property rights to ensure that the quality of its brand and the value of its proprietary rights are maintained. The Company seeks patents to establish and protect its proprietary rights relating to the technologies and products it is currently developing, that it may develop, or that its competitors may develop. The Company has taken and will continue, in the future, to take all steps necessary to broaden and enhance its patent protection by obtaining both utility and design patent protection directed to its proprietary products. For instance, The Sharper Image currently owns 54 U.S. utility patents and more than 100 U.S. design patents.

The Sharper Image has at least seven U.S. utility patents and several U.S. design patents that protect its air purification line of products. The earliest expiration date of any of these utility patents is 2018. In addition, the Company owns license rights under a utility patent relating to its air purification line of products. This patent is due to expire in December 2005. The Company also has multiple foreign and domestic pending patent applications directed to its air purification line of products. Although the Company believes its existing patents, as well as its ongoing patent prosecution efforts, will continue to provide protection for its air purification products, this product line could face additional competition upon the expiration of its licensed patent.

The Sharper Image owns or has rights to various copyrights, trademarks and trade names used in its business. These include The Sharper Image^®, Sharper Image Design^®, Sound Soother^®, Ionic Breeze^®, The Breeze^®, Quadra^®, and Ionic Hair Wand^® 2.0, Personal Cooling System^™, Quiet Power^™ Motorized Tie Rack, Shower Companion^® and Turbo-Groomer^®.

SEASONALITY

The Sharper Image business is highly seasonal, with sales peak during the end-of-year holiday shopping season. A substantial portion of the Company’s total revenues, and all or most of its net earnings, occur in the fourth fiscal quarter ending January 31. The Company generally experiences lower revenues during the other fiscal quarters, and as is typical in the retail industry, has incurred, and may continue to incur losses in these quarters. In addition, as with many retailers, the Company makes merchandising and inventory decisions for the holiday season well in advance of the holiday selling season. The fourth quarter accounted for approximately 40% of total revenues in fiscal 2004 and 2003. In addition, the Company’s fourth quarter accounted for substantially all of the Company’s net earnings in fiscal 2004 and 2003.

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CERTAIN ADDITIONAL BUSINESS RISK FACTORS

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

In order to meet our strategic goals, we must successfully offer our customers new, innovative and high- quality products on a continuous basis. Our product offerings must be affordable, useful to the customer, well-made, distinctive in design and not widely available from other retailers. We cannot predict with certainty that we will successfully offer products that meet these requirements in the future. Some products or a group of related products usually produce sales volumes that are significant to our total sales volume in a particular period.

If other retailers, especially department stores or discount retailers, offer the same products or products similar to those we sell, or if our products become less popular with our customers, our sales may decline or we may decide to offer our products at lower prices. If customers buy fewer of our products or if we have to reduce our prices, our revenues and earnings will decline. Our products must appeal to a broad range of consumers whose preferences we cannot predict with certainty and may change between sales seasons.

If we do not maintain sufficient inventory levels, or if we are unable to deliver our products to our customers in sufficient quantities, our operating results will be adversely affected.

We must be able to deliver our merchandise in sufficient quantities to meet the demands of our customers and deliver this merchandise to customers in a timely manner. We must be able to maintain sufficient inventory levels, particularly during the peak holiday selling season. If we fail to achieve these goals, we may be unable to meet customer demand, and our future results will be adversely affected if we are not successful in achieving these goals. Our success depends on our ability to anticipate and respond to changing product trends and consumer demands in a timely manner.

A significant portion of our sales during any given period of time may be generated by a particular product or line of products and if sales of those products or line of products decrease, our stock price may be adversely affected.

During fiscal 2003 and fiscal 2004, the sales of our air purification line of products constituted a significant portion of our total revenues and net income. Although not as significant, the sales from our home and portable stereo system and massage product lines constituted a substantial portion of our total revenues and net income.

Our future growth will be substantially dependent on the continued increase in sales growth of existing core and new products, while at the same time maintaining our current gross margin rates. We cannot predict whether we will be able to increase the growth of existing core and new products or successfully introduce new products, increase our revenue level or maintain or increase our gross margin rate in future periods. Failure to do so may adversely affect our stock price.

Poor economic conditions may reduce consumer spending on discretionary retail products such as the ones we offer.

Consumer spending patterns, particularly discretionary spending for products such as ours, are affected by, among other things, prevailing economic conditions, stock market volatility, increasing gas prices, threats of war, acts of terrorism, wage rates, interest rates, inflation, taxation, consumer confidence and consumer perception of economic conditions. General economic, political and market conditions, such as recessions, may adversely affect our business results and the market price of our common stock. We may not be able to accurately anticipate the magnitude of these conditions on future quarterly results.

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Our success depends in part on our ability to internally design and develop our Sharper Image Design products.

We have invested significant resources in and are increasingly dependent on the success of the Sharper Image Design products. These products have typically generated higher gross margins than other products and our merchandising strategy emphasizes these products. Some of these products or a group of related products, which are affected by customers’ demands and the level of our marketing and advertising efforts, can produce sales volumes that are significant to our total sales volume in a particular period. In order to be successful, we must continue to design and develop products that meet the demands of our customers, as well as create customer demand for these products. Our goal is to increase the percentage of total revenues attributable to Sharper Image Design and Sharper Image branded products, although we expect this percentage may decline from time to time, and cannot assure you we will otherwise achieve our goal. If we are unable to successfully design and develop these products, our operating results may be adversely affected.

We rely on foreign sources of production and our business would be adversely affected if our suppliers are not able to meet our demand and alternative sources are not available.

We must ensure that the products we design and develop are manufactured cost-effectively. We rely solely on a select group of contract manufacturers, most of whom are located in Asia (primarily China), to produce these products in sufficient quantities to meet customer demand and to obtain and deliver these products to our customers in a timely manner. These arrangements are subject to the risks of relying on products manufactured outside the United States, including political unrest and trade restrictions, local business practice and political issues, including issues relating to compliance with domestic or international labor standards, currency fluctuations, work stoppages, economic uncertainties, including inflation and government regulations, availability of raw materials and other uncertainties. If we are unable to successfully obtain and timely deliver sufficient quantities of these products, our operating results may be adversely affected. There is increasing political pressure on China to permit the exchange rate of its currency, the Chinese Yuan (“CNY”), to float against the U.S. Dollar (“USD”). Although substantially all of our supply contracts in China are denominated in USD, our suppliers could attempt to renegotiate these contracts and increase costs to us if the CNY/USD exchange rate were to change.

We had a single supplier for a number of our products, located in Asia, that provided approximately 28% of the net merchandise purchases in fiscal 2004 and is expected to provide a comparable percentage in the future. If we were unable to obtain products from this supplier on a timely basis or on commercially reasonable terms, our operating results may be adversely affected.

Some of our smaller vendors have limited resources, limited production capacities and limited operating histories. We have no long-term purchase contracts or other contracts that provide continued supply, pricing or access to new products and any vendor or distributor could discontinue selling to us at any time. We compete with many other companies for production facilities and import quota capacity. We cannot assure you that we will be able to acquire the products we desire in sufficient quantities or on terms that are acceptable to us in the future. In addition, we cannot assure you that our vendors will make and deliver high quality products in a cost-effective, timely manner. We also may be unable to develop relationships with new vendors.

We depend on our vendors’ ability to timely deliver sufficient quantities of products and our business can be harmed by work stoppages or other interruptions to delivery of products.

All products we purchase from our vendors in Asia must be shipped to our distribution centers by freight carriers and we cannot assure you that we will be able to obtain sufficient freight capacity on a timely basis and at favorable rates. Our inability to acquire suitable products in a cost-effective, timely manner or the loss of one or more key vendors or freight carriers could have a negative effect on our business.

Many of our shipments that come from Asia move through the West Coast ports that have been negatively impacted by the West Coast port slowdown. During the second half of fiscal 2004, this slowdown caused our airfreight costs to increase as we used alternative delivery methods to mitigate some of the impacts of the

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slowdown. The increased usage of air freight transportation had a negative impact on our gross margins. We are anticipating continuing congestion at West Coast ports through 2005, which may increase our transportation costs and have a negative effect on our gross margins and profits.

Our ability to protect our proprietary technology, which is vital to our business, particularly our air purification products, is uncertain and our inability to protect these rights could impair our competitive advantage and cause us to incur substantial expense to enforce our rights.

We believe our registered house marks “The Sharper Image”, “sharperimage.com”, “Sharper Image Design” and “Sharper Image” as well as the trademark fame that we have established are of significant value. We actively pursue and protect, domestically and internationally, not only all of our corporate trademarks, but other intellectual property rights including patents, copyrights and trade secrets to ensure that the quality of our brand and the value of our proprietary rights are maintained. We protect our proprietary marketing strategies, illustrative catalogs and product packaging through numerous copyright registrations. We also seek patents to establish and protect our proprietary rights relating to the technologies and products we have developed, are in the process of developing, or that we may develop in the future. We have taken and will continue, in the future, to take all steps necessary to broaden and enhance our patent protection by obtaining both utility and design patent protection directed to our proprietary products. For instance, we currently own 54 U.S. utility patents and 100 U.S. design patents.

We cannot assure you that a third party will not infringe upon or design around any patent issued or licensed to us, including the patents and license agreement related to our air purification line of products, or that these patents will otherwise be commercially viable. Litigation to establish the validity of patents, to defend against patent infringement claims of others and to assert patent infringement claims against others can be expensive and time-consuming even if the outcome is favorable to us. If the outcome is unfavorable to us, we may be required to pay damages, stop production and sales of infringing products or be subject to increased competition from similar products. We have taken and may, in the future, take steps to enhance our patent protection, but we cannot assure you that these steps will be successful or that, if unsuccessful, our patent protection will be adequate.

We also rely upon trade secrets, know-how, continuing technological innovations and licensing opportunities to develop and maintain our competitive position. We attempt to protect our proprietary technology in large part by confidentiality agreements with our employees, consultants and other contractors. We cannot assure you, however, that these agreements will not be breached, that we will have adequate remedies for any breach or that competitors will not know of or independently discover our trade secrets.

Our quarterly operating results and comparable store sales are subject to significant fluctuations and seasonality.

Our business is seasonal, reflecting the general pattern of peak sales and earnings for the retail industry during the holiday shopping season. Typically, a substantial portion of our total revenues and all or most of our net earnings occur during our fourth quarter ending on January 31. The fourth quarter accounted for approximately 40% of total revenues in both fiscal 2004 and 2003. In addition, the fourth quarter accounted for substantially all of our net earnings in fiscal 2004 and 2003. In anticipation of increased sales activity during the fourth quarter, we incur significant additional expenses, including significantly higher inventory costs and the costs of hiring a substantial number of temporary employees to supplement our regular store staff. If for any reason our sales were to be substantially below those normally expected during the fourth quarter, our annual operating results would be adversely affected. Due to this seasonality, our operating results for any one period may not be indicative of our operating results for the full fiscal year.

We generally experience lower revenues and net operating results during our first three quarters of the fiscal year and have historically experienced losses in these quarters. Our quarterly results of operations may fluctuate significantly as a result of a variety of factors, including, among other things, the timing of new store openings, net sales contributed by new stores, increases or decreases in comparable store sales, changes in our merchandise mix and net catalog sales.

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In addition, like other retailers, we typically make merchandising and purchasing decisions well in advance of the holiday shopping season. As a result, poor economic conditions or differences from projected customer demand for our products during the fourth quarter could result in lower revenues and earnings.

Our comparable store sales also fluctuate significantly and can contribute to fluctuations in our quarterly operating results. Our comparable store sales are affected by a variety of factors, including customer demand in different geographic regions, our ability to efficiently source and distribute products, changes in our product mix, competition, advertising and our wholesale operations. Although we believe it is sound business strategy to take advantage of broadening our customer base and to leverage our brand and advertising through the increase in our wholesale business, the impact of selling our Sharper Image Design and Sharper Image branded products through an increased number of other selected retailers may put pressure on our own comparable store sales increase percentage.

Our comparable store sales have fluctuated significantly in the past and we believe that such fluctuations may continue. Our historic comparable net store sales changes from the prior fiscal year were as follows:

Comparable store sales are defined as sales from stores where selling square feet did not change by more than 15% in the previous 12 months and which have been open for at least 12 full months. Stores generally become comparable once they have a full year of comparable sales. We cannot assure you that our comparable store sales results will increase in the future. Any reduction in or failure to increase our comparable store sales results could impact our future operating performance and cause the price of our common stock to decrease.

We are dependent on the success of our advertising and direct marketing efforts and our profitability will be adversely affected by increased costs associated with these efforts.

Our revenues depend in part on our ability to effectively market and advertise our products through The Sharper Image catalog and direct marketing operations. Increases in advertising, paper or postage costs may limit our ability to advertise without reducing our profitability. If we decrease our advertising efforts due to increased advertising costs, restrictions placed by regulatory agencies or for any other reason, our future operating results may be materially adversely affected. We are also utilizing and constantly testing other advertising media, such as television infomercials, radio, single product mailings and other print media. Our advertising expenditures increased by approximately $26.6 million or 21.6% in fiscal 2004 from the prior fiscal year. While we believe that increased expenditures on these and other media have resulted in increased revenues during fiscal 2004, we cannot assure you that this trend will continue in the future. If our advertising is ineffective and our increased advertising expenditures do not result in increased sales volumes, our sales and profits will be adversely affected. We depend on the continued availability of television infomercial time at reasonable prices. We expect to continue to spend on advertising and marketing at significant levels in fiscal 2005, but at slightly lower levels than fiscal 2004. We may not be able to continue to produce a sufficient level of sales to cover such expenditures, which would reduce our profitability.

The continued growth of our wholesale sales channel presents certain risks that could adversely affect our profitability.

We sell products through a multichannel strategy. While we believe that the wholesale sales channel offers growth opportunities and exposure to a greater customer base, this growth could adversely impact our business. In general, depending on product mix, our sales to wholesale partners carry lower gross margins than sales made

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through our other channels. In addition, the sales made through this channel could shift sales from our higher margin sales channels, particularly our retail and catalog channels. Wholesale customers may also decide to decrease or eliminate their level of purchases.

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

Our growth strategy primarily includes the following components:

Any failure on our part to successfully implement any or all of our growth strategies would likely have a material adverse effect on our financial condition, results of operations and cash flows. We believe our past growth has been attributable in large part to our success in meeting the merchandise, timing and service demands of an expanding customer base with changing demographic characteristics, but there is no assurance that we will be able to continue to have such success.

The expansion of our store operations could result in increased expenses with no guarantee of increased profitability.

We plan to increase our number of stores by 15% in fiscal 2005. We may not be able to attain our target new store openings, and any of our new stores 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 stores will depend in part on the following factors:

Even though we continue to expand our store base, we have remained concentrated in limited geographic areas. This could increase our exposure to customer demand, weather, competition, distribution problems and poor economic conditions in these regions. In addition, our catalog sales, Internet sales, or existing store sales in a specific region may decrease as a result of new store openings.

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

Some of our expenses will increase with the opening of new stores. If store sales are inadequate to support these new costs, our profitability will decrease. For example, inventory costs will increase as we increase inventory levels to supply additional stores. We may not be able to manage this increased inventory without decreasing our profitability. We may need financing in excess of that available under our current credit facility. Furthermore, our current credit facility has various loan covenants we must comply with in order to maintain the credit facility. We cannot predict whether we will be successful in obtaining additional funds or new credit facilities on favorable terms or at all.

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We rely on our catalog operations which could have significant cost increases and could have unpredictable results.

Our success depends in part on the success of our catalog operations. We believe that the success of our catalog operations depends on the following factors:

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 being 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 costs and would adversely impact our earnings if we were unable to pass such increases directly on to our customers or offset such increases by raising prices or by implementing more efficient printing, mailing, delivery and order fulfillment systems. If we were to experience a significant shortfall in anticipated revenue 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, revenues generated by each mailing are affected by factors such as consumer preferences, economic conditions, the timing and mix of catalog mailings, the timely delivery by the postal system of our catalog mailings and changes in our merchandise mix, several or all of which may be outside our control. Further, we have historically experienced fluctuations in the response rates to our catalog mailings. If we are unable to accurately target the appropriate segment of the consumer catalog market or 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 results.

We have distribution and fulfillment operations located in Little Rock, Arkansas; Ontario, California; and Richmond, Virginia. Any disruption of the operations in these centers could make it difficult to meet customer demand.

We conduct the majority of our distribution operations and all of our catalog and Internet order processing fulfillment functions from our own facility in Little Rock, Arkansas; and leased facilities in Little Rock, Arkansas; Ontario, California; and Richmond, Virginia. We also use contract fulfillment and warehouse facilities for additional seasonal requirements. Any disruption in the operations at any distribution center, particularly during the holiday shopping season, could result in late delivery of products and make it difficult to meet customer demand for our products.

In addition, we rely upon third party carriers for our product shipments, including shipments to and from all of our stores. As a result, we are subject to certain risks, including employee strikes and inclement weather, associated with such carriers’ ability to provide delivery services to meet our shipping needs.

We are also dependent on temporary employees to adequately staff our distribution facilities, particularly during busy periods such as the holiday shopping season. We cannot assure you that we will continue to receive adequate assistance from our temporary employees, or that we will continue to have access to sufficient sources of temporary employees.

We experience intense competition in the rapidly changing retail markets and if we are unable to compete effectively, we may not be able to maintain profitability.

We operate in a highly competitive environment. We principally compete with a variety of department stores, sporting goods stores, discount stores, specialty retailers and other catalogs that offer products similar to

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or the same as our products. We may increasingly compete with major Internet retailers. Many of our competitors are larger companies with greater financial resources, a wider selection of merchandise and greater inventory availability and offer the convenience of one-stop shopping. Specialty retailers, such as electronics stores, may offer only a certain category of product but often offer a wider range of selectio