UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

OR

COMMISSION FILE NO. 001-11679

Orchard Supply Hardware Stores Corporation

(Exact name of Registrant as specified in its charter)

Registrant’s telephone number, including area code: (408) 361-2536281-3500

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 and (2) has been subject to such filing requirements for the past 90 days.    Yes  ¨x    No  x¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 S-T (232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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

As of December 21, 2011,August 24,2012, the registrant had 6,000,0004,830,147 shares of Class A Common Stock, 8,644par value $0.01 per share, 8,644.06788 shares of Class B Common Stock, par value $0.01 per share, and no1,194,000 shares of Class C Common Stock, par value $0.01 per share, outstanding.

ORCHARD SUPPLY HARDWARE STORES CORPORATION AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

QUARTERLY PERIOD ENDED OCTOBER 29, 2011JULY 28, 2012

TABLE OF CONTENTSINDEX

PART I. FINANCIAL INFORMATION

PART I. FINANCIAL INFORMATION

ITEM 1. UNAUDITED INTERIM CONSOLIDATED FINANCIAL STATEMENTS

ORCHARD SUPPLY HARDWARE STORES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

AS OF OCTOBER 29,JULY 28, 2012, JANUARY 28, 2012, AND JULY 30, 2011 JANUARY 29, 2011 AND OCTOBER 30, 2010

(In thousands, unaudited)Unaudited, in thousands)

See notes to condensed consolidated financial statements.

ORCHARD SUPPLY HARDWARE STORES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE 13 AND 39 WEEKS26 WEEK PERIODS ENDED OCTOBER 29,JULY 28, 2012 AND JULY 30, 2011 AND OCTOBER 30, 2010

(InUnaudited, in thousands, except for per share amounts, unaudited)amounts)

See notes to condensed consolidated financial statements.

ORCHARD SUPPLY HARDWARE STORES CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE 39 WEEKS26-WEEK PERIODS ENDED OCTOBER 29,JULY 28, 2012 AND JULY 30, 2011 AND OCTOBER 30, 2010

(In thousands, unaudited)Unaudited, in thousands)

See notes to condensed consolidated financial statements.

ORCHARD SUPPLY HARDWARE STORES CORPORATION AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

FOR THE 13 AND 39 WEEKS26 WEEK PERIODS ENDED OCTOBER 29,JULY 28, 2012 AND JULY 30, 2011 AND OCTOBER 30, 2010

(UNAUDITED)

1. BASIS OF PRESENTATION

Orchard Supply Hardware Stores Corporation (the “Company”) is a specialty retailer primarilyneighborhood hardware and garden store focused on homeowners withpaint, repair maintenance and improvement needs. Foundedthe backyard. The Company was originally founded as a purchasing cooperative in San Jose, California in 1931, as1931. As of October 29, 2011,July 28, 2012, the Company operated 89 full-service hardware88 stores in California.

The accompanying unaudited interim condensedconsolidated financial statements should be read in conjunction with the audited consolidated financial statements, including notes thereto contained in the Company’s Annual Report on Form 10-K filed on April 27, 2012. The unaudited interim consolidated financial statements of the Company have been prepared in accordance with the instructions to Form 10-Q and do not include all the information and notes required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements.

The unaudited interim consolidated financial statements have been prepared from the records of the Company and its wholly-owned subsidiaries, Orchard Supply Hardware LLC (“OSH LLC”),and OSH Properties LLC (“OSH Properties”), and OSH Finance Corporation.LLC. Unless otherwise specified, all references to the “Company” refer to Orchard Supply Hardware Stores Corporation and its subsidiaries, without audit and, in the opinion of management, include all adjustments (consisting of only normal, recurring adjustments) necessary to present fairly the Company’s financial position as of October 29, 2011 and October 30, 2010, the results of operations for the 13 and 39 weeks then ended, and cash flows for the 39 weeks then ended. The condensed consolidated balance sheet as of January 29, 2011, presented herein, has been derived from the Company’s audited consolidated financial statements for the fiscal year then ended.

Accounting policies followed by the Company are described in Note 1 to the audited consolidated financial statements for the fiscal year ended January 29, 2011, which were included in the Company’s Registration Statement on Form S-1 originally filed in June 2011, as amended (the “Registration Statement”). Certain informationinterim periods presented. All intercompany balances and disclosures normally included in the notes to annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of Americatransactions have been condensed or omitted for purposes of these unaudited interim condensed consolidated financial statements. The interim condensed consolidated financial statements should be readeliminated in conjunction with the audited consolidated financial statements, including notes thereto contained in the above mentioned Company’s Form S-1.consolidation.

The results of operations for the 13 and 3926 weeks ended October 29, 2011July 28, 2012 presented herein are not necessarily indicative of the results to be expected for the full fiscal year.

Spin-offLiquidity— As of July 28, 2012, the Company had cash and cash equivalents of $33.9 million and total debt and capital lease obligations of $226.8 million. The Company’s liquidity is dependent upon its cash balance and the continued availability of borrowings under its financing arrangements. The financing arrangements require the Company to maintain compliance with certain covenants including a leverage ratio covenant. With the completion of a six-store sale and leaseback transaction, the Company was in compliance with the leverage ratio covenant under its financing arrangements as of July 2012 (See Note 5. Debt and Capital Lease Obligations). However, in part due to the decline in the Company’s operating results during the first and second quarters of fiscal 2012 and in fiscal 2011, coupled with continued economic weakness in the markets in which the Company operates, the Company would not have been in compliance with the leverage ratio covenant under its financing arrangements as of July 28, 2012 were the sale leaseback transactions not completed. Without improvements in the Company’s financial performance, the consummation of additional sale-leaseback transactions that the Company is currently pursuing, raising additional capital through debt or equity financing transactions, or an amendment and/or waiver of the Company’s leverage ratio, the Company may not be able to maintain compliance with its leverage ratio covenant as of the next measurement date, which is October 27, 2012.

Non-compliance with the leverage ratio covenant as of the next measurement date would cause a default under the financing arrangements. If the Company was unable to obtain a waiver from the debt holders, this could result in accelerated repayments of the Company’s debt from the current maturity dates of December 21, 2013 and December 21, 2015, if the Company’s lenders were to declare all outstanding indebtedness thereunder to be due and payable. As a result of the cross-default provisions in the Company’s debt agreements and other instruments, a default under one agreement or instrument could result in a default under, and the acceleration of, payments in other debt agreements and other instruments. In addition, the Company’s lenders would be entitled to proceed against the collateral securing the indebtedness. If the remaining payments were to be accelerated, the Company would not have sufficient liquidity to make full repayments of the outstanding debt, and such acceleration of all outstanding debt would adversely affect the Company’s ability to operate its business, which could prevent the Company from continuing its ongoing operations.

The Company is currently in discussions to refinance its Senior Secured Credit Facility and its Senior Secured Term Loan. On August 15, 2012, the Company entered into a non-binding Commitment Letter to replace its Senior Secured Credit Facility with a five-year $127.5 million senior secured credit line. In addition, the Company is pursuing various options, including issuing debt and/or equity to replace its Senior Secured Term Loan and may also consider approaching the current debt holders of the Senior Secured Term Loan to refinance or modify the terms of its debt. It is uncertain whether these endeavors by the Company to refinance or modify its debt will be successful. In addition, any refinancing could be at higher interest rates and may require the Company to comply with some or more covenants which could restrict business operations. If the Company is unable to refinance its debt, or do so on terms acceptable to the Company, the Company may be unable to meet its financial covenants, and lenders could demand repayment of the amounts outstanding under the Company’s financing agreements as described above. These interim consolidated financial statements have been prepared on the basis of management’s belief that the Company’s cash on hand, availability under its financing arrangements and cash flow from operations will provide the needed liquidity to continue as a going concern basis that includes the realization of assets and discharge of liabilities in the normal course of business and do not include any adjustments that might result from the outcome of these uncertainties.

Fiscal Year— The fiscal quarters ended July 28, 2012 and July 30, 2011 consist of 13 weeks. Our fiscal year end is the Saturday closest to January 31 each year. Fiscal 2012 consists of 53 weeks and fiscal 2011 consisted of 52 weeks.

Spin-Off from Sears Holdings— The Company filed the Registration Statement in connection with the planned distribution (the “Distribution”) by Sears Holdings Corporation (“Sears Holdings”) to its shareholdersstockholders (“Spin-Off” or “Distribution”) of all the shares of Class A Common Stock of the Company, par value $0.01 per share (the “Class A Common Stock”), and Series A Preferred Stock of the Company, par value $0.00001 per share (the “Preferred Stock”) to be held by Sears Holdings immediately prior to the Distribution. The Registration Statement was declared effective by the Securities and Exchange Commission (“SEC”) on December 12, 2011 and the close of business on December 16, 2011 was set as the record date for the Distribution. The Distribution will be, became effective as of 11:59 p.m., New York City Time on December 30, 2011, which the Company refers to hereinafter as the “Distribution Date.”

On December 19, 2011, the Company entered into a distribution agreement (the “Distribution Agreement”) with Sears Holdings, which setsset forth the principal actions to be taken in connection with the Distribution.Spin-Off. The Distribution Agreement will also governgoverned certain aspects of the Company’s ongoingon-going relationship with Sears Holdings following the Distribution. TheSpin-Off. In accordance with the Distribution Agreement provides thatthe following occurred prior to the Distribution the following actions will occur:Spin-Off:

All agreements, arrangements, commitments and understandings between the Company and its subsidiaries and other affiliates, on the one hand, and Sears Holdings and its other subsidiaries and other affiliates, on the other hand, will terminateterminated effective as of the Distribution,Spin-Off, except certain agreements and arrangements thatbetween the Company and Sears Holdings expressly provide will surviveHoldings. See Note 7 for the Distribution.

The Distribution Agreement governs the rights and obligations of the parties regarding the proposed Distribution. Prior to the spin-off, Sears Holdings will deliver all of the Company’s issued and outstanding Class A Common Stock and Preferred Stock to the distribution agent. At the Distribution, the distribution agent will electronically deliver the shares of the Company’s Class A Common Stock and Preferred Stock to entitled Sears Holdings shareholders based on the applicable distribution ratio. Sears Holdings will have the sole and absolute discretion to determine the terms of, and whether to proceed with, the Distribution.related-party agreements.

Transition Service Arrangements—The Effective with the Spin-Off, the Company does not maintain all of its own legal, tax, and certain other corporate support functions. In connection withentered into a series of recapitalization transactions in November 2005,transition service agreement (the “Transition Services Agreement”) whereby Sears Holdings continues to provide to the Company certain services provided prior to the Spin-Off and which enables the Company to retain access to various other third-party services until the Company is able to set up its stand-alone corporate functions and/or contract with third-party service providers. The services provided under the Transition Services Agreement are individually terminable upon 60 days notification by the Company. All services to be provided under the Transition Services Agreement will terminate upon the first anniversary of the effective date of the Transition Services Agreement. In December 2011, the Company completed its transition of payroll and legal functions from Sears Holdings. The remaining miscellaneous accounting and tax support services are expected to be transitioned by the end of fiscal 2012.

Prior to the Spin-Off, the Company entered into a series of annual shared services agreements (the “Transaction Service“Services Agreement”) to provide the Company with certain corporate support services while the Company buildsbuilt its own stand-alone corporate support functions for legal, tax, and certain other corporate support functions. The costs and allocations charged to the Company by Sears Holdings domay not necessarily reflecthave reflected the costs of obtaining the services from unaffiliated third parties, or ofif the Company providinghad performed the applicable services itself. The methods by which Sears Holdings allocatesallocated its costs arewere based on a

prorated estimate of costs expected to be incurred by Sears Holdings. The interim condensed consolidated financial statements contained herein may not be indicative of the Company’s interim condensed consolidated financial position, operating results and cash flows in the future, or what they would have been if it had been a stand-alone company during all periods presented. The Company has not included an estimate of what these costs would have been on a stand-alone basis because it is not practicable to do so. The Company does not expect the allocated expenses for these functions on a stand-alone basis to be materially different than what is reflected in its historical consolidated financial statements.

Effective with the Distribution, the Company entered into a transition service agreement (the “Transition Service Agreement”) which superceded the Transaction Service Agreement with Sears Holdings whereby Sears Holdings will continue to provide to the Company the same services provided prior to the Distribution and still needed by the Company and to enable the Company to retain access to various other third-party services until the Company is able to set up its stand-alone corporate functions and/or contract with third-party service providers. The services provided under the Transition Service Agreement will be individually terminable upon 60 days notification by the Company. All services to be provided under the Transition Service Agreement will terminate upon the first anniversary of the effective date of the Transition Services Agreement. The Company does not expect the costs incurred under the Transition Service Agreement to differ materially from the costs incurred under the Transaction Service Agreement.

Stock splitSplit— On December 8, 2011, the Company completed a 6-for-1 stock split of its common stock.outstanding securities. The stock split increased the number of shares of the Company’s common stock issued and outstanding from approximately 1.0 million to approximately 6.0 million. All share and per share amounts herein are presented on a post-stock split basis.

2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Segment ReportingUse of Estimates — The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

Merchandise Inventories — The Company’s housewares, hardware, and garden inventory are valued under the retail inventory method, using a last-in, first-out (“LIFO”) cost flow assumption. To estimate the effects of changing prices in inventory, we utilize external price indices determined by an outside source, the Bureau of Labor Statistics. At July 28, 2012, January 28, 2012 and July 30, 2011, approximately $56.4 million, $47.3 million and $43.5 million, respectively, of the Company’s merchandise inventories were valued under LIFO. If the first-in, first-out method of inventory valuation had been used instead of the LIFO method, merchandise inventories would have been $5.4 million, $4.0 million and $1.8 million lower at July 28, 2012, January 28, 2012 and July 30, 2011, respectively. There were no liquidations of the LIFO layers during the periods reported.

Income Taxes and Deferred Taxes — The Company has one reportable segment. The Company’s operations include activitiesmonitors its operating performance and evaluates the likelihood of the future realization of its deferred federal and state tax assets. In assessing the realization of these deferred tax assets and the need for a valuation allowance, the Company considers both positive and negative evidence related to the likelihood of realization of the deferred tax assets taking into account achieving a certain level of future taxable income or being able to carry back any taxable losses and claim refunds against previously paid income taxes. If, based on the weight of available evidence, it is more likely than not the deferred tax assets will not be realized, the Company records a valuation allowance. The weight given to the positive and negative evidence is commensurate with the extent to which the evidence may be objectively verified. As such, it is generally difficult for positive evidence regarding projected future taxable income exclusive of reversing taxable temporary differences to outweigh objective negative evidence of recent financial reporting losses. A pattern of objectively measured recent and cumulative financial reporting losses are a source of significant negative evidence that is difficult to overcome in determining that a valuation allowance is not needed against deferred tax assets. As of July 28, 2012, the Company has concluded that the negative evidence now outweighs the positive evidence, and accordingly, it is more likely that the Company will not be able to realize all of its stores that are all located in California.federal and state deferred tax assets. Therefore, the Company recorded a charge of $18.4 million to income tax expense to establish a valuation allowance against its deferred tax assets.

Vendor RebatesAccounting for the Impairment of Long-lived Assets — Long-lived assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset or asset group may not be recoverable. If the carrying value of the asset or asset group exceeds the expected future cash flows expected to result from the use of the asset, on an undiscounted basis, an impairment loss is recognized. The impairment loss recognized is the excess of the carrying value of the asset or asset group over its fair value. The fair market value of these assets or asset group is determined using the income approach and Allowances —Level 3 inputs (see Note 3), which require management to make estimates about future cash flows. The Company receives various vendor-funded rebatesestimates the amount and allowances through a varietytiming of programsfuture cash flows based on historical experience and arrangements intended to offset the Company’s costs of promoting and selling certain vendor products. These vendor payments are recorded as a reduction to the cost of merchandise inventories when earned and, thereafter, as a reduction of cost of sales, as the merchandise is sold. Up-front consideration received from vendors linked to purchases or other commitments is deferred until performanceknowledge of the specified activityretail market in which each store operates. The Company does not believe there is deemeda reasonable likelihood that there will be a material change in the estimates or assumptions the Company used to be complete. Forcalculate impairment losses of long-lived assets. The Company recorded $7.2 million and $7.7 million of asset impairment charges in connection with store assets for the 13 and 39 weeks26 week periods ended October 29, 2011, the Company earned vendor rebates and allowances of $7.5 million and $22.6 million,July 28, 2012, respectively. ForNo impairment charges were recorded for the 13 and 39 weeks26 week periods ended OctoberJuly 30, 2010, the Company earned vendor rebates and allowances of $7.9 million and $22.0 million, respectively. Vendor rebates and allowances deferred at October 29, 2011, January 29, 2011 and October 30, 2010 were $11.2 million, $11.8 million and $11.9 million, respectively, and2011. The impairment charges are included as a reduction to merchandise inventories in the interim condensedselling and administrative expenses in the consolidated balance sheets.statements of operations.

Assets available for saleDerivatives —— Assets that have met the criteria to be classified as held for sale under ASC 360-10-45 Derivative financial instruments embedded in leases are recorded at fair value within prepaid expenses and other current assets withinin the consolidated balance sheet of the interim condensed consolidated financial statements. At October 29, 2011, the Company had $2.6 million of assets held for sale. There were no assets classifiedsheets as held for sale at January 29, 2011 and October 30, 2010.

Leases— The Company leases certain stores, office facilities, computers, and transportation equipment. The determination of operating and capital lease obligationsasset if the lease is based upona capital lease or as other long-term assets if the expected termslease is an operating lease. The assets are amortized over the life of the lease to depreciation and the contractual minimum lease payments as defined within the lease agreements. The Company may enter into sale-leaseback agreements to sell certain facilitiesamortization expense. In addition, they are recorded in other long-term liabilities at fair value and lease them back consistent with their current operational use. If the lease under a new agreement is determined to be a capital lease, any gain or loss on the sale would be amortizedderivative financial instruments is recorded in proportion toselling and administrative expense and in the amortizationconsolidated statements of operations. At July 28, 2012 and January 28, 2012, the fair value of the leased assetderivative financial instruments embedded in its lease was $5.3 million and $2.3 million, respectively. At July 30, 2011 the Company did not have any derivative financial instruments embedded in its leases.

Stock-Based Compensation —The Company recognizes as expense the fair value of all stock-based compensation awards, including stock options. The Company recognizes compensation expense as awards vest on a straight-line basis over the liferequisite service period of the lease. Ifaward. The Company accounts for stock-based compensation using the new leasefair value method. The total compensation expense is an operating lease, any gain would be amortized in proportionreduced by estimated forfeitures expected to the gross rent charged to expenseoccur over the lease term and any loss on the salevesting period of the asset would be recognized immediately.award.

On October 24, 2011, a subsidiary of the Company entered into a Purchase and Sale Agreement pursuantComprehensive Income (Loss) — Comprehensive income (loss) encompasses all changes in equity other than those arising from transactions with stockholders. Comprehensive income (loss) was equal to which a subsidiary of the Company soldnet income (loss) for $21.2 million, net of fees, all of its interest in its distribution center located in Tracy, California, which is comprised of a building containing approximately 458,000 square feet and the underlying land. In connection with the sale of the distribution center, a subsidiary of the Company entered into a lease agreement with respect to the distribution center. The commencement date of the lease was October 28, 2011. The lease is for a 20-year period and provides for three five-year extension options. The initial base rent under the lease is $1.7 million per year with 10% increases every five years.periods presented. The Company recorded a non-cash losshad no items of $14.3 million on the sale of the distribution center for the 13 weeks ended October 29, 2011. The Company will continue to operate the facility consistent with its existing use throughout the lease term.other comprehensive income (loss) in any period presented.

Earnings Per Share (“EPS”) — — The Company computes and reports both basic EPS and diluted EPS. Basic EPS is computed by dividing net earnings by the weighted average number of common shares outstanding for the period. Diluted EPS is computed by dividing net earnings by the sum of the weighted average number of common shares and dilutive common stock equivalents outstanding during the period. Diluted EPS reflects the total potential dilution that could occur from outstanding equity plan awards, including unexercised stock options.

There are no dilutive common stock equivalents, and therefore basic and dilutive EPS are the same for all periods presented.

Fair Value of Financial InstrumentsNew Accounting Pronouncements — —In July 2012, the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 820, Fair Value Measurements(“FASB”) issued updated guidance on the periodic testing of indefinite-lived intangible assets for impairment. This guidance provides companies the option to first assess qualitative factors to determine if it is more likely than not that an indefinite-lived intangible asset is impaired and Disclosures, (“ASC 820”) defines fair value, establisheswhether it is necessary to perform an annual quantitative impairment test. This guidance is effective for fiscal years beginning after September 15, 2012, with early adoption permitted. The Company is reviewing this guidance and does not believe it will have a framework forsignificant impact on the Company’s consolidated results of operations, financial position or cash flows.

measuring fair value in GAAP and requires certain disclosures about fair value measurements. Under ASC 820, fair3. FAIR VALUE OF FINANCIAL INSTRUMENTS

Fair value is considereddefined as the price that would be received to besell an asset or paid to transfer a liability in the exchange priceprincipal or most advantageous market in an orderly transaction between market participants to sell an asset or transfer a liability aton the measurement date. ASC 820 also establishesEntities are required to use a fair valuethree-level hierarchy, which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The standard describesvaluation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability on the measurement date. The three levels of inputs that may be used to measure fair value:are defined as follows:

Level 1— QuotedUnadjusted quoted prices in active markets for identical assets or liabilities;

Level 2—Inputs other than quoted prices included within Level 1 that are either directly or indirectly observable; and

Level 3—Unobservable inputs that are supported by little or no market activity, therefore requiring an entity to develop its own assumptions about the assumptions that market participants would use in pricing.

Due to their short-term nature, the carrying value of the Company’s cash and cash equivalents, restricted cash, other current assets, merchandise payables, accrued expenses and other current liabilities approximate their fair value. Included in cash and cash equivalents are money market funds of $12.2 million, $3.0 million and $1.0 million at July 28, 2012, January 28, 2012 and July 30, 2011, respectively, which fair value was determined using Level 1 inputs. The fair value of the Senior Secured Term Loan was $93.6 million, $100.7 million and $139.7 million based on the trading values as of July 28, 2012, January 28, 2012 and July 30, 2011, respectively, which was determined using Level 1 inputs. The carrying value of the Senior Secured Term Loan was $135.6 million, $137.6 million and $172.5 million as of July 28, 2012, January 28, 2012 and July 30, 2011, respectively. Based on borrowing rates available to the Company, which are considered Level 2 inputs, the carrying value of the Company’s debt obligations with respect to the Senior Secured Credit Facility and Real Estate Term Loan approximated their fair value at October 29, 2011,July 28, 2012, January 29, 2011,28, 2012 and OctoberJuly 30, 2010.2011.

The Company measures certain non-financial assets and liabilities, includingIn connection with the Company’s evaluation of long-lived assets for impairment, certain long-lived assets were measured at fair value on a non-recurring basis. Thebasis using Company did not record anyspecific assumptions which would fall within Level 3 inputs of the fair value hierarchy. In the determination of impairment for operating stores, the 13Company determined the fair values of individual operating stores using an income approach, which required discounting projected future cash flows. When determining the projected future cash flows associated with an individual operating store, management made assumptions, incorporating local market conditions, about key store variables, including sales growth rates, gross margin and 39 weeks ended October 29, 2011controllable expenses such as store payroll and October 30, 2010.occupancy expense. In order to calculate the present value of those future cash flows, the Company discounted cash flow estimates at a rate commensurate with the risk used as the cost of its capital.

The Company wasmeasures store lease derivatives by Company specific assumptions which would fall within Level 3 inputs of the fair value hierarchy. Ten of our store leases have future rent increases tied to an index of annual changes in the Consumer Price Index (“CPI”). The fair value of the derivative is computed using historical increases in CPI and the value calculated using the maximum rent escalation cap as defined by the leases.

The Company is not required to measure any other significant non-financial assets and liabilities at fair value on a non-recurring basis as of October 29, 2011July 28, 2012, January 28, 2012, and OctoberJuly 30, 2010.2011.

New Accounting Pronouncements — In June 2011, the Financial Accounting Standards Board (“FASB”) issued an accounting standards update to revise the manner in which entities present comprehensive income in their financial statements. This guidance requires entities to present each component of net income along with total net income, each component of other comprehensive income (“OCI”) along with a total for OCI, and a total amount for comprehensive income, either in a single continuous statement of comprehensive income or in two separate but consecutive statements. This accounting standards update is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. 4. SALE-LEASEBACK TRANSACTIONS AND LEASE FINANCING OBLIGATIONS

The Company evaluates sales of properties which occur in sale-leaseback transactions to determine the proper accounting for the proceeds of such sales transactions either as a sale or a deposit. This evaluation requires certain judgments in determining whether all considerations have been exchanged and whether there is continuing involvement with respect to the property. For transactions that have not yet met the sale criteria, the Company accounts for the proceeds as deposits from the sale of real properties and offsets rent payments against the deposits. Once all conditions of the sale have been met, the property will adopt the provisions of this accounting standards update inbe evaluated for sale-leaseback accounting.

In the first quarter of fiscal 2012. This amendment will change2012, the Company sold all of its interest in a store property located in San Lorenzo, California and entered into a sale-leaseback agreement with respect to the store. The term of the lease is from April 2012 to November 2013 and may be terminated after November 2012 with 30 days notice. For accounting purposes, the sale of the store was consummated and the Company recorded a $0.7 million gain on the transaction during the quarter ended April 28, 2012.

In the second quarter of fiscal 2012, the Company sold all of its interest in six store properties located in San Jose, Van Nuys, Pinole, Chico, and Clovis, California and entered into a master sale-leaseback agreement with respect to those stores. In conjunction with the sale-leaseback, the Company entered into a lease agreement allowing the Company to continue to operate the stores in a manner consistent with their existing use throughout the lease term. The initial lease term of the lease is from July 27, 2012 to July 27, 2030 with three 5-year renewal options. For accounting purposes, the sale of these stores was not consummated due to continued involvement and risk. Thus, no gain or loss was recorded on the transaction.

As of July 28, 2012, the Company had $22.5 million of short-term deposits and $41.5 million of long-term deposits from the sale-leaseback of real property on nine stores recorded in the consolidated balance sheet. The sale-leaseback agreement includes provisions for the remodeling of the stores for which the landlord will reimburse the Company presents comprehensive income in its consolidated financial statements.for the costs of Tenant Improvements (“Improvements”) up to an agreed upon amount. In addition, if the Company fails to complete construction during the specified period,

In May 2011,

the FASB issued guidancelandlord will have three years to amendexercise an option to require the accounting and disclosure requirements on fair value measurements. The new guidance limitsCompany to repurchase the highest-and-best-use measureproperties. Due to nonfinancial assets, permits certain financial assets and liabilities with offsetting positions in market or counterparty credit risks to be measured at a net basis, and provides guidance on the applicability of premiums and discounts. Additionally,Company’s continuing involvement during the new guidance expandsremodeling period, as the disclosures on Level 3 inputs by requiring quantitative disclosure of the unobservable inputs and assumptions, as well as description of the valuation processes and the sensitivity of the fair value to changes in unobservable inputs. The new guidance will be effectiveleases provide for the Company beginning January 29, 2012.to assume substantially all of the construction period risk, the sale-leaseback will not be consummated until the Improvements are completed within the specified timeframe, and amounts spent are fully reimbursed to the Company by the landlord. The Company does not anticipate a material impact on its financial statements upon adoption.

3.	DEBT AND CAPITAL LEASE OBLIGATIONS

5. DEBT AND CAPITAL LEASE OBLIGATIONS

The components of the Company’s debt and capital lease obligations as of October 29,at July 28, 2012, January 28, 2012 and July 30, 2011 January 29, 2011 and October 30, 2010, are as follows (in millions):

Senior Secured Credit Facility— On December 21, 2006, OSH LLC entered into an Amended and Restated Senior Secured Credit Agreement (the “Replaced Facility”) with a syndicate of lenders. The Replaced Facility provided revolving availability of up to $130 million (subject to borrowing base limits and fixed charge coverage ratio) for a period of five years, maturing on December 21, 2011. On January 29, 2010, OSH LLCthe Company amended, and restated and extended its credit line. As of July 28, 2012, the Replaced Facility (the “SeniorCompany had $54.6 million available to borrow on the facility, subject to borrowing base limits. The Senior Secured Credit Facility”) and reduced the revolving availability down to $120.0 million (subject to borrowing base

limits). The amendment bifurcated the facility into a $20.0 million tranche maturing December 21, 2011 with lenders who elected not to extend and a $100.0 million tranche maturingFacility matures on the earlier to occur of 90 days prior to the maturity of the Senior Secured Term Loan and December 21, 2013 with lenders who elected to extend. As of January 29, 2011, $48.0 million was borrowed under the facility, with approximately $8.0 million due in December 2011 and approximately $40.0 million due in December 2013. As of October 29, 2011, $32.0 million was borrowed under the facility, with approximately $5.3 million due in December 2011 and approximately $26.7 million due in December 2013. The Company anticipates repaying $20.0 million on the Senior Secured Credit Facility within the next 12 months. The Company intends to draw funds from extending lenders to repay amounts due to non-extending lenders.

The Senior Secured Credit Facility also permitswas amended again in December 2011 in connection with amending and restating the ability to obtain letters of credit.Senior Secured Term Loan. As of October 29, 2011, January 29, 2011 and October 30, 2010, there were $8.1July 28, 2012, $35.0 million $7.3 million and $7.8 million ofwas outstanding letters of credit, respectively.under the facility.

Borrowings under the Senior Secured Credit Facility are subject to a borrowingeither base consisting of the sum of (i) 90% of eligible credit card accounts receivable plus (ii) 80% of other eligible accounts receivable plus (iii) the lesser of (x) 70% of eligible inventory (valuedrate (“BR”) loans or Eurodollar loans, at the lowerCompany’s discretion. BR loans bear interest at the greatest of cost, on a first in first out basis,(a) the prime rate as publicly announced by Wells Fargo Bank, N.A., (b) the federal funds rate plus 0.5%, or market value) or (y) 85% of(c) the appraised net ordinary liquidation value of eligible inventory.one month London Inter-Bank Offered Rate plus 1.0%, plus the “BR extended term applicable rate” which ranges between 1.50% and 2.25%. Eurodollar loans bear interest at LIBOR, plus the “Eurodollar extended term applicable rate” which ranges between 2.50% and 3.25%. At July 28, 2012, the Company’s interest rate was 3.50%. The Company must deliver borrowing base certificates and reports at least monthly. The borrowing base also may be subjectinterest rate spreads applicable to certain other adjustments and reserves to be determinedthe Company’s borrowings fluctuate based upon its performance as measured by the agent. As of October 29, 2011, there was $70.9 million available to borrow under the Senior Secured Credit Facility.its leverage ratio.

The Senior Secured Credit Facility places various restrictions on OSH LLC and Guarantors, including, but not limitedsubjects us to limitations on their ability to incur additional debt, pay dividends, or make distributions, sell assets, or make investments.

The Senior Secured Credit Facility required OSH LLC and the Guarantors to meet specificcertain restrictive covenants, including a fixed charge coverage ratio that is triggered when availability reaches a minimum threshold for three consecutive days. Borrowings under the Senior Secured Credit Facility are also subject toreaches a Fixed Charge Coverage Ratiominimum threshold of 1.1 to 1. At any time10% of the total availability for three consecutive days. The fixed charge coverage ratio falls below 1.1,requires the Company can only borrow up to 90%maintain a minimum ratio of 1.1 to 1.0 EBITDAR (EBITDA plus rent expense) to certain fixed charges. The fixed charge coverage ratio covenant was not triggered during the available borrowing base. The13 and 26 week periods ended July 28, 2012.

Real Estate Secured Term Loan—In October 2010, the Company wasentered into a $50.0 million real estate secured loan . On July 27, 2012 the Company completed a sale-leaseback transaction for six properties. Proceeds of $25.2 million from the sale-leaseback transaction were used to pay-off the Real Estate Secured Term Loan in compliance with these covenantsits entirety as of October 29, 2011, January 29, 2011 and October 30, 2010.July 28, 2012.

Senior Secured Term Loan—On December 21, 2006, OSH LLC entered22, 2011, the Company amended, restated and extended its term facility. The amendment and restatement split the facility into a $200two tranches. The first tranche was for $59.5 million senior secured term loan agreement (the “Senior Secured Term Loan”), which requires quarterly principal paydowns (the “Mandatory Payments”) of $0.5 million and has a seven-year term, maturing onwith lenders who elected not to extend the maturity beyond December 21, 2013. On January2013, of which $58.6 million was outstanding as of July 28, 2011, OSH LLC entered into2012. The second tranche was for $78.1 million with lenders who elected to extend the first amendmentmaturity date to December 21, 2015, of which $77.0 million was outstanding as of July 28, 2012.

At July 28, 2012, the Company’s interest rate under the Senior Secured Term Loan (the “Seniorfor non-extending loans was 5.0%. Eurodollar loans owing to non-extending lenders bear interest at LIBOR, plus the “Eurodollar applicable rate” which ranges between 4.50% and 4.75%. Eurodollar loans owing to extending lenders bear interest at LIBOR (which shall be deemed to be equal to at least 1.25%), plus 5.75%. At July 28, 2012, the Company’s interest rate under the Senior Secured Term Loan First Amendment”), which resulted in changesfor extended loans was 7.0%. In addition, the Company’s extended loans bear a PIK interest due at the end of the term at a rate equal to 3.00% or 4.00% per annum, with such

interest automatically increasing the maximum adjusted leverage ratio covenant (the “Leverage Covenant”), applicableprincipal amount of the extended term loans on an annual basis. At July 28, 2012, the Company’s PIK interest rates, definition of EBITDA and excess cash flow prepayment percentage rate.rate was 3.00% based on its credit rating. The Company’s credit rating has not changed since June 2011. If the Company’s credit rating falls below B3 by Moody’s or B- by S&P, the PIK interest rate will increase to 4.00%.

In addition to the Mandatory Payments,quarterly principal payments of $0.4 million, the Company is required to make annualperiodic repayments on the Senior Secured Term Loan equal to a defined percentage rate (determined based on the Company’s leverage ratio) of excess cash flows. In accordance with the Senior Secured Term Loan First Amendment, the defined percentage rateratio and ratings) of excess cash flows, was increased to 75% from 50%which ranges between 25% and 100%. The Company did not make any prepayments pursuant to this requirement in fiscal 2010 or fiscal 2011during the 13 and does26 week periods ended July 28, 2012 and do not anticipate payingmaking any other prepayment under this requirement through the remainder of fiscal 2012.

In the event of a sale of a property owned by the Company, the Company is required to make repayments on the Senior Secured Term Loan equal to 75% of the proceeds, net of fees, cash tax, and other mandatory debt repayments. If the Company intends to use the proceeds for capital re-investments into the Company, then the Company is not required to make this repayment. Pursuant to the sale-leaseback of the six collateralized stores properties, the Company made a $7.6 million prepayment under this requirement on August 24, 2012. Pursuant to the sale-leaseback of the collateralized store located in San Lorenzo, California, the Company made $1.2 million in prepayments under this requirement in fiscalon May 18, 2012.

The maximum adjusted leverage ratio covenant (as defined in the Senior Secured Term Loan places various restrictionsLoan) is calculated on OSH LLC and the Guarantors, including, but not limited to, limitationslast day of each fiscal quarter as (a) consolidated total funded debt on their ability to incur additional debt, pay dividends, make distributions, sell assets or make investments. Thesuch date minus unrestricted cash over $3 million (as defined in the Senior Secured Term Loan requires OSH LLC andLoan) to (b) trailing four fiscal quarters Adjusted EBITDA (as defined in the Guarantors to meet specific covenants, includingSenior Secured Term Loan). The following table provides the Leverage Covenant. Company’s maximum leverage ratio during the remaining term of the Senior Secured Term Loan:

The Company was in compliance with the Senior Secured Term Loan Leverage Covenants during the first, second and third quarters of fiscal 2011 and all of fiscal 2010.

Real Estate Secured Term Loan— In October 2010, OSH Properties entered into a $50 million real estate secured loan (the “Real Estate Secured Term Loan”) with a group of lenders that required quarterly payments of $0.1 million and that matures in December 2013. On February 17, 2011, OSH Properties entered into the first amendment to the Real Estate Secured Term Loan, which raisedcovenants, including the maximum thresholds, as defined by the Real Estate Secured Term Loan, on the Leverage Covenant for certain periods and amended the definition of EBITDA. On December 19, 2011, the Company entered into the first amendment to the Real Estate Secured Term Loan,leverage ratio, which, among other things, lowered the minimum principal amount required under the Real Estate Secured Term Loan, which allowed the Company to conduct certain sale and leaseback transactions described in Note 7 below.

The Real Estate Secured Term Loan requires the Company to meet the Leverage Covenant, subject to maximum thresholds established by the Real Estate Secured Term Loan. The Companyat July 28, 2012 was in compliance with these covenants during the first, second, and third quarters of fiscal 2011 and all of fiscal 2010.4.94:1.

Change in ControlControl—— The Senior Secured Credit Facility and the Senior Secured Term Loan and Real Estate Secured Term Loan eachboth contain an event of default resulting from a change of control, which includes the following: (i) certain mergers, consolidations, sales or transfers of all or substantially all of the assets of OSH LLCthe Company and OSH LLC’s subsidiaries to persons other than ACOF, ESL Investments, Inc. (“ESL”) and Sears Holdings; (ii) adoption of a plan of liquidation of OSH LLC;the Company; (iii) prior to an initial underwritten public offering of common stock of the Company, Sears Holdings, ESL and ACOF ceasing to collectively hold directly or indirectly at least 50% of the total voting power of all shares of the Company and OSH LLC’sCompany’s voting capital stock; (iv) following an initial underwritten public offering of common stock of the Company, a person or group, other than Sears Holdings, ESL and ACOF, collectively holding directly or indirectly at least 40% of the total voting power of all shares of the Company and OSH LLC’sCompany’s voting capital stock and Sears Holdings, ESL and ACOF collectively holding less than such person or group; and (v) the Company’s boardBoard of directorsDirectors not consisting of continuing directors (“Change in Control”).

If following the Distribution, one or both of ESL and ACOF dispose of all or part of their shareholding in the Company such that their combined total voting power drops below 50% (or 40% after an initial underwritten public offering), this may trigger a Change in Control event of default under the Senior Secured Credit Facility Senior Secured Term Loan and Real Estatethe Senior Secured Term Loan. An event of default could trigger certain acceleration clauses and cause those and the Company’s other obligations to become immediately due and payable and the Company may not have sufficient cash funds available to repay its debt obligations upon such a Change in Control.

Immediately following the Distribution:6. RELATED-PARTY AGREEMENTS

Neither ESL nor ACOF have agreed to maintain their shareholding in the Company following the Distribution.

The Company’s liquidity is dependent upon the continued availability of borrowings under its current financing arrangements. As discussed in Note 3, the Senior Secured Term Loan and Real Estate Secured Term Loan are subject to certain financial and other covenants. As of October 29, 2011, the Company was in compliance with its financial covenants under its financing arrangements, and the Company currently believes that it will continue to be in compliance with these covenants through at least the end of the third quarter of fiscal 2012. However, the decline in the Company’s operating results for the 39 weeks ended October 29, 2011, coupled with continued economic weakness in the markets in which the Company operates, has adversely impacted the Company’s prospective compliance with the financial covenants under the Senior Secured Term Loan and the Real Estate Term Loan. On October 24, 2011, in order to reduce the Company’s leverage, a subsidiary of the Company sold its distribution center located in Tracy, California for cash proceeds of $21.2 million, net of fees and on October 26, 2011, the Company entered into the Appliances Agreement with a subsidiary of Sears Holdings that the Company had planned to enter into at the Distribution, pursuant to which it transferred certain inventory purchased from Sears Holdings to a subsidiary of Sears Holdings, for $1.9 million in cash. Additional actions taken by the Company to further reduce the Company’s leverage include, on December 12, 2011, a subsidiary of the Company completed the sale of all of its interest in the property occupied by its store located in Hollywood, California and on December 20, 2011, a subsidiary of the Company completed the sale of all of its interests in three properties occupied by its stores located in Pismo Beach, California, Cottle Road in San Jose, California, and Capitol Expressway in San Jose, California.

The Company utilized $21.6 million of the proceeds received in the sale and leaseback transactions to pay-down its Real Estate Secured Term Loan and expects to utilize the remainder of the proceeds to pay-down its Senior Secured Term Loan. In connection with that pay-down, the Company expects to enter into an agreement with lenders holding a majority of the principal under the Company’s Senior Secured Term Loan to, among other things, extend the maturity date to December 21, 2015 and to secure improved financial covenants and to make certain other technical amendments.

If the agreement with lenders holding a majority of the principal under the Company’s Senior Secured Term Loan does not occur, the Company seeks to remain in compliance with its financing arrangements and generate sufficient liquidity by executing its sales growth strategy by, among other things, making improvements to its stores and store operations and upgrading and differentiating its product assortment. Notwithstanding the foregoing, the Company continues to examine a number of alternatives with respect to future compliance and liquidity, including asset sales and/or sale-leaseback transactions. In addition, if necessary or advisable, the Company may seek to further renegotiate its financing arrangements in order to remain in compliance while continuing to follow its current business plan, which includes plans for store expansion. In such case, if such renegotiations were necessary but unsuccessful, the Company would expect to take certain actions that would allow it to remain in compliance. Such actions could include, among others, a reduction of capital expenditures by delaying or reducing new store openings and store remodels, a reduction in payroll and benefit costs, deferring certain maintenance and other expenditures, as well as generating additional cash through sale or sale leaseback of certain real estate assets in order to reduce leverage. However, the implementation of these actions could result in slower growth and could potentially reduce future sales.

Notwithstanding the Company’s expectations, if operating results were to continue to decline or if market conditions were to worsen, the Company may be unable to meet its financial covenants, and lenders could demand repayment of the amounts outstanding under its financing agreements. Under such circumstances, no assurances can be given that the Company’s financing arrangements could be renegotiated, or that alternative financing would be available on terms acceptable to the Company, if at all. In addition, any refinancing could be at higher interest rates and may require the Company to comply with more onerous covenants which could further restrict its business operations.

The Company purchases Sears Holdings exclusiveHoldings’ brands such as Craftsman, Kenmore, Easy Living, and Weatherbeater directly from Sears Holdings and outside vendors. Purchases of these exclusive brands forDuring the 13 and 39 weeks ended October 29, 2011July 28, 2012 and OctoberJuly 30, 2010 are as follows (in millions):

For the 13 and 39 weeks ended October 29, 2011, the Company purchased approximately $3.2$0.1 million and $11.0$4.2 million, respectively, of merchandise directly from Sears Holdings, which represented 56% of total purchases ofHoldings. During the exclusive brands for each period. For the 13 and 3926 weeks ended OctoberJuly 28, 2012 and July 30, 2010,2011, the Company purchased approximately $3.3$0.2 million and $8.6$7.8 million, respectively, of merchandise directly from Sears Holdings, which represented 49% and 44%, respectively, of total purchases of the exclusive brands.

Concurrent with the Recapitalization, the Company and Sears Holdings entered into various agreements, including an appliance sales agreement (the “Appliance Sales Agreement”) and a brand sales agreement (the “Brand Sales Agreement”) (collectively, the “Agreements”). The salient terms of the Agreements between the Company and Sears Holdings, all of which have an effective date of November 23, 2005, are as follows:

Appliance Sales Agreement— In 2005, the Company entered into an Appliances Sales Agreement with Sears Holdings that granted the Company the right to purchase from Sears Holdings and to sell certain major branded appliances, including major Kenmore-branded appliances (the “Products”). The Company is permitted to sell the Products at currently identified retail locations and if approved by Sears Holdings, at additional retail locations (the “Appliance Stores”). The price paid by the Company for Products purchased from Sears Holdings equals Sears Holdings’ cost for such Products. If the Appliance Sales Agreement is terminated by Sears Holdings, Sears Holdings has the right, but not an obligation, to purchase all Products held in the Company’s inventory at the last price such Products were sold to the Company. In addition, the Company is required to pay a monthly monitoring fee per Appliance Store to Sears Holdings, which currently approximates $0.1 million per year.Holdings.

In accordance with Sears Holdings’ policy, the Company is entitled to receive from Sears Holdings an allocation of vendor subsidies earned from the purchase of appliances made on behalf of the Company. These vendor subsidies are based on contractual relationships established between Sears Holdings and the vendor and are applicable only to purchases made by Sears Holdings. For the 13 and 39 weeks ended October 29, 2011, the Company recognized approximately $0.2 million and $0.5 million, respectively, in vendor subsidies. For the 13 and 39 weeks ended October 30, 2010, the Company recognized approximately $0.1 million and $0.3 million, respectively, in vendor subsidies.

The agreement from 2005 was terminated on October 26, 2011, when the Company entered into a new appliances agreement (the “Appliances Agreement”) with a subsidiary of Sears Holdings pursuant to which Sears Holdings has authorized the Company to sell the Productscertain major branded appliances, (the “Products”) and related protection agreements on a consignment basis as a distributor through its designated retail locations. The Appliances Agreement requires that Sears Holdings pay the Company commissionslocations on the Company’s sales of the Products and the protection agreements for the Products.a commission basis. Commissions for Products varies by Product category and Sears Holdings may in its sole discretion modify from time to time the

commission rate for each category of Product butas defined in the annual weighted-average aggregate commission rate for all categories ofagreement. The Products for each Sears Holdings fiscal year for the Sears Holdings Authorized Hometown Stores as a group, including the Company, will not be less than a specified rate. The products include specified categories of Kenmore, Bosch, Electrolux, GE, LG, Samsung and Whirlpool branded appliances. The agreement generally incorporates arm’s length terms and conditions, including market-based pricing and term of duration.

The Appliances Agreement was amended on March 22, 2012 (the “Amended Appliances Agreement”). Under the Amended Appliances Agreement, the Company transferredmay close up to Sears Holdings its entire inventory of majorfourteen currently identified retail locations that carry appliances purchased from Sears Holdings for $1.9 million in cash(the “Appliance Centers”) at specified times through August 2013 and close the remaining 13 Appliance Centers on October 27, 2011, which represented the Company’s cost of the purchased appliances, subject to adjustments based on, among other things, the results of a physical inventory of the purchased appliances and the cost of certain clearance markdowns realized by Sears Holdings during the 60-day period following the effective date of the Appliances Agreement.

January 31, 2015. The Amended Appliances Agreement has a term of five years. The Company may terminatehas exercised its right to close six Appliance Centers in specified stores and expects the Appliances Agreement early for convenience afterclosing to be completed by the first 18 monthsthird quarter of the Appliances Agreement or iffiscal 2012.

The Company has a payable of $0, $2.9 million, and $1.7 million with Sears Holdings, failsas of July 28, 2012, January 28, 2012, and July 30, 2011, respectively.

7. COMMITMENTS AND CONTINGENCIES

Two putative class action lawsuits, brought on behalf of current and former employees, are pending against the Company. One of these lawsuits was brought in 2010 and one was brought in 2011. These lawsuits allege the Company failed to comply with anyvarious California labor laws, including misclassification of its material obligationsnon-exempt employees as exempt employees, failure to pay regular, overtime, and final wages, failure to provide meal and/or rest breaks, and failure to provide accurate wage statements. The Company denies the allegations in the Appliances Agreementclaims of these lawsuits and the failure remains uncured for 30 days or more following notice. Sears Holdings may terminate the Appliances Agreement early for its convenience by delivering six months’ prior written noticeintends to vigorously defend itself against them. However, the Company aftercannot predict with assurance the first anniversaryoutcome of these lawsuits and accordingly adverse developments, settlements, or resolutions may occur and negatively impact income in the quarter of such development, settlement, or resolution. Based on the information currently available, the Company does not believe that either of these lawsuits would have a material adverse effect on the consolidated financial position or results of operations of the effective date of the Appliances Agreement or if (a) with respect to a Sears Holdings’ fiscal quarter, the Company sales of Products during the fiscal quarter are not at least 70% of the Company sales of Products during the same fiscal quarter in the prior year or (b) the Company fails to comply with any of its material obligations in the Agreement and the failure remains uncured for 30 days or more following notice. The Appliances Agreement provides that during its term of the Appliances Agreement, the Company will not be able to operate in California other businesses that sell merchandise similar to the Products. The Appliances Agreement also provides that for two years following the end of the term, the Company will not be able to operate a business that competes with Sears Holdings Businesses at, or within ten miles of, its retail locations that sold Products at any time during the term.

Brand Sales Agreement— In 2005, Sears Holdings granted the Company the right to purchase from Sears Holdings and its approved vendors, as well as to sell certain additional products, which include products marketed under Sears Holdings’ exclusive brands, such as Craftsman, Easy Living and Weatherbeater (the “Additional Products”). The price paid by the Company for the Additional Products purchased from Sears Holdings equals Sears Holdings’ cost for such Products.

The agreement from 2005 will be terminated on the Distribution Date, when the Company enters into new brands license agreements (the “Brands Agreements”) with a subsidiary of Sears Holdings to be effective at the Distribution pursuant to which Sears Holdings will allow the Company to purchase a limited assortment of Craftsman products, Easy Living and Weatherbeater paints, Kenmore-branded water heaters and consumer household products directly from vendors. Under the Brands Agreements, the Company will pay specified license fees to Sears Holdings. The Brands Agreements generally will incorporate arm’s length terms and conditions, including market-based pricing and term of duration. Each of the Brands Agreements is expected to have a three-year term and may be extended subject to the mutual agreement of the parties. If the aggregate of the Company’s Craftsman product sales over any 12-month period falls by more than 25% below the preceding 12-month period following the second anniversary of the Distribution, Sears Holdings will be permitted to terminate that Brands Agreement in its sole discretion with 60 days’ notice.

For the 13 and 39 weeks ended October 29, 2011, the Company recognized approximately $0.3 million and $1.0 million, respectively, in royalty expenses. For the 13 and 39 weeks ended October 30, 2010, the Company recognized approximately $0.3 million and $1.0 million, respectively, in royalty expenses.

Stockholders’ Agreement — In November 2005, the Company entered into a stockholders’ agreement with Sears Roebuck and ACOF that was amended and restated as of January 8, 2008 (the “Existing Stockholders’ Agreement”). Pursuant to the terms of the Existing Stockholders’ Agreement, certain of the Company’s preferred stock is issuable to Sears Roebuck. The Company, Sears Holdings and ACOF have agreed that this preferred stock will be issued to Sears Roebuck in the form of the preferred stock described herein, and that Sears Holdings will thereafter distribute such preferred stock to its shareholders in the Distribution. The Existing Stockholders’ Agreement also provides for certain transfer restrictions, governance provisions, registration rights and other matters.

In connection with the Distribution, the Company, ESL, Edward S. Lampert, William C. Crowley and ACOF will amend and restate the Existing Stockholders’ Agreement (as amended and restated, the “Stockholders’ Agreement”), and Sears Roebuck will cease to be a party to the Stockholders’ Agreement. The Existing Stockholders’ Agreement will be terminated and superseded by the provisions of the Stockholders’ Agreement. The Stockholders’ Agreement will be effective immediately following the Distribution and will provide certain rights and obligations to the parties thereto.

On April 1, 2011, a judgment for $5.1 million by the California Superior Court was entered against the Company in favor of Save Mart Supermarkets (“Save Mart”). The Company recorded a $5.1 million liability and expense in selling and administrative expenses in the condensed consolidated statement of operations for the year ended January 29, 2011. On August 24, 2011, the Company entered into a settlement agreement with Save Mart (the “Settlement Agreement”) to satisfy the $5.1 million judgment, release the Company of all liabilities, and waive all rights of appeals by both parties. The Settlement includes three parts: 1) a $0.5 million cash consideration payable to Save Mart, 2) the amendment and extension of an existing lease between Save Mart and the Company, and 3) the lease of a new property to the Company. Pursuant to the Settlement Agreement, the Company paid the $0.5 million cash consideration and recorded a $1.6 million reduction to this liability, which is classified as a reduction to selling and administrative expense in the condensed consolidated statements of operations.

The Company is party toa defendant in various other legal proceedings arising in the ordinary course of its business. Based on the information currently available, the Company is not currently a party to any legal proceeding that management believes would have a material adverse effect on the Company’s consolidated financial position or results of operationsoperations.

8. INCOME TAXES

The Company regularly assesses the need for a valuation allowance against its deferred tax assets. In making that assessment, the Company considers both positive and negative evidence related to the likelihood of realization of the Company.

On December 12, 2011,deferred tax assets to determine, based on the weight of available evidence, if it is more likely than not that some or all of the deferred tax assets will not be realized. In evaluating whether to record a subsidiaryvaluation allowance, the applicable accounting standards deem that the existence of cumulative losses in recent years is a significant piece of objectively verifiable evidence that must be overcome by objectively verifiable positive evidence to avoid the need to record a valuation allowance. Prior to the start of the second quarter of 2012, the Company concluded that positive evidence outweighed negative evidence, and no valuation allowance was necessary. The Company most recently assessed the relevant positive and negative evidence at the conclusion of the second quarter ended July 28, 2012, including the effects of results of the quarter. As a result of this assessment, the Company concluded that, from an accounting perspective, the negative evidence now outweighed the positive evidence as of July 28, 2012. In accordance with that conclusion, the Company recorded a non-cash charge to income tax expense in the second quarter of 2012 in the amount of $18.4 million by establishing a valuation allowance against its deferred tax assets. In determining the appropriate amount of the valuation allowance, the Company considered the timing of future reversal of its taxable temporary differences and available tax strategies that, if implemented, would result in realization of deferred tax assets. Due to the accumulated negative evidence at the end of the second quarter of fiscal 2012, the Company is no longer allowed under those accounting standards to consider future income projections exclusive of the reversing temporary differences. This accounting treatment has no effect on the ability of the Company completed the sale of all of its interestto use loss carryforwards and tax credits in the property occupied byfuture to reduce cash tax payments. As of July 28, 2012, there was a valuation allowance of $27.8 million against its store located in Hollywood, California, which is comprised of a building containing approximately 31,000 square feet of enclosed space, plus approximately 8,000 square feet of nursery and garden area and the

underlying land. In connection with the closing of the sale, a subsidiary of the Company entered into a lease agreement with respect to the Hollywood store. The term of the lease began on December 12, 2011 and may be terminated on January 1, 2014, upon six months notice by the Company. The lease may also terminate upon two months notice from the landlord at any time except during February through June of each year.deferred tax assets. The Company will continue to operateassess the facility consistentlikelihood that the deferred tax assets will be realizable at each reporting period and the valuation allowance will be adjusted accordingly, which could materially affect the Company’s financial position and results of operations.

9. STOCK-BASED COMPENSATION

For the 13 and 26 week periods ended July 28, 2012 stock-based compensation expense was $0.3 million and $0.5 million, respectively. Stock-based compensation expense associated with its existing use throughoutstock-based compensation expense for the term.comparable periods ended July 30, 2011 was $0.1 million and $0.2 million, respectively. The Company has not yet completed its evaluationrecognizes stock-based compensation costs, net of a forfeiture rate, for only those shares expected to vest on a straight-line basis over the requisite service period of the financial impactaward.

The Company uses the Black-Scholes option-pricing model to value its stock options. The weighted average assumptions relating to the valuation of these transactionsthe Company’s stock options for the 13 and 26 week periods ended July 28, 2012 and July 30, 2011 were as follows:

Stock-Based Awards Activity

As of July 28, 2012, approximately 216,000 shares remain available for future grants of either stock options, restricted stock or restricted stock units.

The following table presents a summary of the Company’s stock option activity for the 26 weeks ended July 28, 2012:

The following table presents a summary of the Company’s restricted stock activity for the 26 week period ended July 28, 2012:

Performance-based Unit Awards

In the 13 and 26 week periods ended July 28, 2012, performance-based restricted stock unit awards were granted to certain employees. Under the terms of the performance-based restricted stock unit awards granted, certain employees are eligible to receive restricted stock unit awards, contingent upon the achievement of certain Company-specific performance goals. Any stock unit awards earned as a result of the achievement of such goals vests at a rate of 8.33% in each subsequent fiscal quarter when the Company achieves the certain Company-specific performance goals during any of the trailing four fiscal quarters during the “Performance Period”. The Performance Period commences on the Company’s consolidated financial statements.

On December 20, 2011, a subsidiaryfirst day of the Company completedsecond fiscal quarter of 2012 and ends on the sale of all of its interests in the properties occupied by (i) its store located in Pismo Beach, California, which is comprised of a building containing approximately 34,000 square feet of enclosed space, plus approximately 6,000 square feet of nursery and garden area and the underlying land, (ii) its store located on Cottle Road in San Jose, California, which is comprised of a building containing approximately 38,000 square feet of enclosed space, plus approximately 9,000 square feet of nursery and garden area and the underlying land and (iii) its store located on Capitol Expressway in San Jose, California, which is comprised of a building containing approximately 42,000 square feet of enclosed space, plus approximately 11,000 square feet of nursery and garden area and the underlying land. In connection with the closinglast day of the sale,third fiscal quarter of 2018. Any stock units earned as a subsidiaryresult of the achievement of such goals may vest in full over 6.75 years from the date of grant. The Company entered into lease agreementsrecorded $0 compensation expense with respect to each ofperformance-based stock unit awards in the stores. The term of the Pismo Beach store lease is 16 years, the others are 18 years, beginning on December 20, 2011. The Company will continue to operate the facilities consistent with its existing use throughout the term of each lease. The Company has not yet completed its evaluation of the financial impact of these transactions on the Company’s consolidated financial statements.

The aggregate purchase price received from these four properties was approximately $36 million. The Company expects to pay $3.2 million of additional rent annually with respect to the four leases.

On December 16, 2011, the Company’s Board13 and the Company’s stockholders approved the adoption of the 2011 Equity Incentive Plan (the “Plan”) and forms of Restricted Stock Agreement and Time-Based Option Agreement for use under the Plan. The Plan provides for the issuance of a maximum of 1.0 million shares of our Class A Common Stock in connection with the grant of stock options, stock appreciation rights, restricted stock awards, restricted stock units, stock bonus awards, dividend equivalents, performance compensation awards (including cash bonus awards) or any combination of the foregoing.26 week periods ended July 28, 2012.

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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

CAUTIONARY STATEMENT CONCERNING FORWARD-LOOKING STATEMENTS

You should read the following discussion and analysis in conjunction with ourthe Company’s consolidated financial statements and related notes included elsewhere in this report. Except for historical information, the discussion in this report contains certain forward-looking statements that involve risksrisk and uncertainties.uncertainty. The Company has based these forward-looking statements on our current expectations and assumptions about future events. You can identify these statements by forward-looking words such as “outlook”, “believes”, “expects”, “appears”, “may”, “will”, “should”, “intend”, “target”, “projects”, “estimates”, “plans”, “forecast”, “is likely to”, “anticipates”, or the negative thereof or comparable terminology. Examples of such statements include references to revenue growth, new store openings and remodels, comparable store sales, demand for the Company’s products and services, the state of the California economy, inventory and in-stock positions, cash flow, and the like. Forward-looking statements are based on the Company’s beliefs as well as the Company’s current assumptions, expectations, and projections about future events based on information currently available to the Company. As a result, these statements are subject to various risks and uncertainties. For a discussion of material risks and uncertainties that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements. Forward-looking statements include information concerning our future financial performance, business strategy, plans, goals and objectives.

Statements preceded or followed by, or that otherwise include, the words “believes,” “expects,” “anticipates,” “intends,” “project,” “estimates,” “plans,” “forecast,” “is likely to” and similar expressions or future or conditional verbs such as “will,” “may,” “would,” “should” and “could” are generally forward-looking in nature and not historical facts. Such statements are based uponCompany faces, see the current beliefs and expectations of management and are subject to significant risks and uncertainties. Actual results may differ materially from those set forthdiscussion entitled “Risk Factors” in the forward-looking statements.Company’s Annual Report on Form 10-K for the fiscal year ended January 28, 2012 and in Part II, Item 1A hereof, as supplemented by the Company’s subsequent SEC filings.

EXECUTIVE OVERVIEW

We areOrchard Supply Hardware Stores Corporation, and its wholly-owned subsidiaries, Orchard Supply Hardware LLC and OSH Properties LLC (the “Company” or “we” or “our”), is a specialty retailer primarilyneighborhood hardware and garden store focused on homeowners withpaint, repair maintenance and improvement needs.the backyard. Founded as a purchasing cooperative in San Jose in 1931, as of October 29, 2011, we operated 89 full-service hardware stores in California. Ourtoday our stores average approximately 43,60044,000 square feet of enclosed retail space plus approximately 8,300and 8,000 square feet of exterior nursery and garden area,space, carrying a broad assortment of merchandise across three primary categories:for repair, maintenance and maintenance, lawnimprovement needs for the home and garden and in-home products. Thebackyard. As of July 28, 2012, we had 88 stores in California. Our stores are easy to navigate and convenient to shop and are designed to appeal to do-it-yourself customers for home repair and maintenance.customers. We also serve the small professional customer whose purchases are largely motivated by a need for incremental supplies and tools to complete construction projects. We offer customers a unique value proposition comprised of service, selection and convenience. We believe

On December 30, 2011, we are California’s “large hardware store.became an independent, publicly-traded company as a result of Sears Holdings Corporation’s (“Sears Holdings”) distribution of its shares of the Company to Sears Holdings’ stockholders whereby Sears Holdings’ stockholders of record as of the close of business on December 16, 2011 received one share of our Class A Common Stock and one share of our Series A Preferred Stock for every 22.141777 shares of Sears Holdings’ common stock held (the “Spin-Off”).

At the time of the Spin-Off, Class A Common Stock owned by Ares Corporate Opportunities Fund (“ACOF”) immediately prior to the Spin-Off was exchanged for Class C Common Stock. Class A and Class C Common Stock represent approximately 80% and 20% of the general voting power of our outstanding capital stock, respectively. The outstanding shares of Preferred Stock represent 100% of our outstanding nonvoting capital stock.

Following the Spin-Off, since January 3, 2012, our Class A Common Stock has been listed and traded on NASDAQ under the symbol “OSH” and our Series A Preferred Stock has been quoted on the OTCQB under the symbol “OSHSP.”

Fiscal 2011 represents the year ending January 28, 2012 and fiscal 2010 represents the year ended January 29, 2011.

2011 ThirdSecond Quarter Financial Highlights

2011 Third2012 Second Quarter Business Highlights

We are in the midst of positioning ourselves for future growth and long-term stockholder value. In fiscal 2011, we started to lay the foundation to set us in a new direction to develop and evolve the Orchard brand and implement new business strategies that we believe will lead to positive financial impacts. We areThe Company is focused onagainst five key initiatives:strategic priorities:

DuringKey accomplishments during the first three quarters of fiscal 2011, we have made strong progress in all of these areas. During the thirdsecond quarter of fiscal 2011, in particular, some specific achievements in these areas2012 included:

Brand Identity. During the second quarter, we completed a sale-leaseback transaction with a national REIT for six properties, generating gross proceeds of approximately $42.8 million. As part of the transaction, the landlord is providing an improvement allowance to use across these stores for a combination of remodels and exterior refreshes. This transaction will allow us to continue to make progress in our multi-year brand and repositioning plan, including progress in our remodel program which, we believe, will lead to the achievement of an increase in comparable store sales and an increase in gross margin.

Drive Sales. The increase in comparable store sales during the second quarter was primarily attributable to our marketing and promotional activities designed to increase traffic and drive consumer spending. We openedbelieve these marketing and promotional activities have been necessary given the continuing challenging economic environment in the markets in which we operate. A byproduct of these marketing and promotional activities has been gross margin percentage contraction. Based on the second quarter’s experience, we intend to improve the cadence and effectiveness of our flagship store in Princeton Plaza in San Jose, California. This new store prototype offers an updatedmarketing and innovative customer-friendly design to showcase our merchandise and service offerings. We expect to remodel select existing stores to further testpromotional activities with the new prototype in 2012 and we will evaluate the results to determine longer-term remodeling plans.goal of supporting sales growth without adversely affecting gross margin. We also began a new and comprehensive product line review process to strengthenbelieve the merchandise resets associated with improving our product assortmentassortments disrupted traffic flow and optimize margins as we enhancethe customer experience during the second quarter. We remain focused on not only continuing to improve our customers’ shoppingproduct assortments but also refining our reset implementation processes to ensure a seamless and improved customer experience.

Sales and OperationalImprove Operating Efficiencies. WithWe effectively adjusted our store labor hours in response to sales trends during the second quarter. Additionally, we experienced a goal of putting our customers first and simplifying and enhancing the deploymentbuild-up of our inventory in anticipation of the peak selling season. Inventory levels did not reduce to expected levels given softer sales than anticipated. Accordingly, we are initiating several programs to reduce our inventory levels while at the same time ensuring in-stocks to satisfy customer demand.

Align Resources and Talent. During the second quarter, associates participated in new e-learning tools focused on training to drive sales through an enhanced customer-focused sales process. In addition, with the completion of our stores for sales activities,Benjamin Moore paints and stains line roll-out, we implemented a zone coverage in-store structure and “armed”had special training in collaboration with the Benjamin Moore Company to ensure our associates with radio communications deviceshad the product and process knowledge to quickly contact other associates in the store. We believe these actions have helpedprovide excellent service to drive an increase in average ticket. Sales momentum was also helped by more effective promotional initiatives.our paint customers.

Talent Development. We streamlined our field organization into four geographic regions, led by four newly-hired Regional Vice Presidents, to drive faster decision making with greater accountability and alignment. We also continued to focus on attracting and retaining quality store managers. In anticipation of, and to prepare for, the spin-off, we also hired a new Chief Financial Officer and a new General Counsel.

Spin-off. The spin-off from Sears Holdings is scheduled to occur on December 30, 2011.

Financial Position. We entered into agenerated approximately $42.8 million in gross proceeds from the six-store sale-leaseback transaction involvingin the second quarter. The proceeds were primarily used to pay off our distribution centerReal Estate Secured Term Loan in Tracy, California. This transaction allowed usthe second quarter of 2012 and pay down our Senior Secured Term Loan in the third quarter of 2012. Since October 2011, we have generated proceeds from multiple sale and sale-leaseback transactions related to repay a portion ofour efforts to reduce our debt. We are also in productive discussions concerning refinancing our debt and reduce the leverage under our financial loan covenants. We also negotiated lease amendments for our corporate headquarters (store support center) and one other store and, as part of those lease amendments, received tenant improvement allowances to help upgrade and remodel those properties.through debt and/or equity financing transactions.

RESULTS OF OPERATIONS

Our results of operations are presented using key accounting policiesThe discussion that follows should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements that are further describedincluded in Note 1 of the Notes to the Unaudited Interim Condensed Consolidated Financial Statements derived from the Company’s audited consolidated financial statementsour Annual Report on Form 10-K for the fiscal year ended January 29, 2011. Key definitions include:

Revenue Recognition— We recognize revenues from merchandise sales at28, 2012, as well as the laterunaudited interim consolidated financial statements and accompanying notes contained in this report. Our unaudited consolidated results of point of sale or delivery of goods to customers. Merchandise sales are reported net of estimated returns and allowances and customer rebates, excluding sales taxes. The reserve for returns and allowances is calculated as a percentage of sales based on historical return percentages. Net sales are presented net of any taxes collected from customers and remitted to governmental authorities. We also record deferred revenueoperations for the sale of gift cards13 and recognize this revenue upon the redemption of the gift cards. Comparable sales figures26 week periods ended July 28, 2012 and July 30, 2011 are defined as follows:summarized below (dollars and shares in millions, except per share amounts and store count).