You should read the following discussion and analysis in conjunction with the Company's consolidated financial statements and related notes elsewhere in this report. Except for historical information, the discussion in this report contains certain forward-looking statements that involve risk and 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 the Company faces, see the discussion entitled "Risk Factors" in the 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

Orchard 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 neighborhood hardware and garden store focused on paint, repair and the backyard. Founded as a purchasing cooperative in San Jose in 1931, today our stores average 44,000 square feet of enclosed retail space and 8,000 square feet of exterior nursery and garden space, carrying a broad assortment of merchandise for repair, maintenance and improvement needs for the home and backyard. 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. 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.

On December 30, 2011, we 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."

2012 Second Quarter Financial Highlights

• For the second quarter of fiscal 2012, net sales were $194.1 million, a decrease of $2.3 million, or 1.2%, as compared to net sales of $196.4 million for the second quarter of fiscal 2011. The decrease in net sales was primarily driven by the impact of the Appliances Agreement (see the definition of comparable store sales below).

• Comparable store sales increased 0.9%, which was driven by a 2.1% increase in average ticket comparables, partially offset by a decline in comparable transaction volume of 1.2%.

• Gross margin was $64.5 million, or 33.2% of net sales, for the second quarter of fiscal 2012, a decrease of $1.3 million, or 2.0% as compared to $65.8 million, or 33.5% of net sales, for the second quarter of fiscal 2011. The decrease in gross margin was primarily due to the decrease in net sales. The decrease in gross margin as a percentage of net sales was primarily due to an increase in occupancy costs as a result of paying rent on previously owned properties prior to sale-leaseback transactions slightly offset by improvement in merchandise margin.

• Merchandise inventory was $174.4 million at the end of the second quarter of fiscal 2012, an increase of $12.1 million, or 7.5%, as compared to merchandise inventory of $162.3 million at the end of the second quarter of fiscal 2011. The increase in merchandise inventory was primarily due to lower than anticipated levels of sales, the timing of inventory increases associated with merchandise resets, and increases associated with strategic investments in store presentation quantities.

• Adjusted EBITDA was $14.9 million for the second fiscal quarter of 2012, as compared to Adjusted EBITDA of $19.7 million for the second fiscal quarter of 2011. Adjusted EBITDA as presented below under 'Results of Operations' is a supplemental measure of our operating performance that is not required by or presented in accordance with GAAP. Adjusted EBITDA should not be considered as an alternative to net income (loss) or any other performance measures derived in accordance with GAAP or as an alternative to cash flows from operating activities as a measure of our liquidity. The decrease in Adjusted EBITDA of $4.8 million was primarily due to the Company's increased costs associated with the transition to a public company and to a lesser degree higher advertising spend.

2012 Second Quarter Business Highlights

The Company is focused against five key strategic priorities:

• Project a consistent and compelling brand identity;

• Drive sales through merchandising and marketing initiatives;

• Improve operational efficiencies;

• Align resources and talent; and

• Strengthen our financial position.

Key accomplishments during the second quarter of fiscal 2012 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 believe 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 marketing and promotional activities with the goal of supporting sales growth without adversely affecting gross margin. We also believe the merchandise resets associated with improving our product assortments disrupted traffic flow and the customer experience during the second quarter. We remain focused on not only continuing to improve our product assortments but also refining our reset implementation processes to ensure a seamless and improved customer experience.

Improve Operating Efficiencies. We effectively adjusted our store labor hours in response to sales trends during the second quarter. Additionally, we experienced a build-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 Benjamin Moore paints and stains line roll-out, we had special training in collaboration with the Benjamin Moore Company to ensure our associates had the product and process knowledge to provide excellent service to our paint customers.

Financial Position. We generated approximately $42.8 million in gross proceeds from the six-store sale-leaseback transaction in the second quarter. The proceeds were primarily used to pay off our Real Estate Secured Term Loan in the 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 our efforts to reduce our debt. We are also in productive discussions concerning refinancing our debt through debt and/or equity financing transactions.

RESULTS OF OPERATIONS

The discussion that follows should be read in conjunction with the consolidated financial statements and notes to the consolidated financial statements that are included in our Annual Report on Form 10-K for the fiscal year ended January 28, 2012, as well as the unaudited interim consolidated financial statements and accompanying notes contained in this report. Our unaudited consolidated results of operations for the 13 and 26 week periods ended July 28, 2012 and July 30, 2011 are summarized below (dollars and shares in millions, except per share amounts and store count).

                                                                    13 Weeks Ended                                                       26 Weeks Ended
                                                                  % of Net         July 30,       % of Net                             % of Net         July 30,       % of Net
                                             July 28, 2012         Sales             2011          Sales          July 28, 2012         Sales             2011          Sales
NET SALES                                   $         194.1           100.0 %     $    196.4          100.0 %    $         349.1           100.0 %     $    360.2          100.0 %

COST OF SALES AND EXPENSES:
Cost of sales (excluding depreciation and
amortization)                                         129.6            66.8            130.6           66.5                232.6            66.6            239.2           66.4
Gross Margin                                           64.5            33.2             65.8           33.5                116.5            33.4            121.0           33.6
Selling and administrative                             57.5            29.6             46.2           23.5                103.2            29.6             90.2           25.1
Depreciation and amortization                           7.5             3.9              7.5            3.8                 15.4             4.4             14.7            4.1
Gain on sale of real property                            -               -                -              -                  (0.6 )          (0.2 )             -              -

Total cost of sales and expenses                      194.6           100.3            184.3           93.8                350.6           100.4            344.1           95.6

OPERATING (LOSS) INCOME                                (0.5 )          (0.3 )           12.1            6.2                 (1.5 )          (0.4 )           16.1            4.4
INTEREST EXPENSE, NET                                   7.8             4.0              5.5            2.8                 14.3             4.2             11.1            3.0

(LOSS)INCOME BEFORE TAXES                              (8.3 )          (4.3 )            6.6            3.4                (15.8 )          (4.6 )            5.0            1.4
INCOME TAX EXPENSE                                     18.4             9.5              2.7            1.4                 15.4             4.3              2.1            0.6

NET (LOSS) INCOME                           $         (26.7 )         (13.8 )%    $      3.9            2.0 %    $         (31.2 )          (8.9 )%    $      2.9            0.8 %

Basic and diluted (loss) income per share   $         (4.44 )                     $     0.65                     $         (5.19 )                     $     0.48
Basic and diluted weighted average common
shares outstanding                                      6.0                              6.0                                 6.0                              6.0

OTHER DATA:
ADJUSTED EBITDA                             $          14.9                       $     19.7                     $          22.4                       $     30.8
STORE COUNT                                              88                               89                                  88                               89

In addition to our net (loss) income determined in accordance with accounting principles generally accepted in the United States of America ("GAAP"), for purposes of evaluating operating performance, we use Adjusted Earnings Before Interest, Taxes, Depreciation and Amortization ("Adjusted EBITDA"), a non-GAAP financial measure, which is adjusted to exclude certain significant items as set forth below. Our management uses Adjusted EBITDA to evaluate the operating performance of our business, as well as executive compensation metrics, for comparable periods. Adjusted EBITDA should not be used by investors or other third parties as the sole basis for formulating investment decisions as it excludes a number of important cash and non-cash recurring items. Adjusted EBITDA should not be considered as a substitute for GAAP measurements.

While Adjusted EBITDA is a non-GAAP financial measurement, management believes that it is an important indicator of operating performance because:

• Adjusted EBITDA excludes the effects of financing and investing activities by eliminating the effects of interest and depreciation costs;

• Management considers gain/(loss) on the sale of assets to result from investing decisions. Asset impairments and equity compensation expenses are excluded as they are non-cash charges; and

• Other significant items, while periodically affecting our results, may vary significantly from period to period and have a disproportionate effect in a given period, which affects comparability of results.

The following table and the discussion that follows presents information related to the non-GAAP performance measure Adjusted EBITDA. Due to the fact that Adjusted EBITDA is a non-GAAP measure, we have also included reconciliation from Adjusted EBITDA to net (loss) income (in millions):

                                               13 Weeks Ended                                26 Weeks Ended
                                    July 28, 2012          July 30, 2011          July 28, 2012          July 30, 2011
Net (loss) income                  $         (26.7 )      $           3.9        $         (31.2 )      $           2.9
Interest expense, net                          7.8                    5.5                   14.3                   11.1
Income tax expense                            18.4                    2.7                   15.4                    2.1
Depreciation and amortization                  7.5                    7.5                   15.4                   14.7
Net loss on sale of real
property and impairment of
assets                                         7.4                     -                     7.6                    0.1
Stock-based compensation                       0.3                    0.1                    0.5                    0.2
Other significant items                        0.2                     -                     0.4                   (0.3 )

Adjusted EBITDA                    $          14.9        $          19.7        $          22.4        $          30.8

Adjusted EBITDA as a % of net
sales                                          7.7 %                 10.0 %                  6.4 %                  8.6 %

Adjusted EBITDA is not the same as EBITDA as defined for our Senior Secured Term Loan and Real Estate Term Loan.

Other significant items include certain reserves and charges not in the normal course of our operations that periodically affect the comparability of our results. In the second quarter, we recorded charges of $18.4 million related to the establishment of a valuation allowance against our deferred tax assets, $7.2 million of store impairment charges and a $1.2 million write-off of unamortized transaction costs associated with the pay-off of the Company's Real Estate Secured Term Loan.

Comparable sales figures are defined as follows:

1. Comparable store sales. Measured by the increase or decrease in net sales year over year, excluding new and closed stores and E-commerce. Additionally, and because of an agreement the Company entered into with Sears Holdings (the "Appliances Agreement") on October 26, 2011 whereby the Company now sells appliances on a consignment basis and receives commission income for sales of such appliances and related protection agreements, comparable store sales also exclude approximately $4.5 million and $8.6 million of sales of Sears Holdings branded appliances in the second quarter and year-to-date period, respectively, of fiscal 2011 and approximately $0.4 million and $1.0 million of commission income in the second quarter and year-to-date period, respectively, of fiscal 2012.

2. Comparable transaction volume. Derived from the increase or decrease in the number of transactions year over year, excluding new and closed stores, appliance sales, and E-commerce.

3. Average ticket comparables. Derived using net sales divided by the number of transactions year over year.

A store is included in the calculation of comparable metrics above if it has been open for at least 12 months, including relocated and remodeled stores. Comparable sales metrics discussed above are intended only as supplemental information and are not a substitute for information presented in accordance with generally accepted accounting principles.

13-week period ended July 28, 2012 compared to 13-week period ended July 30, 2011

Net sales

13 Weeks Ended Increase (Decrease) July 28, 2012 July 30, 2011 $ % Net sales $ 194.1 $ 196.4 (2.3 ) (1.2 )%

Net sales decreased $2.3 million, or 1.2%, to $194.1 million for the second quarter of fiscal 2012, as compared to $196.4 million for the second quarter of fiscal 2011. The decline in net sales is primarily attributed to a $4.5 million impact of the Appliances Agreement (see the definition of comparable store sales above). The decline in net sales was offset in part by approximately $1.6 million increase attributable to our 0.9% increase in comparable store sales, comprised of an increase in average ticket comparables of 2.1% partially offset by a decrease in comparable transactions of 1.2%. The increase in comparable store sales is primarily attributable to an increase in sales in the backyard offset by a decrease in sales in repair and maintenance.

Gross Margin



                                                 13 Weeks Ended                            Increase (Decrease)
                                      July 28, 2012            July 30, 2011              $                   %
Gross Margin                        $            64.5         $          65.8               (1.3 )              (2.0 )%
Percent of net sales                             33.2 %                  33.5 %

Gross margin decreased $1.3 million to $64.5 million, or 33.2% of net sales, for the second quarter of fiscal 2012, as compared to $65.8 million or 33.5% of net sales, for the second quarter of fiscal 2011. The decrease of 30 basis points was driven by approximately 100 basis points of higher occupancy costs as a result of paying rent on properties previously owned prior to the sale-leaseback transactions and as a result of higher ongoing rent, DC and other occupancy costs and the deleverage of occupancy and distribution center costs due to lower net sales. These were partially offset by improved merchandise margins of approximately 50 basis points because of improved initial markups and higher vendor subsidies due to product resets offset by increased markdowns to support promotional activity.

Selling and administrative

                                                 13 Weeks Ended                            Increase (Decrease)
                                      July 28, 2012            July 30, 2011              $                  %
Selling and administrative          $            57.5         $          46.2               11.3               24.5 %
Percent of net sales                             29.6 %                  23.5 %

Selling and administrative expenses increased $11.3 million to $57.5 million or 29.6% of net sales, for the second quarter of fiscal 2012, as compared to $46.2 million or 23.5% of net sales, for the second quarter of fiscal 2011. The increase in selling and administrative expenses was primarily due to
(a) non-cash charges of approximately $7.2 million related to the write-down of store assets that were determined to be impaired, (b) a $1.3 million increase in operating costs directly associated with being an independent and public company, (c) a $1.1 million increase in advertising costs as compared to the second quarter of fiscal 2011 and (d) a $1.7 million increase in payroll and other expenses associated with Store Support Center initiatives.

Interest expense, net

13 Weeks Ended Increase (Decrease) July 28, 2012 July 30, 2011 $ % Interest expense, net $ 7.8 $ 5.5 2.3 41.8 %

Interest expense increased $2.3 million to $7.8 million, or 41.8%, for the second quarter of fiscal 2012, as compared to $5.5 million for the second quarter of fiscal 2011. The $2.3 million increase in interest expense was due to
(a) $1.2 million write-off of unamortized deferred financing costs related to the early pay off of the Real Estate Term Loan at the end of the quarter and
(b) higher interest rates associated with amendments to our Senior Secured Term Loan and Real Estate Secured Term Loan, as well as additional interest expense on capital lease properties.

Income tax expense

                                               13 Weeks Ended                             Increase (Decrease)
                                    July 28, 2012           July 30, 2011               $                    %
Income tax expense                 $          18.4         $           2.7                 15.7                581.5 %
Effective tax rate                           222.2 %                  40.7 %

Income tax expense was $18.4 million for the second quarter of fiscal 2012 as compared to income tax expense of $2.7 million recorded for the second quarter of fiscal 2011. The second quarter results reflect the effects of a tax valuation allowance charge recorded in the quarter. We regularly evaluate the need for a valuation allowance against our deferred tax assets. As a result of our most recent evaluation, we recorded a non-cash charge to income tax expense of $18.4 million to record a valuation allowance against our deferred tax assets. This accounting treatment has no effect on our ability to use our operating loss carryforwards and tax credits in the future to reduce cash tax payments. A more detailed discussion of this charge is set forth in Note 8 to the consolidated financial statements.

26-week period ended July 28, 2012 compared to 26-week period ended July 30, 2011

Net sales

26 Weeks Ended Increase (Decrease) July 28, 2012 July 30, 2011 $ % Net sales $ 349.1 $ 360.2 $ (11.1 ) (3.1 )%

Net sales decreased $11.1 million, or 3.1%, to $349.1 million for the current 26-week period ended July 28, 2012 as compared to $360.2 million for the prior 26-week period ended July 30, 2011. The decrease in net sales was attributable to (a) an approximate $8.6 million impact related to the Appliances Agreement (see the definition of comparable store sales above) and (b) a decrease of 0.9% in comparable store sales, comprised of a decrease in comparable transactions of 2.7%, partially offset by a 1.8% increase in average ticket comparables. These declines were partially offset by $0.8 million from the net impact of new stores and closed stores.

Gross margin

                                               26 Weeks Ended                             Increase (Decrease)
                                    July 28, 2012           July 30, 2011               $                     %
Gross Margin                       $         116.5         $         121.0         $       (4.5 )                (3.7 )%
Percent of net sales                          33.4 %                  33.6 %

Gross margin decreased $4.5 million to $116.5 million, or 33.4% of net sales, for the current 26-week period ended July 28, 2012 as compared to $121.0 million or 33.6% of net sales, for the prior 26-week period ended July 30, 2011. The decrease of 20 basis points in gross margin was primarily due to approximately 120 basis points of higher occupancy costs as a result of paying rent on properties previously owned prior to the sale-leaseback transactions and as a result of deleverage of occupancy and distribution center costs due to lower net . . .