Matuschek's, a gift store in Budapest, is the workplace of Alfred Kralik (James Stewart) and Klara Novak (Margaret Sullavan). At work they constantly irritate each other, but this daily aggravation is tempered by the fact that each has a secret pen pal with which they trade long soul-searching letters. Romantic correspondence is sent back and forth, and while Alfred and Klara trade barbs at work, they dream of someday meeting their sensitive, caring and completely wonderful soul-mate. Of course, neither realizes that their soul-mates are really each other.
Christmas is fast approaching, and the store is busy. Alfred had been with the store for some time, and has always been treated well by Mr. Matuschek (Frank Morgan), but lately his attitude has changed. Alfred is at a loss, and Matuschek avoids any explanation, finally telling Alfred that it would be best if he left. Stunned, Alfred accepts his last paycheck and says goodbye to everyone, including Klara. For once they are civil to each other.
A long awaited meeting of the secret pen pals was planned for that night, and Alfred, feeling little romance, has no desire to go. Finding he can't fight his curiosity, he wanders to the restaurant where they'd agreed to meet and peeks in the window. Of course, Klara is there waiting for him, wearing a red carnation they'd agreed to use as a signal. Realizing that he'd been wrong about her all along, and that his irritation with her was actually masking his attraction, he finally enters and goes over to her table, but does not reveal his true reason for being there. He's the last person she wanted to see, and she makes her dislike for him painfully evident. Alfred, hurt by her rudeness, finally leaves, knowing that she will wait all night for someone who is no longer coming.
Meanwhile, back at the store, Mr. Matuschek has a late-night meeting with a private detective. He knows that his wife has been having an affair with one of his employees, and was convinced it was his trusted friend, Alfred. The detective however tells Matuschek it is in fact another man and, heart-broken over his wife's infidelity and his poor treatment of Alfred, he retires to his office. The delivery boy, returning late, stops Matuschek as he is pulling out a pistol. Collapsing in grief and shame, he is rushed to the hospital.
The next day Alfred visits Mr. Matuschek in his sick bed, where he asks for Alfred's forgiveness and puts him back to work, now as manager of the store. Klara arrives late, obviously heartbroken after the failure of her soul-mate to materialize last night. When she finds that the man she insulted is now her boss, she faints in the middle of his office. Later, as she is resting at home, Alfred pays her a visit, bringing her another letter from her secret pen pal (actually himself) that explains his absence. Relieved, she swears to Alfred she'll be back at work in the morning, and even restrains from delivering more than a few mild barbs to Alfred. He is still stung, but feels more and more tenderness towards her.
Christmas Eve is here, and everyone works through the day. Mr. Matuschek has nearly recovered from his sickness and stops by to see how things are going, and when the final tally is made, the store has had its best sales day ever. Delighted, he hands out bonuses to all, and takes the stockboy out for Christmas dinner. Alfred and Klara are getting ready to leave, and she has another date with her mystery pen pal, but Alfred delays her with a few questions. She's never yet seen him, and can't wait to find out what he looks like. Alfred plays along, but tenderly, not wanting to hurt her. He tells her that the mysterious pen pal stopped by to see him earlier, and he is in fact fat, bald, older and broke.
Saddened and deflated, Klara confesses to Alfred that she'd hoped her secret friend was an attractive young man, and she dreamed of becoming engaged. Actually, she'd really hoped that her soul-mate looked like him, and goes on to say that when they'd first met, she had really found him very attractive. "Would it be so bad", he asks her, "if it really was me after all?" He holds up a red carnation, and suddenly eveything becomes clear to her. Realizing they are both in love, they embrace, and go out to celebrate Christmas together.