**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

**FORM 10-Q**

** **
| **(Mark One)**                                                                                                                                                                                                                              |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                                                                                                                                                                                                                                  | ** ** | ** ** |
| **x**                                                                                                                                                                                                                                       | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                                                                                                                                                                                                        |   |   |
| **For the quarterly period ended September 30,  2007**                                                                                                                                                                                      |
|                                                                                                                                                                                                                                        |   |   |
| **Or**                                                                                                                                                                                                                                      |
|                                                                                                                                                                                                                                        |   |   |
| **o**                                                                                                                                                                                                                                       | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934** |
|                                                                                                                                                                                                                                        |   |   |
| **For the transition period from                   to****                ** |

 

**Commission file number:001-33048**

** **

**BareEscentuals, Inc.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                     | ** ** | **20-1062857**       |
|----------------------------------|------------|----------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer     |
| incorporation or  organization)  |       | Identification  No.) |

 

**71 Stevenson Street, 22nd Floor**

**San Francisco, CA 94105**

(Address of principal executive offices withzip code)

 

**(415) 489-5000**

(Registrant’s telephone number, includingarea code)

 

**N/A**

(Former name, former address and formerfiscal year, if changed since last report)

 

Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  YES      x   NO      o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, or a non-accelerated filer. See definition of  “accelerated filer and large acceleratedfiler” in Rule 12b-2 of the Exchange Act).   Large AcceleratedFiler      o   Accelerated Filer      o     Non-AcceleratedFiler      x

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act).   

YES      o  NO      x

 

At November 9, 2007, the number of shares outstanding of the registrant’scommon stock, $0.001 par value, was 91,132,738.

 

 

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**Table of Contents**

 

**Bare Escentuals, Inc.**

 

**INDEX**

 
| **PART I—FINANCIAL  INFORMATION** |                                                                                                                      |
|---------------------------------------------|---------------------------------------------------------------------------------------------------------------------------|
| Item 1                                 | Financial Statements (unaudited):                                                                                         | 3 |
|                                        | Condensed  Consolidated Balance Sheets — September 30, 2007 and December 31, 2006                                    | 3 |
|                                        | Condensed  Consolidated Statements of Operations—Three and Nine Months Ended September  30, 2007 and October 1, 2006 | 4 |
|                                        | Condensed  Consolidated Statements of Cash Flows—Nine Months Ended September 30, 2007  and October 1, 2006           | 5 |
|                                        | Notes to  Condensed Consolidated Financial Statements                                                                     | 6 |
| Item 2                                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                               | 22 |
| Item 3                                 | Quantitative  and Qualitative Disclosures About Market Risk                                                               | 35 |
| Item 4                                 | Controls and  Procedures                                                                                                  | 35 |
|                                        |                                                                                                                      |   |
| **PART II—OTHER  INFORMATION**    |                                                                                                                      |
| Item 1                                 | Legal Proceedings                                                                                                         | 36 |
| Item 1A                                | Risk Factors                                                                                                              | 36 |
| Item 2                                 | Unregistered  Sales of Equity Securities and Use of Proceeds                                                              | 38 |
| Item 3                                 | Defaults Upon  Senior Securities                                                                                          | 38 |
| Item 4                                 | Submission of  Matters to a Vote of Security Holders                                                                      | 38 |
| Item 5                                 | Other Information                                                                                                         | 38 |
| Item 6                                 | Exhibits                                                                                                                  | 39 |
| Signatures                                  |                                                                                                                      | 40 |
| Exhibit Index                          |                                                                                                                      |   |
| Certifications                              |                                                                                                                      |   |
|                                             |                                                                                                                           |  |  |

 

2

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**PART I—FINANCIALINFORMATION**

 

**ITEM1.   FINANCIAL STATEMENTS**

 

**BARE ESCENTUALS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(in thousands, except per share data)**

 
| ** **                                                                                                                                                                                  | ** ** | **September 30,  2007** | ** ** | **December 31,  2006(a)** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **(unaudited)**              | ** ** | ** **                     | ** ** |
| **ASSETS**                                                                                                                                                                                  | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| Current assets:                                                                                                                                                                             |       |                         |       |                           |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                            | 26,301     |                           | $          | 20,875 |   |
| Inventories                                                                                                                                                                                 |       | 62,616                       |       | 62,006                         |       |
| Accounts receivable, net of allowances of  $6,650 and $3,427 at September 30, 2007 and December 31, 2006,  respectively                                                           |       | 34,831                       |       | 30,759                         |       |
| Prepaid expenses and other current assets                                                                                                                                                   |       | 11,122                       |       | 6,249                          |       |
| Prepaid income taxes                                                                                                                                                                        |       | 3,199                        |       | —                         |       |
| Deferred tax assets                                                                                                                                                                         |       | 7,772                        |       | 5,826                          |       |
| Total current assets                                                                                                                                                                        |       | 145,841                      |       | 125,715                        |       |
| Property and equipment, net                                                                                                                                                                 |       | 38,825                       |       | 21,111                         |       |
| Intangible assets, net                                                                                                                                                                      |       | 26,877                       |       | 6,085                          |       |
| Deferred tax assets                                                                                                                                                                         |       | —                       |       | 1,092                          |       |
| Other assets                                                                                                                                                                                |       | 2,320                        |       | 1,832                          |       |
| Total assets                                                                                                                                                                                |       | $                            | 213,863    |                           | $          | 155,835 |   |
| ** **                                                                                                                                                                                  | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                                                                                             | ** ** | ** **                   | ** ** | ** **                     | ** ** |
| Current liabilities:                                                                                                                                                                        |       |                         |       |                           |       |
| Current portion of long-term debt                                                                                                                                                           |       | $                            | 15,131     |                           | $          | 17,624 |   |
| Accounts payable                                                                                                                                                                            |       | 33,239                       |       | 25,357                         |       |
| Accrued liabilities                                                                                                                                                                         |       | 21,945                       |       | 16,123                         |       |
| Accrued restructuring charges                                                                                                                                                               |       | —                       |       | 172                            |       |
| Income taxes payable                                                                                                                                                                        |       | —                       |       | 101                            |       |
| Total current liabilities                                                                                                                                                                   |       | 70,315                       |       | 59,377                         |       |
|                                                                                                                                                                                        |       |                         |       |                           |       |
| Long-term debt, less current portion                                                                                                                                                        |       | 264,802                      |       | 321,639                        |       |
| Other liabilities                                                                                                                                                                           |       | 10,893                       |       | 3,341                          |       |
|                                                                                                                                                                                        |       |                         |       |                           |       |
| Commitments and contingencies                                                                                                                                                               |       |                         |       |                           |       |
|                                                                                                                                                                                        |       |                         |       |                           |       |
| Stockholders’ deficit:                                                                                                                                                                 |       |                         |       |                           |       |
| Preferred stock; $0.001 par value;  10,000 shares authorized; zero shares issued and outstanding                                                                                       |       | —                       |       | —                         |       |
| Common stock; $0.001 par value;  200,000 shares authorized; 91,104 and 89,316 shares issued and  outstanding at September 30, 2007 and December 31, 2006,  respectively |       | 91                           |       | 89                             |       |
| Additional paid–in capital                                                                                                                                                             |       | 415,182                      |       | 378,063                        |       |
| Cumulative effect on accumulated deficit  due to change in accounting principle                                                                                                             |       | (952                         | )          | —                         |       |
| Accumulated other comprehensive loss                                                                                                                                                        |       | (889                         | )          | —                         |       |
| Accumulated deficit                                                                                                                                                                         |       | (545,579                     | )          | (606,674                       | )          |
| Total stockholders’ deficit                                                                                                                                                            |       | (132,147                     | )          | (228,522                       | )          |
| Total liabilities and stockholders’ deficit                                                                                                                                            |       | $                            | 213,863    |                           | $          | 155,835 |   |

 

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(a)          Condensedconsolidated balance sheet as of December 31, 2006 has been derived from theaudited consolidated financial statements.

 

See accompanying notes.

 

3

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**BARE ESCENTUALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(in thousands, except per share data)**

 
| ** **                                                                      | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                      | ** ** | **September 30,  2007**     | ** ** | **October 1,  2006**       | ** ** | **September 30,  2007** | ** ** | **October 1,  2006** | ** ** |
| ** **                                                                      | ** ** | **(unaudited)**                  | ** ** | **(unaudited)**                 | ** ** |
| Sales, net                                                                      |       | $                                | 126,635    |                            | $          | 97,947 |   | $ | 366,392 |   | $ | 284,047 |   |
| Cost of goods sold                                                              |       | 35,956                           |       | 26,890                          |       | 106,984 |   | 79,023 |   |
| Gross profit                                                                    |       | 90,679                           |       | 71,057                          |       | 259,408 |   | 205,024 |   |
| Expenses:                                                                       |       |                             |       |                            |       |   |   |   |   |
| Selling, general and administrative                                             |       | 47,536                           |       | 34,467                          |       | 130,257 |   | 97,323 |   |
| Depreciation and amortization, relating to  selling, general and administrative |       | 2,035                            |       | 552                             |       | 4,835 |   | 1,523 |   |
| Stock-based compensation, relating to  selling, general and administrative      |       | 1,800                            |       | 1,365                           |       | 5,190 |   | 3,832 |   |
| Restructuring charges                                                           |       | —                           |       | 114                             |       | — |   | 114 |   |
| Operating income                                                                |       | 39,308                           |       | 34,559                          |       | 119,126 |   | 102,232 |   |
| Interest expense                                                                |       | (5,725                           | )          | (19,723                         | )          | (18,810 | ) | (41,593 | ) |
| Debt extinguishment costs                                                       |       | —                           |       | —                          |       | — |   | (3,391 | ) |
| Interest income                                                                 |       | 471                              |       | 348                             |       | 1,299 |   | 979 |   |
| Income before provision for income taxes                                        |       | 34,054                           |       | 15,184                          |       | 101,615 |   | 58,227 |   |
| Provision for income taxes                                                      |       | 13,579                           |       | 6,304                           |       | 40,520 |   | 24,339 |   |
| Net income                                                                      |       | $                                | 20,475     |                            | $          | 8,880 |   | $ | 61,095 |   | $ | 33,888 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |   |   |   |   |
| Net income per share:                                                           |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                           |       | $                                | 0.23       |                            | $          | 0.13 |   | $ | 0.68 |   | $ | 0.48 |   |
| Diluted                                                                         |       | $                                | 0.22       |                            | $          | 0.12 |   | $ | 0.66 |   | $ | 0.47 |   |
| Cash dividend per common share                                                  |       | $                                | —     |                            | $          | — |   | $ | — |   | $ | 4.81 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Weighted-average shares used in per share  calculations:                        |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                           |       | 90,532                           |       | 70,839                          |       | 89,994 |   | 69,920 |   |
| Diluted                                                                         |       | 93,208                           |       | 73,317                          |       | 92,939 |   | 72,296 |   |

 

See accompanying notes.

 

4

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**BARE ESCENTUALS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

 
| ** **                                                                              | ** ** | **Nine months ended** | ** ** |
|-----------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                              | ** ** | **September 30,  2007**    | ** ** | **October 1,  2006** | ** ** |
| ** **                                                                              | ** ** | **(unaudited)**                 | ** ** |
| **Operating activities**                                                                |       |                            |       |   |   |
| Net income                                                                              |       | $                               | 61,095     |   | $ | 33,888 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:      |       |                            |       |   |   |
| Depreciation of property and equipment                                                  |       | 3,352                           |       | 1,523 |   |
| Amortization of intangible assets                                                       |       | 1,483                           |       | — |   |
| Amortization of debt issuance costs                                                     |       | 206                             |       | 230 |   |
| Debt extinguishment costs                                                               |       | —                          |       | 3,391 |   |
| Stock-based compensation                                                                |       | 5,190                           |       | 3,832 |   |
| Excess tax benefit from stock option  exercises and disqualifying disposition of shares |       | (9,221                          | )          | (7,507 | ) |
| Deferred income tax provision (benefit)                                                 |       | (339                            | )          | (518 | ) |
| Other                                                                                   |       | 164                             |       | 4 |   |
| Changes in assets and liabilities:                                                      |       |                            |       |   |   |
| Inventories                                                                             |       | 1,335                           |       | (24,713 | ) |
| Accounts receivable                                                                     |       | (2,375                          | )          | (10,138 | ) |
| Income taxes                                                                            |       | 8,128                           |       | 2,571 |   |
| Prepaid expenses and other current assets                                               |       | (1,596                          | )          | (1,360 | ) |
| Other assets                                                                            |       | (694                            | )          | (326 | ) |
| Accounts payable and accrued liabilities                                                |       | 4,021                           |       | 17,396 |   |
| Other liabilities                                                                       |       | 1,001                           |       | 511 |   |
| Net cash provided by operating activities                                               |       | 71,750                          |       | 18,784 |   |
| ** **                                                                              | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Investing activities**                                                                |       |                            |       |   |   |
| Purchase of property and equipment                                                      |       | (20,461                         | )          | (10,353 | ) |
| Acquisition of business, net of $1,847 of  cash and cash equivalents acquired           |       | (18,675                         | )          | — |   |
| Net cash used in investing activities                                                   |       | (39,136                         | )          | (10,353 | ) |
| ** **                                                                              | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Financing activities**                                                                |       |                            |       |   |   |
| Proceeds from issuance of Senior Term Loans  and First and Second Lien Term Loans       |       | —                          |       | 206,583 |   |
| Repayments on Senior Term Loans and First  and Second Lien Term Loans                   |       | (59,330                         | )          | (12,146 | ) |
| Proceeds from issuance of Subordinated  Notes Payable                                   |       | —                          |       | 125,000 |   |
| Payments for debt issuance costs                                                        |       | —                          |       | (4,122 | ) |
| Payment of transaction costs in connection  with initial public offering                |       | —                          |       | (2,614 | ) |
| Dividend paid in connection with the  Recapitalization transactions                     |       | —                          |       | (340,427 | ) |
| Proceeds from issuance of common stock in  public offerings                             |       | 22,645                          |       | — |   |
| Payment of transaction costs in connection  with public offerings                       |       | (1,562                          | )          | — |   |
| Excess tax benefit from stock option  exercises and disqualifying disposition of shares |       | 9,221                           |       | 7,507 |   |
| Exercise of stock options                                                               |       | 1,627                           |       | 1,309 |   |
| Common stock repurchased                                                                |       | —                          |       | (998 | ) |
| Proceeds from issuance of common stock to  directors                                    |       | —                          |       | 300 |   |
| Net cash used in financing activities                                                   |       | (27,399                         | )          | (19,608 | ) |
| Effect of foreign currency exchange rate  changes on cash                               |       | 211                             |       | — |   |
| Net increase (decrease) in cash and cash  equivalents                                   |       | 5,426                           |       | (11,177 | ) |
| Cash and cash equivalents, beginning of  period                                         |       | 20,875                          |       | 18,675 |   |
| Cash and cash equivalents, end of period                                                |       | $                               | 26,301     |   | $ | 7,498 |   |
|                                                                                    |       |                            |       |   |   |
| **Supplemental disclosure of cash flow  information**                                   | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Cash paid for interest                                                                  |       | $                               | 18,947     |   | $ | 39,235 |   |
| Cash paid for income taxes                                                              |       | $                               | 35,279     |   | $ | 22,282 |   |
|                                                                                    |       |                            |       |   |   |
| **Supplemental disclosure of investing and  financing activities**                      |       |                            |       |   |   |
| Shares issued in lieu of transaction fees                                               |       | $                               | —     |   | $ | 2,442 |   |

 

See accompanying notes.

 

5

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**BARE ESCENTUALS, INC.**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**1.     Business**

 

Bare Escentuals, Inc.,together with its subsidiaries (“Bare Escentuals” or the “Company”),develops, markets, and sells branded cosmetics, skin care and body careproducts under the *i.d. bareMinerals, i.d.,RareMinerals* and namesake *BareEscentuals* brands, and professional skin care products under the *md formulations* brand. The *i.d. bareMinerals*cosmetics, particularlythe core foundation products which are mineral-based, offer a highlydifferentiated, healthy alternative to conventional cosmetics. The Company usesa multi-channel distribution model consisting of infomercials, specialty beautyretailers, Company-owned boutiques, home shopping television, and spas andsalons. The Company’s international distributors are primarily located inWestern Europe, Asia, and Australia.

 

**2.     Summaryof Significant Accounting Policies**

 

***Unaudited InterimFinancial Information***

 

The accompanying condensed consolidated balance sheet as of September30, 2007, the condensed consolidated statements of operations for the three andnine months ended September 30, 2007 and October 1, 2006, and the condensedconsolidated statements of cash flows for the nine months ended September 30,2007 and October 1, 2006, are unaudited. These unaudited interim condensedconsolidated financial statements have been prepared in accordance with U.S.generally accepted accounting principles for interim financial information,Form 10-Q and Article 10 of Regulation S-X. In the opinion of theCompany’s management, the unaudited interim condensed consolidated financialstatements have been prepared on the same basis as the annual consolidatedfinancial statements and include all adjustments of a normal recurring naturenecessary for the fair presentation of the Company’s financial position as ofSeptember 30, 2007, its results of operations for the three and nine monthsended September 30, 2007 and October 1, 2006, and its cash flows for the ninemonths ended September 30, 2007 and October 1, 2006. The results for theinterim periods are not necessarily indicative of the results to be expectedfor any future period or for the fiscal year ending December 30, 2007.

 

These unaudited interim condensed consolidated financial statementsshould be read in conjunction with the Company’s consolidated financialstatements and related notes included in the Company’s 2006 Annual Report onForm 10-K filed with the SEC on March 30, 2007.

 

***Principles ofConsolidation***

 

The accompanying condensed consolidated financial statements includethe accounts of the Company and its wholly owned subsidiaries. All significantintercompany accounts and transactions have been eliminated.

 

***Fiscal Quarter***

 

The Company’s fiscal quarters end on the Sunday closest to March 31,June 30, September 30 and December 31. The three months ended September 30,2007 and October 1, 2006 each contained 13 weeks.  The nine months endedSeptember 30, 2007 and October 1, 2006 each contained 39 weeks.

 

***Use of Estimates***

 

The preparation offinancial statements in conformity with U.S. generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the balance sheet dates and the reported amounts ofrevenues and expenses for the periods presented. Actual results could differfrom those estimates, and such differences may be material to the consolidatedfinancial statements.

 

In determining its quarterly provision for income taxes, the Companyuses an estimated annual effective tax rate, which is based on expected annualincome, statutory tax rates and tax planning opportunities available in thevarious jurisdictions in which the Company operates. Certain significant orunusual items are separately recognized in the quarter in which they occur andcan be a source of variability in the effective tax rates from quarter toquarter.

 

6

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***Cash and Cash Equivalents***

 

Cash equivalents areconsidered to be highly liquid investments with maturities of three months orless at the time of the purchase.

 

***Supply and Fulfillment Concentration Risks***

 

All of the Company’sproducts are contract manufactured or supplied by third parties. The Companyhas long-term contracts with four of its suppliers. The terms of thesecontracts have various expiration dates through June 15, 2011. The fact thatthe Company does not have long-term contracts with some of its third-partymanufacturers means that any of those manufacturers could cease manufacturingthe Company’s products at any time and for any reason.

 

Additionally, the Companycurrently depends on one third party for the fulfillment of its infomercialsales, including inventory management, call center operation, website hostingand packing and shipping of product to customers. The Company’s contract withthis service provider expires on December 31, 2007.

 

***Concentration of Credit Risk and Credit Risk Evaluation***

 

Financial instrumentsthat potentially subject the Company to concentrations of credit risk consistprimarily of cash and cash equivalents and accounts receivable. Cash and cashequivalents are held by or invested in various domestic financial institutionswith high credit standing. Management believes that these financialinstitutions are financially sound and, accordingly, minimal credit risk existswith respect to these balances.

 

Sales generated throughcredit card purchases for the three and nine months ended September 30, 2007were approximately 45.6% and 47.1% of total net sales, respectively, andapproximately 53.2% and 50.8% of total net sales, respectively for the threeand nine months ended October 1, 2006. The Company uses third parties tocollect its credit card receivables and believes that its credit risk relatedto these sales is minimal. The Company performs ongoing credit evaluations ofits wholesale customers not paying by credit card and acquires credit insurancefor certain international customers. Generally, the Company does not requirecollateral. An allowance for doubtful accounts is determined with respect tothose amounts that the Company has determined to be doubtful of collectionusing specific identification of doubtful accounts and an aging of receivablesanalysis based on invoice due dates. Actual collection losses may differ frommanagement’s estimates, and such differences could be material to the Company’sconsolidated financial position, results of operations, and cash flows.Uncollectible receivables are written off against the allowance for doubtfulaccounts when all efforts to collect them have been exhausted, and recoveriesare recognized when they are received. Generally, accounts receivable are pastdue after 30 days of an invoice date unless special payment terms areprovided.

 

The table below sets forth the percentage ofconsolidated accounts receivable, net for customers who represented 10% or moreof consolidated accounts receivable, which are included in the wholesalesegment:

 
| ** ** | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------|------------|------------------------------|------------|-----------------------------|------------|
| Customer A |       | 18                           | %          | 11                          | %          |
| Customer B |       | 24                           | %          | 23                          | %          |
| Customer C |       | 29                           | %          | 31                          | %          |

 

The table below sets forth the percentage of consolidated sales, netfor customers who represented 10% or more of consolidated net sales:

 
| ** ** | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** ** | ** ** | **September 30,  2007**     | ** ** | **October 1,  2006**       | ** ** | **September 30,  2007** | ** ** | **October 1,  2006** | ** ** |
| Customer A |       | —                           | %          | —                          | %          | 11 | % | 13 | % |
| Customer B |       | 13                               | %          | 14                              | %          | 13 | % | 12 | % |
| Customer C |       | 17                               | %          | 14                              | %          | 16 | % | 14 | % |

 

For each of the three months ended September 30, 2007 and October 1,2006, Customer A accounted for less than 10% of consolidated net sales. As ofSeptember 30, 2007 and December 31, 2006, the Company had no off-balance sheetconcentrations of credit risk.

 

7

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***Fair Value of Financial Instruments***

 

Financial instrumentsconsist principally of cash and cash equivalents, accounts receivable, accountspayable, long-term debt, and interest rate swap agreements. Interest rate swapagreements are recorded at fair value. The estimated fair value of cash, cashequivalents, accounts receivable, and accounts payable approximates theircarrying value due to the short period of time to their maturities. AtSeptember 30, 2007, all of the Company’s outstanding debt was variable-ratedebt. The estimated fair value of the Company’s variable-rate debt approximatesits carrying value, since the rate of interest on the variable-rate debt isdetermined at a margin over LIBOR or the lenders’ base rate plus an applicablemargin based on a grid in which the pricing depends on the Company’sconsolidated total leverage ratio, and such rates are revised frequently, basedupon current LIBOR or the lenders’ base rate. The fair value of the interestrate swap agreements are based on quotes from brokers using market prices forthose or similar instruments.

 

***Inventories***

 

Inventories consist offinished goods and raw materials and are stated at the lower of cost or market.Cost is determined on a weighted-average basis. The Company regularly monitorsinventory quantities on hand and records write-downs for excess and obsoleteinventories based primarily on the Company’s estimated forecast of productdemand and production requirements. Such write-downs establish a new cost basisof accounting for the related inventory. Actual inventory losses may differfrom management’s estimates, and such differences could be material to theCompany’s consolidated financial position, results of operations, and cashflows.

 

***Property and Equipment***

 

Property and equipmentare stated at cost, net of accumulated depreciation and amortization. Furnitureand equipment, including computers and software, are depreciated using thestraight-line method over the estimated useful lives of the various assets,which are generally three to seven years. Fixtures and leasehold improvementsare amortized using the straight-line method over the lesser of the lease term,which ranges from five to ten years, or the estimated useful lives of theassets. For leases with renewal periods at the Company’s option, the Companygenerally uses the original lease term, excluding renewal option periods, todetermine estimated useful lives.

 

***Impairment of Long-Lived Assets andLong-Lived Assets to Be Disposed of***

 

The Company periodicallyevaluates whether changes have occurred that would require revision of theremaining useful life of equipment and improvements and purchased intangibleassets or render them not recoverable. If such circumstances arise, the Companyuses an estimate of the undiscounted sum of expected future operating cashflows during their holding period to determine whether the long-lived assetsare impaired. If the aggregate undiscounted cash flows are less than thecarrying amount of the assets, the resulting impairment charge to be recordedis calculated based on the excess of the carrying value of the assets over thefair value of such assets, with the fair value determined based on an estimateof discounted future cash flows.

 

***Goodwill and Intangible Assets***

 

Goodwill and otherpurchased intangible assets have been recorded as a result of the Company’sacquisitions. Goodwill and indefinite-lived intangibles are not amortized, butrather are subject to an annual impairment test. Other intangible assets areamortized over their estimated useful lives, generally two to three years.

 

The Company is requiredto perform an annual impairment test of goodwill and indefinite-livedintangible assets. Should certain events or indicators of impairment occurbetween annual impairment tests, the Company performs the impairment test ofgoodwill and indefinite-lived intangible assets at that date. In evaluatinggoodwill, management compares the total book value of the reporting unit to thefair value of those reporting units. The fair value of the Company isdetermined using the income approach. The income approach focuses on the income-producingcapability of an asset, measuring the current value of the asset by calculatingthe present value of its future economic benefits such as cash earnings, costsavings, tax deductions, and proceeds from disposition. Value indications aredeveloped by discounting expected cash flows to their present value at a rateof return that incorporates the risk-free rate for the use of funds, theexpected rate of inflation, and risks associated with the particularinvestment. Through September 30, 2007, no impairment charge has been required.

 

8

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***Debt Issuance Costs***

 

Debt issuance costs are capitalized and amortizedover the terms of the underlying debt instruments using the effective-interestmethod. Debt issuance costs paid directly to lending institutions are recordedas a debt discount, while debt issuance costs paid to third parties are recordedas other assets.

 

***Stock-Based Compensation***

 

Statement of Financial Accounting Standards No. 123(R), *Share-Based Payment*(“Statement 123(R)”)is applicable for stock-based awards exchanged for employee services and incertain circumstances for non-employee directors. Pursuant to Statement 123(R),stock-based compensation cost is measured at the grant date, based on the fairvalue of the award, and is recognized as expense over the requisite serviceperiod for awards expected to vest. The estimation of the number of stockawards that will ultimately vest requires judgment, and to the extent actualresults differ from the Company’s estimates, such amounts will be recorded as acumulative adjustment in the period estimates are revised. The Companyconsiders several factors when estimating expected forfeitures, such as typesof awards. Actual results may differ substantially from these estimates.

 

The compensation costcharged to operations pursuant to Statement 123(R) was $1,800,000 and$5,190,000 for the three and nine months ended September 30, 2007,respectively, and $1,365,000 and $3,654,000 for the three and nine months endedOctober 1, 2006, respectively. The Company records stock-based compensation ona separate operating expense line item in its statement of operations due tothe fact that, to date, all of its stock-based awards have been made toemployees whose salaries are classified as selling, general and administrativeexpenses.

 

***Foreign Currency Translation***

 

The assets and liabilities of foreign subsidiaries,where the local currency is the functional currency, are translated from theirrespective functional currencies into U.S. dollars at the rates in effect atthe balance sheet date, with resulting foreign currency translation adjustmentsrecorded as other comprehensive income (loss) in the accompanying consolidatedstatements of changes in stockholders’ equity (deficit) and comprehensiveincome (loss). Revenue and expense amounts are translated at average ratesduring the period.

 

***Derivative FinancialInstruments***

 

TheCompany accounts for derivative financial instruments in accordance withStatement of Financial Accounting Standards No. 133, *Accountingfor Derivative Instruments and Hedging Activities*, as amended (“SFASNo. 133”), which establishes accounting and reporting standards for derivativeinstruments, including certain derivative instruments embedded in othercontracts, and for hedging activities.  SFAS No. 133 also requires therecognition of all derivative instruments as either assets or liabilities onthe balance sheet and that they be measured at fair value.

 

The Company is exposed to interest rate risksprimarily through borrowings under its credit facilities. Interest on all ofthe Company’s borrowings under its senior secured credit facilities is basedupon variable interest rates. As of September 30, 2007, the Company hadborrowings of $279.9 million outstanding under its senior secured creditfacilities which bear interest at a rate equal to, at the Company’s option,either LIBOR or the lenders’ base rate, plus an applicable margin varying basedon the Company’s consolidated total leverage ratio. As of September 30, 2007,the interest rate on the First Lien Term Loan was accruing at 8.05%. At alltimes after October 2, 2007, the Company is required under its seniorsecured credit facilities to enter into interest rate swap or similaragreements with respect to at least 40% of the outstanding principal amount ofall loans under its senior loan facilities, unless the Company satisfies specifiedcoverage ratio tests. As of September 30, 2007, the Company satisfied thesetests.

 

In August 2007, the Company entered into a two-yearinterest rate swap transaction under the Company’s senior secured creditfacilities. The interest rate swap has an initial notional amount of $200million declining to $100 million after one year under which, on a netsettlement basis, the Company will make monthly fixed rate payments atthe rate of 5.03% and the counterparty makes monthly floating rate payments based upon one-month U.S.D.LIBOR. As a result of the interest rateswap transaction, the Company has fixed for a two-year period the interest ratesubject to market based interest rate risk on $200 million of borrowings forthe first year and $100 million of borrowings for the second year under itsFirst Lien Credit Agreement. The Company’s obligations under the interest rateswap transaction as to the scheduled payments are guaranteed and secured on thesame basis as is its obligations under the First Lien Credit Agreement. Thefair value of the interest rate swap as of September 30, 2007 was $1,100,000which was recorded in other liabilities in the condensed consolidated balancesheets.

 

9

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***Revenue Recognition***

 

The Company’s revenue recognition policy isconsistent with the requirements of Staff Accounting Bulletin No. 104*Revenue Recognition*, and otherapplicable revenue recognition guidance and interpretations. The Companyrecords revenue when all four of the following criteria are met:(i) persuasive evidence that an arrangement exists; (ii) delivery ofthe products and/or services has occurred; (iii) the selling price isfixed or determinable; and (iv) collectibility is reasonably assured.

 

The Company recognizessales when merchandise is shipped from a warehouse directly to wholesalecustomers (except in the case of a consignment sale), infomercial customers,and online shopping customers or when purchased by customers at Company-ownedboutiques, each net of estimated returns. For consignment sales, which includesales to QVC and a Japanese distributor, the Company recognizes sales, net ofexpected returns from consignees, upon the consignee’s shipment to thecustomer. Postage and handling charges billed to customers are also recognizedas sales upon shipment of the related merchandise. Shipping terms are FOBshipping point, and title passes to the customer at the time and place ofshipment or purchase by customers at retail locations. For consignment sales, titlepasses to the consignee concurrent with the consignee’s shipment to thecustomer. The customer has no cancellation privileges after shipment or uponpurchase at retail locations, other than customary rights of return that areaccounted for in accordance with Statement 48, *RevenueRecognition When Right of Return Exists.* The Company’s standardterms for retail sales, including infomercial sales and sales at Company-ownedboutiques, limit returns to approximately 30 to 90 days after the sale ofthe merchandise. For wholesale sales, as is customary in the cosmeticsindustry, the Company allows returns from wholesale customers if properlyrequested and approved. The Company regularly evaluates returns and accrues forexpected future returns that relate to sales prior to the balance sheet dateutilizing a combination of historical and current trends. Deferred revenuereflects amounts received from customers related to merchandise to be shippedin future periods.

 

***Payments to Customers***

 

For wholesale customers, the Company makes payments to certaincustomers for cooperative advertising, royalties, commissions and sharedemployee costs. In accordance with the provisions of EITF 01-9, *Accounting for Consideration Given by a Vendor to aCustomer (Including a Reseller of the Vendor’s Products)*, these feesare recorded as a reduction of net sales in the accompanying consolidatedstatements of operations, unless the Company determines it has received anidentifiable benefit and can reasonably estimate the fair value of thatbenefit, in which case the costs would be recorded as expenses.

 

***Shipping and Fulfillment Costs***

 

Freight costs incurredrelated to shipment of merchandise from the Company’s distribution facilitiesto customers are recorded in cost of goods sold. Third-party fulfillment costsrelating to warehousing, storage, and order processing are included in selling,general and administrative expenses.

 

***Pre-Opening Costs***

 

Costs incurred in connection with the start-up and promotions of newCompany-owned boutiques are expensed as incurred.

 

***Operating Leases***

 

The Company leases retailboutiques, distribution facilities, and office space under operating leases.Most lease agreements contain rent holidays, rent escalation clauses,contingent rent provisions and/or tenant improvement allowances. For purposesof recognizing incentives and minimum rental expenses on a straight-line basisover the original terms of the leases, the Company uses the date of initialpossession to begin amortization, which is generally when the Company entersthe space and begins to make improvements in preparation of intended use. TheCompany does not assume renewals in its determination of the lease term unlessthe renewals are deemed by management to be reasonably assured at leaseinception. For tenant improvement allowances recorded as assets, the Companyalso records a deferred rent liability in the consolidated balance sheets andamortizes the deferred rent over the terms of the leases as reductions to rentexpense in the consolidated statements of income. For scheduled rent escalationclauses and rent holidays during the lease terms or for rental paymentscommencing at a date other than the date of initial occupancy, the Companyrecords minimum rental expenses on a straight-line basis over the terms of theleases. Certain leases provide for contingent rents, which are determined as apercentage of gross sales in excess of specified levels. The Company records arent liability in the consolidated balance sheets and the corresponding rentexpense when management determines that achieving the specified levels duringthe fiscal year is probable.

 

10

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***Research and Development***

 

Research and development costs are charged to selling, general andadministrative expenses as incurred. Major components of research anddevelopment expenses consist of product formulation, testing, regulatoryanalysis, and compliance.

 

***Advertising Costs***

 

The Company purchases commercial airtime on various television stationsthroughout the United States in order to air its direct-response program,or “infomercial.” The Company expenses costs associated with purchasing airtimeas incurred. The Company expenses production costs associated with advertisingas incurred, except for production costs for its infomercials, which arecapitalized and amortized over their expected period of future benefit. Thecapitalized production costs for each infomercial are amortized over atwelve-month period following the first airing of the infomercial.

 

Other advertising costs such as media placements and public relationsare expensed as incurred. Marketing brochures are accounted for as prepaidassets and are expensed based on usage, or at such time that they are no longerexpected to be used, in which case their cost is expensed at that time.

 

***Income Taxes***

 

Deferred tax assets and liabilities are recognized for the expected taxconsequences of temporary differences between the tax bases of assets andliabilities and their reported amounts using enacted tax rates in effect forthe year the differences are expected to reverse. The Company records avaluation allowance to reduce deferred tax assets to the amount that isexpected to be realized on a more-likely-than-not basis. Deferred tax expenseresults from changes in net deferred tax assets or liabilities between periods.

 

Effective January 1, 2007, the Company adopted FASB Interpretation No.48, *Accounting for Uncertainty in Income Taxes*(Note 13). In connection with the adoption of FIN 48, the Companychanged its accounting policy and now recognizes accrued interest and penaltiesrelated to income tax matters in income tax expense. These amounts werepreviously classified in selling, general and administrative expenses.

 

***Earnings per Share***

 

A calculation of earnings per share, as reported is as follows (inthousands, except per share data):

 
| ** **                                                                    | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                    | ** ** | **September 30,  2007**     | ** ** | **October 1,  2006**       | ** ** | **September 30,  2007** | ** ** | **October 1,  2006** | ** ** |
| *Numerator:*                                                                  |       |                             |       |                            |       |   |   |   |   |
| Net income                                                                    |       | $                                | 20,475     |                            | $          | 8,880 |   | $ | 61,095 |   | $ | 33,888 |   |
|                                                                          |       |                             |       |                            |       |   |   |   |   |
| *Denominator:*                                                                |       |                             |       |                            |       |   |   |   |   |
| Weighted average common shares used in per  share calculations — basic   |       | 90,532                           |       | 70,839                          |       | 89,994 |   | 69,920 |   |
| Add: Common stock equivalents from exercise  of stock options                 |       | 2,676                            |       | 2,478                           |       | 2,945 |   | 2,376 |   |
| Weighted-average common shares used in per  share calculations — diluted |       | 93,208                           |       | 73,317                          |       | 92,939 |   | 72,296 |   |
| Net income per share                                                          |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                         |       | $                                | 0.23       |                            | $          | 0.13 |   | $ | 0.68 |   | $ | 0.48 |   |
| Diluted                                                                       |       | $                                | 0.22       |                            | $          | 0.12 |   | $ | 0.66 |   | $ | 0.47 |   |

 

For the three and nine months ended September 30,2007, options to purchase 232,000 and 154,000 shares of common stock,respectively, were excluded from the calculation of weighted average shares fordiluted net income per share as they were anti-dilutive. For the three and ninemonths ended October 1, 2006, options to purchase 54,250 shares of common stockwere excluded from the calculation of weighted average shares for diluted netincome per share as they were anti-dilutive.

 

11

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***Comprehensive Loss***

 

Comprehensive loss consists of net income and othercomprehensive loss. Other comprehensive loss was $992,000 and $889,000 for thethree and nine months ended September 30, 2007. There was no other comprehensiveincome (loss) for the three and nine months ended October 1, 2006.

 

***Recent AccountingPronouncements***

 

In September 2006,the FASB issued SFAS No. 157*, FairValue Measurements*. Statement 157 defines fair value, establishes aframework for measuring fair value, and expands disclosures about fair valuemeasurements. Statement 157 also applies under other accounting pronouncementsthat require or permit fair value measurements, but does not require any newfair value measurements. The provisions of Statement 157 are effective forfiscal years beginning after November 15, 2007. The Company will adoptStatement 157 during its fiscal year ending December 28, 2008. The Companyis currently in the process of determining the impact, if any, of adopting theprovisions of Statement 157 but it is not expected to have a material impact onthe Company’s financial position or results of operations.

 

In February 2007, theFASB issued SFAS No. 159, *Fair Value Option forFinancial Assets and Financial Liabilities.*Statement 159permits entities to choose to measure many financial instruments, and certainother items, at fair value. Statement 159 also establishes presentationand disclosure requirements designed to facilitate comparisons between entitiesthat choose different measurement attributes for similar types of assets andliabilities. The provisions of Statement 159 are effective for fiscal yearsbeginning after November 15, 2007. The Company will adopt Statement 159during its fiscal year ending December 28, 2008. The Company is currentlyin the process of determining the impact, if any, of adopting the provisions ofStatement 159 but it is not expected to have a material impact on the Company’sfinancial position or results of operations.

 

**3.****              Acquisition**

 

On April 3, 2007, the Company completed itsacquisition of U.K.-based Cosmeceuticals Limited (“Cosmeceuticals”), whichdistributes Bare Escentuals’ *bareMinerals*,*md formulations* and *MD Forte* brands primarily to spas andsalons and QVC U.K.  The acquired entity has been renamed Bare EscentualsUK Ltd.  The consideration for the purchase was cash of$22.9 million, comprised of $22.2 million in cash consideration and$0.7 million of transaction costs. The Company’s consolidated financialstatements include the operating results of the business acquired from the dateof acquisition. Pro forma results of operations have not been presented becausethe effect of the acquisition was not material.

 

The total purchase price of $22.9 million wasallocated as follows: $13.4 million to goodwill, $8.9 million toidentifiable intangible assets comprised of customer relationships of$8.0 million and $0.9 million for non-compete agreements,$4.2 million to net tangible assets acquired, and $3.6 million to deferredtax liability. The estimated useful economic lives of the identifiableintangible assets acquired are three years.

 

As of September 30, 2007, approximately $2.3million of the purchase price was unpaid and is included in accrued liabilities.Additionally, included in prepaid expenses and other current assets is $3.2million due from the previous shareholders of the acquired company.

 

12

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# **4.****              Inventories**

#  

Inventories consisted of the following (in thousands):

 
| ** **                   | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Raw materials and components |       | $                            | 2,924      |                        | $          | 2,737 |   |
| Finished goods               |       | 59,692                       |       | 59,269                      |       |
|                         |       | $                            | 62,616     |                        | $          | 62,006 |   |

 

# **5.****              Property andEquipment, Net**

#  

Property and equipment, net, consisted of thefollowing (in thousands):

 
| ** **                                | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Furniture and equipment                   |       | $                            | 7,793      |                        | $          | 4,234 |   |
| Computers and software                    |       | 10,942                       |       | 4,732                       |       |
| Leasehold improvements                    |       | 23,393                       |       | 13,891                      |       |
|                                      |       | 42,128                       |       | 22,857                      |       |
| Accumulated depreciation and amortization |       | (8,346                       | )          | (5,170                      | )          |
|                                      |       | 33,782                       |       | 17,687                      |       |
| Construction-in-progress                  |       | 5,043                        |       | 3,424                       |       |
| Property and equipment, net               |       | $                            | 38,825     |                        | $          | 21,111 |   |

 

# **6.****              Intangible Assets,Net**

#  

Intangible assets, net, consisted of the following (inthousands):

 
| ** **                     | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Goodwill                       |       | $                            | 16,228     |                        | $          | 2,852 |   |
| Customer relationships         |       | 8,000                        |       | —                      |       |
| Trademarks                     |       | 3,233                        |       | 3,233                       |       |
| Domestic customer base         |       | 939                          |       | 939                         |       |
| International distributor base |       | 820                          |       | 820                         |       |
| Non-compete agreements         |       | 900                          |       | —                      |       |
|                           |       | 30,120                       |       | 7,844                       |       |
| Accumulated amortization       |       | (3,243                       | )          | (1,759                      | )          |
| Intangible assets, net         |       | $                            | 26,877     |                        | $          | 6,085 |   |

 

13

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# **7.****              Other Assets**

#  

Other assets consisted of the following (inthousands):

 
| ** **                                                                                                                       | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Debt issuance costs, net of accumulated  amortization of $206 and $61 at September 30, 2007 and December 31, 2006,  respectively |       | $                            | 851        |                        | $          | 1,057 |   |
| Other assets                                                                                                                     |       | 1,469                        |       | 775                         |       |
|                                                                                                                             |       | $                            | 2,320      |                        | $          | 1,832 |   |

 

# **8.****              Accrued Liabilities**

#  

Accrued liabilities consisted of the following (inthousands):

 
| ** **                                 | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| Interest                                   |       | $                            | 1,084      |                        | $          | 1,438 |   |
| Employee compensation and benefits         |       | 6,687                        |       | 7,437                       |       |
| Purchase price for acquisition             |       | 2,380                        |       | —                      |       |
| Gift certificates and customer liabilities |       | 1,746                        |       | 1,975                       |       |
| Sales taxes and local business taxes       |       | 1,929                        |       | 1,339                       |       |
| Royalties                                  |       | 1,751                        |       | 1,192                       |       |
| Deferred revenue                           |       | 1,691                        |       | 898                         |       |
| Other                                      |       | 4,677                        |       | 1,844                       |       |
|                                       |       | $                            | 21,945     |                        | $          | 16,123 |   |

 

# **9.****              Revolving Lines ofCredit**

#  

In February 2005,the Company established a revolving credit facility of up to $15,000,000 (the “Revolver”),the proceeds of which were to provide financing for working capital and othergeneral corporate purposes of the Company. The Revolver has a term of six yearsexpiring on February 18, 2011. In June 2006, the Company increased the Revolverto $25,000,000. In December 2006, the terms of the Revolver were furtheramended to eliminate the requirement that the net proceeds from the issuance ofequity securities by us or any of our subsidiaries be applied to prepay loansunder the credit agreement. The amendment also reduced the interest ratemargins applicable to LIBOR loans and base rate loans, provided for a furtherreduction in the interest rate margins if we achieve a specified consolidatedleverage ratio and specified debt rating, and amended some of the financialcovenants. Amounts available under the Revolver are based on eligiblecollateral that includes certain accounts receivable and inventory and may beused for working capital and capital expenditure needs, as well as the issuanceof documentary and standby letters of credit. At September 30, 2007,$24,900,000 was available and $100,000 was outstanding in letters of credit.Borrowings under the Revolver bear interest at a rate equal to, at the Company’soption, either a margin over LIBOR or the lenders’ base rate, plus anapplicable margin based on a grid in which the pricing depends on the Company’sconsolidated total leverage ratio and debt rating (2.25% plus LIBOR or 1.25%plus lenders’ base rate; actual rate of 8.05% at September 30, 2007 and 7.85%at December 31, 2006). The Company is also required to pay commitment feesof 0.5% per annum on any unused portions of the facility.

 

# **10.****       Long-Term Debt**

#  

Long-term debt consisted of the following (inthousands):

 
| ** **                                    | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| First Lien Term Loan                          |       | $                            | 279,933    |                        | $          | 339,263 |   |
| Less current portion                          |       | (15,131                      | )          | (17,624                     | )          |
| Total long-term debt, net of current  portion |       | $                            | 264,802    |                        | $          | 321,639 |   |

 

## **First Lien Term Loans**

##  

The First Lien Term Loans have an original term of seven years expiringon February 18, 2012 and bear interest at a rate equal to, at the Company’soption, either LIBOR or the lenders’ base rate, plus an applicable marginvarying based on the

 

14

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Company’s consolidated total leverage ratio. As of September 30, 2007and December 31, 2006, the interest rates on the First Lien Term Loanswere accruing at 8.05% and 7.85%, respectively (without giving effect tothe interest rate swap transaction discussed below). As of September 30,2007, $279,933,000 was outstanding on the First Lien Term Loans.

 

On December 20,2006, the Company amended its First Lien Credit Agreement to eliminate therequirement that the net proceeds from the issuance of equity securities of theCompany or any of its subsidiaries be applied to prepay loans under the creditagreement. The amendment also reduced the interest rate margins if the Companyachieves a specified consolidated leverage ratio and specified debt rating, andeliminated the minimum cash interest ratio financial covenant and amended someof the other financial covenants. The maturity date of the First Lien Term Loanwas not adjusted.

 

On March 23, 2007, theCompany further amended its First Lien Credit Agreement to permit the abilityto make acquisitions of up to $30,000,000 in any one fiscal year and up to$60,000,000 in the aggregate as well as to permit additional investments inforeign subsidiaries of up to $25,000,000.

 

Borrowings under theRevolver (Note 9) and the First Lien Term Loans are secured by substantiallyall of the Company’s assets, including, but not limited to, all accountsreceivable, inventory, property and equipment, and intangibles. The terms ofthe senior secured credit facilities require the Company to comply withfinancial covenants, including maintaining a leverage ratio, entering intointerest rate swap or similar agreements with respect to 40% of the principalamounts outstanding under the Company’s senior secured credit facilities as ofOctober 2, 2007. The secured credit facility also contains nonfinancialcovenants that restrict some of the Company’s activities, including its abilityto dispose of assets, incur additional debt, pay dividends, create liens, makeinvestments, and engage in specified transactions with affiliates. As ofSeptember 30, 2007, the Company satisfied its financial and nonfinancialcovenants.

 

**Scheduled Maturities of Long-TermDebt**

 

At September 30, 2007, future scheduled principalpayments on long-term debt were as follows (in thousands):

 
| Year ending:                                    |   |    |    |
|-------------------------------------------------|--------|---------|---------|
| Remainder of the year ending December 30,  2007 |   | $       | 3,783   |   |
| December 28, 2008                               |   | 15,132  |    |
| January 3, 2010                                 |   | 15,132  |    |
| January 2, 2011                                 |   | 15,132  |    |
| January 1, 2012                                 |   | 174,013 |    |
| December 30, 2012                               |   | 56,741  |    |
|                                            |   | $       | 279,933 |   |

 

# **11.  Commitments and Contingencies**

#  

## ***Lease Commitments***

##  

The Company leases retailboutiques, distribution facilities, and office space under noncancelableoperating leases with various expiration dates through March 2018.Additionally, the Company subleases certain real property to third parties. Portionsof these payments are denominated in foreign currencies and were translated inthe tables below based on their respective U.S. dollar exchange rates atSeptember 30, 2007. These future payments are subject to foreign currencyexchange rate risk. The future minimum annual payments and anticipated subleaseincome under such leases in effect at September 30, 2007, were as follows (inthousands):

 
| ** **                                      | ** ** | **Minimum  Rental  Payments** | ** ** | **Sublease  Rental  Income** | ** ** | **Net  Minimum  Lease  Payments** | ** ** |
|-------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|-----------------------------------|------------|
| Year ending:                                    |       |                          |       |                         |       |                              |       |
| Remainder of the year ending December 30,  2007 |       | $                             | 1,332      |                         | $          | 8                                 |       | $ | 1,324 |   |
| December 28, 2008                               |       | 8,307                         |       | 31                           |       | 8,276                             |       |
| January 3, 2010                                 |       | 8,819                         |       | 31                           |       | 8,788                             |       |
| January 2, 2011                                 |       | 8,463                         |       | 31                           |       | 8,432                             |       |
| January 1, 2012                                 |       | 8,204                         |       | 31                           |       | 8,173                             |       |
| Thereafter                                      |       | 38,067                        |       | 1                            |       | 38,066                            |       |
|                                            |       | $                             | 73,192     |                         | $          | 133                               |       | $ | 73,059 |   |

 

15

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Many of the Company’s retail boutique leases requireadditional contingent rents when certain sales volumes are reached. Total rentexpense was $3,782,000 and $10,542,000 for the three and nine months endedSeptember 30, 2007, respectively, and $2,238,000 and $5,932,000 for the threeand nine months ended October 1, 2006, respectively. Total rent expenseincluded contingent rentals of $500,000 and $1,594,000 for the three and ninemonths ended September 30, 2007, respectively, and $394,000 and $1,117,000 forthe three and nine months ended October 1, 2006, respectively. Several leasesentered into by the Company include options that may extend the lease termbeyond the initial commitment period, subject to terms agreed to at leaseinceptions. As of September 30, 2007, under the terms of its corporate officelease, the Company issued an irrevocable standby letter of credit of $100,000to the lessor for the term of the lease.

 

## ***Royalty Agreements***

##  

The Company is a party to a license agreement (the “License”)for use of certain patents associated with some of the skin care products soldby the Company. The License requires that the Company pay a quarterly royaltyof 4% of the net sales of certain skin care products for an indefinite periodof time. The License also requires minimum annual royalty payments of $600,000from the Company. The Company can terminate the agreement at any time with sixmonths written notice. The Company’s royalty expense under the License for thethree and nine months ended September 30, 2007 was $150,000 and $450,000,respectively, and $150,000 and $450,000 for the three and nine months endedOctober 1, 2006, respectively.

 

The Company has obtained a worldwide exclusive rightto license, develop, commercialize, and distribute certain licensed ingredientsto be used in products to be sold by the Company. This agreement requires theCompany to make payments upon achievement of certain product milestones. Inaddition, this agreement requires the Company to pay a royalty of 3.5% of thenet sales upon successful launch of the first product, subject to certainminimum annual royalty amounts. The Company launched commercial sales of theproducts containing the licensed ingredients during the year endedDecember 31, 2006. The minimum royalty amount is $400,000 for 2007 and$500,000 for 2008 after which time the Company may renegotiate the minimumroyalties or other compensation within 120 days after the second anniversary ofthe commercial launch. The Company’s expense under this agreement for the threeand nine months ended September 30, 2007 was $237,000 and $663,000,respectively, and $238,000 and $430,000 for the three and nine months endedOctober 1, 2006, respectively.

 

***Contingencies***

 

The Company is involvedin various legal and administrative proceedings and claims arising in theordinary course of its business. The ultimate resolution of such claims wouldnot, in the opinion of management, have a material effect on the Company’sfinancial position or results of operation.

 

# **12.          Related-Party Transactions**

#  

On June 10, 2004, the Company entered into aManagement Agreement (“Berkshire Agreement”) with Berkshire Partners LLC (“Berkshire”).Under the Berkshire Agreement, the Company engaged Berkshire to providemanagement advisory services in connection with the general business operationsof the Company. In compensation for such services, the Company agreed to pay amanagement fee in an amount of $300,000 per annum for the term of theagreement. The Berkshire Agreement was terminated upon completion of ourinitial public offering on October 4, 2006. Total management fees plus expensesrecognized under the Berkshire Agreement for the three and nine months endedOctober 1, 2006 was $92,000 and $273,000, respectively, which was recorded asselling, general and administrative expenses in the accompanying consolidatedstatements of operations.

 

On June 10, 2004, the Company also entered into aManagement Agreement (“JHP Agreement”) with JH Partners, LLC (“JHP”). Under theJHP Agreement, the Company engaged JHP to provide management advisory servicesin connection with the general business operations of the Company. Incompensation for such services, the Company agreed to pay a management fee inan amount of $300,000 per annum for the term of the JHP Agreement. The JHPAgreement was terminated upon completion of our initial public offering onOctober 4, 2006. Total management fees plus expenses recognized under thisAgreement for the three and nine months ended October 1, 2006 was $75,000 and$282,000, respectively, which was recorded as selling, general andadministrative expenses in the accompanying consolidated statements of operations.

 

FH Capital Partners LLC is 50%-owned by an affiliateof the Company’s former chairman, a major stockholder. In December 2001 and May2002, the Company entered into agreements with FH Capital Partners LLC to rentcertain computer

 

16

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hardware,software, and licenses under operating lease agreements. During the nine monthsended September 30, 2007, the Company purchased the equipment under these leaseagreements. Total expense recognized relating to these arrangements for thethree and nine months ended September 30, 2007 was zero and $16,900,respectively, and for the three and nine months ended October 1, 2006 was$7,500 and $20,000, respectively, which was recorded as selling, general andadministrative expenses in the accompanying consolidated statements ofoperations.

 

# **13.  Income Taxes**

#  

In June 2006, the Financial Accounting StandardsBoard (“FASB”) issued FASB Interpretation 48 (“FIN 48”), *Accounting for Uncertainty in Income Taxes*.FIN 48 clarifies the accounting for uncertainty in income taxes recognized inaccordance with SFAS 109, *Accounting forIncome Taxes*. FIN 48 prescribes a comprehensive model for how acompany should recognize, measure, present and disclose in its financialstatements uncertain tax positions that the Company has taken or expects totake on a tax return.

 

The Company adopted FIN 48 on January 1, 2007. As aresult of the adoption of FIN 48, the changes to the Company’s reserve foruncertain tax positions was accounted for as a $952,000 cumulative effectadjustment to increase the beginning balance of accumulated deficit on theCompany’s balance sheet. As of September 30, 2007, the total amount ofunrecognized tax benefits, including related interest, was $4,135,000. Thisamount includes $2,207,000 of unrecognized tax benefits which would decreasethe Company’s effective tax rate if recognized.

 

The Company believes that it is reasonably possiblethat the amount of unrecognized tax benefits could increase or decrease withinthe next twelve months and that the change could be significant. However, theCompany is unable to estimate the range of possible changes to the amount ofunrecognized tax benefits within the next twelve months.

 

As of September 30, 2007, the Company had approximately $817,000 ofaccrued interest related to uncertain tax positions. The Company files UnitedStates federal income tax returns and income tax returns in multiple statejurisdictions. The tax years 2003-2006 remain open to examination by the majortaxing jurisdictions. In July 2007, the U.S. Internal Revenue Service completedits audit of the Company’s U.S. federal income tax returns for 2004, whichresulted in no changes to reported tax for that year. The outcome of this audithad no impact to the amounts recorded in the financial statements.

 

**14.  Stockholders’Equity**

 

On March 19, 2007, the Company completed afollow-on underwritten public offering pursuant to which the Company sold575,000 shares and selling stockholders sold an additional 13,225,000 shares,which includes 1,800,000 shares sold pursuant to the exercise of theunderwriters’ over-allotment option. The Company received net proceeds ofapproximately $18.1 million, after deducting underwriting discounts andcommissions and estimated offering expenses.

 

On June 19, 2007, the Company completed afollow-on underwritten public offering pursuant to which the Company sold100,000 shares and selling stockholders sold an additional 7,900,000 shares. TheCompany received net proceeds of approximately $3.0 million, afterdeducting underwriting discounts and commissions and estimated offeringexpenses.

 

# **15.  Stock-Based Employee Compensation Plans**

#  

As of September 30, 2007, the Company had reserved 9,704,232 shares ofcommon stock for issuance.

 

## **2004 Equity Incentive Plan**

##  

On June 10, 2004, the board of directors adopted the2004 Equity Incentive Plan (the “2004 Plan”). The 2004 Plan provides for theissuance of non-qualified stock options for common stock to employees,directors, consultants, and other associates. The options generally vest over aperiod of five years from the date of grant and have a maximum term of tenyears.

 

In conjunction with theadoption of the 2006 Equity Incentive Plan in September 2006, noadditional options are permitted to be granted under the 2004 Plan. Inaddition, any outstanding options cancelled under the 2004 Plan will becomeavailable to grant under the 2006 Equity Incentive Plan.

 

17

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A summary of activity under the 2004 Plan is set forthbelow. 

 
| ** **                                             | ** ** | ** **                             | ** ** | **Options Outstanding** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|------------------------------|------------|
| ** **                                             | ** ** | **Options  Available  for Grant** | ** ** | **Number of  Shares**   | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Balance at December 31, 2006                           |       | —                                 |       | 6,211,293                    |       | $ | 2.68 |   |
| Exercised                                              |       | —                                 |       | (1,113,258                   | )          | 1.46 |   |
| Canceled                                               |       | 164,560                                |       | (164,560                     | )          | 4.38 |   |
| Cancellation of remaining options available  for grant |       | (164,560                               | )          | —                       |       | — |   |
| Balance at September 30, 2007                          |       | —                                 |       | 4,933,475                    |       | $ | 2.90 |   |

 

# At September 30, 2007, total outstanding options vested under the 2004Plan were 544,528 at a weighted-average exercise price of $3.45.

#  

The total intrinsic value of options exercised under the 2004 Plan forthe nine months ended September 30, 2007 was $27,445,000.

 

**2006 Equity Incentive Plan**

 

On September 12, 2006, the stockholders of the Company approved the2006 Equity Incentive Award Plan (the “2006 Plan”) for executives, directors,employees and consultants of the Company. A total of 4,500,000 shares of theCompany’s Common Stock have been reserved for issuance under the 2006 Plan.Awards are granted with an exercise price equal to the market price of theCompany’s Common Stock at the date of grant. Those awards generally vest over aperiod of four or five years from the date of grant and have a maximum term often years.

 

A summary of activity under the 2006 Plan is set forthbelow:

 
| ** **                    | ** ** | ** **                             | ** ** | **Options Outstanding** | ** ** |
|-------------------------------|------------|----------------------------------------|------------|------------------------------|------------|
| ** **                    | ** ** | **Options  Available  for Grant** | ** ** | **Number of  Shares**   | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Balance at December 31, 2006  |       | 4,441,947                              |       | 164,250                      |       | $ | 30.95 |   |
| Rolled over from 2004 Plan    |       | 164,560                                |       | —                       |       | — |   |
| Granted                       |       | (166,475                               | )          | 166,475                      |       | 34.26 |   |
| Canceled                      |       | 74,000                                 |       | (74,000                      | )          | 34.64 |   |
| Balance at September 30, 2007 |       | 4,514,032                              |       | 256,725                      |       | $ | 32.03 |   |

 

At September 30, 2007, total outstanding options vested under the 2006Plan were 10,050 at a weighted-average exercise price of $22.00.

 

The total cash received from employees as a result ofemployee stock option exercises under all plans for the nine months endedSeptember 30, 2007 was $1,627,000. In connection with these exercises, the taxbenefits realized by the Company for the nine months ended September 30, 2007was $9,221,000.

 

18

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**16.          Segment and Geographic Information**

 

Operatingsegments are defined as components of an enterprise engaging in businessactivities about where separate financial information is available that isevaluated regularly by the Chief Operating Decision Maker (“CODM”) in decidinghow to allocate resources and assessing performance. The Company’s ChiefExecutive Officer has been identified as the CODM as defined by Statement 131, *Disclosures about Segments of an Enterprise andRelated Information*. The Company has determined that it operates intwo business segments: Retail with sales to end users, and Wholesale with salesto resellers. These reportable segments are strategic business units that aremanaged separately based on the fundamental differences in their operations.The Retail segment consists of sales directly to end users through Company-ownedboutiques and infomercials. The Wholesale segment consists of sales toresellers, home shopping television, specialty beauty retailers, spas andsalons, and international distributors. The following table presents certainfinancial information for each segment. Operating income is the gross margin ofthe segment less direct expenses of the segment. Some direct expenses, such asmedia and advertising spend, do impact the performance of the other segment,but these expenses are recorded in the segment they directly relate to and arenot allocated out to each segment. The Corporate column includes unallocatedselling, general and administrative expenses, depreciation and amortization,stock-based compensation expenses, restructuring charges and asset impairmentcharges. Corporate selling, general and administrative expenses includeheadquarters facilities costs, distribution center costs, product developmentcosts, corporate headcount costs and other corporate costs, includinginformation technology, finance, accounting, legal and human resources costs.

 
| ** **                                | ** ** | **Retail** | ** ** | **Wholesale** | ** ** | **Corporate** | ** ** | **Total**  | ** ** |
|-------------------------------------------|------------|------------|------------|---------------|------------|---------------|------------|------------|------------|
| **Three Months ended September 30, 2007** | ** ** | ** ** | ** ** | ** **    | ** ** | ** **    | ** ** | ** ** | ** ** |
| Sales, net                                |       | $          | 51,292     |          | $          | 75,343        |       | $          | —     |   | $ | 126,635 |   |
| Cost of goods sold                        |       | 9,923      |       | 26,033        |       | —        |       | 35,956     |       |
| Gross profit                              |       | 41,369     |       | 49,310        |       | —        |       | 90,679     |       |
| Operating expenses:                       |       |       |       |          |       |          |       |       |       |
| Selling, general and administrative       |       | 23,931     |       | 4,709         |       | 18,896        |       | 47,536     |       |
| Depreciation and amortization             |       | 382        |       | 75            |       | 1,578         |       | 2,035      |       |
| Stock-based compensation                  |       | —     |       | —        |       | 1,800         |       | 1,800      |       |
| Total expenses                            |       | 24,313     |       | 4,784         |       | 22,274        |       | 51,371     |       |
| Operating income (loss)                   |       | 17,056     |       | 44,526        |       | (22,274       | )          | 39,308     |       |
| Interest expense                          |       |       |       |          |       |          |       | (5,725     | )          |
| Interest income                           |       |       |       |          |       |          |       | 471        |       |
| Income before provision for income taxes  |       |       |       |          |       |          |       | 34,054     |       |
| Provision for income taxes                |       |       |       |          |       |          |       | 13,579     |       |
| Net income                                |       |       |       |          |       |          |       | $          | 20,475     |   |
|                                           |            |            |            |               |            |               |            |            |            |  |  |  |  |

 
| ** **                               | ** ** | **Retail** | ** ** | **Wholesale** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|------------|------------|---------------|------------|---------------|------------|-----------|------------|
| **Three Months ended October 1, 2006**   |       |       |       |          |       |          |       |      |       |
| Sales, net                               |       | $          | 48,113     |          | $          | 49,834        |       | $         | —     |   | $ | 97,947 |   |
| Cost of goods sold                       |       | 9,018      |       | 17,872        |       | —        |       | 26,890    |       |
| Gross profit                             |       | 39,095     |       | 31,962        |       | —        |       | 71,057    |       |
| Operating expenses:                      |       |       |       |          |       |          |       |      |       |
| Selling, general and administrative      |       | 20,768     |       | 1,819         |       | 11,880        |       | 34,467    |       |
| Depreciation and amortization            |       | 200        |       | —        |       | 352           |       | 552       |       |
| Stock-based compensation                 |       | —     |       | —        |       | 1,365         |       | 1,365     |       |
| Restructuring charges                    |       | —     |       | —        |       | 114           |       | 114       |       |
| Total expenses                           |       | 20,968     |       | 1,819         |       | 13,711        |       | 36,498    |       |
| Operating income (loss)                  |       | 18,127     |       | 30,143        |       | (13,711       | )          | 34,559    |       |
| Interest expense                         |       |       |       |          |       |          |       | (19,723   | )          |
| Interest income                          |       |       |       |          |       |          |       | 348       |       |
| Income before provision for income taxes |       |       |       |          |       |          |       | 15,184    |       |
| Provision for income taxes               |       |       |       |          |       |          |       | 6,304     |       |
| Net income                               |       |       |       |          |       |          |       | $         | 8,880      |   |
|                                          |            |            |            |               |            |               |            |           |            |  |  |  |  |

 

19

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| ** **                               | ** ** | **Retail** | ** ** | **Wholesale** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|------------|------------|---------------|------------|---------------|------------|-----------|------------|
| **Nine Months ended September 30, 2007** |       |       |       |          |       |          |       |      |       |
| Sales, net                               |       | $          | 153,679    |          | $          | 212,713       |       | $         | —     |   | $ | 366,392 |   |
| Cost of goods sold                       |       | 31,477     |       | 75,507        |       | —        |       | 106,984   |       |
| Gross profit                             |       | 122,202    |       | 137,206       |       | —        |       | 259,408   |       |
| Operating expenses:                      |       |       |       |          |       |          |       |      |       |
| Selling, general and administrative      |       | 68,964     |       | 11,547        |       | 49,746        |       | 130,257   |       |
| Depreciation and amortization            |       | 1,056      |       | 111           |       | 3,668         |       | 4,835     |       |
| Stock-based compensation                 |       | —     |       | —        |       | 5,190         |       | 5,190     |       |
| Total expenses                           |       | 70,020     |       | 11,658        |       | 58,604        |       | 140,282   |       |
| Operating income (loss)                  |       | 52,182     |       | 125,548       |       | (58,604       | )          | 119,126   |       |
| Interest expense                         |       |       |       |          |       |          |       | (18,810   | )          |
| Interest income                          |       |       |       |          |       |          |       | 1,299     |       |
| Income before provision for income taxes |       |       |       |          |       |          |       | 101,615   |       |
| Provision for income taxes               |       |       |       |          |       |          |       | 40,520    |       |
| Net income                               |       |       |       |          |       |          |       | $         | 61,095     |   |
|                                          |            |            |            |               |            |               |            |           |            |  |  |  |  |

 
| ** **                               | ** ** | **Retail** | ** ** | **Wholesale** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|------------------------------------------|------------|------------|------------|---------------|------------|---------------|------------|-----------|------------|
| **Nine Months ended October 1, 2006**    |       |       |       |          |       |          |       |      |       |
| Sales, net                               |       | $          | 134,730    |          | $          | 149,317       |       | $         | —     |   | $ | 284,047 |   |
| Cost of goods sold                       |       | 26,760     |       | 52,263        |       | —        |       | 79,023    |       |
| Gross profit                             |       | 107,970    |       | 97,054        |       | —        |       | 205,024   |       |
| Operating expenses:                      |       |       |       |          |       |          |       |      |       |
| Selling, general and administrative      |       | 59,264     |       | 6,314         |       | 31,745        |       | 97,323    |       |
| Depreciation and amortization            |       | 527        |       | —        |       | 996           |       | 1,523     |       |
| Stock-based compensation                 |       | —     |       | —        |       | 3,832         |       | 3,832     |       |
| Restructuring charges                    |       | —     |       | —        |       | 114           |       | 114       |       |
| Total expenses                           |       | 59,791     |       | 6,314         |       | 36,687        |       | 102,792   |       |
| Operating income (loss)                  |       | 48,179     |       | 90,740        |       | (36,687       | )          | 102,232   |       |
| Interest expense                         |       |       |       |          |       |          |       | (41,593   | )          |
| Debt extinguishment costs                |       |       |       |          |       |          |       | (3,391    | )          |
| Interest income                          |       |       |       |          |       |          |       | 979       |       |
| Income before provision for income taxes |       |       |       |          |       |          |       | 58,227    |       |
| Provision for income taxes               |       |       |       |          |       |          |       | 24,339    |       |
| Net income                               |       |       |       |          |       |          |       | $         | 33,888     |   |
|                                          |            |            |            |               |            |               |            |           |            |  |  |  |  |

 

The Company’slong-lived assets, excluding goodwill and intangibles, by segment were asfollows (in thousands):

 
| ** ** | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|------------|------------|-------------------------|------------|------------------------|------------|
| Retail     |       | $                       | 14,934     |                   | $          | 8,398 |   |
| Wholesale  |       | 938                     |       | 138                    |       |
| Corporate  |       | 23,125                  |       | 12,715                 |       |
|       |       | $                       | 38,997     |                   | $          | 21,251 |   |

 

Long-livedassets allocated to the retail segment consist of fixed assets and deposits forretail stores. Long-lived assets allocated to the wholesale segment consist offixed assets located at a wholesale customer. Long-lived assets in thecorporate segment consist of fixed assets and deposits related to the Company’scorporate offices and distribution center.

 

No individualgeographical area outside of the United States accounted for more than 10% ofnet sales in any of the periods presented. The Company’s sales by geographicarea were as follows (in thousands):

 
| ** **    | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **    | ** ** | **September 30,  2007**     | ** ** | **October 1,  2006**       | ** ** | **September 30,  2007** | ** ** | **October 1,  2006** | ** ** |
| North America |       | $                                | 116,963    |                            | $          | 93,408 |   | $ | 338,563 |   | $ | 271,127 |   |
| International |       | 9,672                            |       | 4,539                           |       | 27,829 |   | 12,920 |   |
| Sales, net    |       | $                                | 126,635    |                            | $          | 97,947 |   | $ | 366,392 |   | $ | 284,047 |   |

 

20

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**17.  Restructuring Costs**

 

As a result ofthe Company’s growth and a change in strategy to improve its operations, theCompany relocated both the corporate and distribution center facilities duringthe year ended January 1, 2006. Related to these relocations, the Companyexited two facilities that had operating lease commitments through June 2007.These exit costs were accounted for in accordance with Statement 146, *Accounting for Costs Associated with Exit or DisposalActivities.*Costs primarily represent closure and relocation costsof the Company’s corporate headquarters and distribution center. Closure costsinclude payments required under lease contracts after the properties wereabandoned, less any applicable estimated sublease income during the periodafter abandonment. To determine the closure costs, certain estimates were maderelated to the (1) time period over which the relevant building wouldremain vacant, (2) sublease terms, and (3) sublease rates, includingcommon area charges. The accrual is an estimate and will be adjusted in thefuture upon triggering events (such as changes in estimates of time to subleaseand actual sublease rates). During the year ended December 31, 2006, theCompany discontinued the use of one of its office floors located at its formercorporate facility and recorded additional restructuring costs of $114,000. Asof December 31, 2006, the remaining $172,000 of lease termination costs,net of estimated sublease income, was paid on various dates throughJuly 2007.

 

The followingtable set forth the exit activities for the nine months ended September 30,2007 (in thousands):

 
| Accrual balance at December 31, 2006  |   | $    | 172    |   |
|---------------------------------------|--------|------|--------|--------|
| Cash paid                             |   | (172 | )      |
| Accrual balance at September 30, 2007 |   | $    | — |   |

 

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**ITEM 2.****                             MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Forward-Looking Statements**

 

This section and other parts of this QuarterlyReport on Form 10-Q contain forward-looking statements that involve risksand uncertainties. In some cases, forward-looking statements can be identifiedby words such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” andsimilar terms. Such forward-looking statements are based on currentexpectations, estimates and projections about our industry, management’sbeliefs and assumptions made by management. Forward-looking statements are notguarantees of future performance and our actual results may differ materiallyfrom the results discussed below and in the forward-looking statements. Factorsthat might cause such differences include, but are not limited to thosediscussed in Part II, Item 1A, “Risk Factors” below and Item 1A of our AnnualReport on Form 10-K for the year ended December 31, 2006 filed with the SEC onMarch 30, 2007. The following discussion should be read in conjunction with theCompany’s consolidated financial statements and related notes hereto includedelsewhere in this Quarterly Report on Form 10-Q. Except as required bylaw, we expressly disclaim any obligation to update publicly anyforward-looking statements, whether as result of new information, future eventsor otherwise.

 

**ExecutiveOverview**

 

Founded in1976, Bare Escentuals is one of the fastest growing prestige beautycompanies in the U.S. and a leader by sales and consumer awareness in mineral-basedcosmetics. We develop, market and sell branded cosmetics, skin care and bodycare products under our *i.d. bareMinerals,i.d., RareMinerals* and namesake *Bare Escentuals*brands, and professional skin care products under our *md formulations* brand.

 

We utilize adistinctive marketing strategy and a multi-channel distribution modelconsisting of infomercials, premium wholesale, including Sephora and Ulta,company-owned boutiques, home shopping television on QVC, spas and salons andonline shopping. We believe that this strategy provides convenience to ourconsumers and allows us to reach the broadest possible spectrum of consumers.

 

Our businessis comprised of two strategic business units constituting reportable segmentsthat we manage separately based on fundamental differences in their operations:

 

•                  Ourretail segment, which is characterized by sales directly to end users, includesour infomercials, which include sales of our infomercial offers through ourwebsites *www.bareminerals.com* and*www.bareescentuals.com,* and company-ownedboutiques, which include sales through our websites *www.mdformulations.com and www.bareescentuals.com*. Webelieve that our infomercial business helps us to build brand awareness,communicate the benefits of our core products and establish a base of recurringrevenue because a substantial percentage of new consumers participate in ourcontinuity program. Our company-owned boutiques enhance our ability to buildstrong consumer relationships and promote additional product use throughpersonal demonstrations and product consultations.

 

•                  Ourwholesale segment, which is characterized by sales to resellers, includespremium wholesale; home shopping television; spas and salons; and internationaldistributors. Our sales through home shopping television help us to build brandawareness, educate consumers through live product demonstrations and develop close connections with our consumers.We also sell to retailers that we believe feature our products in settings thatsupport and reinforce our brand image and provide a premium in-storeexperience. Similarly, our spa and salon customers provide an informative andtreatment-focused environment in which aestheticians and spa professionals cancommunicate the benefits of our core products. Finally, we primarily sell ourproducts in a number of international markets through a network of third-partydistributors.

 

We manage our businesssegments to maximize sales growth and market share. We believe that our multi-channeldistribution strategy maximizes convenience for our consumers, reinforces brandawareness, increases consumer retention rates, and drives corporate cash flowand profitability. Further, we believe that the broad diversification withinour segments provides us with expanded opportunities for growth and reduces ourdependence on any single distribution channel. Within individual distributionchannels, particularly those in our wholesale segment, financial results areoften affected by the timing of shipments as well as the impact of keypromotional events.

 

22

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In evaluating ourbusiness, we also consider and use Adjusted EBITDA as a supplemental measure ofour operating performance. We use EBITDA only to assist in the reconciliationof net income to Adjusted EBITDA. We define EBITDA as net income beforeinterest, income tax, depreciation and amortization. We define Adjusted EBITDAas EBITDA adjusted for items that we do not consider reflective of our ongoingoperations. See “—Non-GAAP Measures.”

 

**Basis of Presentation**

 

We recognize revenue in accordance with therequirements of Staff Accounting Bulletin No. 104 *Revenue Recognition*, and other applicablerevenue recognition guidance and interpretations. The Company records revenuewhen all four of the following criteria are met: (i) persuasive evidencethat an arrangement exists; (ii) delivery of the products and/or serviceshas occurred; (iii) the selling price is fixed or determinable; and(iv) collectibility is reasonably assured. Revenue is recognized whenmerchandise is shipped from a warehouse to wholesale customers, infomercialcustomers and online shopping customers or when purchased by consumers at company-ownedboutiques, each net of estimated returns (except in the case of our consignmentsales). For our consignment sales, we recognize sales, net of estimatedreturns, upon shipment from our consignment partners to their customers. Werecognize postage and handling charges we bill to customers as revenue uponshipment of the related merchandise.

 

Our cost of goods soldconsists of the costs associated with the sourcing of our products, includingthe cost of the product and associated manufacturing costs, inbound freightcharges, royalties and internal transfer costs. Additionally, cost of goodssold includes postage and handling costs incurred upon shipment of merchandise.Our gross profit is dependent upon a variety of factors, including changes inthe relative sales mix between our business segments, changes in the mix ofproducts sold and fluctuations in material costs. Our gross margins differsignificantly between product lines and our business segments, with sales inour retail segment generally yielding higher gross margins than our wholesalesegment. These factors may cause gross profit and margins to fluctuate fromquarter to quarter. We anticipate that our cost of goods sold will increase inabsolute dollars as we increase our total sales but will remain generallyconsistent with historical periods on an annual basis as a percentage of netsales depending on the mix of sales among our distribution channels.

 

Selling, general andadministrative expenses include infomercial production and media costs,advertising costs, rent and other store operating costs and corporate costssuch as management salaries, information technology, professional fees, financeand accounting personnel, human resources personnel and other administrativefunctions. Selling, general, and administrative expenses also include all ofour distribution center and fulfillment costs, including all warehousing costsassociated with our third-party fulfillment provider and receiving andinspection costs that we do not include in cost of goods sold, which arecomprised primarily of headcount-related costs at our own distribution centerand at our third-party fulfillment provider. Receiving and inspection costs andwarehousing costs are excluded from our gross margins and, therefore, our grossmargins may not be comparable to those of other companies that choose toinclude certain of these costs in cost of goods sold. We are unable to providean estimate of these costs, but we believe these costs are not material.Fluctuations in selling, general and administrative expenses result primarilyfrom changes in media and advertising expenditures, changes in fulfillmentcosts which increase proportionately with net sales, particularly infomercialsales, changes in store operating costs, which are affected by the number ofstores opened in a period, and changes in corporate costs such as for headcountand infrastructure to support our operations. We anticipate that our selling,general and administrative expenses will increase in absolute dollars as weexpect to continue to invest in corporate infrastructure and incur additionalexpenses associated with being a public company, such as increased legal andaccounting costs, investor relations costs and higher insurance premiums.

 

Depreciation and amortizationincludes charges for the depreciation of property and equipment and theamortization of intangible assets. We anticipate that our depreciation andamortization expense will increase in absolute dollars as we continue to opennew boutiques, invest in information systems and amortize intangible assets inconnection with our recent acquisition. We record our depreciation andamortization as a separate line item in our statement of operations because allsuch expense relates to selling, general and administrative costs.

 

Stock-based compensation includes charges incurred inrecognition of compensation expense associated with grants of stock options andstock purchases. On January 3, 2005 we adopted the fair value recognition andmeasurement provisions of SFAS No. 123(R), *Share-Based Payment*(SFAS 123(R)). We record ourstock-based compensation on a separate operating expense line item in ourstatement of operations due to the fact that, to date, all of our stock-basedawards have been made to employees whose salaries are classified as selling,general and administrative costs.

 

Interest expense includes interest costs associatedwith our credit facilities and the amortization of deferred financing costsassociated with these credit facilities. We anticipate that our interestexpense in the future will decrease in absolute terms and as a percentage ofnet sales as we continue to make scheduled repayments of our outstandingindebtedness.

 

23

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Provision for incometaxes depends on the statutory tax rates in the countries where we sell ourproducts. Historically, we have only been subject to taxation in the UnitedStates because we have either sold to consumers in the United States or sold todistributors in the United States who resold our products here and abroad.However, as a result of our acquisition in the second fiscal quarter of 2007,we began to sell our products directly to customers located outside of theUnited States and we became subject to taxation based on the foreign statutoryrates in the countries where those sales took place. Our effective tax ratecould fluctuate accordingly. For fiscal 2007, we anticipate that our effectivetax rate will be approximately 40% of our income before provision for incometaxes.

 

**Results ofOperations**

 

The following is a discussion of our results ofoperations and percentage of net sales for the three months ended September 30,2007 compared to the three months ended October 1, 2006 and for the nine monthsended September 30, 2007 compared to the nine months ended October 1, 2006.

 

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

 
| ** **                               | ** ** | **Three months ended**                      | ** ** | **Nine months ended** | ** ** |
|------------------------------------------|------------|-------------------------------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **September 30,  2007**                          | ** ** | **October 1,  2006**       | ** ** | **September 30,  2007** | ** ** | **October 1,  2006** | ** ** |
| ** **                               | ** ** | **(in thousands, except percentages)** | ** ** |
| Sales, net                               |       | $                                                     | 126,635    |                            | 100.0      | % | $ | 97,947 |   | 100.0 | % | $ | 366,392 |   | 100.0 | % | $ | 284,047 |   | 100.0 | % |
| Cost of goods sold                       |       | 35,956                                                |       | 28.4                            |       | 26,890 |   | 27.5 |   | 106,984 |   | 29.2 |   | 79,023 |   | 27.8 |   |
| Gross profit                             |       | 90,679                                                |       | 71.6                            |       | 71,057 |   | 72.5 |   | 259,408 |   | 70.8 |   | 205,024 |   | 72.2 |   |
| Expenses:                                |       |                                                  |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative      |       | 47,536                                                |       | 37.6                            |       | 34,467 |   | 35.2 |   | 130,257 |   | 35.6 |   | 97,323 |   | 34.3 |   |
| Depreciation and amortization            |       | 2,035                                                 |       | 1.6                             |       | 552 |   | 0.5 |   | 4,835 |   | 1.3 |   | 1,523 |   | 0.5 |   |
| Stock-based compensation                 |       | 1,800                                                 |       | 1.4                             |       | 1,365 |   | 1.4 |   | 5,190 |   | 1.4 |   | 3,832 |   | 1.4 |   |
| Asset impairment charge                  |       | —                                                |       | 0.0                             |       | 114 |   | 0.1 |   | — |   | 0.0 |   | 114 |   | 0.0 |   |
| Total operating expenses                 |       | 51,371                                                |       | 40.6                            |       | 36,498 |   | 37.2 |   | 140,282 |   | 38.3 |   | 102,792 |   | 36.2 |   |
| Operating income                         |       | 39,308                                                |       | 31.0                            |       | 34,559 |   | 35.3 |   | 119,126 |   | 32.5 |   | 102,232 |   | 36.0 |   |
| Other income (expense):                  |       |                                                  |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense                         |       | (5,725                                                | )          | (4.5                            | )          | (19,723 | ) | (20.1 | ) | (18,810 | ) | (5.1 | ) | (41,593 | ) | (14.6 | ) |
| Debt extinguishment costs                |       | —                                                |       | 0.0                             |       | — |   | 0.0 |   | — |   | 0.0 |   | (3,391 | ) | (1.2 | ) |
| Interest income                          |       | 471                                                   |       | 0.4                             |       | 348 |   | 0.3 |   | 1,299 |   | 0.3 |   | 979 |   | 0.3 |   |
| Income before provision for income taxes |       | 34,054                                                |       | 26.9                            |       | 15,184 |   | 15.5 |   | 101,615 |   | 27.7 |   | 58,227 |   | 20.5 |   |
| Provision for income taxes               |       | 13,579                                                |       | 10.7                            |       | 6,304 |   | 6.4 |   | 40,520 |   | 11.0 |   | 24,339 |   | 8.6 |   |
| Net income                               |       | $                                                     | 20,475     |                            | 16.2       | % | $ | 8,880 |   | 9.1 | % | $ | 61,095 |   | 16.7 | % | $ | 33,888 |   | 11.9 | % |

 

Net sales bybusiness segment and distribution channel and percentage of net sales for thethree and nine months ended September 30, 2007 and the three and nine monthsended October 1, 2006 are as follows:

 
| ** **                 | ** ** | **Three Months Ended**                      | ** ** | **Nine Months Ended** | ** ** |
|----------------------------|------------|-------------------------------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **September 30,  2007**                          | ** ** | **October 1,  2006**       | ** ** | **September 30,  2007** | ** ** | **October 1,  2006** | ** ** |
| ** **                 | ** ** | **(in thousands, except percentages)** | ** ** |
| Retail                     |       |                                                  |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Infomercial                |       | $                                                     | 29,411     |                            | 23.2       | % | $ | 33,418 |   | 34.1 | % | $ | 95,268 |   | 26.0 | % | $ | 95,756 |   | 33.7 | % |
| Boutiques                  |       | 21,881                                                |       | 17.3                            |       | 14,695 |   | 15.0 |   | 58,411 |   | 15.9 |   | 38,974 |   | 13.7 |   |
| Total retail               |       | 51,292                                                |       | 40.5                            |       | 48,113 |   | 49.1 |   | 153,679 |   | 41.9 |   | 134,730 |   | 47.4 |   |
| Wholesale                  |       |                                                  |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Premium wholesale          |       | 44,952                                                |       | 35.5                            |       | 28,375 |   | 29.0 |   | 118,131 |   | 32.3 |   | 77,280 |   | 27.2 |   |
| Home shopping television   |       | 11,785                                                |       | 9.3                             |       | 8,862 |   | 9.1 |   | 41,749 |   | 11.4 |   | 36,145 |   | 12.7 |   |
| Spas and salons            |       | 15,075                                                |       | 11.9                            |       | 8,058 |   | 8.2 |   | 39,133 |   | 10.7 |   | 22,972 |   | 8.1 |   |
| International distributors |       | 3,531                                                 |       | 2.8                             |       | 4,539 |   | 4.6 |   | 13,700 |   | 3.7 |   | 12,920 |   | 4.6 |   |
| Total wholesale            |       | 75,343                                                |       | 59.5                            |       | 49,834 |   | 50.9 |   | 212,713 |   | 58.1 |   | 149,317 |   | 52.6 |   |
| Sales, net                 |       | $                                                     | 126,635    |                            | 100.0      | % | $ | 97,947 |   | 100.0 | % | $ | 366,392 |   | 100.0 | % | $ | 284,047 |   | 100.0 | % |

 

24

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Gross profitand gross margin by business segment for the three and nine months endedSeptember 30, 2007 and the three and nine months ended October 1, 2006 are asfollows:

 
| ** **                | ** ** | **Three Months Ended**                      | ** ** | **Nine Months Ended** | ** ** |
|---------------------------|------------|-------------------------------------------------------|------------|---------------------------------|------------|
| ** **                | ** ** | **September 30,  2007**                          | ** ** | **October 1,  2006**       | ** ** | **September 30,  2007** | ** ** | **October 1,  2006** | ** ** |
| ** **                | ** ** | **(in thousands, except percentages)** | ** ** |
| Retail                    |       | $                                                     | 41,369     |                            | 80.7       | % | $ | 39,095 |   | 81.3 | % | $ | 122,202 |   | 79.5 | % | $ | 107,970 |   | 80.1 | % |
| Wholesale                 |       | 49,310                                                |       | 65.4                            |       | 31,962 |   | 64.1 |   | 137,206 |   | 64.5 |   | 97,054 |   | 65.0 |   |
| Gross profit/gross margin |       | $                                                     | 90,679     |                            | 71.6       | % | $ | 71,057 |   | 72.5 | % | $ | 259,408 |   | 70.8 | % | $ | 205,024 |   | 72.2 | % |

 

**Threemonths ended September 30, 2007 compared to three months ended October 1, 2006**

 

**Sales, net**

 

Net sales for the three months ended September30, 2007 increased to $126.6 million from $97.9 million in the threemonths ended October 1, 2006, an increase of $28.7 million, or 29.3%. Thisincrease was primarily attributable to continued growth in sales of our *i.d. bareMinerals*line of cosmetics, as wecontinued to broaden our distribution throughout our sales channels andincrease awareness through greater media spending. The increase in our netsales was realized within both our retail and wholesale segments.

 

***Retail.***Netretail sales increased 6.6% to $51.3 million in the three months endedSeptember 30, 2007 from $48.1 million in the three months ended October 1,2006. Net sales from boutiques increased 48.9% to $21.9 million in the threemonths ended September 30, 2007 from $14.7 million in the three months endedOctober 1, 2006, due to improved productivity at our existing locations as wellas a net increase of 16 boutiques open as of September 30, 2007 compared toOctober 1, 2006. As of September 30, 2007 and October 1, 2006, we had 45and 29 open company owned boutiques, respectively. Offset against this was adecrease of 12.0% in net sales from infomercials to $29.4 million in the threemonths ended September 30, 2007 from $33.4 million in the three months endedOctober 1, 2006, due to the lower performance of our new infomercial launchedin the second fiscal quarter of 2007.

 

***Wholesale.***Netwholesale sales increased 51.2% to $75.3 million in the three months endedSeptember 30, 2007 from $49.8 million in the three months ended October 1,2006. Net sales in our premium wholesale channel increased 58.4% to $45.0million in the three months ended September 30, 2007 from $28.4 million in thethree months ended October 1, 2006, resulting from strong consumer demand andexpansion into additional retail locations at Ulta and Sephora. Net sales toour home shopping television customer grew by 33.0% to $11.8 million in thethree months ended September 30, 2007 from $8.9 million in the three monthsended October 2, 2006, as a result of improved product performance and theinclusion of sales to QVC in the UK and Germany in the three months endedSeptember 30, 2007. Net sales to spas and salons increased 87.1% to $15.1million in the three months ended September 30, 2007 from $8.1 million inthe three months ended October 1, 2006, largely due to the continuedgrowth in sales of our core *i.d.bareMinerals*cosmetics line in this channel and the inclusion ofsales to spas and salons in the UK in the three months ended September 30,2007. Net sales to our international distributors decreased by 22.2% to $3.5million in the three months ended September 30, 2007 from $4.5 million in thethree months ended October 1, 2006, primarily as a result of the elimination ofsales to the UK through a distributor in the current quarter following ouracquisition in the second fiscal quarter.

 

**Grossprofit**

 

Gross profit increased 27.6% to $90.7 million in thethree months ended September 30, 2007 from $71.1 million in the three monthsended October 1, 2006. Our retail segment gross profit increased 5.8% to $41.4million in the three months ended September 30, 2007 from $39.1 million in thethree months ended October 1, 2006, driven principally by growth in ourboutiques sales channel.  Our wholesalesegment gross profit increased 54.3% to $49.3 million in the three months endedSeptember 30, 2007 from $32.0 million in the three months ended October 1,2006, due to increases in sales across our premium wholesale, home shoppingtelevision and spas and salons distribution channels.

 

Gross margindecreased approximately 0.9% to 71.6% in the three months ended September 30,2007 from 72.5% in the three months ended October 1, 2006. This overalldecrease in the three months ended September 30, 2007 is due both to wholesalesales comprising a larger percentage of total net sales compared to the threemonths ended October 1, 2006, which have lower gross margins than retailsegment sales, and to a decrease in gross margins within the retail segment.  Within the retail segment, gross margin decreasedto 80.7% in the three months ended September 30, 2007 from 81.3% in the threemonths ended October 1, 2006, primarily due to increased freight and royaltycosts associated with sales of our products through our catalogue and websites.  This was partially offset by an increase in thewholesale segment gross margin to 65.4% in

 

25

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the three months endedSeptember 30, 2007 from 64.1% in the three months ended October 1, 2006,primarily as a result of a change in product mix and sales mix between channelsand customers.

 

**Selling,general and administrative expenses**

 

Selling,general and administrative expenses increased 37.9% to $47.5 million in thethree months ended September 30, 2007 from $34.5 million in the three monthsended October 1, 2006. The increase was primarily due to a significant increasein investment in our corporate infrastructure of $7.0 million, includingincreased headcount costs, headquarters facilities costs, distribution centercosts, other corporate costs and infrastructure costs relating to our UKacquisition, as well as increased expenses to support sales growth, including$2.7 million in increased store operating costs, $1.1 million in increasedpayroll expenses and $0.7 million in increased media spending. As a percentageof net sales, selling, general and administrative expenses increased 2.4% to37.6% from 35.2%, primarily due to corporate expenses increasing at a greaterrate than net sales.

 

**Depreciationand amortization**

 

Depreciationand amortization expenses increased 268.7% to $2.0 million in the three monthsended September 30, 2007 from $0.6 million in the three months ended October 1,2006. This increase was primarily attributable to the amortization of intangibleassets of $0.7 million from our recent acquisition and also due to higherdepreciation expense as a result of an increase in depreciable assets as wecontinue to increase the number of company-owned boutiques and invest in ourcorporate infrastructure.

 

**Stock-basedcompensation**

 

Stock-basedcompensation expense increased 31.9% to $1.8 million in the three months endedSeptember 30, 2007 from $1.4 million in the three months ended October 1, 2006.This increase resulted primarily from the granting of additional stock optionsin the last quarter of 2006 and the first nine months of 2007.

 

**Restructuringcharge**

 

During thethree months ended October 1, 2006, we discontinued the use of one of ouroffice floors located at our former corporate facility and recorded arestructuring charge of $0.1 million.

 

**Operatingincome**

 

Operatingincome increased 13.7% to $39.3 million in the three months ended September 30,2007 from $34.6 million in the three months ended October 1, 2006. Thisincrease was largely due to an increase in operating income in our wholesalesegment, reflecting growth across our premium wholesale, home shoppingtelevision and spas and salons sales channels, partially offset by an increasedoperating loss in our corporate segment.

 

Our retailsegment operating income decreased 5.9% to $17.1 million in the three monthsended September 30, 2007 from $18.1 million in the three months ended October1, 2006, which was largely a result of a decrease in sales in our infomercialsales channel and increased operating expenses. Our increased sales in theretail segment contributed to an increase in gross profit of $2.3 million whichwas offset by an increase in operating expenses of $3.3 million. The increasein operating expenses was largely due to increased store operating costs of$2.7 million as a result of an increase in the number of boutiques open as ofSeptember 30, 2007 and $0.7 million in increased media spending.

 

Our wholesalesegment operating income increased 47.7% to $44.5 million in the three monthsended September 30, 2007 from $30.1 million in the three months ended October 1,2006, due to increased sales gains across our premium wholesale, home shoppingtelevision and spas and salons sales channels. Our increased sales in thewholesale segment contributed to an increase in gross profit of $17.3 millionwhich was partially offset by an increase in operating expense of $3.0 million.

 

Our corporatesegment operating loss increased 62.5% to $22.3 million in the three monthsended September 30, 2007 from $13.7 million in the three months ended October 1,2006. This increase was largely due to an increase in corporate segmentselling, general and administrative expense of $7.0 million, an increase indepreciation and amortization of $1.2 million and stock-based compensation of$0.4 million.  The increase in corporateselling, general and administrative expense

 

26

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was as a result of the increasein the investment in our corporate infrastructure to support sales growth andadditional expenses associated with being a public company.

 

**Interestexpense**

 

Interestexpense decreased 71.0% to $5.7 million in the three months ended September 30,2007 from $19.7 million in the three months ended October 1, 2006. The decreasewas attributable to decreased debt balances in the three months ended September30, 2007, primarily associated with repayment of outstanding indebtedness fromproceeds of our initial public offering completed on October 4, 2006.

 

**Interestincome**

 

Interestincome increased 35.3% to $0.5 million in the three months ended September 30,2007 from $0.3 million in the three months ended October 1, 2006.  The increase was primarily due to an increasein interest rates on our cash balances and higher average cash balancescompared to the three months ended October 1, 2006.

 

**Provisionfor income taxes**

 

The provisionfor income taxes was $13.6 million, or 39.9% of income before provision forincome taxes, in the three months ended September 30, 2007 compared to $6.3 million,or 41.5% of income before provision for income taxes, in the three months endedOctober 1, 2006. The increase resulted from higher income before provision forincome taxes offset by a lower effective rate in the three months endedSeptember 30, 2007 compared to the three months ended October 1, 2006. Thedecrease in the effective rate is mainly due to the elimination of thenon-deductible interest as a result of our repayment in full of our aggregate principalamount outstanding of $125.0 million of our 15.0% subordinated notes on October4, 2006.

 

**Ninemonths ended September 30, 2007 compared to nine months ended October 1, 2006**

 

**Sales, net**

 

Net sales forthe nine months ended September 30, 2007 increased to $366.4 million from$284.0 million in the nine months ended October 1, 2006, an increase of $82.3million, or 29.0%. This increase was primarily attributable to continued growthin sales of our *i.d. bareMinerals*lineof cosmetics, as we continued to broaden our distribution throughout our saleschannels and increase awareness through greater media spending. The increase inour net sales was realized within both our retail and wholesale segments.

 

***Retail.***Netretail sales increased 14.1% to $153.7 million in the nine months endedSeptember 30, 2007 from $134.7 million in the nine months ended October 1,2006. Net sales from boutiques increased 49.9% to $58.4 million in the ninemonths ended September 30, 2007 from $39.0 million in the nine months endedOctober 1, 2006, due to improved productivity at our existing locations as wellas a net increase of 16 boutiques open as of September 30, 2007 compared toOctober 1, 2006. As of September 30, 2007 and October 1, 2006, we had 45 and 29open company owned boutiques, respectively. Offset against this was a decrease of 0.5% in net sales frominfomercials to $95.3 million in the nine months ended September 30, 2007 from$95.8 million in the nine months ended October 1, 2006, due to the lowerperformance of our new infomercial launched in the second fiscal quarter of2007.  

 

***Wholesale.***Netwholesale sales increased 42.5% to $212.7 million in the nine months endedSeptember 30, 2007 from $149.3 million in the nine months ended October 1,2006. Net sales in our premium wholesale channel increased 52.9% to $118.1million in the nine months ended September 30, 2007 from $77.3 million in thenine months ended October 1, 2006, resulting from strong consumer demand andexpansion into additional retail locations at Ulta, Sephora and departmentstores.  Net sales to our home shoppingtelevision customer grew by 15.5% to $41.7 million in the nine months endedSeptember 30, 2007 from $36.1 million in the nine months ended October 1, 2006,as a result of improved product performance and the inclusion of sales to QVCin the UK and Germany in the nine months ended September 30, 2007. Net sales tospas and salons increased 70.4% to $39.1 million in the nine months endedSeptember 30, 2007 from $23.0 million in the nine months ended October 1, 2006,largely due to the continued growth in sales of our core *i.d. bareMinerals*cosmetics line and theinclusion of sales to spas and salons in the UK in the nine months endedSeptember 30, 2007.  Net sales to ourinternational distributors increased by 6.0% to $13.7 million in the nine monthsended September 30, 2007 from $12.9 million in the nine months ended October 1,2006, primarily as a result of the increased penetration of our *i.d. bareMinerals*cosmetics line into thisdistribution channel partially offset by the elimination of sales to the UKthrough a distributor following our acquisition in the second fiscal quarter.

 

27

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##### **Gross profit**

#####  

Gross profit increased 26.5% to $259.4 million in thenine months ended September 30, 2007 from $205.0 million in the nine monthsended October 1, 2006. Our retail segment gross profit increased 13.2% to$122.2 million in the nine months ended September 30, 2007 from $108.0 millionin the nine months ended October 1, 2006, driven principally by growth in ourboutiques sales channel. Our wholesale segment gross profit increased 41.4% to$137.2 million in the nine months ended September 30, 2007 from $97.1 millionin the nine months ended October 1, 2006, due to increases in sales acrosswholesale distribution channels.

 

Gross margin decreased approximately 1.4% to 70.8% inthe nine months ended September 30, 2007 from 72.2% in the nine months endedOctober 1, 2006. This overall decrease in the nine months ended September 30,2007 is due both to wholesale sales comprising a larger percentage of total netsales compared to the nine months ended October 1, 2006, which have lower grossmargins than retail segment sales, and to a decrease in gross margins withinthe wholesale segment. Within the retail segment, gross margin decreasedslightly to 79.5% in the nine months ended September 30, 2007 from 80.1% thenine months ended October 1, 2006, primarily due to increased freight androyalty costs associated with sales of our products through our catalogue andwebsites. Within the wholesale segment, gross margin decreased to 64.5% in thenine months ended September 30, 2007 from 65.0% in the nine months endedOctober 1, 2006, primarily as a result of a change in product mix and salesbetween channels and customers.

 

##### **Selling, general and administrative expenses**

#####  

Selling, general and administrative expenses increased33.8% to $130.3 million in the nine months ended September 30, 2007 from $97.3million in the nine months ended October 1, 2006. The increase was primarilydue to a significant increase in investment in our corporate infrastructure of$18.0 million, including increased headcount costs, headquarters facilitiescosts, distribution center costs, other corporate costs and infrastructurecosts relating to our UK acquisition, as well as increased expenses to supportsales growth, including $6.3 million in increased store operating costs, $5.5million in payroll and other personnel expenses and $2.7 million in increasedmedia spending. As a percentage of net sales, selling, general andadministrative expenses increased 1.3% to 35.6% from 34.3%, primarily due tocorporate expenses increasing at a greater rate than net sales.

 

##### **Depreciation and amortization**

#####  

Depreciation and amortization expenses increased217.5% to $4.8 million in the nine months ended September 30, 2007 from $1.5million in the nine months ended October 1, 2006. This increase was primarilyattributable to $1.5 million of amortization of intangible assets from our UKacquisition and higher depreciation expense as a result of an increase indepreciable assets as we continue to increase the number of company-ownedboutiques and invest in our corporate infrastructure.

 

##### **Stock-based compensation**

#####  

Stock-based compensation expense increased 35.4% to$5.2 million in the nine months ended September 30, 2007 from $3.8 million inthe nine months ended October 1, 2006. This increase resulted primarily fromthe granting of additional stock options in the last quarter of 2006 and thefirst nine months of 2007.

 

##### **Restructuring charges**

#####  

During the nine months ended October 1, 2006, wediscontinued the use of one of our office floors located at our former corporatefacility and recorded a restructuring charge of $0.1 million.

 

##### **Operating income**

#####  

Operating income increased 16.5% to $119.1 million inthe nine months ended September 30, 2007 from $102.2 million in the nine monthsended October 1, 2006. This increase was largely due to increases in operatingincome in both our retail and wholesale segments, reflecting growth across allsales channels, partially offset by an increased operating loss in ourcorporate segment.

 

Our retail segment operating income increased 8.3% to$52.2 million in the nine months ended September 30, 2007 from $48.2 million inthe nine months ended October 1, 2006, which was largely driven by growth inour boutique sales channel. Our increased sales in the retail segmentcontributed to an increase in gross profit of $14.2 million which was 

 

28

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partially offsetby an increase in operating expenses of $10.2 million. The increase inoperating expenses was largely due to increased store operating costs of $6.3million as a result of an increase in the number of boutiques open as ofSeptember 30, 2007, $2.7 million in increased media spending and $0.4 millionof increased fulfillment costs due to increased sales.

 

Our wholesale segment operating income increased 38.4%to $125.5 million in the nine months ended September 30, 2007 from $90.7million in the nine months ended October 1, 2006, due to increased sales gainsacross all wholesale sales channels. Our increased sales in the wholesale segmentcontributed to an increase in gross profit of $40.2 million which was partiallyoffset by an increase in operating expense of $5.3 million.

 

Our corporate segment operating loss increased 59.7%to $58.6 million in the nine months ended September 30, 2007 from $36.7 millionin the nine months ended October 1, 2006. This increase was largely due to anincrease in corporate segment selling, general and administrative expense of$18.0 million, an increase in depreciation and amortization of $2.7 million andan increase in stock-based compensation of $1.4 million. The increase incorporate selling, general and administrative expense was as a result of theincrease in the investment in our corporate infrastructure to support salesgrowth and additional expenses associated with being a public company.

 

##### **Interest expense**

#####  

Interest expense decreased 54.8% to $18.8 million inthe nine months ended September 30, 2007 from $41.6 million in the nine monthsended October 1, 2006. The decrease was attributable to decreased debt balancesin the nine months ended September 30, 2007, primarily associated withrepayment of outstanding indebtedness from proceeds of our initial publicoffering completed on October 4, 2006.

 

##### **Debt extinguishment costs**

#####  

During the nine months ended October 1, 2006, werecorded debt extinguishment costs of $3.4 million related to our June 2006recapitalization.

 

##### **Interest income**

#####  

Interest income increased 32.7% to $1.3 million in thenine months ended September 30, 2007 from $1.0 million in the nine months endedOctober 1, 2006. The increase was primarily due to an increase in interestrates on our cash balances and higher average cash balances compared to thenine months ended October 1, 2006.

 

##### **Provision for income taxes**

#####  

The provision for income taxes was $40.5 million, or39.9% of income before provision for income taxes, in the nine months endedSeptember 30, 2007 compared to $24.3 million, or 41.8% of income beforeprovision for income taxes, in the nine months ended October 1, 2006. Theincrease resulted from higher income before provision for income taxes offsetby a lower effective rate in the nine months ended September 30, 2007 comparedto the nine months ended October 1, 2006. The decrease in the effective rate ismainly due to the elimination of the non-deductible interest as a result of ourrepayment in full of our aggregate principal amount outstanding of $125.0million of our 15.0% subordinated notes on October 4, 2006.

 

# **Seasonality**

#  

Because our products are largely purchased forindividual use and are consumable in nature, we are not subject to significantseasonal variances in sales. However, fluctuations in sales and operatingincome in any fiscal quarter may be affected by the timing of wholesaleshipments, home shopping television appearances and other promotional events.While we believe our overall business is not currently subject to significantseasonal fluctuations, we have experienced limited seasonality in our premiumwholesale and company-owned boutique channels as a result of increased demandfor our products in anticipation of and during the holiday season. To theextent our sales to specialty beauty retailers and through our boutiquesincrease as a percentage of our net sales, we may experience increasedseasonality.

 

## **Liquidity and Capital Resources**

##  

Our primary liquidity andcapital resource needs are to service our debt, finance working capital needsand fund ongoing capital expenditures. We have financed our operations throughcash flows from operations, sales of common and preferred shares, borrowingsunder our credit facilities and issuances of senior subordinated notes.

 

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Our operations provided us cash of $71.8 million inthe nine months ended September 30, 2007. At September 30, 2007, we had workingcapital of $75.5 million, including cash and cash equivalents of $26.3 million,compared to working capital of $66.3 million, including $20.9 million in cashand cash equivalents, as of December 31, 2006. The $5.4 million increase incash and cash equivalents resulted from cash provided by operations of $71.8million, as a result of net income for the nine months ended September 30, 2007of $61.1 million, partially offset by cash used in investment activities of$39.1 million and cash used in financing activities of $27.4 million. The $9.2million increase in working capital was primarily driven by increases in cashand cash equivalents, accounts receivable, prepaid expenses and other currentassets and prepaid income tax, partially offset by an increase in accountspayable and accrued liabilities.

 

Net cash used ininvesting activities was $39.1 million in the nine months ended September 30,2007, primarily attributable to our acquisition of U.K. based Cosmeceuticals,the opening of twelve company-owned boutiques, and our continued investment inour corporate infrastructure. Our future capital expenditures will depend onthe timing and rate of expansion of our businesses, information technologyinvestments, new store openings, store renovations and international expansionopportunities.

 

Net cash used in financing activities was $27.4million in the nine months ended September 30, 2007, which consisted ofrepayments of $59.3 million on our first-lien term loan, partially offset byproceeds, net of transaction costs, of $21.1 million from our follow-onunderwritten public offerings of common stock and an excess tax benefit of $9.2million relating to stock option exercises.

 

Our revolving creditfacility of $25.0 million, of which approximately $0.1 million in letters ofcredit is outstanding as of September 30, 2007, and our first-lien term loan of$279.9 million, bear interest at a rate equal to, at our option, either LIBORor the lender’s base rate, plus an applicable variable margin based on ourconsolidated total leverage ratio. The current applicable interest margin forthe revolving credit facility and first-lien term loan is 2.25% for LIBOR loansand 1.25% for base rate loans based on our current Moody’s rating. As ofSeptember 30, 2007, interest on the first-lien term loan was accruing at 8.05%(without giving effect to the interest rate swap transaction discussed below).

 

At all times afterOctober 2, 2007, we are required under our senior secured creditfacilities to enter into interest rate swap or similar agreements with respectto at least 40% of the outstanding principal amount of all loans under oursenior secured credit facilities, unless we satisfy specified coverage ratiotests. As of September 30, 2007, we satisfied these tests. If required, theinterest rate protection must extend until February 2008.

 

In August 2007, the Company entered into a two-yearinterest rate swap transaction under the Company’s senior secured creditfacilities. The interest rate swap has an initial notional amount of $200million declining to $100 million after one year under which, on a netsettlement basis, the Company will make monthly fixed rate payments atthe rate of 5.03% and the counterparty makes monthly floating rate payments based upon one-month U.S.D.LIBOR. As a result of the interest rateswap transaction, the Company has fixed for a two-year period the interest ratesubject to market based interest rate risk on $200 million of borrowings forthe first year and $100 million for the second year under its First Lien CreditAgreement. The Company’s obligations under the interest rate swap transactionas to the scheduled payments are guaranteed and secured on the same basis as isits obligations under the First Lien Credit Agreement. The fair value ofthe interest rate swap as of September 30, 2007 was $1,100,000 which wasrecorded in other liabilities in the condensed consolidated balance sheets.

 

The terms of our seniorsecured credit facilities, require us to comply with financial covenants,including a maximum leverage ratio covenant. We are required to maintain amaximum leverage ratio (consolidated total debt to Adjusted EBITDA) of notgreater than 4.5 to 1.0. As of September 30, 2007, our leverage ratio was 1.49to 1.0. If we fail to comply with any of the financial covenants, the lendersmay declare an event of default under the secured credit facility. An event ofdefault resulting from a breach of a financial covenant may result, at theoption of lenders holding a majority of the loans, in an acceleration ofrepayment of the principal and interest outstanding and a termination of therevolving credit facility. The secured credit facility also containsnon-financial covenants that restrict some of our activities, including our abilityto dispose of assets, incur additional debt, pay dividends, create liens, makeinvestments and engage in specified transactions with affiliates. The securedcredit facility also contains customary events of default, including defaultsbased on events of bankruptcy and insolvency, nonpayment of principal, interestor fees when due, subject to specified grace periods, breach of specifiedcovenants, change in control and material inaccuracy of representations andwarranties. We have been in compliance with all financial ratio and othercovenants under our credit facilities during all reported periods and we werein compliance with these covenants as September 30, 2007.

 

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On March 23, 2007, weamended our senior secured credit facilities to permit acquisitions of up to$30.0 million in any one fiscal year and up to $60.0 million in the aggregateand investments in foreign subsidiaries to $25.0 million.

 

Subject to specifiedexceptions, including for investment of proceeds in the case of asset saleproceeds and for permitted equity contributions for capital expenditures, weare required to prepay outstanding loans under our amended senior securedcredit facilities with the net proceeds of certain asset dispositions,condemnation settlements and insurance settlements from casualty losses,issuances of certain debt and, if our consolidated leverage ratio is 2.25 to1.0 or greater, a portion of excess cash flow.

 

On February 16, 2007, we filed a Registration Statementon Form S-1 (File No. 333-140763) with the Securities and Exchange Commissionfor a follow-on underwritten public offering. As amended, the RegistrationStatement provided for the sale of 12.0 million shares of our common stock,consisting of 0.6 million shares sold by us and 11.4 million shares by sellingstockholders. In addition, the selling stockholders granted the underwritersthe right to purchase up to an additional 1.8 million shares to coverover-allotments. The over-allotment option was exercised on March 19, 2007 bythe underwriters. The follow-on underwritten public offering closed on March19, 2007. We received approximately $18.1 million in net proceeds from thisoffering.

 

On May 14, 2007, we filed a Registration Statementon Form S-1 (File No. 333-142935) with the Securities and Exchange Commissionfor a follow-on underwritten public offering. As amended, the RegistrationStatement provided for the sale of 8.0 million shares of our common stock,consisting of 0.1 million shares sold by us and 7.9 million shares by sellingstockholders. The follow-on underwritten public offering closed on June 19,2007. We received approximately $3.0 million in net proceeds from thisoffering.

 

# **Liquidity sources, requirementsand contractual cash requirement and commitments**

#  

We believe that cash flow from operations, cash on hand and amountsavailable under our revolving credit facility will provide adequate funds forour foreseeable working capital needs and planned capital expenditures. As partof our strategy, we intend to invest in making significant improvements to oursystems. We also intend to open approximately eighteen new boutiques in 2007(twelve of which were open as of September 30, 2007), which will requireadditional capital expenditures. Finally, we also plan to continue to invest inour corporate infrastructure facilities. We anticipate that our capitalexpenditures in the year ending December 30, 2007 will be approximately$22.0 million. There can be no assurance that any such capital will beavailable on acceptable terms or at all. Our ability to fund our workingcapital needs, planned capital expenditures and scheduled debt payments, aswell as to comply with all of the financial covenants under our debtagreements, depends on our future operating performance and cash flow, which inturn are subject to prevailing economic conditions and to financial, businessand other factors, some of which are beyond our control.

 

# **Contractual commitments**

#  

We lease retail stores, distribution facilities, andcorporate offices under noncancelable operating leases with various expirationdates through March 2018. Portions of these payments are denominated in foreigncurrencies and were translated in the tables below based on their respectiveU.S. dollar exchange rates at September 30, 2007. These future payments aresubject to foreign currency exchange rate risk. As of September 30, 2007, thescheduled maturities of our long-term contractual obligations were as follows:

 
| ** **                                                             | ** ** | **Remainder of  the year  ending  December 30,  2007** | ** ** | **1 - 3  Years** | ** ** | **4 - 5  Years** | ** ** | **After 5  Years** | ** ** | **Total** | ** ** |
|------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|-------------------------|------------|-----------|------------|
| ** **                                                             | ** ** | **(amounts in millions)**                                   | ** ** |
| Operating leases, net of sublease income                               |       | $                                                                     | 1.3        |                       | $          | 25.5                       |       | $                       | 16.5       |      | $          | 29.7 |   | $ | 73.0 |   |
| Principal payments on long-term debt,  including the current portion   |       | 3.8                                                                   |       | 45.4                       |       | 230.7                      |       | —                  |       | 279.9     |       |
| Interest payments on long-term debt,  including the current portion(1) |       | 5.2                                                                   |       | 59.1                       |       | 15.5                       |       | —                  |       | 79.8      |       |
| Minimum royalties under licensing  arrangements                        |       | 0.4                                                                   |       | 1.3                        |       | —                     |       | —                  |       | 1.7       |       |
| Total                                                                  |       | $                                                                     | 10.7       |                       | $          | 131.3                      |       | $                       | 262.7      |      | $          | 29.7 |   | $ | 434.4 |   |

 

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(1)          Forpurposes of the table, interest expense is calculated after giving effect tothe swap transaction as follows: (i) during the first year of the two-yearterm of the swap agreement, interest expense on the first $200 million of ourfirst-lien term loan is based on the fixed rate of the swap of 5.03%plus a margin of 2.25% and interest expense on the remaining outstanding termloan is estimated based on the rate in effect as of September 30, 2007 and (ii)during the second year of the two-year term of the swap agreement, interestexpense on the first $100 million of our first-lien term loan is based on thefixed rate of the swap of 5.03% plus a margin of 2.25% and interestexpense on the remaining outstanding term loan is estimated based on the ratein effect as of September 30, 2007 and (iii) after the two-year term of theswap agreement, interest expense on the remaining outstanding first-lien termloan is estimated for all periods based on the rate in effect as of September30, 2007. A 1% change in interest rates on our variable rate debt would resultin a change of $10.2 million in our total interest payments, of which $0.7million would be in the remainder of the year ended December 30, 2007,$7.5 million would be in years 1-3 and $1.9 million would be in years4-5.

 

We adopted FASB Interpretation No. 48, “Accounting forUncertainty in Income Taxes” (“FIN 48”) on January 1, 2007. As of September 30,2007, we had approximately $4.1 million of total unrecognized tax benefits,including related interest, of which $2.2 million, if recognized, would affectthe effective income tax rate in future periods. However, as we are unable todetermine the timing of the potential realization of our unrecognized taxbenefits, we have excluded the total unrecognized tax benefits in the scheduleof long-term contractual commitments above.

 

**Off-balance-sheetarrangements**

 

We do not have any off-balance-sheet financing orunconsolidated special purpose entities.

 

**Effectsof inflation**

 

Our monetary assets, consisting primarily of cash andreceivables, are not significantly affected by inflation because they areshort-term in nature. Our non-monetary assets, consisting primarily ofinventory, intangible assets, goodwill and prepaid expenses and other assets,are not currently affected significantly by inflation. We believe thatreplacement costs of equipment, furniture and leasehold improvements will notmaterially affect our operations. However, the rate of inflation affects ourcost of goods sold and expenses, such as those for employee compensation, whichmay not be readily recoverable in the price of the products offered by us. Inaddition, an inflationary environment could materially increase the interestrates on our debt.

 

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**Non-GAAPMeasures**

 

In evaluating our business, we consider and useAdjusted EBITDA as a supplemental measure of our operating performance. We useEBITDA only to assist in reconciliation to Adjusted EBITDA. We define EBITDA asnet income before net interest expense, provision for income taxes,depreciation and amortization. We define Adjusted EBITDA as EBITDA plusexpenses (minus gains) that we do not consider reflective of our ongoingoperations. We use Adjusted EBITDA as a supplemental measure to review andassess our operating performance and also as a key profitability measure forcovenant compliance under our senior secured credit facilities. If we fail tomaintain required levels of Adjusted EBITDA, we could have a default under oursenior secured credit facilities, potentially resulting in an acceleration ofall of our outstanding indebtedness. All of the adjustments made in ourcalculation of Adjusted EBITDA, as described below, are adjustments that wouldbe made in calculating our performance for purposes of coverage ratios underour senior secured credit facilities. In prior periods, we used an adjustedEBITDA calculation for internal purposes and for calculation of compliance withcoverage ratios that incorporated additional adjustments not included in ourcalculation of Adjusted EBITDA. We also believe use of Adjusted EBITDAfacilitates investors’ use of operating performance comparisons from period toperiod and company to company by backing out potential differences caused byvariations in capital structures (affecting relative interest expense,including the impact of write-offs of deferred financing costs when companiesrefinance their indebtedness), the book amortization of intangibles (affectingrelative amortization expense) and the age and book value of facilities andequipment (affecting relative depreciation expense). We also present AdjustedEBITDA because we believe it is frequently used by securities analysts,investors and other interested parties as a measure of financial performance.The terms EBITDA and Adjusted EBITDA are not defined under U.S. generallyaccepted accounting principles, or U.S. GAAP, and are not measures of operatingincome, operating performance or liquidity presented in accordance with U.S.GAAP. Our EBITDA and Adjusted EBITDA have limitations as analytical tools, andwhen assessing our operating performance, you should not consider EBITDA andAdjusted EBITDA in isolation, or as a substitute for net income****(loss) or other consolidated incomestatement data prepared in accordance with U.S. GAAP. Some of these limitationsinclude, but are not limited to:

 

•                  EBITDAand Adjusted EBITDA do not reflect our cash expenditures or future requirementsfor capital expenditures or contractual commitments;

•                  theydo not reflect changes in, or cash requirements for, our working capital needs;

•                  theydo not reflect the significant interest expense, or the cash requirementsnecessary to service interest or principal payments, on our debt;

•                  theydo not reflect income taxes or the cash requirements for any tax payments;

•                  althoughdepreciation and amortization are non-cash charges, the assets beingdepreciated and amortized often will have to be replaced in the future, andEBITDA and Adjusted EBITDA do not reflect any cash requirements for suchreplacements; and

•                  othercompanies may calculate EBITDA and Adjusted EBITDA differently than we do,limiting their usefulness as comparative measures. We compensate for theselimitations by relying primarily on our GAAP results and using Adjusted EBITDAonly supplementally. EBITDA and Adjusted EBITDA are calculated as follows forthe periods presented:

 
| ** **                          | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **September 30,  2007**     | ** ** | **October 1,  2006**       | ** ** | **September 30,  2007** | ** ** | **October 1,  2006** | ** ** |
| ** **                          | ** ** | **(in thousands)**          | ** ** |
| **Net income**                      |       | $                                | 20,475     |                            | $          | 8,880 |   | $ | 61,095 |   | $ | 33,888 |   |
| Plus: interest expense              |       | 5,725                            |       | 19,723                          |       | 18,810 |   | 41,593 |   |
| Less: interest income               |       | (471                             | )          | (348                            | )          | (1,299 | ) | (979 | ) |
| Plus: depreciation and amortization |       | 2,035                            |       | 552                             |       | 4,835 |   | 1,523 |   |
| Plus: provision for income taxes    |       | 13,579                           |       | 6,304                           |       | 40,520 |   | 24,339 |   |
| **EBITDA**                          |       | 41,343                           |       | 35,111                          |       | 123,961 |   | 100,364 |   |
| Plus: debt extinguishment costs(1)  |       | —                           |       | —                          |       | — |   | 3,391 |   |
| Plus: management fees(2)            |       | —                           |       | 150                             |       | — |   | 450 |   |
| Plus: restructuring charges(3)      |       | —                           |       | 114                             |       | — |   | 114 |   |
| Plus: stock-based compensation(4)   |       | 1,800                            |       | 1,365                           |       | 5,190 |   | 3,832 |   |
| **Adjusted EBITDA**                 |       | $                                | 43,143     |                            | $          | 36,740 |   | $ | 129,151 |   | $ | 108,151 |   |

 

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(1)             Duringthe nine months ended October 1, 2006, we incurred debt extinguishment costs of$3.4 million related to the early extinguishment of our previously outstandingdebt in connection with our June 2006 recapitalization.

 

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(2)             Wepaid transaction fees and monthly management fees to Berkshire Partners LLC andJH Partners, LLC under management agreements each in an amount of $300,000 perannum. These management agreements were terminated upon completion of ourinitial public offering on October 4, 2006. We paid an aggregate of $1.8million to Berkshire Partners LLC and JH Partners, LLC as consideration fortermination of these agreements.

 

(3)             Duringthe three and nine months ended October 1, 2006, we discontinued the use of oneof our office floors located at our former corporate facility and we recorded acharge of $0.1 million which primarily reflects the sum of the future leasepayments due.

 

(4)            Thestock-based compensation charges primarily resulted from our adoption of thefair value recognition and measurement provisions of Statement of FinancialAccounting Standards No. 123(R), or SFAS 123(R), effective January 3, 2005.

 

**Critical Accounting Policies and Estimates**

 

The preparation of financial statements in conformity with U.S.generally accepted accounting principles requires management to make estimatesand assumptions. Predicting future events is inherently an imprecise activityand, as such, requires the use of judgment. Actual results may vary fromestimates in amounts that may be material to the financial statements. Anaccounting policy is deemed to be critical if it requires an accountingestimate to be made based on assumptions about matters that are highlyuncertain at the time the estimate is made, and if different estimates thatreasonably could have been used, or changes in the accounting estimates thatare reasonably likely to occur periodically, could materially impact ourconsolidated financial statements. Our critical accounting policies andestimates are discussed in our recently filed Annual Report on Form 10-K forthe fiscal year ended December 31, 2006, which was filed with the SEC on March30, 2007. We believe that there have been no other significant changes duringthe nine months ended September 30, 2007 to the items that we disclosed in ourcritical accounting policies and estimates with the exception of the adoptionof FIN 48 and the accounting for derivative financial instruments as notedbelow.

 

We adopted Financial Accounting Standards Board (“FASB”) InterpretationNo. 48, *Accounting for Uncertainty in IncomeTaxes*, (“FIN 48”) on January 1, 2007. FIN 48 prescribes acomprehensive model for how a company should recognize, measure, present anddisclose in its financial statements uncertain tax positions that the companyhas taken or expects to take on a tax return. In connection with the adoptionof FIN 48, we changed our accounting policy and now recognize accrued interestand penalties related to income tax matters in income tax expense. Theseamounts were previously classified in selling, general and administrativeexpenses.

 

***Derivative Financial Instruments***

 

TheCompany accounts for derivative financial instruments in accordance with SFASNo. 133, “Accounting for Derivative Instruments and Hedging Activities,” asamended (“SFAS No. 133”), which establishes accounting and reporting standardsfor derivative instruments, including certain derivative instruments embeddedin other contracts, and for hedging activities.  SFAS No. 133 alsorequires the recognition of all derivative instruments as either assets orliabilities on the balance sheet and that they be measured at fair value.

 

**New Accounting Standards**

 

In September 2006, the FASB issued SFAS No. 157*, Fair Value Measurements*. Statement 157defines fair value, establishes a framework for measuring fair value, andexpands disclosures about fair value measurements. Statement 157 also appliesunder other accounting pronouncements that require or permit fair valuemeasurements, but does not require any new fair value measurements. Theprovisions of Statement 157 are effective for fiscal years beginning afterNovember 15, 2007. We will adopt Statement 157 during our fiscal yearending December 28, 2008. We are currently in the process of determiningthe impact, if any, of adopting the provisions of Statement 157 but it is notexpected to have a material impact on our financial position or results ofoperations.

 

In February 2007, the FASB issued SFAS No. 159, *Fair Value Option for Financial Assets and Financial Liabilities.*Statement159 permits entities to choose to measure many financial instruments, andcertain other items, at fair value. Statement 159 also establishes presentationand disclosure requirements designed to facilitate comparisons between entitiesthat choose different measurement attributes for similar types of assets andliabilities. The provisions of Statement 159 are effective for fiscal yearsbeginning after November 15, 2007. We will adopt Statement 159 during ourfiscal year ending December 28, 2008. We are currently in the process ofdetermining the impact, if any, of adopting the provisions of Statement 159 butit is not expected to have a material impact on our financial position orresults of operations.

 

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**ITEM 3.****   QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

***Interest rate sensitivity***

 

Weare exposed to interest rate risks primarily through borrowings under ourcredit facilities. We have reduced our exposure to interest rate fluctuationsby entering into an interest rate swap agreement covering a portion of ourvariable rate debt. In August 2007, the Company entered into a two-yearinterest rate swap transaction under the Company’s senior secured creditfacilities. The interest rate swap has an initial notional amount of $200million declining to $100 million after one year under which, on a netsettlement basis, the Company will make monthly fixed rate payments at the rateof 5.03% and the counterparty makes monthly floating rate payments basedupon one-month U.S.D. LIBOR. Our weighted average borrowings outstanding duringthe nine months ended September 30, 2007 were $313.9 million and the annualeffective interest rate for the period was 8.0%, after giving effect to theinterest swap agreement. Based on the foregoing, a hypothetical 1% increase ordecrease in interest rates would have resulted in a $2.4 million change to ourinterest expense in the nine months ended September 30, 2007 and$3.1 million on an annualized basis.

 

***Foreign currency risk***

 

Most of our sales, expenses, assets, liabilities and cash holdings arecurrently denominated in U.S. dollars but a portion of our total net sales isdenominated in currencies other than the U.S. dollar. Additionally,portions of our costs of goods sold and our other operating expenses areincurred by our U.K. operations and denominated in local currencies. Whilefluctuations in the value of these net sales, costs and expenses as measured inU.S. dollars have not materially affected our results of operationshistorically, we cannot assure you that adverse currency exchange ratefluctuations will not have a material impact in the future. In addition, ourbalance sheet reflects non-U.S. dollar denominated assets and liabilitieswhich can be adversely affected by fluctuations in currency exchange rates. Wedo not hedge against foreign currency risks and we believe that our foreigncurrency exchange risk is immaterial.

 

**ITEM 4.****   CONTROLSAND PROCEDURES**

 

The Company maintains disclosure controls and procedures that aredesigned to ensure that information required to be disclosed in its reportspursuant to the Securities Exchange Act of 1934, as amended, is recorded,processed, summarized and reported within the time periods specified in the SEC’srules, and that such information is accumulated and communicated to the Company’smanagement, including its Chief Executive Officer and Chief Financial Officer,as appropriate, to allow timely decisions regarding required disclosure.Management is responsible for establishing and maintaining adequate internalcontrol over financial reporting. In designing and evaluating the disclosurecontrols and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.

 

As required by SEC Rule 13a-15(b), the Company carried out an evaluation,under the supervision and with the participation of its management, includingthe Chief Executive Officer and the Chief Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures as of the end of the quarter covered by this report. Based onthe foregoing, its Chief Executive Officer and Chief Financial Officerdetermined that disclosure controls and procedures were effective at areasonable assurance level.

 

There has been no change in internal controls over financial reportingduring the most recent fiscal quarter that has materially affected, or isreasonably likely to materially affect, internal controls over financialreporting.

 

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**PART II—OTHERINFORMATION**

 

**ITEM 1.****   LEGALPROCEEDINGS**

 

In the ordinary course of our business, we are subject to periodiclawsuits, investigations and claims. Although we cannot predict with certaintythe ultimate resolution of lawsuits, investigations and claims asserted againstus, we do not believe that any currently pending legal proceeding to which weare a party is likely to have a material adverse effect on our business,results of operations, cash flows or financial condition.

 

**ITEM 1A.****   RISKFACTORS**

 

*An investmentin our common stock involves a high degree of risk. Our AnnualReport on Form 10-K for the year ended December 31, 2006 includes adetailed discussion of our risk factors under the heading “Part I,Item 1A—Risk Factors.” Set forth below are certain changes from the riskfactors previously disclosed in our Annual Report on Form 10-K. You shouldcarefully consider the risk factors discussed in this report and our AnnualReport on Form 10-K as well as the other information in this report, before makingan investment decision. If any of the following risks or the risks discussed inthe Annual Report on Form 10-K occur, our business, financial condition,results of operations or future growth could suffer.*

 

***The beauty industryis highly competitive, and if we are unable to compete effectively it couldsignificantly harm our business, prospects, financial condition and results ofoperations.***

 

The beauty industry is highly competitive andat times changes rapidly due to consumer preferences and industry trends. Ourproducts face, and will continue to face, competition for consumer recognitionand market share with products that have achieved significant national andinternational brand name recognition and consumer loyalty, such as thoseoffered by global prestige beauty companies Avon Products, Inc., ElizabethArden, Inc., The Estée Lauder Companies, Inc., L’Oréal S.A. and Neutrogena, ofwhich Avon, L’Oréal and Neutrogena have recently launched mineral-based makeup.These companies have significantly greater resources than we have and are lessleveraged than we are. These competitors typically devote substantial resourcesto promoting their brands through traditional forms of advertising, such asprint media and television commercials. Because of such mass marketing methods,these competitors’ products may achieve higher visibility and recognition thanour products. In addition, these competitors may duplicate our marketingstrategy and distribution model to increase the breadth of their product sales.We also face competition from other companies that recently have launched, ormay in the future launch, mineral-based cosmetics. Some of these competitorshave significant experience using infomercials to market and sell cosmetics andskin care products and have employed marketing strategies and distributionmodels similar to ours.

 

The total market for prestige cosmetics isnot growing rapidly. As a result, competition for market share in thiscosmetics category is especially intense. In order to succeed, we must continueto take market share from our competitors across all of our sales channels. Wecompete with prestige cosmetics companies primarily in department store andspecialty beauty retail channels, but prestige cosmetics companies alsorecently have increased their sales through informercial and home shoppingtelevision channels. Mass cosmetics brands are sold primarily though channelsin which we do not sell our products, such as mass merchants and catalogs, butmass cosmetics companies are increasingly making efforts to acquire marketshare in the higher-margin prestige cosmetics category by introducing brandsand products that address this market. If we are unable to maintain or improvethe inventory levels and in-store positioning of our products in third-partyretailers or maintain and increase sales of our products through our otherdistribution channels, including informercials, home shopping television andother direct-to-consumer methods, our ability to achieve and maintainsignificant market acceptance for our products could be severly impaired.

 

Our *i.d.bareMinerals* foundation products face competition from liquid- orcream-based foundation and, to a lesser extent, mineral-based foundationproducts, sold by our competitors. Because the process for production ofmineral-based cosmetics is not subject to patent protection, there is a lowbarrier to entry into the market for such products as evidenced by the numberof smaller companies recently entering the market for such products. If thesesmaller companies’ products prove successful or if global prestige beautycompanies were to significantly increase production and marketing ofmineral-based cosmetics, our net sales could suffer. If consumers prefer ourcompetitors’ products over ours, we will lose market share and our net saleswill decline. New products that we develop might not generate sufficientconsumer interest and sales to become profitable or to cover the costs of theirdevelopment.

 

Advertising, promotion, merchandising andpackaging, and the timing of new product introductions and line extensions havea significant impact on consumers’ buying decisions and, as a result, our netsales. These factors, as well as 

 

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demographictrends, economic conditions and discount pricing strategies by competitors,could result in increased competition and could harm our net sales andprofitability.

 

***We do not currentlyown any registered patents on our products. If we are unable to protect ourintellectual property rights, our ability to compete could be harmed.***

 

We regard our trademarks, trade dress, copyrights, trade secrets,know-how and similar intellectual property as critical to our success. Ourprincipal intellectual property rights include registered trademarks on ourname, “Bare Escentuals,” as well as our brands “*i.d. bareMinerals*,” “*i.d.*,”“*md formulations*,” “*Bare Escentuals*” and “*RareMinerals*,” copyrights in ourinfomercial broadcasts and website content, rights to our domain names *www.bareescentuals.com*, *www.bareminerals.com*and *www.mdformulations.com*, and tradesecrets and know-how with respect to product formulations, product sourcing,sales and marketing and other aspects of our business. As such, we rely ontrademark and copyright law, trade secret protection and confidentialityagreements with our employees, consultants, suppliers, and others to protectour proprietary rights. We have not received patent protection on any of ourproducts, though we have licenses for the proprietary formulations andingredients used in some of our *mdformulations* and *RareMinerals*products. If we are unable to protect or preserve the value of our trademarks,copyrights, trade secrets or other proprietary rights for any reason, our brandand reputation could be impaired and we could lose customers.

 

Although most of our brand names are registered in the United Statesand in certain foreign countries in which we operate, we may not be successfulin asserting trademark or trade name protection. In addition, the laws ofcertain foreign countries may not protect our intellectual property rights tothe same extent as the laws of the United States. The costs required to protectour trademarks and trade names may be substantial. In addition, therelationship between regulations governing domain names and laws protectingtrademarks and similar proprietary rights is unclear. Therefore, we may beunable to prevent third parties from acquiring domain names that are similarto, infringe upon or otherwise decrease the value of our trademarks and otherproprietary rights.

 

Other parties may infringe on our intellectual property rights and maythereby dilute our brands in the marketplace. Any such infringement of ourintellectual property rights would also likely result in a commitment of ourtime and resources to protect these rights through litigation or otherwise. Forexample, we currently are pursuing claims in litigation against M/D Skin CareLLC and its founder Dr. Dennis Gross regarding their use of thetrademark “MD Skincare.”  M/D Skin CareLLC has also filed claims against us in the case. We are also pursuing claimsin litigation against L’Oréal USA, Inc. and L’Oréal S.A. regarding their use ofthe trademark “Bare Naturale” and for false advertising of this brand. We have incurredand expect to incur significant legal fees and other expenses in pursuing theseclaims. In each case, we believe the competing marks infringe our trademarkrights and create confusion in the marketplace. If we receive an adversejudgment in either of these matters or in any other cases we may bring in thefuture to defend our intellectual property rights, we may suffer furtherdilution of our trademarks and other rights, which could harm our ability tocompete as well as our business, prospects, financial condition and results ofoperations.

 

***We may make acquisitions and strategicinvestments, which will involve numerous risks. We may not be able to addressthese risks without substantial expense, delay or other operational orfinancial problems.***

 

Although we have a limited history of making acquisitions or strategicinvestments, we may acquire or make investments in related businesses orproducts in the future. Acquisitions or investments involve various risks, suchas:

 

•                  higherthan expected acquisition and integration costs;

 

•                  thedifficulty of integrating the operations and personnel of the acquiredbusiness;

 

•                  thepotential disruption of our ongoing business, including the diversion ofmanagement time and attention;

 

•                  thepossible inability to obtain the desired financial and strategic benefits fromthe acquisition or investment;

 

•                  assumptionof unanticipated liabilities;

 

•                  incurrence ofsubstantial debt or dilutive issuances of securities to pay for acquisitions;

 

•                  impairmentin relationships with key suppliers and personnel of any acquired businessesdue to changes in management and ownership;

 

•                  theloss of key employees of an acquired business; and

 

•                  thepossibility of our entering markets in which we have limited prior experience.

 

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Future acquisitions and investments could also result in substantialcash expenditures, potentially dilutive issuance of our equity securities, ourincurring of additional debt and contingent liabilities, and amortizationexpenses related to other intangible assets that could adversely affect ourbusiness, operating results and financial condition.

 

***If we fail to maintain proper and effective internal controls, ourability to produce accurate financial statements could be impaired, which couldadversely affect our operating results, our ability to operate our business andinvestors’ views of us.***

 

We must ensure that we have adequate internal financial and accountingcontrols and procedures in place so that we can produce accurate financialstatements on a timely basis. We will be required to spend considerable efforton establishing and maintaining our internal controls, which will be costly andtime-consuming and will need to be re-evaluated frequently. We have verylimited experience in designing and testing our internal controls. We are inthe process of documenting, reviewing and, if appropriate, improving ourinternal controls and procedures, in accordance with Section 404 of theSarbanes-Oxley Act of 2002, which will require annual management assessments ofthe effectiveness of our internal control over financial reporting. Inaddition, we will be required to file a report by our independent registeredpublic accounting firm addressing these assessments beginning with our AnnualReport on Form 10-K for the year ending December 30, 2007. Both we and ourindependent auditors will be testing our internal controls in anticipation ofbeing subject to Section 404 requirements and, as part of that documentation andtesting, may identify areas for further attention and improvement. Implementingany appropriate changes to our internal controls may entail substantial coststo modify our existing financial and accounting systems, take a significantperiod of time to complete, and distract our officers, directors and employeesfrom the operation of our business. These changes may not, however, beeffective in maintaining the adequacy of our internal controls, and any failureto maintain that adequacy, or a consequent inability to produce accuratefinancial statements on a timely basis, could increase our operating costs andcould materially impair our ability to operate our business. In addition,investors’ perceptions that our internal controls are inadequate or that we areunable to produce accurate financial statements may seriously affect our stockprice.

 

**ITEM 2.****   UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS**

 

None.

 

**ITEM 3.****   DEFAULTSUPON SENIOR SECURITIES**

 

None.

 

**ITEM 4.****   SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

None.

 

**ITEM 5.****   OTHERINFORMATION**

 

None.

 

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**ITEM 6.****   EXHIBITS**

 

Exhibits

 

The following documents are incorporated by reference or filed asExhibits to this report: 

 
| Exhibit  Number | ** ** | **Description**                                                                                                                                   |
|-----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                              |
| 3.2 (1)         |       | Amended and  Restated Certificate of Incorporation.                                                                                               |
|            |       |                                                                                                                                              |
| 3.4 (1)         |       | Amended and  Restated Bylaws.                                                                                                                     |
|            |       |                                                                                                                                              |
| 10.51 (2)       |       | Employment Offer Letter to James Taschetta dated August 23, 2007.                                                                                 |
|            |       |                                                                                                                                              |
| 10.52 (2)       |       | Amendment to Employment Offer Letter to James Taschetta dated August  28, 2007.                                                                   |
|            |       |                                                                                                                                              |
| 31.1            |       | Certification of  the Chief Executive Officer, as required by Section 302 of the  Sarbanes-Oxley Act of 2002.                                |
|            |       |                                                                                                                                              |
| 31.2            |       | Certification of  the Chief Financial Officer, as required by Section 302 of the  Sarbanes-Oxley Act of 2002.                                |
|            |       |                                                                                                                                              |
| 32.1            |       | Certification of  the Chief Executive Officer and the Chief Financial Officer as required by  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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(1)             Incorporatedby reference from our Quarterly Report on Form 10-Q for the period endedOctober 1, 2006 filed on November 15, 2006.

 

(2)             Incorporatedby reference from our Current Report on Form 8-K filed on October 17, 2007.

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934, asamended, the registrant has duly caused this report to be signed on its behalfby the undersigned thereunto duly authorized.

 
|                          | BARE ESCENTUALS,  INC. |
|--------------------------|------------------------|
| Date: November 13,  2007 | By:                    | /s/ LESLIE A.  BLODGETT |   |
|                     |                   | Leslie A.  Blodgett |
|                     |                   | Chief Executive  Officer and Director |
|                     | By:                    | /s/ MYLES B.  MCCORMICK |   |
|                     |                   | Myles B.  McCormick |
|                     |                   | Executive Vice  President, Chief Financial Officer  and Chief Operations Officer |

 

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