**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549**

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**FORM 10-Q**

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**(MarkOne)**
| x                                                  | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|----------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| **For the quarterly period ended October 1, 2006** |
| **Or**                                             |
| o                                                  | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Forthe transition periodfrom                to                **

**Commissionfile number: 001-33048**

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**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, 22****nd FloorSan Francisco, CA 94105**(Address of principal executive offices with zip code)

**(415) 489-5000** (Registrant’stelephone number, including area code)

**N/A**(Former name, former address and former fiscal year, ifchanged since last report)

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Indicate by check markwhether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. YES o  NO x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act).  LargeAccelerated Filer o   Accelerated Filer o   Non-AcceleratedFiler x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). YES o  NO x

At November 15,2006, the number of shares outstanding of the registrant’s common stock, $0.001par value, was 89,315,593.

 

 

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**Table of Contents**

**Bare Escentuals, Inc.INDEX**

** **
| **PART I—FINANCIAL  INFORMATION** |   |
|---------------------------------------------|--------|
| Item 1                                 |   | Financial Statements  (unaudited): |   |
|                                        |   | Condensed  Consolidated Balance Sheets—October 1, 2006 and January 1, 2006 | 3 |
|                                        |   | Condensed  Consolidated Statements of Operations—Three and Nine Months Ended October 1,  2006 and October 2, 2005 | 4 |
|                                        |   | Condensed  Consolidated Statements of Cash Flows—Nine Months Ended October 1, 2006 and  October 2, 2005 | 5 |
|                                        |   | Notes to  Condensed Consolidated Financial Statements | 6 |
| Item 2                                 |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 24 |
| Item 3                                 |   | Quantitative  and Qualitative Disclosures About Market Risk | 37 |
| Item 4                                 |   | Controls and  Procedures | 37 |
|                                        |   |   |   |
| **PART II—OTHER  INFORMATION**    |   |
| Item 1                                 |   | Legal Proceedings | 38 |
| Item 1A                                |   | Risk Factors | 38 |
| Item 2                                 |   | Unregistered Sales  of Equity Securities and Use of Proceeds | 48 |
| Item 3                                 |   | Defaults Upon  Senior Securities | 49 |
| Item 4                                 |   | Submission of  Matters to a Vote of Security Holders | 49 |
| Item 5                                 |   | Other Information | 49 |
| Item 6                                 |   | Exhibits | 49 |
| Signatures                                  |   |   | 51 |
| Exhibit Index                          |   |   |   |
| Certifications                              |   |   |   |

 

 

2

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**PART I—FINANCIAL INFORMATION**

** ITEM 1.   FINANCIAL STATEMENTS**

**BAREESCENTUALS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(inthousands, except per share data)**

 
| ** **                                                                                                                                                                                  | ** ** | **October 1,  2006** | ** ** | **January 1,  2006** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **(unaudited)**           | ** ** |
| **ASSETS**                                                                                                                                                                                  |       |                      |       |                      |       |
| Current assets:                                                                                                                                                                             |       |                      |       |                      |       |
| Cash and cash  equivalents                                                                                                                                                                  |       | $                         | 7,498      |                      | $          | 18,675 |   |
| Inventories                                                                                                                                                                                 |       | 59,044                    |       | 34,331                    |       |
| Accounts  receivable, net of allowances of $3,113 and $2,225 at October 1, 2006  and January 1, 2006, respectively                                                           |       | 28,029                    |       | 17,891                    |       |
| Prepaid income  taxes                                                                                                                                                                       |       | 4,801                     |       | —                    |       |
| Prepaid expenses  and other current assets                                                                                                                                                  |       | 4,539                     |       | 3,179                     |       |
| Deferred tax  assets                                                                                                                                                                        |       | 3,050                     |       | 3,050                     |       |
| Total current assets                                                                                                                                                                        |       | 106,961                   |       | 77,126                    |       |
| Property and equipment,  net                                                                                                                                                                |       | 18,655                    |       | 9,829                     |       |
| Intangible assets, net                                                                                                                                                                      |       | 6,085                     |       | 6,085                     |       |
| Deferred tax assets                                                                                                                                                                         |       | 1,523                     |       | 1,005                     |       |
| Other assets                                                                                                                                                                                |       | 5,471                     |       | 850                       |       |
| Total assets                                                                                                                                                                                |       | $                         | 138,695    |                      | $          | 94,895 |   |
| ** **                                                                                                                                                                                  |       |                      |       |                      |       |
| **LIABILITIES  AND STOCKHOLDERS’ DEFICIT**                                                                                                                                             |       |                      |       |                      |       |
| Current liabilities:                                                                                                                                                                        |       |                      |       |                      |       |
| Current portion  of long-term debt                                                                                                                                                          |       | $                         | 17,963     |                      | $          | 12,667 |   |
| Accounts payable                                                                                                                                                                            |       | 27,352                    |       | 12,974                    |       |
| Accrued  liabilities                                                                                                                                                                        |       | 19,361                    |       | 16,343                    |       |
| Accrued restructuring  charges                                                                                                                                                              |       | 294                       |       | 292                       |       |
| Income taxes  payable                                                                                                                                                                       |       | —                    |       | 135                       |       |
| Total current  liabilities                                                                                                                                                                  |       | 64,970                    |       | 42,411                    |       |
|                                                                                                                                                                                        |       |                      |       |                      |       |
| Long-term debt,  less current portion                                                                                                                                                       |       | 690,045                   |       | 377,166                   |       |
| Deferred rent                                                                                                                                                                               |       | 2,782                     |       | 2,470                     |       |
| Accrued restructuring  charges                                                                                                                                                              |       | —                    |       | 132                       |       |
| Long-term employee  benefits                                                                                                                                                                |       | 477                       |       | 148                       |       |
|                                                                                                                                                                                        |       |                      |       |                      |       |
| Commitments and  contingencies                                                                                                                                                              |       |                      |       |                      |       |
|                                                                                                                                                                                        |       |                      |       |                      |       |
| Stockholders’ deficit:                                                                                                                                                                 |       |                      |       |                      |       |
| Common stock;  $0.001 par value, 200,000 shares authorized; 70,915 and 69,109  shares issued and outstanding at October 1, 2006 and  January 1, 2006, respectively |       | 71                        |       | 69                        |       |
| Additional paid-in  capital                                                                                                                                                                 |       | 3,334                     |       | 1,887                     |       |
| Accumulated  deficit                                                                                                                                                                        |       | (622,984                  | )          | (329,388                  | )          |
| Total stockholders’  deficit                                                                                                                                                           |       | (619,579                  | )          | (327,432                  | )          |
| Total liabilities and stockholders’ deficit                                                                                                                                            |       | $                         | 138,695    |                      | $          | 94,895 |   |

 

See accompanying notes.

3

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**BAREESCENTUALS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(inthousands, except per share data)**

 
| ** **                                                                      | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                      | ** ** | **October 1,  2006**        | ** ** | **October 2,  2005**       | ** ** | **October 1,  2006** | ** ** | **October 2,  2005** | ** ** |
| ** **                                                                      | ** ** | **(unaudited)**                  | ** ** |
| Sales, net                                                                      |       | $                                | 97,947     |                            | $          | 67,634 |   | $ | 284,047 |   | $ | 179,946 |   |
| Cost of goods  sold                                                             |       | 26,890                           |       | 19,308                          |       | 79,023 |   | 50,498 |   |
| Gross profit                                                                    |       | 71,057                           |       | 48,326                          |       | 205,024 |   | 129,448 |   |
| Expenses:                                                                       |       |                             |       |                            |       |   |   |   |   |
| Selling, general and administrative                                             |       | 34,467                           |       | 26,210                          |       | 97,323 |   | 71,489 |   |
| Depreciation and amortization, relating to selling,  general and administrative |       | 552                              |       | 324                             |       | 1,523 |   | 676 |   |
| Stock-based compensation, relating to selling,  general and administrative      |       | 1,365                            |       | 310                             |       | 3,832 |   | 930 |   |
| Restructuring charges                                                           |       | 114                              |       | 643                             |       | 114 |   | 643 |   |
| Asset impairment charge                                                         |       | —                           |       | 1,055                           |       | — |   | 1,055 |   |
| Operating income                                                                |       | 34,559                           |       | 19,784                          |       | 102,232 |   | 54,655 |   |
| Interest expense                                                                |       | (19,723                          | )          | (4,333                          | )          | (41,593 | ) | (12,646 | ) |
| Debt  extinguishment costs                                                      |       | —                           |       | —                          |       | (3,391 | ) | (10,558 | ) |
| Interest income                                                                 |       | 348                              |       | 60                              |       | 979 |   | 70 |   |
| Income before  provision for income taxes                                       |       | 15,184                           |       | 15,511                          |       | 58,227 |   | 31,521 |   |
| Provision for  income taxes                                                     |       | 6,304                            |       | 6,135                           |       | 24,339 |   | 12,468 |   |
| Net income                                                                      |       | $                                | 8,880      |                            | $          | 9,376 |   | $ | 33,888 |   | $ | 19,053 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Net income per  share:                                                          |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                           |       | $                                | 0.13       |                            | $          | 0.14 |   | $ | 0.48 |   | $ | 0.28 |   |
| Diluted                                                                         |       | $                                | 0.12       |                            | $          | 0.13 |   | $ | 0.47 |   | $ | 0.28 |   |
| Cash dividend  per common share                                                 |       | $                                | —     |                            | $          | — |   | $ | 1.79 |   | $ | 4.81 |   |
|                                                                            |       |                             |       |                            |       |   |   |   |   |
| Weighted-average  shares used in per share calculations:                        |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                           |       | 70,839                           |       | 68,270                          |       | 69,920 |   | 67,217 |   |
| Diluted                                                                         |       | 73,511                           |       | 70,830                          |       | 72,361 |   | 68,702 |   |

 

See accompanying notes.

4

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**BAREESCENTUALS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS**

**(inthousands)**

** **
| ** **                                                                              | ** ** | **Nine months ended** | ** ** |
|-----------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                              | ** ** | **October 1,  2006**       | ** ** | **October 2,  2005** | ** ** |
| ** **                                                                              | ** ** | **(unaudited)**                 | ** ** |
| **Operating  activities**                                                               |       |                            |       |   |   |
| Net income                                                                              |       | $                               | 33,888     |   | $ | 19,053 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:      |       |                            |       |   |   |
| Depreciation of property and equipment                                                  |       | 1,523                           |       | 676 |   |
| Amortization of debt issuance costs                                                     |       | 230                             |       | 404 |   |
| Write-off of debt issuance costs upon  extinguishment of debt                           |       | 3,391                           |       | 10,558 |   |
| Stock-based compensation                                                                |       | 3,832                           |       | 930 |   |
| Asset impairment                                                                        |       | —                          |       | 1,055 |   |
| Excess tax benefit from stock option exercises and  disqualifying disposition of shares |       | (7,507                          | )          | — |   |
| Deferred income tax provision (benefit)                                                 |       | (518                            | )          | — |   |
| Other                                                                                   |       | 4                               |       | 98 |   |
| Changes in assets and liabilities:                                                      |       |                            |       |   |   |
| Inventories                                                                             |       | (24,713                         | )          | (7,782 | ) |
| Accounts receivable                                                                     |       | (10,138                         | )          | (3,643 | ) |
| Income taxes                                                                            |       | 2,571                           |       | 1,739 |   |
| Prepaid expenses and other current assets                                               |       | (1,360                          | )          | (918 | ) |
| Other assets                                                                            |       | (326                            | )          | (381 | ) |
| Accounts payable and accrued liabilities                                                |       | 17,396                          |       | 5,821 |   |
| Other liabilities                                                                       |       | 511                             |       | 1,065 |   |
| Net cash  provided by operating activities                                              |       | 18,784                          |       | 28,675 |   |
| ** **                                                                              | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Investing  activities**                                                               |       |                            |       |   |   |
| Purchase of  property and equipment                                                     |       | (10,353                         | )          | (6,283 | ) |
| ** **                                                                              | ** ** | ** **                      | ** ** | ** ** | ** ** |
| **Financing  activities**                                                               |       |                            |       |   |   |
| Proceeds from  issuance of Senior Term Loans and First and Second Lien Credit Loans     |       | 206,583                         |       | 224,500 |   |
| Repayments on  Senior Term Loans and First and Second Lien Credit Loans                 |       | (12,146                         | )          | (69,550 | ) |
| Proceeds from  issuance of Subordinated Notes Payable                                   |       | 125,000                         |       | — |   |
| Repayments on  Subordinated Notes Payable                                               |       | —                          |       | (42,000 | ) |
| Payments for  deferred loan costs                                                       |       | (4,122                          | )          | (8,230 | ) |
| Payment of  transaction costs in connection with the initial public offering            |       | (2,614                          | )          | — |   |
| Dividend paid in  connection with the Recapitalization transactions                     |       | (340,427                        | )          | (122,431 | ) |
| Excess tax  benefit from stock option exercises and disqualifying disposition of shares |       | 7,507                           |       | — |   |
| Exercise of  stock options                                                              |       | 1,309                           |       | 248 |   |
| Common stock  repurchased                                                               |       | (998                            | )          | — |   |
| Proceeds from  issuance of common stock to directors                                    |       | 300                             |       | — |   |
| Net cash used in  financing activities                                                  |       | (19,608                         | )          | (17,463 | ) |
| Net (decrease)  increase in cash and cash equivalents                                   |       | (11,177                         | )          | 4,929 |   |
| Cash and cash  equivalents, beginning of period                                         |       | 18,675                          |       | 4,442 |   |
| Cash and cash  equivalents, end of period                                               |       | $                               | 7,498      |   | $ | 9,371 |   |
|                                                                                    |       |                            |       |   |   |
| **Supplemental  disclosure of cash flow information**                                   | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Cash paid for  interest                                                                 |       | $                               | 39,235     |   | $ | 13,326 |   |
| Cash paid for  income taxes                                                             |       | $                               | 22,282     |   | $ | 12,125 |   |
|                                                                                    |       |                            |       |   |   |
| **Supplemental  disclosure of noncash financing activities**                            | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Construction  allowance received in connection with corporate office lease              |       | $                               | —     |   | $ | 1,376 |   |
| Shares issued in lieu  of transaction fees                                              |       | $                               | 2,442      |   | $ | — |   |

 

See accompanying notes.

5

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**BARE ESCENTUALS,INC.NOTES TO 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, home shoppingtelevision, specialty beauty retailers, Company-owned boutiques, and spas andsalons. The Company’s international distributors are primarily located inWestern Europe, Asia, and Australia.

**2.    Summary of Significant Accounting Policies**

***Principles of Consolidation***

The accompanyingcondensed consolidated financial statements include the accounts of the Companyand its wholly owned subsidiaries. All significant intercompany accounts andtransactions have been eliminated.

***Fiscal Quarter***

The Company’sfiscal quarters end on the Sunday closest to March 31, June 30, September 30and December 31, respectively.  The threemonths ended October 1, 2006 and October 2, 2005 each contained 13 weeks.  The nine months ended October 1, 2006 andOctober 2, 2005 each contained 39 weeks.

***Unaudited Interim Financial Information***

The accompanyingcondensed consolidated balance sheet as of October 1, 2006, the condensedconsolidated statements of operations for the three and nine months endedOctober 1, 2006 and October 2, 2005, and the condensed consolidated statementsof cash flows for the nine months ended October 1, 2006 and October 2, 2005,are unaudited. These unaudited interim condensed consolidated financialstatements have been prepared in accordance with U.S. generally acceptedaccounting principles for interim financial information, Form 10-Q andArticle 10 of Regulation S-X. In the opinion of the Company’s management,the unaudited interim condensed consolidated financial statements have beenprepared on the same basis as the annual consolidated financial statements andinclude all adjustments of a normal recurring nature necessary for the fairpresentation of the Company’s financial position as of October 1, 2006, itsresults of operations for the three and nine months ended October 1, 2006 andOctober 2, 2005, and its cash flows for the nine months ended October 1, 2006and October 2, 2005. The results for the interim periods are not necessarilyindicative of the results to be expected for any future period or for thefiscal year ending December 31, 2006. The condensed consolidated balancesheet as of January 1, 2006 has been derived from the audited consolidatedbalance sheet as of that date.

These unauditedinterim condensed consolidated financial statements should be read inconjunction with the Company’s consolidated financial statements and relatednotes included in the Company’s Form S-1 which was declared effective bythe Securities and Exchange Commission (“SEC”) on September 28, 2006.

***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 itsquarterly provision for income taxes, the Company uses an estimated annualeffective tax rate, which is based on expected annual income, statutory taxrates and tax planning opportunities available in the various jurisdictions inwhich the Company operates.  Certainsignificant or unusual items are separately recognized in the quarter in whichthey occur and can be a source of variability in the effective tax rates fromquarter to quarter.

6

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***Cash and CashEquivalents***

Cash and cashequivalents are considered to be highly liquid investments with maturities ofthree months or less at the time of the purchase.

***Supply andFulfillment Concentration Risks***

All of the Company’sproducts are contract manufactured or supplied by third parties. The Companyhas a long-term contract with only one of its suppliers. The term of thiscontract expires on April 30, 2011. The fact that the Company does not havelong-term contracts with all of its third party manufacturers means that thosemanufacturers could cease manufacturing the Company’s products at any time andfor any reason.

Additionally, theCompany 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, and it will automaticallyrenew for one-year periods unless either party gives 90-day written notice ofits intention not to so renew.

***Concentration ofCredit Risk and Credit Risk Evaluation***

Financialinstruments that potentially subject the Company to concentrations of creditrisk consist primarily of cash and cash equivalents and accounts receivable.Cash and cash equivalents are held with various domestic financial institutionswith high credit standing. Management believes that the financial institutionsthat hold the Company’s cash are financially sound and, accordingly, minimalcredit risk exists with respect to these balances.

Sales generated throughcredit card purchases for the three and nine months ended October 1, 2006 wereapproximately 53.2% and 50.8%, respectively, and approximately 53.8% and 56.0%for the three and nine months ended October 2, 2005, respectively.  The Company uses third parties to collect itscredit card receivables and, as a consequence, believes that its credit risksrelated to these channels of distribution are limited. The Company performsongoing credit evaluations of its wholesale customers not paying by credit cardand acquires credit insurance for certain international customers. Generally,the Company does not require collateral. An allowance for doubtful accounts is determined with respect to thoseamounts that the Company has determined to be doubtful of collection usingspecific 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 thepercentage of consolidated accounts receivable, net for customers whorepresented 10% or more of consolidated accounts receivable:

|            | ** ** | **October 1,  2006** | ** ** | **January 1,  2006** | ** ** |
|------------|------------|---------------------------|------------|---------------------------|------------|
| Customer A |       | 15                        | %          | 14                        | %          |
| Customer B |       | 42                        | %          | 28                        | %          |
| Customer C |       | 19                        | %          | 33                        | %          |

 

The table belowsets forth the percentage of consolidated sales, net for customers whorepresented 10% or more of consolidated net sales:

|            | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** ** | ** ** | **October 1,  2006**        | ** ** | **October 2,  2005**       | ** ** | **October 1,  2006** | ** ** | **October 2,  2005** | ** ** |
| Customer A |       | —                           |       | 12                              | %          | 13 | % | 14 | % |
| Customer B |       | 14                               | %          | —                          |       | 12 | % | — |   |
| Customer C |       | 14                               | %          | 11                              | %          | 14 | % | — |   |

 

As of October 1,2006 and January 1, 2006, the Company had no off-balance sheet concentrationsof credit risk, such as option contracts or other hedging arrangements.

7

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***Fair Value ofFinancial Instruments***

Financialinstruments consist principally of cash and cash equivalents, accountsreceivable, accounts payable and long-term debt. The estimated fair value ofcash, accounts receivable, and accounts payable approximates their carryingvalue due to the short period of time to their maturities. The estimated fairvalue of the Company’s variable-rate debt approximates its carrying value,since the rate of interest on the variable-rate debt is determined at a marginover LIBOR or the lenders’ base rate plus an applicable margin based on a gridin which the pricing depends on the Company’s consolidated total leverageratio, and such rates are revised frequently, based upon current LIBOR or thelenders’ base rate. The estimated fair value of the Company’s fixed-rate debtapproximates its carrying value at October 1, 2006, as the debt was issued inthe second fiscal quarter of 2006.

***Inventories***

Inventoriesconsist of finished goods and raw materials and are stated at the lower of costor market, determined on a weighted-average basis. The Company regularlymonitors inventory quantities on hand and records write-downs for excess andobsolete inventories based primarily on the Company’s estimated forecast ofproduct demand and production requirements. Such writedowns establish a newcost basis of accounting for the related inventory. Actual inventory losses maydiffer from management’s estimates, and such differences could be material tothe Company’s consolidated financial position, results of operations, and cashflows.

***Property andEquipment***

Property andequipment are stated at cost, net of accumulated depreciation and amortization.Furniture and equipment, including computers, 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 ofLong-Lived Assets and Long-Lived Assets to Be Disposed of***

The Companyperiodically evaluates whether changes have occurred that would requirerevision of the remaining useful life of equipment and improvements andpurchased intangible assets or render them not recoverable. If suchcircumstances arise, the Company uses an estimate of the undiscounted sum ofexpected future operating cash flows during their holding period to determinewhether the long-lived assets are impaired. If the aggregate undiscounted cashflows are less than the carrying amount of the assets, the resulting impairmentcharge to be recorded is calculated based on the excess of the carrying valueof the assets over the fair value of such assets, with the fair valuedetermined based on an estimate of discounted future cash flows.

During the ninemonths ended October 2, 2005, the Company abandoned a contract with a softwarevendor and recognized an impairment charge of $1,055,000. The costs associatedwith the termination of the contract relate primarily to the cost of thesoftware license arrangement and other capitalized costs that were accountedfor as development in progress, as the software had not yet been placed in service.As of January 1, 2006, there were no remaining amounts to be paid under thecontract.

***Goodwill andIntangible Assets***

Goodwill and otherpurchased intangible assets have been recorded as a result of the Company’sacquisition of Bioceutix, Inc. in December 2001. Trademarks acquired in theacquisition relate to the Company’s exclusive rights to make, use, and sell thebrands acquired and, together with goodwill, were deemed to be indefinite-livedat the acquisition date.

Goodwill andindefinite-lived intangibles are not amortized, but rather are subject to anannual impairment test. Other intangible assets are amortized over theirestimated useful lives, generally two to three years, and were fully amortizedas of January 2, 2005. The Company is required to perform an annual impairmenttest of goodwill and indefinite-lived intangible assets. Should certain eventsor indicators of impairment occur between annual impairment tests, the Companyperforms the impairment test of goodwill and indefinite-lived intangible assetsat that date. In evaluating goodwill, management compares the total book valueof the reporting unit to the fair value of those reporting units. The fairvalue of the Company is determined using the income approach. The incomeapproach focuses on the income-producing capability of an asset, measuring thecurrent value of the asset by calculating the present value of its futureeconomic benefits such as cash earnings, cost savings, tax deductions, andproceeds from disposition. Value indications are developed by discountingexpected cash flows to their present value at a rate of return thatincorporates the risk-free rate for the use of funds, the expected rate ofinflation, and risks associated with the particular investment. Through October1, 2006, no impairment charge has been required.

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***Debt IssuanceCosts***

Debt issuancecosts are capitalized and amortized over the terms of the underlying debtinstruments using the effective-interest method. Debt issuance costs paiddirectly to lending institutions are recorded as a debt discount, while debtissuance costs paid to third parties are recorded as other assets. In June2006, the Company agreed with the lenders under the senior secured creditfacilities to restructure the credit facilities to increase the Company’sborrowings by an additional aggregate principal amount of $206,583,000 (the ‘‘June2006 Recapitalization’’). The Company wrote off the remaining unamortized debtissuance costs of $867,000 and expensed as debt extinguishment costs $2,524,000of fees paid directly to the lender, as the amendment was determined to besubstantially different in accordance with the provisions of EITF 96-19. InJune 2006, the Company also issued 15% senior subordinated notes in theaggregate principal amount of $125,000,000. The Company capitalized $2,411,000of third-party costs related to these credit agreements and capitalized$1,315,000 of costs related to the senior subordinated notes as a debtdiscount.

***RecapitalizationTransactions***

In February 2005,we incurred approximately $224.5 million of new indebtedness, repaid a total of$92.6 million of existing debt and paid a special dividend to stockholders of$122.4 million.  In October 2005, weincurred approximately $187.5 million of new indebtedness and paid a specialdividend to stockholders of $183.5 million. In June 2006, we incurred approximately $331.6 million of newindebtedness and paid a special dividend to stockholders of $340.4 million.  We refer to these transactions as ourFebruary 2005 recapitalization, October 2005 recapitalization and June 2006recapitalization, respectively.

***Stock-BasedCompensation***

Effective January3, 2005, the Company adopted the fair value recognition and measurementprovisions of Statement of Financial Accounting Standards No. 123(R), *Share-Based Payment*(‘‘Statement 123(R)’’).Statement 123(R) is applicable for stock-based awards exchanged for employeeservices and in certain circumstances for non-employee directors. Pursuant toStatement 123(R), stock-based compensation cost is measured at the grant date,based on the fair value of the award, and is recognized as expense over therequisite service period for awards expected to vest. The estimation 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. TheCompany elected to adopt the modified-prospective-transition method, asprovided by Statement 123(R). Under this transitional method, the Company isrequired to record compensation expense in the consolidated statement ofoperations for all awards granted after the date of adoption using grant-datefair value estimated in accordance with the provisions of Statement 123(R), andfor the unvested portion of previously granted awards as of January 3, 2005using the grant-date fair value estimated in accordance with the provisions ofStatement 123.

The compensationcost charged to operations pursuant to Statement 123(R) was $1,365,000 and$3,654,000 and for the three and nine months ended October 1, 2006,respectively and $310,000 and $903,000 for the three and months ended October2, 2005, respectively. The Company records stock-based compensation on aseparate operating expense line item in its statement of operations due to thefact that, to date, all of its stock-based awards have been made to employeeswhose salaries are classified as selling, general and administrative expenses.

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***RevenueRecognition***

The Companyrecognizes sales when merchandise is shipped from a warehouse directly towholesale customers (except in the case of a consignment sale), infomercialcustomers, and internet customers or when purchased by customers at retailboutiques, each net of estimated returns. For consignment sales, which includesales to QVC, the Company recognizes sales, net of expected returns fromconsignees, upon the consignee’s shipment to the customer. Postage and handlingcharges billed to customers are also recognized as sales upon shipment of therelated merchandise. Shipping terms are FOB shipping point, and title passes tothe customer at the time and place of shipment or purchase by customers atretail locations. For consignment sales, title passes to the consigneeconcurrent with the consignee’s shipment to the customer. The customer has nocancellation privileges after shipment or upon purchase at retail locations,other than customary rights of return that are accounted for in accordance withStatement 48, *Revenue Recognition When Rightof Return Exists.*The Company’s standard terms for retail sales,including infomercial sales and sales at retail boutiques, limit returns toapproximately 30 to 60 days after the sale of the merchandise. For wholesalesales, as is customary in the cosmetics industry, the Company allows returnsfrom wholesale customers if properly requested and approved. The Companyregularly evaluates returns and accrues for expected future returns that relateto sales prior to the balance sheet date utilizing a combination of historicaland current trends. Deferred revenue reflects amounts received from customersrelated to merchandise to be shipped in future periods.

***Payments toCustomers***

For wholesalesales, the Company makes payments to certain customers for cooperativeadvertising, commissions and shared employee costs. In accordance with theprovisions of EITF 01-9, *Accounting forConsideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)*, these fees are recorded as a reduction of netsales in the accompanying consolidated statements of operations, unless theCompany determines it has received an identifiable benefit and can reasonablyestimate the fair value of that benefit.

***Shipping andFulfillment Costs***

Freight costsincurred related to shipment of merchandise from the Company’s distributionfacilities to customers are recorded in cost of goods sold. Third-partyfulfillment costs relating to warehousing, storage, and order processing areincluded in selling, general and administrative expenses.

***Pre-OpeningCosts***

Costs incurred inconnection with the start-up and promotions of new Company-owned boutiques areexpensed as incurred.

***Operating Leases***

The Company leasesretail boutiques, a distribution facility, and office space under operatingleases. 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.

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***Research andDevelopment***

Research anddevelopment costs are charged to operations as incurred. Major components ofresearch and development expenses consist of product formulation, testing,regulatory analysis, and compliance.

***AdvertisingCosts***

The Companypurchases commercial airtime on various television stations throughout theUnited States in order to air its direct-response program, or ‘‘infomercial.’’The Company expenses costs associated with purchasing airtime as incurred. TheCompany expenses production costs associated with advertising as incurred,except for production costs for its infomercial, which are capitalized andamortized over their expected period of future benefit.

Other advertisingcosts such as media placements, public relations and marketing brochures areexpensed as incurred. Marketing brochures are accounted for as prepaid assets andare expensed based on usage, or at such time that they are no longer expectedto be used, in which case their cost is expensed at that time.

***Income Taxes***

Deferred taxassets and liabilities are recognized for the expected tax consequences oftemporary differences between the tax bases of assets and liabilities and theirreported amounts using enacted tax rates in effect for the year the differencesare expected to reverse. The Company records a valuation allowance to reducedeferred tax assets to the amount that is expected to be realized on amore-likely-than-not basis. Deferred tax expense results from changes in netdeferred tax assets or liabilities between periods.

***Earnings perShare***

A calculation ofearnings per share, as reported is as follows (in thousands):

|                                                                               | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                    | ** ** | **October 1,  2006**        | ** ** | **October 2,  2005**       | ** ** | **October 1,  2006** | ** ** | **October 2,  2005** | ** ** |
| *Numerator:*                                                                  |       |                             |       |                            |       |   |   |   |   |
|                                                                          |       |                             |       |                            |       |   |   |   |   |
| Net income                                                                    |       | $                                | 8,880      |                            | $          | 9,376 |   | $ | 33,888 |   | $ | 19,053 |   |
|                                                                          |       |                             |       |                            |       |   |   |   |   |
| *Denominator:*                                                                |       |                             |       |                            |       |   |   |   |   |
| Weighted average common shares used in per share  calculations — basic   |       | 70,839                           |       | 68,270                          |       | 69,920 |   | 67,217 |   |
| Add: Common stock equivalents from exercise of stock  options                 |       | 2,672                            |       | 2,560                           |       | 2,441 |   | 1,485 |   |
| Weighted-average common shares used in per share calculations  — diluted |       | 73,511                           |       | 70,830                          |       | 72,361 |   | 68,702 |   |
| Net income per  share                                                         |       |                             |       |                            |       |   |   |   |   |
| Basic                                                                         |       | $                                | 0.13       |                            | $          | 0.14 |   | $ | 0.48 |   | $ | 0.28 |   |
| Diluted                                                                       |       | $                                | 0.12       |                            | $          | 0.13 |   | $ | 0.47 |   | $ | 0.28 |   |

 

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For the three and nine months ended October 1, 2006,options to purchase 54,250 were excluded from the calculation of weightedaverage shares for diluted net income per share as they were anti-dilutive. Forthe three and nine months ended October 2, 2005, there were no anti-dilutivecommon shares excluded from the calculation of weighted average shares fordiluted net income per share.

***Comprehensive Income***

The Company doesnot have any items of other comprehensive income; therefore, net income isequal to comprehensive income for all periods presented.

***RecentAccounting Pronouncements***

In June 2006, theFASB ratified the consensus reached on Emerging Issues Task Force IssueNo. 06-03, *How Sales Taxes Collected from Customers andRemitted to Governmental Authorities Should Be Presented in the IncomeStatement (That is, Gross Versus Net Presentation)*. The EITF reacheda consensus that the presentation of taxes on either a gross or net basis is anaccounting policy decision that requires disclosure. EITF 06-03 is effectivefor the first interim or annual reporting period beginning after December 15,2006. The Company does not intend to modify its current accounting policy ofrecording sales tax collected on a net basis. Therefore, the adoption of EITF06-03 will not have any effect on the Company’s financial position or resultsof operations.

In July 2006, theFASB issued Interpretation No. 48, *Accountingfor Income Tax Uncertainties*(‘‘FIN 48’’). FIN 48 defines thethreshold for recognizing the benefits of tax return positions in the financialstatements as ‘‘more-likely-than-not’’ to be sustained. FIN 48 also providesguidance on the derecognition, measurement and classification of income taxuncertainties, along with any related interest and penalties. FIN 48 alsoincludes guidance concerning accounting for income tax uncertainties in interimperiods and increases the level of disclosures associated with any recordedincome tax uncertainties. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. The differences between the amounts recognized in thestatements of financial position prior to the adoption of FIN 48 and theamounts reported after adoption will be accounted for as a cumulative effectadjustment recorded to the beginning balance of retained earnings. The Companyis currently in the process of determining the impact, if any, of adopting theprovisions of FIN 48 on its financial position and results of operations. TheCompany will adopt FIN 48 on January 1, 2007.

InSeptember 2006, the FASB issued SFAS No. 157*, Fair ValueMeasurements*.  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.  The Company willadopt Statement 157 during its fiscal year ending December 28, 2008. TheCompany is currently in the process of determining the impact, if any, ofadopting the provisions of Statement 157 but it is not expected to have amaterial impact on the Company’s financial position or results of operations.

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# **3.****              Inventories**

Inventoriesconsisted of the following (in thousands):

|                               | ** ** | **October 1,  2006** | ** ** | **January 1,  2006** | ** ** |
|-------------------------------|------------|---------------------------|------------|---------------------------|------------|
| Raw materials  and components |       | $                         | 3,442      |                      | $          | 1,679 |   |
| Finished goods                |       | 55,602                    |       | 32,652                    |       |
|                          |       | $                         | 59,044     |                      | $          | 34,331 |   |

 

# **4.****              Property andEquipment, Net**

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

|                              | ** ** | **October 1,  2006** | ** ** | **January 1,  2006** | ** ** |
|------------------------------|------------|---------------------------|------------|---------------------------|------------|
| Furniture and  equipment     |       | $                         | 4,116      |                      | $          | 3,477 |   |
| Computers                    |       | 3,404                     |       | 2,389                     |       |
| Leasehold  improvements      |       | 15,707                    |       | 8,496                     |       |
|                         |       | 23,227                    |       | 14,362                    |       |
| Accumulated  depreciation    |       | (4,572                    | )          | (4,533                    | )          |
| Property and equipment,  net |       | $                         | 18,655     |                      | $          | 9,829 |   |

 

# **5.****              Intangible Assets,Net**

Intangible assets,net, consisted of the following (in thousands):

|                                 | ** ** | **October 1,  2006** | ** ** | **January 1,  2006** | ** ** |
|---------------------------------|------------|---------------------------|------------|---------------------------|------------|
| Goodwill                        |       | $                         | 2,852      |                      | $          | 2,852 |   |
| Trademarks                      |       | 3,233                     |       | 3,233                     |       |
| Domestic  customer base         |       | 939                       |       | 939                       |       |
| International  distributor base |       | 820                       |       | 820                       |       |
|                            |       | 7,844                     |       | 7,844                     |       |
| Accumulated  amortization       |       | (1,759                    | )          | (1,759                    | )          |
| Intangible assets, net          |       | $                         | 6,085      |                      | $          | 6,085 |   |

 

As of January 2,2005, the Company’s amortizable intangible assets were fully amortized.

# **6.****              Other Assets**

Other assetsconsisted of the following (in thousands):

|                                                                                                                             | ** ** | **October 1,  2006** | ** ** | **January 1,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| Debt issuance  costs, net of accumulated amortization of $134 and $26 at October 1, 2006 and  January 1, 2006, respectively |       | $                         | 2,277      |                      | $          | 597 |   |
| Offering costs                                                                                                              |       | 2,614                     |       | —                    |       |
| Other assets                                                                                                                |       | 580                       |       | 253                       |       |
|                                                                                                                        |       | $                         | 5,471      |                      | $          | 850 |   |

 

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# **7.**              Accrued Liabilities

Accruedliabilities consisted of the following (in thousands):

|                                             | ** ** | **October 1,  2006** | ** ** | **January 1,  2006** | ** ** |
|---------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| Interest                                    |       | $                         | 7,907      |                      | $          | 5,876 |   |
| Employee compensation  and benefits         |       | 5,795                     |       | 4,334                     |       |
| Gift certificates and  customer liabilities |       | 1,565                     |       | 1,920                     |       |
| Product development  costs                  |       | —                    |       | 1,000                     |       |
| Sales taxes and local  business taxes       |       | 1,009                     |       | 936                       |       |
| Deferred revenue                            |       | 2                         |       | 361                       |       |
| Other                                       |       | 3,083                     |       | 1,916                     |       |
|                                        |       | $                         | 19,361     |                      | $          | 16,343 |   |

 

# **8.**              Revolving Lines ofCredit

In conjunctionwith the February 2005 Recapitalization, the Company established a newrevolving credit facility of up to $15,000,000 (the ‘‘Revolver’’), the proceedsof which were to provide financing for working capital and other generalcorporate purposes of the Company and its subsidiaries. This new revolvingcredit facility has a term of six years expiring on February 18, 2011.

In connection withthe June 2006 Recapitalization, the Company increased the Revolver to$25,000,000, the proceeds of which are to be used to provide financing forworking capital and other general corporate purposes of the Company and itssubsidiaries. At October 1, 2006, the entire $25,000,000 was available andthere were no outstanding borrowings. The Company is required to pay commitmentfees of 0.5% per annum on any unused portions of the facility. Borrowings underthe Revolver bear interest at a rate equal to, at the Company’s option, eithera margin over LIBOR or the lenders’ base rate, plus an applicable margin basedon a grid in which the pricing depends on the Company’s consolidated totalleverage ratio (3.0% plus LIBOR or 2.0% plus lenders’ base rate; actual rate of8.08% at October 1, 2006 and 7.25% at January 1, 2006).

# **9.**              Long-Term Debt

Long-term debtconsisted of the following (in thousands):

|                                               | ** ** | **October 1,  2006** | ** ** | **January 1,  2006** | ** ** |
|-----------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| First Lien  Credit Loans                      |       | $                         | 350,269    |                      | $          | 243,833 |   |
| Second Lien  Credit Loans                     |       | 234,000                   |       | 146,000                   |       |
| Subordinated  Notes Payable                   |       | 125,000                   |       | —                    |       |
| Discount on long-term  debt                   |       | (1,261                    | )          | —                    |       |
|                                          |       | 708,008                   |       | 389,833                   |       |
| Less current  portion                         |       | (17,963                   | )          | (12,667                   | )          |
| Total long-term  debt, net of current portion |       | $                         | 690,045    |                      | $          | 377,166 |   |

 

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## **SubordinatedNotes Payable**

On June 7, 2006,in connection with the June 2006 Recapitalization, the Company entered into aNote Purchase Agreement pursuant to which the lenders named therein agreed topurchase $125,000,000 of 15.0% Senior Subordinated Notes due June 7, 2014 (the ‘‘June2006 Subordinated Notes’’). The June 2006 Subordinated Notes are unsecured andsubordinated in priority of payment to the Company’s obligations under theFirst and Second Lien Credit Agreements.

## **Firstand Second Lien Credit Loans**

On June 7, 2006,the Company agreed with the lenders under the senior secured credit facilitiesto restructure the then-existing credit facilities to increase the Company’sborrowings by an additional aggregate principal amount of $331,583,000,comprised of additional First Lien Term Loans of $118,583,000 and additionalSecond Lien Term Loans of $88,000,000, the proceeds of which were used togetherwith the June 2006 Subordinated Notes of $125,000,000, to pay a dividend toholders of the Company’s common stock in the aggregate amount of $340,427,000and to pay transaction costs in connection with the June 2006Recapitalization.  The maturity dates ofthe First Lien Term Loans and Second Lien Term Loans were not adjusted.

The First LienTerm Loans have a term of seven years expiring on February 18, 2012, the SecondLien Term Loans have a term of eight years expiring on February 18, 2013 andthe Senior Subordinated Loans have a term of eight years expiring on June 7,2014. The First Lien Term Loans bear interest at a rate equal to, at theCompany’s option, either LIBOR or the lenders’ base rate, plus an applicablemargin varying based on the Company’s consolidated total leverage ratio.  Borrowings on the Second Lien Term Loansgenerally bear interest at a rate equal to, at the Company’s option, either7.0% over LIBOR or 6.0% over the lender’s base rate. As of October 1, 2006 andJanuary 1, 2006, the interest rates on the First Lien Term Loans were accruingat 8.08% and 7.25% and the Second Lien Term Loans were accruing at 14.25% and11.25%, respectively.

All borrowingsunder the Revolver (Note 8) and the First Lien Term Loans and Second Lien TermLoans are secured by substantially all of the Company’s assets, including, butnot limited to, all accounts receivable, inventory, property and equipment, andintangibles. The terms of the Company’s senior secured credit facilitiesrequire it to comply with financial covenants, including maintaining leverageand fixed charge coverage ratios and limitations, entering into interest rateswap or similar agreements with respect to 40% of the principal amountsoutstanding under senior secured credit facilities as of October 2, 2007, andlimiting capital expenditures. The Company has not entered into any hedgingactivities as of October 1, 2006 and January 1, 2006. Some of the financialcovenants become more restrictive over the term of the secured creditfacilities. The secured credit facilities also contain nonfinancial covenantsthat restrict some of the Company’s activities, including its ability todispose of assets, incur additional debt, pay dividends, create liens, makeinvestments, make capital expenditures and engage in specified transactionswith affiliates.

On September 11,2006, the Company’s First Lien Credit Agreement was amended to permit theissuance of up to $135,000,000 in supplemental term loans under that creditagreement concurrently with or following a public offering and uponsatisfaction of a maximum leverage test and other conditions contained in thatcredit agreement. The proceeds of those supplemental term loans must be appliedto repay the Company’s existing indebtedness or to pay fees and expenses ofcertain transactions, including a public offering, as described in that creditagreement. The financial covenants, interest rates and scheduled maturity termsof the Company’s existing debt were not changed by the amendment.

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## **ScheduledMaturities of Long-Term Debt**

At October 1,2006, future scheduled principal payments on long-term debt were as follows (inthousands):

| Year ending:                                    |   |    |    |
|-------------------------------------------------|--------|---------|---------|
| Remainder of the  year ending December 31, 2006 |   | $       | 4,491   |   |
| December 30,  2007                              |   | 17,962  |    |
| December 28,  2008                              |   | 17,962  |    |
| January 3, 2010                                 |   | 17,962  |    |
| January 2, 2011  and thereafter                 |   | 650,892 |    |
|                                            |   | $       | 709,269 |   |

 

# **10.  Commitmentsand Contingencies**

## ***Lease Commitments***

The Company leasesretail boutiques, a warehouse, its corporate offices, and certain equipment undernoncancelable operating leases with various expiration dates through June 2017.Additionally, in connection with the Company’s restructuring (Note 15), theCompany sublet part of the facilities it exited. The future minimum annualpayments and anticipated sublease income under such leases in effect at October1, 2006, were as follows (in thousands):

|                                                | ** ** | **Minimum  Rental  Payments** | ** ** | **Sublease  Rental  Income** | ** ** | **Net  Minimum  Lease  Payments** | ** ** |
|------------------------------------------------|------------|-------------------------------|------------|------------------------------|------------|-----------------------------------|------------|
| Year ending:                                   |       |                          |       |                         |       |                              |       |
| Remainder of the year ending December 31, 2006 |       | $                             | 793        |                         | $          | 44                                |       | $ | 749 |   |
| December 30, 2007                              |       | 4,714                         |       | 36                           |       | 4,678                             |       |
| December 28, 2008                              |       | 4,635                         |       | —                       |       | 4,635                             |       |
| January 3, 2010                                |       | 4,575                         |       | —                       |       | 4,575                             |       |
| January 2, 2011                                |       | 4,308                         |       | —                       |       | 4,308                             |       |
| Thereafter                                     |       | 20,025                        |       | —                       |       | 20,025                            |       |
|                                           |       | $                             | 39,050     |                         | $          | 80                                |       | $ | 38,970 |   |

 

Many of theCompany’s retail boutique leases require additional contingent rents whencertain sales volumes are reached. Total rent expense was $2,238,000 and$5,932,000 for the three and nine months ended October 1, 2006, respectively,and $1,372,000, and $3,874,000 for the three and nine months ended October 2,2005, respectively.  Total rent expenseincluded contingent rentals of $394,000 and $1,117,000 for the three and ninemonths ended October 1, 2006, respectively, and $235,000, and $756,000 for thethree and nine months ended October 2, 2005, respectively.  Several leases entered into by the Companyinclude options that may extend the lease term beyond the initial commitmentperiod, subject to terms agreed to at lease inceptions.  As of October 1, 2006, under the terms of itscorporate office lease, the Company issued an irrevocable standby letter ofcredit of $387,000 to the lessor for the term of the lease.

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## ***Royalty Agreements***

The Company is aparty to a license agreement (the ‘‘License’’) for use of certain patentsassociated with some of the skin care products sold by the Company. The Licenserequires that the Company pay a quarterly royalty of 4% of the net sales ofcertain skin care products for an indefinite period of time. The License alsorequires minimum annual royalty payments from the Company. The minimum royaltyamount was $500,000 for 2005; the minimum will increase to $600,000 for 2006and remain at $600,000 for 2007 and thereafter. The Company can terminate theagreement at any time with six months written notice. The Company’s royaltyexpense under the License for the three and nine months ended October 1, 2006was $150,000, and $450,000, respectively, and $125,000, and $375,000 for thethree and nine months ended October 2, 2005, respectively.

In the year endedJanuary 1, 2006, the Company entered into an agreement to obtain a worldwideexclusive right to license, develop, commercialize, and distribute certainlicensed ingredients to be used in products to be sold by the Company. Thisagreement requires the Company to make payments upon achievement of certainproduct milestones. In addition, this agreement requires the Company to pay aroyalty of 3.5% of the net sales upon successful launch of the first product,subject to certain minimum annual royalty amounts. The Company’s expense underthis agreement for the three and nine months ended October 1, 2006 was$238,000, and $430,000, respectively, and $187,000, and $750,000 for the threeand nine months ended October 2, 2005, respectively.

## ***Contingencies***

The Company isinvolved in various legal and administrative proceedings and claims arising inthe ordinary course of its business. The ultimate resolution of such claimswould not, in the opinion of management, have a material effect on the Company’sfinancial position or results of operation.

# **11. Related-Party Transactions**

On June 10, 2004,the Company entered into a Management Agreement (‘‘Berkshire Agreement’’) withBerkshire. Under the Berkshire Agreement, the Company engaged Berkshire toprovide management advisory services in connection with the general businessoperations of the Company. In compensation for such services, the Companyagreed to pay a management fee in an amount of $300,000 per annum for the termof the agreement. The Berkshire Agreement was terminated upon completion of ourinitial public offering on October 4, 2006 (Note 16). Total management feesplus expenses recognized under the Berkshire Agreement for the three and ninemonths ended October 1, 2006 was $92,000, and $273,000, respectively, and$91,000, and $274,000 for the three and nine months ended October 2, 2005,respectively, and was recorded as selling, general and administrative expensesin the accompanying consolidated statements of operations.

On June 10, 2004,the Company also entered into a Management Agreement (‘‘JHP Agreement’’) withJHP. Under the JHP Agreement, the Company engaged JHP to provide managementadvisory services in connection with the general business operations of theCompany.  In compensation for suchservices, the Company agreed to pay a management fee in an amount of $300,000per annum for the term of the JHP Agreement. The JHP Agreement was terminatedupon completion of our initial public offering on October 4, 2006 (Note 16).Total management fees plus expenses recognized under this Agreement for thethree and nine months ended October 1, 2006 was $75,000, and $282,000,respectively, and $75,000, and $230,000 for the three and nine months endedOctober 2, 2005, respectively, and was recorded as selling, general andadministrative expenses in the accompanying consolidated statements ofoperations.

In connection withthe February 2005 Recapitalization, the Company paid to Berkshire and JHPapproximately $2,395,000 relating to transactional fees and expenses. Inconnection with the June 2006 Recapitalization, the Company issued 102,022shares of common stock to each of Berkshire and JHP relating to transactionalfees and expenses. The Company valued the common stock at $10.43 per share,representing the estimated fair value of the shares of the Company’s commonstock based on a contemporaneous valuation obtained from an independentvaluation firm. This amount was capitalized as debt issuance costs.

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The holders of theSenior Term Loans issued in connection with the February 2005 Recapitalizationare also stockholders of the Company. Fees paid to these lenders in connectionwith the February 2005 Recapitalization totaled $2,395,0000 and were reflectedas debt extinguishment costs in the nine months ended October 2, 2005.  Additionally, the Company paid a prepaymentpenalty of $2,700,000 that was reflected as debt extinguishment costs in thenine months ended October 2, 2005.

The holders of theSenior Term Loans issued in connection with June 2006 Recapitalization are alsostockholders of the Company. Fees paid to these lenders in connection with theJune 2006 Recapitalization totaled $2,524,000 and were reflected as debtextinguishment costs in the nine month period ended October 1, 2006.

FH Capital PartnersLLC is 50%-owned by an affiliate of the Company’s former chairman, a majorstockholder. In December 2001 and May 2002, the Company entered into agreementswith FH Capital Partners LLC to rent certain computer hardware, software, andlicenses under operating lease agreements. Rental expense recognized relatingto these arrangements for the three and nine months ended October 1, 2006 were$7,500 and $20,000, respectively, and $7,500 and $22,500 for the three and ninemonths ended October 2, 2005, respectively was recorded as selling, general andadministrative expenses in the accompanying consolidated statements ofoperations.

# **12. Stockholders’ Equity**

## ***Common Stock***

In September 2006,the Company’s board of directors and stockholders approved a 1.5-for-one splitof its common stock and a change in the par value of its common stock from$0.01 to $0.001, which were effected on September 12, 2006. All common stock,common stock equivalents, options and warrants to purchase common stock, andper share amounts in the condensed consolidated financial statements have beenadjusted retroactively to reflect the stock split and change in par value. Inaddition, the Company’s board of directors and stockholders approved anincrease in the authorized common stock to 200,000,000 shares.

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

As of October 1,2006, the Company had reserved 10,817,492 shares of common stock for issuance.

## **2004Equity Incentive Plan**

On June 10, 2004,the board of directors adopted the 2004 Equity Incentive Plan (the ‘‘2004 Plan’’).The Company reserved a total of 11,564,718 shares for new grants under the 2004Plan.  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 at arate of 20% per year from the date of grant and have a maximum term of tenyears.

A summary ofactivity under the 2004 Plan is set forth below. All exercise prices have beenadjusted to reflect the impact of the exercise price modifications inconnection with the February 2005, October 2005 and June 2006Recapitalizations.

|                                                        | ** ** | ** **                        | ** ** | **Options Outstanding** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                                             | ** ** | **Options  Available  for Grant** | ** ** | **Number of  Shares**        | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Balance at January  1, 2006                            |       | 4,393,983                         |       | 6,441,440                    |       | $ | 0.87 |   |
| Granted                                                |       | (2,089,386                        | )          | 2,089,386                    |       | 6.70 |   |
| Exercised                                              |       | —                            |       | (1,679,704                   | )          | 0.78 |   |
| Canceled                                               |       | 533,630                           |       | (533,630                     | )          | 2.64 |   |
| Cancellation of  remaining options available for grant |       | (2,838,227                        | )          | —                       |       | — |   |
| Balance at October 1,  2006                            |       | —                            |       | 6,317,492                    |       | $ | 2.68 |   |

 

18

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At October 1,2006, total outstanding options vested under the 2004 Plan were 22,500 at aweighted-average exercise price of $1.87.

The totalintrinsic value of options exercised under the 2004 Plan for the nine monthsended October 1, 2006 was $19,333,000.

In conjunctionwith the adoption of the 2006 Plan, no additional options were permitted to begranted under the 2004 Plan.  Inaddition, any options cancelled under the 2004 Plan will become available togrant under the 2006 Plan.

**2006Equity Incentive Plan**

On September 12,2006, the stockholders of the Company approved the 2006 Equity Incentive AwardPlan (the “2006 Plan”) for executives, directors, employees and consultants ofthe Company. A total of 4,500,000 shares of the Company’s Common Stock havebeen reserved for issuance under the 2006 Plan. Awards are generally grantedwith an exercise price equal to the market price of the Company’s Common Stockat the date of grant. Those awards generally vest over a period of five yearsfrom the date of grant and have a maximum term of ten years.

A summary ofactivity under the 2006 Plan is set forth below:

|                                            | ** ** | ** **                        | ** ** | **Options Outstanding** | ** ** |
|--------------------------------------------|------------|-----------------------------------|------------|------------------------------|------------|
| ** **                                 | ** ** | **Options  Available  for Grant** | ** ** | **Number  of Shares**   | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
| Balance at  September 28, 2006 (inception) |       | 4,500,000                         |       | —                       |       | $ | — |   |
| Granted                                    |       | (54,250                           | )          | 54,250                       |       | 22.00 |   |
| Balance at October 1,  2006                |       | 4,445,750                         |       | 54,250                       |       | $ | 22.00 |   |

 

At October 1,2006, there were no outstanding options vested under the 2006 Plan.

The total cashreceived from employees as a result of employee stock option exercises underall plans for the nine months ended October 1, 2006 was $1,309,000. Inconnection with these exercises, the tax benefits realized by the Company forthe nine months ended October 1, 2006 were $7,507,000.

**14.  Segment and Geographic Information**

Operating segmentsare defined as components of an enterprise engaging in business activitiesabout where separate financial information is available that is evaluatedregularly by the Chief Operating Decision Maker (‘‘CODM’’) in deciding how toallocate resources and assessing performance. The Company’s Chief ExecutiveOfficer has been identified as the CODM as defined by Statement 131, *Disclosures about Segments of an Enterprise and RelatedInformation*.  The Company hasdetermined that it operates in two business segments: Retail with sales to endusers, and Wholesale with sales to resellers. These reportable segments arestrategic business units that are managed separately based on the fundamentaldifferences in their operations. The Retail segment consists of sales directlyto end users through Company-owned boutiques and infomercials. The Wholesalesegment consists of sales to resellers, home shopping television, specialtybeauty retailers, spas and salons, and international distributors. Thefollowing table presents certain financial information for each segment.Operating income is the gross margin of the segment less direct expenses of thesegment. Some direct expenses, such as media and advertising spend, do impactthe performance of the other segment, but these expenses are recorded in thesegment they directly relate to and are not allocated out to each segment. TheCorporate column includes unallocated selling, general and administrativeexpenses, depreciation and amortization, stock-based compensation expenses,restructuring charges and asset impairment charges. Corporate selling, generaland administrative expenses include headquarters facilities costs, distributioncenter costs, product development costs, corporate headcount costs and othercorporate costs, including information technology, finance, accounting, legaland human resources costs.

19

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|                                           | ** ** | **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      |   |
|                                           |            |            |            |               |            |               |            |           |            |  |  |  |  |

 

|                                           | ** ** | **Retail** | ** ** | **Wholesale** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|------------|------------|---------------|------------|---------------|------------|-----------|------------|
| **Three  Months ended October 2, 2005**   |       |       |       |          |       |          |       |      |       |
| Sales, net                                |       | $          | 34,004     |          | $          | 33,630        |       | $         | —     |   | $ | 67,634 |   |
| Cost of goods  sold                       |       | 7,730      |       | 11,578        |       | —        |       | 19,308    |       |
| Gross profit                              |       | 26,274     |       | 22,052        |       | —        |       | 48,326    |       |
| Operating  expenses:                      |       |       |       |          |       |          |       |      |       |
| Selling, general and administrative       |       | 14,935     |       | 2,828         |       | 8,447         |       | 26,210    |       |
| Depreciation and amortization             |       | 103        |       | —        |       | 221           |       | 324       |       |
| Stock-based compensation                  |       | —     |       | —        |       | 310           |       | 310       |       |
| Restructuring charges                     |       | —     |       | —        |       | 643           |       | 643       |       |
| Asset impairment charge                   |       | —     |       | —        |       | 1,055         |       | 1,055     |       |
| Total expenses                            |       | 15,038     |       | 2,828         |       | 10,676        |       | 28,542    |       |
| Operating income  (loss)                  |       | 11,236     |       | 19,224        |       | (10,676       | )          | 19,784    |       |
| Interest expense                          |       |       |       |          |       |          |       | (4,333    | )          |
| Interest income                           |       |       |       |          |       |          |       | 60        |       |
| Income before  provision for income taxes |       |       |       |          |       |          |       | 15,511    |       |
| Provision for  income taxes               |       |       |       |          |       |          |       | 6,135     |       |
| Net income                                |       |       |       |          |       |          |       | $         | 9,376      |   |
|                                           |            |            |            |               |            |               |            |           |            |  |  |  |  |

 

20

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|                                           | ** ** | **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     |   |
|                                           |            |            |            |               |            |               |            |           |            |  |  |  |

 

|                                           | ** ** | **Retail** | ** ** | **Wholesale** | ** ** | **Corporate** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|------------|------------|---------------|------------|---------------|------------|-----------|------------|
| **Nine  Months ended October 2, 2005**    |       |       |       |          |       |          |       |      |       |
| Sales, net                                |       | $          | 94,933     |          | $          | 85,013        |       | $         | —     |   | $ | 179,946 |   |
| Cost of goods  sold                       |       | 21,365     |       | 29,133        |       | —        |       | 50,498    |       |
| Gross profit                              |       | 73,568     |       | 55,880        |       | —        |       | 129,448   |       |
| Operating  expenses:                      |       |       |       |          |       |          |       |      |       |
| Selling, general and administrative       |       | 44,334     |       | 7,085         |       | 20,070        |       | 71,489    |       |
| Depreciation and amortization             |       | 326        |       | —        |       | 350           |       | 676       |       |
| Stock-based compensation                  |       | —     |       | —        |       | 930           |       | 930       |       |
| Restructuring charges                     |       | —     |       | —        |       | 643           |       | 643       |       |
| Asset impairment charge                   |       | —     |       | —        |       | 1,055         |       | 1,055     |       |
| Total expenses                            |       | 44,660     |       | 7,085         |       | 23,048        |       | 74,793    |       |
| Operating income  (loss)                  |       | 28,908     |       | 48,795        |       | (23,048       | )          | 54,655    |       |
| Interest expense                          |       |       |       |          |       |          |       | (12,646   | )          |
| Debt  extinguishment costs                |       |       |       |          |       |          |       | (10,558   | )          |
| Interest income                           |       |       |       |          |       |          |       | 70        |       |
| Income before  provision for income taxes |       |       |       |          |       |          |       | 31,521    |       |
| Provision for  income taxes               |       |       |       |          |       |          |       | 12,468    |       |
| Net income                                |       |       |       |          |       |          |       | $         | 19,053     |   |
|                                           |            |            |            |               |            |               |            |           |            |  |  |  |  |

 

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

|           | ** ** | **October 1,  2006** | ** ** | **January 1,  2006** | ** ** |
|-----------|------------|---------------------------|------------|---------------------------|------------|
| Retail    |       | $                         | 7,596      |                      | $          | 3,566 |   |
| Wholesale |       | —                    |       | —                    |       |
| Corporate |       | 11,195                    |       | 6,395                     |       |
|      |       | $                         | 18,791     |                      | $          | 9,961 |   |

 

Long-lived assetsallocated to the retail segment consist of fixed assets and deposits for retailstores. The wholesale segment does not have any long lived assets as theCompany does not own fixtures within its wholesale customers. Long-lived assetsin the corporate segment consist of fixed assets and deposits related to theCompany’s corporate 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** | ** ** |
|---------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **    | ** ** | **October 1,  2006**        | ** ** | **October 2,  2005**       | ** ** | **October 1,  2006** | ** ** | **October 2,  2005** | ** ** |
| United States |       | $                                | 93,408     |                            | $          | 62,573 |   | $ | 271,127 |   | $ | 168,714 |   |
| International |       | 4,539                            |       | 5,061                           |       | 12,920 |   | 11,232 |   |
| Sales, net    |       | $                                | 97,947     |                            | $          | 67,634 |   | $ | 284,047 |   | $ | 179,946 |   |

 

# **15.  Restructuring Costs**

As a result of theCompany’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 2007. Theseexit costs were accounted for in accordance with S*tatement 146, Accounting for Costs Associated with Exit or DisposalActivities*. Facility costs primarily represent closure andrelocation costs of the Company’s corporate headquarters and distributioncenter. Closure costs include payments required under lease contracts after theproperties were abandoned, less any applicable estimated sublease income duringthe period after abandonment. To determine the closure costs, certain estimateswere made related to the (1) time period over which the relevant building wouldremain vacant, (2) sublease terms, and (3) sublease rates, including commonarea charges. The accrual is an estimate and will be adjusted in the futureupon triggering events (such as changes in estimates of time to sublease andactual sublease rates).  During the threemonths ended October 1, 2006, the Company discontinued the use of one of itsoffice floors located at its former corporate facility and recorded additionalrestructuring costs of $114,000.  As ofJanuary 1, 2006 and October 1, 2006, the remaining $424,000 and $294,000accrual, respectively, of lease termination costs, net of estimated subleaseincome, is expected to be paid on various dates through June 2007.

The followingtable set forth the exit activities for the nine months ended October 1, 2006(in thousands):

| Accrual balance at January  1, 2006  |   | $      | 424    |   |
|--------------------------------------|--------|--------|--------|--------|
| Cost incurred and charged to expense |   | 114    |   |
| Non-cash charges                     |   | — |   |
| Cash paid                            |   | (244   | )      |
| Accrual balance at  October 1, 2006  |   | $      | 294    |   |

 

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# **16.**       Subsequent Events

***Initial PublicOffering and Repayment of Subordinated Notes Payable and Second Lien Term Loans***

On June 30, 2006,the Company filed a Registration Statement on Form S-1 (File No. 333-135484)with the Securities and Exchange Commission for an initial public offering ofthe Company’s common stock. As amended, the Registration Statement provided forthe sale of 16.0 million shares of the Company’s common stock. In addition, theCompany granted the underwriters the right to purchase up to an additional 2.4million shares to cover over-allotments. The over-allotment was exercised onSeptember 29, 2006 by the underwriters. The public offering closed on October4, 2006. The Company received approximately $373.9 million in net proceeds fromthe offering, of which $372.5 million was used to repay all outstandingprincipal and interest owed on the June 2006 Subordinated Notes and the SecondLien Term Loans and a portion of the outstanding principal on the First LienTerm Loans.

***Adoption ofAmended and Restated Certificate of Incorporation***

Upon completion ofthe Company’s initial public offering on October 4, 2006, the Company adoptedan amended and restated Certificate of Incorporation providing for theauthorization of 10,000,000 shares of undesignated preferred stock.

# ***Pro Forma Balance Sheet***

The following proforma balance sheet reflects the receipt of $373.9 million for the sale of 18.4million shares of common stock by the Company in its initial public offering ata price to the public of $22.00 per share, after deducting the underwritingdiscounts and commissions and estimated offering expenses payable by theCompany, and the application of such proceeds and cash and cash equivalents torepay all outstanding principal and interest on the June 2006 SubordinatedNotes and the Second Lien Term Loans and a portion of the outstanding principalon the First Lien Term Loans, the termination of the Berkshire Agreement andJHP Agreements of $1.8 million and the non-cash write-off of unamortizeddiscount and debt issuance costs of $2.5 million.

|                                                   | ** ** | **Historical** | ** ** | **Pro Forma  Adjustments  for the  Offering** | ** ** | **Pro Forma  for the  Offering** | ** ** |
|---------------------------------------------------|------------|----------------|------------|---------------------------------------------------------|------------|--------------------------------------------|------------|
| **Assets**                                        |       |           |       |                                                    |       |                                       |       |
| Current assets:                                   |       |           |       |                                                    |       |                                       |       |
| Cash and cash equivalents                         |       | $              | 7,498      |                                                    | $          | 1,316                                      |       | $ | 8,814 |   |
| Inventories                                       |       | 59,044         |       |                                                    |       | 59,044                                     |       |
| Accounts receivable, net                          |       | 28,029         |       |                                                    |       | 28,029                                     |       |
| Income taxes receivable                           |       | 4,801          |       | 1,787                                                   |       | 6,588                                      |       |
| Prepaid expenses and other current assets         |       | 4,539          |       |                                                    |       | 4,539                                      |       |
| Deferred tax assets                               |       | 3,050          |       |                                                    |       | 3,050                                      |       |
| Total current  assets                             |       | 106,961        |       | 3,103                                                   |       | 110,064                                    |       |
| Property and  equipment, net                      |       | 18,655         |       |                                                    |       | 18,655                                     |       |
| Intangible  assets, net                           |       | 6,085          |       |                                                    |       | 6,085                                      |       |
| Deferred tax  assets                              |       | 1,523          |       |                                                    |       | 1,523                                      |       |
| Other assets                                      |       | 5,471          |       | (3,773                                                  | )          | 1,698                                      |       |
| Total assets                                      |       | $              | 138,695    |                                                    | $          | (670                                       | )          | $ | 138,025 |   |
| **Liabilities  and stockholders’ deficit**   |       |           |       |                                                    |       |                                       |       |
| Current  liabilities:                             |       |           |       |                                                    |       |                                       |       |
| Current portion of long-term debt                 |       | 17,963         |       |                                                    |       | 17,963                                     |       |
| Accounts payable                                  |       | 27,352         |       | (835                                                    | )          | 26,517                                     |       |
| Accrued liabilities                               |       | 19,361         |       | (6,858                                                  | )          | 12,503                                     |       |
| Accrued restructuring charges                     |       | 294            |       |                                                    |       | 294                                        |       |
| Total current  liabilities                        |       | 64,970         |       | (7,693                                                  | )          | 57,277                                     |       |
| Long-term  debt, less current portion             |       | 690,045        |       | (364,338                                                | )          | 325,707                                    |       |
| Deferred rent                                     |       | 2,782          |       |                                                    |       | 2,782                                      |       |
| Long-term  employee benefits                      |       | 477            |       |                                                    |       | 477                                        |       |
| Commitments and  contingencies                    |       |           |       |                                                    |       |                                       |       |
| Stockholders’  deficit:                      |       |           |       |                                                    |       |                                       |       |
| Common stock                                      |       | 71             |       | 18                                                      |       | 89                                         |       |
| Additional paid-in capital                        |       | 3,334          |       | 373,832                                                 |       | 377,166                                    |       |
| Accumulated  deficit                              |       | (622,984       | )          | (2,489                                                  | )          | (625,473                                   | )          |
| Total  stockholders’ deficit                 |       | (619,579       | )          | 371,361                                                 |       | (248,218                                   | )          |
| Total liabilities and  stockholders’ deficit |       | $              | 138,695    |                                                    | $          | (670                                       | )          | $ | 138,025 |   |

 

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**ITEM2.**      MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS

**Forward-LookingStatements**

This section and other parts of this Quarterly Reporton Form 10-Q contain forward-looking statements that involve risks anduncertainties. In some cases, forward-looking statements can be identified bywords 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 differsignificantly from the results discussed in the forward-looking statements.Factors that might cause such differences include, but are not limited to thosediscussed in Part II, Item 1A, “Risk Factors”. The following discussion shouldbe read in conjunction with our unaudited condensed interim financial statements and this Management’s Discussion andAnalysis of Financial Condition and Results of Operations should be read inconjunction with the financial statements and notes thereto for the year endedJanuary 1, 2006 and the related Management’s Discussion and Analysis of FinancialCondition and Results of Operations, both of which are contained in ourProspectus filed pursuant to Rule 424(b) under the Securities Act with theSecurities and Exchange Commission on September 29, 2006, and theunaudited condensed consolidated financial statements and notes theretoincluded elsewhere in this Quarterly Report on Form 10-Q. Unless requiredby law, we expressly disclaim any obligation to update publicly anyforward-looking statements, whether as result of new information, future eventsor otherwise.

## **ExecutiveOverview**

Founded in 1976,Bare Escentuals is one of the fastest growing prestige beauty companies in theU.S. and a leader by sales and consumer awareness in mineral-based cosmetics.We develop, market and sell branded cosmetics, skin care and body care productsunder our *i.d. bareMinerals, i.d.,RareMinerals*and namesake *BareEscentuals*brands, and professional skin care products under our *md formulations*brand.

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

Our business iscomprised of two strategic business units constituting reportable segments thatwe manage separately based on fundamental differences in their operations:

·                  Our retailsegment, which is characterized by sales directly to end users, includes ourinfomercials, which include sales through our website *www.bareminerals.com*, and company ownedboutiques, which include sales through our website *www.mdformulations.com*. We believe that our infomercialbusiness helps us to build brand awareness, communicate the benefits of ourcore products and establish a base of recurring revenue because a substantialpercentage of new consumers participate in our continuity program. Ourcompany-owned boutiques enhance our ability to build strong consumerrelationships and promote additional product use through personaldemonstrations and product consultations.

·                  Our wholesale segment, which ischaracterized by sales to resellers, includes premium wholesale; home shoppingtelevision; spas and salons; and international distributors. Our sales throughhome shopping television help us to build brand awareness, educate consumersthrough live product demonstrations and develop close connections with ourconsumers. We also sell to retailers that we believe feature our products insettings that support and reinforce our brand image and provide a premiumin-store experience. Similarly, our spa and salon customers provide aninformative and treatment-focused environment in which aestheticians and spaprofessionals can communicate the benefits of our core products. Finally, weprimarily sell our products in a number of international markets through anetwork of third-party distributors.

We manage ourbusiness segments to maximize sales growth and market share. We believe thatour multi-channel distribution strategy maximizes convenience for ourconsumers, reinforces brand awareness, increases consumer retention rates, anddrives corporate cash flow and profitability. Further, we believe that thebroad diversification within our segments provides us with expandedopportunities for growth and reduces our dependence on any single distributionchannel.  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.

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.’’

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## **Basis of Presentation**

We recognizerevenue when merchandise is shipped from a warehouse to wholesale customers(except in the case of our consignment sales to QVC), infomercial customers andinternet customers or when purchased by consumers at company-owned boutiques,each net of estimated returns. For our consignment sales to QVC, we recognizesales, net of estimated returns, upon QVC’s shipments to its customers. Werecognize postage and handling charges we bill to customers as revenue uponshipment of the related merchandise.

Our cost of goodssold consists of the costs associated with the sourcing of our products,including the cost of the product and associated manufacturing costs, inboundfreight charges, and internal transfer costs. Additionally, cost of goods soldincludes postage and handling costs incurred upon shipment of merchandise. Ourgross profit is dependent upon a variety of factors, including changes in therelative 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 to fluctuate from quarter toquarter. We anticipate that our cost of goods sold will increase in absolutedollars as we increase our total sales but will remain generally consistentwith historical periods on an annual basis as a percentage of net salesdepending on the mix of sales among our distribution channels.

Selling, generaland administrative 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 in fiscal year 2006 will increase inabsolute dollars compared to fiscal year 2005 and also may increase as apercentage of total sales as we expect to continue to invest in corporateinfrastructure and incur additional expenses associated with being a publiccompany, such as increased legal and accounting costs, investor relations costsand higher insurance premiums.

Depreciation andamortization includes charges for the depreciation of property and equipmentand the amortization of intangible assets. All of our intangible assets werefully amortized as of January 2, 2005. We anticipate that our depreciation andamortization expense will increase in absolute dollars in fiscal 2006 as wecontinue to open new boutiques and invest in information systems. We record ourdepreciation and amortization as a separate line item in our statement ofoperations because all such expense relates to selling, general andadministrative costs.

Stock-basedcompensation includes charges incurred in recognition of compensation expenseassociated with grants of stock options and stock purchases. On January 3, 2005we adopted the fair value recognition and measurement provisions of SFAS No.123(R), *Share-Based Payment*(SFAS123(R)). We record our stock-based compensation on a separate operating expenseline item in our statement of operations due to the fact that, to date, all ofour stock-based awards have been made to employees whose salaries areclassified as selling, general and administrative costs.

Interest expenseincludes interest costs associated with our credit facilities and theamortization of deferred financing costs associated with these creditfacilities. We anticipate that our interest expense in the future will decreasein absolute terms and as a percentage of net sales as a result of applying theproceeds from our initial public offering completed on October 4, 2006 to repaya portion of our outstanding indebtedness.

Provision forincome taxes depends on the statutory tax rates in the countries where we sellour products. 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. Ifwe continue to sell our products exclusively to customers located within theUnited States, we anticipate that our future effective tax rate will beapproximately 40% of our income before provision for income taxes. In the yearending December 31, 2006, we expect that our annual effective tax rate will beapproximately 41.0% to 41.5%.  Theanticipated reduction in the Company’s estimated effective tax rate from 41.8%for nine months ended October 1, 2006 to approximately 41.0% to 41.5% for theyear ending December 31, 2006, is primarily due to the decrease in thenon-deductible portion of the Company’s interest expense as a result of therepayment of a portion of our indebtedness from the proceeds of the Company’sinitial public offering, which is being recorded as a discrete item in thefourth fiscal quarter of the year.  Inaddition, we anticipate that in the future we may 

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start to sell our products directly to some customerslocated outside of the United States for international distribution, in whichcase we would become subject to taxation based on the foreign statutory ratesin the countries where these sales took place and our effective tax rate couldfluctuate accordingly.

In February 2005,we incurred approximately $224.5 million of new indebtedness, repaid a total of$92.6 million of existing debt and paid a special dividend to stockholders of$122.4 million.  In October 2005, weincurred approximately $187.5 million of new indebtedness and paid a specialdividend to stockholders of $183.5 million. In June 2006, we incurred approximately $331.6 million of newindebtedness and paid a special dividend to stockholders of $340.4million.  We refer to these transactionsas our February 2005 recapitalization, October 2005 recapitalization and June2006 recapitalization, respectively.

## **Resultsof Operations**

The following is adiscussion of our results of operations for the three months ended October 1,2006 compared to the three months ended October 2, 2005 and for the nine monthsended October 1, 2006 compared to the nine months ended October 2, 2005.

The followingtable sets forth condensed consolidated statements of operations for the threeand nine months ended October 1, 2006 and October 2, 2005:

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

 
| ** **                                | ** ** | **Three months ended**                      | ** ** | **Nine months ended** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                | ** ** | **October 1,  2006**                             | ** ** | **October 2,  2005**       | ** ** | **October 1,  2006** | ** ** | **October 2,  2005** | ** ** |
| ** **                                | ** ** | **(in thousands, except percentages)** | ** ** |
| Sales, net                                |       | $                                                     | 97,947     |                            | 100.0      | % | $ | 67,634 |   | 100.0 | % | $ | 284,047 |   | 100.0 | % | $ | 179,946 |   | 100.0 | % |
| Cost of goods  sold                       |       | 26,890                                                |       | 27.5                            |       | 19,308 |   | 28.5 |   | 79,023 |   | 27.8 |   | 50,498 |   | 28.1 |   |
| Gross profit                              |       | 71,057                                                |       | 72.5                            |       | 48,326 |   | 71.5 |   | 205,024 |   | 72.2 |   | 129,448 |   | 71.9 |   |
| Expenses:                                 |       |                                                  |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and administrative       |       | 34,467                                                |       | 35.2                            |       | 26,210 |   | 38.7 |   | 97,323 |   | 34.3 |   | 71,489 |   | 39.7 |   |
| Depreciation and amortization             |       | 552                                                   |       | 0.5                             |       | 324 |   | 0.5 |   | 1,523 |   | 0.5 |   | 676 |   | 0.4 |   |
| Stock-based compensation                  |       | 1,365                                                 |       | 1.4                             |       | 310 |   | 0.5 |   | 3,832 |   | 1.4 |   | 930 |   | 0.5 |   |
| Restructuring charges                     |       | 114                                                   |       | 0.1                             |       | 643 |   | 0.9 |   | 114 |   | 0.0 |   | 643 |   | 0.3 |   |
| Asset impairment charge                   |       | —                                                |       | 0.0                             |       | 1,055 |   | 1.6 |   | — |   | 0.0 |   | 1,055 |   | 0.6 |   |
| Operating income                          |       | 34,559                                                |       | 35.3                            |       | 19,784 |   | 29.3 |   | 102,232 |   | 36.0 |   | 54,655 |   | 30.4 |   |
| Interest expense,  net                    |       | (19,375                                               | )          | (19.8                           | )          | (4,273 | ) | (6.4 | ) | (40,614 | ) | (14.3 | ) | (12,576 | ) | (7.0 | ) |
| Debt  extinguishment costs                |       | —                                                |       | 0.0                             |       | — |   | 0.0 |   | (3,391 | ) | (1.2 | ) | (10,558 | ) | (5.9 | ) |
| Income before  provision for income taxes |       | 15,184                                                |       | 15.5                            |       | 15,511 |   | 22.9 |   | 58,227 |   | 20.5 |   | 31,521 |   | 17.5 |   |
| Provision for  income taxes               |       | 6,304                                                 |       | 6.4                             |       | 6,135 |   | 9.0 |   | 24,339 |   | 8.6 |   | 12,468 |   | 6.9 |   |
| Net income                                |       | $                                                     | 8,880      |                            | 9.1        | % | $ | 9,376 |   | 13.9 | % | $ | 33,888 |   | 11.9 | % | $ | 19,053 |   | 10.6 | % |

 

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Net sales bybusiness segment and distribution channel and percentage of net sales for thethree and nine months ended October 1, 2006 and the three and nine months endedOctober 2, 2005 are as follows:

 
| ** **               | ** ** | **Three Months Ended**                      | ** ** | **Nine Months Ended** | ** ** |
|--------------------------|------------|-------------------------------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **October 1,  2006**                             | ** ** | **October 2,  2005**       | ** ** | **October 1,  2006** | ** ** | **October 2,  2005** | ** ** |
| ** **               | ** ** | **(in thousands, except percentages)** | ** ** |
| Retail                   |       |                                                  |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Infomercial              |       | $                                                     | 33,418     |                            | 34.1       | % |   | $ | 25,295 |   | 37.4 | % |   | $ | 95,756 |   | 33.7 | % |   | $ | 70,298 |   | 39.1 | % |   |
| Boutiques                |       | 14,695                                                |       | 15.0                            |       |   | 8,708 |   | 12.9 |   |   | 38,974 |   | 13.7 |   |   | 24,636 |   | 13.7 |   |   |
| Total retail             |       | 48,113                                                |       | 49.1                            |       |   | 34,003 |   | 50.3 |   |   | 134,730 |   | 47.4 |   |   | 94,934 |   | 52.8 |   |   |
| Wholesale                |       |                                                  |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Premium wholesale        |       | 28,375                                                |       | 29.0                            |       |   | 14,467 |   | 21.4 |   |   | 77,280 |   | 27.2 |   |   | 31,047 |   | 17.2 |   |   |
| Home shopping television |       | 8,862                                                 |       | 9.1                             |       |   | 8,299 |   | 12.3 |   |   | 36,145 |   | 12.7 |   |   | 25,846 |   | 14.4 |   |   |
| Spas and salons          |       | 8,058                                                 |       | 8.2                             |       |   | 5,804 |   | 8.5 |   |   | 22,972 |   | 8.1 |   |   | 16,887 |   | 9.4 |   |   |
| International            |       | 4,539                                                 |       | 4.6                             |       |   | 5,061 |   | 7.5 |   |   | 12,920 |   | 4.6 |   |   | 11,232 |   | 6.2 |   |   |
| Total wholesale          |       | 49,834                                                |       | 50.9                            |       |   | 33,631 |   | 49.7 |   |   | 149,317 |   | 52.6 |   |   | 85,012 |   | 47.2 |   |   |
| Sales, net               |       | $                                                     | 97,947     |                            | 100.0      | % |   | $ | 67,634 |   | 100.0 | % |   | $ | 284,047 |   | 100.0 | % |   | $ | 179,946 |   | 100.0 | % |   |

 

Gross profit andgross margin by business segment for the three and nine months ended October 1,2006 and the three and nine months ended October 2, 2005 are as follows:
| ** **                 | ** ** | **Three Months Ended**                      | ** ** | **Nine Months Ended** | ** ** |
|----------------------------|------------|-------------------------------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **October 1,  2006**                             | ** ** | **October 2,  2005**       | ** ** | **October 1,  2006** | ** ** | **October 2,  2005** | ** ** |
| ** **                 | ** ** | **(in thousands, except percentages)** | ** ** |
| Retail                     |       | $                                                     | 39,095     |                            | 81.3       | % |   | $ | 26,274 |   | 77.3 | % |   | $ | 107,970 |   | 80.1 | % |   | $ | 73,568 |   | 77.5 | % |   |
| Wholesale                  |       | 31,962                                                |       | 64.1                            |       |   | 22,052 |   | 65.6 |   |   | 97,054 |   | 65.0 |   |   | 55,880 |   | 65.7 |   |   |
| Gross profit/gross  margin |       | $                                                     | 71,057     |                            | 72.5       | % |   | $ | 48,326 |   | 71.5 | % |   | $ | 205,024 |   | 72.2 | % |   | $ | 129,448 |   | 71.9 | % |   |

##### ** **

##### **Three months ended October 1, 2006 comparedto three months ended October 2, 2005**

##### **   Sales, net**

Net sales for thethree months ended October 1, 2006 increased to $97.9 million from $67.6million in the three months ended October 2, 2005, an increase of $30.3million, or 44.8%. 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.***Net retail sales increased41.5% to $48.1 million in the three months ended October 1, 2006 from $34.0million in the three months ended October 2, 2005. Net sales from infomercialsincreased 32.1% to $33.4 million in the three months ended October 1, 2006 from$25.3 million in the three months ended October 2, 2005, as a result ofincreased media spending and the growth of sales in our continuity program. Netsales from boutiques increased 68.8% to $14.7 million in the three months endedOctober 1, 2006 from $8.7 million in the three months ended October 2, 2005,due to improved productivity at our existing locations as well as a netincrease of three boutiques open as of October 1, 2006 compared to October 2,2005. As of October 1, 2006 and October 2, 2005, we had 29 and 26 open companyowned boutiques, respectively.

***Wholesale.***Net wholesale sales increased 48.2% to $49.8 million in the three months endedOctober 1, 2006 from $33.6 million in the three months ended October 2, 2005.Net sales in our premium wholesale channel increased 96.1% to $28.4 million inthe three months ended October 1, 2006 from $14.5 million in the three monthsended October 2, 2005, resulting from strong consumer demand and expansion intoadditional retail locations at Sephora and Ulta. Net sales to our home shoppingtelevision customer grew by 6.8% to $8.9 million in the three months endedOctober 1, 2006 from $8.3 million in the three months ended October 2, 2005, asa result of increased sales of our products through QVC’s website, catalogs andcontinuity programs. Net sales to spas and salons increased 38.8% to $8.1million in the three months ended October 1, 2006 from $5.8 million in thethree months ended October 2, 2005, largely due to the continued growth insales of our core i.d. bareMinerals cosmetics line in this channel in which oursales historically had been concentrated in sales of our md formulations products.Net sales to our international distributors decreased by 10.3% to $4.5 millionin the three months ended October 1, 2006 from $5.1 million in the three monthsended October 2, 2005, primarily as a result of our focus on developing newbusinesses in key markets instead of growth through our existing distributionbase and the timing of shipments to one customer in the three months endedOctober 2, 2005.

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##### **   Grossprofit**

Gross profitincreased 47.0% to $71.1 million in the three months ended October 1, 2006 from$48.3 million in the three months ended October 2, 2005. Our retail segmentgross profit increased 48.8% to $39.1 million in the three months ended October1, 2006 from $26.3 million in the three months ended October 2, 2005, drivenprincipally by growth in our infomercial and boutiques sales channels. Ourwholesale segment gross profit increased 44.9% to $32.0 million in the threemonths ended October 1, 2006 from $22.1 million in the three months endedOctober 2, 2005, due to increases in sales across all wholesale distributionchannels.

Gross marginincreased approximately 1.0% to 72.5% in the three months ended October 1, 2006from 71.5% in the three months ended October 2, 2005. This overall increase inthe three months ended October 1, 2006 is primarily due to an increase in grossmargins in the retail segment offset in part by a decrease in gross margins inthe wholesale segment. Within the retail segment, gross margin increased to81.3% in the three months ended October 1, 2006 from 77.3% in the three monthsended October 2, 2005, primarily as a result of a change in the mix of productssold. Within the wholesale segment, gross margin decreased to 64.1% in thethree months ended October 1, 2006 from 65.6% in the three months ended October2, 2005, primarily as a result of a change in sales between channels andcustomers.

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

Selling, generaland administrative expenses increased 31.5% to $34.5 million in the threemonths ended October 1, 2006 from $26.2 million in the three months endedOctober 2, 2005. The increase was primarily due to a significant increase ininvestment in our corporate infrastructure of $3.4 million, including increasedheadcount costs, headquarters facilities costs, distribution center costs andother corporate costs, as well as increased expenses to support sales growth,including $1.0 million in increased fulfillment expenses and $1.4 million inincreased media spending. As a percentage of net sales, selling, general andadministrative expenses decreased 3.5% to 35.2% from 38.7%. This decrease inthe three months ended October 1, 2006 is primarily due to wholesale segmentsales, which have lower expenses as a percentage of net sales than retailsegment sales, comprising a larger percentage of total net sales compared tothe three months ended October 2, 2005.. Wholesale segment sales have increasedby 48.2% compared to a 35.7% decrease in selling, general and administrativecosts. The decrease in costs was mainly due to a decrease in advertising costsof $0.5 million and a decrease in third party fulfillment costs of $0.4 millionas the company moved its wholesale fulfillment operations to its company ownedfacility.

##### **   Depreciationand amortization**

Depreciation andamortization expenses increased 70.4% to $0.6 million in the three months endedOctober 1, 2006 from $0.3 million in the three months ended October 2, 2005.This increase was primarily attributable to higher depreciation expense as aresult of an increase in capital expenditures.

##### **   Stock-basedcompensation**

Stock-basedcompensation expense increased 340.3% to $1.4 million in the three months endedOctober 1, 2006 from $0.3 million in the three months ended October 2, 2005.This increase resulted from the granting of additional stock options and theimpact of option modifications (as to exercise price and term) in connectionwith the February 2005, October 2005 and June 2006 recapitalizations.

##### **   Restructuringcharges**

Restructuringcharges decreased 82.3% to $0.1 million in the three months ended October 1,2006 from $0.6 million in the three months ended October 2, 2005.  The decrease resulted from the discontinueduse of one of our office floors located at our former corporate facility in thethree months ended October 1, 2006 compared with exit activities to relocateboth our corporate headquarters and distribution center facilities in the threemonths ended October 2, 2005.

##### **   Assetimpairment charge**

During the three****months ended October 2, 2005, we abandoned a contract witha software vendor and recorded an impairment charge of $1.1 million.

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##### **   Operatingincome**

Operating incomeincreased 74.7% to $34.6 million in the three months ended October 1, 2006 from$19.8 million in the three months ended October 2, 2005. This increase waslargely due to increases in operating income in both our retail and wholesalesegments, reflecting growth across all sales channels, partially offset by anincreased operating loss in our corporate segment.

 Our retail segment operating income increased61.3% to $18.1 million in the three months ended October 1, 2006 from $11.2million in the three months ended October 2, 2005, which was largely driven bygrowth in all of our retail sales channels. Our increased sales in the retailsegment contributed to an increase in gross profit of $12.8 million which waspartially offset by an increase in operating expenses of $5.9 million. Theincrease in operating expenses was largely due to increased store operatingcosts of $2.3 million as a result of an increase in the number of boutiquesopen as of October 1, 2006, $1.3 million of increased fulfillment costs due toincreased sales and $1.4 million in increased media spending.

Our wholesalesegment operating income increased 56.8% to $30.1 million in the three monthsended October 1, 2006 from $19.2 million in the three months ended October 2,2005, due to increased sales gains across all wholesale sales channels. Ourincreased sales in the wholesale segment contributed to an increase in grossprofit of $9.9 million and a decrease in operating expense of $1.0 million.

Our corporatesegment operating loss increased 28.4% to $13.7 million in the three monthsended October 1, 2006 from $10.7 million in the three months ended October 2,2005. This increase was largely due to an increase in corporate segmentselling, general and administrative expense of $3.4 million, an increase indepreciation and amortization of $0.1 million and stock-based compensation of$1.1 million, offset by a decrease in restructuring charges of $0.5 million anda decrease in asset impairment charges of $1.1 million. The increase incorporate selling, general and administrative expense was as a result of theincrease in the investment in our corporate infrastructure.

##### **   Interestexpense**

Interest expenseincreased 355.2% to $19.7 million in the three months ended October 1, 2006from $4.3 million in the three months ended October 2, 2005. The increase wasattributable to increased debt balances in the three months ended October 1,2006, primarily associated with our October 2005 and June 2006recapitalizations.

##### **   Interestincome**

Interest incomeincreased to $0.3 million in the three months ended October 1, 2006 from $0.06million in the three months ended October 2, 2005. The increase was primarilydue to an increase in interest rates on our cash balances and higher averagecash balances compared with the three months ended October 2, 2005.

##### **   Provisionfor income taxes**

The provision forincome taxes was $6.3 million, or 41.5% of income before provision for incometaxes, in the three months ended October 1, 2006 compared to $6.1 million, or39.6% of income before provision for income taxes, in the three months endedOctober 2, 2005. The increase resulted from higher income before provision forincome taxes and a higher effective rate in the three months ended October 1,2006 compared to the three months ended October 2, 2005. The increase in theeffective rate was mainly due to an increase in the non-deductible portion ofour interest expense in the three months ended October 1, 2006.

##### **Nine months ended October 1, 2006 compared tonine months ended October 2, 2005**

##### **   Sales,net**

Net sales for thenine months ended October 1, 2006 increased to $284.0 million from $179.9million in the nine months ended October 2, 2005, an increase of $104.1million, or 57.9%. 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.***Net retail sales increased41.9% to $134.7 million in the nine months ended October 1, 2006 from $94.9million in 

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the nine months ended October 2, 2005. Net sales frominfomercials increased 36.2% to $95.8 million in the nine months ended October1, 2006 from $70.3 million in the nine months ended October 2, 2005, as aresult of increased media spending and the growth of sales in our continuityprogram. Net sales from boutiques increased 58.2% to $39.0 million in the ninemonths ended October 1, 2006 from $24.6 million in the nine months endedOctober 2, 2005, due to improved productivity at our existing locations as wellas a net increase of 3 boutiques open as of October 1, 2006 compared to October2, 2005. As of October 1, 2006 and October 2, 2005, we had 29 and 26 open companyowned boutiques, respectively.

***Wholesale.***Net wholesale salesincreased 75.6% to $149.3 million in the nine months ended October 1, 2006 from$85.0 million in the nine months ended October 2, 2005. Net sales in ourpremium wholesale channel increased 148.9% to $77.3 million in the nine monthsended October 1, 2006 from $31.0 million in the nine months ended October 2,2005, resulting from strong consumer demand and expansion into additionalretail locations at Sephora and Ulta. Net sales to our home shopping televisioncustomer grew by 39.8% to $36.1 million in the nine months ended October 1,2006 from $25.8 million in the nine months ended October 2, 2005, as a resultof increased sales of our products through QVC’s website, catalogs andcontinuity programs. Net sales to spas and salons increased 36.0% to $23.0million in the nine months ended October 1, 2006 from $16.9 million in the ninemonths ended October 2, 2005, largely due to the continued growth in sales ofour core *i.d. bareMinerals*cosmeticsline in this channel in which our sales historically had been concentrated insales of our *md formulations*products.Net sales to our international distributors grew by 15.0% to $12.9 million inthe nine months ended October 1, 2006 from $11.2 million in the nine monthsended October 2, 2005, primarily as a result of the increased penetration ofour *i.d. bareMinerals*cosmeticsline into this distribution channel.

##### **   Grossprofit**

Gross profitincreased 58.4% to $205.0 million in the nine months ended October 1, 2006 from$129.4 million in the nine months ended October 2, 2005. Our retail segmentgross profit increased 46.8% to $108.0 million in the nine months ended October1, 2006 from $73.6 million in the nine months ended October 2, 2005, drivenprincipally by growth in our infomercial and boutiques sales channels. Ourwholesale segment gross profit increased 73.7% to $97.1 million in the ninemonths ended October 1, 2006 from $55.9 million in the nine months endedOctober 2, 2005, due to increases in sales across all wholesale distributionchannels.

Gross marginincreased approximately 0.3% to 72.2% from 71.9% in the nine months endedOctober 1, 2006. This overall increase in the nine months ended October 1, 2006is primarily due to increases in gross margin in the retail segment offset inpart by  wholesale segment sales, whichhave lower gross margins than retail segment sales, comprising a largerpercentage of total net sales compared to the nine months ended October 2,2005.  In the retail segment, grossmargin increased to 80.1% in the nine months ended October 1, 2006 from 77.5%in the nine months ended October 2, 2005, primarily as a result of a change inthe mix of products sold. Wholesale segment sales increased to 52.6% of totalnet sales in the nine months ended October 1, 2006 from 47.2% in the ninemonths ended October 2, 2005. Within the wholesale segment, gross margindecreased to 65.0% in the nine months ended October 1, 2006 from 65.7% in thenine months ended October 2, 2005, primarily as a result of increased freightcosts incurred to ensure product availability to meet increased demand inpremium wholesale.

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

Selling, generaland administrative expenses increased 36.1% to $97.3 million in the nine monthsended October 1, 2006 from $71.5 million in the nine months ended October 2,2005. The increase was primarily due to a significant increase in investment inour corporate infrastructure of $11.7 million, including increased headcountcosts, headquarters facilities costs, distribution center costs and othercorporate costs, as well as increased expenses to support sales growth,including $4.0 million in increased fulfillment expenses, $3.1 million inincreased media spending and $1.0 million in increased other advertisingexpenses. As a percentage of net sales, selling, general and administrativeexpenses decreased 5.4% to 34.3% from 39.7%. This decrease in the nine months ended October 1, 2006 is primarily dueto wholesale segment sales, which have lower expenses as a percentage of netsales than retail segment sales, comprising a larger percentage of total netsales compared to the nine months ended October 2, 2005. This decrease waspartially offset by investments in our corporate infrastructure to support ourgrowth across all distribution channels.

##### **   Depreciationand amortization**

Depreciation andamortization expenses increased 125.3% to $1.5 million in the nine months endedOctober 1, 2006 from $0.7 million in the nine months ended October 2, 2005.This increase was primarily attributable to higher depreciation expense as aresult of an increase in capital expenditures.

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##### **   Stock-basedcompensation**

Stock-basedcompensation expense increased 312.0% to $3.8 million in the nine months endedOctober 1, 2006 from $0.9 million in the nine months ended October 2, 2005.This increase resulted from the additional granting of stock options and theimpact of option modifications (as to exercise price and term) in connectionwith the February 2005, October 2005 and June 2006 recapitalizations.

##### **   Restructuringcharges**

Restructuringcharges decreased 82.3% to $0.1 million in the nine months ended October 1,2006 from $0.6 million in the nine months ended October 2, 2005.  The decrease resulted from the discontinueduse of one of our office floors located at our former corporate facility in thenine months ended October 1, 2006 compared with exit activities to relocateboth our corporate headquarters and distribution center facilities in the ninemonths ended October 2, 2005.

##### **   Assetimpairment charge**

During the ninemonths ended October 2, 2005, we abandoned a contract with a software vendorand recorded an impairment charge of $1.1 million.  The costs associated with the termination ofthe software vendor contract relate primarily to the cost of the softwarelicense arrangement and related fees that were accounted for as construction inprogress, as the software had not been placed into service.

##### **   Operatingincome**

Operating incomeincreased 87.0% to $102.2 million in the nine months ended October 1, 2006 from$54.7 million in the nine months ended October 2, 2005. This increase waslargely due to increases in operating income in both our retail and wholesalesegments, reflecting growth across all sales channels, partially offset by anincreased operating loss in our corporate segment.

Our retail segmentoperating income increased 66.7% to $48.2 million in the nine months endedOctober 1, 2006 from $28.9 million in the nine months ended October 2, 2005,which was largely driven by growth in all of our retail sales channels. Ourincreased sales in the retail segment contributed to an increase in grossprofit of $34.4 million which was partially offset by an increase in operatingexpenses of $15.1 million. The increase in operating expenses was largely dueto increased store operating costs of $5.9 million as a result of an increasein the number of boutiques open as of October 1, 2006, $4.0 million ofincreased fulfillment costs due to increased sales and $3.1 million inincreased media spending.

Our wholesalesegment operating income increased 86.0% to $90.7 million in the nine monthsended October 1, 2006 from $48.8 million in the nine months ended October 2,2005, due to increased sales gains across all wholesale sales channels. Ourincreased sales in the wholesale segment contributed to an increase in grossprofit of $41.2 million and a decrease in operating expenses of $0.8 million.

Our corporatesegment operating loss increased 59.2% to $36.7 million in the nine monthsended October 1, 2006 from $23.0 million in the nine months ended October 2,2005. This increase was largely due to the increase in the corporate segmentselling, general and administrative expense of $11.7 million, an increase indepreciation and amortization of $0.6 million and stock-based compensation of$2.9 million, offset by a decrease in restructuring charges of $0.5 million anda decrease in asset impairment charges of $1.1 million. The increase incorporate selling, general and administrative expense was as a result of theincrease in the investment in our corporate infrastructure.

##### **   Interestexpense**

Interest expenseincreased 228.9% to $41.6 million in the nine months ended October 1, 2006 from$12.6 million in the nine months ended October 2, 2005. The increase wasattributable to increased debt balances in the nine months ended October 1,2006, primarily associated with our October 2005 and June 2006recapitalizations.

##### **   Debtextinguishment costs**

Debtextinguishment costs decreased to $3.4 million in the nine months ended October1, 2006 from $10.6 million in the nine months ended October 2, 2005. The chargefor the nine months ended October 1, 2006 related to our June 2006recapitalization and included $0.9 million related to the write-off of deferredfinancing fees and $2.5 million of fees paid directly to the lender under thenew debt that were expensed as debt extinguishment costs. The charge for thenine months 

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ended October 2, 2005 related to the February 2005recapitalization and included $5.5 million related to the write-off of deferredfinancing fees and a prepayment penalty of $2.7 million for our prior creditfacilities and $2.4 million of fees paid directly to the lender under the newdebt that was expensed as debt extinguishment costs.

##### **   Interestincome**

Interest incomeincreased to $1.0 million in the nine months ended October 1, 2006 from $0.1million in the nine months ended October 2, 2005. The increase was primarilydue to an increase in interest rates on our cash balances and higher averagecash balances compared with the nine months ended October 2, 2005.

##### **   Provisionfor income taxes**

The provision forincome taxes was $24.3 million, or 41.8% of income before provision for incometaxes, in the nine months ended October 1, 2006 compared to $12.5 million, or39.6% of income before provision for income taxes, in the nine months endedOctober 2, 2005. The increase resulted from higher income before provision forincome taxes and a higher effective rate in the nine months ended October 1,2006 compared to the nine months ended October 2, 2005. The increase in the effectiverate was mainly due to an increase in the non-deductible portion of ourinterest expense in the nine months ended October 1, 2006.

# **   Seasonality**

Because ourproducts are largely purchased for individual use and are consumable in nature,we are not subject to significant seasonal variances in sales. However,fluctuations in sales and operating income in any fiscal quarter may be affectedby the timing of wholesale shipments, home shopping television appearances andother promotional events. While we believe our overall business is notcurrently subject to significant seasonal fluctuations, we have experiencedlimited seasonality in our premium wholesale and company-owned boutiquechannels as a result of increased demand for our products in anticipation ofand during the holiday season. To the extent our sales to specialty beautyretailers and through our boutiques increase as a percentage of our net sales,we may experience increased seasonality.

## **Liquidityand Capital Resources**

Our primaryliquidity and capital resource needs are to service our debt, finance workingcapital needs and fund ongoing capital expenditures. We have financed our operationsthrough cash flows from operations, private sales of common stock, borrowingsunder our credit facilities and issuances of senior subordinated notes.

Our operationsprovided us cash of $18.8 million in the nine months ended October 1, 2006. AtOctober 1, 2006, we had working capital of $42.0 million, including cash andcash equivalents of $7.5 million, compared to working capital of $34.7 million,including $18.7 million in cash and cash equivalents, as of January 1, 2006.The $11.2 million decrease in cash and cash equivalents resulted from cash usedin investment activities of $10.4 million related primarily to capitalexpenditures, together with cash used in financing activities of $19.6 million,partially offset by cash provided by operations of $18.8 million, as a resultof net income for the nine months ended October 1, 2006 of $33.9 million. The$7.3 million increase in working capital was primarily driven by increases inprepaid income taxes, accounts receivable and inventory, partially offset by anincrease in accounts payable and the current portion of long-term debt.

Net cash used ininvesting activities was $10.4 million in the nine months ended October 1,2006, primarily attributable to the opening of six new retail boutiques andinvestment in our corporation infrastructure. Our future capital expenditureswill depend on the timing and rate of expansion of our businesses, informationtechnology investments, new store openings, store renovations and internationalexpansion opportunities.

We used cash of$19.6 million for financing activities in the nine months ended October 1,2006, which related to our June 2006 recapitalization and repayments of $12.1million of senior term loans and payment of $2.6 million of offering costs,partially offset by $1.6 million from the sale of common stock and the exerciseof stock options and an excess tax benefit of $7.5 million relating to stockoption exercises. In connection with our June 2006 recapitalization, wereceived gross proceeds of $331.6 million from amendments to our senior termloans and the issuance of senior subordinated notes and paid $4.1 million indebt issuance costs. We used these net proceeds plus additional cash to paydividends totaling $340.4 million to the holders of our common stock.

In connection withour June 2006 recapitalization, we amended our senior secured credit facilitiesand increased our term 

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loan borrowings under these credit facilities by anadditional $206.6 million, and increased the amount available under ourrevolving loan facility to $25.0 million. Also as part of our June 2006 recapitalization, we issued 15% seniorsubordinated notes in the aggregate principal amount of $125.0 million, whichnotes mature on June 7, 2014. Until such maturity, interest on the notes ispayable, at our election, in cash or through the issuance of payments-in-kind,or PIK, notes on a quarterly basis. Until payment in full of the senior securedloans, we may not make cash interest payments on the 15% senior subordinatednotes. We used the proceeds of the additional term loans and the note issuanceto pay a dividend in the aggregate amount of $340.4 million to the holders ofour common stock and pay transaction costs in connection with thisrecapitalization.

Our amended seniorsecured credit facilities provided a total of $618.3 million in debt financing,consisting of:

·      A$25.0 million revolving credit facility (under which no borrowings areoutstanding);

·      Anaggregate of $359.3 million first-lien term loans; and

·      An aggregate of $234.0 million second-lienterm loans.

In September 2006,we amended our senior secured credit facilities to permit the issuance of up to$135.0 million in additional first-lien term loans. The revolving creditfacility and the first-lien term loan bear interest at a rate equal to, at ouroption, either LIBOR or the lender’s base rate, plus an applicable variablemargin based on our consolidated total leverage ratio. The current applicableinterest margin for the revolving credit facility and first-lien term loanranges from 2.5% to 2.75% for LIBOR loans and from 1.5% to 1.75% for base rateloans. Borrowings on the second-lien term loan generally bear interest at arate equal to, at our option, either 7.0% over LIBOR or 6.0% over the lender’sbase rate. As of October 1, 2006, interest on the first-lien term loan and thesecond-lien term loan was accruing at 8.08% and 14.25%, respectively.

The facilities aresecured by substantially all of our assets. Our revolving credit facilitymatures in 2011, our first-lien term loan facility matures in 2012 and oursecond-lien term loan facility matures in 2013. The revolving facility also provides for the issuance of letters ofcredit. Allocation of the revolving facility to such letters of credit willreduce the amounts available under the facility.  The terms of our senior secured creditfacilities require us to comply with financial covenants, including maintainingleverage and cash interest coverage ratios. Our maximum leverage ratio willbecome more restrictive over the term of the secured credit facility.

Additionally, asof October 2, 2007, we also must enter into interest rate swap or similaragreements with respect to 40% of the principal amounts outstanding under oursenior secured credit facilities as of such date, unless we satisfy specifiedcoverage ratio tests. Currently, we do not engage or intend to engage in anyhedging activities. If we fail to comply with any of the financial covenants,the lenders may declare an event of default under the secured credit facility.An event of default resulting from a breach of a financial covenant may result,at the option of lenders holding a majority of the loans, in an acceleration ofrepayment of the principal and interest outstanding and a termination of the revolvingcredit facility. The secured credit facility also contains non-financialcovenants that restrict some of our activities, including our ability todispose 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 were in compliancewith these covenants as of October 1, 2006.

Subject tospecified exceptions, including for investment of proceeds in the case of assetsale proceeds or, in the case of equity issuance proceeds, for prepayment ofour 15.0% senior subordinated notes (to the extent permitted under the seniorsecured credit facilities) and for permitted equity contributions for capitalexpenditures, we are required to prepay outstanding loans under our amendedsenior secured credit facilities with the net proceeds of certain assetdispositions, condemnation settlements and insurance settlements from casualtylosses, issuances of certain equity (including the proceeds of the offeringcompleted on October 4, 2006), issuances of certain debt and a portion ofexcess cash flow. We are not required to pay a prepayment premium in the eventof a prepayment following an issuance of equity.

On June 30, 2006,we filed a Registration Statement on Form S-1 (File No. 333-135484) with theSecurities and Exchange Commission for an initial public offering of our commonstock. As amended, the Registration Statement provided for the sale of 16.0million shares of our common stock. In addition, we granted the underwritersthe right to purchase up to an additional 2.4 million shares to coverover-allotments. The over-allotment was exercised on September 29, 2006 by theunderwriters. The public offering closed on October 4, 2006. We receivedapproximately $373.9 million in net proceeds from the offering, of which $372.5million was used to repay all outstanding principal and interest owed on thesubordinated notes and the second lien loan and a portion of the outstandingprincipal on the first lien loan under our secured credit facility.

# **Liquiditysources, requirements and contractual cash requirement and commitments**

We believe thatcash flow from operations and cash on hand will provide adequate funds for ourforeseeable working 

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capital needs, and planned capital expenditures. Aspart of our strategy, we intend to invest in making significant improvements toour systems. We also intend to open seven new boutiques in 2006 (of which sixwere open as of October 1, 2006) and ten new boutiques in 2007, which willrequire additional capital expenditures. Finally, we also plan to continue toinvest in our corporate infrastructure facilities. We anticipate that ourcapital expenditures in the years ending December 31, 2006 and December 30,2007 will be approximately $12.5 million and $15.0 million, respectively. Therecan be no assurance that any such capital will be available on acceptable termsor at all. Our ability to fund our working capital needs, planned capitalexpenditures and scheduled debt payments, as well as to comply with all of thefinancial covenants under our debt agreements, depends on our future operatingperformance and cash flow, which in turn are subject to prevailing economicconditions and to financial, business and other factors, some of which arebeyond our control.

# **Contractualcommitments**

We lease retailstores, warehouses, corporate offices and certain equipment under noncancelableoperating leases with various expiration dates through June 2017. As of October1, 2006, the scheduled maturities of our long-term contractual obligations wereas follows: 
| ** **                                      | ** ** | **Remainder of  the year  ending** | ** ** | ** **                 | ** ** | ** **                 | ** ** | ** **              | ** ** | ** ** | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|----------------------------|------------|----------------------------|------------|-------------------------|------------|------------|------------|
| ** **                                      | ** ** | **December 31,  2006**                  | ** ** | **1 - 3  Years** | ** ** | **4 - 5  Years** | ** ** | **After 5  Years** | ** ** | **Total**  | ** ** |
| ** **                                      | ** ** | **(amounts in millions)**          | ** ** |
| Operating  leases, net of sublease income       |       | $                                            | 0.7        |                       | $          | 13.9                       |       | $                       | 8.5        |       | $          | 15.9 |   | $ | 39.0 |   |
| Long-term debt,  including the current portion  |       | 4.5                                          |       | 53.9                       |       | 224.5                      |       | 426.4                   |       | 709.3      |       |
| Minimum  royalties under licensing arrangements |       | —                                       |       | 1.2                        |       | —                     |       | —                  |       | 1.2        | ** ** |
| Total                                           |       | $                                            | 5.2        |                       | $          | 69.0                       |       | $                       | 233.0      |       | $          | 442.3 |   | $ | 749.5 |   |

 

We are also partyto a sublicense agreement for use of certain patents associated with certain ofour mineral-based skin care products. The agreement requires that we pay aquarterly royalty of 3.5% of the net sales of these skin care products up tothe date of the last to expire licensed patent rights. This sublicense alsorequires minimum royalty annual royalty payments of approximately $0.6 millionfor 2006 and thereafter. The minimum annual royalty payments have not beenincluded in the schedule of long-term contractual obligations above as we canterminate the agreement at any time with nine months written notice.

In addition, theschedule of long-term contractual obligations above does not include theapplication of the net proceeds from our initial public offering completed onOctober 4, 2006, of which $365.6 million was used to repay our principaloutstanding indebtedness, leaving us with $343.7 million of debt as of October4, 2006.

# **Off-balance-sheetarrangements**

We do not have anyoff-balance-sheet financing or unconsolidated special purpose entities.

# **Effectsof inflation**

Our monetaryassets, consisting primarily of cash and receivables, are not significantlyaffected by inflation because they are short-term in nature. Our non-monetaryassets, consisting primarily of inventory, intangible assets, goodwill andprepaid expenses and other assets, are not currently affected significantly byinflation. We believe that replacement costs of equipment, furniture andleasehold improvements will not materially affect our operations. However, therate of inflation affects our cost of goods sold and expenses, such as thosefor employee compensation, which may not be readily recoverable in the price ofthe products offered by us.

In addition, aninflationary environment could materially increase the interest rates on ourdebt.

## **Non-GAAPMeasures**

In evaluating ourbusiness, we consider and use Adjusted EBITDA as a supplemental measure of ouroperating performance. We use EBITDA only to assist in reconciliation toAdjusted EBITDA.  We define EBITDA as netincome before net interest expense, provision for income taxes, depreciationand amortization. We define Adjusted EBITDA as EBITDA plus expenses (minusgains) that we do not consider reflective of our ongoing operations. We useAdjusted EBITDA as a 

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supplemental measure to review and assess ouroperating performance, to measure our performance when determining managementbonuses and also as a key profitability measure for covenant compliance underour senior secured credit facilities. If we fail to maintain required levels ofAdjusted EBITDA, we could have a default under our senior secured creditfacilities, potentially resulting in an acceleration of all of our outstandingindebtedness.  All of the adjustmentsmade in our calculation of Adjusted EBITDA, as described below, are adjustmentsthat would be made in calculating our performance for purposes of coverageratios under our senior secured credit facilities. In prior periods, we used anadjusted EBITDA calculation for internal purposes and for calculation ofcompliance with coverage ratios that incorporated additional adjustments notincluded in our calculation of Adjusted EBITDA. We also believe use of AdjustedEBITDA facilitates investors’ use of operating performance comparisons fromperiod to period and company to company by backing out potential differencescaused by variations in capital structures (affecting relative interestexpense, including the impact of write-offs of deferred financing costs whencompanies refinance their indebtedness), the book amortization of intangibles(affecting relative amortization expense) and the age and book value offacilities and equipment (affecting relative depreciation expense). We alsopresent Adjusted EBITDA because we believe it is frequently used by securitiesanalysts, 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:

·                  EBITDA andAdjusted EBITDA do not reflect our cash expenditures or future requirements forcapital expenditures or contractual commitments;

·                  they do notreflect changes in, or cash requirements for, our working capital needs;

·                  they do notreflect the significant interest expense, or the cash requirements necessary toservice interest or principal payments, on our debt;

·                  they do notreflect 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

·                  other companies may calculate EBITDAand Adjusted EBITDA differently than we do, limiting their usefulness ascomparative measures.

We compensate forthese limitations by relying primarily on our GAAP results and using AdjustedEBITDA only supplementally. EBITDA and Adjusted EBITDA are calculated asfollows for the periods presented:
|                                     | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                          | ** ** | **October 1,  2006**        | ** ** | **October 2,  2005**       | ** ** | **October 1,  2006** | ** ** | **October 2,  2005** | ** ** |
| ** **                          | ** ** | **(in thousands)**          | ** ** |
| **Net  income**                     |       | $                                | 8,880      |                            | $          | 9,376 |   | $ | 33,888 |   | $ | 19,053 |   |
| Plus: interest expense              |       | 19,723                           |       | 4,333                           |       | 41,593 |   | 12,646 |   |
| Less: interest income               |       | (348                             | )          | (60                             | )          | (979 | ) | (70 | ) |
| Plus: depreciation and amortization |       | 552                              |       | 324                             |       | 1,523 |   | 676 |   |
| Plus: provision for income taxes    |       | 6,304                            |       | 6,135                           |       | 24,339 |   | 12,468 |   |
| **EBITDA**                          |       | 35,111                           |       | 20,108                          |       | 100,364 |   | 44,773 |   |
| Plus: debt extinguishment costs(1)  |       | —                           |       | —                          |       | 3,391 |   | 10,558 |   |
| Plus: management fees(2)            |       | 150                              |       | 150                             |       | 450 |   | 450 |   |
| Plus: restructuring charges(3)      |       | 114                              |       | 643                             |       | 114 |   | 643 |   |
| Plus: asset impairment charge(4)    |       | —                           |       | 1,055                           |       | — |   | 1,055 |   |
| Plus: stock-based compensation(5)   |       | 1,365                            |       | 310                             |       | 3,832 |   | 930 |   |
| **Adjusted EBITDA**                 |       | $                                | 36,740     |                            | $          | 22,266 |   | $ | 108,151 |   | $ | 58,409 |   |

 

(1)        During thenine 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.  During the nine months ended October 2, 2005,we incurred debt extinguishment costs of $10.6 million related to the earlyextinguishment of our previously outstanding debt in connection with ourFebruary 2005 recapitalization.

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(2)        Wepaid transaction fees and monthly management fees to Berkshire Partners LLC andJH Partners, LLC under management agreements that were terminated uponcompletion of our initial public offering on October 4, 2006.  We paid an aggregate of $1.8 million toBerkshire Partners LLC and JH Partners, LLC as consideration for termination ofthese 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.  In connection with therelocations of both of our corporate headquarters and distribution center facilitiesduring the three and nine months ended October 2, 2005, we recorded a charge of$0.6 million which primarily reflects the sum of the future lease payments duefor these facilities, net of estimated sublease income.

(4)        Duringthe three and nine months ended October 2, 2005, we abandoned a contract with asoftware vendor and recorded an impairment charge of $1.1 million.

(5)        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 andEstimates**

The preparation of financial statements in conformitywith U.S. generally accepted accounting principles requires management to makeestimates and assumptions. Predicting future events is inherently an impreciseactivity and, as such, requires the use of judgment. Actual results may varyfrom estimates 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..  Ourcritical accounting policies and estimates are discussed in our recently filedRegistration Statement on Form S-1 (File No. 333-135484).

# **NewAccounting Standards**

In June 2006, theFASB ratified the consensus reached on Emerging Issues Task Force IssueNo. 06-03, *How Sales Taxes Collected from Customers andRemitted to Governmental Authorities Should Be Presented in the IncomeStatement (That is, Gross Versus Net Presentation)*. The EITF reacheda consensus that the presentation of taxes on either a gross or net basis is anaccounting policy decision that requires disclosure. EITF 06-03 is effectivefor the first interim or annual reporting period beginning afterDecember 15, 2006. The Company does not intend to modify its currentaccounting policy of recording sales tax collected on a net basis. Therefore,the adoption of EITF 06-03 will not have any effect on the Company’s financialposition or results of operations.

In July 2006, theFASB issued Interpretation No. 48, *Accountingfor Income Tax Uncertainties*(‘‘FIN 48’’). FIN 48 defines thethreshold for recognizing the benefits of tax return positions in the financialstatements as ‘‘more-likely-than-not’’ to be sustained. FIN 48 also providesguidance on the derecognition, measurement and classification of income taxuncertainties, along with any related interest and penalties. FIN 48 alsoincludes guidance concerning accounting for income tax uncertainties in interimperiods and increases the level of disclosures associated with any recordedincome tax uncertainties. FIN 48 is effective for fiscal years beginning afterDecember 15, 2006. The differences between the amounts recognized in thestatements of financial position prior to the adoption of FIN 48 and theamounts reported after adoption will be accounted for as a cumulative effectadjustment recorded to the beginning balance of retained earnings. The Companyis currently in the process of determining the impact, if any, of adopting theprovisions of FIN 48 on its financial position and results of operations. TheCompany will adopt FIN 48 on January 1, 2007.

 InSeptember 2006, the FASB issued SFAS No. 157*, Fair ValueMeasurements*.  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 value measurements,but does not require any new fair value measurements. The provisions ofStatement 157 are effective for fiscal years beginning after November 15,2007.  The Company will adopt Statement157 during its fiscal year ending December 28, 2008. The Company is currentlyin the process of determining the impact, if any, of adopting the provisions ofStatement 157 but it is not expected to have a material impact on the Company’sfinancial position or results of operations.

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** ITEM 3.****               QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

# ***Interest rate sensitivity***

We are exposed tointerest rate risks primarily through borrowings under our creditfacilities.  Interest on all of ourborrowings under our senior secured credit facilities is based upon variableinterest rates. Our weighted average borrowings outstanding during the ninemonths ended October 1, 2006 were $527.3 million and the annual effectiveinterest rate for the period was 10.4%. Presently, we do not hedge againstinterest rate risks. Based on the foregoing, a hypothetical 1% increase ordecrease in interest rates would have resulted in a $4.0 million change to ourinterest expense in the nine months ended October 1, 2006.

# ***Foreign currency risk***

All of our sales,expenses, assets, liabilities and cash holdings are denominated in U.S.dollars.  Although we are increasing oursale of products outside of the United States, all of these transactions aresettled in U.S. dollars and therefore we have only minimal exposure to foreigncurrency exchange risks. We do not hedge against foreign currency risks and webelieve that our foreign currency exchange risk is immaterial.

** ITEM 4.****               CONTROLS AND PROCEDURES**

The Company maintains disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in its reports pursuant to the Securities Exchange Act of 1934, asamended, is recorded, processed, summarized and reported within the timeperiods specified in the SEC’s rules, and that such information is accumulatedand communicated to the Company’s management, including its Chief ExecutiveOfficer and Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure. Management is responsible for establishing andmaintaining adequate internal control over financial reporting. In designingand evaluating the disclosure controls and procedures, management recognizedthat any controls and procedures, no matter how well designed and operated, canprovide only reasonable assurance of achieving the desired control objectives,and management 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 carriedout an evaluation, under the supervision and with the participation of itsmanagement, including the Chief Executive Officer and the Chief FinancialOfficer, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures as of the end of the quarter covered by thisreport. Based on the foregoing, its Chief Executive Officer and Chief FinancialOfficer determined that disclosure controls and procedures were effective at areasonable assurance level.

There has been nochange in internal controls over financial reporting during the most recentfiscal quarter that has materially affected, or is reasonably likely tomaterially affect, internal controls over financial reporting.

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**PART II—OTHER INFORMATION**

**ITEM1.****                             LEGALPROCEEDINGS**

In the ordinarycourse of our business, we are subject to periodic lawsuits, investigations andclaims. Although we cannot predict with certainty the ultimate resolution oflawsuits, investigations and claims asserted against us, we do not believe thatany currently pending legal proceeding to which we are a party is likely tohave a material adverse effect on our business, results of operations, cashflows or financial condition.

**ITEM 1A.****                    RISK FACTORS**

*An investment in our common stock involves a highdegree of risk.  You should considercarefully the risks described below, together with all of the other informationcontained in this report, before making an investment decision.  If any of the following risks occur, ourbusiness, financial condition, results of operations or future growth couldsuffer.  In these circumstances, themarket price of our common stock could decline, and you may lose all or part ofyour investment.*

***Our success is dependent on sales of our mineral-basedfoundation. A change in consumer preferences for such products could harm ourbusiness.***

We derive nearlyone-half of our net sales from foundation products. We are vulnerable toshifting consumer tastes and demands and cannot assure you that our foundationwill maintain its popularity and market acceptance. Our growth and futuresuccess will depend, in part, upon consumer preferences for our mineral-basedfoundation. A decline in consumer demand for our mineral-based foundation wouldresult in decreased net sales of our products and harm our business. Moreover,we are identified as a mineral-based cosmetics company, and it would likelydamage our reputation were these products to fall out of favor with consumers.

***We do not have long-term purchase commitments from oursignificant customers, and a decrease or interruption in their business with uswould reduce our sales and profitability.***

We depend onwholesale sales to QVC Inc. and to specialty beauty retailers for a significantportion of our net sales. Sales to QVC, Sephora and Ulta accounted for anaggregate of 33.5% of our net sales for the year ended January 1, 2006, withsales to one of these customers accounting for greater than 10% of our netsales for the year ended January 1, 2006. Sales to QVC, Sephora and Ultaaccounted for an aggregate of 39.4% of our net sales for the nine months endedOctober 1, 2006, with sales to each of these customers accounting for greaterthan 10% of our net sales for the nine months ended October 1, 2006. Ourarrangement with QVC does not obligate QVC to make any purchases of ourproducts or to undertake any efforts to promote our products on air orotherwise, and our arrangements with each of Sephora and Ulta are by purchaseorder and are terminable at will at the option of either party. A substantialdecrease or interruption in business from these significant customers couldresult in inventory write-offs or in the loss of future business and couldreduce our liquidity and profitability. In addition, our appearances on QVCenhance our brand awareness and drive sales both on QVC and in our other saleschannels. As a result, a decision by QVC to reduce the number of times per yearit features our products on air or the type of such appearances would cause adecline in our sales to QVC and could cause sales in our other channels tosuffer.

In the future, oursignificant customers may undergo restructurings or reorganizations, or realigntheir affiliations, any of which could decrease their orders for our products.Further, one or more of these customers may decide to exclusively feature acompetitor’s mineral-based products, develop their own store-brandmineral-based products or reduce the number of brands of cosmetics and beautyproducts they sell, either of which could affect our ability to sell ourproducts to them on favorable terms, if at all. Our loss of significantcustomers would impair our sales and profitability and harm our business,prospects, financial condition and results of operations.

***The beauty industry is highly competitive, and if we areunable to compete effectively it could significantly harm our business,prospects, financial condition and results of operations.***

The beautyindustry is highly competitive and at times changes rapidly due to consumerpreferences and industry trends. Our products face, and will continue to face,competition for consumer recognition and market share with products that haveachieved significant national and international brand name recognition andconsumer loyalty, such as those offered by global prestige beauty companiesElizabeth Arden, Inc., The Estée Lauder Companies, Inc. and L’Oréal  S.A. These companies have significantlygreater resources than we have and are less leveraged than we are even after wehave applied the net proceeds of our initial public offering. Our competitorstypically devote substantial resources to promoting their brands throughtraditional forms of advertising, such as print media and televisioncommercials. Because of such mass marketing methods, our competitors’ productsmay achieve higher visibility and recognition than our products.  In addition, our competitors may duplicateour marketing strategy and distribution model to increase the breadth of theirproduct sales.

The total marketfor prestige cosmetics is not growing rapidly. As a result, competition formarket share in this cosmetics category is especially intense. In order tosucceed, we must continue to take market share from our competitors across allof our sales channels. We compete with prestige cosmetics companies primarilyin department store and specialty beauty retail

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channels, but prestige cosmetics companies alsorecently have increased their sales through infomercial 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 infomercials, home shopping television andother direct-to-consumer methods, our ability to achieve and maintainsignificant market acceptance for our products could be severely impaired.

Our *i.d. bareMinerals*foundation products facecompetition from liquid- or cream-based foundation and, to a lesser extent,mineral-based foundation products, 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. 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 and packaging, and the timing of new product introductions andline extensions have a significant impact on consumers’ buying decisions and,as a result, our net sales. These factors, as well as demographic trends,economic conditions and discount pricing strategies by competitors, couldresult in increased competition and could harm our net sales and profitability.

***We may be unable to manage our growth effectively, whichcould cause our liquidity and profitability to suffer.***

We have grownrapidly, with our net sales increasing from approximately $94.7 million for theyear ended December 31, 2003 to approximately $259.3 million for the year endedJanuary 1, 2006.

Our growth hasplaced, and will continue to place, a strain on our management team, informationsystems and other resources. To manage growth effectively, we must:

·      continueto enhance our operational, financial and management systems, including ourwarehouse management, inventory control and in-store point-of-sale systems;

·      maintainand improve our internal controls and disclosure controls and procedures; and

·      expand, train and manage our employeebase.

We may not be ableto effectively manage this expansion in any one or more of these areas, and anyfailure to do so could significantly harm our business, prospects, financialcondition or results of operations. Our rapid growth also makes it difficultfor us to adequately predict the expenditures we will need to make in thefuture. If we do not make the necessary overhead expenditures to accommodateour future growth, we may not be successful in executing our growth strategy,and our prospects and results of operations would suffer.

***We may be unable to sustain our growth or profitability,which could impair our future success and ability to make investments in ourbusiness.***

Our ability tosucceed depends, to a significant extent, on our ability to grow our businesswhile maintaining profitability. We may not be able to sustain our growth orprofitability on a quarterly or annual basis in future periods. Our futuregrowth and profitability will depend upon a number of factors, including,without limitation:

·                  thelevel of competition in the beauty industry;

·                  ourability to continue to execute successfully our strategic initiatives andgrowth strategy;

·                  ourability to sell our products effectively through our various distributionchannels in volumes sufficient to drive growth and leverage our cost structureand media spending;

·                  ourability to improve our products continuously in order to offer new and enhancedconsumer benefits and better quality;

·                  ourability to maintain efficient, timely and cost-effective production anddelivery of our products;

·                  theefficiency and effectiveness of our sales and marketing efforts, includingthrough infomercials and QVC, in building product and brand awareness, drivingtraffic to our various distribution channels and increasing sales;

·                  ourability to identify and respond successfully to emerging trends in the beautyindustry;

·                  ourability to maintain and intensify our consumers’ emotional connection with ourbrand, including through friendly and effective customer service and contacts;

·                  ourability to maintain public association of our brand with prestige beautyproducts;

·                  thelevel of consumer acceptance of our products; and

·                  general economicconditions and consumer confidence.

We may not besuccessful in executing our growth strategy, and even if we achieve our strategicplan, we may not be able

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to sustain profitability. Failure to execute anymaterial part of our strategic plan or growth strategy successfully couldsignificantly impair our ability to service our indebtedness and makeinvestments in our business.

***If we are unable to retain key executives and otherpersonnel, particularly Leslie Blodgett, our Chief Executive Officer andprimary spokesperson, and recruit additional executives and personnel, we maynot be able to execute our business strategy and our growth may be hindered.***

Our successlargely depends on the performance of our management team and other keypersonnel and our ability to continue to recruit qualified senior executivesand other key personnel.  Our futureoperations could be harmed if any of our senior executives or other keypersonnel ceased working for us. Competition for senior management personnel isintense and there can be no assurance that we will be able to retain ourpersonnel or attract additional qualified personnel.  The loss of a member of senior management mayrequire the remaining executive officers to divert immediate and substantialattention to fulfilling his or her duties and to seeking a replacement. Anyinability to fill vacancies in our senior executive positions on a timely basiscould harm our ability to implement our business strategy, which would harm ourbusiness and results of operations.  Inaddition, we are particularly dependent on Leslie Blodgett, our Chief ExecutiveOfficer and primary spokesperson, as her talents, efforts, personality andleadership have been, and continue to be, critical to our success. Many of ourcustomers identify our products by their association with Ms. Blodgett, and shegreatly enhances the success of our sales and marketing. There can be noassurance that we will be successful in retaining her services. We maintain keyexecutive life insurance policies with respect to Ms. Blodgett totalingapproximately $34 million, which is payable to the lenders under our seniorsecured credit facility in the event we collect payments on the policy. Adiminution or loss of the services of Ms. Blodgett would significantly harm ournet sales, and as a result, our business, prospects, financial condition andresults of operations.

***Our senior management team has limited experience workingtogether as a group, and may not be able to manage our business effectively.***

Most of themembers of our senior management team, including our President, Chief FinancialOfficer and Chief Operations Officer, Vice President of Finance, Vice Presidentof Creative, Vice President of Operations and Vice President of InformationTechnology, have been hired since December 2004. As a result, our seniormanagement team has limited experience working together as a group. This lackof shared experience could harm our senior management team’s ability to quicklyand efficiently respond to problems and effectively manage our business.

***Our planned expansion of our boutique operations will resultin increased expenses with no guarantee of increased earnings. In addition, wemay close boutiques that are not profitable or incur other costs, which couldcause our results of operations to suffer.***

We plan to open atotal of seven new boutiques in 2006 (of which six were open at October 1,2006) and ten new boutiques in 2007. We expect our total capital expendituresassociated with opening these new boutiques to be approximately $2.5 million in2006 and $3.5 million in 2007.  However,we may not be able to attain our target number of new boutique openings, andany of the new boutiques that we open may not be profitable, either of whichcould cause our financial results to suffer. Our ability to expand by openingnew boutiques will depend in part on the following factors:

·      theavailability of attractive boutique locations;

·      ourability to negotiate favorable lease terms;

·      ourability to identify customer demand in different geographic areas;

·      generaleconomic conditions; and

·      availability of sufficient funds forexpansion.

In order tocontinue our expansion of boutiques, we will need to hire additional managementand staff for our corporate offices and employees for each new boutique. Inaddition, we will need to expand our information technology systems toaccommodate the growth of our operations. If we are unable to hire necessarypersonnel or grow our existing information technology systems, our expansionefforts may not succeed and our results of operations may suffer.  Some of our expenses will increase with theopening of new boutiques, such as headcount and lease occupancy expenses aswell as information technology system expenses. Moreover, as we stock newboutiques with product inventory, our inventory expenditures will increase. Wemay not be able to manage these increased expenses without decreasing ourearnings. If any of our boutiques fails to generate attractive financial returnsor otherwise does not serve our strategic goals, we may be required to closethat boutique. If we were to close any boutique, we likely would incur expensesin connection with such closing, would be unable to recover our investment inleasehold improvements at that boutique and would be liable for remaining leaseobligations, which could harm our results of operations.

***Our media spending might not result in increased net salesor generate the levels of product and brand name awareness we desire, and we mightnot be able to increase our net sales at the same rate as we increase ouradvertising expenditures. In addition, our infomercials might not continue tobe an effective distribution channel, which could harm our net sales.***

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Our future growthand profitability will depend in part on the effectiveness and efficiency ofour media spending, including our ability to:

·                  creategreater awareness of our products and brand name;

·                  determinethe appropriate creative message and media mix for future expenditures; and

·                  effectivelymanage advertising costs, including creative and media costs, to maintainacceptable costs per sale and operating margins.

Our infomercialsand advertising may not result in increased sales or generate desired levels ofproduct and brand name awareness, and we may not be able to increase our netsales at the same rate as we increase our advertising expenditures.

We depend oninfomercials as one of our most significant distribution channels for marketingand selling our products. To the extent that sales resulting from ourinfomercials decrease or if there is a marked increase in the price we pay forour media time, the cost-effectiveness for such infomercials will decrease. Ifour infomercials are broadcast during times when viewership is low, this couldalso result in a decrease of the cost-effectiveness of such broadcasts, whichcould cause our results of operations to suffer. Also, to the extent we havecommitted in advance for broadcast time for our infomercials, we would havefewer resources available for potentially more effective distribution channels.

***We depend on third parties to manufacture all of theproducts we sell, and we have a long-term contract with only one of themanufacturers of our products. If we are unable to maintain these manufacturingrelationships or enter into additional or different arrangements, we may failto meet customer demand and our net sales and profitability may suffer as aresult.***

All of ourproducts are contract manufactured or supplied by third parties. We have along-term contract with only one of the manufacturers of our products. The factthat we do not have long-term contracts with our other third-partymanufacturers means that they could cease manufacturing these products for usat any time and for any reason. In addition, our third-party manufacturers arenot restricted from manufacturing our competitors’ products, includingmineral-based products. We also source some of our products through a supplieragent that purchases products from third-party manufacturers. This supplieragent, with whom we do not have a long-term contract, accounted forapproximately 44% and 41% of our net product received for the year endedJanuary 1, 2006 and the nine months ended October 1, 2006, respectively. If weare unable to obtain adequate supplies of suitable products because of the lossof one or more key vendors or manufacturers or our supplier agent or otherwise,our business and results of operations would suffer because we would be missingproducts from our merchandise mix unless and until we could make alternativesupply arrangements. In addition, identifying and selecting alternative vendorswould be time-consuming and expensive, and we might experience significantdelays in production during this selection process. Our inability to secureadequate and timely supplies of merchandise would harm inventory levels, netsales and gross profit, and ultimately our results of operations.

Our manufacturersalso may increase the cost of the products we purchase from them. If ourmanufacturers increase our costs, our margins would suffer unless we were ableto pass along these increased costs to our customers. We may not be able todevelop relationships with new vendors and manufacturers, and even if we doestablish such relationships, such new vendors and manufacturers might notallocate sufficient capacity to us to meet our requirements. Furthermore,products from alternative sources, if any, may be of a lesser quality or moreexpensive than those we currently purchase. In addition, if we increase ourproduct orders significantly from the amounts we have historically ordered fromour manufacturers, our manufacturers might be unable to meet this increaseddemand. To the extent we fail to obtain additional products from our manufacturers,we may not be able to meet customer demand, which could harm our net sales andprofitability.

***Our third-party manufacturers may not continue to produceproducts that are consistent with our standards or applicable regulatoryrequirements, which could harm our brand, cause customer dissatisfaction andrequire us to find alternative suppliers of our products.***

Our third-partymanufacturers may not maintain adequate controls with respect to productspecifications and quality and may not continue to produce products that areconsistent with our standards or applicable regulatory requirements, asdescribed below. If we are forced to rely on products of inferior quality, thenour customer satisfaction and brand reputation would likely suffer, which wouldlead to reduced net sales. In addition, we may be required to find newthird-party manufacturers to supply our products. There can be no assurancethat we would be successful in finding third-party manufacturers that makeproducts meeting our standards of quality.

In accordance withthe Federal Food, Drug and Cosmetic Act, or FDC Act, and regulations enforcedby the Food and Drug Administration, or FDA, the manufacturing processes of ourthird party manufacturers must comply with the FDA’s current Good ManufacturingPractices, or cGMPs, for manufacturing drug products. The manufacturing of ourcosmetic products are subject to the misbranding and adulteration sections ofthe FDC Act applicable to cosmetics. The FDA may inspect our facilities andthose of our third-party manufacturers periodically to determine if we and ourthird-party manufacturers are complying with cGMPs and the FDC Act provisionsapplicable to manufacturing cosmetic products. We will have limited

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control over the FDA compliance of our third-partymanufacturers. A history of past compliance is not a guarantee that future FDAregulatory manufacturing requirements will not mandate other compliance stepswith associated expense.

If we or ourthird-party manufacturers fail to comply with federal, state or foreignregulations, we could be required to suspend manufacturing operations, changeproduct formulations, suspend the sale of products with non-complyingspecifications, initiate product recalls or change product labeling, packagingor advertising or take other corrective action. In addition, sanctions underthe FDC Act may include seizure of products, injunctions against futureshipment of products, restitution and disgorgement of profits, operatingrestrictions and criminal prosecution. If any of the 18 above events occurs, wewould be required to expend significant resources to comply with FDArequirements and we might need to seek the services of alternative third-partymanufacturers.  Obtaining the requiredregulatory approvals, including from the FDA, to use alternative third-partymanufacturers may involve a lengthy and uncertain process. A prolongedinterruption in the manufacturing of one or more of our products as a result ofnon-compliance could decrease our supply of products available for sale whichcould reduce our net sales, gross profits and market share, as well as harm ouroverall business, prospects, financial condition and results of operations.

***We depend on Datapak Services Corporation, or Datapak, forfulfillment of products sold through our infomercials.***

We depend onDatapak for fulfillment of our infomercial sales, which represented 37% and 34%of our net sales for the year ended January 1, 2006 and the nine months endedOctober 1, 2006, respectively. We contract with Datapak for inventorymanagement, call center operation, hosting of our bareminerals.com website andpacking and shipping of product to our customers. Our contract with Datapakexpires on December 31, 2007 subject to automatic one-year renewals thereafter forone-year periods unless either party gives 90 days’ written notice ofnonrenewal. If Datapak were to terminate its relationship with us, we couldexperience a delay in reestablishing our inventory management and ability topack and ship product to our infomercial customers, which could harm ourbusiness. Additionally, our ability to provide satisfactory levels of customerservice depends, to a large degree, on the efficient and uninterruptedoperation of Datapak’s customer call center operations. In the past, we havereceived customer complaints related to the services provided by Datapak’scustomer call center operations. Because our success depends in large part onkeeping our customers satisfied, and because infomercial sales constitute asignificant portion of our net sales, our failure to provide satisfactorylevels of customer service in the future and any failure by Datapak to providesatisfactory levels of customer service in the future would likely impair ourreputation and harm our business, prospects, financial condition and results ofoperations.

***Our manufacturers ship a significant portion of the productwe order to our distribution center in Hayward, California, and any significantdisruption of this center’s operations would hurt our ability to make timelydelivery of our products.***

We distributeproducts to our premium wholesale, spa and salon and international customers,QVC and our company-owned boutiques from our facility in Hayward, California.Approximately 63% of our net sales for the year ended January 1, 2006 and 66%of our net sales for the nine months ended October 1, 2006 were derived fromthese channels. A natural disaster or other catastrophic event, such as a fire,flood, severe storm, break-in, terrorist attack or other comparable event couldcause interruptions or delays in our business and loss of inventory and couldrender us unable to accept or fulfill customer orders in a timely manner, or atall. In addition, Hayward is located on a major fault line, increasing oursusceptibility to the risk that an earthquake could significantly harm theoperations of our distribution facility, and our coverage under our existingearthquake insurance is limited to $10 million. The impact of any of thesenatural disasters or other catastrophic events on our business may beexacerbated by the fact that we are still in the process of developing ourformal disaster recovery plan, and we do not have a final plan currently inplace.  In addition, our businessinterruption insurance may not adequately compensate us for losses that mayoccur. In the event that an earthquake, fire, natural disaster or othercatastrophic event were to destroy a significant part of our Hayward,California facility or interrupt our operations for an extended period of time,our net sales would be reduced and our results of operations would be harmed.

***Our quarterly results of operations may fluctuate due to thetiming of customer orders, the number of QVC appearances we make, new boutiqueopenings, as well as limited seasonality and other factors.***

We may experiencevariability in net sales and net income on a quarterly basis as a result of avariety of factors, including the timing of orders from our premium wholesalecustomers, the timing and number of our appearances on QVC, the timing of newboutique openings, seasonality and other factors. We make sales to our premiumwholesale customers on a purchase order basis, and we receive new orders whenand as these customers need replenishment product. As a result, their orders typicallyare not evenly distributed through the course of the year. In addition, oursales to QVC are largely dependent on the timing and number of our on-airappearances, with our greatest sales generated through appearances where ourproducts are featured as ‘‘Today’s Special Value’’ or ‘‘TSV.’’ As such, weexpect our quarterly results to continue to fluctuate based on the number ofshows in a quarter and whether a particular quarter includes a TSV or not.  We plan to open a total of seven newboutiques in 2006, six of which were open as of October 1, 2006, and ten newboutiques in 2007. The timing of these boutique openings will impact both ournet sales and our selling, general and administrative expenses. For example, ifwe were to open a number of new boutiques at the end of a quarter, our resultsof operations for that quarter would include limited net sales from the new

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boutiques but substantially all of the pre-openingexpenses associated with such boutiques.

In addition, ourplans to open a number of new boutiques and expand our retail presence couldhave the effect of increasing the percentage of sales driven through thesesales channels.  While we believe ouroverall business is not currently subject to significant seasonal fluctuations,we have experienced limited seasonality in our specialty beauty retail andcompany-owned boutique channels as a result of increased demand for ourproducts in anticipation of and during the holiday season. To the extent oursales to specialty beauty retailers and through our boutiques increase as apercentage of our total sales, we may experience increased seasonality.

***We are planning a replacement of our core systems that mightdisrupt our supply chain operations.***

We are in theprocess of substantially modifying our information technology systemssupporting our financial management and reporting, inventory and purchasingmanagement, order management, warehouse management and forecasting.Modifications will involve replacing legacy systems with successor systems duringthe course of 2006 and 2007. There are inherent risks associated with replacingour core systems, including supply chain disruptions that may affect ourability to deliver products to our customers. We believe that other companieshave experienced significant delays and cost overruns in implementing similarsystems changes, and we may encounter similar problems. We may not be able tosuccessfully implement these new systems or implement them without supply chaindisruptions in the future. Any resulting supply chain disruptions could harmour business, prospects, financial condition and results of operations. We donot believe our existing systems are adequate to support our growth. Thus, ifwe are not able to implement these new systems successfully, our business,prospects, financial condition and results of operations may suffer.

***Our computer and communications hardware and softwaresystems are vulnerable to damage and interruption, which could harm ourbusiness.***

Our ability toreceive and fulfill orders successfully is critical to our success and largelydepends upon the efficient and uninterrupted operation of our computer andcommunications hardware and software systems. Our primary computer systems andoperations are located at a co-location facility in San Francisco, Californiaand our corporate headquarters also in San Francisco, California and arevulnerable to damage or interruption from power outages, computer andtelecommunications failures, computer viruses, security breaches, catastrophicevents and errors in usage by our employees and customers. Systems integrationissues are complex, time-consuming and expensive.

We outsource thehosting of our websites bareescentuals.com, bareminerals.com andmdformulations.com. In the event that any of our website service providersexperiences any interruption in its operations or ceases operations for anyreason or if we are unable to agree on satisfactory terms for a continuedhosting relationship, we would be forced to enter into a relationship with anotherservice provider or take over hosting responsibilities ourselves. In the eventit becomes necessary to switch hosting facilities in the future, we may not besuccessful in finding an alternative service provider on acceptable terms or inhosting our websites ourselves.  Anysignificant interruption in the availability or functionality of our website orour sales processing, distribution or communications systems, for any reason,could seriously harm our business, prospects, financial condition and resultsof operations.

***Our independent auditors have indicated to us that theybelieve there were material weaknesses in our internal controls for the fiscalyear ended January 2, 2005. Our failure to implement and maintain effectiveinternal controls in our business could have a material adverse effect on ourbusiness, financial condition, results of operations and stock price.***

In connection withthe completion of its audit of, and the issuance of an unqualified report on,our financial statements for the fiscal year ended January 2, 2005, ourindependent auditors, Ernst & Young LLP, delivered a management letteridentifying the following reportable conditions involving our internal controlsthat it considers to be material weaknesses:

·                  our financialclosing procedures and processes did not support timely and accurate reportingof the Company’s financial results, and the internal control structure in thefinancial accounting department did not provide for adequate supervision andreview of personnel; and

·                  the technical accounting knowledge ofour accounting personnel during the year ended January 2, 2005 was notsufficient in relation to our business, the nature and complexity of ourfinancial statement reporting obligations and the increasing complexity of generallyaccepted accounting principles.

Ernst & YoungLLP noted that these weaknesses resulted in numerous post-closing adjustments,affecting a number of financial statement accounts.  We have taken steps to strengthen ourinternal control processes to address the matters identified by Ernst &Young LLP, including (1) hiring a new chief financial officer and new financeexecutives with substantial industry and public company accounting experienceand (2) establishing processes to improve communications between the financedepartment and the operations and executive departments to ensure that allsignificant transactions and contracts entered into by authorized individualsare captured in our financial accounting records. While no material weaknesseswere identified during the course of our audit for the fiscal year endedJanuary 1, 2006, we cannot assure you that these issues will not arise in

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future periods. The existence of one or more material weaknesses or significantdeficiencies could result in errors in our financial statements, andsubstantial costs and resources may be required to rectify any internal controldeficiencies. If we fail to achieve and maintain the adequacy of our internalcontrols in accordance with applicable standards, we may be unable to concludeon an ongoing basis that we have effective internal controls over financialreporting. If we cannot produce reliable financial reports, our business andfinancial condition could be harmed, investors could lose confidence in ourreported financial information, the market price of our stock could declinesignificantly and we may be unable to obtain additional financing to operateand expand our business.

***Our indebtedness could limit our ability to plan for orrespond to changes in our business, and we may be unable to generate sufficientcash flow to satisfy significant debt service obligations or to refinance theobligations on acceptable terms, or at all.***

In connection withour June 2006 recapitalization, we restructured our first-lien and second-liensenior secured credit facilities originally entered into in February 2005 andamended in October 2005, and we issued $125.0 million of 15.0% seniorsubordinated notes. Our consolidated long-term indebtedness as of October 1,2006 was $709.3 million, excluding debt discount. Upon completion of ourinitial public offering on October 4, 2006, we paid $365.6 million in principalamount of such indebtedness with the proceeds of the offering, leaving us with$343.7 million of debt, all of which is first-lien senior debt, at October 4,2006. We may incur up to an additional $25.0 million under our revolving creditfacility, subject to compliance with the maximum leverage ratio and cashinterest coverage ratio covenants contained in those credit facilities. Oursenior secured credit facilities contain a number of significant covenants,which limit our ability to, among other things, incur additional indebtedness,make investments, pay dividends, make distributions, or redeem or repurchasecapital stock and grant liens on our assets or the assets of our subsidiaries.For example, we are restricted from incurring additional indebtedness unless wesatisfy the maximum leverage ratio and cash interest coverage ratio covenantsin those credit facilities.  Our seniorsecured credit facilities also require us to maintain specified financialratios and satisfy financial condition tests at the end of each fiscal quarter.Our ability to meet these financial ratios and tests can be affected by eventsbeyond our control, and we may not meet those tests. A breach of any of thesecovenants could result in a default under the senior secured credit facilities.If the lenders accelerate amounts owing under our senior secured creditfacilities because of a default and we are unable to pay such amounts, thelenders have the right to foreclose on substantially all of our assets.

In addition, oursubstantial indebtedness and the fact that a substantial portion of our cashflow from operations must be used to make principal and interest payments onthis indebtedness could have important consequences, including:

·                  increasingour vulnerability to general adverse economic and industry conditions, placingus at a disadvantage compared to our competitors who are less leveraged;

·                  reducingthe availability of our cash flow for other purposes, including workingcapital, capital expenditures, product development, acquisitions or othercorporate requirements;

·                  limitingour flexibility in planning for, or reacting to, changes in our business and theindustry in which we operate, which would place us at a competitivedisadvantage compared to our competitors that may have less debt; and

·                  limiting ourability to obtain additional financing in the future that we may need to fundworking capital, capital expenditures, product development, acquisitions orother corporate requirements.

Our ability toincur significant future indebtedness, whether to finance capital expenditures,product development, potential acquisitions or for general corporate purposes,will depend on our ability to generate cash flow. This, to a certain extent, issubject to general economic, financial, competitive, legislative, regulatoryand other factors that are beyond our control. If our business does notgenerate sufficient cash flow from operations or if future borrowings are notavailable to us under our senior secured credit facilities in amountssufficient to enable us to fund our liquidity needs, our financial conditionand results of operations may be harmed. If we cannot make scheduled principaland interest payments on our debt obligations in the future, we may need torefinance all or a portion of our indebtedness on or before maturity, sellassets, delay capital expenditures or seek additional equity financing. If we areunable to refinance this or any of our indebtedness on commercially reasonableterms or at all, or to effect any other action relating to our indebtedness onsatisfactory terms or at all, our business may be harmed.

***Ourdebt obligations have variable interest rates, which makes us vulnerable toincreases in interest rates and could cause our interest expense to increaseand decrease cash available for operations and other purposes.***

As of October 1,2006, we had $584.3 million of consolidated indebtedness that was subject tovariable interest rates.  After givingeffect to the application of the net proceeds upon completion of our initialpublic offering on October 4, 2006, we would have had $343.7 million ofconsolidated indebtedness that was subject to variable interest rates. Interestrates in the U.S. recently have been near historic lows, and any increase inthese rates would increase our interest expense and reduce our funds availablefor operations and other purposes. Presently, we do not hedge any of ourvariable rate indebtedness against interest rate fluctuations. Accordingly, wemay experience material increases in our interest expense as a result ofincreases in interest rate levels generally. Based on the $343.7 million ofvariable interest rate indebtedness that would have been outstanding as ofOctober 1, 2006, after giving effect to the application of the net proceeds ofour initial public offering on October 4, 2006, a

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hypothetical 1% increase or decrease in interest rateswould have resulted in a $0.9 million change to our interest expense for thethree months ending December 31, 2006.

***Wehad a negative net worth as of October 1, 2006, which may make it moredifficult and costly for us to obtain financing in the future.***

As of October 1,2006, we had a negative net worth of $619.6 million.  Our negative net worth resulted from the useof borrowings to fund our repurchase of stock in connection with our June 2004recapitalization and to fund dividends in connection with our February 2005recapitalization, October 2005 recapitalization and June 2006 recapitalizationtransactions. After giving effect to the application of the net proceeds of ourinitial public offering on October 4, 2006, we would have had a negative networth of $248.2 million.  As a result ofour negative net worth, we may face greater difficulty and expense in obtainingfuture financing than we would face if we had a greater net worth, which maylimit our ability to meet our needs for liquidity or otherwise competeeffectively in the marketplace.

***Our products may cause unexpected and undesirable sideeffects that could limit their use, require their removal from the market orprevent further development. In addition, we are vulnerable to claims that ourproducts are not as effective as we claim them to be.***

Unexpected andundesirable side effects caused by our products for which we have not providedsufficient label warnings could result in our recall or discontinuance of salesof our products. Unexpected and undesirable side effects could prevent us fromachieving or maintaining market acceptance of the affected products or couldsubstantially increase the costs and expenses of commercializing new products. Inaddition, consumers or industry analysts may assert claims that our productsare not as effective as we claim them to be. Unexpected and undesirable sideeffects associated with our products or assertions that our products are not aseffective as we claim them to be also could cause negative publicity regardingour company, brand or products, which could in turn harm our reputation and netsales. We are particularly susceptible to these risks because our marketingcampaign heavily relies on the assertion that our products are ‘‘pure’’ andideal for women who have skin conditions that can be exacerbated by traditionalcosmetics.

***We may face product liability claims and may be required torecall products, either of which could result in unexpected costs and damage toour reputation.***

Our businessexposes us to potential liability risks that arise from the testing,manufacture and sale of our beauty products. Plaintiffs in the past havereceived substantial damage awards from other cosmetics companies based uponclaims for injuries allegedly caused by the use of their products. We currentlymaintain general liability insurance with an annual aggregate coverage limit of$15.0 million. Any claims brought against us may exceed our existing or futureinsurance policy coverage or limits. Any judgment against us that is in excessof our policy limits would have to be paid from our cash reserves, which wouldreduce our capital resources. Further, we may not have sufficient capitalresources to pay a judgment, in which case our creditors could levy against ourassets. Any product liability claim or series of claims brought against uscould harm our business significantly, particularly if a claim were to resultin adverse publicity or damage awards outside or in excess of our insurancepolicy limits. In addition, in the past, we have recalled certain of ourproducts, and in the future, it may be necessary for us to recall products thatdo not meet approved specifications or because of the side effects resultingfrom the use of our products, which would result in adverse publicity,potentially significant costs in connection with the recall and a loss of netsales from such products.

***We do not currently own any patents on our products. If weare unable to protect our intellectual property rights, our ability to competecould be harmed.***

We regard ourtrademarks, trade dress, copyrights, trade secrets, know-how and similarintellectual property as critical to our success. Our principal intellectualproperty rights include registered trademarks on our name, ‘‘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 trade secrets and know-howwith respect to product formulations, product sourcing, sales and marketing andother aspects of our business. As such, we rely on trademark and copyright law,trade secret protection and confidentiality agreements with our employees,consultants, suppliers, and others to protect our proprietary rights. We havenot received patent protection on any of our products, though we have licensesfor the proprietary formulations and ingredients used in some of our *md formulations*products and *RareMinerals*. If we are unable to protector preserve the value of our trademarks, copyrights, trade secrets or otherproprietary rights for any reason, our brand and reputation could be impairedand we could lose customers.

Although most ofour brand names are registered in the United States and in certain foreigncountries in which we operate, we may not be successful in asserting trademarkor trade name protection. In addition, the laws of certain foreign countriesmay not protect our intellectual property rights to the same extent as the lawsof the United States. The costs required to protect 

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our trademarks and trade names may be substantial. Inaddition, the relationship between regulations governing domain names and lawsprotecting trademarks and similar proprietary rights is unclear.  Therefore, we may be unable to prevent thirdparties from acquiring domain names that are similar to, infringe upon orotherwise decrease the value of our trademarks and other proprietaryrights.  Other parties may infringe onour intellectual property rights and may thereby dilute our brands in themarketplace. Any such infringement of our intellectual property rights wouldalso likely result in a commitment of our time and resources to protect theserights through litigation or otherwise. For example, we currently are pursuing claims in litigation against L’OréalUSA, Inc. regarding its use of the mark COLOR ID and against MD Skincare LLCand its founder Dr. Dennis Gross regarding MD Skincare’s use of the trademark ‘‘MDSkincare.’’ MD Skincare LLC has also filed counter-claim against us.  In each case, we believe the competing marksinfringe our trademark rights and create confusion in the marketplace. We haveincurred and expect to incur significant legal fees and other expenses inpursuing these claims. If we receive an adverse judgment in either of thesematters or in any other cases we may bring in the future to defend our intellectualproperty rights, we may suffer further dilution of our trademarks and otherrights, which could harm our ability to compete as well as our business,prospects, financial condition and results of operations.

***Legal proceedings or third-party claims of intellectualproperty infringement may require us to spend time and money and could preventus from developing or commercializing products. We currently sell our md formulations products in sales channels that arguablyexceed the permitted field of use.***

Our technologies,products or potential products in development may infringe rights underpatents, patent applications, trademark, copyright or other intellectualproperty rights of third parties in the United States and abroad. These thirdparties could bring claims against us that would cause us to incur substantialexpenses and, if successful, could cause us to pay substantial damages.  Further, if a third party were to bring anintellectual property infringement suit against us, we could be forced to stopor delay development, manufacturing, or sales of the product that is thesubject of the suit.

Our Bioceutix Inc.subsidiary acquired rights to the *mdformulations*trademarks and some of our *md formulations*product rights from a large specialtypharmaceutical company in 1999. We currently sell our *md formulations*products in sales channelsthat arguably exceed the permitted field of use specified in the purchaseagreement. The agreement provides for the sale to Bioceutix of *md formulations*product rights for use ina field of use defined as the research, development, manufacture, marketing andsale of alpha hydroxy acid, or AHA, skin care products to ‘‘skin careaestheticians’’ worldwide and to physicians outside of the United States. Forthe year ended January 1, 2006, we made approximately 65.3% of our sales of *md formulations*products to spas andsalons, which we require to employ aestheticians and to internationaldistributors, but during the past five years, we also have sold these productsin our premium wholesale channels, through our own boutiques and on ourmdformulations.com website. The party from which we purchased the *md formulations*product rights is aware ofour sales in these channels and has not requested that we discontinue sales inthese channels, although it has to date refused our requests to expand thepermitted field of use to explicitly cover all of these sales. However, if itwere to challenge our rights to sell *mdformulations*products in these distribution channels, we could be requiredto engage in litigation or negotiation with the objective of obtaining theserights. Any such litigation would cause us to incur substantial expenses and,if we were unsuccessful, could cause us to lose 25 the right to sell ourproducts in one or more of our existing distribution channels or to paydamages, either of which could significantly harm our business, prospects,financial condition and results of operations.

As a result ofintellectual property infringement claims, or to avoid potential claims, we maychoose to seek, or be required to seek, a license from the third party andwould most likely be required to pay license fees or royalties or both. Theselicenses may not be available on acceptable terms, or at all. Even if we wereable to obtain a license, the rights may be nonexclusive, which would give ourcompetitors access to the same intellectual property. Ultimately, we could beprevented from commercializing a product or be forced to cease some aspect ofour business operations if, as a result of actual or threatened intellectualproperty infringement claims, we are unable to enter into licenses onacceptable terms. This inability to enter into licenses could harm our businesssignificantly.

In addition toinfringement claims against us, we may become a party to other patentlitigation and other proceedings, including interference proceedings declaredby the USPTO and opposition proceedings in the European Patent Office,regarding intellectual property rights with respect to our products andtechnology. The cost to us of any intellectual property litigation or otherproceeding, even if resolved in our favor, could be substantial. Some of ourcompetitors may be able to sustain the costs of such litigation or proceedingsbetter than us because of their substantially greater financial resources.Uncertainties resulting from the initiation and continuation of intellectualproperty litigation or other proceedings could impair our ability to compete inthe marketplace.  Intellectual propertylitigation and other proceedings may also absorb significant management timeand resources.

## ***We may be subject to liability for thecontent that we publish.***

As a publisher ofinfomercial broadcasts and online content, we face potential liability forintellectual property 

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infringement and other similar claims based on theinformation and other content contained in our infomercials, website andinstructional DVDs and videos. In the past, parties have brought these types ofclaims and sometimes successfully litigated them against other online services.If we incur liability for our infomercial or online content, our business,prospects, financial condition and results of operations could suffer.

***The regulatory status of our cosmetics or skin care productscould change, and we may be required to conduct clinical trials to establishefficacy and safety or cease to market these products.***

The FDA does nothave a premarket approval system for cosmetics, and we believe we are permittedto market our cosmetics and have them manufactured without submitting safety orefficacy data to the FDA. However, the FDA may in the future determine toregulate our cosmetics or the ingredients included in our cosmetics as drugs orbiologics. If certain of our *i.d. bareMinerals*,*RareMinerals*or our otherproducts are deemed to be drugs or biologics, rather than cosmetics, we wouldbe required to conduct clinical trials to demonstrate the safety and efficacyof these products in order to continue to market and sell them. In such event,we may not have sufficient resources to conduct any required clinical trials,and we may not be able to establish sufficient efficacy or safety data toresume the sale of these products. Any inquiries by the FDA or any foreignregulatory authorities into the regulatory status of our cosmetics and anyrelated interruption in the marketing and sale of these products could severelydamage our brand reputation and image in the marketplace, as well as ourrelationships with customers, which would harm our business, prospects,financial condition and results of operations.

Our foundationsand concealers as well as some of our *mdformulations*products are considered over-the-counter (OTC) drugproducts by the FDA. The FDA regulates the formulation, manufacturing, packaging,labeling and distribution of OTC drug products pursuant to a ‘‘monograph’’system that specifies active drug ingredients and acceptable product claimsthat are generally recognized as safe and effective for particular uses. If anyof these products that are OTC drugs are not in compliance with the applicableFDA monograph, we would be required to (i) reformulate such product, (ii) ceaseto make certain use claims relating to such product or (iii) cease to sell suchproduct until we receive further FDA approval. There can be no assurance that,if more stringent regulations are promulgated, we will be able to comply withsuch statutes or regulations without incurring substantial expense. Inaddition, OTC drug products must be manufactured in accordance with drug goodmanufacturing practice regulations. Our OTC drug manufacturers are subject toongoing periodic unannounced inspection by the FDA and corresponding stateagencies to ensure strict compliance with drug good manufacturing practices andother government regulations and corresponding foreign standards. We do nothave control over third-party manufacturers’ compliance with these regulationsand standards. If the FDA finds a violation of drug good manufacturingpractices, it may enjoin the manufacturer’s operations, seize products, orcriminally prosecute the manufacturer, any of which could require us to findalternative manufacturers, resulting in additional time and expense.

***Regulatory matters governing our industry could decrease ournet sales and increase our operating costs.***

In both our U.S.and foreign markets, we are affected by extensive laws, governmentalregulations, administrative determinations, court decisions and similarconstraints. Such laws, regulations and other constraints may exist at thefederal, state or local levels in the United States and at analogous levels ofgovernment in foreign jurisdictions.  Theformulation, manufacturing, packaging, labeling, distribution, importation,sale and storage of our products are subject to extensive regulation by variousfederal agencies, including the FDA, the Federal Trade Commission, or FTC,state attorneys general in the U.S., the Ministry of Health, Labor and Welfarein Japan, as well as by various other federal, state, local and internationalregulatory authorities in the countries in which our products are manufactured,distributed or sold. If we or our manufacturers fail to comply with thoseregulations, we could become subject to significant penalties or claims, whichcould harm our results of operations or our ability to conduct our business. Inaddition, the adoption of new regulations or changes in the interpretations ofexisting regulations may result in significant compliance costs ordiscontinuation of product sales and may impair the marketing of our products,resulting in significant loss of net sales. In addition, our failure to comply with FTC or state regulations, orwith regulations in foreign markets that cover our product claims and advertising,including direct claims and advertising by us, may result in enforcementactions and imposition of penalties or otherwise harm the distribution and saleof our products.

***We may need to raise additional funds to pursue our growthstrategy or continue our operations, and we may be unable to raise capital whenneeded.***

From time to time,we may seek additional equity or debt financing to provide for the capitalexpenditures required to finance working capital requirements, to increase thenumber of our boutiques or to make acquisitions. In addition, if our businessplans change, if general economic, financial or political conditions in ourmarkets change, or if other circumstances arise that have a material effect onour cash flow, the anticipated cash needs of our business as well as our conclusionsas to the adequacy of our available sources of capital could changesignificantly. Any of these events or circumstances could result in significantadditional funding needs, requiring us to raise additional capital to meetthose needs. We cannot predict the timing or amount of any such capitalrequirements at this time. If financing is not available on satisfactory termsor at all, we may be 

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unable to expand our business or to develop newbusiness at the rate desired and our results of operations may suffer.

***We may seek to expand our product portfolio through internaldevelopment. There can be no assurance that we will be successful in marketingand selling any products we develop.***

Our businessstrategy contemplates the continued expansion of our portfolio of brandsthrough internal product development. However, we may not be successful ininternally developing new products. Even if we are able to develop newproducts, we might not be successful in marketing and selling these products.

***We are subject to risks related to our internationaloperations.***

As we expand ourinternational operations, we will be increasingly susceptible to the followingrisks associated with international operations:

·      importand export license requirements;

·      traderestrictions;

·      changes in tariffs and taxes;

·      restrictions on repatriating foreignprofits back to the United States;

·      the imposition of foreign and domesticgovernmental controls;

·      unfamiliarity with foreign laws andregulations;

·      difficulties in staffing and managinginternational operations;

·      product registration, permitting andregulatory compliance;

·      thefts and other crimes; and

·      geopoliticalconditions, such as terrorist attacks, war or other military action.

In addition, weplan to develop formal and informal marketing and distribution relationshipswith existing and new local business partners who can provide local expertiseand sales and distribution infrastructure to support our expansion in ourtarget international markets, which will be time-consuming and costly. Severalof the risks associated with our international business may be within thecontrol (in whole or in part) of these local business partners with whom wehave established relationships or may be affected by the acts or omissions ofthese local business partners. No assurances can be provided that these localbusiness partners will effectively help us in their respective markets or thatthey will act in compliance with foreign laws and regulations in providing uswith services. The failure of these local business partners to assist us intheir local markets and the other risks set forth above could harm ourbusiness, prospects, financial condition and results of operations.

***Our common stock has only been publicly traded sinceSeptember 29, 2006 and the price of our common stock may fluctuatesubstantially.***

There has onlybeen a public market for our common stock since September 29, 2006. Broadmarket and industry factors may adversely affect the market price of our commonstock, regardless of our actual operating performance. Factors that could causefluctuations in our stock price may include, among other things:

·      introductionsof new products or new pricing policies by us or by our competitors;

·      thegain or loss of significant customers or product orders;

·      actualor anticipated variations in our quarterly results;

·      theannouncement of acquisitions or strategic alliances by us or by ourcompetitors;

·      recruitmentor departure of key personnel;

·      thelevel and quality of securities research analyst coverage for our common stock;

·      changesin the estimates of our operating performance or changes in recommendations byus or any research analysts that follow our stock or any failure to meet theestimates made by research analysts; and

·      marketconditions in our industry and the economy as a whole.

In addition,public announcements by our competitors concerning, among other things, theirperformance, strategy, accounting practices, or legal problems could cause themarket price of our common stock to decline regardless of our actual operatingperformance.

**ITEM 2.**   UNREGISTERED SALES OFEQUITY SECURITIES AND USE OF PROCEEDS

*Sales of Unregistered Securities*

In the quarterended October 1, 2006, we granted options to purchase 276,975 shares of common stockunder the Bare Escentuals, Inc. 2004 Equity Incentive Plan (“the 2004 Plan”) toemployees at a weighted average exercise price of $8.87.  The issuances of the options were deemed tobe exempt from registration under the Securities Act in reliance on Rule 701of the 

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Securities Act in that the transactions were undercompensatory benefit plans and contracts relating to compensation as providedunder such rule. The recipients of such options were our employees, directorsor consultants and received the securities under our stock incentive plan.  Each of these recipients had adequate access,through employment or other relationships, to information about us.  As of October 1, 2006, options to purchase6,317,492 shares of common stock were outstanding under the  2004 Plan.  No further option grantswill be made under our 2004 Equity Incentive Plan.

*Use of Proceeds from Public Offering*

The Securities and Exchange Commission declared ourregistration statement on Form S-1 (File No. 333-135484) (the “RegistrationStatement”), effective on September 28, 2006. The underwriters were Goldman,Sachs & Co., CIBC World Markets, Banc of America Securities LLC, PiperJaffrey, Thomas Weisel Partners LLC, SunTrust Robinson Humphrey and SandersMorris Harris.

Our initial public offering closed on October 4, 2006.All 18,400,000 shares of common stock registered under the RegistrationStatement, which included 2,400,000 shares of common stock covered by anover-allotment option granted to the underwriters, were sold at a price to thepublic of $22.00 per share.

The aggregate gross proceeds from the sale of sharesof common stock by us were $404.8 million. The aggregate estimated net proceedsto us was $373.9 million after deducting $28.3 million in underwritingdiscounts and commissions and $2.6 million in estimated expenses incurred by usin connection with the offering. We used the proceeds to repay all outstandingprincipal and interest owed on our June 2006 Subordinated Notes and our SecondLien Term Loans and a portion of the outstanding principal on our First LienTerm Loans and the buyout of our management agreements with Berkshire PartnersLLC and JH Partners, LLC of $1.8 million. The use of proceeds does not represent a material change from the use ofproceeds described in the final prospectus we filed pursuant toRule 424(b) of the Securities Act of 1933, as amended, with the SECon September 29, 2006.

**ITEM 3.**    DEFAULTS UPONSENIOR SECURITIES

None

**ITEM 4.**    SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

On September 12,2006, the following items were approved by written consent of stockholdersholding a majority of our outstanding shares of common stock:

·                  The adoption of the Bare Escentuals,Inc. 2006 Equity Incentive Award Plan and the reservation of 4,500,000 shares(after taking into account the stock split) of our common stock for issuancethereunder;

·                  An amendment to our amended andrestated certificate of incorporation providing for (i) 1.5-for-one stock splitof our common stock, (ii) a change in the par value of our common stock from$0.01 to $0.001, and (iii) an increase in the number of authorized shares ofcommon stock to 200,000,000 shares;

·                  The classification of the board ofdirectors into three classes effective upon the closing of our initial publicoffering;

·                  The adoption of our amended andrestated certificate of incorporation providing for the authorization of10,000,000 shares of undesignated preferred stock and various stockholderprotection measures customary for certificates of incorporation of publiclytraded companies, effective upon the closing of our initial public offering;and

·                  Theadoption of amended and restated bylaws containing various stockholderprotection measures customary for bylaws of publicly traded companies, effectiveupon the closing of our initial public offering.

**ITEM 5.**    OTHERINFORMATION

None

**ITEM 6.**    EXHIBITS

Exhibits

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The following documentsare filed as Exhibits to this report:
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                               |
|-----------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2             |       | Amended and Restated Certificate of Incorporation.                                                                                                                                            |
| 3.4             |       | Amended and Restated  Bylaws.                                                                                                                                                                 |
| 10.6(1)         |       | Bare Escentuals, Inc.  2006 Equity Incentive Award Plan.                                                                                                                                      |
| 10.42(1)        |       | Third Amendment to  Amended and Restated Agreement between Bare Escentuals Beauty, Inc. and QVC,  Inc. dated September 5, 2006.                                                          |
| 10.43(2)        |       | Fifth Amendment to  Credit Agreement among Bare Escentuals Beauty, Inc., formerly known as MD  Beauty, Inc., Registrant, BNP Paribas and certain lenders dated  September 11, 2006. |
| 10.44(2)        |       | Name and Likeness  License Agreement between the Registrant and Leslie A. Blodgett dated  September 22, 2006.                                                                       |
| 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 Amendment No. 3 to our Registration Statement on Form S-1(File No. 333-135484), filed on September 13, 2006.

(2)             Incorporatedby reference from Amendment No. 4 to our Registration Statement on Form S-1(File No. 333-135484), filed on September 25, 2006.

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.
|                         |   | BARE ESCENTUALS, INC. |
|-------------------------|--------|-----------------------|
|                    |   |                  |
| Date: November 15, 2006 |   | By:                   |   | /s/ LESLIE A. BLODGETT |
|                    |   |                  |   | Leslie A. Blodgett |
|                    |   |                  |   | Chief Executive Officer and Director |
|                    |   |                  |   |   |
|                    |   | By:                   |   | /s/ MYLES B. MCCORMICK |
|                    |   |                  |   | Myles B. McCormick |
|                    |   |                  |   | Senior Vice President, Chief Financial Officer,  Chief Operations Officer and Secretary |

 

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