**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**ý****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

###### **Forthe quarterly period ended October 1, 2005**

 

###### **OR**

 

**o****        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

###### **CommissionFile Number 0-24395**

 

**bebe stores, inc.**

(Exact name ofregistrant as specified in its charter)

 
| **California**                                             | ** ** | **94-2450490**                         |
|------------------------------------------------------------|------------|----------------------------------------|
| (State  or Jurisdiction of  Incorporation or Organization) |       | (IRS  Employer  Identification Number) |

 

**400 ValleyDrive**

**Brisbane,California 94005**

(Address of principal executive offices)

 

**Telephone:(415) 715-3900**

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 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.

ý Yes   o No

 

Indicate by checkmark whether the registrant (1) is an accelerated filer (as defined in Rule 12b-2if the Securities Exchange Act).  ý Yes   o No

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the Exchange Act). o Yes   ý No

 

Thenumber of shares of registrant’s common stock, par value $0.001 per share,outstanding as of November 1, 2005 was 91,206,293

 

 

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**bebe stores, inc.**

 

#### **TABLE OF CONTENTS**

 

 
| **PART I.**       | **FINANCIAL INFORMATION**                                                                                              |   |
|------------------------|------------------------------------------------------------------------------------------------------------------------|--------|
|                   |                                                                                                                   |   |
| ITEM  1.               | Condensed Consolidated  Financial Statements                                                                           |   |
|                   |                                                                                                                   |   |
|                   | Condensed Consolidated  Balance Sheets as of October 1, 2005, July 2, 2005 and October 2,  2004         |   |
|                   |                                                                                                                   |   |
|                   |                                                                                                                   |   |
|                   | Condensed Consolidated Statements  of Earnings for the quarters ended October 1, 2005 and October 2,  2004   |   |
|                   |                                                                                                                   |   |
|                   | Condensed Consolidated  Statements of Cash Flows for the quarters ended October 1, 2005 and October 2,  2004 |   |
|                   |                                                                                                                   |   |
|                   | Notes to Condensed  Consolidated Financial Statements                                                                  |   |
|                   |                                                                                                                   |   |
| ITEM  2.               | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                            |   |
|                   |                                                                                                                   |   |
| ITEM  3.               | Quantitative and Qualitative  Disclosures about Market Risk                                                            |   |
|                   |                                                                                                                   |   |
| ITEM  4.               | Controls and Procedures                                                                                                |   |
|                   |                                                                                                                   |   |
| **PART II.**      | **OTHER INFORMATION**                                                                                                  |   |
|                   |                                                                                                                   |   |
| ITEM 1.                | Legal Proceedings                                                                                                      |   |
|                   |                                                                                                                   |   |
| ITEM  2.               | Unregistered Sales of Equity  Securities and Use of Proceeds                                                           |   |
|                   |                                                                                                                   |   |
| ITEM  3.               | Defaults Upon Senior  Securities                                                                                       |   |
|                   |                                                                                                                   |   |
| ITEM  4.               | Submission of Matters to a  Vote of Security Holders                                                                   |   |
|                   |                                                                                                                   |   |
| ITEM 5.                | Other Information                                                                                                      |   |
|                   |                                                                                                                   |   |
| ITEM 6.                | Exhibits                                                                                                               |   |
|                   |                                                                                                                   |   |
| **SIGNATURE**          | ** **                                                                                                             |
| ** **             | ** **                                                                                                             |
| **EXHIBIT INDEX** |                                                                                                                   |
|                        |                                                                                                                        |        |  |

 

2

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**PART I.**    **FINANCIAL INFORMATION**

 

ITEM 1.     Condensed ConsolidatedFinancial Statements

 

**bebe stores, inc.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(In thousands, except share data)**

**(unaudited)**

 
| ** **                                                                                                                                      | ** ** | **As of  October 1,  2005** | ** ** | **As of  July 2,  2005** | ** ** | **As of  October 2,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|-------------------------------|------------|----------------------------------|------------|
|                                                                                                                                            |       |                             |       |                          |       |                             |       |
| **Assets:**                                                                                                                                     |       |                             |       |                          |       |                             |       |
| Current assets:                                                                                                                                 |       |                             |       |                          |       |                             |       |
| Cash and equivalents                                                                                                                            |       | $                                | 31,479     |                          | $          | 27,072                           |       | $ | 27,305 |   |
| Short-term marketable securities                                                                                                                |       | 253,632                          |       | 241,604                       |       | 166,650                          |       |
| Receivables (net of allowance of $912, $843 and  $678)                                                                                          |       | 8,029                            |       | 6,547                         |       | 4,176                            |       |
| Inventories                                                                                                                                     |       | 39,638                           |       | 31,785                        |       | 36,886                           |       |
| Prepaid and other                                                                                                                               |       | 13,170                           |       | 12,599                        |       | 12,640                           |       |
| Total current assets                                                                                                                            |       | 345,948                          |       | 319,607                       |       | 247,657                          |       |
| Property and equipment, net                                                                                                                     |       | 78,349                           |       | 77,753                        |       | 63,346                           |       |
| Long-term marketable securities                                                                                                                 |       | —                           |       | 2,000                         |       | 7,875                            |       |
| Other assets                                                                                                                                    |       | 8,899                            |       | 8,186                         |       | 4,211                            |       |
| Total assets                                                                                                                                    |       | $                                | 433,196    |                          | $          | 407,546                          |       | $ | 323,089 |   |
|                                                                                                                                            |       |                             |       |                          |       |                             |       |
| **Liabilities and Shareholders’ Equity:**                                                                                                  |       |                             |       |                          |       |                             |       |
| Current liabilities:                                                                                                                            |       |                             |       |                          |       |                             |       |
| Accounts payable                                                                                                                                |       | $                                | 25,575     |                          | $          | 20,682                           |       | $ | 24,909 |   |
| Accrued liabilities                                                                                                                             |       | 27,369                           |       | 23,041                        |       | 23,464                           |       |
| Current portion of capital leases                                                                                                               |       | 168                              |       | 167                           |       | —                           |       |
| Total current liabilities                                                                                                                       |       | 53,112                           |       | 43,890                        |       | 48,373                           |       |
| Long term portion of capital leases                                                                                                             |       | 184                              |       | 226                           |       | —                           |       |
| Deferred rent and other lease incentives                                                                                                        |       | 32,912                           |       | 30,187                        |       | 19,157                           |       |
| Total liabilities                                                                                                                               |       | 86,208                           |       | 74,303                        |       | 67,530                           |       |
|                                                                                                                                            |       |                             |       |                          |       |                             |       |
| Commitments and contingencies                                                                                                                   |       | —                           |       | —                        |       | —                           |       |
| Shareholders’ equity:                                                                                                                      |       |                             |       |                          |       |                             |       |
| Preferred stock-authorized 1,000,000 shares at  $0.001 par value per share; no shares issued and outstanding                                    |       | —                           |       | —                        |       | —                           |       |
| Common stock-authorized 135,000,000 shares at $0.001  par value per share; issued and outstanding 91,206,371, 91,127,616 and  88,411,095 shares |       | 91                               |       | 91                            |       | 88                               |       |
| Additional paid-in capital                                                                                                                      |       | 83,606                           |       | 80,526                        |       | 50,328                           |       |
| Deferred compensation                                                                                                                           |       | —                           |       | (35                           | )          | (9                               | )          |
| Accumulated other comprehensive income                                                                                                          |       | 1,676                            |       | 971                           |       | 719                              |       |
| Retained earnings                                                                                                                               |       | 261,615                          |       | 251,690                       |       | 204,433                          |       |
| Total shareholders’ equity                                                                                                                 |       | 346,988                          |       | 333,243                       |       | 255,559                          |       |
| Total liabilities and shareholders’ equity                                                                                                 |       | $                                | 433,196    |                          | $          | 407,546                          |       | $ | 323,089 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

3

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**bebestores, inc.**

**CONDENSEDCONSOLIDATED STATEMENTS OF EARNINGS**

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

**(unaudited)**

 
| ** **                                        | ** ** | **Quarters Ended**        | ** ** |
|---------------------------------------------------|------------|---------------------------|------------|
| ** **                                        | ** ** | **October 1,  2005** | ** ** | **October 2,  2004** | ** ** |
| Net sales                                         |       | $                         | 126,155    |   | $ | 103,147 |   |
| Cost of sales, including production and occupancy |       | 63,952                    |       | 53,048 |   |
| Gross profit                                      |       | 62,203                    |       | 50,099 |   |
| Selling, general and administrative expenses      |       | 42,249                    |       | 32,538 |   |
|                                              |       |                      |       |   |   |
| Income from operations                            |       | 19,954                    |       | 17,561 |   |
| Interest and other income, net                    |       | 2,115                     |       | 855 |   |
|                                              |       |                      |       |   |   |
| Earnings before income taxes                      |       | 22,069                    |       | 18,416 |   |
| Provision for income taxes                        |       | 8,496                     |       | 6,998 |   |
| Net earnings                                      |       | $                         | 13,573     |   | $ | 11,418 |   |
| Basic earnings per share                          |       | $                         | 0.15       |   | $ | 0.13 |   |
| Diluted earnings per share                        |       | $                         | 0.14       |   | $ | 0.13 |   |
| Basic weighted average shares outstanding         |       | 91,147                    |       | 88,283 |   |
| Diluted weighted average shares outstanding       |       | 94,159                    |       | 90,045 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

4

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**bebestores, inc.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In thousands)**

**(unaudited)**

 
| ** **                                                                       | ** ** | **Quarters Ended**        | ** ** |
|----------------------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                                       | ** ** | **October 1,  2005** | ** ** | **October 2,  2004** | ** ** |
| Cash flows from operating activities:                                            |       |                      |       |   |   |
| Net earnings                                                                     |       | $                         | 13,573     |   | $ | 11,418 |   |
| Adjustments to reconcile net earnings to cash  provided by operating activities: |       |                      |       |   |   |
| Non-cash compensation expense                                                    |       | 2,309                     |       | 27 |   |
| Depreciation and amortization                                                    |       | 3,769                     |       | 3,151 |   |
| Net loss on disposal of property                                                 |       | 1                         |       | 4 |   |
| Deferred income taxes                                                            |       | (504                      | )          | — |   |
| Deferred rent and other  lease incentives                                        |       | 2,687                     |       | 961 |   |
| Changes in operating assets and liabilities:                                     |       |                      |       |   |   |
| Receivables                                                                      |       | (915                      | )          | (1,242 | ) |
| Inventories                                                                      |       | (8,053                    | )          | (11,322 | ) |
| Prepaid expenses and other assets                                                |       | (803                      | )          | (5,089 | ) |
| Accounts payable                                                                 |       | 4,889                     |       | 10,442 |   |
| Accrued liabilities                                                              |       | 4,628                     |       | 4,275 |   |
| Net cash provided by operating activities                                        |       | 21,581                    |       | 12,625 |   |
|                                                                             |       |                      |       |   |   |
| Cash flows from investing activities:                                            |       |                      |       |   |   |
| Purchase of property and equipment                                               |       | (4,950                    | )          | (4,348 | ) |
| Purchase of marketable  securities                                               |       | (82,702                   | )          | (60,400 | ) |
| Proceeds from sales of marketable securities                                     |       | 72,901                    |       | 53,950 |   |
| Net cash used by investing activities                                            |       | (14,751                   | )          | (10,798 | ) |
|                                                                             |       |                      |       |   |   |
| Cash flows from financing activities:                                            |       |                      |       |   |   |
| Net proceeds from issuance of common stock                                       |       | 551                       |       | 994 |   |
| Tax benefit on options exercised                                                 |       | 256                       |       | — |   |
| Cash dividends paid                                                              |       | (3,648                    | )          | (1,962 | ) |
| Other                                                                            |       | (41                       | )          | — |   |
| Net cash used by financing activities                                            |       | (2,882                    | )          | (968 | ) |
|                                                                             |       |                      |       |   |   |
| Net increase in cash and equivalents                                             |       | 3,948                     |       | 859 |   |
| Effect of exchange rate changes on cash                                          |       | 459                       |       | 391 |   |
| Cash and equivalents:                                                            |       |                      |       |   |   |
| Beginning of period                                                              |       | 27,072                    |       | 26,055 |   |
| End of period                                                                    |       | $                         | 31,479     |   | $ | 27,305 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

5

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##### **bebe stores, inc.**

 

##### **NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

##### **INTERIM FINANCIAL STATEMENTS**

 

The accompanying condensed consolidated balance sheetsof bebe stores, inc. as of October 1, 2005, July 2, 2005, and October 2,2004, and the condensed consolidated statements of earnings and cash flows forthe quarters ended October 1, 2005 and October 2, 2004 have beenprepared in accordance with accounting principles generally accepted in theUnited States of America for interim financial information and with theinstructions to Form 10-Q and Article 10 of Regulation S-X withoutaudit. Accordingly, they do not include all of the information and footnotesrequired by accounting principles generally accepted in the United States ofAmerica for annual financial statements. In the opinion of management, alladjustments (consisting of normal recurring accruals) considered necessary topresent fairly the financial position at the balance sheet dates and theresults of earnings for the periods presented have been included. The condensedconsolidated balance sheet at July 2, 2005, presented herein, was derivedfrom the audited balance sheet included in the Form 10-K for the fiscalyear ended July 2, 2005.

 

Our business is affected by the pattern of seasonalitycommon to most retail apparel businesses. The results for the current and priorperiods are not necessarily indicative of future financial results.

 

Certainnotes and other information have been condensed or omitted from the interimcondensed consolidated financial statements presented in this Quarterly Reporton Form 10-Q. Therefore, these condensed consolidated financial statementsshould be read in conjunction with our Annual Report on Form 10-K for theyear ended July 2, 2005.

 

##### **FISCAL YEAR**

 

##### **Beginning on July 1, 2004,the Company changed their fiscal year to a 52/53 week year, each period endingon a Saturday.  The first quarter offiscal year 2006 began on July 3, 2005 and ended on October 1, 2005and included 91 days.  The first quarterof fiscal year 2005 began on July 1, 2004 and ended on October 2,2004 and included three additional days in the reporting period than the comparativeperiod of fiscal year 2006.**

##### ** **

**RECLASSIFICATIONS**

 

Certainprior year amounts have been reclassified to conform to the current yearpresentation.

 

##### **EARNINGS PER SHARE**

##### ** **

Basicearnings per share is computed as net earnings divided by the weighted averagenumber of common shares outstanding for the period. Diluted earnings per sharereflects the potential dilution that could occur from common shares issuablethrough the exercise of dilutive stock options.

 

Thefollowing is a reconciliation of the number of shares used in the basic anddiluted earnings per share computations:

 
| ** **                                                     | ** ** | **Quarters Ended**        | ** ** |
|----------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                     | ** ** | **October 1,  2005** | ** ** | **October 2,  2004** | ** ** |
| ** **                                                     |       | **(In thousands)**        |       |
| Basic weighted average number of shares outstanding            |       | 91,147                    |       | 88,283 |   |
| Incremental shares from the assumed issuance of  stock options |       | 3,012                     |       | 1,762 |   |
| Diluted weighted average number of shares  outstanding         |       | 94,159                    |       | 90,045 |   |

 

6

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Thenumber of incremental shares from the assumed issuance of stock options iscalculated applying the treasury stock method.

 

Excludedfrom the computation of the number of diluted weighted average sharesoutstanding were antidilutive options of approximately 917,000 and 4,230,000,for the quarters ended October 1, 2005 and October 2, 2004,respectively.

 

##### **COMPREHENSIVE INCOME**

 

Comprehensiveincome consists of net income and other comprehensive income (income, expenses,gains and losses that bypass the income statement and are reported directly asa separate component of equity).  TheCompany’s comprehensive income consists of net income and foreign currencytranslation adjustments for all periods presented.

 
| ** **                 | ** ** | **Quarters Ended**        | ** ** |
|----------------------------|------------|---------------------------|------------|
| ** **                 | ** ** | **October 1,  2005** | ** ** | **October 2,  2004** | ** ** |
| ** **                 | ** ** | **(In thousands)**        | ** ** |
| Net income                 |       | $                         | 13,573     |   | $ | 11,418 |   |
| Other comprehensive income |       | 705                       |       | 423 |   |
| Total comprehensive income |       | $                         | 14,278     |   | $ | 11,841 |   |

 

##### **CREDIT FACILITIES**

 

**The Company has an unsecured commercial line ofcredit agreement with a bank, which provides for borrowings and issuance ofletters of credit of up to $25.0 million and expires on March 1, 2006. Outstandingcash borrowings bear interest at either the bank’s reference rate (which was 6.75%as of October 1, 2005) or the LIBOR rate plus 1.75 percentage points. Asof October 1, 2005, there were no outstanding cash borrowings under theline of credit, and there was $8.4 million outstanding in letters of credit.**

** **

**This credit facility requires the Company to complywith certain financial covenants, including amounts for minimum tangible networth, unencumbered liquid assets and profitability, and certain restrictionson making loans and investments.**

** **

##### **STOCK BASED COMPENSATION**

 

**The 1997 Stock Plan as amended (the “Stock Plan”)provides for the grant of incentive stock options, non-qualified stock options,stock purchase rights, stock awards and restricted stock units. Although theStock Plan allows for stock options and related awards to be granted at pricesbelow fair market value, the Company has historically granted such options atthe fair market value of the stock on the date of grant.  Stock options and related awards have amaximum term of ten years.  Optionsgranted vest over four years with 20% of the award vested in each of the firstand second years, and 30% vested in each of the remaining two years.  Restricted stock units awarded to Directorsgenerally vest over a period of one year from the date of grant.  As of October 1, 2005, the Company hasreserved 19,113,750 shares of common stock for issuance under the Stock Planand there were 1,140,838 shares available for future grant.**

** **

Priorto July 3, 2005, the Company accounted for stock-based awards granted toemployees and non-employee Directors under the Stock Plan in accordance withthe measurement and recognition provisions of Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees,” and relatedinterpretations, Financial Accounting Standards Board (“FASB”) Statement No. 123“Accounting for Stock-Based Compensation,” and complied with the disclosureprovisions of FASB Statement No. 148, “Accounting for Stock BasedCompensation Transition and Disclosure, an Amendment of FASB Statement No. 123.”

 

7

----

 

EffectiveJuly 3, 2005, the Company adopted the fair value recognition provisions ofFASB Statement No. 123(R), “Share-Based Payment”, using the modifiedprospective transition method.  Underthis transition method, compensation cost in 2006 includes the portion vestingin the period for (1) all share-based payments granted prior to, but notvested as of July 2, 2005, based on the grant date fair value estimated inaccordance with the original provisions of FASB Statement No. 123 and (2) allshare-based payments granted subsequent to July 2, 2005, based on thegrant date fair value estimated in accordance with the provisions of FASBStatement No. 123(R). Results for prior periods have not been restated.

 

TheCompany recognized share-based compensation expense of $2.3 million ($0.02 perdiluted share, after related tax benefit of $0.9 million) in the quarter ended October 1,2005 as a component of selling, general and administrative expenses.  As of October 1, 2005, there was $25.2million (before any related tax benefit) of total unrecognized compensationcost related to nonvested share-based compensation that is expected to berecognized over a weighted-average period of 1.9 years.

 

Priorto the adoption of FASB Statement No. 123(R), the Company presented allbenefits of tax deductions resulting from the exercise of share-basedcompensation as operating cash flows in the Statements of Cash Flows. FASBStatement No. 123(R) requires the benefits of tax deductions in excess ofthe compensation cost recognized for those options (excess tax benefits) to beclassified as financing cash flows. First quarter 2006 results include $0.3million of excess tax benefits as a financing cash inflow.

 

Hadstock based employee compensation expense been determined based upon the fairvalues at the grant dates for awards under the Company’s stock plan inaccordance with FASB Statement No. 123 in the first quarter of fiscal year2005, the Company’s pro forma net earnings, basic and diluted earnings percommon share would have been as follows:

 
| ** **                                                                                           | ** ** | **Quarter Ended  October 2,  2004**       | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **(In thousands,  except per share  amounts)** | ** ** |
|                                                                                                 |       |                                           |       |
| Net income, as reported                                                                              |       | $                                              | 11,418     |   |
| Add: Stock-based employee compensation expense  included in reported net income, net of income tax   |       | 17                                             |       |
| Deduct: Stock based employee compensation determined  under the fair value method, net of income tax |       | (1,626                                         | )          |
| Net income, pro forma                                                                                |       | $                                              | 9,809      |   |
|                                                                                                 |       |                                           |       |
| Basic EPS, as reported                                                                               |       | $                                              | 0.13       |   |
| Basic EPS, pro forma                                                                                 |       | $                                              | 0.11       |   |
|                                                                                                 |       |                                           |       |
| Diluted EPS, as reported                                                                             |       | $                                              | 0.13       |   |
| Diluted EPS, pro forma                                                                               |       | $                                              | 0.11       |   |

 

The fair value of each option grant was estimated onthe date of the grant using the Black-Scholes valuation model.  The expected life of the options represents the periodof time the options are expected to be outstanding and is based on historicaltrends. For the quarter ended October 1, 2005, expected stock pricevolatility is based on an average of the historical volatility of the Company’sstock for a period approximating the expected life and the implied volatilitybased on traded options of the Company’s stock. For the quarter ended October 2, 2004, expected stock volatilitywas based on historical volatility only. The expected dividend yield is based on the Company’s most recent annualdividend payout. The risk-free interest rate is based on the U.S. Treasuryyield curve in effect at the time of grant and has a term that approximates theexpected life.

 

8

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The following tablepresents the weighted-average assumptions used in the option pricing model forthe first quarter 2006 and 2005 stock option grants.

 
| ** **                    | ** ** | **Quarters Ended**        | ** ** |
|-------------------------------|------------|---------------------------|------------|
| ** **                    | ** ** | **October 1,  2005** | ** ** | **October 2,  2004** | ** ** |
| ** **                    | ** ** | ** **                | ** ** | **(Pro forma)** | ** ** |
| Expected dividend rate        |       | 0.9                       | %          | 1.0 | % |
| Volatility                    |       | 54.5                      | %          | 72.1 | % |
| Risk-free interest rate       |       | 4.0                       | %          | 3.5 | % |
| Expected lives (years)        |       | 4.4                       |       | 6.0 |   |
| Fair value per option granted |       | $                         | 8.35       |   | $ | 4.89 |   |
|                               |            |                           |            |  |  |  |  |

 

##### **The following table summarizesstock option activity during the quarter ended October 1, 2005:**

 
| ** **                        | ** ** | **Options**        | ** ** | **Weighted  Average  Exercise Price  Per Share** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-----------------------------------|------------|--------------------|------------|--------------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **(In thousands)** | ** ** | ** **                                       | ** ** | ** **                                          | ** ** | **(In thousands)**             | ** ** |
| Outstanding, July 2, 2005    |       | 7,663              |       | $                                                | 8.48       |                                                |       |                           |       |   |
| Granted                           |       | 409                |       | 18.57                                            |       |                                                |       |                           |       |
| Exercised                         |       | (77                | )          | 6.59                                             |       |                                                |       |                           |       |
| Cancelled                         |       | (149               | )          | 5.37                                             |       |                                                |       |                           |       |
| Outstanding, October 1, 2005 |       | 7,846              |       | $                                                | 9.08       |                                                | 7.90       |                           | $          | 66,092 |   |
| Exercisable, October 1, 2005 |       | 2,090              |       | $                                                | 5.85       |                                                | 6.24       |                           | $          | 24,349 |   |

 

**Intrinsic value for stock options is defined as thedifference between the current market value and the grant price. During thequarter ended October 1, 2005, the total intrinsic value of stock optionsexercised was $0.9 million. Cash received from stock options exercised duringthe quarter was $0.6 million and the actual tax benefit realized for taxdeductions from stock options exercised totaled $0.4 million.**

 

##### **The following table summarizes restrictedstock unit activity during the quarter ended October 1, 2005:**

 
| ** **                      | ** ** | **Shares**         | ** ** | **Weighted  Average Grant  Date Fair Value  Per Share** | ** ** |
|---------------------------------|------------|--------------------|------------|---------------------------------------------------------|------------|
| ** **                      | ** ** | **(In thousands)** | ** ** | ** **                                              | ** ** |
| Nonvested, July 2, 2005    |       | 6                  |       | $                                                       | 16.67      |   |
| Granted                         |       | 8                  |       | $                                                       | 17.36      |   |
| Nonvested, October 1, 2005 |       | 14                 |       | $                                                       | 17.06      |   |

 

9

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##### **LEGAL MATTERS**

 

**As of the date of this filing, the Company isinvolved in several ongoing legal proceedings as described below.**

 

A former candidate for anexecutive position sued the Company and two other named defendants in a FirstAmended Complaint, filed November 9, 2004 in the Superior Court of theState of California, County of San Francisco (case No. CGC-04-435517),seeking unspecified monetary damages and other equitable relief. The claimsagainst bebe allege intentional and negligent interference with prospectiveeconomic advantage and contractual relations, breach of contract, breach ofimplied covenant of good faith and fair dealing, fraud, promissory estoppel,negligence, intentional and negligent infliction of emotional distress, andviolation of Labor Code Section 970. The Company believes that the claimsagainst the Company are without merit, therefore has not made an estimate ofpotential liabilities, and will continue to vigorously defend this matter.

 

A former employee suedthe Company in a complaint filed on April 28, 2005 in the United StatesDistrict Court for the Northern District of California (case No. C05-0177-MHP)alleging violations under the Fair Labor Standards Act, specifically that theCompany obligated her to buy and wear its brand clothing as a uniform, withoutreimbursement or credit, and the net effect of deducting the value of suchrequired purchases from her wages would often result in her not being paidminimum wages. The plaintiff purports to bring the action also on behalf of aclass of hourly, non-managerial employees who are similarly situated. Thelawsuit seeks compensatory, statutory and injunctive relief. The Companybelieves plaintiff’s claims are without merit, therefore has not made anestimate of potential liabilities, and will continue to vigorously defend thismatter.

 

The Company was a nameddefendant in four separate California Superior Court cases, (case No. CIV435794in San Mateo County, case No. GIC824505 in San Diego County, case No. 04AS03109in Sacramento County and case No. CIV 447421 in San Mateo County) eachalleging Labor Code violations due to misclassification of employees as exemptunder California state law.  All of these cases have been resolved anddismissals have been filed for case No. CIV 435794 and case No. GIC824505and dismissals will be filed no later than November 14, 2005 for case No. 04AS03109and case No. CIV 447421.  The resolution of these cases did not havea material adverse effect on the Company’s business, financial condition, orresults of operations.

 

The Company intends todefend itself vigorously against these claims. However, the results of anylitigation are inherently uncertain. The Company cannot assure you that it willbe able to successfully defend itself in these lawsuits. Where required, and/orotherwise appropriate, the Company has made an estimate of potentialliabilities that management believes are reasonable. This estimate will berevised as further information becomes available. Although the final resolutionof these matters may be greater than the Company’s recorded liability,management does not believe the ultimate resolution will have a materialadverse effect on the Company’s business, financial condition or results ofoperations.

 

In addition to the above,the Company is also involved in various other legal proceedings arising in thenormal course of business. None of these matters are expected, individually orin the aggregate, to have a material adverse effect on the Company’s business,financial condition or results of operations.

 

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**ITEM2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

Thefollowing Management’s Discussion and Analysis of Financial Condition andResults of Operations contains forward-looking statements, which involve risksand uncertainties. Our actual results may differ materially from those anticipatedin these forward-looking statements.  Statementsthat are predictive in nature, that depend upon or refer to future events orconditions or that include words such as “expects,” “anticipates,” “intends,” “plans,”“believes,” “estimates,” “thinks,” and similar expressions are forward-lookingstatements.   Forward looking statementsinclude statements about our expected results of operations, capitalexpenditures and store openings.  Althoughwe believe that these statements are based upon reasonable assumptions, wecannot assure you that our goals will be achieved. These forward-lookingstatements are made as of the date of this Form 10-Q, and we assume noobligation to update or revise them or provide reasons why actual results maydiffer. Factors that might cause such a difference include, but are not limitedto, our ability to respond to changing fashion trends, miscalculation of thedemand for our products, effective management of our growth, decline incomparable store sales performance, ongoing competitive pressures in theapparel industry, changes in the level of consumer spending or preferences inapparel, our ability to attract and retain key management personnel and/orother factors discussed in “Risks That May Affect Results” and elsewherein this Form 10-Q.

 

##### **OVERVIEW**

 

Wedesign, develop and produce a distinctive line of contemporary women’s appareland accessories. While we attract a broad audience, our target customer is a 21to 35-year-old woman who seeks current fashion trends to suit her lifestyle.The “bebe look,” appeals to a modern, sexy, sophisticated, body-conscious womanwho takes pride in her appearance. The bebe customer expects value in the formof current fashion and high quality at a competitive price.

 

Ourdistinctive product offering includes a full range of separates, tops,sweaters, dresses, active wear and accessories in the following lifestylecategories:  career, evening, casual, and active. We design and developthe majority of our merchandise in-house, which is manufactured to ourspecifications. The remainder of our merchandise is sourced directly from thirdparty manufacturers.

 

Wemarket our products under the bebe, BEBE SPORT and bebe O brand names throughour 220 retail stores, of which 169 are bebe stores, 34 are BEBE SPORT stores,and 17 are bebe outlet stores.  Thesestores are located in 32 states, the District of Columbia, Puerto Rico andCanada. In addition, we have an on-line store at www.bebe.com and our licenseesoperate 14 international stores.  Duringthe first quarter of fiscal 2006, we opened 7 stores, including 4 bebe storesand 3 BEBE SPORT stores, and closed 1 bebe store.  We expect to open approximately 35 stores,including 20 bebe stores, 12 BEBE SPORT stores and 3 outlet stores, during theyear.  We also plan to renovate, relocateor expand approximately 17 existing stores and close approximately 4 stores,resulting in square footage growth of approximately 15%.

 

*bebestores.*  The Companywas founded by Manny Mashouf, Chairman of the Board. We opened our first storein San Francisco, California in 1976, which was also the year we incorporated.

 

*BEBESPORT stores.* The Company launched BEBE SPORT during fiscal2003 to address the active lifestyle needs of the bebe customer. The BEBE SPORTcollection includes sportswear, tops, sweaters, outerwear and accessories.

 

*bebeoutlet stores.*  TheCompany utilizes the outlets as a clearance vehicle for merchandise from ourretail stores. In addition, the inventory includes a strong presentation ofbebe logo merchandise and special cuts produced under the bebe O labelexclusively for the outlet stores.

 

*On-linestore.* bebe.com is an extension of the bebe store experienceand provides a complete assortment of bebe and BEBE SPORT merchandise. It isalso used as an advertising vehicle to communicate with our customers.

 

*Directto consumer.  *The Company launched a direct mailmarketing program in fiscal 2005 and plans to increase the circulation andfrequency of mailings during fiscal 2006. We effectively communicate our brandstrategy to our best customers through direct to consumer marketing.

 

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**CRITICALACCOUNTING POLICIES**

 

Management’s Discussion and Analysis of FinancialCondition and Results of Operations are based upon our consolidated financialstatements, which have been prepared in conformity with accounting principlesgenerally accepted in the United States of America.

 

The preparation of these financial statements requiresthe appropriate application of certain accounting policies, many of whichrequire us to make estimates and assumptions about future events and theirimpact on amounts reported in our financial statements and related notes. Sincefuture events and their impact cannot be determined with certainty, the actualresults will inevitably differ from our estimates. Such differences could bematerial to the financial statements. We believe our application of accountingpolicies, and the estimates inherently required therein, are reasonable. Theseaccounting policies and estimates are constantly reevaluated, and adjustments aremade when facts and circumstances dictate a change. Our accounting policies aremore fully described in Note 1 to the consolidated financial statements in ourannual report on Form 10-K for the year ended July 2, 2005.

 

We have identified certain critical accounting policies,which are described below:

 

*Revenue recognition.  *Werecognize revenue at the time the products are received by the customers inaccordance with the provisions of Staff Accounting Bulletin (“SAB”) No. 101,“Revenue Recognition in Financial Statements” as amended by SAB No. 104, “RevenueRecognition”. Revenue is recognized for store sales at the point at which thecustomer receives and pays for the merchandise at the register with either cashor credit card. For online sales, revenue is recognized at the time thecustomer receives the product. We estimate and defer revenue and the relatedproduct costs for shipments that are in transit to the customer. Customerstypically receive goods within a few days of shipment. Amounts related to shippingbilled to customers are reflected in net sales and the related costs arereflected in cost of goods sold.

 

Discounts offered tocustomers consist primarily of point of sale markdowns and are recorded at thetime of the related sale as a reduction of revenue. The value of points earnedby our loyalty program members is included as a liability and a reduction ofrevenue at the time the points are earned.

 

Gift certificates soldare carried as a liability and revenue is recognized when the gift certificateis redeemed. Similarly, customers may receive a store credit in exchange forreturned goods. Store credits are carried as a liability until redeemed.

 

Royalty revenue fromproduct licensees is recorded as earned.

 

*Inventories.* Our inventories are stated at the lowerof weighted average cost or market. Market is determined based on the estimatednet realizable value, which is generally the merchandise selling price. Toensure that our raw material is properly valued we age the fabric inventory andrecord a reserve in accordance with our established policy, which is based onhistorical experience. To ensure our finished goods inventory is properlyvalued we review the age and turnover of our inventory and record a reserve ifthe selling price is marked down below cost. These assumptions can have animpact on current and future operating results and financial position. Weestimate shrinkage for the period between the last physical count and balancesheet date based on historic shrinkage trends.

 

*Long-lived assets.* We review long-lived assets forimpairment whenever events or changes in circumstances, such as store closuresor poor performing stores, indicate that the carrying value of an asset may notbe recoverable. If the undiscounted cash flows from the long-lived assets areless than the carrying value we record an impairment charge equal to thedifference between the carrying value and the asset’s fair value. In addition,at the time a decision is made to close a store, we record an impairmentcharge, if appropriate, or accelerate depreciation over the revised useful lifeof the asset. Historically, our impairment charges have been immaterial.  Duringthe quarters ended October 1, 2005 and October 2, 2004 we recorded$73,000 and $0, respectively, of impairment charges.  We believe at this time that the long-livedassets’ carrying values and useful lives continue to be appropriate.

 

*SalesReturn Reserve.* We record a reserve for estimated productreturns based on historical return trends. As of October 1, 2005 and October 2, 2004, the reserve was$868,000 and $734,000, respectively.  Ifactual returns are greater than those projected, additional sales returns maybe recorded in the future.

 

*AccruedLitigation.*  We accrue estimates of probableliabilities associated with lawsuits and claims. The results of any litigationare inherently uncertain. As information becomes available, we assess thepotential liabilities related to pending

 

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litigation and may reviseour estimates as necessary. Such revisions of estimates could materially impactthe results of operations and financial position.

 

*Self-Insurance*.  We use a combination of insurance and self insurance for employee relatedhealth care benefits. We record self insurance liabilities based on claimsfiled and an estimate of those claims incurred but not reported. Any projectionof losses concerning our liability is subject to a high degree of variability.Among the causes of this variability are unpredictable external factors such asfuture inflation rates, changes in severity, benefit level changes, medicalcosts and claim settlement patterns. Should a different amount of claims occurcompared to what was estimated or costs of the claims increase or decreasebeyond what was anticipated, reserves may need to be adjusted in the future.

 

*IncomeTaxes*. Weaccrue liabilities for estimates of probable settlements of domestic andforeign tax audits. At any one time, many tax years may be subject to audit byvarious taxing jurisdictions. The results of these audits and negotiations withtaxing authorities may affect the ultimate settlement of these issues. Oureffective tax rate in a given financial statement period may be materiallyimpacted by changes in the mix and level of earnings. We also record avaluation allowance against our deferred tax assets arising from foreign taxcredit carryforwards as the utilization of these credits is not assured.

 

**RESULTSOF OPERATIONS**

 

Beginningon July 1, 2004, we changed our fiscal year to a 52/53 week year, eachperiod ending on a Saturday.  The firstquarter of fiscal year 2006 began on July 3, 2005 and ended on October 1,2005 and includes 91 days.  The firstquarter of fiscal year 2005 began on July 1, 2004 and ended on October 2,2004 and includes three additional days in the reporting period than thecomparative period of fiscal year 2006. For the first quarter of fiscal 2006, comparable store sales weredetermined using a comparable period of 91 days.

 

Thefollowing table sets forth certain financial data as a percentage of net salesfor the periods indicated:

 
| ** **                                             | ** ** | **Quarters Ended**        | ** ** |
|--------------------------------------------------------|------------|---------------------------|------------|
| ** **                                             | ** ** | **October 1,  2005** | ** ** | **October 2,  2004** | ** ** |
| **Statements  of Operations Data:**                    | ** ** | ** **                | ** ** | ** ** | ** ** |
| Net sales                                              |       | 100.0                     | %          | 100.0 | % |
| Cost of sales,  including production and occupancy (1) |       | 50.7                      |       | 51.4 |   |
| Gross profit                                           |       | 49.3                      |       | 48.6 |   |
| Selling, general  and administrative expenses (2)      |       | 33.5                      |       | 31.5 |   |
| Income from  operations                                |       | 15.8                      |       | 17.1 |   |
| Interest and  other income, net                        |       | 1.7                       |       | 0.8 |   |
| Earnings before  income taxes                          |       | 17.5                      |       | 17.9 |   |
| Provision for  income taxes                            |       | 6.7                       |       | 6.8 |   |
| Net earnings                                           |       | 10.8                      | %          | 11.1 | % |

 

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(1)                                  Cost of sales includes the cost of merchandise,occupancy costs, distribution center and production costs.

(2)                                  Selling, general and administrative expensesprimarily consist of non-occupancy store costs, corporate overhead andadvertising costs.  Stock basedcompensation expense is included for the quarter ended October 1, 2005.

 

*Net Sales.* Net sales increased to $126.2million during the quarter ended October 1, 2005 from $103.1 million forthe quarter ended October 2, 2004, an increase of $23.1 million, or 22.4%.During the quarter an increase in comparable store sales of 17.3% versus theprior year contributed $15.3 million to the increase in sales.  The increase in comparable store salesperformance was largely due to customer acceptance of the productoffering.  The remaining increase insales of $7.8 million was generated by stores not included in the comparablestore sales base and increases over the same period of the prior year inon-line sales, wholesale sales to international licensees, and royalty revenuefrom product licensees.

 

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***Gross Profit.*** Gross profit increased to $62.2 million during the quarter ended October 1,2005 from $50.1 million for the quarter ended October 2, 2004, an increaseof $12.1 million, or 24.2%.As a percentage of net sales, gross profit increased to 49.3% for thequarter ended October 1, 2005 from 48.6% in the quarter ended October 2,2004. The increase in gross profit as a percentage of net sales resultedprimarily from favorable occupancy leverage as a result of higher comparablestore sales.

 

*Selling, General and Administrative Expenses.*Selling, general and administrative expenses, which primarily consist ofnon-occupancy store costs, corporate overhead and advertising costs, increasedto $42.2 million during the quarter ended October 1, 2005 from $32.5million in the quarter ended October 2,2004, an increase of $9.7 million, or 29.8%. As a percentage of net sales,these expenses increased to 33.5% during the quarter from 31.5% in thecomparable period of the prior year. The increase as a percent of net sales isprimarily due to a $2.3 million pre-tax charge, or 1.8% of sales, related tothe expensing of stock based compensation, and to an increase in advertisingexpenses of 0.8% of net sales, partially offset by lower compensation expenseas a result of higher store productivity.

 

*Interest and Other Income, Net.*Wegenerated approximately $2.1 million of interest and other income (net of otherexpenses) during the quarter ended October 1, 2005 as compared toapproximately $0.9 million in the quarter ended October 2, 2004. Theincrease in interest and other income is a result of higher average cashbalances and higher interest rates.

 

***Provision forIncome Taxes.*** The effective tax rate increased to 38.5% for the quarter ended October 1,2005 from 38.0% for the quarter ended October 2, 2004 due to the adoption of FASBStatement No. 123(R) which changed the requirements regarding recognitionof stock based compensation. As a result of adopting FASB Statement No. 123(R),the compensation expense associated with incentive stock options increases theCompany’s effective tax rate.  Due to thetiming of when an incentive stock option is exercised and sold and the level ofearnings, the effective tax rate is expected to fluctuate from quarter toquarter under FASB Statement No. 123(R).

 

**Seasonalityof Business and Quarterly Results**

 

* *Ourbusiness varies with general seasonal trends that are characteristic of theretail and apparel industries. As a result, our typical store generates ahigher percentage of its annual net sales and profitability in the secondquarter of our fiscal year (which includes the holiday selling season) comparedto the other quarters of our fiscal year. If for any reason our sales werebelow seasonal norms during the second quarter of our fiscal year, our annualoperating results would be negatively impacted. Because of the seasonality ofour business, results for any quarter are not necessarily indicative of resultsthat may be achieved for a full fiscal year.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

Our working capital requirements vary widely throughoutthe year and generally peak in the first and second fiscal quarters. At October 1,2005, we had approximately $285.1 million of cash and equivalents andshort-term marketable securities on hand. In addition, we had a revolving lineof credit under which we could borrow or issue letters of credit up to acombined total of $25.0 million. As of October 1, 2005, there were no cashborrowings outstanding under the line of credit and letters of creditoutstanding totaled $8.4 million.

 

Net cash provided by operating activities for thequarter ended October 1, 2005 was $21.6 million. Cash provided byoperating activities for the period was primarily generated by earningsadjusted for stock compensation, depreciation and deferred rent, increases inaccounts payable and accrued liabilities, primarily due to the timing ofpayments, offset by an increase in inventory in preparation for the fall andholiday selling seasons.

 

Net cash used by investingactivities for the quarter ended October 1, 2005 was $14.8 million due tothe purchase of marketable securities and capital expenditures, primarilyrelated to the opening of new stores.  Weopened seven new stores in the first quarter of fiscal 2006 and expect to openapproximately 35 stores during fiscal 2006. We estimate that total capital expenditures will be approximately $33million in fiscal 2006.

 

Net cash used byfinancing activities was $2.9 million for the quarter ended October 1,2005 and was due to the payment of a cash dividend on our common stockpartially offset by proceeds from stock option exercises.

 

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We believe that our cash on hand, together with our cashflows from operations, will be sufficient to meet our capital and operatingrequirements for at least the next twelve months. Our future capitalrequirements, however, will depend on numerous factors, including withoutlimitation, the size and number of new and expanded stores and/or storeconcepts, investment costs for management information systems, potentialacquisitions and/or joint ventures, dividend payments, repurchase of stock andfuture results of operations.

 

**Inflation**

 

We do not believe that inflation has had a materialeffect on the results of operations in the recent past. However, we cannotassure that our business will not be affected by inflation in the future.

 

**RISKSTHAT MAY AFFECT RESULTS**

 

Factors that might cause our actual results to differmaterially from the forward looking statements discussed elsewhere in thisreport, as well as affect our ability to achieve our financial and other goals,include, but are not limited to, the following:

 

RISKS RELATING TO OURBUSINESS:

 

**1.   The success of ourbusiness depends in large part on our ability to identify fashion trends aswell as to react to changing customer demand in a timely manner.  **Consequently,we depend in part upon the customer response to the creative efforts of ourmerchandising, design and marketing teams and their ability to anticipatetrends and fashions that will appeal to our consumer base. If we miscalculateour customers’ product preferences or the demand for our products, we may befaced with excess inventory. Historically, this type of occurrence has resultedin excess fabric for some products and markdowns and/or write-offs, which hasimpaired our profitability, and may do so in the future. Similarly, any failureon our part to anticipate, identify and respond effectively to changingconsumer demands and fashion trends will adversely affect our sales.

 

**2.   If we are unable toobtain raw materials, unable to find manufacturing facilities or ourmanufacturers perform unacceptably, our sales may be negatively affected andour financial condition may be harmed.  **We do notown any manufacturing facilities and therefore depend on contractors and thirdparties to manufacture our products. We place all of our orders for productionof merchandise and raw materials by purchase order and do not have anylong-term contracts with any manufacturer or supplier. If we fail to maintainfavorable relationships with our manufacturers and suppliers or are unable toobtain sufficient quantities of quality raw materials on commerciallyreasonable terms, it could harm our business and results of operations. Wecannot assure you that contractors and third party manufacturers (1) willnot supply similar products to our competitors, (2) will not stopsupplying products to us completely, or (3) will supply products in atimely manner. Untimely receipt of products may result in markdowns which wouldhave a negative impact on earnings. Furthermore, we have received in the past,and may receive in the future, shipments of products from manufacturers thatfail to conform to our quality control standards. In such event, unless we areable to obtain replacement products in a timely manner, we may lose sales.Certain of our third party manufacturers store our raw materials. In the eventour inventory was damaged or destroyed and we were unable to obtain replacementraw materials, our earnings may be negatively impacted.

 

**3.   Our success depends onour ability to attract and retain key employees in order to support ourexisting business and future expansion.  **From timeto time we actively recruit qualified candidates to fill key executivepositions from within the Company. There is substantial competition forexperienced personnel, which we expect will continue. We compete forexperienced personnel with companies who have greater financial resources thanwe do. In the past, we have experienced significant turnover of our executivemanagement team and retail store personnel. We are also exposed to employmentpractice litigation due to the large number of employees and high turnover ofour sales associates. If we fail to attract, motivate, and retain qualifiedpersonnel, it could harm our business and limit our ability to expand.

 

In addition, we dependupon the expertise and execution of our key employees, particularly MannyMashouf, the founder, Chairman of the Board, and majority shareholder, andGregory Scott, our Chief Executive Officer and member of the Board ofDirectors. If we lose the services of Mr. Mashouf, Mr. Scott, or anykey officers or employees, it could harm our business and results ofoperations.

 

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**4.   If we are not able tosuccessfully expand our bebe and BEBE SPORT stores our revenue base andearnings may be impaired.  **We believe that thereis opportunity to expand the number of bebe and BEBE SPORT stores in new andexisting markets. For fiscal 2006, we plan to grow our operations in acontrolled manner, primarily through the opening of new stores. As part of ourgrowth strategy, we will also open larger bebe stores and accessory “shop inshops”. If these stores are not successful, our financial condition may beharmed.

 

**5.   There can be noassurance that future store openings will be successful and new store openingsmay impact existing stores.  **We expect to openapproximately 35 stores in fiscal 2006, of which approximately 20 will be bebestores, approximately 12 will be BEBE SPORT stores and approximately three willbe outlet stores. In the past, we have closed stores as a result of poorperformance, and there can be no assurance that the stores that we plan to openin fiscal 2006, or any other stores that we might open in the future, will besuccessful or that our overall operating profit will increase as a result ofopening these stores. During fiscal 2005 we closed 6 stores and during fiscal2006, we anticipate closing four stores. Most of our new store openings infiscal 2006 will be in existing markets. These openings may affect the existingstores’ net sales and profitability. Our failure to predict accurately thedemographic or retail environment at any future store location could have amaterial adverse effect on our business, financial condition and results ofoperations.

 

**6.   We are subject torisks associated with our on-line sales.  **Weoperate an on-line store at *www.bebe.com*to sell our merchandise, which we plan to migrate to a third party platform inthe spring season of fiscal 2006. Although our online sales encompass arelatively small percentage of our total sales, our on-line operations aresubject to numerous risks, including unanticipated operating problems, relianceon third-party computer hardware and software providers, system failures andthe need to invest in additional computer systems. The on-line operations alsoinvolve other risks that could have an impact on our results of operationsincluding, but not limited to, diversion of sales from our other stores, rapidtechnological change, liability for online content, credit card fraud, risksrelated to the failure of the computer systems that operate the website and itsrelated support systems. In addition, with the migration to a third party wewill no longer have direct control of our on-line business. There can be noassurance that our on-line store will continue to achieve sales andprofitability growth or even remain at its current level.

 

**7.   Any serious disruptionat our major facilities could have a harmful effect on ourbusiness.  **We currently operate a corporate officein Brisbane, California, a distribution facility in Benicia, California, and adesign studio and production facility in Los Angeles, California. Any seriousdisruption at these facilities whether due to construction, relocation, fire,earthquake, terrorist acts or otherwise would harm our operations and couldhave a harmful effect on our business and results of operations. Furthermore,we have little experience operating essential functions away from our maincorporate offices and are uncertain what effect operating such satellitefacilities might have on business, personnel and results of operations.

 

**8.   We rely on informationtechnology, the disruption of which could adversely impact ourbusiness.  **We rely on various managementinformation systems to manage our operations and regularly make investments toupgrade, enhance or replace such systems. For example, in the first quarter offiscal year 2006, we launched a customer loyalty program to a select number ofstores to be used in conjunction with our direct marketing initiatives. We willcontinue to test, monitor and update this program as we complete the roll outof the program during the second quarter of fiscal 2006.  In addition, in fiscal year 2006 we plan toimplement an enhanced production system supporting our design, manufacturingand merchandising needs. We cannot assure you that we will be successful withthe implementation of these and other new systems. Any delays or difficultiesin transitioning to new systems, or in integrating them with our currentsystems, or any other disruptions affecting any of our management informationsystems, could have a material adverse impact on our business, financialcondition and results of operations.

 

**9.   We face significantcompetition in the retail and apparel industry, which could harm our sales andprofitability.  **The retail and apparel industriesare highly competitive and are characterized by low barriers to entry. Keycompetitors include, but are not limited to Arden B, BCBG, Express, Guess, andthe t.b.d. and Savvy Departments within Nordstrom. We expect competition in ourmarkets to increase. The primary competitive factors in our markets are: brandname recognition, sourcing, product styling, quality, presentation and pricing,timeliness of product development and delivery, store ambiance, customerservice and convenience.

 

We compete withtraditional department stores, specialty store retailers, business to consumerwebsites, off-price retailers and direct marketers for, among other things, rawmaterials, market share, retail space, finished goods, sourcing and personnel.Because many of these competitors are larger and have substantially greaterfinancial, distribution and marketing

 

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resources than we do, wemay lack the resources to adequately compete with them. If we fail to competein any way, it could harm our business, financial condition, and results ofoperations.

 

**10.   Purchases of themerchandise we sell are generally discretionary and are therefore particularlysusceptible to economic conditions.  **The outlookfor the United States economy is uncertain and is directly affected by factorsthat are beyond our control. Such factors include disposable consumer income,oil prices, recession and fears of recession, war and fears of war, inclementweather, consumer debt, interest rates, sales tax rates, consumer confidence infuture economic conditions and political conditions, and consumer perceptionsof personal well-being and security. Consumers are generally more willing tomake discretionary purchases, including purchases of fashion products, duringperiods in which favorable economic conditions prevail. If economic conditionschange, our business, financial condition and results of operations could beadversely affected. While the temporary closure of our three stores that weredirectly affected by Hurricane Katrina will not have a material impact on ouroperating results, we cannot predict the indirect effects such as rising oiland freight prices, consumer spending, or other economic factors that this, orany other, natural disasters will have on our results of operations.

 

**11.   Our business could beadversely impacted by unfavorable international conditions.  **Dueto our international operations, our sales and operating results are, and willcontinue to be, affected by international social, political, legal and economicconditions. In particular, our business could be adversely impacted byinstability or changes resulting in the disruption of trade with the countriesin which our contractors, suppliers or customers are located, significantfluctuations in the value of the dollar against foreign currencies or restrictionson the transfer of funds, or additional trade restrictions imposed by theUnited States and other foreign governments. Trade restrictions, includingincreased tariffs or quotas, embargoes, and customs restrictions could increasethe cost or reduce the supply of merchandise available to us and adverselyaffect our financial condition and results of operations.

 

**12.   If we are not able tosuccessfully protect our intellectual property our ability to capitalize on thevalue of our brand name may be impaired.  **Eventhough we take actions to establish, register and protect our trademarks andother proprietary rights, we cannot assure you that we will be successful orthat others will not imitate our products or infringe upon our intellectualproperty rights. In addition, there is no assurance that others will not resistor seek to block the sale of our products as infringements of their trademarkand proprietary rights.

 

We are seeking to register our trademarks domesticallyand internationally. Obstacles may exist that may prevent us from obtaining atrademark for the bebe name or related names in certain jurisdictions and/orclasses of use. We may not be able to register certain trademarks or purchasethe right or obtain a license to use the bebe name or related names oncommercially reasonable terms. If we fail to obtain trademark, ownership orlicense the requisite rights, it would limit our ability to expand.Furthermore, if we do not demonstrate use of our trademarks, our existingtrademark rights may lapse over time.  Insome jurisdictions, despite successful registration of our trademarks, thirdparties may allege infringement and bring actions against us. In addition, ifour licensees fail to use our intellectual property correctly, the reputationand value associated with our trademarks may be diluted.

 

**13.   If an independentmanufacturer violates labor or other laws, or is accused of violating any suchlaws, or if their labor practices diverge from those generally accepted asethical, it could harm our business and brand image.  **Whilewe maintain a policy to monitor the operations of our independent manufacturersby having an independent firm inspect these manufacturing sites, and allmanufacturers are contractually required to comply with such labor practices,we cannot control the actions or the public’s perceptions of suchmanufacturers, nor can we assure that these manufacturers will conduct theirbusinesses using ethical or legal labor practices. While we do not controltheir employees’ employment conditions or the manufacturers’ businesspractices, and the manufacturers act in their own interest, they may act in amanner that results in negative public perceptions of us and/or employeeallegations, and courts may or may not determine that we are jointly liable insuch cases.

 

RISKS RELATING TO OURCOMMON STOCK:

 

** 1.   Our stock price may fluctuatebecause of the small number of shares that can be publicly traded and the lowaverage daily trading volumes.  **The vast majorityof our outstanding shares of our common stock are subject to tradingrestrictions. As of October 1, 2005, approximately 24,000,000 shares ofour common stock were available to be publicly

 

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traded, and as a result,our average daily trading volumes are relatively low, and our stock price isvulnerable to market swings due to large purchases, sales and short sales ofour common stock.

 

**2.    Our operatingresults are subject to seasonal and quarterly fluctuations, which could adverselyaffect the market price of our common stock.  **Ourbusiness varies with general seasonal trends that are characteristic of theretail and apparel industries. As a result, our stores typically generate ahigher percentage of our annual net sales and profitability in the secondquarter of our fiscal year (which includes the holiday selling season) comparedto other quarters. Such seasonal and quarterly fluctuations could adverselyaffect the market price of our common stock.

 

**3.   Because a principalshareholder controls the company, other shareholders may not be able toinfluence the direction the company takes.  **As of October 1,2005, Manny Mashouf, the Chairman of the Board, beneficially ownedapproximately 74% of the outstanding shares of our common stock. As a result,he alone can control the election of directors and the outcome of all issuessubmitted to the shareholders. This may make it more difficult for a thirdparty to acquire shares, may discourage acquisition bids, and could limit theprice that certain investors might be willing to pay for shares of commonstock. This concentration of stock ownership may have the effect of delaying,deferring or preventing a change in control of our company.

 

**ITEM 3.  QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

We are exposed to market risks, which include changes inU.S. interest rates and, to a lesser extent, foreign exchange rates. We do notengage in financial transactions for trading or speculative purposes.

 

*Interest Rate Risk*

* *

Wecurrently maintain a portfolio of variable interest rate investments consistingof cash equivalents and short-term marketable securities.  Marketable securities are comprised ofclosed-end variable interest rate funds that invest primarily in tax-exemptmunicipal bonds.  Due to the variablenature of these investments, their value is typically not subject to marketrate changes.  According to ourinvestment policy, we may invest in taxable and tax exempt instruments.  In addition, the policy establishes limits oncredit quality, maturity, issuer and type of instrument.  Marketable securities are classified as “availablefor sale”.  We do not use derivativefinancial instruments in our investment portfolio.

 

Allhighly liquid investments with a maturity of three months or less at the dateof purchase are considered to be cash equivalents.  The remaining investments are consideredshort-term marketable securities if original maturities range between four andtwelve months or long-term marketable securities if original maturities areover twelve months.

 

The following table lists our cash equivalents andshort-term marketable securities at October 1, 2005:

 
| ** **                          | ** ** | **Book  Value**             | ** ** | **Fair  Value** | ** ** |
|-------------------------------------|------------|-----------------------------|------------|-----------------|------------|
| ** **                          | ** ** | **(Dollars  in thousands)** | ** ** |
| Cash equivalents                    |       | $                           | 21,289     |            | $          | 21,289 |   |
| Weighted average interest rate  (1) |       | 2.00                        | %          |            |       |
| Short-term marketable securities    |       | 253,632                     |       | 253,632         |       |
| Weighted average interest rate  (1) |       | 2.71                        | %          |            |       |
|                                |       |                        |       |            |       |
| Total                               |       | $                           | 274,921    |            | $          | 274,921 |   |

 

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(1)  Represents the weighted average interest ratesfor tax exempt municipal bonds, municipal preferreds, corporate preferreds andtaxable and tax exempt institutional money market instruments.

 

The interest payable on outstanding cash borrowingsunder our bank line of credit is based on variable interest rates and thereforeaffected by changes in market interest rates. As we have no outstanding cash borrowings, if interest rates rosesignificantly, our results from operations and cash flows would not beaffected.

 

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*Foreign Currency Risks*

 

We enter into a significant amount of purchaseobligations outside of the United States, substantially all of which aresettled in U.S. Dollars and, therefore, have only minimal exposure to foreigncurrency exchange risks. We also operate a subsidiary for which the functionalcurrency is the Canadian Dollar. Fluctuations in exchange ratestherefore impact our financial condition and results of operations, as reportedin U.S. Dollars.   To date, we have not experienced any significantnegative impact as a result of fluctuations in foreign currency markets. We do not hedge against foreign currency risksand believe that foreign currency exchange risk is immaterial.

 

**ITEM4.  CONTROLS AND PROCEDURES**

 

(a)                                  Underthe supervision and with the participation of our management, including our Chief Executive Officer andChief Financial Officer, we evaluated the effectiveness of ourdisclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgatedunder the Securities Exchange Act of 1934, as amended. Based upon thatevaluation, our Chief Executive Officer and Chief Financial Officer concludedthat our disclosure controls and procedures were effective as of the end of theperiod covered by this quarterlyreport.

 

(b)                                 There has been no change in our internalcontrol over financial reporting during the quarter ended October 1, 2005that has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

**PART II  OTHER INFORMATION**

 

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

 

**As of the date of this filing, the Company isinvolved in several ongoing legal proceedings as described below.**

 

A former candidate for anexecutive position sued the Company and two other named defendants in a FirstAmended Complaint, filed November 9, 2004 in the Superior Court of theState of California, County of San Francisco (case No. CGC-04-435517),seeking unspecified monetary damages and other equitable relief. The claimsagainst bebe allege intentional and negligent interference with prospectiveeconomic advantage and contractual relations, breach of contract, breach ofimplied covenant of good faith and fair dealing, fraud, promissory estoppel,negligence, intentional and negligent infliction of emotional distress, andviolation of Labor Code Section 970. The Company believes that the claimsagainst the Company are without merit, therefore has not made an estimate ofpotential liabilities, and will continue to vigorously defend this matter.

 

A former employee suedthe Company in a complaint filed on April 28, 2005 in the United StatesDistrict Court for the Northern District of California (case No. C05-0177-MHP)alleging violations under the Fair Labor Standards Act, specifically that theCompany obligated her to buy and wear its brand clothing as a uniform, withoutreimbursement or credit, and the net effect of deducting the value of suchrequired purchases from her wages would often result in her not being paidminimum wages. The plaintiff purports to bring the action also on behalf of aclass of hourly, non-managerial employees who are similarly situated. Thelawsuit seeks compensatory, statutory and injunctive relief. The Companybelieves plaintiff’s claims are without merit, therefore has not made anestimate of potential liabilities, and will continue to vigorously defend thismatter.

 

The Company was a nameddefendant in four separate California Superior Court cases, (case No. CIV435794in San Mateo County, case No. GIC824505 in San Diego County, case No. 04AS03109in Sacramento County and case No. CIV 447421 in San Mateo County) eachalleging Labor Code violations due to misclassification of employees as exemptunder California state law.  All of these cases have been resolved anddismissals have been filed for case No. CIV 435794 and case No. GIC824505and dismissals will be filed no later than November 14, 2005 for case No. 04AS03109and case No. CIV 447421.  The resolution of these cases did not havea material adverse effect on the Company’s business, financial condition, or resultsof operations.

 

The Company intends todefend itself vigorously against these claims. However, the results of anylitigation are inherently uncertain. The Company cannot assure you that it willbe able to successfully defend itself in these lawsuits. Where required, and/orotherwise appropriate, the Company has made an estimate of potentialliabilities that management believes are reasonable. This estimate will berevised as further information becomes available. Although the final resolution

 

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of these matters may begreater than the Company’s recorded liability, management does not believe theultimate resolution will have a material adverse effect on the Company’sbusiness, financial condition or results of operations.

 

In addition to the above,the Company is also involved in various other legal proceedings arising in thenormal course of business. None of these matters are expected, individually orin the aggregate, to have a material adverse effect on the Company’s business,financial condition or results of operations.

 

**ITEM2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

Notapplicable.

 

**ITEM3.  DEFAULTS UPON SENIOR SECURITIES**

 

Notapplicable.

 

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

Notapplicable.

 

**ITEM 5.  OTHER INFORMATION**

 

Notapplicable.

 

**ITEM 6. EXHIBITS**

 

(a) Exhibits.  The following is a list of exhibits filed aspart of this Report on Form 10-Q.

 
| **Exhibit Number** | ** ** | **Description**                                             |
|-------------------------|------------|-------------------------------------------------------------|
|                    |       |                                                        |
| 10.19*                  |       | Management Bonus  Plan                                      |
| 31.1                    |       | Section 302  Certification of Chief Executive Officer. |
| 31.2                    |       | Section 302  Certification of Chief Financial Officer. |
| 32.1                    |       | Section 906  Certification of Chief Executive Officer. |
| 32.2                    |       | Section 906  Certification of Chief Financial Officer. |

 

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*  Incorporated by reference from exhibit of thesame number in Registrant’s Annual Report on For 10-K filed on September 14,2005.

 

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**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, as amended, theregistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|   | Dated November 10,  2005          |
|--------|----------------------------------------|
|   |                                   |
|   | bebe stores,  inc.                     |
|   |                                   |
|   | /s/ Walter Parks                       |   |
|   | Walter Parks,  Chief Financial Officer |

 

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Description**                                            |
|---------------------|------------|------------------------------------------------------------|
|                |       |                                                       |
| 10.19*              |       | Management Bonus Plan                                      |
| 31.1                |       | Section 302 Certification of Chief Executive  Officer |
| 31.2                |       | Section 302 Certification of Chief Financial  Officer |
| 32.1                |       | Section 906 Certification of Chief Executive  Officer |
| 32.2                |       | Section 906 Certification of Chief Financial  Officer |

 

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*  Incorporated by reference from exhibit of thesame number in Registrant’s Annual Report on For 10-K filed on September 14,2005.

 

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