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EX-32.1 - SECTION 906 CEO AND CFO CERTIFICATION - BARE ESCENTUALS INCdex321.htm
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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 27, 2009

Or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from            to            

Commission file number: 001-33048

 

 

Bare Escentuals, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   20-1062857

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

71 Stevenson Street, 22nd Floor

San Francisco, CA 94105

(Address of principal executive offices with zip code)

(415) 489-5000

(Registrant’s telephone number, including area code)

N/A

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

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    YES  x    NO  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    YES  ¨    NO  x

At October 28, 2009, the number of shares outstanding of the registrant’s common stock, $0.001 par value, was 92,019,902.

 

 

 


Table of Contents

Table of Contents

Bare Escentuals, Inc.

INDEX

 

PART I—FINANCIAL INFORMATION    3
Item 1    Financial Statements (unaudited):    3
   Condensed Consolidated Balance Sheets—September 27, 2009 and December 28, 2008    3
   Condensed Consolidated Statements of Income—Three and Nine Months Ended September 27, 2009 and September 28, 2008    4
   Condensed Consolidated Statements of Cash Flows—Nine Months Ended September 27, 2009 and September 28, 2008    5
   Notes to Condensed Consolidated Financial Statements    6
Item 2    Management’s Discussion and Analysis of Financial Condition and Results of Operations    19
Item 3    Quantitative and Qualitative Disclosures About Market Risk    29
Item 4    Controls and Procedures    29
PART II—OTHER INFORMATION    30
Item 1    Legal Proceedings    30
Item 1A    Risk Factors    30
Item 2    Unregistered Sales of Equity Securities and Use of Proceeds    44
Item 3    Defaults Upon Senior Securities    44
Item 4    Submission of Matters to a Vote of Security Holders    44
Item 5    Other Information    44
Item 6    Exhibits    45
Signatures    46

 

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PART I—FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

BARE ESCENTUALS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

     September 27,
2009
    December 28,
2008(a)
 
     (unaudited)        
ASSETS     

Current assets:

    

Cash and cash equivalents

   $ 98,737      $ 47,974   

Inventories

     74,334        92,576   

Accounts receivable, net of allowances of $5,145 and $8,930 at September 27, 2009 and December 28, 2008, respectively

     47,425        42,304   

Prepaid expenses and other current assets

     12,918        10,302   

Prepaid income taxes

     1,750       —     

Deferred tax assets, net

     9,854        10,011   
                

Total current assets

     245,018        203,167   

Property and equipment, net

     81,775        71,157   

Goodwill

     15,409        15,409   

Intangible assets, net

     4,718        6,943   

Other assets

     3,262        3,105   
                

Total assets

   $ 350,182      $ 299,781   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)     

Current liabilities:

    

Current portion of long-term debt

   $ 17,216      $ 17,216   

Accounts payable

     14,490        16,534   

Accrued liabilities

     20,948        20,260   

Income taxes payable

     —          3,053   
                

Total current liabilities

     52,654        57,063   

Long-term debt, less current portion

     213,478        223,808   

Other liabilities

     18,284        19,218   

Commitments and contingencies

    

Stockholders’ equity (deficit):

    

Preferred stock; $0.001 par value; 10,000 shares authorized; zero shares issued and outstanding

     —          —     

Common stock; $0.001 par value; 200,000 shares authorized; 92,017 and 91,608 shares issued and outstanding at September 27, 2009 and December 28, 2008, respectively

     92        92   

Additional paid-in capital

     430,053        425,352   

Accumulated other comprehensive loss

     (1,881     (4,155

Accumulated deficit

     (362,498     (421,597
                

Total stockholders’ equity (deficit)

     65,766        (308
                

Total liabilities and stockholders’ equity (deficit)

   $ 350,182      $ 299,781   
                

 

(a) Condensed consolidated balance sheet as of December 28, 2008 has been derived from the audited consolidated financial statements as of that date.

See accompanying notes.

 

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Table of Contents

BARE ESCENTUALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except per share data)

 

     Three months ended     Nine months ended  
     (unaudited)     (unaudited)  
     September 27,
2009
    September 28,
2008
    September 27,
2009
    September 28,
2008
 

Sales, net

   $ 135,710      $ 130,199      $ 392,430      $ 409,075   

Cost of goods sold

     34,819        35,354        103,689        113,028   
                                

Gross profit

     100,891        94,845        288,741        296,047   

Expenses:

        

Selling, general and administrative

     56,950        51,208        167,177        152,363   

Depreciation and amortization, relating to selling, general and administrative

     4,609        3,065        12,950        8,507   

Stock-based compensation, relating to selling, general and administrative

     1,248        1,533        4,262        4,413   
                                

Operating income

     38,084        39,039        104,352        130,764   

Interest expense

     (2,141     (3,917     (7,755     (12,841

Other income, net

     653        24        814        691   
                                

Income before provision for income taxes

     36,596        35,146        97,411        118,614   

Provision for income taxes

     13,948        12,247        38,312        45,240   
                                

Net income

   $ 22,648      $ 22,899      $ 59,099      $ 73,374   
                                

Net income per share:

        

Basic

   $ 0.25      $ 0.25      $ 0.64      $ 0.80   
                                

Diluted

   $ 0.24      $ 0.25      $ 0.63      $ 0.79   
                                

Weighted-average shares used in per share calculations:

        

Basic

     91,911        91,454        91,814        91,364   
                                

Diluted

     93,682        93,207        93,310        93,282   
                                

See accompanying notes.

 

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Table of Contents

BARE ESCENTUALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Nine months ended  
     September 27,
2009
    September 28,
2008
 
     (unaudited)  

Operating activities

    

Net income

   $ 59,099      $ 73,374   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Depreciation of property and equipment

     10,672        6,284   

Amortization of intangible assets

     2,225        2,223   

Amortization of debt issuance costs

     149        178   

Stock-based compensation

     4,262        4,413   

Excess tax benefit from stock option exercises

     (305     (3,034

Deferred income tax benefit

     (1,272     (1,283

Loss on disposal of property and equipment

     507       38  

Changes in assets and liabilities:

    

Inventories

     18,326        (37,135

Accounts receivable

     (4,867     (469

Income taxes

     (4,769     (4,433

Prepaid expenses and other current assets

     (2,569     (42

Other assets

     (302     (553

Accounts payable and accrued liabilities

     (1,711     (7,012

Other liabilities

     2,147        641   
                

Net cash provided by operating activities

     81,592        33,190   

Investing activities

    

Purchase of property and equipment

     (21,708     (27,257

Proceeds from sale of property and equipment

     —          1,299   
                

Net cash used in investing activities

     (21,708     (25,958

Financing activities

    

Repayments on First Lien Term Loan

     (10,330     (20,466

Excess tax benefit from stock option exercises

     305        3,034   

Exercise of stock options

     378        1,319   
                

Net cash used in financing activities

     (9,647     (16,113

Effect of foreign currency exchange rate changes on cash

     526        (198
                

Net increase (decrease) in cash and cash equivalents

     50,763        (9,079

Cash and cash equivalents, beginning of period

     47,974        32,117   
                

Cash and cash equivalents, end of period

   $ 98,737      $ 23,038   
                

Supplemental disclosure of cash flow information

    

Cash paid for interest

   $ 9,524      $ 10,424   
                

Cash paid for income taxes

   $ 44,310      $ 50,726   
                

See accompanying notes.

 

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Table of Contents

BARE ESCENTUALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

1. Business

Bare Escentuals, Inc., together with its subsidiaries (“Bare Escentuals” or the “Company”), develops, markets, and sells branded cosmetics, skin care and body care products under the bareMinerals, RareMinerals, Buxom and md formulations brands. The bareMinerals cosmetics, particularly the core foundation products which are mineral-based, offer a differentiated, healthy alternative to conventional cosmetics. The Company uses a multi-channel distribution model utilizing traditional retail distribution channels consisting of premium wholesale customers including Sephora, Ulta and select department stores; company-owned boutiques; and spas and salons; as well as direct-to-consumer media distribution channels consisting of home shopping television on QVC, infomercials, and online shopping. The Company also sells products internationally in the United Kingdom, Japan, France, Germany and Canada, as well as in smaller international markets via distributors.

2. Summary of Significant Accounting Policies

The Company’s significant accounting policies are disclosed in Note 2 in the Company’s Form 10-K for the year ended December 28, 2008. The Company’s significant accounting policies have not changed significantly as of September 27, 2009 with the exception of the adoption of the new accounting pronouncements as noted below.

Unaudited Interim Financial Information

The accompanying condensed consolidated balance sheet as of September 27, 2009, the condensed consolidated statements of income for the three and nine months ended September 27, 2009 and September 28, 2008, and the condensed consolidated statements of cash flows for the nine months ended September 27, 2009 and September 28, 2008, are unaudited. These unaudited interim condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information, Form 10-Q and Article 10 of Regulation S-X. In the opinion of the Company’s management, the unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual consolidated financial statements and include all adjustments of a normal recurring nature necessary for the fair presentation of the Company’s financial position as of September 27, 2009, its results of operations for the three and nine months ended September 27, 2009 and September 28, 2008, and its cash flows for the nine months ended September 27, 2009 and September 28, 2008. The results for the interim periods are not necessarily indicative of the results to be expected for any future period or for the fiscal year ending January 3, 2010. We have evaluated subsequent events through November 5, 2009, which is the date these financial statements were issued.

These unaudited interim condensed consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes included in the Company’s 2008 Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) on February 26, 2009.

Fiscal Quarter

The Company’s fiscal quarters end on the Sunday closest to March 31, June 30, September 30 and December 31. The three months ended September 27, 2009 and September 28, 2008 each contained 13 weeks. The nine months ended September 27, 2009 and September 28, 2008 each contained 39 weeks.

Concentration of Credit Risk and Credit Risk Evaluation

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. Cash and cash equivalents are held by or invested in various financial institutions with high credit standing and as such, management believes that minimal credit risk exists with respect to these balances.

Sales generated through credit card purchases were approximately 41.9% and 44.3% of total net sales for the three and nine months ended September 27, 2009, respectively, and approximately 43.8% and 44.2% of total net sales for the three and nine months ended September 28, 2008, respectively. The Company uses a third party to collect its credit card sales and, as a consequence, believes that its credit risks related to these channels of distribution are limited. The Company performs ongoing credit evaluations of its third-party resellers not paying by credit card. Generally, the Company does not require collateral. An allowance for doubtful accounts is determined with respect to those amounts that the Company has determined to be doubtful of collection using specific identification of doubtful accounts and an aging of receivables analysis based on invoice due dates. Actual collection losses may differ from management’s estimates, and such differences could be material to the Company’s consolidated financial position, results of operations, and cash flows. Uncollectible receivables are written off against the allowance for doubtful accounts when all efforts to collect them have been exhausted, and recoveries are recognized when they are received. Generally, accounts receivable are past due 30 to 60 days after an invoice date unless special payment terms are provided.

 

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The table below sets forth the percentage of consolidated accounts receivable, net for customers who represented 10% or more of consolidated accounts receivable:

 

     September 27,
2009
    December 28,
2008
 

Customer A

   —   %*    15

Customer B

   31   19

Customer C

   26   39

 

* Represents less than 10%

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

 

    Three months ended     Nine months ended  
    September 27,
2009
    September 28,
2008
    September 27,
2009
    September 28,
2008
 

Customer A

  —   %*    —   %*    11   12

Customer B

  14   12   13   12

Customer C

  17   18   14   15

 

* Represents less than 10%

As of September 27, 2009 and December 28, 2008, the Company had no off-balance sheet concentrations of credit risk.

Derivative Financial Instruments

The Company accounts for derivative financial instruments as either assets or liabilities on the balance sheet, and they are measured at fair value.

Earnings per Share

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

 

     Three months ended    Nine months ended
     September 27,
2009
   September 28,
2008
   September 27,
2009
   September 28,
2008

Numerator:

           

Net income

   $ 22,648    $ 22,899    $ 59,099    $ 73,374
                           

Denominator:

           

Weighted average common shares used in per share calculations — basic

     91,911      91,454      91,814      91,364

Add: Dilution from employee stock plans

     1,771      1,753      1,496      1,918
                           

Weighted-average common shares used in per share calculations — diluted

     93,682      93,207      93,310      93,282
                           

Net income per share

           

Basic

   $ 0.25    $ 0.25    $ 0.64    $ 0.80
                           

Diluted

   $ 0.24    $ 0.25    $ 0.63    $ 0.79
                           

For the three and nine months ended September 27, 2009, options to purchase 768,310 and 1,389,309 shares of common stock, respectively, were excluded from the calculation of weighted average shares for diluted net income per share as their impact was anti-dilutive. For the three and nine months ended September 28, 2008, options to purchase 705,825 and 565,900 shares of common stock, respectively, were excluded from the calculation of weighted average shares for diluted net income per share as their impact was anti-dilutive.

Comprehensive Income

Comprehensive income consists of net income and other comprehensive income (loss). Other comprehensive income (loss) consists of foreign currency translation adjustments and changes in unrealized gains or losses on interest rate swap, net of tax.

 

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Reclassifications

Certain reclassifications of prior year amounts have been made to conform to the current year presentation. In the fourth quarter of fiscal 2008, the Company changed its operating segments, and historical segment financial information presented has been revised to reflect these new operating segments (Note 17).

Recent Accounting Pronouncements

Effective July 29, 2009, the Company adopted a new accounting standard that establishes the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) as the exclusive reference to be applied in the preparation of financial statements in conformity with GAAP. Accordingly, all references to legacy guidance issued under previously recognized authoritative literature have been removed in the third quarter of fiscal 2009. As the ASC was not intended to change or alter existing GAAP, it did not have any impact on the Company’s results of operations or financial position.

In February 2008, the FASB issued an accounting standard update that delayed the effective date of fair value measurements accounting for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of fiscal 2009. These include goodwill and other non-amortizable intangible assets. The Company adopted this accounting standard update on December 29, 2008. The adoption did not have any material impact on the Company’s results of operations or financial position (Note 14).

Effective December 29, 2008, the Company adopted an accounting standard update regarding business combinations. This update establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquired business. It also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The adoption did not have any material impact on the Company’s results of operations or financial position.

Effective December 29, 2008, the Company adopted an accounting standard update that amended and expanded the disclosure requirements related to derivative instruments to provide users of financial statements with an enhanced understanding of the following: 1) how and why an entity uses derivative instruments; 2) how derivative instruments and related hedged items are accounted for; and 3) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. The adoption of this standard had no financial impact on the Company’s financial position or results of operations as it is disclosure-only in nature.

During the second quarter of 2009, the Company adopted an accounting standard update that requires quarterly disclosure of information about the fair value of financial instruments. The adoption of this standard had no financial impact on the Company’s financial position or results of operations as it is disclosure-only in nature.

During the second quarter of 2009, the Company adopted a new accounting standard for subsequent events which establishes general standards of accounting for, and requires disclosures of, events that occur after the balance sheet date but before the financial statements are issued or are available to be issued. It did not have any material impact on the Company’s results of operations or financial position.

In August 2009, the FASB issued authoritative guidance on how to measure the fair value of a liability. The guidance has three primary components: 1) sets forth the types of valuation techniques to be used to value a liability when a quoted price in an active market for the identical liability is not available; 2) clarifies that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability; and 3) clarifies that both a quoted price in an active market for the identical liability at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. This standard is effective beginning in the fourth quarter of 2009. The Company does not expect the adoption to have a material impact on its financial position or results of operations.

3. Acquisition

On April 3, 2007, the Company completed its acquisition of U.K.-based Cosmeceuticals Limited (“Cosmeceuticals”), which distributed Bare Escentuals’ bareMinerals, md formulations and MD Forte brands primarily to spas and salons and QVC U.K. The acquired entity has been renamed Bare Escentuals U.K. Ltd. The Company’s primary reason for the acquisition was to reacquire its distribution rights and to expand its market share. The consideration for the purchase was cash of $23.1 million, comprised of $22.4 million in cash consideration and $0.7 million of transaction costs. The Company’s consolidated financial statements include the operating results of the business acquired from the date of acquisition. Pro forma results of operations have not been presented because the effect of the acquisition was not material.

 

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The total purchase price of $23.1 million was allocated as follows: $12.6 million to goodwill included as corporate assets (not deductible for income tax purposes); $8.9 million to identifiable intangible assets, comprised of customer relationships of $8.0 million and $0.9 million for non-compete agreements; $4.4 million to net tangible assets acquired; and $2.8 million to deferred tax liability. The estimated useful economic lives of the identifiable intangible assets acquired are three years. The most significant factor that resulted in the recognition of goodwill in the purchase price allocation was the ability to expand on an accelerated basis into trade areas beyond the acquired distribution rights.

During the nine months ended September 28, 2008, the Company sold $1.3 million of the net tangible assets acquired to a third party for proceeds of $1.3 million. There was no gain or loss recorded in this transaction.

4. Comprehensive Income

The components of comprehensive income were as follows (in thousands):

 

     Three months ended     Nine months ended  
     September 27,
2009
   September 28,
2008
    September 27,
2009
   September 28,
2008
 

Net income

   $ 22,648    $ 22,899      $ 59,099    $ 73,374   

Foreign currency translation adjustments, net of tax

     46      (1,093     611      (1,099

Unrealized gain on interest rate swap, net of tax

     465      639        1,663      448   
                              

Comprehensive income

   $ 23,159    $ 22,445      $ 61,373    $ 72,723   
                              

The components of accumulated other comprehensive loss were as follows (in thousands):

 

     September 27,
2009
    December 28,
2008
 

Foreign currency translation adjustments, net of tax

   $ (1,881   $ (2,492

Unrealized loss on interest rate swap, net of tax

     —          (1,663
                

Total accumulated other comprehensive loss

   $ (1,881   $ (4,155
                

5. Inventories

Inventories consisted of the following (in thousands):

 

     September 27,
2009
   December 28,
2008

Work in process

   $ 11,285    $ 14,058

Finished goods

     63,049      78,518
             
   $ 74,334    $ 92,576
             

 

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6. Property and Equipment, Net

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

 

     September 27,
2009
    December 28,
2008
 

Furniture and equipment

   $ 22,376      $ 16,749   

Computers and software

     28,008        22,347   

Leasehold improvements

     54,904        45,959   
                
     105,288        85,055   

Accumulated depreciation

     (27,131     (17,285
                
     78,157        67,770   

Construction-in-progress

     3,618        3,387   
                

Property and equipment, net

   $ 81,775      $ 71,157   
                

7. Intangible Assets, Net

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

 

     September 27,
2009
    December 28,
2008
 

Customer relationships

   $ 8,000      $ 8,000   

Trademarks

     3,233        3,233   

Domestic customer base

     939        939   

International distributor base

     820        820   

Non-compete agreements

     900        900   
                
     13,892        13,892   

Accumulated amortization

     (9,174     (6,949
                

Intangible assets, net

   $ 4,718      $ 6,943   
                

8. Other Assets

Other assets consisted of the following (in thousands):

 

     September 27,
2009
   December 28,
2008

Debt issuance costs, net of accumulated amortization of $719 and $570 at September 27, 2009 and December 28, 2008, respectively

   $ 399    $ 548

Other assets

     2,863      2,557
             
   $ 3,262    $ 3,105
             

9. Accrued Liabilities

Accrued liabilities consisted of the following (in thousands):

 

     September 27,
2009
   December 28,
2008

Employee compensation and benefits

   $ 7,929    $ 6,793

Gift cards and customer liabilities

     2,320      2,817

Royalties

     1,412      1,646

Sales taxes and local business taxes

     1,062      1,983

Interest

     517      311

Other

     7,708      6,710
             
   $ 20,948    $ 20,260
             

 

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Table of Contents

10. Revolving Lines of Credit

At September 27, 2009, $24,284,000 was available under our revolving line of credit (the “Revolver”) and $716,000 was outstanding in standby letters of credit. The Revolver is contractually available to the Company until February 18, 2011. Borrowings under the Revolver bear interest at a rate equal to, at the Company’s option, either LIBOR or the lenders’ base rate, plus an applicable margin based on a grid in which the pricing depends on the Company’s consolidated total leverage ratio and debt rating (2.25% plus LIBOR or 1.25% plus lenders’ base rate; actual rate of 2.52% at September 27, 2009 and 2.76% at December 28, 2008). The Company is also required to pay commitment fees of 0.5% per annum on any unused portions of the facility.

11. Long-Term Debt

Long-term debt consisted of the following (in thousands):

 

     September 27,
2009
    December 28,
2008
 

First Lien Term Loan

   $ 230,694      $ 241,024   

Less current portion

     (17,216     (17,216
                

Total long-term debt, net of current portion

   $ 213,478      $ 223,808   
                

First Lien Term Loan

The First Lien Term Loan has an original term of seven years expiring on February 18, 2012 and bears interest at a rate equal to, at the Company’s option, either LIBOR or the lenders’ base rate, plus an applicable margin varying based on the Company’s consolidated total leverage ratio. As of September 27, 2009 and December 28, 2008, the interest rate on the First Lien Term Loan was accruing at 2.52% and 2.76%, respectively.

Borrowings under the Revolver (Note 10) and the First Lien Term Loan are secured by substantially all of the Company’s assets, including, but not limited to, all accounts receivable, inventory, property and equipment, and intangibles. The terms of the senior secured credit facilities require the Company to comply with financial covenants, including maintaining a leverage ratio and entering into interest rate swap or similar agreements with respect to 40% of the principal amounts outstanding under the Company’s senior secured credit facilities as of October 2, 2007. The secured credit facility also contains nonfinancial covenants that restrict some of the Company’s activities, including its ability to dispose of assets, incur additional debt, pay dividends, create liens, make investments, and engage in specified transactions with affiliates. As of September 27, 2009, the Company was in compliance with its financial and nonfinancial covenants.

Scheduled Maturities of Long-Term Debt

At September 27, 2009, future scheduled principal payments on long-term debt were as follows (in thousands):

 

Year ending:

  

Remainder of the year ending January 3, 2010

   $ 6,887

January 2, 2011

     13,773

January 1, 2012

     158,386

December 30, 2012

     51,648
      
   $ 230,694
      

12. Derivative Financial Instruments

The Company is exposed to interest rate risks primarily through borrowings under its senior secured credit facilities. Interest on all of the Company’s borrowings under its senior secured credit facilities is based upon variable interest rates. As of September 27, 2009, the Company had borrowings of $230.7 million outstanding under its senior secured credit facilities which bear interest at a rate equal to, at the Company’s option, either LIBOR or the lenders’ base rate, plus an applicable margin varying based on the Company’s consolidated total leverage ratio. As of September 27, 2009, the interest rate on the First Lien Term Loan was accruing at 2.52%. At all times after October 2, 2007, the Company was required under its senior secured credit facilities to enter into interest rate swap or similar agreements with respect to at least 40% of the outstanding principal amount of all loans under its senior loan facilities, unless the Company satisfied specified coverage ratio tests. For the three and nine months ended September 27, 2009, the Company satisfied these tests.

 

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In August 2007, the Company entered into a two-year interest rate swap agreement under the Company’s senior secured credit facilities which expired during the three months ended September 27, 2009. The interest rate swap was designated as a cash flow hedge of future interest payments of LIBOR and had an initial notional amount of $200 million which declined to $100 million after one-year under which, on a net settlement basis, the Company made monthly fixed rate payments, excluding a margin of 2.25%, at the rate of 5.03% and the counterparty made monthly floating rate payments based upon one-month U.S. dollar LIBOR. As a result of the interest rate swap transaction, the Company had fixed for a two-year period the interest rate subject to market-based interest rate risk on $200 million of borrowings for the first year and $100 million of borrowings for the second year under its First Lien Credit Agreement. The Company’s obligations under the interest rate swap transaction as to the scheduled payments were guaranteed and secured on the same basis as is its obligations under the First Lien Credit Agreement.

The following table summarizes the fair value and presentation within the unaudited condensed consolidated balance sheets for derivatives designated as hedging instruments (in thousands):

 

     Liability Derivative
     September 27,
2009
   December 28,
2008
     Balance
Sheet
Location
   Fair
Value
   Balance
Sheet
Location
   Fair
Value

Interest rate swap

   Other liabilities    $ —      Other liabilities    $ 2,752
                   

The following table presents the impact of derivative instruments and their location within the unaudited condensed consolidated statements of income and accumulated other comprehensive income (AOCI) (in thousands):

Derivatives in Cash Flow Hedging Relationships

 

     Amount of (Gain) Loss
Recognized in AOCI on
Derivatives (Effective
Portion)
    Amount of (Gain) Loss
Reclassified from AOCI into
Income (Effective Portion)
   Amount of (Gain) Loss
Recognized in Income on
Derivatives (Ineffective
Portion)
     Three months ended     Three months ended    Three months ended
     September 27,
2009
    September 28,
2008
    September 27,
2009
   September 28,
2008
   September 27,
2009
   September 28,
2008

Interest rate swap, net of tax

   $ (465   $ (639   $ —      $ —      $  —      $ —  
                                           
     Amount of (Gain) Loss
Recognized in AOCI on
Derivatives (Effective
Portion)
    Amount of (Gain) Loss
Reclassified from AOCI into
Income (Effective Portion)
   Amount of (Gain) Loss
Recognized in Income on
Derivatives (Ineffective
Portion)
     Nine months ended     Nine months ended    Nine months ended
     September 27,
2009
    September 28,
2008
    September 27,
2009
   September 28,
2008
   September 27,
2009
   September 28,
2008

Interest rate swap, net of tax

   $ (1,663   $ (448   $  —      $ —      $  —      $ —  
                                           

 

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13. Commitments and Contingencies

Lease Commitments

The Company leases retail boutiques, distribution facilities, office space and certain office equipment under non-cancelable operating leases with various expiration dates through January 2021. Additionally, the Company subleases certain real property to third parties. Portions of these payments are denominated in foreign currencies and were translated in the tables below based on their respective U.S. dollar exchange rates at September 27, 2009. These future payments are subject to foreign currency exchange rate risk. The future minimum annual payments and anticipated sublease income under such leases in effect at September 27, 2009, were as follows (in thousands):

 

     Minimum
Rental
Payments
   Sublease
Rental
Income
   Net
Minimum
Lease
Payments

Year ending:

        

Remainder of the year ending January 3, 2010

   $ 4,827    $ 6    $ 4,821

January 2, 2011

     20,647      24      20,623

January 1, 2012

     20,796      24      20,772

December 30, 2012

     20,949      1      20,948

December 29, 2013

     21,355      —        21,355

Thereafter

     94,608      —        94,608
                    
   $ 183,182    $ 55    $ 183,127
                    

Many of the Company’s retail boutique leases require additional contingent rents when certain sales volumes are reached. Total rent expense was $7,291,000 and $19,921,000 for the three and nine months ended September 27, 2009, respectively, and $5,514,000 and $14,917,000 for the three and nine months ended September 28, 2008, respectively. Total rent expense included contingent rents of $124,000 and $469,000 for the three and nine months ended September 27, 2009, respectively, and $146,000 and $1,086,000 for the three and nine months ended September 28, 2008, respectively. Several leases entered into by the Company include options that may extend the lease term beyond the initial commitment period, subject to terms agreed to at lease inception.

As of September 27, 2009, under the terms of its corporate office lease and the lease of one of its company-owned boutiques, the Company had outstanding irrevocable standby letters of credit of $100,000 and $396,000, respectively, to the lessors for the terms of the leases.

Royalty Agreements

The Company is party to a license agreement (the “License”) for use of certain patents associated with some of the skin care products sold by the Company. The License requires that the Company pay a quarterly royalty of 4% of the net sales of certain skin care products for an indefinite period of time, with minimum annual royalty payments of $600,000 from the Company. The Company can terminate the agreement at any time with six months written notice. The Company’s royalty expense under the License for the three and nine months ended September 27, 2009 was $150,000 and $450,000, respectively and $150,000 and $450,000, for the three and nine months ended September 28, 2008, respectively.

In March 2009, the Company entered into a new agreement for the license rights to proprietary mineral extraction technology and a limited exclusive right to purchase certain ingredients based on such technology. The license is exclusive to the Company for a specified period from the date of the agreement in certain defined fields of use and is otherwise nonexclusive for the term of the agreement. However, the Company has the right to extend the term of the exclusivity in the defined fields of use to the full term of the agreement upon a one-time payment of a specified amount or achievement of a specified level of annual aggregate gross revenues from the sale of licensed products in the defined fields of use. The Company is required to pay three lump-sum commencement payments over the course of the first year of the term of the agreement. In addition, on a quarterly basis during the term of the agreement, the Company is required to pay royalties on its net revenue resulting from the sale of products containing the licensed ingredients. Such royalties are not subject to any minimum annual amounts. The new agreement has an initial term of 10 years. As a result of the new agreement, the Company’s previous agreement was terminated. The Company’s expense under these agreements for the three and nine months ended September 27, 2009 was $247,000 and $373,000, respectively, and was $129,000 and $698,000 for the three and nine months ended September 28, 2008, respectively.

Contingencies

Beginning on July 17, 2009, three purported stockholder class actions were filed in the United States District Court for the Northern District of California against the Company, certain of its current and former officers and directors and the underwriters for the Company’s initial public offering and March 2007 secondary offering. On October 15, 2009, the court consolidated the three

 

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cases into the first-filed case (C-09-03268 PJH) and appointed Westmoreland County Retirement System and Vincent J. Takas as lead plaintiffs and their counsel as lead plaintiffs’ counsel. The original complaint filed by Westmoreland purports to be brought on behalf of persons who purchased the Company’s stock on the open market between September 28, 2006 and October 31, 2008 and persons who purchased the Company’s stock pursuant to its initial public offering and March 2007 registration statements and prospectuses. The original complaint alleges that the Company and the officer-defendants made false or misleading statements about the Company’s business and prospects in violation of Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The original complaint also alleges that all defendants made false or misleading statements in the registration statements and prospectuses pertaining to the initial public offering and March 2007 secondary offering, in violation of Sections 11, 12 and 15 of the Securities Act of 1933. The original complaint seeks compensatory damages, attorneys’ fees and costs and such other relief as the court may deem proper. Lead plaintiffs will file a consolidated amended complaint and defendants will file motions to dismiss that complaint.

In addition, the Company is involved in various legal and administrative proceedings and claims arising in the ordinary course of its business. The ultimate resolution of such claims would not, in the opinion of management, have a material effect on the Company’s financial position, results of operations or cash flows.

14. Fair Value Measurements

The Company measures certain financial assets and liabilities at fair value on a recurring basis. The fair value of these financial assets and liabilities is based on a three-tier hierarchy for fair value measurements, which prioritizes the inputs used in measuring fair value as follows:

 

   

Level 1 – observable inputs such as quoted prices for identical instruments in active markets.

 

   

Level 2 – inputs other than quoted prices in active markets that are observable either directly or indirectly through corroboration with observable market data.

 

   

Level 3 – unobservable inputs for which there is little or no market data and which would require the Company to develop its own assumptions.

As of September 27, 2009 and December 28, 2008, the Company held certain assets that are required to be measured at fair value on a recurring basis. These included the Company’s interest rate swap agreement and certain investments associated with the Company’s Long-Term Employee-Related Benefits Plan. The fair value of the Company’s interest rate swap agreement is determined based on inputs that are readily available in public markets or can be derived from information available in publicly quoted markets. Therefore, the Company has categorized the interest rate swap as Level 2. The fair value of the Company’s investments associated with its Long-Term Employee-Related Benefits Plan is based on third-party reported net asset values, which is primarily based on quoted market prices of the underlying assets of the funds, and have been categorized as Level 2.

The following table presents the Company’s financial assets and liabilities measured at fair value on a recurring basis as of September 27, 2009 (in thousands):

 

          Fair Value Measurements Using
     Total    Level 1    Level 2    Level 3

Other assets:

           

Deferred compensation

   $ 1,396    $ —      $ 1,396    $ —  
                           

Other liabilities:

           

Deferred compensation

   $ 850    $ —      $ 850    $ —  
                           

The following table presents the Company’s financial assets and liabilities measured at fair value on a recurring basis as of December 28, 2008 (in thousands):

 

          Fair Value Measurements Using
     Total    Level 1    Level 2    Level 3

Other assets:

           

Deferred compensation

   $ 1,232    $ —      $ 1,232    $ —  
                           

Other liabilities:

           

Interest rate swap

   $ 2,752    $ —      $ 2,752    $ —  

Deferred compensation

     886      —        886      —  
                           

Total liabilities

   $ 3,638    $ —      $ 3,638    $ —  
                           

 

14


Table of Contents

15. Income Taxes

As of September 27, 2009, the total amount of net unrecognized tax benefits was $2,600,000. The amount of net unrecognized tax benefits that, if recognized, would affect the effective tax rate is insignificant. The Company accrues interest related to unrecognized tax benefits in its provision for income taxes. As of September 27, 2009, the Company had approximately $284,000 of accrued interest, net of tax, related to uncertain tax positions.

The Company does not anticipate any material change to the amount of unrecognized tax benefits in the next twelve months.

The Company files income tax returns in the United States and in various states, local and foreign jurisdictions. The tax years subsequent to 2004 remain open to examination by the major taxing jurisdictions in the United States.

16. Stock-Based Employee Compensation Plans

As of September 27, 2009, the Company had reserved 8,790,631 shares of common stock for future issuance.

2004 Equity Incentive Plan

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

In conjunction with the adoption of the 2006 Equity Incentive Plan in September 2006, no additional options are permitted to be granted under the 2004 Plan. In addition, any shares subject to outstanding options cancelled under the 2004 Plan became available for grant under the 2006 Equity Incentive Plan.

A summary of activity under the 2004 Plan is set forth below:

 

           Options Outstanding
     Shares Subject
to Options
Available
for Grant
    Number of
Shares
    Weighted-
Average
Exercise
Price

Balance at December 28, 2008

   —        3,550,729      $ 2.37

Exercised

   —        (322,328     1.17

Canceled

   74,106      (74,106     5.39

Rolled over to 2006 Plan

   (74,106   —          —  
              

Balance at September 27, 2009

   —        3,154,295      $ 2.42
              

At September 27, 2009, there were total outstanding vested options to purchase 2,448,138 shares under the 2004 Plan at a weighted-average exercise price of $1.80.

The total intrinsic value of options exercised under the 2004 Plan for the nine months ended September 27, 2009 was $1,259,000.

2006 Equity Incentive Plan

On September 12, 2006, the Company’s stockholders approved the 2006 Equity Incentive Award Plan (the “2006 Plan”) for executives, directors, employees and consultants of the Company. A total of 4,500,000 shares of the Company’s Common Stock were authorized for issuance under the 2006 Plan. Awards are granted with an exercise price equal to the closing market price of the Company’s Common Stock at the date of grant except for restricted stock awards (“RSAs”) and restricted stock units (“RSUs”). The awards generally vest over a period of one to five years from the date of grant and have a maximum term of ten years.

A summary of stock options activity under the 2006 Plan is set forth below:

 

           Options Outstanding
     Shares Subject
to Options
Available
for Grant
    Number of
Shares
   Weighted-
Average
Exercise
Price

Balance at December 28, 2008

   4,131,681      1,518,350    $ 12.36

Rolled over from 2004 Plan

   74,106      —        —  

Granted

   (522,985   522,985      7.19

 

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          Options Outstanding
     Shares Subject
to Options
Available
for Grant
   Number of
Shares
    Weighted-
Average
Exercise
Price

Canceled

   261,311    (261,311     11.86
             

Balance at September 27, 2009

   3,944,113    1,780,024      $ 10.91
             

At September 27, 2009, there were total outstanding vested options to purchase 184,171 shares under the 2006 Plan at a weighted-average exercise price of $23.97.

The total cash received from employees as a result of employee stock option exercises under all plans for the nine months ended September 27, 2009 was $378,000. In connection with these exercises, the tax benefits realized by the Company for the nine months ended September 27, 2009 were $305,000.

A summary of RSA and RSU activity under the 2006 Plan is set forth below:

 

     Shares  

Balance at December 28, 2008

   50,000   

Granted

   116,947   

Vested

   (12,500

Canceled

   (37,500
      

Balance at September 27, 2009

   116,947   
      

The weighted average fair value of RSAs and RSUs granted during the nine months ended September 27, 2009 was $5.81. The total fair value of RSAs vested during the nine months ended September 27, 2009 was $248,000.

17. Segment and Geographic Information

Operating segments are defined as components of an enterprise engaging in business activities for which separate financial information is available that is evaluated regularly by the Chief Operating Decision Maker (“CODM”) in deciding how to allocate resources and assessing performance.

One of the Company’s key objectives is the further expansion of its business internationally and as a consequence, the operating results that the CODM reviews to make decisions about resource allocations and to assess performance have changed to be more geographically focused. In the fourth quarter of fiscal 2008, the Company re-evaluated its operating segments to bring them in line with these changes and how management currently reviews and evaluates the operating performance of the Company and accordingly, the new segments include North America Retail, North America Direct to Consumer, and International. The North America Retail segment includes all products marketed in the United States and Canada and consists of sales to end users either directly through company-owned boutiques or through third-party resellers in a branded, prestige retail environment. The North America Direct to Consumer segment includes all products marketed in the United States and Canada and consists of sales through television or online media to end users who then receive their product via mail. The International segment includes all operations outside the United States and Canada, regardless of method of delivery to the end user. Prior to fiscal 2008, the Company’s operating segments were Retail and Wholesale. As a result, historical segment financial information presented has been revised to reflect these new operating segments.

These reportable segments are strategic business units that are managed separately based on the fundamental differences in their operations. The following table presents certain financial information for each segment. Operating income is the gross margin of the segment less direct expenses of the segment. Some direct expenses, such as media and advertising spend, do impact the performance of the other segments, but these expenses are recorded in the segment to which they directly relate and are not allocated among the segments. The Corporate column includes unallocated selling, general and administrative expenses, depreciation and amortization and stock-based compensation expenses. Corporate selling, general and administrative expenses include headquarters facilities costs, distribution center costs, product development costs, corporate headcount costs and other corporate costs, including information technology, finance, accounting, legal and human resources costs. These items, while often times related to the operations of a segment, are not considered by segment operating management and the CODM in assessing segment performance.

 

16


Table of Contents
     North America
Retail
   North America
Direct to
Consumer
   International    Corporate     Total  

Three Months ended September 27, 2009

             

Sales, net

   $ 88,284    $ 26,852    $ 20,574    $ —        $ 135,710   

Cost of goods sold

     20,985      7,405      6,429      —          34,819   
                                     

Gross profit

     67,299      19,447      14,145      —          100,891   

Operating expenses:

             

Selling, general and administrative

     25,813      9,673      5,979      15,485        56,950   

Depreciation and amortization

     1,632      —        1,181      1,796        4,609   

Stock-based compensation

     —        —        —        1,248        1,248   
                                     

Total expenses

     27,445      9,673      7,160      18,529        62,807   
                                     

Operating income (loss)

     39,854      9,774      6,985      (18,529     38,084   

Interest expense

                (2,141

Other income, net

                653   
                   

Income before provision for income taxes

                36,596   

Provision for income taxes

                13,948   
                   

Net income

              $ 22,648   
                   
     North America
Retail
   North America
Direct to
Consumer
   International    Corporate     Total  

Three Months ended September 28, 2008

             

Sales, net

   $ 80,524    $ 32,431    $ 17,244    $ —        $ 130,199   

Cost of goods sold

     21,022      8,729      5,603      —          35,354   
                                     

Gross profit

     59,502      23,702      11,641      —          94,845   

Operating expenses:

             

Selling, general and administrative

     21,124      12,179      3,705      14,200        51,208   

Depreciation and amortization

     973      7      893      1,192        3,065   

Stock-based compensation

     —        —        —        1,533        1,533   
                                     

Total expenses

     22,097      12,186      4,598      16,925        55,806   
                                     

Operating income (loss)

     37,405      11,516      7,043      (16,925     39,039   

Interest expense

                (3,917

Other expense, net

                24   
                   

Income before provision for income taxes

                35,146   

Provision for income taxes

                12,247   
                   

Net income

              $ 22,899   
                   
     North America
Retail
   North America
Direct to
Consumer
   International    Corporate     Total  

Nine Months ended September 27, 2009

             

Sales, net

   $ 239,423    $ 100,993    $ 52,014    $ —        $ 392,430   

Cost of goods sold

     56,451      30,294      16,944      —          103,689   
                                     

Gross profit

     182,972      70,699      35,070      —          288,741   

Operating expenses:

             

Selling, general and administrative

     73,313      30,509      15,710      47,645        167,177   

Depreciation and amortization

     4,439      7      3,156      5,348        12,950   

Stock-based compensation

     —        —        —        4,262        4,262   
                                     

Total expenses

     77,752      30,516      18,866      57,255        184,389   
                                     

Operating income (loss)

     105,220      40,183      16,204      (57,255     104,352   

Interest expense

                (7,755

Other income, net

                814   
                   

Income before provision for income taxes

                97,411   

Provision for income taxes

                38,312   
                   

Net income

              $ 59,099   
                   

 

17


Table of Contents
     North America
Retail
   North America
Direct to
Consumer
   International    Corporate     Total  

Nine Months ended September 28, 2008

             

Sales, net

   $ 232,676    $ 129,099    $ 47,300    $ —        $ 409,075   

Cost of goods sold

     58,055      39,094      15,879      —          113,028   
                                     

Gross profit

     174,621      90,005      31,421      —          296,047   

Operating expenses:

             

Selling, general and administrative

     54,370      41,777      9,159      47,057        152,363   

Depreciation and amortization

     2,371      21      2,556      3,559        8,507   

Stock-based compensation

     —        —        —        4,413        4,413   
                                     

Total expenses

     56,741      41,798      11,715      55,029        165,283   
                                     

Operating income (loss)

     117,880      48,207      19,706      (55,029     130,764   

Interest expense

                (12,841

Other income, net

                691   
                   

Income before provision for income taxes

                118,614   

Provision for income taxes

                45,240   
                   

Net income

              $ 73,374   
                   

The Company’s long-lived assets, excluding goodwill and intangibles, by segment were as follows (in thousands):

 

     September 27,
2009
   December 28,
2008

North America Retail

   $ 46,589    $ 38,628

North America Direct to Consumer

     —        84

International

     6,342      2,594

Corporate

     30,199      31,036
             
   $ 83,130    $ 72,342
             

Long-lived assets allocated to the North America Retail segment consist of fixed assets and deposits for retail stores. Long-lived assets in Corporate consist of fixed assets, tooling costs and deposits related to the Company’s corporate offices and distribution centers.

The Company’s long-lived assets, excluding goodwill and intangibles, by geographic area were as follows (in thousands). For the table below, Canada is included in International.

 

     September 27,
2009
   December 28,
2008

United States

   $ 76,606    $ 69,390

International

     6,524      2,952
             
   $ 83,130    $ 72,342
             

No individual geographical area outside of the United States accounted for more than 10% of net sales in any of the periods presented. The Company’s sales by geographic area were as follows (in thousands). For the table below, Canada is included in International.

 

     Three months ended    Nine months ended
     September 27,
2009
   September 28,
2008
   September 27,
2009
   September 28,
2008

United States

   $ 113,797    $ 112,338    $ 338,137    $ 361,156

International

     21,913      17,861      54,293      47,919
                           

Sales, net

   $ 135,710    $ 130,199    $ 392,430    $ 409,075
                           

 

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

Forward-Looking Statements

This Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. In some cases, forward-looking statements can be identified by words such as “anticipate,” “expect,” “believe,” “plan,” “intend,” “predict,” “will,” “may,” and similar terms. The forward-looking statements in this Form 10-Q include, but are not limited to, statements regarding our plans to grow our business by expanding product offerings and developing new brands or brand extensions; our planned opening of new boutiques; our intention to invest strategically in areas of our business and the potential for those investments to create long-term value; our plans to enhance our information technology systems and make other investments in domestic and international corporate infrastructure; our expectations for future revenue, margins, expenses, operating results, inventory levels and capital expenditures; our anticipated working capital needs and the adequacy of our capital resources; our possible acquisition of or investment in complementary businesses or products; and our expectations with regard to our ongoing legal proceedings. Such forward-looking statements are based on current expectations, estimates and projections about our industry, as well as our management’s beliefs and assumptions. Forward-looking statements, by their nature, involve risks and uncertainties and are not guarantees of future performance. Our actual results may differ materially from the results discussed in the forward-looking statements due to a variety of factors including, but not limited to, those discussed in Item 1A “Risk Factors” in this Form 10-Q. The discussion throughout this Form 10-Q should be read in conjunction with the consolidated financial statements and notes thereto included in Item 1 “Financial Statements” in this Form 10-Q. Unless required by law, we undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

Executive Overview

Founded in 1976, Bare Escentuals is one of the leading prestige cosmetic companies in the United States and an innovator in mineral-based cosmetics. We develop, market and sell branded cosmetics and skin care products primarily under our bareMinerals, RareMinerals, Buxom and md formulations brands worldwide.

We utilize a distinctive marketing strategy and a multi-channel distribution model consisting of premium wholesale customers including Sephora, Ulta and select department stores; company-owned boutiques; spas and salons; home shopping television on QVC; infomercials; online shopping and international distributors. We believe that this strategy provides convenience to our consumers and allows us to reach a broad spectrum of consumers.

In the fourth quarter of fiscal 2008, we re-evaluated how we internally review our business performance and, in turn, changed our operating segments to be more geographically focused (and have revised historical segment financial information presented to reflect these new operating segments). As a result, our business is now comprised of three strategic business units constituting reportable segments that we manage separately based on fundamental differences in their operations:

 

   

Our North America Retail segment includes the United States and Canada and consists of our company-owned boutiques and outlet stores, premium wholesale customers and spas and salons. Our company-owned boutiques enhance our ability to build strong consumer relationships and promote additional product use through personal demonstrations and product consultations. We also sell to retailers that we believe feature our products in settings that support and reinforce our brand image and provide a premium in-store experience. Similarly, our spa and salon customers provide an informative and treatment-focused environment in which aestheticians and spa professionals can communicate the benefits of our core products.

 

   

Our North America Direct to Consumer segment includes infomercials, home shopping television in the United States and Canada and online shopping. We believe that our infomercial business helps us to build brand awareness, communicate the benefits of our core products and establish a base of recurring revenue. Our sales through home shopping television help us to build brand awareness, educate consumers through live product demonstrations and develop close connections with our consumers. In addition, our online shopping business allows us to educate consumers as to the benefits as well as proper usage and application techniques for each product offered.

 

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Our International segment includes premium wholesale, spas and salons, home shopping television, infomercial, company-owned boutique and international distributors outside of North America. We have partnered with a third party to build our infomercial business in Japan and currently have an international home shopping television presence and appear on QVC in Japan, the U.K. and Germany. We have a presence in brick-and-mortar locations overseas, including in certain international Sephora locations as well as our first company-owned boutique and spas, salons and department stores in the U.K. We also sell our products in smaller international markets primarily through a network of third-party distributors.

We manage our business segments to maximize overall sales growth and market share. We believe that our multi-channel distribution strategy enhances convenience for our consumers, reinforces brand awareness, helps to maintain consumer retention rates, and drives corporate cash flow and profitability. Further, we believe that the broad diversification within our segments provides us with expanded opportunities for growth and reduces our dependence on any single distribution channel. Within individual distribution channels, financial results can be affected by the timing of shipments as well as the impact of key promotional events.

Our performance depends on economic conditions in the United States and globally and their impact on levels of consumer confidence and spending. We have continued to see a trend, driven in part by the recent challenging economic environment, across our distribution channels of customers favoring lower-ticket, non-kit items in lieu of higher-priced kits. Although this trend has the impact of reducing our sales growth, the impact to net income is partially mitigated as these non-kit items sell at a higher gross margin.

In the current economic environment, we continue to closely manage our expenses and allocate resources with the goal of maximizing cash flow and liquidity. This includes continuing a more conservative approach to inventory management in light of the challenging retail environment. At the same time, we continue to invest strategically in areas that we believe will create long-term value including our international operations, domestic distribution expansion, education and field teams, and customer acquisition activities. We anticipate that our capital expenditures for fiscal 2009 will be approximately $29.0 million to support boutique and department store build-outs as well as international infrastructure investments.

During the third quarter of fiscal 2009, net sales increased $5.5 million, or 4.2%, to $135.7 million as compared to the third quarter of fiscal 2008. Net sales for the nine months ended September 27, 2009 decreased $16.6 million, or 4.1%, to $392.4 million as compared to the same period last year.

Diluted earnings per share for the third quarter of fiscal 2009 decreased 4.0% to $0.24 compared to $0.25 per diluted share in the third quarter of fiscal 2008. Diluted earnings per share for the nine months ended September 27, 2009 decreased 20.3% to $0.63 compared to $0.79 per diluted share in the same period last year. For the nine months ended September 27, 2009, diluted earnings per share decreased due to a decline in sales combined with increased selling, general and administrative expenses largely resulting from the addition of 40 boutiques and 3 outlet stores as compared with the prior year.

Basis of Presentation

Our significant accounting policies are disclosed in Note 2 in our Form 10-K for the year ended December 28, 2008. Our significant accounting policies have not changed significantly as of September 27, 2009.

Results of Operations

The following is a discussion of our results of operations and percentage of net sales for the three months ended September 27, 2009 compared to the three months ended September 28, 2008 and for the nine months ended September 27, 2009 compared to the nine months ended September 28, 2008.

 

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CONDENSED CONSOLIDATED STATEMENTS OF INCOME

 

     Three months ended     Nine months ended  
     September 27,
2009
    September 28,
2008
    September 27,
2009
    September 28,
2008
 
     (in thousands, except percentages)  

Sales, net

   $ 135,710      100.0   $ 130,199      100.0   $ 392,430      100.0   $ 409,075      100.0

Cost of goods sold

     34,819      25.7        35,354      27.2        103,689      26.4        113,028      27.6   
                                        

Gross profit

     100,891      74.3        94,845      72.8        288,741      73.6        296,047      72.4   

Expenses:

                

Selling, general and administrative

     56,950      41.9        51,208      39.3        167,177      42.6        152,363      37.2   

Depreciation and amortization

     4,609      3.4        3,065      2.3        12,950      3.3        8,507      2.1   

Stock-based compensation

     1,248      0.9        1,533      1.2        4,262      1.1        4,413      1.1   
                                        

Operating income

     38,084      28.1        39,039      30.0        104,352      26.6        130,764      32.0   

Interest expense

     (2,141   (1.6     (3,917   (3.0     (7,755   (2.0     (12,841   (3.1

Other income, net

     653      0.5        24      0.0        814      0.2        691      0.1   
                                        

Income before provision for income taxes

     36,596      27.0        35,146      27.0        97,411      24.8        118,614      29.0   

Provision for income taxes

     13,948      10.3        12,247      9.4        38,312      9.8        45,240      11.1   
                                        

Net income

   $ 22,648      16.7   $ 22,899      17.6   $ 59,099      15.0   $ 73,374      17.9
                                        

Net sales by business segment and percentage of net sales for the three and nine months ended September 27, 2009 and the three and nine months ended September 28, 2008 are as follows:

 

     Three months ended     Nine months ended  
     September 27,
2009
    September 28,
2008
    September 27,
2009
    September 28,
2008
 
     (in thousands, except percentages)  

North America Retail

   $ 88,284      65.0   $ 80,524      61.9   $ 239,423      61.0   $ 232,676      56.9

North America Direct to Consumer

     26,852      19.8        32,431      24.9        100,993      25.7        129,099      31.5   

International

     20,574      15.2        17,244      13.2        52,014      13.3        47,300      11.6   
                                                        

Sales, net

   $ 135,710      100.0   $ 130,199      100.0   $ 392,430      100.0   $ 409,075      100.0
                                                        

Gross profit and gross margin by business segment for the three and nine months ended September 27, 2009 and the three and nine months ended September 28, 2008 are as follows:

   

     Three months ended     Nine months ended  
     September 27,
2009
    September 28,
2008
    September 27,
2009
    September 28,
2008
 
     (in thousands, except percentages)  

North America Retail

   $ 67,299      76.2   $ 59,502      73.9   $ 182,972      76.4   $ 174,621      75.0

North America Direct to Consumer

     19,447      72.4        23,702      73.1        70,699      70.0        90,005      69.7   

International

     14,145      68.8        11,641      67.5        35,070      67.4        31,421      66.4   
                                        

Gross profit/gross margin

   $ 100,891      74.3   $ 94,845      72.8   $ 288,741      73.6   $ 296,047      72.4
                                        

Operating income (loss) by business segment and operating income (loss) as a percent of net sales for the three and nine months ended September 27, 2009 and the three and nine months ended September 28, 2008 are as follows:

   

     Three months ended     Nine months ended  
     September 27,
2009
    September 28,
2008
    September 27,
2009
    September 28,
2008
 
     (in thousands, except percentages)  

North America Retail

   $ 39,854      45.1   $ 37,405      46.5   $ 105,220      43.9   $ 117,880      50.7

North America Direct to Consumer

     9,774      36.4        11,516      35.5        40,183      39.8        48,207      37.3   

International

     6,985      34.0        7,043      40.8        16,204      31.2        19,706      41.7   
                                        

Total

     56,613      41.7     55,964      43.0     161,607      41.2     185,793      45.4

Corporate

     (18,529       (16,925       (57,255       (55,029  
                                        

Operating income

   $ 38,084      28.1   $ 39,039      30.0   $ 104,352      26.6   $ 130,764      32.0
                                        

 

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Three months ended September 27, 2009 compared to three months ended September 28, 2008

Sales, net

Net sales for the three months ended September 27, 2009 increased to $135.7 million from $130.2 million in the three months ended September 27, 2008, an increase of $5.5 million, or 4.2%. The increase in our net sales was mainly driven by our North America Retail segment.

North America Retail. North America Retail net sales increased 9.6% to $88.3 million in the three months ended September 27, 2009 from $80.5 million in the three months ended September 28, 2008. This increase as compared with the prior year was mainly due to the addition of 40 boutiques and 3 outlet stores open as of September 27, 2009 compared to September 28, 2008. As of September 27, 2009 and September 27, 2008, we had 121 and 81 open company-owned boutiques, respectively.

North America Direct to Consumer. North America Direct to Consumer net sales decreased 17.2% to $26.9 million in the three months ended September 27, 2009 from $32.4 million in the three months ended September 28, 2008. This decrease primarily resulted from a reduction in net sales from our infomercial channel due to reduced media spending versus the prior year while net sales from home shopping television and our website remained relatively flat.

International. International net sales increased 19.3% to $20.6 million in the three months ended September 27, 2009 from $17.2 million in the three months ended September 28, 2008. The increase was primarily due to our expansion in Europe through additional locations with our premium wholesale customers.

Gross profit

Gross profit increased $6.0 million, or 6.4%, to $100.9 million in the three months ended September 27, 2009 from $94.8 million in the three months ended September 28, 2008. Our North America Retail segment gross profit increased 13.1% to $67.3 million in the three months ended September 27, 2009 from $59.5 million in the three months ended September 28, 2008, primarily as a result of higher sales across our boutique channel. Our North America Direct to Consumer segment gross profit decreased 18.0% to $19.4 million in the three months ended September 27, 2009 from $23.7 million in the three months ended September 28, 2008, primarily due to lower net sales from our infomercial compared to the prior year. Our International segment gross profit increased 21.5% to $14.1 million in the three months ended September 27, 2009 from $11.6 million in the three months ended September 28, 2008 due to our growth in Europe.

Gross margin increased approximately 150 basis points to 74.3% in the three months ended September 27, 2009 from 72.8% in the three months ended September 28, 2008. This overall increase resulted primarily from a shift in product mix towards higher-margin open stock merchandise as well as a shift towards higher-margin sales channels.

Selling, general and administrative expenses

Selling, general and administrative expenses increased $5.7 million, or 11.2%, to $57.0 million in the three months ended September 27, 2009 from $51.2 million in the three months ended September 28, 2008. This increase was primarily due to increased expenses to support distribution expansion, including $3.9 million in increased operating costs mainly relating to boutique expansion and $2.3 million in increased international infrastructure expenses to support anticipated growth. This increase was partially offset by a $2.4 million decrease in infomercial operating expenses. As a percentage of net sales, selling, general and administrative expenses increased 260 basis points to 41.9% from 39.3%, primarily due to infrastructure and operating expenses increasing at a greater rate than net sales.

Depreciation and amortization

Depreciation and amortization expenses increased $1.5 million, or 50.4%, to $4.6 million in the three months ended September 27, 2009 from $3.1 million in the three months ended September 28, 2008. This increase was primarily attributable to increases in depreciable assets as we continue to expand the number of company-owned boutiques and invest in our corporate infrastructure.

Stock-based compensation

Stock-based compensation expense decreased $0.3 million, or 18.6%, to $1.2 million in the three months ended September 27, 2009 from $1.5 million in the three months ended September 28, 2008. This decrease resulted primarily from the effect of actual forfeitures.

 

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Operating income

Operating income decreased 2.4% to $38.1 million in the three months ended September 27, 2009 from $39.0 million in the three months ended September 28, 2008, primarily due to decreases in operating income from our North America Direct to Consumer segment and an increase in operating loss in Corporate due to slightly higher corporate operating expenses.

Our North America Retail segment operating income increased 6.5% to $39.9 million in the three months ended September 27, 2009 from $37.4 million in the three months ended September 28, 2008. This increase was primarily driven by sales growth combined with gross margin improvement partially offset by an increase in operating expenses of $5.3 million primarily related to the increase in the number of company-owned boutiques.

Our North America Direct to Consumer segment operating income decreased 15.1% to $9.8 million in the three months ended September 27, 2009 from $11.5 million in the three months ended September 28, 2008. This decrease was primarily driven by lower net sales from our infomercial compared to the prior year, partially offset by lower operating costs for this channel.

Our International segment operating income remained relatively flat at $7.0 million in the three months ended September 27, 2009 compared to the three months ended September 28, 2008.

Our Corporate operating loss increased 9.5% to $18.5 million in the three months ended September 27, 2009 from $16.9 million in the three months ended September 28, 2008 primarily due to increased selling, general and administrative expense of $1.3 million resulting from higher incentive compensation expense and an increase in depreciation and amortization of $0.6 million.

Interest expense

Interest expense decreased $1.8 million, or 45.3%, to $2.1 million in the three months ended September 27, 2009 from $3.9 million in the three months ended September 28, 2008. The decrease was attributable to lower average interest rates on our variable interest rate debt and the termination of our interest rate swap agreement versus the prior year, combined with decreased debt balances during the three months ended September 27, 2009 as a result of repayment of outstanding indebtedness.

Other income, net

Other income, net increased $0.6 million in the three months ended September 27, 2009 from $0.02 million in the three months ended September 28, 2008. The increase was primary attributable to a positive foreign currency impact resulting from fluctuations in the value of the U.S. dollar as compared to certain foreign currencies, offset by lower interest income on our cash and cash equivalent balances resulting from lower interest rates versus the prior year.

Provision for income taxes

The provision for income taxes was $13.9 million, or 38.1% of income before provision for income taxes, in the three months ended September 27, 2009 compared to $12.2 million, or 34.8% of income before provision for income taxes, in the three months ended September 28, 2008. The increase resulted from a higher effective rate in the three months ended September 27, 2009 compared to the three months ended September 28, 2008. The lower effective rate for the three months ended September 28, 2008 is due to a net tax benefit of $1.6 million related to the reversal of tax reserves resulting from the settlement of a state tax audit and the expiration of applicable statutes of limitation in certain jurisdictions.

Nine months ended September 27, 2009 compared to nine months ended September 28, 2008

Sales, net

Net sales for the nine months ended September 27, 2009 decreased to $392.4 million from $409.1 million in the nine months ended September 28, 2008, a decrease of $16.6 million, or 4.1%. The decrease in our net sales was driven by our North America Direct to Consumer segment.

North America Retail. North America Retail net sales increased 2.9% to $239.4 million in the nine months ended September 27, 2009 from $232.7 million in the nine months ended September 28, 2008, primarily reflecting an increase in net sales from company-owned boutiques versus the prior year due to a net increase of 40 boutiques and 3 outlet stores open as of September 27, 2009 compared to September 28, 2008. As of September 27, 2009 and September 28, 2008, we had 121 and 81 open company-owned boutiques, respectively. Offsetting this increase was a decrease in our net sales as a result of inventory de-stocking by our major retail partners.

North America Direct to Consumer. North America Direct to Consumer net sales decreased 21.8% to $101.0 million in the nine months ended September 27, 2009 from $129.1 million in the nine months ended September 28, 2008. This decrease primarily resulted from a decline in net sales from our infomercial channel due to a reduction in infomercial performance and reduced media spending versus the prior year and a decline in home shopping television net sales due to lower on-air productivity compared to the prior year.

 

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Table of Contents

International. International net sales increased 10.0% to $52.0 million in the nine months ended September 27, 2009 from $47.3 million in the nine months ended September 28, 2008 as we expanded our business across our international channels. Net sales to our global premium wholesale customers increased due to continued expansion into additional locations. Partially offsetting this increase was a decrease in net sales from international distributors and international home shopping sales.

Gross profit

Gross profit decreased $7.3 million, or 2.5%, to $288.7 million in the nine months ended September 27, 2009 from $296.0 million in the nine months ended September 28, 2008. Our North America Retail segment gross profit increased 4.8% to $183.0 million in the nine months ended September 27, 2009 from $174.6 million in the nine months ended September 28, 2008, as a result of the change in sales mix towards our higher margin boutiques. Our North America Direct to Consumer segment gross profit decreased 21.4% to $70.7 million in the nine months ended September 27, 2009 from $90.0 million in the nine months ended September 28, 2008, primarily due to lower net sales from our infomercial and at QVC compared to the prior year. Our International segment gross profit increased 11.6% to $35.1 million in the nine months ended September 27, 2009 from $31.4 million in the nine months ended September 28, 2008, due to increases in sales across our global premium wholesale channel.

Gross margin increased approximately 120 basis points to 73.6% in the nine months ended September 27, 2009 from 72.4% in the nine months ended September 28, 2008. This overall increase resulted primarily from a shift towards higher-margin sales channels as well as a shift in product mix towards higher-margin open stock merchandise.

Selling, general and administrative expenses

Selling, general and administrative expenses increased $14.8 million, or 9.7%, to $167.2 million in the nine months ended September 27, 2009 from $152.4 million in the nine months ended September 28, 2008. The increase was primarily due to increased expenses to support distribution expansion including $14.4 million in increased operating costs mainly relating to boutique expansion and $6.6 million in increased international infrastructure expenses. This increase was partially offset by decreased expenses of $10.8 million mainly from savings in infomercial operating expenses. As a percentage of net sales, selling, general and administrative expenses increased 540 basis points to 42.6% from 37.2%, primarily due to infrastructure and operating expenses increasing at a greater rate than net sales.

Depreciation and amortization

Depreciation and amortization expenses increased $4.4 million, or 52.2%, to $13.0 million in the nine months ended September 27, 2009 from $8.5 million in the nine months ended September 28, 2008. This increase was primarily attributable to increases in depreciable assets as we continue to expand the number of company-owned boutiques and invest in our corporate infrastructure.

Stock-based compensation

Stock-based compensation expense decreased $0.2 million, or 3.4%, to $4.3 million in the nine months ended September 27, 2009 from $4.4 million in the nine months ended September 28, 2008. This decrease resulted primarily from the effect of actual forfeitures offset in part by the granting of additional stock awards.

Operating income

Operating income decreased 20.2% to $104.4 million in the nine months ended September 27, 2009 from $130.8 million in the nine months ended September 28, 2008, primarily due to decreases in operating income across all segments.

Our North America Retail segment operating income decreased 10.7% to $105.2 million in the nine months ended September 27, 2009 from $117.9 million in the nine months ended September 28, 2008. This decrease was primarily driven by increased operating expenses of $21.0 million, primarily related to the increase in the number of company-owned boutiques.

Our North America Direct to Consumer segment operating income decreased 16.6% to $40.2 million in the nine months ended September 27, 2009 from $48.2 million in the nine months ended September 28, 2008. This decrease was primarily driven by sales declines due to the lower productivity of our infomercial program compared to the prior version, partially offset by lower operating costs for this channel.

Our International segment operating income decreased 17.8% to $16.2 million in the nine months ended September 27, 2009 from $19.7 million in the nine months ended September 28, 2008 due to increased operating costs of $7.2 million, which more than offset sales growth and gross margin improvements in this segment.

 

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Table of Contents

Our Corporate operating loss increased 4.0% to $57.3 million in the nine months ended September 27, 2009 from $55.0 million in the nine months ended September 28, 2008 primarily due to increases in depreciation and amortization of $1.8 million.

Interest expense

Interest expense decreased $5.1 million, or 39.7%, to $7.8 million in the nine months ended September 27, 2009 from $12.8 million in the nine months ended September 28, 2008. The decrease was attributable to lower average interest rates on our variable interest rate debt (excluding the debt under the interest rate swap agreement) versus the prior year combined with decreased debt balances during the nine months ended September 27, 2009 as a result of repayment of outstanding indebtedness.

Other income, net

Other income, net increased $0.1 million, or 17.8%, to $0.8 million in the nine months ended September 27, 2009 from $0.7 million in the nine months ended September 28, 2008. The increase was primary attributable to lower interest income on our cash and cash equivalent balances resulting from lower interest rates versus the prior year.

Provision for income taxes

The provision for income taxes was $38.3 million, or 39.3% of income before provision for income taxes, in the nine months ended September 27, 2009 compared to $45.2 million, or 38.1% of income before provision for income taxes, in the nine months ended September 28, 2008. The lower effective rate for the nine months ended September 28, 2008 is due to a net tax benefit of $1.6 million related to the reversal of tax reserves resulting from the settlement of a state tax audit and expiration of applicable statutes of limitation in certain jurisdictions.

Seasonality

Because our products are largely purchased for individual use and are consumable in nature, we are not generally subject to significant seasonal variances in sales. However, fluctuations in sales and operating income in any fiscal quarter may be affected by the timing of wholesale shipments, home shopping television appearances and other promotional events. While we believe our overall business is not currently subject to significant seasonal fluctuations, we have experienced limited seasonality in our premium wholesale and company-owned boutique channels as a result of increased demand for our products in anticipation of, and during, the holiday season. To the extent our sales to specialty beauty retailers and through our boutiques increase as a percentage of our net sales, we may experience increased seasonality.

Liquidity and Capital Resources

Our primary liquidity and capital resource needs are to service our debt, finance working capital needs and fund ongoing capital expenditures. We have financed our operations through cash flows from operations, sales of common shares and borrowings under our credit facilities.

Our operations provided us cash of $81.6 million in the nine months ended September 27, 2009. At September 27, 2009, we had working capital of $192.4 million, including cash and cash equivalents of $98.7 million, compared to working capital of $146.1 million, including $48.0 million in cash and cash equivalents, as of December 28, 2008. The $50.8 million increase in cash and cash equivalents resulted from cash provided by operations of $81.6 million, including net income for the nine months ended September 27, 2009 of $59.1 million, partially offset by cash used in investing activities of $21.7 million related to capital expenditures and cash used in financing activities of $9.6 million. The $46.3 million increase in working capital was primarily driven by increases in cash and cash equivalents, accounts receivable and prepaid expenses and other current assets and decreases in accounts payable and income taxes payable.

Net cash used in investing activities was $21.7 million in the nine months ended September 27, 2009, attributable to the build-out of additional company-owned boutiques and department stores as well as our continued investment in our corporate and information systems infrastructure to support our distribution expansion both in the U.S. and internationally. Our future capital expenditures will depend on the timing and rate of expansion of our business, information technology investments, new store openings, store renovations and international expansion opportunities.

Net cash used in financing activities was $9.6 million in the nine months ended September 27, 2009, which consisted of repayments of $10.3 million on our first-lien term loan partially offset by the exercise of stock options of $0.4 million.

Our revolving credit facility of $25.0 million, of which approximately $0.7 million was utilized for outstanding letters of credit as of September 27, 2009, and our first-lien term loan of $230.7 million, bear interest at a rate equal to, at our option, either LIBOR or the lender’s base rate, plus an applicable variable margin based on our consolidated total leverage ratio and debt rating. The current applicable interest margin for the revolving credit facility and first-lien term loan is 2.25% for LIBOR loans and 1.25% for base rate loans based on our current Moody’s rating. As of September 27, 2009, interest on the first-lien term loan was accruing at 2.52%.

 

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Borrowings under our revolving credit facility and the first-lien term loan are secured by substantially all of our assets, including, but not limited to, all accounts receivable, inventory, property and equipment, and intangibles. The terms of the senior secured credit facilities require us to comply with financial covenants, including maintaining a leverage ratio, and entering into interest rate swap or similar agreements with respect to 40% of the principal amounts outstanding under our senior secured credit facilities as of October 2, 2007 unless we satisfy specified coverage ratio tests. For the nine months ended September 27, 2009, we satisfied these tests.

In August 2007, we entered into a two-year interest rate swap transaction under our senior secured credit facilities which expired during the three months ended September 27, 2009. The interest rate swap had an initial notional amount of $200 million which declined to $100 million after one-year under which, on a net settlement basis, we made monthly fixed rate payments at the rate of 5.03% and the counterparty makes monthly floating rate payments based upon one-month U.S. dollar LIBOR. As a result of the interest rate swap transaction, we had fixed the interest rate for a two-year period subject to market-based interest rate risk on $200 million of borrowings for the first year and $100 million for the second year under our First Lien Credit Agreement. Our obligations under the interest rate swap transaction as to the scheduled payments were guaranteed and secured on the same basis as our obligations under the First Lien Credit Agreement.

The terms of our senior secured credit facilities require us to comply with a number of financial covenants, including maintaining a maximum leverage ratio (consolidated total debt to Adjusted EBITDA as defined in the agreement) of not greater than 4.5 to 1.0. As of September 27, 2009, our leverage ratio was 0.77 to 1.0. If we fail to comply with any of the financial covenants, the lenders may declare an event of default under the secured credit facility. An event of default resulting from a breach of a financial covenant may result, at the option of lenders holding a majority of the loans, in an acceleration of repayment of the principal and interest outstanding and a termination of the revolving credit facility. The secured credit facility also contains non-financial covenants that restrict some of our activities, including our ability to dispose of assets, incur additional debt, pay dividends, create liens, make investments and engage in specified transactions with affiliates. The secured credit facility also contains customary events of default, including defaults based on events of bankruptcy and insolvency, nonpayment of principal, interest or fees when due, subject to specified grace periods, breach of specified covenants, change in control and material inaccuracy of representations and warranties. We have been in compliance with all financial ratio and other covenants under our credit facilities during all reported periods, and we were in compliance with these covenants as of September 27, 2009.

Subject to specified exceptions, including for investment of proceeds from asset sales and for permitted equity contributions for capital expenditures, we are required to prepay outstanding loans under our amended senior secured credit facilities with the net proceeds of certain asset dispositions, condemnation settlements and insurance settlements from casualty losses, issuances of certain debt and, if our consolidated leverage ratio is 2.25 to 1.0 or greater, a portion of excess cash flow.

Liquidity sources, requirements and contractual cash requirement and commitments

We believe that cash flow from operations, cash on hand and amounts available under our revolving credit facility will provide adequate funds for our working capital needs, debt payments and planned capital expenditures for the next 12 months. As part of our business strategy, we intend to invest in making improvements to our information technology systems. We opened 45 boutiques in 2008 and closed two locations. We plan to open approximately 29 new boutiques and 3 outlet stores in 2009 (of which 27 boutiques and 3 outlet stores were opened as of September 27, 2009). Additionally, we also plan to continue to invest in our corporate infrastructure, particularly in support of our international growth. We may also look to acquire or invest in businesses or products complementary to our own. We anticipate that our capital expenditures in the year ending January 3, 2010 will be approximately $29.0 million. Our ability to fund our working capital needs, planned capital expenditures and scheduled debt payments, as well as to comply with all of the financial covenants under our debt agreements, depends on our future operating performance and cash flow, which in turn are subject to prevailing economic conditions, including the limited availability of capital in light of the recent financial crisis and continued volatility in financial conditions, and to financial, business and other factors, some of which are beyond our control.

 

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Contractual commitments

We lease retail stores, warehouses, corporate offices and certain office equipment under noncancelable operating leases with various expiration dates through January 2021. Portions of these payments are denominated in foreign currencies and were translated in the tables below based on their respective U.S. dollar exchange rates at September 27, 2009. These future payments are subject to foreign currency exchange rate risk. As of September 27, 2009, the scheduled maturities of our long-term contractual obligations were as follows:

 

     Remainder of
the year
ending
January 3,
2010
   1 - 3
Years
   4 - 5
Years
   After 5
Years
   Total
     (amounts in millions)

Operating leases, net of sublease income

   $ 4.8    $ 62.3    $ 42.6    $ 73.4    $ 183.1

Principal payments on long-term debt, including the current portion

     6.9      223.8      —        —        230.7

Interest payments on long-term debt, including the current portion(1)

     1.4      9.6      —        —        11.0

Payments under licensing arrangements

     —        0.2      —        —        0.2

Purchase obligations(2)

     1.5      —        —        —        1.5
                                  

Total

   $ 14.6    $ 295.9    $ 42.6    $ 73.4    $ 426.5
                                  

 

(1) For purposes of the table, interest expense is calculated for all periods based on the rate in effect as of September 27, 2009. A 1% change in interest rates on our variable rate debt would result in a change of $4.4 million in our total interest payments, of which $0.6 million would be in the remainder of the year ended January 3, 2010 and $3.8 million would be in years 1-3.
(2) Purchase obligations include agreements to purchase goods that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Agreements that are cancelable without penalty have been excluded.

We are also party to a sublicense agreement for use of certain patents associated with certain of our mineral-based skin care products. The agreement requires that we pay a quarterly royalty of 4.0% of the net sales of these skin care products up to the date of the last to expire licensed patent rights. This sublicense also requires minimum annual royalty payments of approximately $0.6 million for 2007 and thereafter. The minimum annual royalty payments have not been included in the schedule of long-term contractual obligations above as we can terminate the agreement at any time with six months written notice.

Off-balance-sheet arrangements

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

Effects of inflation

Our monetary assets, consisting primarily of cash and receivables, are not significantly affected by inflation because they are short-term in nature. Our non-monetary assets, consisting primarily of inventory, intangible assets, goodwill and prepaid expenses and other assets, are not currently affected significantly by inflation. We believe that replacement costs of equipment, furniture and leasehold improvements will not materially affect our operations. However, the rate of inflation affects our cost of goods sold and expenses, such as those for employee compensation, which may not be readily recoverable in the price of the products offered by us. In addition, an inflationary environment could materially increase the interest rates on our debt and reduce consumers’ discretionary spending.

Critical Accounting Policies and Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions. Predicting future events is inherently an imprecise activity and, as such, requires the use of judgment. Actual results may vary from estimates in amounts that may be material to the financial statements. An accounting policy is deemed to be critical if it requires an accounting estimate to be made based on assumptions about matters that are highly uncertain at the time the estimate is made, and if different estimates that reasonably could have been used, or changes in the accounting estimates that are reasonably likely to occur periodically, could materially impact our consolidated financial statements. Our critical accounting policies and estimates are discussed in our Annual Report on Form 10-K for the fiscal year ended December 28, 2008, which was filed with the SEC on February 26, 2009. We believe that there have been no significant changes during the nine months ended September 27, 2009 to the items that we disclosed in our critical accounting policies and estimates with the exception of the adoption of the new accounting pronouncements as noted below.

Recent Accounting Pronouncements

Effective June 29, 2009, we adopted a new accounting standard that establishes the FASB ASC as the exclusive reference to be applied in the preparation of financial statements in conformity with GAAP. Accordingly, all references to legacy guidance issued under previously recognized authoritative literature have been removed in the third quarter of fiscal 2009. As the ASC was not intended to change or alter existing GAAP, it did not have any impact on our results of operations or financial position.

 

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In February 2008, the FASB issued an accounting standard update that delayed the effective date of fair value measurements accounting for all non-financial assets and non-financial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until the beginning of the first quarter of fiscal 2009. These include goodwill and other non-amortizable intangible assets. We adopted this accounting standard update on December 29, 2008. The adoption did not have any material impact on our results of operations or financial position (Note 14).

Effective December 29, 2008, we adopted an accounting standard update regarding business combinations. This update establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any non-controlling interest in the acquired business. It also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statements to evaluate the nature and financial effects of the business combination. The adoption did not have any material impact on our results of operations or financial position.

Effective December 29, 2008, we adopted an accounting standard update that amended and expanded the disclosure requirements related to derivative instruments to provide users of financial statements with an enhanced understanding of the following: 1) how and why an entity uses derivative instruments; 2) how derivative instruments and related hedged items are accounted for; and 3) how derivative instruments and related hedged items affect an entity’s financial position, financial performance and cash flows. The adoption had no financial impact on our financial position or results of operations as it is disclosure-only in nature.

During the second quarter of 2009, we adopted an accounting standard update that requires quarterly disclosure of information about fair value of financial instruments. The adoption of this standard had no financial impact on our financial position or results of operations as it is disclosure-only in nature.

During the second quarter of 2009, we adopted a new accounting standard for subsequent events which establishes general standards of accounting for, and requires disclosures of, events that occur after the balance sheet date but before the financial statements are issued or are available to be issued. It did not have any material impact on our results of operations or financial position.

In August 2009, the FASB issued authoritative guidance on how to measure the fair value of a liability. The guidance has three primary components: 1) sets forth the types of valuation techniques to be used to value a liability when a quoted price in an active market for the identical liability is not available; 2) clarifies that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability; and 3) clarifies that both a quoted price in an active market for the identical liability at the measurement date and the quoted price for the identical liability when traded as an asset in an active market when no adjustments to the quoted price of the asset are required are Level 1 fair value measurements. This standard is effective beginning in the fourth quarter of 2009. We do not expect the adoption to have a material impact on our financial position or results of operations.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest rate sensitivity

We are exposed to interest rate risks primarily through borrowings under our credit facilities. We had reduced our exposure to interest rate fluctuations by entering into an interest rate swap agreement covering a portion of our variable rate debt. In August 2007, we entered into a two-year interest rate swap transaction under our senior secured credit facilities. The interest rate swap had an initial notional amount of $200 million declining to $100 million after one-year under which, on a net settlement basis, we made monthly fixed rate payments at the rate of 5.03% and the counterparty made monthly floating rate payments based upon one-month U.S. dollar LIBOR. Our weighted average borrowings outstanding during the nine months ended September 27, 2009 were $234.2 million and the annual effective interest rate for the period was 4.36%, after giving effect to the interest swap agreement. The interest swap agreement terminated in August 2009. A hypothetical 1% increase or decrease in interest rates would have resulted in a $1.8 million change to our interest expense in the nine months ended September 27, 2009 and $2.3 million on an annualized basis.

Foreign currency risk

Most of our sales, expenses, assets, liabilities and cash holdings are currently denominated in U.S. dollars but a portion of the net revenues we receive from sales is denominated in currencies other than the U.S. dollar. Additionally, portions of our costs of goods sold and other operating expenses are incurred by our foreign operations and denominated in local currencies. While fluctuations in the value of these net revenues, costs and expenses as measured in U.S. dollars have not materially affected our results of operations historically, we cannot assure that adverse currency exchange rate fluctuations will not have a material impact in the future. In addition, our balance sheet reflects non-U.S. dollar denominated assets and liabilities which can be adversely affected by fluctuations in currency exchange rates. We do not currently hedge against foreign currency risks.

 

ITEM 4. CONTROLS AND PROCEDURES

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports pursuant to the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Management is responsible for establishing and maintaining adequate internal control over financial reporting. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by SEC Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the quarter covered by this report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer determined that our disclosure controls and procedures were effective as of the end of the quarter covered by this report at a reasonable assurance level.

There has been no change in our internal control over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II—OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

Beginning on July 17, 2009, three purported stockholder class actions were filed in the United States District Court for the Northern District of California against us, certain of our current and former officers and directors and the underwriters for our initial public offering and March 2007 secondary offering. On October 15, 2009, the court consolidated the three cases into the first-filed case (C-09-03268 PJH) and appointed Westmoreland County Retirement System and Vincent J. Takas as lead plaintiffs and their counsel as lead plaintiffs’ counsel. The original complaint filed by Westmoreland purports to be brought on behalf of persons who purchased our stock on the open market between September 28, 2006 and October 31, 2008 and persons who purchased our stock pursuant to our initial public offering and March 2007 registration statements and prospectuses. The original complaint alleges that we and our officer-defendants made false or misleading statements about our business and prospects in violation of Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The original complaint also alleges that all defendants made false or misleading statements in the registration statements and prospectuses pertaining to our initial public offering and March 2007 secondary offering, in violation of Sections 11, 12 and 15 of the Securities Act of 1933. The original complaint seeks compensatory damages, attorneys’ fees and costs and such other relief as the court may deem proper. Lead plaintiffs will file a consolidated amended complaint and defendants will file motions to dismiss that complaint.

In addition, we are subject to various claims and legal actions during the ordinary course of our business. We believe that currently none of these claims or legal actions would have a material adverse impact on our financial position, operations or potential performance.

 

ITEM 1A. RISK FACTORS

The risks set forth below may adversely affect our business, financial condition and operating results. In addition to the risks set forth below, there may also be risks of which we are currently unaware, or that we currently regard as immaterial based on the information available to us that later prove to be material. These risk factors should be read in conjunction with the other information contained in our other SEC filings, including our Form 10-K for the fiscal year ended December 28, 2008.

Our success is dependent on sales of our mineral-based foundation. A change in consumer preferences for such products could harm our business.

During the year ended December 28, 2008, approximately 71.0% of our net sales were derived from our sales of foundation products.

We are vulnerable to shifting consumer tastes and demands and cannot be certain that our foundation will maintain its popularity and market acceptance. Our growth and future success will depend, in part, upon consumer preferences for our mineral-based foundation products. A decline in consumer demand for our mineral-based foundation would result in decreased net sales of our products and harm our business. Moreover, we are identified as a mineral-based cosmetics company, and it would likely damage our reputation were these products to fall out of favor with consumers.

The recent global economic crisis and continued volatility in global economic conditions and the financial markets has had, and may continue to have, an adverse effect on our industry, business and results of operations.

The recent global economic crisis reached nearly unprecedented levels and the continued volatility and disruption to the capital and credit markets have significantly adversely impacted global economic conditions, resulting in additional significant recessionary pressures and declines in consumer confidence and economic growth. These conditions have led to decreases in consumer spending across the economy, our industry and our business. Many economists predict that the recession will be prolonged and that conditions may deteriorate further before there is any improvement or even after some improvement has occurred. These conditions have resulted in pricing pressures, and could further lead to additional pricing pressures and reduced consumer spending in the foreseeable future. Reduced consumer spending may cause changes in customer order patterns including order cancellations, and changes in the level of inventory at our customers, which may adversely affect our industry, business and results of operations.

These conditions have also resulted in a substantial tightening of the credit markets, including lending by financial institutions which is a source of capital for our borrowing and liquidity. This tightening of the credit markets has increased the cost of capital and reduced the availability of credit. It is difficult to predict how long the current economic and capital and credit market conditions will continue, the extent to which they will continue to deteriorate and which aspects of our products or business may be adversely affected. However, if current levels of economic and capital and credit market disruption and volatility continue or worsen, we are likely to experience an adverse impact, which may be material, on our business, the cost of and access to capital and credit markets, and our results of operations. Further, even when the global economy improves and the recession ends, there can be no guarantee that such changes in the economy will positively impact our industry of prestige consumer goods, our business or our results of operations.

 

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

We depend on sales to specialty beauty retailers and QVC, Inc. for a significant portion of our net sales. Sales to Sephora, Ulta and QVC accounted for an aggregate of 40.5% of our net sales for the year ended December 28, 2008, with sales to each of these customers accounting for greater than 10% of our net sales for the year ended December 28, 2008. In addition, sales to Sephora, Ulta and QVC accounted for an aggregate of 37.2% of our net sales for the nine months ended September 27, 2009, with sales to each of these customers accounting for greater than 10% of our net sales for the nine months ended September 27, 2009. Our arrangement with QVC does not obligate QVC to make any purchases of our products or to undertake any efforts to promote our products on air or otherwise, and our arrangements with each of Sephora and Ulta are by purchase order and are terminable at will at the option of either party. A substantial decrease or interruption in business from these significant customers could result in inventory write-offs or in the loss of future business and could reduce our liquidity and profitability. In addition, our appearances on QVC enhance our brand awareness and drive sales both on QVC and in our other sales channels. As a result, a decision by QVC to reduce the number of times per year it features our products on air or the type of such appearances would cause a decline in our sales to QVC and could cause sales in our other channels to suffer.

In the future, our significant customers may undergo restructurings or reorganizations, or realign their affiliations, any of which could decrease their orders for our products. Any severe adverse impact on the business operations of our significant customers may have a corresponding negative effect on us. One or more of these customers may decide to exclusively feature a competitor’s mineral-based products, develop their own store-brand mineral-based products or reduce the number of brands of cosmetics and beauty products they sell, any of which could affect our ability to sell our products to them on favorable terms, if at all. Our loss of significant customers would impair our sales and profitability and harm our business, prospects, financial condition and results of operations.

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

The beauty industry is highly competitive and at times changes rapidly due to consumer preferences and industry trends. Our products face, and will continue to face, competition for consumer recognition and market share with products that have achieved significant national and international brand name recognition and consumer loyalty, such as those offered by global prestige beauty companies Avon Products, Inc., Elizabeth Arden, Inc., The Estée Lauder Companies, Inc., Johnson & Johnson, Inc., L’Oréal Group, Mary Kay, Inc. and The Proctor & Gamble Company, each of which have launched and are promoting mineral-based makeup brands. These companies have significantly greater resources than we have and are less leveraged than we are. These competitors typically devote substantial resources to promoting their brands through traditional forms of advertising, such as print media and television commercials. Because of such mass marketing methods, these competitors’ products may achieve higher visibility and recognition than our products. In addition, these competitors may duplicate our marketing strategy and distribution model to increase the breadth of their product sales.

Competition for market share in the cosmetics industry is especially intense, even when economic conditions are favorable. In order to succeed, we must take market share from our competitors across all of our sales channels. We compete with prestige cosmetics companies primarily in online retailing, department stores and specialty beauty retail channels, but prestige cosmetics companies also recently have increased their sales through infomercial and home shopping television channels. Mass cosmetics brands are sold primarily though channels in which we do not sell our products, such as mass merchants, but mass cosmetics companies are increasingly making efforts to acquire market share in the higher-margin prestige cosmetics category by introducing brands and products that address this market. In addition, the recent entry of mass cosmetic brands into the mineral-based makeup category with lower price points has placed additional pressure on us to remain competitive and further differentiate the quality of our products. If we are unable to maintain or improve the inventory levels and in-store positioning of our products in third-party retailers or maintain and increase sales of our products through our other distribution channels, including infomercials, home shopping television and other direct-to-consumer methods, our ability to achieve and maintain significant market acceptance for our products could be severely impaired. Further, the trend toward consolidation in the retail industry, particularly in developed markets such as the United States and Western Europe, could result in our becoming increasingly dependent upon some retailers, which have increased their respective bargaining strengths.

Advertising, promotion, merchandising and packaging, and the timing of new product introductions and line extensions have a significant impact on consumers’ buying decisions and, as a result, our net sales. These factors, as well as demographic trends, economic conditions and discount pricing strategies by competitors, could result in increased competition and could harm our net sales and profitability.

 

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The mineral-based makeup category has become highly competitive and we may be unable to differentiate our products from other mineral-based makeup brands, which would adversely affect our ability to maintain existing customers and acquire new customers, harming our sales.

In addition to global beauty companies such as Avon Products, Inc., Elizabeth Arden, Inc., The Estee Lauder Companies, Inc., Johnson & Johnson, Inc., L’Oreal Group, Mary Kay, Inc. and The Proctor & Gamble Company launching their own mineral-based makeup brands, a number of smaller companies and mass cosmetics companies have also launched mineral-based makeup lines given that the process for production of mineral-based cosmetics is not subject to patent protection and there is a low barrier to entry into the market for such products. Some of these competitors have significant experience using infomercials to market and sell cosmetics and skin care products and have employed marketing strategies and distribution models similar to ours. If these companies’ products prove successful or if global beauty companies were to significantly increase production and marketing of their mineral-based cosmetics, our net sales could suffer. If, through our marketing efforts, such as our infomercial and foundation sampling initiative, we are unable to successfully differentiate the quality of our mineral-based makeup from our competitors’ products, our ability to acquire new customers will suffer. If consumers prefer our competitors’ products over ours, we would lose market share and our net sales would decline. New products that we develop might not generate sufficient consumer interest and sales to become profitable or to cover the costs of their development.

Our plans to expand our product offerings and launch new brands or brand extensions may not be successful, and implementation of these plans may divert our operational, managerial and administrative resources, which could impact our competitive position.

We plan to grow our business by expanding our product offerings and developing new brands or brand extensions, such as our RareMinerals brand and line of products and our Buxom brand and line of products. These plans involve various risks, including:

 

   

if our expanded product offerings or new brands or brand extensions fail to maintain and enhance our distinctive brand identity, our brand image may be diminished and our net sales may decrease; and

 

   

the implementation of these plans may divert management’s attention from other aspects of our business and place a strain on our management, operational and financial resources, as well as our information systems.

The development and launch of a new product line or brand or brand extension could be delayed or abandoned, could cost more than anticipated and could divert resources from other areas of our business, any of which could impact our competitive position and reduce our net sales and profitability.

Our future success depends on our ability to continue to grow our international business.

Our future success depends on our ability to continue to grow our international business, which increased from approximately 7.9% of our net sales in 2007 to approximately 12.1% of our net sales in 2008 to approximately 13.3% of our net sales in the first nine months of 2009. In order to successfully grow our international business, we need to develop successful retail and distribution partnerships in each international market and effectively translate the appeal of our products within those markets. As other global prestige beauty companies have more experience developing, marketing and selling their products for and to markets outside of the U.S., we are competing against well-established brands with sophisticated international operations and significantly greater resources than us. Achieving growth in our international business will require investment in product development, marketing initiatives, distribution channels, information technology, operating infrastructure and the hiring and training of additional international employees. In addition to the monetary investment required to grow our international business, time and energy spent by our executive team on our international business may distract them from our core domestic business and operations. Our ability to grow our international business involves significant risks and uncertainties. Our efforts to increase sales of our products outside the U.S. may not be successful and may not achieve higher sales or gross margins or otherwise contribute to profitability.

We are subject to risks related to our international operations.

As we seek to expand our international operations, we will be increasingly susceptible to the following risks associated with international operations:

 

   

import and export license requirements;

 

   

trade restrictions;

 

   

changes in tariffs and taxes;

 

   

restrictions on repatriating foreign profits back to the United States;

 

   

the imposition of foreign and domestic governmental controls;

 

   

unfamiliarity with foreign laws and regulations;

 

   

difficulties in staffing and managing international operations;

 

   

product registration, permitting and regulatory compliance;

 

   

thefts and other crimes;

 

   

currency conversion risks and currency fluctuations, which have recently been more pronounced;

 

   

greater difficulty enforcing intellectual property rights and weaker laws protecting such rights; and

 

   

geopolitical conditions, such as terrorist attacks, war or other military action, public health problems and natural disasters.

 

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

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

Our ability to succeed depends, to a significant extent, on our ability to grow our business while maintaining profitability. We may not be able to sustain our growth or profitability on a quarterly or annual basis in future periods. Our future growth and profitability has depended in the past and will in the future depend upon a number of factors, including, without limitation:

 

   

the level of competition in the beauty industry;

 

   

our ability to continue to execute successfully our strategic initiatives and growth strategy;

 

   

general economic conditions and consumer confidence,

 

   

our ability to sell our products effectively through our various distribution channels in volumes sufficient to drive growth and leverage our cost structure and media spending;

 

   

our ability to improve our products continuously in order to offer new and enhanced consumer benefits and better quality;

 

   

our ability to maintain efficient, timely and cost-effective production and delivery of our products;

 

   

the efficiency and effectiveness of our sales and marketing efforts, including through infomercials and QVC, in building product and brand awareness, driving traffic to our various distribution channels and increasing sales;

 

   

our ability to identify and respond successfully to emerging trends in the beauty industry;

 

   

our ability to maintain and intensify our consumers’ emotional connection with our brand, including through friendly and effective customer service and contacts;

 

   

our ability to maintain public association of our brand with prestige beauty products; and

 

   

the level of consumer acceptance of our products.

We may not be successful in executing our growth strategy, and even if we achieve our strategic plan, we may not be able to sustain profitability. Failure to execute any material part of our strategic plan or growth strategy successfully could significantly impair our ability to service our indebtedness and make investments in our business.

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

Our growth has placed, and will continue to place, a strain on our management team, information systems and other resources. To manage growth effectively, we must:

 

   

continue to enhance our operational, financial and management systems, including our warehouse management, inventory control and in-store point-of-sale systems both in the U.S. and abroad;

 

   

maintain and improve our internal controls and disclosure controls and procedures; and

 

   

expand, train and manage our employee base both in the U.S. and abroad.

We may not be able to effectively manage this expansion in any one or more of these areas, and any failure to do so could significantly harm our business, prospects, financial condition or results of operations. Our growth also may make it difficult for us to adequately predict the expenditures we will need to make in the future. If we do not make the necessary overhead expenditures to accommodate our future growth, we may not be successful in executing our growth strategy, and our prospects and results of operations would suffer.

A prolonged continuation of the current economic climate or further decline in general economic conditions could create pricing pressures and lead to reduced consumer demand for our products and/or the financial strength of our customers that are retailers, which could adversely affect our net sales, liquidity and profitability.

Since purchases of our merchandise are dependent upon discretionary spending by our consumers, our financial performance is sensitive to changes in overall economic conditions that affect consumer spending. Consumer spending habits are affected by, among other things, prevailing economic conditions, levels of employment, salaries and wage rates, consumer confidence and consumer

 

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perception of economic conditions. The current crises in the United States economy and the economies of other countries where we sell our products and increased uncertainty as to the economic outlook has reduced, and may continue to reduce discretionary spending or cause a shift in consumer discretionary spending to other products or a shift in the mix of our products purchased by consumers and these effects could continue for the foreseeable future. Consumer purchases of discretionary items tend to decline during recessionary periods, when disposable income is lower, and may impact sales of our products. A decline in consumer purchases of discretionary items may also impact our customers that are retailers. We generally extend credit to a retailer based on an evaluation of its financial condition, generally without requiring any collateral. Financial difficulties of a retailer could cause us to limit or terminate business with that customer. We may also assume more risk associated with receivables from that retailer and our inability to collect the receivable from one of our larger customers or a group of customers could harm our financial condition. Any of these factors would likely cause us to delay or slow our expansion plans, result in lower net sales and excess inventories and hinder our ability to raise prices in line with costs, which could, in turn, lead to increased merchandise markdowns and impairment charges, adversely affecting our profitability.

If we are unable to retain key executives and other personnel, particularly Leslie Blodgett, our Chief Executive Officer and primary spokesperson, and recruit additional executives and personnel, we may not be able to execute our business strategy and our growth may be hindered.

Our success largely depends on the performance of our management team and other key personnel and our ability to continue to recruit qualified senior executives and other key personnel. Our future operations could be harmed if any of our senior executives or other key personnel ceased working for us. Our President of Retail resigned in July 2009, and we are currently recruiting for a Senior Vice President Retail and a Senior Vice President Wholesale to fill this vacancy. Competition for qualified senior management personnel is intense, and there can be no assurance that we will be able to attract additional qualified personnel or to retain our current personnel. The loss of a member of senior management, such as the President of Retail, requires the remaining executive officers and other personnel to divert immediate and substantial attention to fulfilling his or her duties and to seeking a replacement. We may not be able to continue to attract or retain qualified executive personnel in the future. Any inability to fill vacancies in our senior executive positions on a timely basis could harm our ability to implement our business strategy, which would harm our business and results of operations.

We are particularly dependent on Leslie Blodgett, our Chief Executive Officer and primary spokesperson, as her talents, efforts, personality and leadership have been, and continue to be, critical to our success. Many of our customers identify our products by their association with Ms. Blodgett, and she greatly enhances the success of our sales and marketing. There can be no assurance that we will be successful in retaining her services. We maintain key executive life insurance policies with respect to Ms. Blodgett totaling approximately $34 million, which is payable to the lenders under our senior secured credit facility in the event we collect payments on the policy. A diminution or loss of the services of Ms. Blodgett would significantly harm our net sales, and as a result, our business, prospects, financial condition and results of operations.

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

A few members of our senior management team have relatively recently joined the company. Additionally, our President of Retail resigned in July 2009, and we are currently recruiting for a Senior Vice President Retail and a Senior Vice President Wholesale to fill this vacancy on the senior management team. As a result, our senior management team has, and will continue to have, limited experience working together as a group. This lack of shared experience could harm our senior management team’s ability to quickly and efficiently respond to problems and effectively manage our business. Our success also depends on our ability to continue to attract, manage and retain other qualified senior management members as we grow.

Our planned expansion of our boutique operations will result in increased expenses with no guarantee of increased earnings. In addition, we may close boutiques that are not profitable or incur other costs, which could cause our results of operations to suffer.

We opened a total of 45 new boutiques in 2008. To date, we have opened approximately 27 new boutiques and 3 outlet stores in 2009, and we plan to open approximately 2 new boutiques in the remainder of 2009. We expect our total capital expenditures associated with opening our new boutiques to be approximately $14.0 million in 2009. However, we may not be able to attain our target number of new boutique openings, and any of the new boutiques that we open may not be profitable, either of which could cause our financial results to suffer. Our ability to expand by opening new boutiques will depend in part on the following factors:

 

   

the availability of attractive boutique locations;

 

   

our ability to negotiate favorable lease terms;

 

   

our ability to identify customer demand in different geographic areas;

 

   

general economic conditions; and

 

   

the availability of sufficient funds for expansion.

 

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In order to continue our expansion of boutiques, we will need to hire additional management and staff for our corporate offices and employees for each new boutique. In addition, we will need to continue to invest in our information technology systems to accommodate the growth of our operations. If we are unable to hire necessary personnel or support our existing information technology systems, our expansion efforts may not succeed and our results of operations may suffer.

Some of our expenses will increase with the opening of new boutiques, such as headcount and lease occupancy expenses as well as information technology system expenses. Moreover, as we stock new boutiques with product inventory, our inventory expenditures will increase. We may not be able to manage these increased expenses without decreasing our earnings. If any of our boutiques fails to generate attractive financial returns or otherwise does not serve our strategic goals, we may be required to close that boutique. If we were to close any boutique, we likely would incur expenses and impairment charges in connection with such closing, would be unable to recover our investment in leasehold improvements at that boutique and would be liable for remaining lease obligations, which could harm our results of operations.

We are currently subject to securities class action litigation and may be subject to similar litigation in the future. If the outcome of this litigation is unfavorable, it could have a material adverse effect on our financial condition, results of operations and cash flows.

Beginning on July 17, 2009, three purported stockholder class actions were filed in the United States District Court for the Northern District of California against us, certain of our current and former officers and directors and the underwriters for our initial public offering and March 2007 secondary offering. On October 15, 2009, the court consolidated the three cases into the first-filed case (C-09-03268 PJH) and appointed Westmoreland County Retirement System and Vincent J. Takas as lead plaintiffs and their counsel as lead plaintiffs’ counsel. The original complaint filed by Westmoreland purports to be brought on behalf of persons who purchased our stock on the open market between September 28, 2006 and October 31, 2008 and persons who purchased our stock pursuant to our initial public offering and March 2007 registration statements and prospectuses. The original complaint alleges that we and our officer-defendants made false or misleading statements about our business and prospects in violation of Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. The original complaint also alleges that all defendants made false or misleading statements in the registration statements and prospectuses pertaining to our initial public offering and March 2007 secondary offering, in violation of Sections 11, 12 and 15 of the Securities Act of 1933. The original complaint seeks compensatory damages, attorneys’ fees and costs and such other relief as the court may deem proper. Lead plaintiffs will file a consolidated amended complaint and defendants will file motions to dismiss that complaint.

In the future, especially following periods of volatility in the market price of our shares, other purported class action or derivative complaints may be filed against us. The outcome of the pending and potential future litigation is difficult to predict and quantify and the defense of such claims or actions can be costly. In addition to diverting financial and management resources and general business disruption, we may suffer from adverse publicity that could harm our brand or reputation, regardless of whether the allegations are valid or whether we are ultimately held liable. A judgment or settlement that is not covered by or is significantly in excess of our insurance coverage for any claims, or our obligations to indemnify the underwriters and the individual defendants, could materially and adversely affect our financial condition, results of operations and cash flows.

We depend on third parties to manufacture all of the products we sell and we do not have long-term contracts with all of these manufacturers. If we are unable to maintain these manufacturing relationships, if the economic climate adversely affects our third party manufacturers or we enter into additional or different arrangements, we may fail to meet customer demand and our net sales and profitability may suffer as a result.

All of our products are contract manufactured or supplied by third parties who are located in both the U.S. and China. We do not have long-term contracts with all of these manufacturers of our products. The fact that we do not have long-term contracts with all of our other third-party manufacturers means that they could cease manufacturing these products for us suddenly and unpredictably. In addition, our third-party manufacturers are generally not restricted from manufacturing our competitors’ products, including mineral-based products. We source some of our products through a supplier agent that purchases products from third-party manufacturers and some of the ingredients in certain products are sole-sourced. Also, the current economic climate or further decline in general economic conditions may cause our third party manufacturers to experience liquidity problems which may result in their inability to continue as going concerns or to produce the quantity of products that we require. If we are unable to obtain adequate supplies of suitable products or ingredients because of the loss of one or more key vendors or manufacturers or our supplier agent or otherwise, our business and results of operations would suffer because we would be missing products from our merchandise mix unless and until we could make alternative supply arrangements. In addition, identifying and selecting alternative vendors would be time-consuming and expensive, and we might experience significant delays in production during this selection process. Our inability to secure adequate and timely supplies of merchandise would harm inventory levels, net sales and gross profit, and ultimately our results of operations.

 

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Some of our products are currently being produced by third-party manufacturers located in China. Due to cost advantages, we expect that our dependence on third-party manufacturers located in China will continue to increase. Recently there have been concerns regarding the quality and safety of goods manufactured in China. If our China-based manufacturers fail to produce quality products on time, at expected cost targets and in sufficient quantities, or if any of our products are found to be tainted or otherwise raise health or safety concerns, our reputation and operating results would suffer.

Any of our manufacturers also may increase the cost of the products we purchase from them. If our manufacturers increase our costs, our margins would suffer unless we were able to pass along these increased costs to our customers. We may not be able to develop relationships with new vendors and manufacturers, and even if we do establish such relationships, such new vendors and manufacturers might not allocate sufficient capacity to us to meet our requirements. Furthermore, products from alternative sources, if any, may be of a lesser quality or more expensive than those we currently purchase. In addition, if we increase our product orders significantly from the amounts we have historically ordered from our manufacturers, our manufacturers might be unable to meet this increased demand. To the extent we fail to obtain additional products from our manufacturers, we may not be able to meet customer demand, which could harm our net sales and profitability.

Our third-party manufacturers may not continue to produce products that are consistent with our quality and safety standards or applicable regulatory requirements, which could harm our brand, cause customer dissatisfaction and require us to find alternative suppliers of our products.

Our third-party manufacturers may not maintain adequate controls with respect to product specifications and quality and may not continue to produce products that are consistent with our standards or applicable regulatory requirements, as described below. If we are forced to rely on products of inferior quality, then our customer satisfaction and brand reputation would likely suffer, which would lead to reduced net sales, or products may become subject to liability claims. In addition, we may be required to find new third-party manufacturers to supply our products. There can be no assurance that we would be successful in finding third-party manufacturers that make products meeting our standards of quality or safety.

In accordance with the Federal Food, Drug and Cosmetic Act (“FDCA”) and the Food and Drug Administration (“FDA”) regulations, our products may not be sold if they are deemed to be adulterated or misbranded. Our third party manufacturers may deviate from good manufacturing practices or, through their action or inaction, otherwise render our products misbranded. Labeling and claims made for products must follow specific requirements to avoid being deemed misbranded. The FDA may inspect our facilities and those of our third-party manufacturers periodically to determine if we and our third-party manufacturers are complying with the FDCA. Certain claims may subject our products to being deemed an illegal new drug. Some of our competitors may currently be making these claims at their own risk. We have limited control over the FDA compliance of our third-party manufacturers. A history of past compliance is not a guarantee that future FDA regulatory manufacturing requirements will not mandate other compliance steps with associated expense.

If we or our third-party manufacturers fail to comply with federal, state or foreign regulations, we could be required to suspend manufacturing operations, change product formulations, suspend the sale of products with non-complying specifications, initiate product recalls, change product labeling, packaging or advertising or take other corrective action. In addition, sanctions under the FDCA may include seizure of products, injunctions against future shipment of products, restitution and disgorgement of profits, operating restrictions and criminal prosecution. If any of the above events occurs, we would be required to expend significant resources on compliance, fines, and/or legal fees and we might need to seek the services of alternative third-party manufacturers. A prolonged interruption in the manufacturing of one or more of our products as a result of non-compliance could decrease our supply of products available for sale which could reduce our net sales, gross profits and market share, as well as harm our overall business, prospects, financial condition and results of operations.

Our manufacturers ship a significant portion of the product we order to our distribution centers in Obetz, Ohio and Hayward, California, and any significant disruption of the operations of the centers would hurt our ability to make timely delivery of our products.

We distribute products to our domestic channels from our facility in Obetz, Ohio. Approximately 88% of our net sales for the year ended December 28, 2008 and approximately 84% of our net sales for the nine months ended September 27, 2009 were derived from these sales channels. We currently distribute products primarily in support of our international business from our facility in Hayward, California. Approximately 12% of our net sales for the year ended December 28, 2008 and approximately 13% of our net sales for the nine months ended September 27, 2009 were derived from these sales channels. A natural disaster or other catastrophic event, such as a fire, flood, severe storm, break-in, terrorist attack or other comparable event could cause interruptions or delays in our business and loss of inventory and could render us unable to accept or fulfill customer orders in a timely manner, or at all. Hayward, California is located on a major fault line, increasing our susceptibility to the risk that an earthquake could significantly harm the operations of our distribution facility. The impact of any of these natural disasters or other catastrophic events on our business may be exacerbated by the fact that we are still in the process of developing our formal disaster recovery plan, and we do not have a final plan currently in place. In addition, our business interruption insurance may not adequately compensate us for losses that may occur. In the event that an earthquake, fire, natural disaster or other catastrophic event were to destroy a significant part of either facility or interrupt our operations for an extended period of time, our net sales would be reduced and our results of operations would be harmed.

 

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

We may experience variability in net sales and net income on a quarterly basis as a result of a variety of factors, including the timing of orders from our premium wholesale customers, the timing and number of our appearances on QVC, the timing of new boutique openings, seasonality and other factors, including economic conditions. We make sales to our premium wholesale customers on a purchase order basis, and we receive new orders when and as these customers need replenishment product. As a result, their orders typically are not evenly distributed through the course of the year. In addition, our sales to QVC are largely dependent on the timing and number of our on-air appearances, with our greatest sales generated through appearances where our products are featured as “Today’s Special Value” or “TSV.” As such, we expect our quarterly results to continue to fluctuate based on the number of shows in a quarter and whether a particular quarter includes a TSV or not.

We opened a total of 45 new boutiques in 2008. To date, we have opened approximately 27 new boutiques and 3 outlet stores in 2009, and we plan to open approximately 2 new boutiques in the remainder of 2009. The timing of these boutique openings will impact both our net sales and our selling, general and administrative expenses. For example, if we were to open a number of new boutiques at the end of a quarter, our results of operations for that quarter would include limited net sales from the new boutiques but substantially all of the pre-opening expenses associated with such boutiques.

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

Our operations may be impaired as a result of disasters, business interruptions or similar events.

A natural disaster such as an earthquake, fire, flood, or severe storm, or a catastrophic event such as a terrorist attack, an epidemic affecting our operating activities, major facilities, or a computer system failure could cause an interruption or delay in our business and loss of inventory and/or data or render us unable to accept and fulfill customer orders in a timely manner, or at all. In addition, we are located in areas that are susceptible to an earthquake or other similar event could prevent us from delivering products in a timely manner. We do not currently have a disaster recovery plan, other than with respect to our information technology systems, and our business interruption insurance may not adequately compensate us for losses that may occur. In the event that an earthquake, natural disaster, terrorist attack or other catastrophic event were to destroy any part of our facilities or interrupt our corporate headquarters or any of our distribution facilities operations for any extended period of time, or if harsh weather conditions prevent us from delivering products in a timely manner, our business, financial condition and operating results could be seriously harmed.

Our computer and communications hardware and software systems are vulnerable to damage and interruption, which could harm our business.

Our ability to receive and fulfill orders successfully is critical to our success and largely depends upon the efficient and uninterrupted operation of our computer and communications hardware and software systems. Our primary computer systems and operations are located at a co-location facility in San Francisco, California and our corporate headquarters also in San Francisco, California and are vulnerable to damage or interruption from power outages, computer and telecommunications failures, computer viruses, security breaches, catastrophic events and errors in usage by our employees and customers. Systems integration issues are complex, time-consuming and expensive.

We outsource the hosting of our websites bareescentuals.com, bareminerals.com and mdformulations.com. In the event that any of our website service providers experiences any interruption in its operations or ceases operations for any reason or if we are unable to agree on satisfactory terms for a continued hosting relationship, we would be forced to enter into a relationship with another service provider or take over hosting responsibilities ourselves. In the event it becomes necessary to switch hosting facilities in the future, we may not be successful in finding an alternative service provider on acceptable terms or in hosting our websites ourselves. Any significant interruption in the availability or functionality of our website or our sales processing, distribution or communications systems, for any reason, could seriously harm our business, prospects, financial condition and results of operations.

 

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We are required to evaluate our internal control over financial reporting under Section 404 of the Sarbanes-Oxley Act of 2002 and are exposed to future risks of non-compliance.

We were required to furnish a report by our management on our internal control over financial reporting pursuant to the Sarbanes-Oxley Act of 2002 in connection with the Annual Report on Form 10-K for the years ended December 28, 2008 and December 30, 2007. Such report contains, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. Such report must also contain a statement that our independent registered public accounting firm has issued an attestation report on management’s assessment of such internal control.

We cannot predict the outcome of our testing in future periods and if our internal controls are ineffective in future periods, our financial results or the market price of our stock could be adversely affected. In any event, we will incur additional expenses and commitment of management’s time in connection with further evaluations, which may adversely affect our future operating results and financial condition.

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

Our consolidated long-term indebtedness as of September 27, 2009 was $230.7 million. As of September 27, 2009, we may borrow up to an additional $24.3 million under our revolving credit facility, subject to compliance with a maximum leverage ratio covenant.

Our senior secured credit facilities, as amended in March 2007, contain a number of significant covenants, which limit our ability to, among other things, incur additional indebtedness, make investments, pay dividends, make distributions, or redeem or repurchase capital stock and grant liens on our assets or the assets of our subsidiaries. For example, we are restricted from incurring additional indebtedness from a third party unless we satisfy the maximum leverage ratio covenant in our credit facility. Our senior secured credit facilities also require us to maintain specified financial ratios and satisfy financial condition tests at the end of each fiscal quarter. Our ability to meet these financial ratios and tests can be affected by events beyond our control, and we may not meet those tests. A breach of any of these covenants could result in a default under the senior secured credit facilities. If the lenders accelerate amounts owing under our senior secured credit facilities because of a default and we are unable to pay such amounts, the lenders have the right to foreclose on substantially all of our assets.

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

 

   

increasing our vulnerability to general adverse economic and industry conditions, placing us at a disadvantage compared to our competitors who are less leveraged;

 

   

reducing the availability of our cash flow for other purposes, including working capital, capital expenditures, product development, acquisitions or other corporate requirements;

 

   

limiting our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate, which would place us at a competitive disadvantage compared to our competitors that may have less debt; and

 

   

limiting our ability to obtain additional financing in the future that we may need to fund working capital, capital expenditures, product development, acquisitions or other corporate requirements.

Our ability to incur significant future indebtedness, whether to finance capital expenditures, product development, potential acquisitions or for general corporate purposes, will depend on our ability to generate cash flow. This, to a certain extent, is subject to general economic, financial, competitive, legislative, regulatory and other factors that are beyond our control. If our business does not generate sufficient cash flow from operations or if future borrowings are not available to us under our senior secured credit facilities in amounts sufficient to enable us to fund our liquidity needs, our financial condition and results of operations may be harmed. If we cannot make scheduled principal and interest payments on our debt obligations in the future, we may need to refinance all or a portion of our indebtedness on or before maturity, sell assets, delay capital expenditures or seek additional equity financing. If we are unable to refinance this or any of our indebtedness on commercially reasonable terms or at all, or to effect any other action relating to our indebtedness on satisfactory terms or at all, our business may be harmed.

Our debt obligations have variable interest rates, which makes us vulnerable to increases in interest rates and could cause our interest expense to increase and decrease cash available for operations and other purposes.

As of September 27, 2009, we had $230.7 million of consolidated indebtedness that was subject to variable interest rates. Interest rates in the U.S. recently have been near historic lows, and any increase in these rates would increase our interest expense and reduce our funds available for operations and other purposes. We may experience material increases in our interest expense as a result of increases in interest rate levels generally. Based on the $230.7 million of variable interest rate indebtedness outstanding as of September 27, 2009, a hypothetical 1% increase or decrease in interest rates would result in a change of approximately $2.3 million to our annual interest expense.

 

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Our products may cause unexpected and undesirable side effects that could limit their use, require their removal from the market or prevent further development. In addition, we are vulnerable to claims that our products are not as effective as we claim them to be.

Unexpected and undesirable side effects caused by our products for which we have not provided sufficient label warnings could result in our recall or discontinuance of sales of our products. Unexpected and undesirable side effects could prevent us from achieving or maintaining market acceptance of the affected products or could substantially increase the costs and expenses of commercializing new products. In addition, consumers or industry analysts may assert claims that our products are not as effective as we claim them to be. Unexpected and undesirable side effects associated with our products or assertions that our products are not as effective as we claim them to be also could cause negative publicity regarding our company, brand or products, which could in turn harm our reputation and net sales. We are particularly susceptible to these risks because our marketing campaign heavily relies on the assertion that our products are “pure,” “healthy” and ideal for women who have skin conditions that can be exacerbated by traditional cosmetics.

We may face product liability claims and may be required to recall products, either of which could result in unexpected costs and damage to our reputation.

Our business exposes us to potential liability risks that arise from the testing, manufacture and sale of our beauty products. Plaintiffs in the past have received substantial damage awards from other cosmetics companies based upon claims for injuries allegedly caused by the use of their products. We currently maintain general liability insurance with an annual aggregate coverage limit of $20.0 million. Any claims brought against us may exceed our existing or future insurance policy coverage or limits. Any judgment against us that is in excess of our policy limits would have to be paid from our cash reserves, which would reduce our capital resources. Further, we may not have sufficient capital resources to pay a judgment, in which case our creditors could levy against our assets. Any product liability claim or series of claims brought against us could harm our business significantly, particularly if a claim were to result in adverse publicity or damage awards outside or in excess of our insurance policy limits. In addition, in the past, we have recalled certain of our products, and in the future, it may be necessary for us to recall products that do not meet approved specifications or because of the side effects resulting from the use of our products, which would result in adverse publicity, potentially significant costs in connection with the recall and a loss of net sales from such products.

We currently own only one patent on our products. If we are unable to protect our intellectual property rights, our ability to compete could be harmed.

We regard our trademarks, trade dress, copyrights, trade secrets, know-how and similar intellectual property as critical to our success. Our principal intellectual property rights include the registered trademarks, “bareMinerals,” “Buxom,” md formulations,” “Bare Escentuals” and “RareMinerals,” among others, copyrights in our infomercial broadcasts and website content rights to our domain names bareescentuals.com, bareminerals.com and mdformulations.com and trade secrets and know-how with respect to product formulations, product sourcing, sales and marketing and other aspects of our business. As such, we rely on trademark and copyright law, trade secret protection and confidentiality agreements with our employees, consultants, suppliers, and others to protect our proprietary rights. We have received patent protection on only one of our products, though we have licenses for the proprietary formulations and ingredients used in some of our md formulations and RareMinerals products. If we are unable to protect or preserve the value of our trademarks, copyrights, trade secrets or other proprietary rights for any reason, our brand and reputation could be impaired and we could lose customers.

Although many of our brands are registered in the United States and in certain foreign countries in which we operate, we may not be successful in asserting trademark or trade name protection. In addition, the laws of certain foreign countries may not protect our intellectual property rights to the same extent as the laws of the United States. The costs required to protect our trademarks and trade names may be substantial. In addition, the relationship between regulations governing domain names and laws protecting trademarks, copyright, and advertising is evolving. Therefore, we may be unable to prevent third parties from acquiring domain names that are similar to, infringe upon or otherwise decrease the value of our trademarks and other proprietary rights.

Other parties may infringe on our intellectual property rights and may dilute our brands in the marketplace. Any such infringement or dilution of our intellectual property rights would also likely result in a commitment of our time and resources to protect these rights through litigation or otherwise. For example, we have sued Intelligent Beauty LLC over false advertising and trademark infringement arising from its marketing of “Raw Minerals” brand products. We have incurred and expect to incur significant legal fees and other expenses in pursuing this claim. We believe the competing marks infringe our trademark rights and create confusion in the marketplace and that false advertising harms our reputation. If we receive an adverse judgment in this matter or in any other cases we may bring in the future to protect our intellectual property rights, we may suffer further dilution of our trademarks and other rights, which could harm our ability to compete as well as our business, prospects, financial condition and results of operations.

 

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

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

Our MD Formulations, Inc. subsidiary acquired rights to the md formulations trademarks and some of our md formulations product rights from a large specialty pharmaceutical company in 1999. For some time we have sold, and we currently sell our md formulations products in sales channels that arguably exceed the permitted field of use specified in the purchase agreement. The agreement provides for the sale to MD Formulations of md formulations product rights for use in a field of use defined as the research, development, manufacture, marketing and sale of alpha hydroxy acid, or AHA, skin care products to “skin care aestheticians” worldwide and to physicians outside of the United States. Over the past several years, we have sold md formulations products in our premium wholesale channels, through our own boutiques, on our mdformulations.com website, to spas and salons and to international distributors. The party from which we purchased the md formulations product rights is aware of our sales in these channels and has not requested that we discontinue sales in these channels, although it has to date refused our requests to expand the permitted field of use to explicitly cover all of these sales. However, if it were to challenge our rights to sell md formulations products in these distribution channels, we could be required to engage in litigation or negotiation with the objective of obtaining these rights. Any such litigation would cause us to incur substantial expenses and, if we were unsuccessful, could cause us to lose the right to sell our products in one or more of our existing distribution channels or to pay damages, either of which could significantly harm our business, prospects, financial condition and results of operations.

As a result of intellectual property infringement claims, or to avoid potential claims, we may choose to seek, or be required to seek, a license from the third party and might be required to pay license fees or royalties or both. These licenses may not be available on acceptable terms, or at all. Even if we were able to obtain a license, the rights may be non-exclusive, which would give our competitors access to the same intellectual property. Ultimately, we could be prevented from commercializing a product or be forced to cease some aspect of our business operations if, as a result of actual or threatened intellectual property infringement claims, we are unable to enter into licenses on acceptable terms. This inability to enter into licenses could harm our business significantly.

In addition to infringement claims against us, we may become a party to other patent or trademark litigation and other proceedings, including interference proceedings declared by the United States Patent and Trademark Office, or the USPTO, proceedings before the USPTO’s Trademark Trial and Appeal Board and opposition proceedings in the European Patent Office or in patent or trademark offices of other jurisdictions, regarding intellectual property rights with respect to our products and technology. The cost to us of any intellectual property litigation or other proceeding, even if resolved in our favor, could be substantial. Some of our competitors may be able to sustain the costs of such litigation or proceedings better than us because of their substantially greater financial resources. Uncertainties resulting from the initiation and continuation of intellectual property litigation or other proceedings could impair our ability to compete in the marketplace. Intellectual property litigation and other proceedings may also absorb significant management time and resources.

 

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We may be subject to liability for the content that we publish.

As a publisher of infomercial broadcasts and online content, we face potential liability for intellectual property infringement and other similar claims based on the information and other content contained in our infomercials, website and instructional DVDs and videos. In the past, parties have brought these types of claims and sometimes successfully litigated them against other online services. If we incur liability for our infomercial or online content, our business, prospects, financial condition and results of operations could suffer.

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

The FDA does not have a premarket approval system for cosmetics, and we believe we are permitted to market our cosmetics and have them manufactured without submitting safety or efficacy data to the FDA. However, the FDA may in the future determine to regulate our cosmetics or the ingredients included in our cosmetics as drugs or biologics. If certain of our bareMinerals products, RareMinerals products or our other products are deemed to be drugs or biologics, rather than cosmetics, we would be required to conduct clinical trials to demonstrate the safety and efficacy of these products in order to continue to market and sell them. In such event, we may not have sufficient resources to conduct any required clinical trials, and we may not be able to establish sufficient efficacy or safety data to resume the sale of these products. Any inquiries by the FDA or any foreign regulatory authorities into the regulatory status of our cosmetics and any related interruption in the marketing and sale of these products could severely damage our brand reputation and image in the marketplace, as well as our relationships with customers, which would harm our business, prospects, financial condition and results of operations.

Certain of our products intended to treat acne or otherwise affect the structure or function of the body are considered over-the-counter, or OTC, drug products by the FDA. The FDA regulates the formulation, manufacturing, packaging, labeling and distribution of OTC drug products pursuant to a “monograph” system that specifies active drug ingredients and concentrations and acceptable product claims. If any of our products that are OTC drugs are not in compliance with the applicable FDA monograph, we could be required to (i) reformulate such product, (ii) cease to make certain use claims relating to such product and/or (iii) cease to sell such product until we receive further FDA approval. There can be no assurance that, if more stringent regulations are promulgated, we will be able to comply with such statutes or regulations without incurring substantial expense or at all. In addition, OTC drug products must be manufactured in accordance with drug good manufacturing practice regulations. Our OTC drug manufacturers are subject to ongoing periodic unannounced inspection by the FDA and corresponding state agencies to ensure strict compliance with good manufacturing practices and other government regulations and corresponding foreign standards. We do not have control over third-party manufacturers’ compliance with these regulations and standards. If the FDA finds a violation of drug good manufacturing practices, it may enjoin the manufacturer’s operations, seize products, or criminally prosecute the manufacturer, any of which could require us to find alternative manufacturers, resulting in additional time and expense.

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

In both our U.S. and foreign markets, we are affected by extensive laws, governmental regulations, administrative determinations, court decisions and similar constraints. Such laws, regulations and other constraints may exist at the federal, state or local levels in the United States and at analogous levels of government in foreign jurisdictions.

The formulation, manufacturing, packaging, labeling, distribution, importation, sale and storage of our products are subject to extensive regulation by various federal agencies, including the FDA, the Federal Trade Commission, or FTC, state attorneys general in the U.S., the Ministry of Health, Labor and Welfare in Japan, as well as by various other federal, state, local and international regulatory authorities in the countries in which our products are manufactured, distributed or sold. If we or our manufacturers fail to comply with those regulations, we could become subject to significant penalties or claims, which could harm our results of operations or our ability to conduct our business. In addition, the adoption of new regulations or changes in the interpretations of existing regulations may result in significant compliance costs or discontinuation of product sales and may impair the marketing of our products, resulting in significant loss of net sales.

Our failure to comply with federal or state regulations, or with regulations in foreign markets that cover our product claims and advertising, including direct claims and advertising by us, may result in enforcement actions and imposition of penalties or otherwise harm the distribution and sale of our products. Further, our business is subject to laws governing our accounting, tax, and import and export activities. Failure to comply with these requirements could result in legal and/or financial consequences that might adversely affect our sales and profitability. In addition, changes in the laws, regulations and policies that affect our business, or the interpretations thereof, and actions we may take in response to such changes, could have an adverse effect on our financial results.

 

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Our marketing campaigns and media spending might not result in increased net sales or generate the levels of product and brand name awareness we desire, and we might not be able to increase our net sales at the same rate as we increase our advertising and marketing expenditures.

Our future growth and profitability will depend in part on the effectiveness and efficiency of our marketing campaigns and media spending, including our ability to:

 

   

create greater awareness of our products and brand name;

 

   

determine the appropriate creative message and media mix for future expenditures; and

 

   

effectively manage advertising costs, including creative and media costs, to maintain acceptable costs per sale and operating margins.

Recently, we allocated more of our media spending on marketing campaigns targeted at the North America Retail segment and integrated both traditional and non-traditional marketing efforts. There can be no assurance that these marketing campaigns will result in increased net sales or increased product or brand awareness.

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

We periodically update the content of our infomercials and revise our product offerings and pricing. If customers are not as receptive to new infomercial content or product offerings, our sales through our infomercial sales channel will continue to decline. In addition, if there is a marked increase in the price we pay for our media time, the cost-effectiveness of our infomercials will decrease. If our infomercials are broadcast during times when viewership is low, this could also result in a decrease of the cost-effectiveness of such broadcasts, which could cause our results of operations to suffer. Also, to the extent we have committed in advance for broadcast time for our infomercials, we would have fewer resources available for potentially more effective distribution channels.

We may need to raise additional funds to pursue our growth strategy or continue our operations, and we may be unable to raise capital when needed.

From time to time, we may seek additional equity or debt financing to provide for the capital expenditures required to finance working capital requirements, to increase the number of our boutiques or to make acquisitions. In addition, if our business plans change, if general economic, financial or political conditions in our markets change, or if other circumstances arise that have a material effect on our cash flow, the anticipated cash needs of our business as well as our conclusions as to the adequacy of our available sources of capital could change significantly. Any of these events or circumstances could result in significant additional funding needs, requiring us to raise additional capital to meet those needs. We cannot predict the timing or amount of any such capital requirements at this time. If financing is not available on satisfactory terms or at all, we may be unable to expand our business or to develop new business at the rate desired and our results of operations may suffer.

We have and will continue to enhance our core systems which might disrupt our supply chain operations.

We have and will continue to enhance our information technology systems supporting our financial management and reporting, inventory and purchasing management, order management, warehouse management and forecasting. There are inherent risks associated with enhancing our core systems, including supply chain disruptions that may affect our ability to deliver products to our customers. We may not be able to successfully transition these new systems or transition them without supply chain disruptions in the future. Any resulting supply chain disruptions could harm our business, prospects, financial condition and results of operations.

We may make acquisitions and strategic investments, which will involve numerous risks. We may not be able to address these risks without substantial expense, delay or other operational or financial problems.

Although we have a limited history of making acquisitions or strategic investments, we may acquire or make investments in related businesses or products in the future. Acquisitions or investments involve various risks, such as:

 

   

higher than expected acquisition and integration costs;

 

   

the difficulty of integrating the operations and personnel of the acquired business;

 

   

the potential disruption of our ongoing business, including the diversion of management time and attention;

 

   

the possible inability to obtain the desired financial and strategic benefits from the acquisition or investment;

 

   

assumption of unanticipated liabilities;

 

   

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

 

   

impairment in relationships with key suppliers and personnel of any acquired businesses due to changes in management and ownership;

 

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the loss of key employees of an acquired business; and

 

   

the possibility of our entering markets in which we have limited prior experience.

Our common stock has only been publicly traded since 2006, and the price of our common stock has fluctuated substantially.

Our common stock has only been publicly traded since September 29, 2006, and we expect that the price of our common stock will continue to fluctuate substantially. From our initial public offering through September 27, 2009, the trading price of our common stock has ranged from a low of $2.45 to a high of $43.22. Many factors could cause the market price of our common stock to rise and fall, including the following:

 

   

introductions of new products, media or marketing campaigns or new pricing policies by us or by our competitors;

 

   

the gain or loss of significant customers or product orders;

 

   

actual or anticipated variations in our quarterly results;

 

   

the announcement of acquisitions or strategic alliances by us or by our competitors;

 

   

recruitment or departure of key personnel;

 

   

the level and quality of securities research analyst coverage for our common stock;

 

   

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

 

   

market conditions in our industry and the economy as a whole.

In addition, public announcements by our competitors concerning, among other things, their performance, strategy, accounting practices, or legal problems could cause the market price of our common stock to decline regardless of our actual operating performance.

Our operating and financial performance in any given period might not meet the guidance that we have provided to the public.

At times, we provide public guidance on our expected operating and financial results for future periods. Such guidance is comprised of forward-looking statements subject to the risks and uncertainties described in this report and in our other public filings and public statements. Our guidance may not always be accurate. If, in the future, our operating or financial results for a particular period do not meet our guidance or the expectations of investment analysts or if we reduce our guidance for future periods, the market price of our common stock could significantly decline.

 

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Our current principal stockholders have significant influence over us, and they could delay, deter, or prevent a change of control or other business combination or otherwise cause us to take action that advances their best interests and not necessarily those of other stockholders.

As of August 4, 2009, affiliates of Berkshire Partners LLC beneficially owned approximately 15.6% of our outstanding common stock. In addition, two of our directors are affiliated with Berkshire Partners LLC. As a result, these stockholders have significant influence over our potential decisions to enter into any corporate transaction and may have the ability to prevent any transaction that requires the approval of stockholders regardless of whether or not other stockholders believe that such transaction is in their own best interests. Such concentration of voting power could have the effect of delaying, deterring, or preventing a change of control or other business combination that might otherwise be beneficial to our stockholders. In addition, the significant concentration of share ownership may adversely affect the trading price of our common stock because investors often perceive disadvantages in owning shares in companies with controlling stockholders.

We do not anticipate paying dividends on our capital stock in the foreseeable future.

We do not anticipate paying any dividends in the foreseeable future. We currently intend to retain our future earnings, if any, to repay existing indebtedness and to fund the development and growth of our business. In addition, the terms of our senior secured credit facilities currently, and any future debt or credit facility may, restrict our ability to pay any dividends. As a result, capital appreciation, if any, of our common stock will be your sole source of gain from your purchase of our common stock for the foreseeable future.

Anti-takeover provisions in our organizational documents and Delaware law may discourage or prevent a change in control, even if an acquisition would be beneficial to our stockholders, which could cause our stock price to decline and prevent attempts by our stockholders to replace or remove our current management.

Our amended and restated certificate of incorporation and amended and restated bylaws contain provisions that may delay or prevent a change in control, discourage bids at a premium over the market price of our common stock and harm the market price of our common stock and diminish the voting and other rights of the holders of our common stock. These provisions include:

 

   

dividing our board of directors into three classes serving staggered three-year terms;

 

   

authorizing our board of directors to issue preferred stock and additional shares of our common stock without stockholder approval;

 

   

prohibiting stockholder actions by written consent;

 

   

prohibiting our stockholders from calling a special meeting of stockholders;

 

   

prohibiting our stockholders from making certain changes to our amended and restated certificate of incorporation or amended and restated bylaws except with 66 2/3% stockholder approval; and

 

   

requiring advance notice for raising business matters or nominating directors at stockholders’ meetings.

We are also subject to provisions of Delaware law that, in general, prohibit any business combination with a beneficial owner of 15% or more of our common stock for three years after the stockholder becomes a 15% stockholder, subject to specified exceptions. Together, these provisions of our amended and restated certificate of incorporation and amended and restated bylaws and of Delaware law could make the removal of management more difficult and may discourage transactions.

 

ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Issuer Purchases of Equity Securities

The following table sets forth certain information with respect to all purchases by us or any “affiliated purchaser” as defined in Rule 10b-18(a)(3) under the Securities Exchange Act of 1934, as amended, of shares of our common stock during the third quarter of fiscal 2009.

 

Period

   (a)
Total
Number of
Shares
Purchased (1)
   (b)
Average
Price
Paid per
Share (1)
   (c)
Total
Number of
Shares
Purchased
as Part of
Publicly
Announced
Plans or
Programs
   (d)
Maximum
Number
of Shares
that May
Yet be
Purchased
Under the
Plans or
Programs

June 29, 2009 – July 28, 2009

   37,500    $ 0.001    —      —  

July 29, 2009 – August 28, 2009

   —        —      —      —  

August 29, 2009 – September 27, 2009

   —        —      —      —  
                 

Total

   37,500       —      —  
                 

 

(1) Reflects the repurchase at par value of unvested restricted stock forfeited under our 2006 Equity Incentive Plan during the third quarter of fiscal 2009.

 

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

None.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

None.

 

ITEM 5. OTHER INFORMATION

None.

 

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ITEM 6. EXHIBITS

Exhibits

The following documents are incorporated by reference or filed herewith as Exhibits to this report:

 

Exhibit

Number

  

Description

    3.1(1)    Amended and Restated Certificate of Incorporation.
    3.2(2)    Amended and Restated Bylaws.
     10.3(3)*    Separation and Release Agreement between Bare Escentuals Beauty, Inc., a wholly owned subsidiary of the Registrant, and Michael Dadario dated July 20, 2009.
31.1      Certification of the Chief Executive Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002.
31.2      Certification of the Chief Financial Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002.
32.1      Certification of the Chief Executive Officer and the Chief Financial Officer as required by Section 906 of the Sarbanes-Oxley Act of 2002.

 

(1) Incorporated by reference from our Quarterly Report on Form 10-Q for the period ended October 1, 2006 filed on November 15, 2006.
(2) Incorporated by reference from our Current Report on Form 8-K filed on November 30, 2007.
(3) Incorporated by reference from our Quarterly Report on Form 10-Q for the period ended June 28, 2009 filed on August 6, 2009.
* Indicates management contract or compensatory plan or arrangement

 

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SIGNATURES

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

 

 

    BARE ESCENTUALS, INC.
Date: November 5, 2009     By:  

/s/    LESLIE A. BLODGETT        

      Leslie A. Blodgett
      Chief Executive Officer and Director
    By:  

/s/    MYLES B. MCCORMICK        

      Myles B. McCormick
     

Executive Vice President, Chief Financial Officer and

Chief Operating Officer

 

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EXHIBIT INDEX

 

Exhibit

Number

  

Description

    3.1(1)    Amended and Restated Certificate of Incorporation.
    3.2(2)    Amended and Restated Bylaws.
     10.3(3)*    Separation and Release Agreement between Bare Escentuals Beauty, Inc., a wholly owned subsidiary of the Registrant, and Michael Dadario dated July 20, 2009.
31.1      Certification of the Chief Executive Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002.
31.2      Certification of the Chief Financial Officer, as required by Section 302 of the Sarbanes-Oxley Act of 2002.
32.1      Certification of the Chief Executive Officer and the Chief Financial Officer as required by Section 906 of the Sarbanes-Oxley Act of 2002.

 

(1) Incorporated by reference from our Quarterly Report on Form 10-Q for the period ended October 1, 2006 filed on November 15, 2006.
(2) Incorporated by reference from our Current Report on Form 8-K filed on November 30, 2007.
(3) Incorporated by reference from our Quarterly Report on Form 10-Q for the period ended June 28, 2009 filed on August 6, 2009.
* Indicates management contract or compensatory plan or arrangement

 

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