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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended April 3, 2010

OR

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

Commission File Number 0-24395

bebe stores, inc.

(Exact name of registrant as specified in its charter)

400 Valley Drive

Brisbane, California 94005

(Address of principal executive offices)

Telephone: (415) 715-3900

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 o

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o  No o

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):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b—2 of the Exchange Act).   Yes o No  x

The number of shares of the registrant’s common stock, par value $0.001 per share, outstanding as of April 30, 2010 was 86,089,177.

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bebe stores, inc.

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PART I.        FINANCIAL INFORMATION

ITEM 1.        Condensed Consolidated Financial Statements

bebe stores, inc.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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bebe stores, inc.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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bebe stores, inc.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)

See accompanying notes to condensed consolidated financial statements.

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bebe stores, inc.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

INTERIM FINANCIAL STATEMENTS

The accompanying condensed consolidated balance sheets of bebe stores, inc. (the “Company”) as of April 3, 2010, July 4, 2009 and April 4, 2009, the condensed consolidated statements of operations for the three and nine months ended April 3, 2010 and April 4, 2009 and the condensed consolidated statements of cash flows for the nine months ended April 3, 2010 and April 4, 2009 have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X, without audit. Accordingly, they do not include all of the information required by accounting principles generally accepted in the United States of America for annual financial statements. Therefore, these condensed consolidated financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the fiscal year ended July 4, 2009.

In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary to present fairly the financial position at the balance sheet dates and the results of operations for the periods presented have been included. The condensed consolidated balance sheet at July 4, 2009, presented herein, was derived from the audited balance sheet included in the Company’s Annual Report on Form 10-K for the fiscal year ended July 4, 2009.

The Company’s business is affected by the pattern of seasonality common to most retail apparel businesses. The results for the periods presented are not necessarily indicative of future financial results.

The Company revised cash flows from operating activities for the nine months ended April 4, 2009 on its statements of cash flows to separately present the tax benefit and excess tax benefit from exercise of stock options and awards.  Net cash provided (used) by operating and financing activities for the prior year period changed by immaterial amounts.  Certain prior year amounts have been reclassified to conform to current year presentation.

The Company has evaluated all subsequent events that occurred after the balance sheet date through the date the condensed consolidated financial statements were issued.

FISCAL YEAR

The Company’s fiscal year is a 52 or 53 week period, each period ending on the first Saturday after June 30.  Fiscal years 2010 and 2009 each include 52 weeks.

The three month periods ended April 3, 2010 and April 4, 2009 each include 13 weeks.  The nine month periods ended April 3, 2010 and April 4, 2009 each include 39 weeks.

RECENT ACCOUNTING PRONOUNCEMENTS

Codification

Effective July 1, 2009, the Financial Accounting Standards Board’s (“FASB”) Accounting Standards Codification (“ASC”) became the single official source of authoritative, nongovernmental generally accepted accounting principles (“GAAP”) in the United States.  The historical GAAP hierarchy was eliminated, and the ASC became the only level of authoritative GAAP, other than guidance issued by the Securities and Exchange Commission.  The Company’s accounting policies were not affected by the conversion to ASC.  However, references to specific accounting standards in the footnotes to the Company’s condensed consolidated financial statements have been changed to refer to the appropriate section of ASC.

Fair Value

In September 2006, the FASB issued guidance which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements.  This guidance is contained in ASC 820, “Fair Value Measurements and Disclosures”.  In February 2008, the FASB deferred the effective date for non-financial assets and liabilities, except for certain items that are recognized or disclosed at fair value at least annually.  The Company elected to partially adopt the provisions ASC 820 as of July 6, 2008 for financial instruments. Although the partial adoption did not materially impact the Company’s financial condition, results of operations or cash flow, the Company is now required to provide additional disclosures as part of its financial statements.  The Company’s adoption of the remaining provisions of ASC 820, pertaining to fair value disclosures related to non-financial assets and liabilities, on July 5, 2009 has not had a material impact on the Company’s consolidated financial position, statements of operations or cash flows.

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In April 2009, the FASB issued additional guidance in accordance with ASC 825, “Financial Instruments”.  The additional guidance adds required disclosures about fair value of financial instruments in interim financial statements as well as in annual financial statements.  The guidance also requires those disclosures in summarized financial information at interim reporting periods.  This guidance is effective for interim periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.  The Company’s adoption of this requirement has not had a material impact on the Company’s consolidated financial position, statements of operations or cash flows, as it relates to disclosure only.

In January 2010, the FASB issued ASU No. 2010-06, “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.” ASU No. 2010-06 amends ASC 820 and clarifies and provides additional disclosure requirements related to recurring and non-recurring fair value measurements and employers’ disclosures about postretirement benefit plan assets. This ASU is effective for the Company on January 3, 2010. The Company’s adoption of this requirement has not had a material impact on the Company’s consolidated financial position, statements of operations or cash flows, as it relates to disclosure only.

INVENTORIES

The Company’s inventories consisted of:

EARNINGS PER SHARE

Basic earnings per share is computed as net earnings divided by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflects the potential dilution that could occur from common shares issuable through the exercise of dilutive stock options.

The following is a reconciliation of the number of shares used in the basic and diluted earnings per share computations:

The number of incremental shares from the assumed issuance of stock options is calculated by applying the treasury stock method.

Excluded from the computation of the number of diluted weighted average shares outstanding were options to purchase 3,872,000 and 7,018,000 shares of common stock for the three months ended April 3, 2010 and April 4, 2009, respectively, and 4,723,000 and 6,731,000 shares of common stock for the nine months ended April 3, 2010 and April 4, 2009, respectively, which would have been anti-dilutive.

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COMMON STOCK PURCHASES

Share repurchases were as follows:

In October 2008, the board of directors authorized a program to repurchase up to $30 million of the Company’s common stock.  The Company intends, from time to time, as business conditions warrant, to purchase stock in the open market or through private transactions.  Purchases may be increased, decreased or discontinued at any time without prior notice.  The plan does not obligate the Company to repurchase any specific number of shares and may be suspended at any time at management’s discretion.  As of April 3, 2010, there was approximately $12.5 million available for repurchase under the program.

COMPREHENSIVE LOSS

Comprehensive income consists of net income (loss) and other comprehensive income (income, expenses, gains and losses that bypass the income statement and are reported directly as a separate component of equity).  The Company’s comprehensive income consists of net income (loss), gain (loss) on available for sale securities and foreign currency translation adjustments for all periods presented.

INVESTMENTS

The Company’s investment portfolio consists of treasury bills, certificates of deposit and auction rate securities. The Company holds a variety of interest bearing auction rate securities (“ARS”) consisting of federally insured student loan backed securities and insured municipal authority bonds. As of April 3, 2010, the Company’s ARS portfolio totaled approximately $170.7 million, $58.3 million classified as trading securities (net of impairment charges of $9.3 million, of which a $3.4 million gain has been recognized in the current year) and $112.4 million (net of a temporary impairment charge of $14.6 million, of which a $2.2 million unrealized gain has been recorded in the current year) classified as available for sale securities. The Company’s ARS portfolio includes approximately 98% federally insured student loan backed securities and 2% municipal authority bonds. The Company’s ARS portfolio consists of approximately 42% AAA rated investments, 3% AA rated investments, 35% A rated investments, 14% BBB rated investments and 6% CCC rated investments. This is a change from the portfolio as of July 4, 2009, which consisted of 46% AAA rated investments, 14% AA rated investments, 30% A rated investments and 10% BBB rated investments. These ARS investments are intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such investments at par. The uncertainties in the credit markets that began in February 2008 have affected the Company’s holdings in ARS investments and auctions for the Company’s investments in these securities have failed to settle on their respective settlement dates. Historically the fair value of ARS investments had approximated par value due to the frequent resets through the auction process. While the Company continues to earn interest on its ARS investments at the maximum contractual rate, these investments are not currently trading and therefore do not currently have a readily determinable market value. Accordingly, the estimated fair value of ARS no longer approximates par value. Consequently, the investments are not currently liquid, and the Company will not be able to access these funds until a future auction of these investments is successful, the issuer redeems the securities, or at maturity. Maturity dates for these ARS investments range from 2010 to 2044 with principal distributions occurring on certain securities prior to maturity.

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In November 2008, the Company entered into a settlement agreement related to its ARS held with UBS Financial Services, Inc. (“UBS”) that grants the Company certain rights related to these ARS (the “Right”). Beginning June 30, 2010, at the Company’s request, UBS has agreed to purchase all of the Company’s ARS currently held with them at par value. Conversely, UBS has the right, in its discretion, to purchase or sell the Company’s ARS at any time until July 2, 2012, so long as the Company receives payment at par value upon any sale or disposition. The enforceability of the Right results in a put option which should be recognized as a free standing asset separate from the ARS. Upon acceptance of the offer from UBS in November 2008, the Company recorded the put option at fair value of $11.6 million, with a corresponding credit to interest and other income, net. Although it is a financial instrument, the put option does not meet the FASB’s definition of a derivative instrument; therefore the Company has elected to measure the put option at fair value. As a result, unrealized gains and losses are included in earnings.  At April 3, 2010, the fair value of the put option is $8.8 million, net of a reserve of $0.5 million, of which a gain of $0.1 million has been recognized in the current year.

Prior to accepting the UBS offer, the Company recorded its ARS held with UBS as investments available for sale, with an associated unrealized loss included in other comprehensive income. In connection with our acceptance of the UBS offer in November 2008, the Company transferred approximately $84.4 million in ARS subject to the UBS settlement from investments available for sale to trading securities and recorded a loss on investments of approximately $12.1 million. As a result, subsequent changes in fair value of the ARS have been recorded as a component of net income. The Company intends to exercise the Right when it becomes available, and as such the associated investments of $58.8 million, net of impairment charges of $9.3 million, at April 3, 2010, have been classified as short term on the balance sheet.

The remainder of the Company’s ARS investment portfolio of $112.4 million, net of a temporary impairment charge of $14.6 million, remains available for sale on the Company’s balance sheet. The related temporary impairment charge remains as a loss in accumulated other comprehensive income.

The Company also holds short term available for sale securities totaling $59.0 million as of April 3, 2010, that consist of $40.0 million in treasury bills and $19.0 million in certificates of deposit which are classified as available for sale securities on the Company’s balance sheet at cost which approximates fair value.

The Company reviews its impairments in accordance with guidance issued by the FASB and SEC in order to determine the classification of the impairment as “temporary” or “other-than-temporary”. A temporary impairment charge results in an unrealized loss being recorded in the accumulated other comprehensive income component of shareholders’ equity. Such an unrealized loss does not affect net income for the applicable accounting period. An other-than-temporary impairment charge is recorded as a loss in the condensed consolidated statements of operations for the applicable accounting period. When evaluating the investments for other-than-temporary impairment, the Company estimates the expected cash flows of the underlying collateral by reviewing factors such as the length of time and extent to which fair value has been below cost basis, the financial condition of the issuer and any changes thereto, and the Company’s intent to sell, or whether it is more likely than not it will be required to sell, the investment before recovery of the investment’s amortized cost basis. The Company has not recorded any impairment loss from its available for sale investments as other-than-temporary based on such analysis.

The valuation of the Company’s investment portfolio is subject to uncertainties that are difficult to predict. Factors that may impact its valuation include changes to credit ratings of the securities as well as to the underlying assets supporting those securities, rates of default of the underlying assets, underlying collateral value, discount rates and ongoing strength and quality of market credit and liquidity.

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The following is a summary of the Company’s available for sale securities:

CREDIT FACILITIES

The Company has an unsecured commercial line of credit agreement which provides for borrowings and issuance of letters of credit of up to a combined total of $25.0 million and expires on March 31, 2012. The outstanding balance bears interest at either the bank’s reference rate (which was 3.25% as of April 3, 2010) or the LIBOR rate (which was 0.25% as of April 3, 2010) plus 1.75 percentage points. As of April 3, 2010, there were no outstanding cash borrowings and there was $1.8 million of letters of credit outstanding.

This credit facility requires the Company to maintain a $2.5 million compensating balance and to comply with certain financial covenants, including amounts for minimum tangible net worth, unencumbered liquid assets and profitability, and certain restrictions on making loans and investments. As of April 3, 2010, the Company was in compliance with all financial covenants.

UNREDEEMED GIFT CARDS

The Company sells gift cards with no expiration dates to customers in its retail store locations, through its online stores, and through third parties.  Income from gift cards is recognized when they are redeemed by the customer.  In addition, the Company recognizes income on unredeemed gift cards when it can determine that the likelihood of the gift card being redeemed is remote and there is no legal obligation to remit the unredeemed gift cards to relevant jurisdictions (gift card breakage).  The Company determines the gift card breakage income based on historical redemption patterns.  The Company accumulated sufficient historical data to determine elapsed time for recording breakage income during the second quarter of fiscal 2010, which the Company estimates is five years.  Gift card breakage is included as other income within selling, general and administrative expenses.  The Company recognized $1.1 million in pre-tax income related to the initial recognition of gift card breakage.

STOCK BASED COMPENSATION

The following table summarizes the stock based compensation expense recognized under the Company’s stock plan during the three months and the nine months ended April 3, 2010 and April 4, 2009:

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Unrecognized compensation cost related to nonvested stock options and unvested stock awards/units totaled approximately $4.5 million and $0.1 million, respectively, as of April 3, 2010.  This cost is expected to be recognized over a weighted average period of 2.8 years.  The weighted average fair value of stock options at their grant date during the three months ended April 3, 2010 and April 4, 2009 was $3.41 and $2.43, respectively.  For the nine month periods ended April 3, 2010 and April 4, 2009, the weighted average fair values of stock options at their grant date were $2.90 and $3.26, respectively.

Adjustments During the Three and Nine Months Ended April 3, 2010:

Since fiscal 2006, the Company has licensed software from a third party provider to automate the administration of its employee equity programs and calculate its stock-based compensation expense (the “Software”).  Subsequent to the issuance of the Company’s June 2009 annual financial statements the Company was notified of errors in the calculation of stock based compensation expense for fiscal years 2009, 2008, 2007 and 2006 and for the three months ended October 3, 2009 and the three and six months ended January 2, 2010. The errors were identified after the Company’s third-party software provider notified its clients that it made a change to how its software program calculates stock based compensation expense. Specifically, the prior version of this software calculated stock based compensation expense by incorrectly applying a weighted average forfeiture rate to the vested portion of stock option awards until the grant’s final vest date, rather than calculating stock based compensation expense based upon the actual vested portion of the grant date fair value, resulting in an understatement of stock based compensation expense in certain periods prior to the grant’s final vest date. Thus, this error affected the timing of stock-based compensation expense recognition.

The Company determined that the cumulative error from the understatement of stock based compensation expense related to the periods discussed above totaled $2.5 million, net of tax effects through April 3, 2010. The impact of the errors on fiscal years 2009, 2008, 2007 and 2006, is to increase (decrease) net income by $0.1 million, $0.7 million, ($0.8) million and ($2.3) million, respectively and for three months ended October 3, 2009 and three months ended January 2, 2010 to increase (decrease) net loss by $0.3 million and ($0.1) million, respectively.

The Company has determined that the impact of this error is not material to the previously issued annual and interim unaudited consolidated financial statements using the guidance of SEC Staff Accounting Bulletin No. 99 (“SAB 99”) and SAB 108. Accordingly, the interim unaudited consolidated financial statements for the three and nine months ended April 3, 2010 include the cumulative adjustment to increase stock-based compensation expense by $1.8 million net of tax effect, (or $0.02 per share) and $2.5 million net of tax effect, (or $0.03 per share), respectively to correct these errors. The Company does not believe the correction of these errors is material to the consolidated financial statements for the three and nine months ended April 3, 2010 and does not believe that it will be material to the 2010 annual consolidated financial statements.

Offer to Exchange Certain Outstanding Options:

During the first quarter of 2010, the Company filed a Tender Offer Statement on Schedule TO with the SEC pursuant to which the Company extended an offer to employees and non-employee directors to exchange up to an aggregate of 2,058,475 options to purchase shares of our common stock, whether vested or unvested. Options with an exercise price greater than $10.74 per share and an expiration date after September 29, 2009 were eligible to be tendered pursuant to the offer. The closing market price on September 29, 2009 was $7.64. In accordance with the Tender Offer (the “TO”), the number of new options issued was based on exchange ratios as set forth in the table below:

A total of 1,710,735 options were tendered and cancelled, and a total of 1,126,267 replacement options were granted on September 29, 2009 with an exercise price of $7.64 per share.  Replacement options granted in exchange for fully or partially unvested surrendered options at the time they were surrendered for cancellation will vest as follows: (A) vested shares subject to eligible options and unvested shares subject to eligible options scheduled to vest prior to the one-year anniversary of the replacement grant date shall vest on the one-year anniversary of the replacement grant date and (B) unvested shares subject to eligible options scheduled to vest after the one-year anniversary of the replacement grant date shall vest according to the original vest dates of the eligible option. The TO was subject to modification accounting pursuant to FASB ASC 718-20-35-3 whereby the total compensation cost measured at the date of modification was the incremental cost resulting from the modification. The incremental cost resulting from the modification is measured as the excess of the fair value of the modified award over the fair value of the original award immediately before its terms are modified. The incremental fair value of $0.3 million for the new awards was computed using an expected life of 4.07 years, a risk-free interest rate of 1.94% and a volatility of 54%. The incremental fair value of the unvested awards is being amortized over the remaining service period.

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FAIR VALUE MEASUREMENTS

The FASB has established a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.

Assets and Liabilities Measured at Fair Value on a Recurring Basis:

As of April 3, 2010, the Company held financial instruments that are measured at fair value on a recurring basis. These included cash equivalents, trading securities, a written put option related to a UBS settlement and available for sale securities. Cash equivalents consist of money market funds. Short term available for sale securities consist of government treasury bills and certificates of deposit. Trading securities consist of auction rate securities (“ARS”) held with UBS. Long term available for sale securities consist of ARS held with another broker and a certificate of deposit. The ARS securities consist of federally insured student loan backed securities and insured municipal authority bonds.

The Company determined the estimated fair value of its investment in ARS as of April 3, 2010 using a discounted cash flow model. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, timing, credit ratings, credit wrap and amount of cash flows and expected holding periods of the ARS. The ARS written put right is a free-standing asset separate from the ARS and represents the Company’s contractual right to require UBS to purchase its ARS at par value during the two-year period beginning June 30, 2010. In order to value the ARS written put right, the Company considered intrinsic value, time value of money and its assessment of the credit worthiness of UBS.

The following items are measured at fair value on a recurring basis as of April 3, 2010:

During the nine months ended April 3, 2010 there were no transfers of assets and liabilities between Level 1 (quoted prices in active markets for identical assets) and Level 2 (significant other observable inputs) of the fair value measurement hierarchy.  The following table presents the Company’s activity for assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the nine months ended April 3, 2010:

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Assets and Liabilities Measured at Fair Value on a Non-Recurring Basis:

The Company measures certain non-financial assets and liabilities, including long-lived assets, at fair value on a non-recurring basis.  During the three and nine months ended April 3, 2010, the Company recorded a charge of approximately $0.5 million and $4.7 million, respectively, related to the impairment of assets related to under-performing stores.  The fair market value of these assets was determined using the income approach and Level 3 inputs, which required management to make significant estimates about future cash flows.  Management estimates the amount and timing of future cash flows based on its experience and knowledge of the retail market in which each store operates.  This impairment charge is included in selling, general and administrative expenses (“SG&A”) in the accompanying condensed consolidated statements of operations.  The Company was not required to measure any other significant non-financial assets and liabilities at fair value.

LEGAL MATTERS

As of the date of this filing, the Company was involved in ongoing legal proceedings as described below.

A former employee sued the Company in a complaint filed July 27, 2006 in the Superior Court of California, San Mateo County (Case No. CIV 456550) alleging a failure to pay all wages, failure to pay overtime wages, failure to pay minimum wages, failure to provide meal periods, violation of Labor Code §450, violation of Labor Code §2802 and California Code of Regulations §11040(9)(A), statutory wage violations (late payment of wages), unlawful business practices under Business and Professions Code §16720 and §17200, conversion of wages and violation of Civil Code §52.1. The plaintiff purported to bring the action also on behalf of current and former California bebe employees who were similarly situated. The lawsuit seeks compensatory, statutory, punitive, restitution and injunctive relief.  The court formally denied class certification regarding certain claims Plaintiff purportedly brought on behalf of non-managers.  The Court allowed the named plaintiff to be replaced by two managers who will now try to certify a manager based class on the original claims brought in the complaint.  Discovery is ongoing and the court has not set a date for hearing on class certification.

A former employee sued the Company in a complaint filed in the Superior Court of California, Los Angeles County (BC 429230) and served on us February 4, 2010, alleging a failure to pay all wages, failure to provide meal periods and rest breaks, violation of Labor Code §450, §2802 and California Code of Regulations §11070(9)(A), statutory wage violations (late payment of wages), unlawful business practices under Business and Professions Code §16720 and §17200, and other associated claims.  The plaintiff purported to bring the action also on behalf of current and former California bebe employees who are similarly situated.  The plaintiff has since dismissed the matter with prejudice.

The Company sued Skechers, U.S.A., Inc. in a complaint filed October 8, 2009 in the Superior Court for the State of California, County of San Mateo (Case No. CIV 488671), alleging breach of contract, among other claims.  The case has been moved to the County of San Francisco.  The defendant has yet to file an answer.

A customer sued the Company in a complaint filed October 14, 2009 in the Superior Court for the State of California, County of Los Angeles (BC 423835) alleging the Company violated the Song-Beverly Credit Card Act, Civil Code §1747.08.  The plaintiff purported to bring the action also on behalf of other California bebe customers who are similarly situated.  The parties have since resolved the case with no liability to the Company.

Four former employees sued the Company in a complaint filed December 14, 2009 in the United States District Court, Southern District of Texas (C.A. NO. 4:09-CV-039777) alleging discrimination and retaliation under Title VII of the Civil Rights Act of 1964 and 42 U.S.C. §1981, defamation, negligent hiring, supervision, retention and training, among other claims. The Company has answered the complaint and discovery is underway.

The Company is also involved in various other legal proceedings arising in the normal course of business.  None of these matters, nor the matters listed above are expected, individually or in the aggregate, to have a material adverse effect on the Company’s business, financial condition or results of operations.

The Company will defend itself vigorously against each of these claims. However, the results of any litigation are inherently uncertain, and thus the Company cannot assure you that it will be able to successfully defend in these lawsuits. Where required, and/or otherwise appropriate, the Company has recorded an estimate of potential liabilities that the Company believes is reasonable. Any estimates are revised as further information becomes available.

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

The following Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements, which involve risks and uncertainties. Our actual results may differ materially from those anticipated in these forward-looking statements.  Statements that are predictive in nature, that depend upon or refer to future events or conditions or that include words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “estimates,” “thinks,” and similar expressions are forward-looking statements.  Forward-looking statements include statements about our expected results of operations, capital expenditures and store openings.  Although we believe that these statements are based upon reasonable assumptions, we cannot assure you that our goals will be achieved. These forward-looking statements are made as of the date of this quarterly report, and we assume no obligation to update or revise them or provide reasons why actual results may differ. Factors that might cause such a difference include, but are not limited to, our ability to respond to changing fashion trends, obtain raw materials and find manufacturing facilities, attract and retain key management personnel, develop new concepts, successfully open future stores, successfully manage our online business, maintain and protect information technology, respond effectively to competitive pressures in the apparel industry and adverse economic conditions and protect our intellectual property as well as declines in comparable store sales performance, changes in the level of consumer spending or preferences in apparel and/or other factors discussed in “Risk Factors” and elsewhere in this quarterly report.

OVERVIEW

We design, develop and produce a distinctive line of contemporary women’s apparel and accessories. While we attract a broad audience, our target customer is a 18 to 34-year-old woman who seeks current fashion trends to suit her lifestyle. The “bebe look” appeals to a hip, sexy, sophisticated, body-conscious woman who takes pride in her appearance. The bebe customer expects value in the form of current fashion and high quality at a competitive price.

Our distinctive product offering includes a full range of separates, tops, sweaters, dresses, active wear and accessories in the following lifestyle categories:  career, evening, casual and active. We design and develop the majority of our merchandise in-house, which is manufactured to our specifications. The remainder of our merchandise is sourced directly from third-party manufacturers.

We market our products under the bebe, BEBE SPORT, bbsp, 2b bebe and PH8 brand names through our 300 retail stores, of which 214 are bebe stores, 52 are PH8 stores, 33 are 2b bebe stores and 1 is a bebe accessories store as of April 3, 2010. These stores are located in 36 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands and Canada. In addition, we have an on-line store at www.bebe.com, and our licensees operate 45 international stores as of April 3, 2010. During the nine months ended April 3, 2010, we opened 4 bebe stores and a PH8 store and closed a bebe store, 11 PH8 stores and a 2b bebe store.  We expect to open a total of approximately 5 bebe stores, a PH8 store as a pop-up location and 2 2b bebe stores during fiscal 2010. We also plan to expand an existing bebe store.  The number of anticipated store closures includes 3 bebe stores, 1 2b bebe store and up to 16 PH8 stores, including the pop-up location opened last fall.

bebe stores.  We were founded by Manny Mashouf, our Chief Executive Officer and Chairman of the Board. We opened our first store in San Francisco, California in 1976, which was also the year we incorporated. We also operate one bebe accessory store that features a limited assortment of bebe merchandise, including outerwear, shoes and accessories. bebe stores offer a limited selection of BEBE SPORT and PH8 merchandise.

PH8. We launched BEBE SPORT during fiscal 2003 to address the performance and active lifestyle needs of the bebe customer.  In November 2009, we converted all of our BEBE SPORT storefronts to PH8 and began to offer BEBE SPORT product in bebe and 2b bebe stores in the 2009 holiday season.  In addition, we changed our product offering to offer a selection of casual weekend apparel, work-out attire and accessories such as bags, shoes and various seasonal items under the new PH8 label.  Due to the change in store fronts and product offering, we have excluded the new PH8 stores from comparable store sales as of November 2009.  During fiscal 2010, we recorded asset impairment charges of $4.1 million to write-off underperforming PH8 stores.  Management will continue to assess the performance of the PH8 concept, which may result in an evaluation of strategic alternatives for our PH8 stores.

2b bebe stores.  We currently operate 15 2b bebe stores and 18 stores operating in the outlet store design under the 2b bebe name.  The stores operating in the 2b bebe design sell bebe logo, 2b bebe merchandise and a small percentage of bebe retail markdowns.  The stores operating in the outlet design sell bebe logo, 2b bebe merchandise and a large percentage of bebe retail markdowns, including PH8.

On-line. bebe.com is an extension of the bebe store experience and provides a complete assortment of bebe merchandise and a limited selection of BEBE SPORT and 2b bebe merchandise. It is also used as a vehicle to communicate with our customers.

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CRITICAL ACCOUNTING POLICIES

Management’s Discussion and Analysis of Financial Condition and Results of Operations are based upon our consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America.

The preparation of these financial statements requires the appropriate application of certain accounting policies, many of which require us to make estimates and assumptions about future events and their impact on amounts reported in our financial statements and related notes. Since future events and their impact cannot be determined with certainty, the actual results will inevitably differ from our estimates. Such differences could be material to our financial statements. We believe our application of accounting policies, and the estimates inherently required therein, are reasonable. Our most critical accounting policies are those related to revenue recognition, stock based compensation, inventories, investments, impairment of long lived assets, uncertain tax positions and liabilities for self-insurance. We continually evaluate these accounting policies and estimates, and we make adjustments when facts and circumstances dictate a change. Our accounting policies are described in Note 1 to the consolidated financial statements in our annual report on Form 10-K for the fiscal year ended July 4, 2009. This discussion and analysis should be read in conjunction with such discussion and with our condensed consolidated financials statements and related notes included in Part 1, Item 1 of this quarterly report.

RESULTS OF OPERATIONS

Our fiscal year is a 52 or 53 week period, each period ending on the first Saturday after June 30.  Fiscal years 2010 and 2009 each include 52 weeks.  The three months ended April 3, 2010 and April 4, 2009 each include 13 weeks.  The nine months ended April 3, 2010 and April 4, 2009 each include 39 weeks.

The following table sets forth certain financial data as a percentage of net sales for the periods indicated:

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

(2)                                        Selling, general and administrative expenses primarily consist of non-occupancy store costs, corporate overhead and advertising costs.

Net Sales. Net sales decreased to $114.4 million during the three months ended April 3, 2010 from $127.7 million for the comparable period of the prior year, a decrease of $13.3 million, or 10.4%. The decrease in net sales was primarily due to an 11.2% decrease in comparable store sales resulting primarily from lower traffic in stores, a reduced customer acceptance of the merchandise offering and a 7.0% decrease in our on-line sales.  These decreases were partially offset by higher conversion in stores, an increase in wholesale sales to international licensees and an increase in royalty revenue.

For the nine months ended April 3, 2010, net sales decreased to $381.6 million from $472.8 million for the comparable period of the prior year, a decrease of $91.2 million, or 19.3%.  The decrease in net sales was primarily due to a 20.8% decrease in comparable store sales resulting primarily from lower traffic in stores, a reduced customer acceptance of the merchandise offering and a 12.1% decrease in our on-line sales.  These decreases were partially offset by higher conversion in stores, stores not included in the comparable store sales, an increase in wholesale sales to international licensees and an increase in royalty revenue.

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(1)                                                           Beginning in November 2009, comparable store sales excludes PH8 stores.

(2)                                                           We calculate net sales per average square foot using net store sales and monthly average store square footage.

Gross Margin. Gross margin decreased to $44.3 million during the three months ended April 3, 2010 from $48.3 million for the comparable period of the prior year, a decrease of $4.0 million, or 8.3%. As a percentage of net sales, gross margin increased to 38.8% for the three months ended April 3, 2010 from 37.8% in the comparable period of the prior year.  The increase in gross margin as a percentage of net sales was primarily due to lower markdowns and lower other costs including inventory shrink and damages as well as $1.2 million of income related to the expiration of loyalty points partially offset by lower initial markup, unfavorable occupancy leverage and expense related to our change in return policy from 14 days to 21 days.

For the nine months ended April 3, 2010, gross margin decreased to $145.9 million from $191.7 million for the comparable period of the prior year, a decrease of $45.8 million, or 23.9%.  As a percentage of net sales, gross margin decreased to 38.2% for the nine months ended April 3, 2010 from 40.6% in the comparable period of the prior year.  The decrease in gross margin as a percentage of net sales was primarily due to lower initial markup, expense related to our change in return policy from 14 days to 21 days and deleveraging of occupancy costs partially offset by lower other costs including inventory shrink and damages as well as $1.2 million of income related to expiration of loyalty points.

Selling, General and Administrative Expenses. Selling, general and administrative expenses, which primarily consist of non-occupancy store costs, corporate overhead and advertising costs, decreased to $52.1 million during the three months ended April 3, 2010 from $56.8 million for the comparable period of the prior year, a decrease of $4.7 million, or 8.3 %. As a percentage of net sales, selling, general and administrative expenses increased to 45.6% during the three months ended April 3, 2010 from 44.5% in the comparable period of the prior year as a result of lower sales.  The decrease in dollars over the prior year was primarily due to lower compensation, advertising, depreciation and a reduction in impairment charges in the quarter for underperforming stores partially offset by a $2.1 million non-cash stock based compensation adjustment primarily related to prior years that was a result of errors caused by flaws in third party software.  We determined that the impact of this error is not material to the previously issued annual and interim unaudited consolidated financial statements using the guidance of SEC Staff Accounting Bulletin No. 99 (“SAB 99”) and SAB 108.  We do not believe that the correction of this error is material to the consolidated financial statements for the three months ended April 3, 2010 and do not believe that it will be material to the 2010 annual financial statements.

For the nine months ended April 3, 2010, selling, general and administrative expenses decreased to $156.4 million from $177.4 million for the comparable period of the prior year, a decrease of $21.0 million, or 11.8%.  As a percentage of net sales, selling, general and administrative expenses increased to 41.0% from 37.6% in the comparable period of the prior year as a result of lower sales.  The decrease in dollars over the prior year was primarily due to lower compensation, advertising and gift card breakage income recorded for the first time in the second quarter of fiscal 2010 offset by a $4.7 million impairment charge related to under-performing stores, of which $4.0 million related to PH8 and BEBE SPORT stores and $0.7 million related to bebe stores versus $2.9 million in the comparable period of fiscal 2009 and a $3.0 million non-cash stock based compensation adjustment primarily related to prior years that was a result of errors caused by flaws in third party software.  We determined that the impact of this error is not material to the previously issued annual and interim unaudited consolidated financial statements using the guidance of SEC Staff Accounting Bulletin No. 99 (“SAB 99”) and SAB 108.  We do not believe that the correction of this error is material to the consolidated financial statements for the nine months ended April 3, 2010 and do not believe that it will be material to the 2010 annual financial statements.

Interest and Other Income, Net. We generated approximately $0.4 million of interest and other income, net of other expenses during the three months ended April 3, 2010 compared to approximately $0.7 million in the comparable period of the prior year. The decrease in interest and other income resulted from an increase in investments in lower-yielding tax-exempt investments and money market funds.

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For the nine month period ended April 3, 2010, we recorded approximately $2.3 million of interest and other income (net of other expenses), compared to $5.6 million in the comparable period of the prior year.  The decrease in interest and other income resulted from an increase in investments in lower-yielding tax-exempt investments and money market funds.

Provision for Income Taxes. Our effective tax rate decreased to 26.2% for the three months ended April 3, 2010 from 35.3% for the comparable period in the prior year.  The lower effective tax rate was primarily due to incentive stock option compensation expense offset by higher tax exempt interest income as a percent of taxable income.

For the nine months ended April 3, 2010, our effective tax rate decreased to 12.9% from 34.9% for the comparable period in the prior year primarily due to incentive stock option compensation expense offset by higher tax exempt interest income as a percent of taxable income.

SEASONALITY OF BUSINESS AND QUARTERLY RESULTS

Our business varies with general seasonal trends that are characteristic of the retail and apparel industries. As a result, our typical store generates a higher percentage of our annual net sales and profitability in the second quarter of our fiscal year, which includes the holiday selling season, compared to the other quarters of our fiscal year. If for any reason our sales were below seasonal norms during the second quarter of our fiscal year, our annual operating results would be negatively impacted. Because of the seasonality of our business, results for any quarter are not necessarily indicative of results that may be achieved for a full fiscal year.

LIQUIDITY AND CAPITAL RESOURCES

Our working capital requirements vary widely throughout the year and generally peak during the first and second fiscal quarters. As of April 3, 2010, we had approximately $330.4 million of cash and equivalents and investments on hand of which approximately $40.0 million were invested in government treasury bills, approximately $19.0 million were invested in certificates of deposit, and approximately $170.7 million, net of impairment charges of $23.9 million, were invested in auction rate securities (“ARS”). We do not anticipate the lack of liquidity in the ARS to impact our ability to fund our operations in the foreseeable future and believe we have sufficient cash and equivalents to fund ongoing operations. In addition, we have a revolving line of credit, under which we may borrow or issue letters of credit up to a combined total of $25 million. As of April 3, 2010, there were no cash borrowings outstanding under the line of credit, and letters of credit outstanding totaled $1.8 million.  This credit facility requires us to maintain a $2.5 million compensating balance and to comply with certain financial covenants, including amounts for minimum tangible net worth, unencumbered liquid assets and profitability, and certain restrictions on making loans and investments.  As of April 3, 2010, we were in compliance with all covenants under the credit facility.

As of April 3, 2010, we had cash and equivalents of $100.7 million held in accounts managed by third party financial institutions consisting of invested cash and cash in our operating accounts.  The invested cash is invested in interest bearing funds managed by third party financial institutions.  These funds invest in direct obligations of the government of the United States.  To date, we have experienced no loss or lack of access to our invested cash or equivalents; however, we can provide no assurances that access to our invested cash and equivalents will not be impacted by adverse conditions in the financial markets.

At any point in time we also have approximately $75 to $105 million of invested cash and cash in operating accounts that are with third party financial institutions.  These balances exceed the Federal Deposit Insurance Corporation insurance limits.  While we monitor daily the cash balances in our operating accounts and adjust the cash balances as appropriate, these cash balances could be impacted if the underlying financial institutions fail or could be subject to other adverse conditions in the financial markets.  To date, we have experienced no loss or lack of access to invested cash or cash in our operating accounts.

Net cash provided by operating activities for the nine months ended April 3, 2010 was $20.8 million versus cash provided by operating activities of $27.8 million for the nine months ended April 4, 2009. The decrease of $7.0 million from the comparable period was primarily due to a decrease in net earnings of $20.2 million and lower accounts payable related to lower inventory balances offset by other changes in working capital primarily related to lower prepaid taxes as a result of a federal tax refund received during the second quarter and lower estimated tax payments made this year versus the prior due to an anticipated decrease in projected income.

Net cash used by investing activities for the nine months ended April 3, 2010 was $4.6 million versus $1.0 million used for the nine months ended April 4, 2009.  The increase of $3.6 million versus the prior year comparable period was primarily due to lower net proceeds on investment securities offset by lower capital expenditures.  We expect that total capital expenditures will be below $17 million in fiscal 2010.

Net cash used by financing activities was $12.7 million for the nine months ended April 3, 2010 versus $26.0 million for the nine months ended April 4, 2009.  The decrease in cash used of $13.3 million from the prior year comparable period was primarily due to a reduction in purchases of our common stock through our stock buyback program and lower dividends paid related to a lower rate declared for the first, second and third quarters of fiscal 2010 ($0.025 per share versus $0.05 per share in the prior year).

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We hold a variety of interest bearing ARS consisting of federally insured student loan backed securities and insured municipal authority bonds. As of April 3, 2010, our ARS portfolio totaled approximately $170.7 million, $58.3 million (net of an impairment charge of $9.3 million) classified as trading securities and $112.4 million (net of temporary impairment charge of $14.6 million) classified as long term available for sale securities. Our ARS portfolio includes approximately 98% federally insured student loan backed securities and 2% municipal authority bonds. Our ARS portfolio consists of approximately 42% AAA rated investments, 3% AA rated investments, 35% A rated investments, 14% BBB rated investments and 6% CCC rated investments.  This is a change from our fiscal 2009 portfolio, which consisted of 46% AAA rates investments, 14% AA rated investments, 30% A rated investments and 10% BBB related investments.  These ARS investments are intended to provide liquidity via an auction process that resets the applicable interest rate at predetermined calendar intervals, allowing investors to either roll over their holdings or gain immediate liquidity by selling such interests at par. The uncertainties in the credit markets that began in February 2008 have affected our holdings in ARS investments and auctions for our investments in these securities have failed to settle on their respective settlement dates. Historically the fair value of ARS investments had approximated par value due to the frequent resets through the auction process. While we continue to earn interest on our ARS investments at the maximum contractual rate, these investments are not currently trading and therefore do not currently have a readily determinable market value. Accordingly, the estimated fair value of ARS no longer approximates par value.  Consequently, the investments are not currently liquid, and we will not be able to access these funds until a future auction of these investments is successful, the issuer redeems the securities or at maturity. Maturity dates for these ARS investments range from 2010 to 2044 with principal distributions occurring on certain securities prior to maturity.

In November 2008, we entered into a settlement agreement related to our ARS held with UBS Financial Services, Inc. (“UBS”) that grants us certain rights related to these ARS (the “Right”).  Beginning June 30, 2010, at our request, UBS has agreed to purchase all of our ARS currently held with them at par value.  Conversely, UBS has the right, in its discretion, to purchase or sell our ARS at any time until July 2, 2012, so long as we receive payment at par value upon any sale or disposition.  The enforceability of the Right results in a put option which should be recognized as a free standing asset separate from the ARS.  Upon acceptance of the offer from UBS, we recorded the put option at fair value of $11.6 million, with a corresponding credit to interest income.  Although it is a financial instrument, the put option does not meet the FASB’s definition of a derivative instrument, therefore we have elected to measure the put option at fair value.  As a result, unrealized gains and losses are included in earnings.  At April 3, 2010, the fair value of the put option is $8.8 million, net of a reserve of $0.5 million, of which a gain of $0.1 million has been recognized in the current year.

Prior to accepting the UBS offer, we recorded our ARS held with UBS as investments available for sale, with an associated unrealized loss included in other comprehensive income.  In connection with our acceptance of the UBS offer in November 2008, we transferred approximately $84.4 million in ARS subject to the UBS settlement from investments available for sale to trading securities and recorded a loss on investments of approximately $12.1 million.  As a result, changes in fair value of the ARS are recorded as a component of net income.  We intend to exercise the Right when it becomes available, and as such the associated investments have been classified as short-term on our balance sheet.

In October 2008, our board of directors authorized a program to repurchase up to $30 million of our common stock.  We may, from time to time, as business conditions warrant, purchase stock in the open market or through private transactions.  Purchases may be increased, decreased or discontinued at any time without prior notice.  The plan does not obligate us to repurchase any specific number of shares and may be suspended at any time at management’s discretion.  During the third quarter of fiscal 2010 we purchased 0.1 million shares at an average price of $6.00 per share.  As of April 3, 2010, there was approximately $12.5 million available for additional purchases under the program.

We believe that our cash and cash equivalents on hand, will be sufficient to meet our capital and operating requirements for at least the next twelve months. Our future capital requirements, however, will depend on numerous factors, including without limitation, liquidity of our auction rate securities, the size and number of new and expanded stores and/or store concepts, investment costs for management information systems, potential acquisitions and/or joint ventures, purchases of our stock and future results of operations.

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ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risks, which include changes in U.S. interest rates and, to a lesser extent, foreign exchange rates. We do not engage in financial transactions for trading or speculative purposes.

Interest Rate Risk

We currently maintain a portfolio of variable interest rate investments consisting of cash equivalents, government treasury bills, certificates of deposit and both short-term and long-term investments consisting of ARS.  According to our investment policy, we may invest in taxable and tax-exempt instruments.  In addition, the policy establishes limits on credit quality, maturity, issuer and type of instrument. Investments are classified as “trading” or “available for sale”.  We do not use derivative financial instruments in our investment portfolio.

All highly liquid investments with a maturity of three months or less at the date of purchase are considered to be cash equivalents.  Investments are considered short-term available for sale securities if the original maturity is between three months and twelve months, short-term trading securities if they are ARS related to the Right with UBS, or long term investments if the original maturity is greater than twelve months. Historically the fair value of ARS investments had approximated par value due to the frequent resets through the auction process. While we continue to earn interest on our ARS investments at the maximum contractual rate, these investments are not currently trading and therefore do not currently have a readily determinable market value. Accordingly, the estimated fair value of ARS no longer approximates par value. We determined the estimated fair value of our investment in ARS as of April 3, 2010 using a discounted cash flow model to estimate the fair value of our investments in ARS. The assumptions used in preparing the discounted cash flow model include estimates for interest rates, timing and amount of cash flows and expected holding periods of the ARS. The ARS written put right is a free standing asset separate from the ARS, and represents our contractual right to require UBS to purchase our ARS at par value during the two year period beginning June 30, 2010.  In order to value the ARS written put right, we considered intrinsic value, time value of money and our assessment of the credit worthiness of UBS.  We have modified our investment strategy and increased our investments in more liquid money market investments.

The following table lists our cash, cash equivalents and investments as of April 3, 2010:

The interest payable on outstanding cash borrowings under our bank line of credit is based on variable interest rates and is therefore affected by changes in market interest rates. If interest rates rose significantly, our results from operations and cash flows would not be materially affected since we have no outstanding borrowings.

Foreign Currency Risks

We enter into a significant amount of purchase obligations outside of the United States, substantially all of which are negotiated and settled in U.S. Dollars and, therefore, have only minimal exposure to foreign currency exchange risks. We also operate a subsidiary for which the functional currency is the Canadian Dollar. In accordance with FASB ASC 830, “Foreign Currency Matters”, we translate assets and liabilities of Canada’s operations into U.S. dollars at month-end rates, while we translate income and expenses at the weighted average exchange rates for the month. We record the related translation adjustments in accumulated other comprehensive income as a separate component of shareholders’ equity. Fluctuations in exchange rates therefore impact our financial condition and results of operations, as reported in U.S. Dollars.  We do not hedge against foreign currency risks and believe that foreign currency exchange risk is immaterial.

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ITEM 4.               CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of our disclosure controls and procedures, as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report at the reasonable assurance level.

There has been no change in our internal control over financial reporting during the quarter ended April 3, 2010 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