UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 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 September 30, 2007
OR
o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to .
COMMISSION FILE NUMBER: 001-33142
Physicians Formula Holdings, Inc.
(Exact name of registrant as specified in its charter)
DELAWARE | | 20-0340099 |
(State or other jurisdiction of incorporation or organization) | | (I.R.S. Employer Identification No.) |
1055 West 8th Street | | 91702 |
Azusa, California | | (Zip Code) |
| (Address of principal executive offices) | | |
(626) 334-3395
(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 o
Indicate by check mark whether the Registrant is a large accelerated filer, an accelerate filer, or a non-accelerated filer. See definition of “accelerated filer and larger accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer o | Accelerated filer o | Non-accelerated filer x |
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 outstanding of the registrant’s common stock, par value $.01 per share, as of November 12, 2007, was 14,095,727.
TABLE OF CONTENTS
FINANCIAL INFORMATION
PHYSICIANS FORMULA HOLDINGS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited)
(dollars in thousands, except share data)
| | | September 30, | | | December 31, | |
| | | 2007 | | | 2006 | |
ASSETS | | | | | | |
| CURRENT ASSETS: | | | | | | |
| Cash and cash equivalents | | $ | 56 | | | $ | 26 | |
| Accounts receivable, net of allowance for bad debts of $384 and $348 | | | 15,368 | | | | 26,654 | |
| Inventories | | | 28,205 | | | | 23,472 | |
| Prepaid expenses and other current assets | | | 1,221 | | | | 1,775 | |
| Income taxes receivables | | | 1,772 | | | | - | |
| Deferred income taxes—net | | | 4,905 | | | | 5,139 | |
| Total current assets | | | 51,527 | | | | 57,066 | |
| | | | | | | | | |
| PROPERTY AND EQUIPMENT—Net | | | 3,690 | | | | 2,506 | |
| OTHER ASSETS—Net | | | 1,209 | | | | 968 | |
| INTANGIBLE ASSETS—Net | | | 54,987 | | | | 56,311 | |
| GOODWILL | | | 17,463 | | | | 17,463 | |
| TOTAL | | $ | 128,876 | | | $ | 134,314 | |
| | | | | | | | | |
LIABILITIES AND STOCKHOLDERS' EQUITY | | | | | | | | |
| CURRENT LIABILITIES: | | | | | | | | |
| Accounts payable | | $ | 6,009 | | | $ | 12,670 | |
| Accrued expenses | | | 2,041 | | | | 1,915 | |
| Trade allowances | | | 3,630 | | | | 3,479 | |
| Sales returns reserve | | | 7,293 | | | | 9,440 | |
| Income taxes payable | | | - | | | | 378 | |
| Line of credit borrowings | | | 6,761 | | | | 7,522 | |
| Current portion of long-term debt | | | 2,625 | | | | 2,063 | |
| Total current liabilities | | | 28,359 | | | | 37,467 | |
| | | | | | | | | |
| DEFERRED COMPENSATION | | | 845 | | | | 721 | |
| DEFERRED INCOME TAXES-Net | | | 21,434 | | | | 21,617 | |
| LONG-TERM DEBT | | | 11,250 | | | | 12,937 | |
| | | | | | | | | |
| COMMITMENTS AND CONTINGENCIES | | | | | | | | |
| STOCKHOLDERS' EQUITY: | | | | | | | | |
| Series A preferred stock, $.01 par value—10,000,000 shares authorized, 0 and 0 shares issued and outstanding | | | - | | | | - | |
| Common stock, $.01 par value—50,000,000 shares authorized, 14,095,727 and 13,843,056 shares issued and outstanding | | | 141 | | | | 138 | |
| Additional paid-in capital | | | 58,579 | | | | 57,047 | |
| Retained earnings | | | 8,268 | | | | 4,387 | |
| Total stockholders' equity | | | 66,988 | | | | 61,572 | |
| | | | | | | | | |
| TOTAL | | $ | 128,876 | | | $ | 134,314 | |
See notes to condensed consolidated financial statements.
PHYSICIANS FORMULA HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(unaudited)
(dollars in thousands, except per share data)
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| | | | | | | | | | | | | |
| NET SALES | | $ | 19,807 | | | $ | 18,093 | | | $ | 77,628 | | | $ | 68,865 | |
| COST OF SALES | | | 10,085 | | | | 8,449 | | | | 35,108 | | | | 29,826 | |
| GROSS PROFIT | | | 9,722 | | | | 9,644 | | | | 42,520 | | | | 39,039 | |
| | | | | | | | | | | | | | | | | |
| SELLING, GENERAL AND ADMINISTRATIVE EXPENSES | | | 8,902 | | | | 7,540 | | | | 34,467 | | | | 26,820 | |
| INCOME FROM OPERATIONS | | | 820 | | | | 2,104 | | | | 8,053 | | | | 12,219 | |
| | | | | | | | | | | | | | | | | |
| INTEREST EXPENSE-NET | | | 370 | | | | 1,945 | | | | 1,086 | | | | 5,457 | |
| OTHER INCOME | | | (24 | ) | | | (32 | ) | | | (78 | ) | | | (35 | ) |
| INCOME BEFORE INCOME TAXES | | | 474 | | | | 191 | | | | 7,045 | | | | 6,797 | |
| | | | | | | | | | | | | | | | | |
| PROVISION (BENEFIT) FOR INCOME TAXES | | | 372 | | | | (32 | ) | | | 3,164 | | | | 2,527 | |
| NET INCOME | | $ | 102 | | | $ | 223 | | | $ | 3,881 | | | $ | 4,270 | |
| | | | | | | | | | | | | | | | | |
| NET INCOME PER COMMON SHARE: | | | | | | | | | | | | | | | | |
| Basic | | $ | 0.01 | | | $ | 0.02 | | | $ | 0.28 | | | $ | 0.41 | |
| Diluted | | $ | 0.01 | | | $ | 0.02 | | | $ | 0.27 | | | $ | 0.37 | |
| | | | | | | | | | | | | | | | | |
| WEIGHTED-AVERAGE COMMON SHARES OUTSTANDING: | | | | | | | | | | | | | |
| Basic | | | 14,011,041 | | | | 10,421,916 | | | | 13,935,389 | | | | 10,399,331 | |
| Diluted | | | 14,553,130 | | | | 11,614,506 | | | | 14,566,860 | | | | 11,603,042 | |
See notes to condensed consolidated financial statements.
PHYSICIANS FORMULA HOLDINGS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited)
(dollars in thousands)
| | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | |
CASH FLOWS FROM OPERATING ACTIVITIES: | | | | | | |
| Net income | | $ | 3,881 | | | $ | 4,270 | |
| Adjustments to reconcile net income to net cash provided by operating activities: | | | | | | | | |
| Depreciation and amortization | | | 2,058 | | | | 1,898 | |
| Exchange rate gain | | | (78 | ) | | | | |
| Deferred income taxes | | | 51 | | | | 762 | |
| Provision for bad debts | | | 61 | | | | 58 | |
| Amortization of debt issuance costs | | | 28 | | | | 150 | |
| Accrued payment-in-kind interest | | | - | | | | 155 | |
| Recognition of stock-based compensation | | | 1,507 | | | | - | |
| Tax benefit on exercise of options | | | (79 | ) | | | - | |
| Changes in operating assets and liabilities: | | | | | | | | |
| Accounts receivable | | | 11,303 | | | | 6,531 | |
| Inventories | | | (4,673 | ) | | | 113 | |
| Prepaid expenses and other current assets | | | 554 | | | | (367 | ) |
| Other assets | | | (100 | ) | | | (25 | ) |
| Accounts payable | | | (7,014 | ) | | | (1,531 | ) |
| Accrued expenses, trade allowances and sales returns reserve | | | (1,870 | ) | | | (2,158 | ) |
| Income taxes payable/receivable | | | (2,208 | ) | | | (3,271 | ) |
| Net cash provided by operating activities | | | 3,421 | | | | 6,585 | |
| | | | | | | | | |
CASH FLOWS FROM INVESTING ACTIVITIES: | | | | | | | | |
| Purchase of property and equipment | | | (1,565 | ) | | | (528 | ) |
| | | | | | | | | |
CASH FLOWS FROM FINANCING ACTIVITIES: | | | | | | | | |
| Paydowns of term loans | | | (1,125 | ) | | | (2,088 | ) |
| Net paydowns under line of credit | | | (761 | ) | | | (3,607 | ) |
| Debt issuance costs | | | (45 | ) | | | (172 | ) |
| Bank overdraft | | | - | | | | (177 | ) |
| Exercise of stock options | | | 26 | | | | 37 | |
| Tax benefit on exercise of options | | | 79 | | | | - | |
| Cash payment of common stock dividend | | | - | | | | (46 | ) |
| Net cash used in financing activities | | | (1,826 | ) | | | (6,053 | ) |
| | | | | | | | | |
| NET INCREASE IN CASH AND CASH EQUIVALENTS | | | 30 | | | | 4 | |
| CASH AND CASH EQUIVALENTS—Beginning of period | | | 26 | | | | 20 | |
| CASH AND CASH EQUIVALENTS—End of period | | $ | 56 | | | $ | 24 | |
| | | | | | | | | |
| SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION—Cash paid during the period for: | | | | | | | | |
| Interest, net of amounts capitalized | | $ | 1,103 | | | $ | 3,715 | |
| Income taxes | | $ | 5,320 | | | $ | 5,037 | |
| | | | | | | | | |
| SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING ACTIVITIES - The Company had accounts payable of $352,000 outstanding as of September 30, 2007, relating to purchases of property and equipment. | | | | | | | | |
See notes to condensed consolidated financial statements.
PHYSICIANS FORMULA HOLDINGS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. ORGANIZATION AND BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements include the accounts of Physicians Formula Holdings, Inc., a Delaware corporation (the ‘‘Company’’), and its wholly owned subsidiary, Physicians Formula, Inc. (‘‘Physicians’’), a New York corporation, and its wholly owned subsidiaries, Physicians Formula Cosmetics, Inc., a Delaware corporation, and Physicians Formula DRTV, LLC, a Delaware limited liability company.
The Company develops, markets, manufactures and distributes innovative, premium-priced products for the mass market channel. The Company’s products include face powders, bronzers, concealers, blushes, foundations, eye shadows, eyeliners, brow makeup and mascaras. The Company sells its products to mass market retailers such as Wal-Mart, Target, CVS, Walgreens and Albertsons.
The accompanying condensed consolidated balance sheet as of September 30, 2007, the condensed consolidated statements of income for the three and nine months ended September 30, 2007 and 2006 and the condensed consolidated statements of cash flows for the nine months ended September 30, 2007 and 2006 are unaudited. These unaudited condensed interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and Article 10 of Regulation S-X. In the opinion of the Company’s management, the unaudited condensed interim consolidated financial statements include all adjustments of a normal recurring nature necessary for the fair presentation of the Company’s financial position as of September 30, 2007, its results of operations for the three and nine months ended September 30, 2007 and 2006, and its cash flows for the nine months ended September 30, 2007 and 2006. 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 December 31, 2007. The condensed consolidated balance sheet as of December 31, 2006 has been derived from the audited consolidated balance sheet as of that date.
These condensed interim consolidated financial statements should be read in conjunction with the Company’s audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2006.
Use of Estimates—The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.
2. NEW ACCOUNTING STANDARD
In June 2006, the Financial Accounting Standards Board (‘‘FASB’’) issued FASB Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes. FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition of income tax assets and liabilities, accounting for interest and penalties associated with tax positions, accounting for income taxes in interim periods and income tax disclosures. The Company adopted FIN 48 on January 1, 2007, and did not record any cumulative effect adjustment to retained earnings as a result of adopting FIN 48. Interest and penalties, if any, related to unrecognized tax benefits are recorded in income tax expense. Total unrecognized tax benefits and interest and penalties were not significant at January 1, 2007. The Company is subject to U.S. Federal income tax examinations for the tax years 2003 through 2006, and is subject to state and local income tax examinations for the tax years 2002 through 2006.
3. NET INCOME PER SHARE
Basic net income per common share is computed as net income divided by the weighted-average number of common shares outstanding during the period. Diluted net income per share reflects the potential dilution that could occur from the exercise of outstanding stock options and is computed by dividing net income by the weighted-average number of common shares outstanding for the period, plus the dilutive effect of outstanding stock options, calculated using the treasury stock method. The following table summarizes the potential dilutive effect of outstanding stock options, calculated using the treasury stock method:
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| | | | | | | | | | | | | |
| Weighted-average number of common shares—basic | | | 14,011,041 | | | | 10,421,916 | | | | 13,935,389 | | | | 10,399,331 | |
| Effect of dilutive employee stock options | | | 542,089 | | | | 1,192,590 | | | | 631,471 | | | | 1,203,711 | |
| Weighted-average number of common shares—diluted | | | 14,553,130 | | | | 11,614,506 | | | | 14,566,860 | | | | 11,603,042 | |
Stock options for the purchase of 325,000 shares of common stock were excluded from the above calculation during the three and nine months ended September 30, 2007, as the effect of those options was anti-dilutive. There were no anti-dilutive options during the three months and nine months ended September 30, 2006.
4. INVENTORIES
Inventories consist of the following (dollars in thousands):
| | | September 30, | | | December 31, | |
| | | 2007 | | | 2006 | |
| | | | | | | |
| Raw materials and components | | $ | 16,076 | | | $ | 11,955 | |
| Finished goods | | | 12,129 | | | | 11,517 | |
| Total | | $ | 28,205 | | | $ | 23,472 | |
5. PROPERTY AND EQUIPMENT
Property and equipment consist of the following (dollars in thousands):
| | | | September 30, | | | December 31, | |
| | Useful Lives | | 2007 | | | 2006 | |
| | | | | | | | |
| Tooling | 3 to 5 years | | $ | 406 | | | $ | 379 | |
| Leasehold improvements | Lesser of term of lease to 10 years | | | 916 | | | | 753 | |
| Machinery and equipment | 3 to 8 years | | | 2,426 | | | | 2,284 | |
| Furniture and fixtures | 5 to 8 years | | | 275 | | | | 240 | |
| Computer equipment | 3 years | | | 1,036 | | | | 804 | |
| Construction in progress | | | | 1,575 | | | | 408 | |
| Total property and equipment | | | | 6,634 | | | | 4,868 | |
| Accumulated depreciation | | | | (2,944 | ) | | | (2,362 | ) |
| Total | | | $ | 3,690 | | | $ | 2,506 | |
Depreciation expense was $252,000 and $198,000 for the three months ended September 30, 2007 and 2006, respectively. Depreciation expense was $734,000 and $576,000 for the nine months ended September 30, 2007 and 2006, respectively.
Capitalized interest is recorded on construction-in-progress using the average interest rate over the construction period during the nine months ended September 30, 2007. Interest of $46,000 and $0 was capitalized for the three and nine months ended September 30, 2007 and 2006, respectively, and is included in property and equipment.
6. INTANGIBLE ASSETS
Intangible assets consist of the following as of September 30, 2007 (dollars in thousands):
| | | Gross Carrying Amount | | | Accumulated Amortization | | | Total | |
| | | | | | | | | | |
| Trade names | | $ | 29,500 | | | $ | - | | | $ | 29,500 | |
| Patents | | | 8,699 | | | | 2,272 | | | | 6,427 | |
| Distributor relationships | | | 23,701 | | | | 4,641 | | | | 19,060 | |
| Total | | $ | 61,900 | | | $ | 6,913 | | | $ | 54,987 | |
Intangible assets consist of the following as of December 31, 2006 (dollars in thousands):
| | | Gross Carrying Amount | | | Accumulated Amortization | | | Total | |
| | | | | | | | | | |
| Trade names | | $ | 29,500 | | | $ | - | | | $ | 29,500 | |
| Patents | | | 8,699 | | | | 1,836 | | | | 6,863 | |
| Distributor relationships | | | 23,701 | | | | 3,753 | | | | 19,948 | |
| Total | | $ | 61,900 | | | $ | 5,589 | | | $ | 56,311 | |
Amortization expense was $441,000 in each of the three month periods ended September 30, 2007 and 2006 and $1,324,000 in each of the nine month periods ended September 30, 2007 and 2006. Amortization of intangible assets for the remainder of 2007 will be approximately $441,000 and will be approximately $1,765,000 in each of the next five years.
7. STOCKHOLDERS’ EQUITY
Secondary Public Offering
On April 25, 2007, the Company completed a secondary public offering in which certain stockholders sold 5,049,650 shares of the Company’s common stock, which included 658,650 shares of common stock sold pursuant to the underwriters’ over-allotment option. The Company did not receive any proceeds from the sale of the shares but incurred approximately $725,000 of the expenses related to the offering.
Initial Public Offering
On November 14, 2006, the Company completed an initial public offering of shares of the Company’s common stock. In the initial public offering, the Company sold 3,125,000 shares of common stock and the selling stockholders sold 5,500,000 shares of common stock, which included 1,125,000 shares of common stock sold by the selling stockholders pursuant to the underwriters' over-allotment option.
8. EQUITY AND STOCK OPTION PLANS
2006 Equity Incentive Plan
In connection with the Company’s initial public offering, the Company adopted the Physicians Formula Holdings, Inc. 2006 Equity Incentive Plan (the “2006 Plan”). The 2006 Plan provides for grants of stock options, stock appreciation rights, restricted stock, restricted stock units, deferred stock units and other performance awards to directors, officers and employees of the Company, as well as others performing services for the Company. The options generally have a 10-year life and vest in equal monthly installments over a four-year period. As of September 30, 2007, a total of 851,861 shares of the Company’s common stock were available for issuance under the 2006 Plan. This amount will automatically increase on the first day of each fiscal year ending in 2016 by the lesser of: (i) 2% of the shares of common stock outstanding on the last day of the immediately preceding fiscal year or (ii) such lesser number of shares as determined by the compensation committee of the Board of Directors. On February 6, 2007, the Company granted 300,000 stock options to certain employees and on August 30, 2007, the Company granted 25,000 stock options to a newly elected director under the 2006 Plan.
2003 Stock Option Plan
In November 2003, the Board of Directors adopted the 2003 Stock Option Plan (the “2003 Plan”) and reserved a total of 2,500,000 shares for grants under the 2003 Plan. The 2003 Plan provides for the issuance of stock options for common stock to executives and other key employees. The options generally have a 10-year life and vest over a period of time ranging from 24 months to 48 months. Options granted under the 2003 Plan were originally granted as time-vesting options and performance-vesting options. The original time-vesting options vest in equal annual installments over a four-year period. In connection with the initial public offering, the 713,334 performance-vesting options were amended to accelerate the vesting of 550,781 of such options, and 296,140 of these options were exercised. The remaining 162,553 performance-vesting options were converted to time-vesting options that vest in equal monthly installments over a two-year period. Options are granted with exercise prices not less than the fair value at the date of grant, as determined by the Board of Directors, which subsequent to our initial public offering is the closing price on the grant date.
The equity incentive and stock option plan activity is summarized below:
| | | Time-Vesting Options | | | Performance-Vesting Options | |
| | | | | | Weighted-Average Exercise Price | | | Aggregate Intrinsic Value | | | | | | Weighted-Average Exercise Price | | | Aggregate Intrinsic Value | |
| | | | | | | | | | | | | | | | | | | |
| Options outstanding—January 1, 2007 | | | 652,053 | | | $ | 0.11 | | | | | | | 254,641 | | | $ | 0.10 | | | | |
| Options granted | | | 325,000 | | | | 19.91 | | | $ | - | | | | - | | | | - | | | | |
| Options exercised | | | (134,711 | ) | | | 0.10 | | | | 2,014,000 | | | | (117,960 | ) | | | 0.10 | | | $ | 1,061,000 | |
| Options forfeited | | | (5,000 | ) | | | 20.75 | | | | - | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Options outstanding—September 30, 2007 | | | 837,342 | | | $ | 7.79 | | | $ | 3,295,000 | | | | 136,681 | | | $ | 0.10 | | | $ | 1,590,000 | |
| | | | | | | | | | | | | | | | | | | | | | | | | |
| Vested and expected to vest-September 30, 2007 | | | 837,342 | | | $ | 7.79 | | | $ | 3,295,000 | | | | 136,681 | | | $ | 0.10 | | | $ | 1,590,000 | |
The fair value of options granted during the nine months ended September 30, 2007 totaled $3,277,000. The Company utilized the Black-Scholes option valuation model to calculate the fair value of these options using the following weighted-average assumptions:
| | | 2007 | |
| | | August | | | February | |
| Risk-free interest rate | | | 4.2 | % | | | 4.9 | % |
| Volatility | | | 47.9 | % | | | 52.2 | % |
| Dividend rate | | None | | | None | |
| Life in years | | | 5.0 | | | | 5.0 | |
The risk-free interest rate is based-upon the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the options. The expected volatility rate is based on companies of similar growth and maturity and our peer group in the industry in which the Company does business. The dividend rate assumption is excluded from the calculation, as the Company intends to retain all earnings. The expected life of our stock options represents management’s best estimate based upon historical and expected trends in the Company's stock option activity.
The vesting activity for the equity incentive and stock option plans is summarized below:
| | | Time-Vesting Options | | Performance-Vesting Options |
| | | | | | | | Weighted-Average | | | | | | | | Weighted-Average | |
| | | Vested and Exercisable | | | Aggregate Exercise Price | | Exercise Price | Remaining Contractual Life | Aggregate Intrinsic Value | | Vested and Exercisable | | | Aggregate Exercise Price | | Exercise Price | Remaining Contractual Life | Aggregate Intrinsic Value |
| | | | | | | | | | | | | | | | | | | |
| January 1, 2007 | | | 246,108 | | | $ | 25,000 | | | | | | | 254,641 | | | $ | 25,000 | | | | |
| Vesting during period | | | 131,413 | | | | 912,000 | | | | | | | - | | | | - | | | | |
| Options exercised | | | (134,711 | ) | | | (14,000 | ) | | | | | | (117,960 | ) | | | (12,000 | ) | | | |
| Options forfeited | | | (520 | ) | | | (11,000 | ) | | | | | | - | | | | - | | | | |
| | | | | | | | | | | | | | | | | | | | | | | |
| September 30, 2007 | | | 242,290 | | | $ | 912,000 | | $ 3.76 | 7.5 years | $ 1,930,000 | | | 136,681 | | | $ | 13,000 | | $ 0.10 | 6.1 years | $ 1,590,000 |
As of September 30, 2007, the options outstanding under the 2003 Plan and 2006 Plan had exercise prices between $0.10 and $20.75 and the weighted-average remaining contractual life for all options was 7.3 years.
A summary of the weighted-average grant date fair value of the non-vested stock option awards is presented in the table below:
| | | | | | Weighted-Average Grant Date Fair Value | |
| January 1, 2007 | | | 405,945 | | | $ | 6.56 | |
| Vested | | | (131,413 | ) | | | 11.33 | |
| Granted | | | 325,000 | | | | 10.08 | |
| Forfeited | | | (4,480 | ) | | | 10.54 | |
| September 30, 2007 | | | 595,052 | | | $ | 7.36 | |
The total fair value of options that vested during the nine months ended September 30, 2007 and 2006 was $1,489,000 and $6,000, respectively.
As of September 30, 2007, total unrecognized estimated compensation cost related to non-vested stock options was approximately $4,277,000, which is expected to be recognized over a weighted-average period of approximately 2.6 years. The Company recorded cash received from the exercise of stock options of $26,000 during the nine months ended September 30, 2007. Upon option exercise, the Company issues new shares of stock.
The Company incurred $1,877,000 and $0 of pre-tax non-cash share-based compensation expense for the nine months ended September 30, 2007 and 2006, respectively. A non-cash share-based compensation cost of $370,000 was a component of cost of sales and $1,507,000 was a component of selling, general and administrative expenses in the accompanying condensed consolidated statement of income for the nine months ended September 30, 2007. The tax benefit recognized of $826,000 and $0 was recorded for the nine months ended September 30, 2007 and 2006, respectively. The Company capitalized non-cash share-based compensation expense of $63,000 in inventory for the nine months ended September 30, 2007.
Excess tax benefits exist when the tax deduction resulting from the exercise of options exceeds the compensation cost recorded. Prior to the adoption of SFAS No. 123R, the Company presented all such excess benefits as operating cash flows on the condensed consolidated statements of cash flows. SFAS No. 123R requires the cash flows resulting from such excess tax benefits to be classified as financing cash flows. Under SFAS No. 123R, the Company has classified excess tax benefits of $79,000 for the nine months ended September 30, 2007 as financing cash inflows.
The stock options exercised during the three months ended September 30, 2007 resulted in a reduction in a deferred income tax asset because the share-based compensation cost previously recognized by the Company was greater than the deduction allowed for income tax purposes based on the price of the stock on the date of exercise. This reduction in the deferred income tax asset was in excess of the Company's additional paid-in capital pool by $333,000. Therefore, there was an increase in the Company's effective income tax rate for the three and nine month periods ended September 30, 2007.
9. COMMITMENTS AND CONTINGENCIES
Litigation—The Company is involved in various lawsuits in the ordinary course of business. In management’s opinion, the ultimate resolution of these matters will not result in a material impact to the Company’s condensed consolidated financial statements.
Manufacturing—The Company is party to an agreement that requires it to purchase equipment to automate a product assembly line for approximately $1,100,000, of which $762,000 has been incurred as of September 30, 2007.
Environmental—The shallow soils and groundwater below our City of Industry facilities were contaminated by the former operator of the property. The former operator performed onsite cleanup and we anticipate that we will receive written confirmation from the State of California that no further onsite cleanup is necessary. Such confirmation would not rule out potential liability for regional groundwater contamination or alleged potable water supply contamination discussed below. If further onsite cleanup is required, the Company believes the cost, which the Company is not able to estimate, would be indemnified, without contest or material limitation, by companies that have fulfilled similar indemnity obligations to the Company in the past, and that the Company believes remain financially able to do so.
The facility is located within an area of regional groundwater contamination known as the Puente Valley “operable unit” (“PVOU”) of the San Gabriel Valley Superfund Site. The Company, along with many others, was named a potentially responsible party (“PRP”) for the regional contamination by the United States Environmental Protection Agency (“EPA”). The Company entered into a settlement with another PRP at the site, pursuant to which, in return for a payment the Company has already made and that was fully indemnified and paid by a second company, the other PRP indemnified the Company against most claims for PVOU contamination. The Company expects to enter into a consent decree with EPA and the other PRP that will resolve its liability for the cleanup of regional groundwater contamination without any payment by us to EPA. Depending on the scope and duration of the cleanup, the Company may be required to make further payments to the other PRP for regional groundwater remediation costs. The Company estimates the amount of any such additional payments would not exceed approximately $130,000. The estimate is based on component estimates for two distinct contaminants that may require remediation. Those estimates in turn are based on a number of assumptions concerning the likelihood that remediation will be required, the cost of remediation if required and other matters. Uncertainty in predicting these matters limits the reliability and precision of the estimates. The Company expects any such additional payments by the Company to be covered by indemnities given to the Company by other companies. Those companies may contest their indemnity obligation for these payments. The Company believes the companies are financially able to pay the liability. Because the Company believes it is not probable that it will be held liable for any of these expenses, the Company has not recorded a liability for such potential claims.
The Company is also one of approximately 25 parties considered potentially liable by a regional water authority for alleged contamination of two of that water authority’s wells. The Company is fully indemnified for this liability under a past settlement with a private company. The indemnity is not materially limited and the Company does not believe it would be contested. The Company believes it is financially able to pay the liability. Because the Company believes it is not probable that it will be held liable for any of these expenses, the Company has not recorded a liability for such potential claims for alleged contamination of the area’s potable water supply.
The Company’s liability for these contamination matters and related claims is substantially covered by third-party indemnities and resolved by prior settlements, and borne by prior operators of the facility, their successors and their insurers. The Company is attempting to recoup approximately $0.7 million in defense costs from one of these indemnitors. These costs have been expensed as paid by the Company and are not recorded in its condensed consolidated balance sheets.
10. GEOGRAPHIC INFORMATION
Geographic revenue information is based on the location of the customer. All of the Company’s assets are located in the United States. Net sales to external customers by geographic region are as follows (dollars in thousands):
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
Customer | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| | | | | | | | | | | | | |
| United States | | $ | 18,069 | | | $ | 16,521 | | | $ | 69,411 | | | $ | 63,787 | |
| Canada | | | 1,552 | | | | 1,451 | | | | 7,814 | | | | 4,776 | |
| Other | | | 185 | | | | 121 | | | | 403 | | | | 302 | |
| | | $ | 19,807 | | | $ | 18,093 | | | $ | 77,628 | | | $ | 68,865 | |
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General
This discussion should be read in conjunction with the Notes to Condensed Consolidated Financial Statements included herein and the Notes to Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our Annual Report on Form 10-K for the year ended December 31, 2006.
Overview of the Business
We are one of the fastest growing cosmetics companies of the ten largest in the U.S. mass market channel by retail sales. We specialize in developing and marketing innovative, premium-priced products for the mass market channel. Our products focus on addressing skin imperfections through a problem-solution approach, rather than focusing on changing fashion trends. Our products address specific, everyday cosmetics needs and include face powders, bronzers, concealers, blushes, foundations, eye shadows, eyeliners, brow makeup and mascaras.
We sell our products to mass market retailers such as Wal-Mart, Target, CVS, Walgreens and Albertsons. Our products provide above-average profitability for retailers due to their higher price points and sales per linear foot. Our products are currently sold in approximately 26,000 of the 49,000 stores in which we estimate our masstige competitors’ products are sold. We seek to be first-to-market with new products within this channel, and are able to take new products from concept development to shipment in less than 12 months. New products are a very important part of our business and have contributed, on average, approximately 38% of our net sales for the last three years.
Overview of U.S. Market Share Data
We define the masstige market as products sold in the mass market channel under the following premium-priced brands: Physicians Formula, Almay, L’Oreal, Max Factor, Neutrogena, Revlon and Vital Radiance. The following table sets forth the approximate market share, based on retail sales, of our products in total and for selected categories within the masstige market, as we define it, based on ACNielsen(1) data for the 52 weeks ended October 6, 2007:
| | 52 Weeks Ended October 6, 2007 |
| | Masstige ($ Share)(1) | | % Change vs. Prior Year ($ Sales)(1) |
| Total Company | 7.3% | | 13% |
| Face | 14.3% | | 17% |
| Eye | 4.9% | | -5% |
| | (1)ACNielsen is an independent research entity. ACNielsen data does not include Wal-Mart, which is our largest customer. |
Seasonality
Our business, similar to others in the cosmetic industry, is subject to seasonal variation due to the annual “sell-in” period when retailers decide on a plan for how much retail space will be allotted to each supplier and the number of new and existing products to be offered in their stores. We refer to these plans as "Plan-o-grams". For us, this period has historically been from December through April. Sales during these months are typically greater due to the shipments required to fill the inventory at retail stores and the retailers’ warehouses. Retailers typically reset their retail selling space during these months to accommodate changes in space allocation to each supplier and to incorporate the addition of new products and the deletion of slow-selling items. For example, our net sales for the three months ended September 30, 2006 were lower than our net sales for the first and fourth quarter of 2006, as a result of this seasonality. Our quarterly results of operations may also fluctuate as a result of a variety of other reasons including the timing of new product introductions, general economic conditions or consumer buyer behavior. In addition, results for any one quarter may not be indicative of results for the same quarter in subsequent years.
Critical Accounting Policies
Our condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America, which require management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Critical accounting policies represent the areas where more significant judgments and estimates are used in the preparation of our condensed consolidated financial statements. A discussion of such critical accounting policies, which include revenue recognition, inventory valuation, goodwill and other intangible assets, share-based compensation and income taxes can be found in our Annual Report on Form 10-K for the year ended December 31, 2006. Except for income taxes, there have been no material changes to these policies as of this Quarterly Report on Form 10-Q for the three and nine months ended September 30, 2007. The methodology applied to management’s estimate for income taxes has changed due to the implementation of a new accounting pronouncement as described below.
Effective January 1, 2007, we adopted the provisions of Financial Accounting Standards Board Interpretation No. (“FIN”) 48, Accounting for Uncertainty in Income Taxes. FIN 48 prescribes a more likely than not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Upon adoption of FIN 48 on January 1, 2007, we did not record any cumulative effect adjustment to retained earnings.
Results of Operations
The following table sets forth our condensed consolidated statements of income for the three and nine months ended September 30, 2007 and 2006:
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2007 | | | 2006 | | | 2007 | | | 2006 | |
| | | | | | | | | | | | | |
| | | (dollars in thousands, except per share data) | |
Statement of Income Data: | | | | | | | | | | | | |
| Net sales | | $ | 19,807 | | | $ | 18,093 | | | $ | 77,628 | | | $ | 68,865 | |
| Cost of sales | | | 10,085 | | | | 8,449 | | | | 35,108 | | | | 29,826 | |
| Gross profit | | | 9,722 | | | | 9,644 | | | | 42,520 | | | | 39,039 | |
| Selling, general and administrative expenses | | | 8,902 | | | | 7,540 | | | | 34,467 | | | | 26,820 | |
| Income from operations | | | 820 | | | | 2,104 | | | | 8,053 | | | | 12,219 | |
| Interest expense-net | | | 370 | | | | 1,945 | | | | 1,086 | | | | 5,457 | |
| Other income | | | (24 | ) | | | (32 | ) | | | (78 | ) | | | (35 | ) |
| Income before income taxes | | | 474 | | | | 191 | | | | 7,045 | | | | 6,797 | |
| Provisions (benefit) for income taxes | | | 372 | | | | (32 | ) | | | 3,164 | | | | 2,527 | |
| Net income | | $ | 102 | | | $ | 223 | | | $ | 3,881 | | | $ | 4,270 | |
| Net income per common share: | | | | | | | | | | | | | | | | |
| Basic | | $ | 0.01 | | | $ | 0.02 | | | $ | 0.28 | | | $ | 0.41 | |
| Diluted | | $ | 0.01 | | | $ | 0.02 | | | $ | 0.27 | | | $ | 0.37 | |
| Weighted-average common shares outstanding: | | | | | | | | | | | | | |
| Basic | | | 14,011,041 | | | | 10,421,916 | | | | 13,935,389 | | | | 10,399,331 | |
| Diluted | | | 14,553,130 | | | | 11,614,506 | | | | 14,566,860 | | | | 11,603,042 | |
The following is a discussion of our results of operations for the three and nine months ended September 30, 2007 and 2006.
Three Months Ended September 30, 2007 Compared to Three Months Ended September 30, 2006
Net Sales. Net sales increased $1.7 million, or 9.4%, to $19.8 million for the three months ended September 30, 2007, from $18.1 million for the three months ended September 30, 2006. The increase was primarily attributable to growth in sales of our face makeup products, as we continued to broaden our total distribution. Total distribution represents the number of stores in which we sell products multiplied by our number of stock keeping units per store. Unit sales for our face makeup increased by 0.4 million units, or 13.3%, to 3.4 million units for the three months ended September 30, 2007 from 3.0 million units for the same period a year ago. New products represented 22% of our net sales for the three months ended September 30, 2007, 11% lower than the same period a year ago, when new products contributed 33% of net sales. Partially offsetting our net sales growth for the three months ended September 30, 2007 was a decrease in sales of our eye makeup products and an increase in trade spending with retailers. Unit sales for our eye makeup decreased by 0.6 million units, or 35.3%, to 1.1 million units for the three months ended September 30, 2007 from 1.7 million units for the same period a year ago. Trade spending with retailers increased by $2.4 million, which includes an increase in cooperative advertising expense of $2.0 million and an increase in our provision for markdowns of $0.3 million. The variance is primarily due to management's strategic decision to increase trade spending with retailers for in-store advertising and promotions to increase consumer retail sales. During the three months ended September 30, 2007, our results included net sales of $1.7 million from our international customers, compared to $1.6 million for the three months ended September 30, 2006.
Cost of Sales. Cost of sales increased $1.6 million, or 18.8%, to $10.1 million for the three months ended September 30, 2007, from $8.5 million for the three months ended September 30, 2006. The increase in cost of sales resulted primarily from a change in product mix as volume of higher cost products increased when compared to the same period a year ago. Cost of sales as a percentage of net sales was 50.9% of net sales for the three months ended September 30, 2007, compared to 46.7% for the three months ended September 30, 2006. The increase in cost of sales, as a percentage of net sales, was primarily due to the impact of higher trade spending with retailers in an effort to increase consumer retail sales.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by $1.4 million, or 18.7%, to $8.9 million for the three months ended September 30, 2007, from $7.5 million for the three months ended September 30, 2006. The increase was primarily due to a $1.3 million increase in fixed costs that included a $0.6 million expense for stock option awards, a $0.4 million increase in employee compensation associated with our growth, a $0.2 million increase in distribution costs related to our growth, as well as an increase in accounting and other expenses associated with being a public company.
Interest Expense-Net. Interest expense decreased by $1.5 million, or 78.9%, to $0.4 million for the three months ended September 30, 2007, from $1.9 million for the three months ended September 30, 2006. The decrease in interest expense was due to the decrease in average borrowings outstanding under our credit facility as we repaid all borrowings under our former senior credit agreement with the net proceeds of the initial public offering and borrowings under our senior credit agreement.
Other Income. Other income decreased by $8,000, or 25.0%, to $24,000 for the three months ended September 30, 2007, from $32,000 for the three months ended September 30, 2006. Other income for the three months ended September 30, 2007 and 2006 was attributable to realized and unrealized gains related to investments held as part of our non-qualified deferred compensation plan.
Provision (Benefit) for Income Taxes. The income tax expense for the three months ended September 30, 2007 was $372,000 compared to an income tax benefit of $32,000 for the three months ended September 30, 2006. The effective rates differed from the statutory rates due to the effect of varying state and local taxes, the impact of the change in the deferred carrying rate and certain permanent items such as tax benefit deficiencies on stock options exercised, extra-territorial income exclusion, and research and development credits.
Nine Months Ended September 30, 2007 Compared to Nine Months Ended September 30, 2006
Net Sales. Net sales increased $8.7 million, or 12.6%, to $77.6 million for the nine months ended September 30, 2007, from $68.9 million for the nine months ended September 30, 2006. The increase was primarily attributable to growth in sales of our face makeup products, as we continued to broaden our total distribution. Total distribution represents the number of stores in which we sell products multiplied by our number of stock keeping units per store. Total unit volume increased by 1.6 million units, or 9.2%, to 18.9 million units for the nine months ended September 30, 2007 from 17.3 million units for the same period a year ago. New products represented 37% of our net sales for the nine months ended September 30, 2007, 1% lower than the same period a year ago, when new products contributed 38% of net sales. Partially offsetting our net sales growth for the nine months ended September 30, 2007 was an increase in trade spending with retailers of $12.4 million, which includes an increase in cooperative advertising expense of $6.1 million and an increase in coupon expense of $0.5 million, as well as an increase in our provision for markdowns of $3.0 million and an increase in our provision for returns of $2.3 million. The variance in cooperating advertising expense and coupon expense is primarily due to management's strategic decision to increase trade spending with retailers for in-store advertising and promotions in an effort to increase consumer retail sales. The variance in our provision for markdowns is primarily due to retailers resetting their Plan-o-grams, including changing their wall displays during the nine months ended September 30, 2007. The variance in our provision for returns is due to higher returns resulting from our retailer customers' wall display changes. During the nine months ended September 30, 2007, our results included net sales of $8.2 million from our international customers, compared to $5.1 million for the nine months ended September 30, 2006.
Cost of Sales. Cost of sales increased $5.3 million, or 17.8%, to $35.1 million for the nine months ended September 30, 2007, from $29.8 million for the nine months ended September 30, 2006. The increase in cost of sales resulted primarily from an increase in volume for the nine months ended September 30, 2007. Cost of sales as a percentage of net sales was 45.2% for the nine months ended September 30, 2007, compared to 43.3% for the nine months ended September 30, 2006. The increase in cost of sales, as a percentage of net sales, was primarily due to the impact of higher trade spending with retailers in an effort to increase consumer retail sales, including cooperative advertising expense and coupon expense, as well as an increase in our provision for markdowns.
Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by $7.7 million, or 28.7%, to $34.5 million for the nine months ended September 30, 2007, from $26.8 million for the nine months ended September 30, 2006. The increase was primarily due to a $1.3 million increase in marketing spending and a $5.7 million increase in fixed costs that included a $1.9 million increase in employee compensation associated with our growth, a $1.5 million expense for our stock option awards, a $0.7 million expense for transaction fees associated with the secondary public offering, a $0.5 million increase in distribution costs related to our growth, as well as an increase in accounting and other expenses associated with being a public company. In addition, there were higher costs associated with increased sales volumes, including a $0.6 million increase in outbound freight costs.
Interest Expense-Net. Interest expense decreased by $4.4 million, or 80%, to $1.1 million for the nine months ended September 30, 2007, from $5.5 million for the nine months ended September 30, 2006. The decrease in interest expense was due to the decrease in average borrowings outstanding under our credit facility as we repaid all borrowings under our former senior credit agreement with the net proceeds of the initial public offering and borrowings under our senior credit agreement.
Other Income. Other income increased by $43,000 to $78,000 for the nine months ended September 30, 2007, from $35,000 for the nine months ended September 30, 2006. Other income for the nine months ended September 30, 2007 and 2006 was attributable to realized and unrealized gains related to investments held as part of our non-qualified deferred compensation plan.
Provision (Benefit) for Income Taxes. The income tax expense for the nine months ended September 30, 2007 was $3.2 million, representing an effective income tax rate of 44.9%, compared to income tax expense of $2.5 million, representing an effective income tax rate of 37.2%, for the nine months ended September 30, 2006. The effective rates differed from the statutory rates due to the effect of varying state and local taxes, the impact of the change in the deferred carrying rate and certain permanent items such as tax benefit deficiencies on stock options exercised, extra-territorial income exclusions, research and development credits and certain transaction fees associated with the secondary public offering.
Liquidity and Capital Resources
Cash Flows
As of September 30, 2007, we had $56,000 in cash and cash equivalents compared to $26,000 in cash and cash equivalents as of December 31, 2006. The low level of cash reflects the use of cash to pay down the revolving credit facility on a regular basis. As of September 30, 2007, we had $13.2 million of availability under our revolving credit facility. The significant components of our working capital are accounts receivable and inventories, reduced by accounts payable and accrued expenses.
Operating activities. Cash provided by operating activities decreased $3.2 million, or 48.5%, to $3.4 million for the nine months ended September 30, 2007, from $6.6 million for the nine months ended September 30, 2006. The net decrease in cash provided by operating activities resulted primarily from unfavorable changes in working capital such as inventory, accounts payable and accrued expenses. The net decrease in cash provided by operating activities was offset by favorable changes in accounts receivable. Inventory increased by $4.7 million when compared to prior year end due to lower than expected unit sales resulting from a softer consumer spending environment. Our inventory turnover rate decreased slightly to an annualized 1.9 times per year for the nine months ended September 30, 2007, from an annualized 2.1 times per year for the nine months ended September 30, 2006. Days sales outstanding decreased by 1 day, to 45.9 days for the nine months ended September 30, 2007 from 46.9 days for the nine months ended September 30, 2006.
Investing activities. Cash used in investing activities for the nine months ended September 30, 2007 was $1.6 million, which was related to capital expenditures for the replacement of machinery and equipment, the automation of an assembly line to accommodate future growth and improvements to our warehouse distribution systems. Cash used in investing activities for the nine months ended September 30, 2006 of $528,000 was related to capital expenditures for the replacement and upgrade of machinery and equipment.
Financing activities. Cash used in financing activities was $1.8 million for the nine months ended September 30, 2007 compared to cash used in financing activities of $6.1 million for the nine months ended September 30, 2006. The decrease in cash used in financing activities between periods primarily resulted from lower debt service related to our long-term debt, as well as prior year repayments of our revolving credit facility.
Future Liquidity and Capital Needs. The significant components of our working capital are accounts receivable and inventory, reduced by accounts payable and accrued expenses. Net working capital requirements increased by $13.2 million, or approximately 132%, to $23.2 million in the nine months ended September 30, 2007, from $10.0 million in the nine months ended September 30, 2006. We anticipate that working capital will increase during the fourth quarter of 2007, when we typically experience higher inventory levels as we produce new products for shipment in the first quarter of the following year. We have budgeted capital expenditures of $2.5 million for 2007, compared to $1.0 million in 2006, for several key projects, including completion of our automated assembly line, investment in our information technology infrastructure and improvements to our warehouse distribution systems. Capital requirements related to manufacturing include a major project to automate a product assembly line that is used to assemble products representing approximately 44% of our net sales in 2006. We expect this to add approximately $800,000 of a $1.1 million project to our normal level of capital expenditures in 2007, of which $300,000 was incurred in 2006 and $462,000 was incurred during the nine months ended September 30, 2007. We have completed the replacement of our IBM AS/400 mainframe computer to accommodate future growth at a cost of approximately $0.3 million. Further, we are implementing improvements to our warehouse distribution systems at a cost of approximately $0.5 million we expect to incur during the fourth quarter of 2007. We believe that our cash flows from operations and funds from our revolving credit facility will provide adequate funds for our working capital needs and planned capital expenditures for at least the next twelve months. No assurance can be given, however, that this will be the case.
Credit Facilities
On November 14, 2006, we entered into a senior credit agreement with a bank that will terminate in 2011 and consists of a $15.0 million term loan facility and a revolving credit facility providing for borrowings of up to $20.0 million. At September 30, 2007, there was $6.8 million outstanding under the revolving credit facility at an interest rate of 8.25% and we had $13.2 million of availability under the revolving credit facility. The interest rate on the term loan was 7.5% at September 30, 2007. The availability under the revolving credit facility is reduced by outstanding letters of credit. There were no outstanding letters of credit as of September 30, 2007.
We used the borrowings under our senior credit agreement and a portion of the net proceeds of our initial public offering to repay borrowings and accrued interest under our former senior credit agreement. Borrowings under our senior credit agreement are guaranteed by Physicians Formula Holdings, Inc. and the domestic subsidiaries of Physicians Formula, Inc., and borrowings under our senior credit agreement are secured by liens on substantially all of the assets of Physicians Formula, Inc., including the assets of its subsidiaries. Amounts outstanding under the term loan facility totaled $13.9 million at September 30, 2007. Payments under the term loan facility are due quarterly, increasing from initial quarterly payments of $375,000 to $562,500 as of December 31, 2007, $750,000 as of December 31, 2008, $937,500 as of December 31, 2009 and $1,125,000 as of December 31, 2010. Quarterly payments of $375,000 were made on January 1, 2007, April 2, 2007, July 16, 2007 and October 2, 2007.
Amounts outstanding under the term loan facility and the revolving credit facility bear interest at a LIBOR Adjusted Rate (as defined in our senior credit agreement) plus 2.0% or at a Base Rate (as defined in our senior credit agreement) plus 0.5%. The revolving credit facility is also subject to a commitment fee of 0.25% on any unused commitments.
Our senior credit agreement contains the following financial covenants: a maximum total leverage ratio; a minimum fixed charge coverage ratio; a minimum net worth requirement; and a limitation on capital expenditures (which may be no more than $3,000,000 per fiscal year). As of September 30, 2007, we were in compliance with these covenants.
Our senior credit agreement contains certain additional negative covenants, including limitations on the ability of Physicians Formula, Inc., our operating subsidiary, to incur other indebtedness and liens; fundamentally change its business through a merger, consolidation, amalgamation or liquidation; sell assets; pay cash dividends or pay for expenses of Physicians Formula Holdings, Inc., unless certain conditions are satisfied; make certain acquisitions, investments, loans and advances; engage in transactions with our affiliates; enter into certain agreements; engage in sale-leaseback transactions; incur certain unfunded liabilities; and change our line of business.
Our senior credit agreement requires us to make mandatory prepayments with the proceeds of certain asset dispositions and upon the receipt of insurance or condemnation proceeds to the extent we do not use the proceeds for the purchase of satisfactory replacement assets.
Off-Balance Sheet Transactions
We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts that rely on estimation techniques to calculate fair value. As such, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had engaged in such relationships.
Forward-Looking Statements
This section and other parts of this Quarterly Report on Form 10-Q contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended. In some cases, forward-looking statements can be identified by words such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” and similar terms. Such forward-looking statements are based on current expectations, estimates and projections about our industry, management’s beliefs and assumptions made by management. Forward-looking statements are not guarantees of future performance and our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to those discussed in Part I, Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006. Unless otherwise required by law, we expressly disclaim any obligation to update publicly any forward-looking statements, whether as result of new information, future events or otherwise.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
(a) Foreign Currency Risk.
The Company sells to Canadian customers in Canadian dollars and pays overseas suppliers and third-party manufacturers in U.S. dollars. An increase in the Canadian dollar relative to the U.S. dollar could result in lower net sales and higher selling, general and administrative expenses. Further, a decrease in the value of the euro and the Chinese yuan relative to the U.S. dollar could cause our suppliers to raise prices that would result in higher cost of sales. The volatility of the applicable rates and prices are dependent on many factors that cannot be forecasted with reliable accuracy. Our current sales to Canadian customers and reliance on foreign suppliers for many of the raw materials and components used to produce products make it possible that our operating results may be affected by fluctuations in the exchange rate of the currencies of our customers and suppliers. We do not have any foreign currency hedges.
(b) Interest Rate Risk.
We are exposed to interest rate risks primarily through borrowings under our revolving loan and term loan facilities. Interest on these borrowings is based upon variable interest rates. Our weighted-average borrowings outstanding under our revolving loan and term loan facilities during the nine months ended September 30, 2007, was $18.2 million and the weighted-average interest rate in effect at September 30, 2007, was 7.75%. A hypothetical 1% increase or decrease in interest rates would have resulted in an $137,000 change to interest expense for the nine months ended September 30, 2007.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in its reports pursuant to the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Rule 13a-15 under the Exchange Act, and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Management is responsible for establishing and maintaining adequate internal control over financial reporting.
As required by Rule 13a-15(b) under the Exchange Act, the Company carried out an evaluation, under the supervision and with the participation of its management, including the Chief Executive Officer and the Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the foregoing, the Company's Chief Executive Officer and Chief Financial Officer determined that disclosure controls and procedures were effective at a reasonable assurance level as of the end of the period covered by this report.
There has been no change in internal controls over financial reporting during the most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, internal controls over financial reporting.
OTHER INFORMATION
The Company is involved in various lawsuits in the ordinary course of business. In management’s opinion, the ultimate resolution of these matters will not result in a material impact to the Company’s condensed consolidated financial statements.
There have been no material changes to our risk factors as disclosed in Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006.
Exhibit Number | | | | Description |
| 31.1 | | Certification by Ingrid Jackel, Chief Executive Officer. |
| 31.2 | | Certification by Joseph J. Jaeger, Chief Financial Officer. |
| 32.1 | | Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2 | | Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | Physicians Formula Holdings, Inc. |
| | | /s/ Ingrid Jackel |
| Date: November 12, 2007 | | By: Ingrid Jackel |
| | | Its: Chief Executive Officer (principal executive officer) |
| | | /s/ Joseph J. Jaeger |
| Date: November 12, 2007 | | By: Joseph J. Jaeger |
| | | Its: Chief Financial Officer (principal financial officer) |
| | | |
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