Cosmetics IPO: Highlights from Physicians Formula's S-1 Filing

Physicians Formula Holdings, a developer of cosmetics for the mass market, filed recently for a Nasdaq IPO. Below are highlights from the filing; all excerpts are from the company's S-1:

Proposed Ticker: (PHYS)

Underwriters: Deutsche Bank, Citigroup, Banc of America, Cowen, Piper Jaffray

Maximum Offering: $115 million

History: The brand was established in 1937 by allergist Dr. Crandall for his wife; Pierre Fabre Dermo-Cosmetique, a French pharma company, acquired the brand in 1990. In November 2003, Summit Partners and affiliated entities together with management completed an MBO of the company.

Business Overview:

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, unlike competitors whose products focus primarily on changing fashion trends. Our products address specific, everyday cosmetics needs and include face powders, bronzers, concealers, blushes, foundations, eye shadows, eye liners, 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. As of June 30, 2006, our products were sold in approximately 23,200 of the 45,000 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 30% of our net sales for the last three years.

Cosmetics Industry

The beauty care industry, which includes cosmetics, skin care products, fragrances, hair care products and sun care products, generated retail sales of $159.9 billion globally and $31.8 billion in the U.S. in 2004, based on Euromonitor data. Cosmetics, which include face makeup, eye makeup, lip products and nail products, generated retail sales of $8.1 billion in the U.S. in 2005, reflecting a 3.1% compounded annual growth rate since 2000, based on Euromonitor data. We compete primarily in the face makeup and eye makeup cosmetics categories. Face makeup and eye makeup comprised $2.8 billion and $2.5 billion in retail sales in 2005, respectively, reflecting compounded annual growth rates since 2000 of 3.0% and 5.9%, respectively.

Financial Highlights The company grew revenues 26% from $62.3 million in 2004 to $78.7 million in 2005. Cost of sales grew 30% in this period to $32 million. For the first six months of the year, revenue grew 17.8% from $43.1 million to $50.8 million in Q1 06; cost of sales increased 25.8% in the period. The company puts all OPEX into an SG&A category (surprisingly no R&D as a separate category). For 2004, the company's net income was $4.2 million growing to $7.8 million in 2005. In the first half of the year, net income dropped from $5 million in 2005 to $4 million in 2006.

At the end of June, the company had $62 million of long term debt, and $19k of cash. From the S-1, "The low level of cash reflects an increase in working capital requirements largely due to the growth of our business, higher debt service payments related to the Recapitalization and the use of cash to pay down the existing revolving credit facility on a regular basis. As of June 30, 2006, we had $10.2 million of availability under the existing revolving credit facility." On top of the long term debt, the company has $4.8 million of a revolving credit facility.

Customers: As of the end of June, the company's products were sold in 23,000 stores in the US through 70 retailers, with the top four customers (WalMart, CVS, Walgreens, and Target) contributing 66% of total sales for the year.

Use of Proceeds: The company plans to use the IPO to repay debt ($20.4 million of senior subordinated notes, $4.8 million of revolving credit borrowings and $39.7 million outstanding under a term loan facility); the rest is for general corporate purposes. After the offering, the company will execute a new senior credit agreement including a $15.0 million term loan facility and a revolving credit facility providing for borrowings of up to $20.0 million.

Competition: In the market segment in which the company operates are the following key competitors: L'Oreal (traded in Paris, and in an OTC listed ADR), Revlon (REV), Procter and Gamble (PG) through the Max Factor brand and Johnson & Johnson (JNJ) through the Neutrogena brand.

Management:

Ingrid Jackel has served as our Chief Executive Officer since August 2006 and as our Senior Vice President—Marketing from April 2003 to August 2006. Ms. Jackel oversees all aspects of our marketing, research and development and quality control functions. Ms. Jackel joined Pierre Fabre in the U.S. in 1994 and served in a variety of management roles, including Vice President of Marketing for Physicians Formula from May 1998 to March 2003 and Director of Marketing for Physicians Formula from July 1997 to April 1998. Prior to joining Physicians Formula in 1995, Ms. Jackel served in a variety of marketing management roles in the U.S. and France for cosmeceutical brands such as Avene, Elancyl and Aderma of the Pierre Fabre group. Ms. Jackel was awarded the Women's Wear Daily prize for the "most innovative marketer of the year" in mass market cosmetics in 2003.

Ownership: Summit Partners is the largest shareholder with 76.8% of the company; the CEO holds 1.6%. Following the MBO, Pierre Fabre transferred its shares (currently 17.3%) to an entity called Cofilance.

Noteworthy
Seasonality: The company notes in its S-1 that seasonality is a major factor in the cosmetics industry:

Our business, similar to others in the cosmetic industry, is subject to seasonal variation due to the annual "sell-in" period when retailers decide how much retail space will be allotted to each supplier and the number of new and existing products to be offered in their stores. 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 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.

Lack of Research and Development? The company does not break out R&D as a separate expense; while this is a key component of the business, it appears to be industry standard (for comparison's sake, Revlon does not either). However, as a company which prides itself in product innovation, one would expect to see more than the approximately half of a percentage point currently allocated to R&D.