Parlux Fragrances: The Turnaround Begins

Parlux Fragrances (PARL) has been both a financial and emotional roller coaster for investors from 2004 to the present. Shares began in 2004 under $3 (split adjusted) and proceeded to rocket to a high of over $19 per share in early 2006 before falling back below $3 in August 2007. Today, shares trade at approximately $4.60 per share after bouncing off a recent low below $3. Various factors contributed to the decline in share price including: Sarbanes-Oxley compliance issues, negative publicity regarding the former CEO, failure to enter into new license agreements, significant insider stock sales, the sale of its Perry Ellis brand perfume and most importantly declining financial performance (which has recently improved – more on that later).

In August 2006, Glenn Nussdorf (a major investor in PARL customer Perfumania) requested (and subsequently received) permission to purchase 15% of PARL's outstanding common stock. Shortly thereafter, Nussdorf began an activist shareholder leading to the ouster of then CEO Ilia Lekach and the installation of Neil Katz as Chairman and CEO in May 2007. For more details on this wild saga, interested readers should review the most recent 10-K.

There is no doubt that the fall has been mighty and mighty ugly along the way, as evidenced by the fiscal 2007 operating loss of $43.2 million. However, this writer believes that the decline in share price has been too severe. More importantly, PARL shares appear to be a very interesting turnaround investment opportunity. At current prices, PARL has a market cap of $86 million which is $22 million or 20% below the $108 million book value reported in the most recent 10-Q. More importantly, many signs of a turnaround have begun to emerge including:

• Dramatic cuts in SG&A costs. Management has indicated that PARL will save $500k on a change in auditors and $2.0 million from moving its distribution center from FL to NJ. Review of the recent June 30, 2007 10-Q reveals operating income of $368,000 and essentially a breakeven first quarter of fiscal 2008. This dramatically improved performance was achieved primarily through cost reductions including: advertising and general/administrative costs that have been reduced from an annual run rate of $8.7 million and $5.0 million, respectively. Combined with the savings from the distribution center and change in auditors, it appears that annual reductions in excess of $16 million of operating costs are very possible if not likely. While on the surface this amount may seem aggressive, consideration must be given to the elimination of certain related party transactions with entities owned or affiliated with the former CEO as a contributing factor to the cost reductions.

• Improvement in gross margin. Historically, PARL's gross margins were 52% in 2005 and 58% in 2006 before declining to 43% in 2007 (PARL's fiscal year ends March 31st). The recent June 30, 2007 10-Q reveals a 51% gross margin. This improvement seems to signal a return to pre-2007 higher margins more typical in the industry. A return to a 52% gross margin would have improved 2007's r esults by approximately $11.5 million.

• New License Agreements. PARL recently announced agreements to market Nicole Miller (fashion designer) and Jessica Simpson branded perfumes. Initial shipments of Nicole Miller perfume will begin in the upcoming December (third) quarter. Jessica Simpson branded perfume shipments will begin next year. Additionally, Katz has promised an additional license agreement in the near future. These agreements should serve to increase and diversify the current revenue stream over the current base primarily comprised of Paris Hilton and Guess branded products. While it is always very difficult to estimate revenues and profit contribution from new brands, both Jessica Simpson and Nicole Miller branded products are in the marketplace at present and demand exists for the products. While a wide range of possibilities exists for these three new products ranging from failure to in excess of $100 million in revenues, an estimate of $50 million in additional revenues and an operating income contribution of $15 million could be achievable.

In order to project where PARL share price could go as a result of these initiatives, it is first worthwhile to project where PARL financial performance is headed. In analyzing 2007 results, it is important to note that the $43.2 million net loss includes a non-recurring $18.9 million of stock based compensation (non-cash) charge related to a revision to terms of warrants/options. After excluding this nonrecurring item, the operating loss falls to $24.3 million. Next, starting with the recast 2007 operating loss of $24.3 million and adding (i) the $16 million estimate of SG&A cost savings, (ii) the $11.5 million in gross margin improvement and (iii) the estimate operating income from new brands of $15 million, recast operating income would be $18.2 million.

So where does this put PARL's share price? Based on a conservative multiple of 10 times operating income, the earnings stream of PARL would be valued at $182 million. Adding the book value of $108 million to the $182 million would yield a projected market cap of $290 million which would result in a share price of $15.26 (based on 19 million outstanding shares). Is this a stretch? One can never be certain in a turnaround situation. While there is no doubt that risks remain in shares of PARL (concentration of sales to Perfumania and within the Paris Hilton, Guess and new brands, risk of US recession, etc. to name a few), downside risk (remember shares are trading below book value) seems to be significantly outweighed by upside potential.

Disclosure: Author has a long position in PARL