Description

Parlux is a ‘turned around’ prestige fragrance company that offers a compelling value opportunity.  The company currently trades at 6.5x forward earnings (only one street analyst, at $.45 for year ended 3/10) , and .53x book.  Parlux markets prestige fragrances under the Paris Hilton, Nicole Miller, Jessica Simpson and Guess brands among others

Simple business, simple thesis, compelling opportunity.  I don’t know when things will turn (ie investors realizing this is not the end of the world), and neither do you, but I am confident you will at least double your money in PARL when that time comes. While I understand everyone has a long list of such stocks, PARL’s rock solid balance sheet and proven mgmt team give me the comfort needed to put capital to work in this environment. Additionally, with their share repurchase program, investors are getting “paid to wait”. 

A quick look at the numbers, at a current price of $2.92, s/o of roughly 21M, true net cash of roughly $20M ( and I am being conservative regarding the cash, it is more likely $25M, and it is a true number left at the end of their annual working capital cycle which is March quarter) And mgmt has said they will not need to draw down their revolver at any point during this fiscal year, truly a self financing business.  So you are paying roughly $41M for the business that continues to grow despite week end markets. (10% growth for the first 6 months of fiscal year)

Regarding valuation, I believe PARL’s book value of $5.53 is very accurate, the CEO has cleaned up the legacy inventory issues, and in fact, earlier this year the company had trouble meeting shipments as they had too few inventory on hand. As for the receivables, while worth watching the health of these customers, at this point I do not know of any major customers who are causing issues, and the company’s product continues to be bright spot selling well at Macy’s, etc.

From an earnings perspective, based on published estimates, the company sells at 6.5 PE on 3/10 numbers, before taking out a third of the enterprise value in cash. I look at another way. Mgmt has a goal of reaching $300M in sales, though they are not specific on when. They state they have the infrastructure in place today to handle these sales, and thus op leverage should follow. They believe pre-tax margins ( in a normal world) could be up to 13-14% percent. I believe that at some point during the next 12-18 months you will be looking forward at a company doing $300M in sales (Paris, Jessica, Guess, Marc Ecko, Natori, Nicole Miller, Queen Latifah, etc. And they continue to work on new licenses)  and being conservative, assume 10% pretax margin, that gets you to $1.50 per share in pre tax earnings, not far away from the $1.92 per share the company net of cash sells for in the market today. Now admittedly, I am quite high on Neil Katz and his team and believe they will achieve this as long as the world doesn’t come apart. Others may be less confident. But when you look at the book value, the cash, the repurchase program, mgmt’s proven past in building Liz Claiborne’s fragrance business, the potential earnings power, and the progress and rational behavior of mgmt so far, I think you can find much comfort in today’s valuation, from a variety of perspectives.  When you think about the margins, note they are spending a fortune on advertising to launch new fragrances (Jessica Simpson) and current expenses are temporarily inflated do to lease expense on old facility and legacy Paris Hilton issues (handbags, sunglasses, cosmetics, license fees) which go away over time.   

The previous management team were good entrepreneurs but not prepared to run a maturing public company, and made some grievous errors, and was replaced by proxy fight in early 2007.  The reorganized company is led by Neil Katz, an experienced CEO, who built The Liz Claiborne prestige fragrance division.

Previous management left the company with several major problems including;

(i)                  material weaknesses in accounting and less than perfect cash controls;

(ii)                late filings (10Q and 10K) and a potential de-listing;

(iii)               $3.4 (2% of sales) in royalty obligations they were paying, but on which they are not realizing revenue;

(iv)              A materially damaged relationship with Guess, a key brand;

(v)                large amounts of badly selected inventory (eventually classified as non current);

(vi)              a fully drawn revolver (35MM) and a working capital shortage

(vii)             0% operating margin compared to 10-12% for similar businesses

The new management has made significant progress on all of these.  Material weaknesses have been resolved, filings are up to date and audited, progress has been made in shedding the unused licenses to third parties, the guess relationship has been mended, inventory is cleaned up, the company has a net cash position, and operating margins are on a 6-8% run rate. 

Management has signed five new licenses with Nicole Miller, Jessica Simpson, Queen Latifah, and Natori and Mark Ecko.  We have done the work on the celebrity fragrances, and believe that they are sustainable in the foreseeable future.  Natori is a high fashion fragrance with limited, by high end distribution (Bloomingdales, Bergdorf) and provides highly profitable entry into those channels.  I

Celebrity Fragrances

(i)                  Paris Hilton represents approximately 100MM of sales, and has been wildly successful over the last three years.  The line includes 7 scents, Paris Hilton men and women, Heiress men and women, Just Me men and women, and Can Can for women.  Several key events have taken place in the last year regarding the brand that have helped sell through.  In December, the company launched Can Can.  The advertising and promotion including PR were handled by the new management and represents an important litmus test as this was the first time they had executed on this platform.  The spending at the time was material ~4MM, but there was excellent execution, and the demand for all of the products, not just the new launch increased through the holidays and into 2008.  It is fair to say that this brand will grow slightly into the new year as they remain a “front case” brand for the department stores.  Including annual launches (at much less cost) for the next few years will maintain the brand into the near future.  Given the success over a multi year period, and confirmations with various industry buyers that the brand has proven sticky, it is unlikely that the line will have a prompt, and material decrease in sales over the next 5 years. 

(ii)                Jessica Simpson is a newly licensed client of Parlux.  She is adding a fragrance to her portfolio of consumer products, and PARL was selected to manage the introduction early in 2007.  It is relevant to note that her brand manager is Vince Camuto, the co-founder of Nine West.  Mr. Camuto is a respected industry participant, and it is a testament to Neil Katz that in the midst of much uncertainty with the company (proxy fight, balance sheet issues, recent management change) he was able to sign the brand.  In summer 2008, her fragrance will launch with spending on the order of 1-2MM.  It will likely be ready for the back to school market, and into the holiday shipments in early September.  The brand will offer the potential for 15-20MM in sales, on an annualized basis.  Indications of demand for the product among the department stores are strong going into the launch. 

(iii)               Maria Sharapova offers a very small fragrance line through the company.  I estimate that this product offers approximately 1-2MM of sales and is likely breakeven after the small marketing expenses and royalties.  I believe it is unlikely that the company will renew the license when it expires in approximately 1 year

(iv)              Andy Roddick offers a similarly small fragrance line through the company.  Sales are likely less than 500k, and are breakeven after royalties.  Similar to the Maria line, the company is unlikely to resign the license when it expires in one year.

Prestige Fragrances

(i)                  Guess fragrances are approximately 50MM of sales, and represent the largest fashion brand.  It is very important to note some history with this brand to better understand the improvements that have been made, and the future potential.  The previous CEO of the company materially overbought product for this brand (bottles caps etc to the tune of many millions of dollars).  He had been overselling the perfume in violation of agreements overseas, at lower margins, and it was being re-imported to the US in the gray market.  This is obviously very disruptive to a company like Guess who has strict brand management policies etc.  The relationship between the two companies was stressed to a breaking point by the time the new management team arrived.  The Marciano brothers (Guess founders) wanted to pull the contract which would have left PARL with at least 20MM of unusable inventory on an equity base of 110MM.  In addition it would have materially impacted sales and the future potential of the company.  The new management has over the last year patched the relationship, and beginning in limited quantities to ship internationally after shutting this part of the business down for several months.  There is strict brand control, and Guess has demonstrated that they have no intention to distance themselves from Parlux.  This brand has 4 major products, two for men and two for women.  Most recently in March 2008 Guess by Marciano which is marketed as a more upscale fragrance than the other Guess products was introduced and preliminary sales checks have indicated excellent acceptance.  The women’s version will begin shipping next year.  The fragrances are sold in department stores, and the Guess stand alones.  The business has the potential to reach a steady 70MM sales run rate over time in the near future. 

(ii)                Nicole Miller, the fashion designer, is a recently licensed product.  The company is producing the fragrance for a fall launch, and will be distributing it at higher level stores such as Bloomingdale’s and Nordstrom’s.  It is important to note that the fall launch is for a new fragrance under her name, and differs from a previously discontinued fragrance that was produced for under the same name over approximately five years ago by another company.  The management made a very clever choice with this license as they found through research that here was pent up demand for her discontinued line.  They licensed the brand under very good terms, and immediately turned around and made a limited run of the previous fragrance, selling it in the last fiscal calendar quarter.  Based on the limited marketing spend It is likely that they recouped much of the initial costs of the licensing and development through this maneuver.  T is likely that the newly launched brand will do 8MM to 10MM of sales in the first full year. 

(iii)               Oceans Pacific or “OP” as it is known is a license that the company owns that has had limited to no production over the past several years.  In a recent development however, the branding company Iconix has acquired the remaining product licenses under the same name from a separate owner.  They have announced publicly that Wal-Mart will be using the OP brand for a new line.  It is likely that the fragrance will be used as part of this campaign, and may lead to 4-5MM of sales late in the year. 

Customers

The company has several categories of customers.  A major consideration is international versus domestic.  International customers are sold through distributors, and domestic customers are sold directly.  International customers do not require that the products offer put back arrangements, or co-promotion dollars.  For international sales, one should assume 25-30% gross margin.  Domestic sales are different in that they go to both department stores, and retail chains such as Perfumanina.  The department stores commonly require put back options on most purchases and co-promotion dollars for in store activities, domestic pricing allows gross margins of 55-60%. 

Perfumania is a large customer for the company, however the company now longer owns any of the ECOM’s equity (parent company).  Management has also made a point of reducing the dependence on them as a distribution point.  Increased international distribution and growth at new department stores in the US has helped, and continued to improve the mix. 

We are pleased to see tha the company is diversifying their channels.  Domestically, Neil Katz has some very strong contacts in the industry, and is leveraging them appropriately.  They are beginning to use Dillards in addition to Macy’s for mass market, and will access the Bloomingdales/Nordstroms channels as they roll out the newer higher fashion brands.  Internationally, the previous distribution structure consisted of many smaller distributors who were difficult to guide, and put the company and brands at risk with substandard planning and uncontrolled distribution.  The company is actively seeking to amend the distribution network to larger more reputable distributors who can help them tap proper markets, and ensure the proper handling of the brands which is paramount to the licensors.  Neil and his team have made some great strides on this front. 

It is important to note that US sales tend to lead the international demand, so each incremental step towards proper brand management and promotion in the US has an effect domestically as well as abroad. 

Balance Sheet

The cash conversion cycle for this company is very seasonal, longer in the spring, and shorter in the fall.  Most of the purchasing occurs through the spring into the summer for the September shipments.  The packaging products tend to be a large part of the COGS, and have a painfully long inventory cycle of 2 to 6 months. 

Controls and Financial Management

The previous management left the company with some underdeveloped controls and procedures.  There were no the appropriate accounting professionals in the organization, and many individuals had both control and functional responsibilities.  We anticipate that most of the control issues have been rectified, and those remaining will be rectified in the near future. 

Catalyst