Description

We recommend taking a short position in Parlux Fragrances, Inc. (PARL). PARL management is trying to hide the deterioration of their core business by stuffing inventory into an affiliated company. The stock has run up on the expectation that their new Paris Hilton perfume will be a hit, but we believe that’s a pretty cheesy reason for an otherwise deteriorating business to trade at 75 times earnings, especially for a company whose related party dealings reek worse than any we’ve ever seen. Even if PARL traded at a slightly-less-ridiculous-Paris-premium of 30 times earnings, it would provide a 60% return to short sellers.

Background
PARL is a fragrance designer and distributor. A license to market Perry Ellis fragrances accounted for 80% of their 2003 revenue. An affiliated company, E Com Ventures (Nasdaq: ECMV), accounted for 43% of their first half revenue. ECMV owns a chain of fragrance retailers called Perfumania. PARL recently announced their intention to launch perfumes carrying the namesake of Maria Sharapova (a sure fire winner we’re sure) and Paris Hilton. PARL is 14% owned and ECMV is 16% owned by Ilia Lekach (Chairman & CEO of PARL, formerly also held the same positions with ECMV until Sarbanes-Oxley put the kibosh on that). There is a multitude of other fishy connections of this sort at PARL, but none of the others really warrant our focus because they are relatively insignificant compared to ECMV.

Parlux’s Whipping Boy
This whole exercise is made possible by a quick comparison of PARL’s and ECMV’s public filings. To sum up the situation, PARL’s revenues to unrelated parties has been declining at 20%+ for the past several quarters. Meanwhile, PARL’s revenues to related parties has skyrocketed, presumably to keep pace with the deterioration in PARL’s legitimate business. The net effect is that PARL has managed to manufacture the appearance of 20%+ growth for the past several quarters, instead of 20% shrinkage. We will let the numbers speak for themselves. PARL uses a March 31 fiscal year.

Q1 Q4 Q3 Q2 Q1
Affil. Rev. 13.9 11.7 13.8 10.9 6.1
YOY Growth 127% 158% 173% 65% 10%
Unaffil. Rev. 9.1 7.9 12.0 7.4 10.8
YOY Growth -16% -22% -18% -35% -24%
Total Revenue 23.0 19.6 25.8 18.3 16.9
YOY Growth 36% 34% 30% 1% -15%

Rev. to ECMV 10.6 7.5 10.8 9.7 4.0

ECMV is 75% of revenue to affiliates, so we will limit our focus to ECMV, and we will assume that the rest of the affiliated revenue is legit.
At this juncture one could draw two conclusions: sell-through at Perfumania must be stellar, or PARL is stuffing the channel. Two sets of numbers from ECMV’s filings will answer that question. ECMV uses an impeccably-chosen January 31 fiscal year.

Q2 Q1 Q4 Q3 Q2
Retail Rev. Growth -3% 6% 6% -3% -1%
ECMV Inventories 80.8 75.7 60.9 76.8 66.8

An interesting side note is the rate at which ECMV’s sales to another affiliated company, Quality King (private), have increased; $9.0 mill in the first half of 2004 versus $2.6 mill in the first half of 2003. This leads us to believe that it’s completely possible that ECMV is dumping inventory onto Quality King. If this were the case, inventories might be closer to $87 mill today at ECMV.
Unlike most channel stuffing stories, PARL’s receivables don’t seem to be ballooning, despite the fact that PARL readily admits that ECMV gets extra premo terms (around 100 days, presumably). We theorize that PARL is probably able to avoid this appearance because they use a different fiscal year than ECMV. Since PARL’s quarters always end a month before ECMV’s, it’s possible that they are sweeping the receivables under the rug by quarter-end. ECMV’s balance sheet validates this theory.

PARL 6/30 3/31 12/31 9/30 6/30 3/31
Affil. Rec. 14.1 11.5 15.1 17.6 15.2 11.9

ECMV 7/31 5/1 1/31 11/1 8/2 5/3
Affil. Pybl. 34.2 29.8 17.7 24.7 19.0 15.2
Due to PARL 32.6 22.0 14.5 19.8 16.6 12.9

The Upshot
We believe that PARL’s earnings manipulation has caused a dramatic overstatement of earnings over the past four quarters. Backing out the excessive growth in sales to Perfumania paints a drastically different picture.

Q1PF Q4 PF
Affil. Rev. 7.2 6.3
Unaff. Rev. 9.1 7.9
Total Rev. 16.3 14.2
YOY Growth -3.6% -3.3%

Affil. GPM 50% 60% (1)
Affil. GP 3.6 3.8
Unaff. GPM 47% 56%
Unaffil. GP 4.3 4.4

Gen. & Adm. 7.8 7.3
Oper. Inc. 0.1 0.9
Net Income 0.1 0.5
Rep. Net Inc 2.2 2.6

(1) We use the reported gross profit margin. Reported gross profit margins are likely overstated (and are much higher than historical margins) due to higher sales volumes to Perfumania.

Valuation
So PARL appears to be earning $1.2 million run-rate (an aggressive assumption since the first half is typically stronger than the second half). But for conservatism’s sake, let’s just say they’re earning $2 million. So what’s a deteriorating fragrance company whose largest customer is posting negative comps and laden with inventory, with the possibility of a winning new product worth? Since valuing shorts frequently seems akin to boxing in the dark, we’ll just say 30 times earnings.

Net Inc. 2.0
Multiple 30
Ent. Val. 60.0
Net Cash 7.6
Equity 67.6
Shares 10.6
Price 6.40

Catalyst

We believe the market will have zero tolerance for a story like this: a forthcoming earnings disappointment topped off with a little earnings manipulation. And, we don’t believe the scheme can be maintained for long. ECMV is losing money on an operating basis, and is one stiff wind away from bankruptcy.