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,” “we” or “our”), and its wholly owned subsidiary, Physicians Formula, Inc., a New York corporation (“Physicians”), 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 cosmetic and skin care products for the mass market channel. The Company’s cosmetic products include face powders, bronzers, concealers, blushes, foundations, eye shadows, eyeliners, mascaras and brow makeup and skin care products include cleansers, moisturizers and treatments. The Company sells its products to mass market retailers such as Wal-Mart, Target, CVS and Rite Aid. The Company is headquartered in Azusa, California.
The accompanying condensed consolidated balance sheet as of
September 30, 2012
, the condensed consolidated statements of operations for the
three and nine
months ended
September 30, 2012
and
2011
and the condensed consolidated statements of cash flows for the
nine
months ended
September 30, 2012
and
2011
are unaudited. These unaudited condensed consolidated interim financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) for interim financial information and Article 10 of Regulation S-X. In the opinion of the Company’s management, the unaudited condensed consolidated interim 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, 2012
, its results of operations for the
three and nine
months ended
September 30, 2012
and
2011
and its cash flows for the
nine
months ended
September 30, 2012
and
2011
. 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, 2012
. The condensed consolidated balance sheet as of
December 31, 2011
has been derived from the audited consolidated balance sheet as of that date.
These condensed consolidated interim 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, as amended on Form 10-K/A, for the year ended
December 31, 2011
.
Concentration of Credit Risk.
Certain financial instruments subject the Company to concentration of credit risk. These financial instruments consist primarily of accounts receivable. The Company regularly reevaluates its customers’ ability to satisfy credit obligations and records a provision for doubtful accounts based on such evaluations. Our top three customers accounted for the following percentages of gross sales:
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Three Months Ended
|
|
Nine Months Ended
|
|
September 30,
|
|
September 30,
|
|
2012
|
|
2011
|
|
2012
|
|
2011
|
Customer A
|
33
|
%
|
|
40
|
%
|
|
32
|
%
|
|
35
|
%
|
Customer B
|
22
|
%
|
|
13
|
%
|
|
22
|
%
|
|
19
|
%
|
Customer C
|
9
|
%
|
|
11
|
%
|
|
9
|
%
|
|
11
|
%
|
Two
customers individually accounted for
10%
or more of gross accounts receivable and together accounted for
58%
and
62%
of gross accounts receivable at
September 30, 2012
and
December 31, 2011
, respectively.
Fair Value Measurements.
The Company’s financial instruments are primarily composed of cash and cash equivalents, accounts receivable, restricted investments, accounts payable and line of credit borrowings. The fair value of cash and cash equivalents, accounts receivable, accounts payable and line of credit borrowings closely approximates their carrying value due to their short maturities. Additionally, the fair value of the line of credit borrowings is estimated based on reference to market prices and closely approximates its carrying value
.
The valuation techniques required by the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 820,
Fair Value Measurements
, are based upon observable and unobservable inputs. Observable inputs reflect market data
obtained from independent sources, while unobservable inputs reflect internal market assumptions. These two types of inputs create the following fair value hierarchy:
•
Level 1 – Quoted prices in active markets for identical assets or liabilities.
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•
|
Level 2 – Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the related asset or liabilities.
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•
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Level 3 – Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of assets or liabilities.
|
The use of observable market inputs (quoted market prices) is required when measuring fair value and requires Level 1 quoted prices to be used to measure fair value whenever possible. The Company’s restricted investments are classified within Level 1 of the fair value hierarchy and are based on quoted market prices in active markets (see Note 4 for further details).
Indefinite-lived assets are measured at fair value on a non-recurring basis when the fair value exceeds the carrying value. Indefinite-lived intangible assets, consisting exclusively of trade names, are not amortized, but rather are tested for impairment annually or whenever events or circumstances occur indicating that they might be impaired. Trade names are valued using a projected discounted cash flow analysis based on unobservable inputs including projected net sales, discount rate, royalty rate and terminal value assumptions and are classified within Level 3 of the valuation hierarchy.
Use of Estimates.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Significant estimates made by management include: provisions for sales returns, trade allowances, allowance for doubtful accounts and inventory obsolescence; stock-based compensation; useful lives of intangible assets; expected future cash flows used in evaluating intangible assets for impairment; provisions for loss contingencies; provisions for income taxes and realizability of deferred tax assets. On an ongoing basis, management reviews its estimates to ensure that these estimates reflect changes to the Company’s business and new information as it becomes available. If historical experience and other factors used by management to make these estimates do not reasonably reflect future activity, the Company’s consolidated financial statements could be materially impacted.
Accounting Standards Update.
In May 2011, the FASB issued Accounting Standards Update (“ASU”) No. 2011-04,
Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S
.
GAAP and IFRS
(“ASU 2011-04”). This update results in common principles and requirements for measuring fair value and for disclosing information about fair value measurements in accordance with U.S. GAAP and IFRS. ASU 2011-04 is required to be applied prospectively in interim and annual periods beginning after December 15, 2011. The adoption of this standard did not have a material impact on the Company’s financial statements and disclosures.
In July 2012, the FASB issued ASU No. 2012-02,
Intangibles–Goodwill and Other (Topic 350)–Testing Indefinite-Lived Intangible Assets for Impairment
(“ASU 2012-02”), which provides guidance on impairment testing of indefinite-lived intangible assets. ASU 2012-02 allows an entity to first assess qualitative factors to determine if it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount. If based on its qualitative assessment an entity concludes it is more than 50% likely that the fair value of an indefinite-lived intangible asset is less than its carrying amount, quantitative impairment testing is required. However, if an entity concludes otherwise, quantitative impairment testing is not required. ASU 2012-02 is effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, with early adoption permitted. The Company is currently evaluating the impact of adopting this standard.
2. NET (LOSS) INCOME PER COMMON SHARE
Basic net (loss) income per common share is computed as net (loss) income divided by the weighted-average number of common shares outstanding during the period. Diluted net (loss) income per common share reflects the potential dilution that could occur from the exercise of outstanding stock options and warrants and is computed by dividing net (loss) income by the weighted-average number of common shares outstanding for the period plus the dilutive effect of outstanding stock options and warrants, if any, calculated using the treasury stock method. The following table summarizes the potential dilutive effect of outstanding stock options and warrants, calculated using the treasury stock method (in thousands, except per share data):
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|
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Three Months Ended
|
|
Nine Months Ended
|
|
September 30,
|
|
September 30,
|
|
2012
|
|
2011
|
|
2012
|
|
2011
|
Numerator:
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|
|
|
|
|
Net (loss) income
|
$
|
(1,342
|
)
|
|
$
|
(537
|
)
|
|
$
|
3,038
|
|
|
$
|
(414
|
)
|
Denominator:
|
|
|
|
|
|
|
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|
Weighted-average number of common shares—basic
|
13,713
|
|
|
13,606
|
|
|
13,698
|
|
|
13,595
|
|
Effect of dilutive stock options
|
—
|
|
|
—
|
|
|
674
|
|
|
—
|
|
Effect of dilutive warrants
|
—
|
|
|
—
|
|
|
604
|
|
|
—
|
|
Weighted-average number of common shares—diluted
|
13,713
|
|
|
13,606
|
|
|
14,976
|
|
|
13,595
|
|
Net (loss) income per common share:
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Basic
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$
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(0.10
|
)
|
|
$
|
(0.04
|
)
|
|
$
|
0.22
|
|
|
$
|
(0.03
|
)
|
Diluted
|
$
|
(0.10
|
)
|
|
$
|
(0.04
|
)
|
|
$
|
0.20
|
|
|
$
|
(0.03
|
)
|
Stock options and warrants for the purchase of approximately
830,000
and
3,007,000
shares of common stock were excluded from the above calculation during the
three
months ended
September 30, 2012
and
2011
, respectively, as the effect of those options was anti-dilutive. Stock options and warrants for the purchase of approximately
855,000
and
3,007,000
shares of common stock were excluded from the above calculation during the
nine
months ended
September 30, 2012
and
2011
, respectively, as the effect of those options was anti-dilutive.
3. INVENTORIES
Inventories consisted of the following (in thousands):
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September 30,
2012
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|
December 31,
2011
|
Raw materials and components
|
$
|
13,019
|
|
|
$
|
14,451
|
|
Finished goods
|
12,004
|
|
|
10,772
|
|
Total
|
$
|
25,023
|
|
|
$
|
25,223
|
|
4. OTHER ASSETS
Other assets consisted of the following (in thousands):
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|
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September 30,
2012
|
|
December 31,
2011
|
Retail permanent fixtures, net of accumulated amortization of $5,471 and $4,226 as of September 30, 2012 and December 31, 2011, respectively
|
$
|
3,678
|
|
|
$
|
4,063
|
|
Capitalized debt issuance costs, net of accumulated amortization of $1,954 and $1,829 as of September 30, 2012 and December 31, 2011, respectively
|
513
|
|
|
635
|
|
Restricted investments
|
307
|
|
|
272
|
|
Deposits
|
381
|
|
|
378
|
|
Other
|
9
|
|
|
9
|
|
Total
|
$
|
4,888
|
|
|
$
|
5,357
|
|
During 2008, the Company implemented a key project of creating new permanent fixtures (“retail permanent fixtures”) for the display of the Company’s products which began being delivered to certain retail customer stores in 2009. The Company incurred costs for retail permanent fixtures of
$34,000
and
$86,000
for the
three
months ended
September 30, 2012
and
2011
, respectively. The Company incurred costs for retail permanent fixtures of
$1.0 million
and
$1.7 million
for the
nine
months ended
September 30, 2012
and
2011
, respectively. These retail permanent fixtures are being placed in service in connection with the retail customers’ resets of selling space and are recorded at cost. These costs are amortized over a period of three years. Amortization expense was
$401,000
and
$499,000
for the
three
months ended
September 30, 2012
and
2011
, respectively. Amortization expense was
$1.2 million
and
$1.4
million
for the
nine
months ended
September 30, 2012
and
2011
, respectively. As of
September 30, 2012
, amortization of retail permanent fixtures is expected to be approximately
$394,000
for the remainder of
2012
,
$1.3 million
for 2013,
$719,000
for 2014 and
$127,000
for 2015. As of
September 30, 2012
, approximately
$1.2 million
in costs of retail permanent fixtures had been incurred but not yet amortized as a result of these fixtures not having yet been placed into service.
The Company incurred costs of
$2.4 million
primarily during late 2009 associated with obtaining the Company’s senior revolving credit facility with Wells Fargo Bank, N.A. (“Wells Fargo”) and its senior subordinated loan from Mill Road Capital L.P. (“Mill Road”), and the subsequent amendments thereto (see Note 6,
Financing Arrangements
, for further details). In November 2011, the Company repaid its senior subordinated loan and wrote-off
$412,000
of capitalized debt issuance costs. The remaining capitalized debt issuance costs related to the senior revolving credit facility with Wells Fargo are being amortized over the life of the related debt obligation as an additional component of interest expense and are expected to be fully amortized by November 6, 2015.
Restricted investments represent a diversified portfolio of mutual funds held in a Rabbi Trust, which funds the non-qualified, unfunded deferred compensation plans. These investments, which are considered trading securities, are recorded at fair value. Unrealized gains (losses) related to these investments were
$11,000
and
$(44,000)
for the
three
months ended
September 30, 2012
and
2011
, respectively. Unrealized gains (losses) related to these investments were
$33,000
and
$(33,000)
for the
nine
months ended
September 30, 2012
and
2011
, respectively.
5. INTANGIBLE ASSETS
Definite-lived intangible assets consisted of the following (in thousands):
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|
|
September 30, 2012
|
|
December 31, 2011
|
|
Gross
Amount
|
|
Accumulated
Amortization
|
|
Net
Amount
|
|
Gross
Amount
|
|
Accumulated
Amortization
|
|
Net
Amount
|
Patents
|
$
|
8,699
|
|
|
$
|
(5,172
|
)
|
|
$
|
3,527
|
|
|
$
|
8,699
|
|
|
$
|
(4,736
|
)
|
|
$
|
3,963
|
|
Distributor relationships
|
23,701
|
|
|
(10,566
|
)
|
|
13,135
|
|
|
23,701
|
|
|
(9,678
|
)
|
|
14,023
|
|
Total
|
$
|
32,400
|
|
|
$
|
(15,738
|
)
|
|
$
|
16,662
|
|
|
$
|
32,400
|
|
|
$
|
(14,414
|
)
|
|
$
|
17,986
|
|
Amortization expense was
$442,000
for each of the
three
months ended
September 30, 2012
and
2011
and
$1.3 million
for each of the
nine
months ended
September 30, 2012
and
2011
. Amortization of definite-lived intangible assets will be approximately
441,000
for the remainder of
2012
and approximately
$1.8 million
in each of the next five years. Additionally, the Company did not identify any events or circumstances that would require an impairment analysis of its definite-lived intangible assets and other long-lived assets as of
September 30, 2012
.
Indefinite-lived intangible assets consist exclusively of trade names and had a carrying amount of
$12.5 million
as of
September 30, 2012
and
December 31, 2011
. The Company evaluates indefinite-lived intangible assets for impairment in the second quarter of each fiscal year or whenever events or circumstances occur that potentially indicate that the carrying amounts of these assets may not be recoverable.
In order to test the trade names for impairment, the Company determines the fair value of the trade names and compares such amount to its carrying value. The Company determines the fair value of the trade names using a projected discounted cash flow analysis based on the relief-from-royalty approach. The principal factors used in the discounted cash flow analysis requiring judgment are the projected net sales, discount rate, royalty rate and terminal value assumptions. The royalty rate used in the analysis is based on transactions that have occurred in the Company’s industry. During the second quarter of
2012
, the Company tested trade names for impairment and based on the analysis, no impairment charge was recorded as the fair value of the trade names exceeded their carrying value.
The
Physicians Formula
trade name has been used since 1937 and is a recognized brand within the cosmetics industry. It is management’s intent to leverage the Company’s trade names indefinitely into the future. The Company will continue to monitor operational performance measures and general economic conditions. A continuous downward trend could result in the Company recognizing an impairment charge of the Physicians Formula trade name in connection with a future impairment test.
6. FINANCING ARRANGEMENTS
Senior Credit Agreement
Physicians is a party to a senior credit agreement (as amended, the “Credit Agreement”) with Wells Fargo, which replaced Physicians’ previous asset-based revolving credit facility with Union Bank, N.A. and includes a
$4.0 million
term loan (the “Term Loan”) and a
$25.0 million
asset-based revolving credit facility. An amendment entered into in September 2011 (the “Third Amendment”), among other things, extended the maturity date of the Credit Agreement from November 6, 2012 to November 6, 2015, as more fully described below.
The maximum amount available for borrowing under the revolving credit facility of the Credit Agreement is equal to the lesser of
$25.0 million
and a borrowing base formula equal to: (i)
65%
or such lesser percentage of eligible accounts receivable as Wells Fargo in its discretion as an asset-based lender may deem appropriate; plus (ii) the lesser of (1)
$14.0 million
and (2) the sum of specified percentages (or such lesser percentages as Wells Fargo in its discretion as an asset-based lender may deem appropriate) of each of the following items of eligible inventory (as defined in the Credit Agreement): (A) eligible inventory consisting of finished goods that are fully packaged, labeled and ready for shipping, not to exceed
65%
of such eligible inventory, (B) eligible inventory consisting of semi-finished goods which are ready for packaging and shipping, not to exceed
$4.0 million
, (C) eligible inventory consisting of raw materials, not to exceed
$1.5 million
, (D) eligible inventory consisting of blank components, not to exceed
$1.0 million
and (E) eligible inventory consisting of returned items, not to exceed
$750,000
; plus (iii) the cash balance in a certain Canadian concentration account; less (iv) a working capital reserve of
$1.0 million
, as such amount may be adjusted by Wells Fargo from time to time, and a borrowing base reserve that Wells Fargo establishes from time to time in its discretion as a secured asset-based lender; less (v) indebtedness owed to Wells Fargo other than indebtedness outstanding under the revolving credit facility. Availability under the revolving credit facility is reduced by outstanding letters of credit.
Floating rate borrowings on the revolving credit facility under the Credit Agreement, as amended by the Third Amendment, accrue interest at a daily rate equal to the three-month LIBOR plus
2.75%
and fixed rate borrowings on the revolving credit facility accrue interest at a fixed rate equal to the three-month LIBOR plus
2.75%
on the date of borrowing. Interest on floating rate borrowings is payable monthly in arrears and interest on fixed rate borrowings is payable upon the expiration of the fixed rate term, subject to minimum monthly interest payments in the amount of
$15,000
with a
$250,000
annual minimum. Under the Credit Agreement, Physicians is required to pay to Wells Fargo an unused credit line fee equal to
0.5%
per annum and various other fees associated with cash management and other related services. Physicians may at any time reduce the maximum amount available for borrowing or terminate the revolving credit facility prior to the scheduled maturity date by paying breakage fees, which have been amended so that if the maximum amount available for borrowing is reduced or terminated on or before November 6, 2012, the breakage fee would equal
1.0%
of the maximum amount of the revolving credit facility or amount of the reduction in the credit facility, decreasing to
0.5%
if the termination or reduction occurs after November 6, 2012.
Under the Credit Agreement, all payments to Physicians and its subsidiaries are required to be deposited into a lock-box account provided by Wells Fargo, except that payments in connection with the Company’s Canadian operations may be deposited into a lock-box account with Royal Bank of Canada. Any amounts deposited into a lock-box account with Wells Fargo will be swept to a collection account to be applied to repay the outstanding borrowings under the revolving credit facility. If the balance in Physicians’ Canadian account at any time exceeds Canadian
$2.0 million
, Physicians must, within 10 days after such occurrence, transfer the excess amount to the collection account to repay borrowings under the revolving credit facility. In addition, at any time, Physicians may transfer amounts out of the Canadian accounts to repay borrowings under the revolving credit facility or, so long as no event of default exists, pay costs and expenses incurred in connection with the Company’s Canadian operations from its Canadian operating account.
The Company used the entire proceeds from the Term Loan in addition to monies from the existing revolving credit facility to repay in full all outstanding borrowings, interest, prepayment fees, and any other amounts due and owing under its senior subordinated note with Mill Road on November 10, 2011. The Term Loan bears interest at a rate equal to the three-month LIBOR plus
3.5%
. The Term Loan is payable in 48 monthly equal installments of
$83,333
, beginning on the first day of the first calendar month after the funds were disbursed. As of
September 30, 2012
and
December 31, 2011
, there was
$3.2 million
and
$3.9 million
outstanding under the Term Loan, respectively, at interest rates of
3.88%
and
4.13%
, respectively. Scheduled maturities of the Term Loan as of
September 30, 2012
were
$250,000
for the remainder of
2012
,
$1.0 million
for 2013,
$1.0 million
for 2014 and
$917,000
for 2015.
On April 30, 2012, Physicians entered into an amendment to the Credit Agreement (the “Fourth Amendment”) with Wells Fargo to establish financial covenants that will apply to periods after December 31, 2011, including the Company’s minimum book net worth covenant, minimum Adjusted EBITDA covenant, maximum leverage ratio and maximum capital expenditure covenant. The Fourth Amendment also requires the Company to negotiate with Wells Fargo and establish, no later than April 30, 2013, its financial covenants that will apply to periods not covered by this amendment.
As amended, the Credit Agreement requires that the Company maintain a monthly minimum book net worth in amounts per month ranging from
$48.0 million
to
$50.0 million
, as applicable. The Credit Agreement defines “book net worth” as the Company’s stockholders’ equity, determined in accordance with GAAP and calculated without regard to any change in the valuation of goodwill
and intangible assets made in accordance with ASC 350,
Intangibles–Goodwill and Other
(“ASC 350”). The Credit Agreement also requires the Company to maintain a minimum Adjusted EBITDA each fiscal quarter for the twelve month period ended September 30, 2012, December 31, 2012 and March 31, 2013 of no less than
$5.5 million
,
$7.0 million
and
$7.0 million
, respectively, and at least
$1
for each
two
consecutive calendar quarter period, commencing with the quarter ending March 31, 2011. In addition, the Company is required to comply with a maximum leverage ratio, which is borrowed money of Physicians divided by Adjusted EBITDA, of not greater than
2.0
to 1.0 as of September 30, 2012, December 31, 2012 and March 31, 2013. The Credit Agreement defines “Adjusted EBITDA” as the Company’s consolidated net income, calculated before (i) interest expense, (ii) provision (benefit) for income taxes, (iii) depreciation and amortization expense, (iv) gains arising from the write-up of assets, (v) any extraordinary gains, (vi) stock-based compensation expenses, (vii) changes resulting from the valuation of goodwill and intangible assets made in accordance with ASC 350, (viii) changes resulting from foreign exchange adjustments arising from a revaluation of assets subject to foreign currency revaluation and (ix) provisions arising from adjustments to the Company’s inventory reserves for obsolete, excess, or slow moving inventory.
The Company is also required to comply with certain negative covenants, including limitations on its ability to: incur other indebtedness and liens; make certain investments, loans or advances; guaranty indebtedness; pay cash dividends from Physicians, except in an amount up to
$100,000
to allow the Company to pay ordinary course expenses; sell assets; suspend operations; consolidate or merge with another entity; enter into sale-leaseback arrangements; enter into unrelated lines of business or acquire assets not related to the business; or make capital expenditures in excess of
$5.5 million
for the year ending
December 31, 2012
. As of
September 30, 2012
and
December 31, 2011
, the Company was in compliance with the covenants contained in the Credit Agreement.
The Credit Agreement contains provisions that could result in the acceleration of maturity of the indebtedness and entitle the lenders to exercise remedies upon an event of default, including a default of the financial covenants. There is no assurance that the Company would receive waivers should it not meet its financial covenant requirements.
Borrowings under the revolving credit facility are guaranteed by both the Company and the domestic subsidiaries of Physicians and are secured by (i) a pledge of the capital stock of Physicians and its subsidiaries and (ii) substantially all of the assets of the Company and its subsidiaries.
As of
September 30, 2012
, there was no balance outstanding under the revolving credit facility. As of
December 31, 2011
, there was
$4.7 million
outstanding under the revolving credit facility at an interest rate of
3.38%
. As of
September 30, 2012
and
December 31, 2011
, there were no outstanding letters of credit and
$14.6 million
and
$10.5 million
available under the revolving credit facility, respectively. Because the revolving credit facility contains a lock-box feature as described above, whereby remittances made by customers to the lock-box repays the outstanding obligation under the revolving credit facility, in accordance with ASC 470-10-45,
Debt–Other Presentation
, the Company classified the above outstanding amount under the revolving credit facility as a current liability in the accompanying condensed consolidated balance sheets.
Senior Subordinated Note
Physicians, along with the Company and certain guarantor subsidiaries, was party to a Senior Subordinated Note Purchase and Security Agreement (the “Note Agreement”) with Mill Road. Pursuant to the Note Agreement, on November 6, 2009, Physicians issued a senior subordinated note to Mill Road in an aggregate principal amount equal to
$8.0 million
(the “Senior Subordinated Note”). On November 10, 2011, the Senior Subordinated Note was repaid using proceeds from the Term Loan and borrowings under the Company’s existing line of credit with Wells Fargo (as described above).
As required by the Note Agreement, on April 30, 2010, the Company entered into a Common Stock Purchase Warrant agreement with Mill Road pursuant to which warrants have been issued entitling Mill Road to purchase
650,000
shares of the Company’s common stock. The warrants have an exercise price equal to
$0.25
per share and expire on April 30, 2017. Upon issuance of the warrants, Mill Road beneficially owned
2,516,943
shares of the Company’s common stock and warrants to purchase
650,000
shares of common stock, representing aggregate beneficial ownership of
3,166,943
shares (approximately
22%
) of the Company’s common stock. As of
September 30, 2012
, no warrants have been exercised.
The issuance of the warrants and reduction in interest payments have been accounted for as a partial conversion of the required payments under the Note Agreement for equity interests under ASC 470-20,
Debt–Debt With Conversion and Other Options
(“ASC 470-20”). ASC 470-20 requires the issuer of convertible debt instruments to separately account for the liability and equity components of the convertible debt instrument in a manner that reflects the issuer’s borrowing rate at the date of issuance for a similar debt instrument without the conversion feature. ASC 470-20 requires bifurcation of a component of the convertible debt instrument, classification of that component in equity and the accretion of the resulting discount on the debt to be recognized as interest expense. The equity component of the Senior Subordinated Note was
$940,000
at the time of issuance and was applied as debt discount and as additional paid-in capital. Interest expense related to the contractual coupon rate and amortization of debt discount was
$237,000
and
$41,000
for the three months ended September 30, 2011, respectively. Interest expense related to the contractual coupon rate and amortization of debt discount was
$890,000
and
$112,000
for the nine months ended September 30, 2011, respectively.
The Company incurred total costs of
$2.4 million
in connection with the Credit Agreement, the Senior Subordinated Note and the amendments thereto.
7.
COMMITMENTS AND CONTINGENCIES
Litigation
To our knowledge, as of November 13, 2012, three stockholder class action lawsuits are pending asserting claims against the Company and the members of its board of directors in connection with the Merger. The Company believes that these lawsuits are without merit and intends to defend them vigorously.
Continuum Capital vs. Ingrid Jackel, et al
., Case No. BC492325, was filed in Los Angeles County Superior Court for the State of California. This lawsuit asserts generally that the members of the Company's board of directors breached their fiduciary duties to maximize stockholder value in the Merger, and as a result its stockholders will not receive adequate or fair value for their shares of common stock in the Merger. This lawsuit also asserts that the members of the Company's board of directors breached their fiduciary duties of disclosure by concealing material information in its filings with the SEC regarding the Merger. This lawsuit further asserts that the Company and Markwins and MergerSub aided and abetted those breaches of duty. The complaint seeks, among other relief, an order enjoining the consummation of the Merger, rescission of the Merger if it is consummated, other damages in an unspecified amount and an award of attorneys' fees and expenses of litigation. On October 16, 2012, the Court entered an order staying the action until a case management conference set for January 18, 2013.
In re Physicians Formula Holdings, Inc. Shareholder Litigation
, Consolidated Case No. 7794-VCL, was filed in the Court of Chancery of the State of Delaware. This lawsuit, which is a consolidation of two lawsuits previously filed (
Bushansky v. Physicians Formula Holdings, Inc., et al.
and
L2 Opportunity Fund v. Charles Hinkaty, et al
.) asserts generally that the members of the Company's board of directors breached their fiduciary duties to maximize stockholder value in the Merger and the merger agreement it previously entered into with affiliates of Swander Pace Capital, and as a result the Company's stockholders will not receive adequate or fair value for their shares of common stock in the Merger. This lawsuit also asserts that the members of the Company's board of directors breached their fiduciary duties of disclosure by concealing material information in its filings with the SEC regarding the Merger. The complaint seeks, among other relief, an order enjoining the consummation of the Merger, rescission of the Merger if it is consummated, other damages in an unspecified amount and an award of attorneys' fees and expenses of litigation. On October 19, 2012, the Court denied plaintiffs' motion for expedited discovery and a preliminary injunction. On November 13, 2012, defendants filed their answer to the amended complaint, generally denying plaintiffs' allegations of wrongdoing and asserting various affirmative defenses. Discovery is proceeding. No trial date has been set.
Hutton v. Charles Hinkaty, et al.
, Case No. 3:12-CV-02533-LAB-DHB, was filed in the United States District Court for the Southern District of California. This lawsuit asserts that the Company and members of the Company's board of directors violated Section 14(a) of the Securities Exchange Act of 1934 and breached their fiduciary duties of disclosure by concealing material information in the Company's filings with the SEC regarding the Merger. This lawsuit further asserts that the Company and Markwins and MergerSub aided and abetted those breaches of duty. The time for defendants to answer or move against the complaint has not yet expired. By operation of the Private Securities Litigation Reform Act of 1995, all discovery and other proceedings in the action are stayed pending a motion to dismiss.
The outcome of these cases (and any other litigation that may be filed related to the Merger) is uncertain. If a dismissal is not granted or a settlement is not reached, these lawsuits could prevent or delay completion of the Merger and result in substantial costs to the Company, including any costs associated with the indemnification of its directors and officers.
The Company is also 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 interim financial statements.
Environmental
The Company is subject to a broad range of frequently changing federal, state and local environmental, health and safety laws and regulations, including those governing discharges to air, soil and water, the handling and disposal of, and exposure to, hazardous substances and the investigation and remediation of any contamination resulting from the release of any hazardous substances. The Company believes that its business, operations and facilities are in material compliance with all applicable environmental, health and safety laws and regulations, and future expenditures will be necessary in order to maintain such compliance.
The shallow soils and groundwater below the Company’s City of Industry, California facilities were contaminated by the former operator of the property. The former operator performed onsite cleanup, and the Company anticipates that it 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 which the Company believes remain financially able to supply such indemnification.
The facilities are 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 PVOU PRP, pursuant to which, in return for a payment the Company's indemnitor made to the other PRP on behalf of Physicians, the other PRP indemnified the Company against most claims for PVOU contamination. A court approved and entered a consent decree among the other PRP, the Company and the EPA that resolves the Company's liability for the EPA-ordered Interim Remedy for the regional groundwater contamination without any payment by the Company to the EPA. The Company expects that if any Final Remedy or any further remediation requirement is ordered by EPA in the future, the Company's share of any such additional remediation costs also will be covered by these same 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 any such liabilities. 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 believes its liability for these contamination matters and related claims is substantially covered by third-party indemnities, has been resolved by prior agreements and settlements, and any costs or expenses associated therewith will be borne by prior operators of the facilities, their successors and their insurers. The Company is attempting to recoup approximately
$778,000
in defense costs from one of these indemnitors. These costs have been expensed as paid by the Company and are not recorded in the accompanying condensed consolidated balance sheets.
8. EQUITY AND STOCK OPTION PLANS
On April 30, 2010, in connection with the Note Agreement, the Company entered into a Common Stock Purchase Warrant agreement with Mill Road pursuant to which warrants were issued entitling Mill Road to purchase
650,000
shares of the Company’s common stock at an exercise price of
$0.25
per share. As of
September 30, 2012
,
none
of these warrants have been exercised. See Note 6,
Financing Arrangements
, for a detailed discussion.
2006 Equity Incentive Plan
In connection with the Company’s initial public offering in November 2006, the Company adopted the Physicians Formula Holdings, Inc. 2006 Equity Incentive Plan (as amended, 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, 2012
, a total of
614,624
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. The Compensation Committee determined that no additional shares will be added to the 2006 Plan in 2012.
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 Company’s initial public offering during 2006, 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 vested in equal monthly installments over a two-year period through November 2008.
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 the Company’s initial public offering is the closing price on the grant date.
The Company utilized the Black-Scholes option valuation model to calculate the fair value of the options granted or modified during the
nine
months ended
September 30, 2011
utilizing the following weighted-average assumptions: risk-free interest rate of
1.8%
, volatility of
81.1%
, dividend rate of
0.0%
and a life of
six
years. 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 was based on the daily historical volatility of the Company's own stock. The dividend rate assumption is excluded from the calculation, as the Company intends to retain all earnings. The expected life of the Company’s stock options represents management’s best estimate based upon historical and expected trends in the Company’s stock option activity.
There were no stock option grants during the
nine
months ended
September 30, 2012
.
The 2006 Plan and 2003 Plan activity is summarized below:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Time-Vesting Options
|
|
Performance-Vesting Options
|
|
Number of Shares
|
|
Weighted-Average Exercise Price
|
|
Aggregate Intrinsic Value
|
|
Number of Shares
|
|
Weighted-Average Exercise Price
|
|
Aggregate Intrinsic Value
|
Options outstanding—January 1, 2012
|
2,220,708
|
|
|
$
|
5.18
|
|
|
|
|
136,681
|
|
|
$
|
0.10
|
|
|
|
Granted
|
—
|
|
|
—
|
|
|
|
|
—
|
|
|
—
|
|
|
|
Exercised
|
(93,547
|
)
|
|
2.17
|
|
|
$
|
91,000
|
|
|
—
|
|
|
—
|
|
|
|
Cancelled
|
(135,225
|
)
|
|
2.50
|
|
|
|
|
—
|
|
|
—
|
|
|
|
Forfeited
|
(55,228
|
)
|
|
10.46
|
|
|
|
|
|
—
|
|
|
—
|
|
|
|
|
Options outstanding—September 30, 2012
|
1,936,708
|
|
|
$
|
5.36
|
|
|
$
|
(956,000
|
)
|
|
136,681
|
|
|
$
|
0.10
|
|
|
$
|
652,000
|
|
Vested and expected to vest—September 30, 2012
|
1,936,708
|
|
|
$
|
5.36
|
|
|
$
|
(956,000
|
)
|
|
136,681
|
|
|
$
|
0.10
|
|
|
$
|
652,000
|
|
The vesting activity for the 2006 Plan and 2003 Plan 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, 2012
|
1,438,725
|
|
|
$
|
9,119,000
|
|
|
|
|
|
|
|
|
136,681
|
|
|
$
|
14,000
|
|
|
|
|
|
|
|
Vested
|
197,591
|
|
|
601,000
|
|
|
|
|
|
|
|
|
—
|
|
|
—
|
|
|
|
|
|
|
|
Exercised
|
(93,547
|
)
|
|
(203,000
|
)
|
|
|
|
|
|
|
|
—
|
|
|
—
|
|
|
|
|
|
|
|
Forfeited
|
(55,228
|
)
|
|
(578,000
|
)
|
|
|
|
|
|
|
|
—
|
|
|
—
|
|
|
|
|
|
|
|
September 30, 2012
|
1,487,541
|
|
|
$
|
8,939,000
|
|
|
$
|
6.01
|
|
|
4.9
|
|
|
$
|
(1,695,000
|
)
|
|
136,681
|
|
|
$
|
14,000
|
|
|
$
|
0.10
|
|
|
1.1
|
|
|
$
|
652,000
|
|
As of
September 30, 2012
, the options outstanding under the 2006 Plan and 2003 Plan had exercise prices between
$0.10
and
$20.75
and the weighted-average remaining contractual life for all options was
5.4
years.
A summary of the weighted-average grant date fair value of the non-vested stock option awards is presented in the table below:
|
|
|
|
|
|
|
|
|
Number
of Options
|
|
Weighted-
Average
Grant Date
Fair Value
|
January 1, 2012
|
781,983
|
|
|
$
|
1.81
|
|
Vested
|
(197,591
|
)
|
|
1.74
|
|
Cancelled
|
(135,225
|
)
|
|
1.30
|
|
September 30, 2012
|
449,167
|
|
|
1.99
|
|
The total fair value of options that vested during the
nine
months ended
September 30, 2012
and
2011
was
$344,000
and
$623,000
, respectively.
As of
September 30, 2012
, total unrecognized estimated compensation cost related to non-vested stock options was approximately
$0.9 million
, which is expected to be recognized over a weighted-average period of approximately
2.4
years. The Company recorded approximately
$203,000
of cash received from the exercise of
93,547
stock options during the
nine
months ended
September 30, 2012
. The Company recorded approximately
$29,000
of cash received from the exercise of
16,007
stock options during the
nine
months ended
September 30, 2011
.
The Company recognized
$339,000
and
$596,000
of pre-tax, non-cash share-based compensation expense for the
nine
months ended
September 30, 2012
and
2011
, respectively. Non-cash share-based compensation cost of
$35,000
was a component of cost of sales and
$304,000
was a component of selling, general and administrative expenses in the accompanying condensed consolidated statement of operations for the
nine
months ended
September 30, 2012
. Non-cash share-based compensation cost of
$46,000
was a component of cost of sales and
$550,000
was a component of selling, general and administrative expenses in the accompanying condensed consolidated statement of operations for the
nine
months ended
September 30, 2011
. The Company recognized a related tax benefit of
$138,000
and
$244,000
for the
nine
months ended
September 30, 2012
and
2011
, respectively. The Company capitalized non-cash share-based compensation expense of
$29,000
and
$38,000
in inventory for the
nine
months ended
September 30, 2012
and
2011
, respectively.
Excess tax benefits exist when the tax deduction resulting from the exercise of options exceeds the compensation cost recorded. The cash flows resulting from such excess tax benefits, if any, are classified as financing cash flows. During the
nine
months ended
September 30, 2012
and
2011
, there were
no
significant excess tax benefits.
9. GEOGRAPHIC INFORMATION
Geographic revenue information is based on the location of the customer. Substantially all of the Company’s assets are located in the United States and Canada. As of
September 30, 2012
, the Company had total assets of
$2.1 million
located in Canada, or
2.2%
of the Company’s total assets, including approximately
$1.1 million
of retail permanent fixtures, which are classified in other assets on the accompanying condensed consolidated balance sheets. As of
December 31, 2011
, the Company had total assets of
$1.7 million
located in Canada, or
1.7%
of the Company’s total assets, including approximately
$882,000
of retail permanent fixtures, which are classified
in other assets on the accompanying condensed consolidated balance sheets. Net sales to unaffiliated customers by geographic region are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
September 30,
|
|
September 30,
|
|
2012
|
|
2011
|
|
2012
|
|
2011
|
United States
|
$
|
16,839
|
|
|
$
|
13,862
|
|
|
$
|
62,889
|
|
|
$
|
50,609
|
|
Canada
|
1,909
|
|
|
1,821
|
|
|
7,404
|
|
|
6,797
|
|
Other foreign countries
|
364
|
|
|
187
|
|
|
1,155
|
|
|
470
|
|
|
$
|
19,112
|
|
|
$
|
15,870
|
|
|
$
|
71,448
|
|
|
$
|
57,876
|
|
10. MERGER AGREEMENT
On September 26, 2012, the Company entered into an agreement and plan of merger (the “Merger Agreement”) with Markwins International Corporation (“Markwins”) and Markwins Merger Sub, Inc. (“MergerSub”), a wholly owned subsidiary of Markwins. Pursuant to the Merger Agreement, Markwins agreed to acquire the Company in an all cash merger for
$4.90
per share, representing approximately
$74.9 million
in equity value (the “Merger”).
Upon completion of the Merger, the Company will operate as a wholly owned subsidiary of Markwins and each share of the Company's common stock issued and outstanding immediately prior to the effective time of the Merger will be automatically converted into the right to receive
$4.90
in cash, without interest, other than (i) shares that are owned by stockholders who are entitled to and who have properly perfected and not withdrawn a demand for, or lost their right to, appraisal rights under Delaware law and (ii) shares that the Company, Markwins or MergerSub own.
The Merger is conditioned upon, among other things, the approval of the Company's stockholders, and covenants regarding the operation of the Company's business prior to the closing of the Merger. The Merger Agreement contains certain termination rights for both the Company and Markwins or MergerSub, including if the Company receives an acquisition proposal that its board of directors determines in good faith constitutes a superior proposal. If the Company terminates the Merger Agreement because it receives such an acquisition proposal, the Company must pay Markwins a
$1.5 million
termination fee.
On September 26, 2012, prior to entering into the Markwins Merger Agreement, the Company terminated the agreement and plan of merger dated August 14, 2012, by and among the Company and affiliates of Swander Pace Capital in accordance with its terms. In connection with the termination of this merger agreement, the Company paid a termination fee of
$1.3 million
to affiliates of Swander Pace Capital. The termination fee is included in selling, general and administrative expenses in the accompanying condensed consolidated statements of operations for the quarter ended September 30, 2012.
11. SUBSEQUENT EVENTS
The Company's stockholders adopted the Merger Agreement on November 8, 2012, and as a result, the closing of the Merger was to occur no later than November 14, 2012. Markwins subsequently informed the Company that although the equity and debt commitment letters Markwins received in connection with the signing of the Merger Agreement remain in full force and effect, notwithstanding the availability of the financing represented by such commitment letters, Markwins is pursuing alternative financing with more favorable terms and that Markwins intends to close the Merger no later than December 13, 2012.