**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe quarterly period ended September 30, 2006**

**OR**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from                        to                         **

**CommissionFile Number: 001-33142**

**PHYSICIANS FORMULA HOLDINGS, INC.**

(Exact name of registrant as specified in its charter)

 

| **D****elaware**                                                 |   | **23-0340099**                        |
|------------------------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                             |   |                                  |
| **1055  West 8th Street, Azusa, California**                     |   | **91702**                             |
| (Address of  principal executive offices)                        |   | (Zip Code)                            |

** **

**626-334-3395**

(Registrant’stelephone number, including area code)

**N/A**

(Formername, former address and former fiscal year, if changed since last report)

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for the past90 days.   Yes o   No x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of ‘‘accelerated filer’’ and ‘‘largeaccelerated filer’’ in Rule 12b-2 of the Exchange Act. (Check one):

Largeaccelerated filer o            Acceleratedfiler o            Non-acceleratedfiler x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theAct).   Yes o   No x

The number of sharesoutstanding of the registrant’s common stock, par value $.01 per share, as ofDecember 20, 2006, was 13,843,056.

 

 

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**PHYSICIANS FORMULA HOLDINGS, INC.**

**INDEX**
| **PART 1 — Financial  Information** |   |                                                                                                         |   |
|------------------------------------------|--------|--------------------------------------------------------------------------------------------------------------|--------|
|                                     |   |                                                                                                         |   |   |   |
| **Item  1.**                             |   | Financial  Statements (unaudited)                                                                            |   |   |   |
|                                     |   | Condensed Consolidated Balance Sheets as of September  30, 2006 and December 31, 2005                        |   | 3 |   |
|                                     |   | Condensed Consolidated Statements of Income for the  Three and Nine Months Ended September 30, 2006 and 2005 |   | 4 |   |
|                                     |   | Condensed Consolidated Statements of Cash Flows for  the Nine Months Ended September 30, 2006 and 2005       |   | 5 |   |
|                                     |   | Notes to Condensed Consolidated Financial Statements                                                         |   | 6 |   |
|                                     |   |                                                                                                         |   |   |   |
| **Item 2.**                              |   | Management’s Discussion and Analysis of Financial  Condition and Results of Operations                  |   | 13 |   |
| ** **                               |   |                                                                                                         |   |   |   |
| **Item 3.**                              |   | Quantitative and Qualitative Disclosures About Market  Risk                                                  |   | 18 |   |
| **Item 4.**                              |   | Controls and Procedures                                                                                      |   | 19 |   |
| ** **                               |   |                                                                                                         |   |   |   |
| ** **                               |   |                                                                                                         |   |   |   |
| **PART  II — Other Information**    |   |                                                                                                         |   |
|                                     |   |                                                                                                         |   |   |   |
| **Item  1A.**                            |   | Risk  Factors                                                                                                |   | 20 |   |
| **Item 2.**                              |   | Unregistered Sales of Equity Securities and Use of  Proceeds                                                 |   | 33 |   |
| **Item 4.**                              |   | Submission of Matters to a Vote of Security Holders                                                          |   | 33 |   |
| **Item 6.**                              |   | Exhibits                                                                                                     |   | 33 |   |
|                                     |   | Signatures                                                                                                   |   | 34 |   |
|                                          |        |                                                                                                              |        |  |  |  |

 

2

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**PART I — FINANCIAL INFORMATION**

**Item 1.Financial Statements**

**PHYSICIANSFORMULA HOLDINGS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS**

**(unaudited)(dollars in thousands, except share data)**
| ** **                                                                                                                | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **ASSETS**                                                                                                                |       |                   |       |                  |       |
| CURRENT ASSETS                                                                                                            |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                |       | $                      | 24         |                  | $          | 20 |   |
| Accounts  receivable, net of allowance for bad debts of $254 and $254                                                     |       | 13,815                 |       | 20,404                |       |
| Inventories                                                                                                               |       | 17,264                 |       | 17,377                |       |
| Prepaid expenses  and other current assets                                                                                |       | 1,985                  |       | 1,618                 |       |
| Income taxes  receivable                                                                                                  |       | 990                    |       | —                |       |
| Deferred income  taxes - net                                                                                              |       | 3,467                  |       | 3,902                 |       |
| Total current  assets                                                                                                     |       | 37,545                 |       | 43,321                |       |
| PROPERTY AND  EQUIPMENT - Net                                                                                             |       | 2,213                  |       | 2,261                 |       |
| OTHER ASSETS-Net                                                                                                          |       | 1,793                  |       | 1,675                 |       |
| INTANGIBLE  ASSETS-Net                                                                                                    |       | 56,754                 |       | 58,076                |       |
| GOODWILL                                                                                                                  |       | 17,463                 |       | 17,463                |       |
| TOTAL                                                                                                                     |       | $                      | 115,768    |                  | $          | 122,796 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                            |       |                   |       |                  |       |
| CURRENT LIABILITIES:                                                                                                      |       |                   |       |                  |       |
| Bank overdraft                                                                                                            |       | $                      | —     |                  | $          | 177 |   |
| Accounts payable                                                                                                          |       | 5,701                  |       | 7,232                 |       |
| Accrued expenses                                                                                                          |       | 3,273                  |       | 2,690                 |       |
| Trade allowances                                                                                                          |       | 3,030                  |       | 4,027                 |       |
| Sales returns  reserve                                                                                                    |       | 5,199                  |       | 6,989                 |       |
| Income taxes  payable                                                                                                     |       | —                 |       | 2,339                 |       |
| Line of credit  borrowings                                                                                                |       | 5,162                  |       | 8,769                 |       |
| Current portion  of long-term debt                                                                                        |       | 5,221                  |       | 4,177                 |       |
| Total current  liabilities                                                                                                |       | 27,586                 |       | 36,400                |       |
| DEFERRED  COMPENSATION                                                                                                    |       | 668                    |       | 597                   |       |
| DEFERRED INCOME  TAXES-Net                                                                                                |       | 23,304                 |       | 22,977                |       |
| LONG-TERM DEBT                                                                                                            |       | 55,059                 |       | 58,036                |       |
| COMMITMENTS AND  CONTINGENCIES                                                                                            |       |                   |       |                  |       |
| STOCKHOLDERS’  EQUITY:                                                                                               |       |                   |       |                  |       |
| Series A  preferred stock, $.01 par value—40,000 shares authorized, 0 shares issued and  outstanding                 |       | —                 |       | —                |       |
| Common stock,  $.01 par value—13,000,000 shares authorized, 10,421,916 and 10,051,750 shares  issued and outstanding |       | 104                    |       | 100                   |       |
| Additional  paid-in capital                                                                                               |       | 996                    |       | 905                   |       |
| Retained  earnings                                                                                                        |       | 8,051                  |       | 3,781                 |       |
| Total  stockholders’ equity                                                                                          |       | 9,151                  |       | 4,786                 |       |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                           |       | $                      | 115,768    |                  | $          | 122,796 |   |

 

Seenotes to condensed consolidated financial statements.

3

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**PHYSICIANSFORMULA HOLDINGS, INC.CONDENSED CONSOLIDATED STATEMENTS OF INCOME(unaudited)**

**(dollars in thousands, except per share data)**

 
| ** **                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                          | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| ** **                                          | ** ** | **2006**               | ** ** | **2005**              | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                           |       | $                      | 18,093     |                  | $          | 13,976 |   | $ | 68,865 |   | $ | 57,082 |   |
| Cost of sales                                       |       | 8,449                  |       | 5,481                 |       | 29,826 |   | 22,474 |   |
| Gross profit                                        |       | 9,644                  |       | 8,495                 |       | 39,039 |   | 34,608 |   |
|                                                |       |                   |       |                  |       |   |   |   |   |
| Selling, general and  administrative expenses       |       | 7,540                  |       | 6,988                 |       | 26,820 |   | 23,811 |   |
|                                                |       |                   |       |                  |       |   |   |   |   |
| Income from operations                              |       | 2,104                  |       | 1,507                 |       | 12,219 |   | 10,797 |   |
| Interest expense                                    |       | 1,945                  |       | 566                   |       | 5,457 |   | 1,623 |   |
| Other (income) expense                              |       | (32                    | )          | 9                     |       | (35 | ) | (109 | ) |
|                                                |       |                   |       |                  |       |   |   |   |   |
| Income before income  taxes                         |       | 191                    |       | 932                   |       | 6,797 |   | 9,283 |   |
| Income tax (benefit)  provision                     |       | (32                    | )          | 343                   |       | 2,527 |   | 3,595 |   |
|                                                |       |                   |       |                  |       |   |   |   |   |
| Net income                                          |       | 223                    |       | 589                   |       | 4,270 |   | 5,688 |   |
|                                                |       |                   |       |                  |       |   |   |   |   |
| Allocation of income to  preferred stockholders     |       | —                 |       | 819                   |       | — |   | 2,458 |   |
|                                                |       |                   |       |                  |       |   |   |   |   |
| Net income(loss)  available for common stockholders |       | $                      | 223        |                  | $          | (230 | ) | $ | 4,270 |   | $ | 3,230 |   |
|                                                |       |                   |       |                  |       |   |   |   |   |
| Net income(loss) per  common share:                 |       |                   |       |                  |       |   |   |   |   |
| Basic                                               |       | $                      | 0.02       |                  | $          | (0.02 | ) | $ | 0.41 |   | $ | 0.32 |   |
| Diluted                                             |       | $                      | 0.02       |                  | $          | (0.02 | ) | $ | 0.37 |   | $ | 0.28 |   |
|                                                |       |                   |       |                  |       |   |   |   |   |
| Weighted-average common  shares outstanding:        |       |                   |       |                  |       |   |   |   |   |
| Basic                                               |       | 10,421,916             |       | 10,051,750            |       | 10,399,331 |   | 10,042,485 |   |
| Diluted                                             |       | 11,614,506             |       | 10,051,750            |       | 11,603,042 |   | 11,530,184 |   |

 

Seenotes to condensed consolidated financial statements.

4

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**PHYSICIANSFORMULA HOLDINGS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(unaudited)(dollars in thousands)**
| ** **                                                                               | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                               | ** ** | **September 30,** | ** ** |
| ** **                                                                               | ** ** | **2006**               | ** ** | **2005** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                               | ** ** | ** **             | ** ** | ** ** | ** ** |
| Net income                                                                               |       | $                      | 4,270      |   | $ | 5,688 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:       |       |                   |       |   |   |
| Depreciation and  amortization                                                           |       | 1,898                  |       | 1,937 |   |
| Deferred income  taxes                                                                   |       | 762                    |       | 133 |   |
| Provision for  bad debts                                                                 |       | 58                     |       | 37 |   |
| Amortization of  debt issuance costs                                                     |       | 150                    |       | 38 |   |
| Accrued payment-in-kind  interest                                                        |       | 155                    |       | — |   |
| Changes in  operating assets and liabilities:                                            |       |                   |       |   |   |
| Accounts  receivable                                                                     |       | 6,531                  |       | 4,270 |   |
| Inventories                                                                              |       | 113                    |       | (1,524 | ) |
| Prepaid expenses  and other current assets                                               |       | (367                   | )          | 89 |   |
| Other assets                                                                             |       | (25                    | )          | (45 | ) |
| Accounts payable                                                                         |       | (1,531                 | )          | (3,097 | ) |
| Accrued  expenses, trade allowances and sales returns reserve                            |       | (2,158                 | )          | (1,276 | ) |
| Income taxes  payable/receivable                                                         |       | (3,271                 | )          | 131 |   |
| Net cash  provided by operating activities                                               |       | 6,585                  |       | 6,381 |   |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                               | ** ** | ** **             | ** ** | ** ** | ** ** |
| Purchase of property  and equipment                                                      |       | (528                   | )          | (394 | ) |
| **CASH FLOWS FROM FINANCING  ACTIVITIES:**                                               | ** ** | ** **             | ** ** | ** ** | ** ** |
| Paydowns of term  loans                                                                  |       | (2,088                 | )          | (2,002 | ) |
| Net paydowns  under line of credit                                                       |       | (3,607                 | )          | — |   |
| Debt issuance  costs                                                                     |       | (172                   | )          | — |   |
| Bank overdraft                                                                           |       | (177                   | )          | — |   |
| Exercise of  stock options                                                               |       | 37                     |       | 3 |   |
| Cash payment of  common stock dividend                                                   |       | (46                    | )          | — |   |
| Net cash used in  financing activities                                                   |       | (6,053                 | )          | (1,999 | ) |
|                                                                                     |       |                   |       |   |   |
| NET INCREASE IN CASH  AND CASH EQUIVALENTS                                               |       | 4                      |       | 3,988 |   |
| CASH AND CASH  EQUIVALENTS—Beginning of period                                      |       | 20                     |       | 417 |   |
| CASH AND CASH EQUIVALENTS—End  of period                                            |       | $                      | 24         |   | $ | 4,405 |   |
|                                                                                     |       |                   |       |   |   |
|                                                                                     |       |                   |       |   |   |
| SUPPLEMENTAL DISCLOSURE  OF CASH FLOW  INFORMATION—Cash paid during the period for: |       |                   |       |   |   |
| Interest                                                                                 |       | $                      | 3,715      |   | $ | 1,585 |   |
| Income taxes                                                                             |       | $                      | 5,037      |   | $ | 3,332 |   |

 

Seenotes to condensed consolidated financial statements.

 

5

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**PHYSICIANS FORMULA HOLDINGS, INC.NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Unaudited)**

**1. ORGANIZATIONAND BASIS OF PRESENTATION**

The accompanying unaudited condensed consolidatedfinancial statements include the accounts of Physicians Formula Holdings, Inc.(the ‘‘Company’’ or ‘‘Holdings’’), a Delaware corporation, and its wholly ownedsubsidiary, Physicians Formula, Inc. (‘‘Physicians’’), a New York corporation,and its wholly owned subsidiary, Physicians Formula Cosmetics, Inc.

The Company develops,markets, manufactures and distributes innovative, premium-priced products forthe mass market channel. The Company’s products include face powders, bronzers,concealers, blushes, foundations, eye shadows, eye liners, brow makeup andmascaras. The Company sells its products to mass market retailers such asWal-Mart, Target, CVS, Walgreens and Albertsons.

The accompanyingcondensed consolidated balance sheet as of September 30, 2006, the condensedconsolidated statements of income for the three and nine months ended September30, 2006 and 2005 and the condensed consolidated statements of cash flows forthe nine months ended September 30, 2006 and 2005 are unaudited. Theseunaudited condensed interim consolidated financial statements have beenprepared in accordance with U.S. generally accepted accounting principles forinterim financial information and Article 10 of Regulation S-X. In the opinionof the Company’s management, the unaudited condensed interim consolidatedfinancial statements include all adjustments of a normal recurring naturenecessary for the fair presentation of the Company’s financial position as ofSeptember 30, 2006, its results of operations for the three and nine monthsended September 30, 2006 and 2005, and its cash flows for the nine months endedSeptember 30, 2006 and 2005. The results for the interim periods are notnecessarily indicative of the results to be expected for any future period orfor the fiscal year ending December 31, 2006. The condensed consolidatedbalance sheet as of December 31, 2005 has been derived from the auditedconsolidated balance sheet as of that date.

These condensed interimconsolidated financial statements should be read in conjunction with theCompany’s financial statements and notes thereto for the year ended December31, 2005 included in our Prospectus dated November 8, 2006 and filed pursuantto Rule 424(b) under the Securities Act with the Securities and ExchangeCommission on November 9, 2006.

***Use of Estimates***—The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the amounts reported in the condensed consolidatedfinancial statements and accompanying notes. Actual results could differ fromthose estimates.

**2. NET INCOME PER SHARE**

Basic net income pershare is computed as net income (loss) attributable to common stockholdersdivided by the weighted-average number of common shares outstanding during theperiod. Diluted net income per share reflects the potential dilution that couldoccur from the exercise of outstanding stock options and is computed bydividing net income attributable to common stockholders by the weighted-averagenumber of common shares outstanding for the period, plus the dilutive effect ofoutstanding stock options, calculated using the treasury stock method. Thefollowing table summarizes the incremental shares from potentially dilutivesecurities:

6

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| ** **                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                       | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                             |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted-average number  of common shares-basic  |       | 10,421,916                                           |       | 10,051,750                                          |       | 10,399,331 |   | 10,042,485 |   |
| Effect of dilutive  employee stock options       |       | 1,192,590                                            |       | —                                              |       | 1,203,711 |   | 1,487,699 |   |
| Weighted-average number of common shares-diluted |       | 11,614,506                                           |       | 10,051,750                                          |       | 11,603,042 |   | 11,530,184 |   |

 

**3. NEW ACCOUNTING PRONOUNCEMENTS**

In June 2006, the Financial Accounting Standards Board(‘‘FASB’’) issued FASB Interpretation No. (“FIN”) 48, *Accounting for Uncertainty in Income Taxes*.FIN 48 prescribes a more likely than not threshold for financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN 48 also provides guidance on derecognition of income taxassets and liabilities, accounting for interest and penalties associated withtax positions, accounting for income taxes in interim periods and income taxdisclosures. FIN 48 is effective as of January 1, 2007. The Company iscurrently evaluating the impact of FIN 48 on the consolidated financial statements.

During September 2006, the Securities and ExchangeCommission issued Staff Accounting Bulletin (“SAB”) No. 108, *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements*,which provides interpretive guidance on the consideration of the effects ofprior year misstatements in quantifying current year misstatements for thepurpose of a materiality assessment. SAB No. 108 is effective for the firstfiscal year ending after November 15, 2006. The Company does not expect theadoption of SAB No. 108 to materially impact the consolidated financialstatements.

During September 2006, the FASB issued Statement ofFinancial Accounting Standard (“SFAS”) No. 157, *Fair Value Measurements*(“SFAS No. 157”). SFAS No. 157defines fair value, establishes a framework for measuring fair value andrequires enhanced disclosures about fair value measurements. SFAS No. 157requires companies to disclose the fair value of financial instrumentsaccording to a fair value hierarchy as defined in the standard. SFAS No. 157 iseffective for the Company at the beginning of fiscal 2008 and will be appliedon a prospective basis. The Company is currently evaluating the impact of SFASNo. 157 on the consolidated financial statements.

**4. INVENTORIES**

Inventories consist of the following (dollars inthousands):
| ** **                    | ** ** | **September 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                          |       |                         |       |                        |       |
| Raw materials and  components |       | $                            | 9,935      |                        | $          | 10,129 |   |
| Finished goods                |       | 7,329                        |       | 7,248                       |       |
|                          |       | $                            | 17,264     |                        | $          | 17,377 |   |

 

**5. INTANGIBLE ASSETS**

Intangible assets consist ofthe following as of September 30, 2006 (dollars in thousands):
| ** **                 | ** ** | **Gross Carrying Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
|----------------------------|------------|-------------------------------------|------------|-------------------------------|------------|-----------|------------|
| Trade names                |       | $                                   | 29,500     |                          | $          | —    |       | $ | 29,500 |   |
| Patents                    |       | 8,699                               |       | 1,691                         |       | 7,008     |       |
| Distributor  relationships |       | 23,701                              |       | 3,455                         |       | 20,246    |       |
| Total                      |       | $                                   | 61,900     |                          | $          | 5,146     |       | $ | 56,754 |   |

 

Intangible assets consist ofthe following as of December 31, 2005 (dollars in thousands):
| ** **                 | ** ** | **Gross Carrying Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
|----------------------------|------------|-------------------------------------|------------|-------------------------------|------------|-----------|------------|
| Trade names                |       | $                                   | 29,500     |                          | $          | —    |       | $ | 29,500 |   |
| Patents                    |       | 8,699                               |       | 1,256                         |       | 7,443     |       |
| Distributor  relationships |       | 23,701                              |       | 2,568                         |       | 21,133    |       |
| Total                      |       | $                                   | 61,900     |                          | $          | 3,824     |       | $ | 58,076 |   |

 

Amortization expense was$441,000 for both of the three month periods ended September 30, 2006 and 2005and $1,322,000 for both of the nine month periods ended September 30, 2006 and2005.  Amortization of intangible assetsfor the remainder of 2006 will be approximately $443,000 and for the next fiveyears will be approximately $1,765,000.

**6. TRANSACTIONS WITH RELATED PARTIES**

The Company had a subcontracting and managementservices agreement with entities controlled by one of its minoritystockholders. Sales to related parties under the subcontracting agreementtotaled $916,000 and $5,000 for the nine month periods ended

7

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September 30, 2005 and 2006, respectively. Thesubcontracting agreement expired in November 2006 and there was not asignificant level of sales in connection with the agreement through theremainder of the term. Expenses under the management service agreement, whichexpired in 2005, totaled $83,000 for the nine month period ended September 30,2005. Amounts due from related parties at December 31, 2005 were $20,000. Therewere no outstanding amounts due to related parties as of December 31, 2005. The2005 receivable is included in accounts receivable in the accompanyingcondensed consolidated balance sheets. There were no amounts due to or fromrelated parties at September 30, 2006.

The Company entered into a settlement agreement withPierre Fabre Dermo-Cosmetique, S.A. (“PFDC”) with respect to certainindemnification claims the Company asserted against PFDC under the terms of thepurchase agreement for the acquisition of Physicians by the Company in November2003 (the “Acquisition”). Pursuant to the settlement agreement, the Companyreceived $100,000 in July 2006 and agreed to set off certain claims against theindemnification deductible threshold, as established in the purchase agreementfor the Acquisition.

**7. SHARE-BASED COMPENSATION AND STOCKOPTION PLAN**

In November 2003, the Board of Directors adopted the2003 Stock Option Plan (the ‘‘2003 Plan’’) and reserved a total of 2,500,000shares for grants under the 2003 Plan. The 2003 Plan provides for the issuanceof stock options for common stock to executives and other key employees. As ofSeptember 30, 2006, the options generally have a 10-year life and generallyvest over a four-year period from the date of grant (‘‘Time-Vesting Options’’)or vest upon achieving certain performance criteria or upon a change of control(‘‘Performance-Vesting Options’’). Options are granted with exercise prices notless than the fair value at the date of grant, as determined by the Board ofDirectors.

On January 1, 2006, the Company adopted SFAS No. 123(revised 2004), *Share-Based Payment*(‘‘SFASNo. 123R’’) using the prospective method. Under the prospective method, thosenonpublic companies that used the minimum value method of measuring equityshare options and similar instruments for either recognition or pro formadisclosure purposes under this statement will apply SFAS No. 123R prospectivelyto new awards and to awards modified, repurchased, or cancelled after January1, 2006. The Company continues to account for any portion of awards outstandingat December 31, 2005 using the accounting principles originally applied tothose awards which were the provisions of Accounting Principles Board (“APB”)Opinion No. 25, *Accounting for Stock Issuedto Employees*, and its related interpretive guidance. Under SFAS No.123R, share-based payments (‘‘SBP’’) awards result in a cost that will bemeasured at fair value on the awards’ grant date, based on the estimated numberof awards that are expected to vest. Compensation cost for awards that vestwould not be reversed if the awards expire without being exercised. Theadoption of SFAS No. 123R did not have an impact on the Company’s consolidatedfinancial statements as no options have been granted or modified since January1, 2006 through September 30, 2006. Through December 31, 2005, the Companyaccounted for stock-based employee compensation arrangements in accordance withthe provisions of APB Opinion No. 25, and related interpretations. Under theintrinsic value method prescribed in APB Opinion No. 25, compensation expenseis based on the difference, if any, on the date of grant between the fair valueof the common stock and the exercise price of the option. For the periods priorto December 31, 2005, the Company did not record any compensation expense relatedto the option plan, since the exercise price of the options equaled their fairvalue at the date of grant. If the Company had recognized compensation expenseusing the provisions of SFAS No. 123R, the pro forma effects on theconsolidated net income for the nine months ended September 30, 2005, wouldhave been immaterial.

The stock option plan activity is summarized below:

8

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| ** **                                | ** ** | **Time-Vesting Options** | ** ** | **Performance-Vesting Options**      | ** ** |
|-------------------------------------------|------------|-------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | ** **                    | ** ** | **Weighted-Average  Exercise Price** | ** ** | ** ** | ** ** | **Weighted-Average  Exercise Price** | ** ** |
| Options  outstanding - January 1, 2006    |       | 863,666                       |       | $                                         | 0.11       |   | 713,334 |   | $ | 0.10 |   |
| Options  forfeited                        |       | (3,000                        | )          | 0.25                                      |       | — |   |   |   |
| Options  exercised                        |       | (370,166                      | )          | 0.10                                      |       | — |   |   |   |
| Options outstanding -  September 30, 2006 |       | 490,500                       |       | 0.11                                      |       | 713,334 |   | 0.10 |   |
|                                           |            |                               |            |                                           |            |  |  |  |  |  |  |

 

The Performance-Vesting Options have not vested as thecriteria for vesting has not been reached as of September 30, 2006 (See Note 10).

The vesting activity for the Time-Vesting Options issummarized below:
| ** **                                | ** ** | **Time-Vesting Options**    | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | ** **                       | ** ** | ** ** | ** ** | **Weighted Average** | ** ** |
| ** **                                | ** ** | **Vested and  Exercisable** | ** ** | **Aggregate  Exercise Price** | ** ** | **Exercise  Price** | ** ** | **Remaining  Contractual Life** | ** ** |
| Options  outstanding - January 1, 2006    |       | 394,584                          |       | $ | 39,000 |   |   |   |   |   |
| Vesting during  period                    |       | 49,250                           |       | 6,000 |   |   |   |   |   |
| Options  exercised                        |       | (370,166                         | )          | (37,000 | ) |   |   |   |   |
| Options outstanding -  September 30, 2006 |       | 73,668                           |       | 9,000 |   | $ | 0.12 |   | 7.4 years |   |
|                                           |            |                                  |            |  |  |  |  |  |  |  |  |

 

As of September 30, 2006,the options outstanding have exercise prices of $0.10 and $0.25 and theweighted-average remaining contractual life of the options outstanding was 7.2years.

**8. COMMITMENTS AND CONTINGENCIES**

***Litigation***—TheCompany has been named in various lawsuits in the ordinary course of business.In management’s opinion, the ultimate resolution of these matters will notresult in a material impact to the Company’s consolidated financial statements.

***Environmental***—Theshallow soils and groundwater below our City of Industry facility werecontaminated by the former operator of the property. The former operatorperformed onsite cleanup and we anticipate that we will receive writtenconfirmation from the State of California that no further onsite cleanup isnecessary. Such confirmation would not rule out potential liability forregional groundwater contamination or alleged potable water supplycontamination discussed below. If further onsite cleanup is required, theCompany believes the cost, which the Company is not able to estimate, would beindemnified, without contest or material limitation, by companies that havefulfilled similar indemnity obligations to the Company in the past, and thatthe Company believes remain financially able to do so.

The facility is located within an area of regionalgroundwater 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 regionalcontamination by the United States Environmental Protection Agency (“EPA”). TheCompany entered into a settlement with another PRP at the site, pursuant towhich, in return for a payment the Company has already made and that was fullyindemnified and paid by a second company, the other PRP indemnified the Companyagainst most claims for PVOU contamination. The 

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Company expects to enter into a consent decree withEPA and the other PRP that will resolve its liability for the cleanup ofregional groundwater contamination without any payment by us to EPA. Dependingon the scope and duration of the cleanup, the Company may be required to makefurther payments to the other PRP for regional groundwater remediation costs.The Company estimates the amount of any such additional payments would notexceed approximately $130,000. The estimate is based on component estimates fortwo distinct contaminants that may require remediation. Those estimates in turnare based on a number of assumptions concerning the likelihood that remediationwill be required, the cost of remediation if required and other matters.Uncertainty in predicting these matters limits the reliability and precision ofthe estimates. The Company expects any such additional payments by the Companyto be covered by indemnities given to the Company by other companies. Thosecompanies may contest their indemnity obligation for these payments. TheCompany believes the companies are financially able to pay the liability.Because the Company believes it is not probable that it will be held liable forany of these expenses, the Company has not recorded a liability for suchpotential claims.

The Company is also one of approximately 25 partiesconsidered potentially liable by a regional water authority for allegedcontamination of two of that water authority’s wells. The Company is fullyindemnified for this liability under a past settlement with a private company.The indemnity is not materially limited and the Company does not believe itwould be contested. The Company believes it is financially able to pay theliability. Because the Company believes it is not probable that it will be heldliable for any of these expenses, the Company has not recorded a liability forsuch potential claims for alleged contamination of the area’s potable watersupply.

The Company’s liability for these contaminationmatters and related claims is substantially covered by third-party indemnitiesand resolved by prior settlements, and borne by prior operators of thefacility, their successors and their insurers. The Company is attempting torecoup approximately $0.6 million in defense costs from one of theseindemnitors. These costs have been expensed as paid by the Company and are notrecorded in its condensed consolidated balance sheets.

***Bonus Agreement***—OnDecember 16, 2005, the Company committed to pay its Chief Financial Officer a$500,000 bonus upon a sale of the Company so long as the aggregate cashproceeds received by the majority owner is equal to or greater than three timesthe amount of the majority owner’s original investment in the Company. Noamounts have been accrued under this arrangement as of September 30, 2006.

**9. GEOGRAPHIC INFORMATION**

Geographic revenue information is based on thelocation of the customer. All of the Company’s assets are located in the UnitedStates. Net sales to external customers by geographic region are as follows(dollars in thousands):
| ** **    | ** ** | **Three Months Ended September 30,** | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Customer**  | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| United States |       | $                                                        | 16,521     |                                                    | $          | 12,909 |   | $ | 63,787 |   | $ | 52,804 |   |
| Canada        |       | 1,451                                                    |       | 817                                                     |       | 4,776 |   | 3,290 |   |
| Other         |       | 121                                                      |       | 250                                                     |       | 302 |   | 988 |   |
|          |       | $                                                        | 18,093     |                                                    | $          | 13,976 |   | $ | 68,865 |   | $ | 57,082 |   |

 

**10. SUBSEQUENTEVENTS**

***InitialPublic Offering and New Senior Credit Agreement***

On November 14, 2006, the Company completed an initialpublic offering of shares of the Company’s common stock. In the initial publicoffering, the Company sold 3,125,000 shares of common stock and the sellingstockholders sold 5,500,000 shares of common stock, which includes 1,125,000shares of common stock sold by the selling stockholders pursuant to theunderwriters’ over-allotment option. The underwriters exercised thisover-allotment on November 10, 2006 and the initial public offering closed onNovember 14, 2006. In connection with the initial public offering the Companyamended the then-existing certificate of incorporation and by-laws to 

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increase the number of authorized shares of commonstock to 50,000,000 shares, par value $0.01 per share, and the number ofauthorized shares of preferred stock to 10,000,000 shares, par value $.01 pershare.

The Company receivedapproximately $49.4 million in net proceeds from the initial public offering,after deducting underwriting discounts and commissions of approximately $3.7million, and $15.0 million under the new term loan and borrowed approximately$4.4 million under the new revolving credit facility, the proceeds from whichwere used to repay all its borrowings and accrued interest under the existingsenior credit agreement of $47.6 million, to repay its senior subordinatednotes, to pay all accrued and unpaid cash and payment-in-kind interest on thosenotes of $20.9 million and to pay certain expenses of the offering. The Companyestimates that the total expenses of the offering were $2.8 million, of which$1.5 million was paid prior to the closing date of the offering. In addition,the Company paid debt issuance costs associated with the new senior creditagreement of $0.2 million and paid IPO completion bonuses of $0.3 million.

On November 14, 2006, PhysiciansFormula, Inc. entered into a new senior credit agreement with a bank that willterminate in 2011 and consists of a $15.0 million term loan facility and arevolving credit facility providing for borrowings of up to $20.0 million. Theavailability under the revolving credit facility is reduced by outstandingletters of credit. Borrowings under the new senior credit agreement areguaranteed by the Company and the domestic subsidiary of Physicians Formula,Inc., and borrowings under the new senior credit agreement are secured by lienson substantially all of the assets of Physicians Formula, Inc., including theassets of its subsidiary. Amounts outstanding under the term loan facility aredue in quarterly payments, starting December 31, 2006, of $375,000, andincreasing to $562,500 on December 31, 2007, $750,000 on December 31, 2008,$937,500 on December 31, 2009 and $1,125,000 on December 31, 2010.

Amounts outstanding underthe term loan facility and revolving credit facility bear interest at a LIBOR AdjustedRate (as defined in the new senior credit agreement) plus 2.0% or at a BaseRate (as defined in the new senior credit agreement) plus 0.5%. The revolvingcredit facility is also subject to a commitment fee of one-quarter of 1.0% onany unused commitments.

The new senior creditagreement contains the following financial covenants: a maximum total leverageratio; a minimum fixed charge coverage ratio; a minimum net worth requirement;and a limitation on capital expenditures (which may be no more than $3,000,000per fiscal year).

The new senior creditagreement contains certain additional negative covenants, including limitationson our ability to: incur other indebtedness and liens; fundamentally change ourbusiness through a merger, consolidation, amalgamation or liquidation; sellassets; pay cash dividends or pay for expenses of Physicians Formula Holdings, Inc.,unless certain conditions are satisfied; make certain acquisitions,investments, loans and advances; engage in transactions with our affiliates;enter into certain agreements; engage in sale-leaseback transactions; incurcertain unfunded liabilities; and change our line of business.

The new senior creditagreement requires us to make mandatory prepayments with the proceeds ofcertain asset dispositions and upon the receipt of insurance or condemnationproceeds to the extent we do not use the proceeds for the purchase ofsatisfactory replacement assets.

On December 18, 2006, theCompany terminated the existing interest rate collar agreement at a cost of$7,500.

***2006 EquityIncentive Plan***

In connection with theCompany’s initial public offering, the Company adopted the Physicians FormulaHoldings, Inc. 2006 Equity Incentive Plan. The equity incentive plan providesfor grants of stock options, stock appreciation rights, restricted stock,restricted stock units, deferred stock units and other performance awards todirectors, officers and employees of the Company, as well as others performingservices for the Company. A total of 900,000 shares of common stock areavailable for issuance under the equity incentive plan. This amount willautomatically increase on the first day of each fiscal year beginning in 2007and ending in 2016 by the lesser of: (i) 2% of the shares of common stockoutstanding on the last day of the immediately preceding fiscal year or (ii) 

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such lesser number ofshares as determined by the compensation committee of the Board of Directors. Nogrants have been made under the equity incentive plan as of the date of this filing.

***Amendment ofPerformance-Vesting Options***

In connection with theCompany’s initial public offering, the Company amended the Performance-VestingOptions to accelerate the vesting of 550,781 of such options on November 14,2006, the closing date of the initial public offering.  The remaining Performance-Vesting Optionsthat did not vest on November 14, 2006 became time-vesting options that vestand become exercisable in 24 equal installments over a period of two years fromNovember 14, 2006.

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**Item 2.**                          Management’s Discussion andAnalysis of Financial Condition and Results of Operations

**General**

This discussion should beread in conjunction with the Notes to Condensed Consolidated FinancialStatements included herein and the Notes to Consolidated Financial Statementsand Management’s Discussion and Analysis of Financial Condition and Results ofOperations included in our Prospectus dated November 8, 2006 and filed pursuantto Rule 424(b) under the Securities Act with the Securities and ExchangeCommission on November 9, 2006.

**Overview of the Business**

We are one of the fastest growing cosmetics companiesof the ten largest in the U.S. mass market channel by retail sales. Wespecialize in developing, marketing and distributing innovative, premium-pricedproducts for the mass market channel. Our products focus on addressing skinimperfections through a problem-solution approach, unlike competitors whoseproducts focus primarily on changing fashion trends. Our products addressspecific, everyday cosmetics needs and include face powders, bronzers,concealers, blushes, foundations, eye shadows, eye liners, brow makeup andmascaras.

We sell our products to mass market retailers such asWal-Mart, Target, CVS, Walgreens and Albertsons. Our products provideabove-average profitability for retailers due to their higher price points andsales per linear foot. Our products are currently sold in approximately 23,200of the 45,000 stores in which we estimate our *masstige* (*asdefined below*)**competitors’products are sold. We seek to be first-to-market with new products within thischannel, and are able to take new products from concept development to shipmentin less than 12 months. New products are a very important part of our businessand have contributed, on average, approximately 30% of our net sales for thelast three years.

**Overview of U.S. Market Share Data**

We define the *masstige* market as products sold in themass market channel under the following premium-priced brands: PhysiciansFormula, Almay, L’Oreal, Max Factor, Neutrogena, Revlon and Vital Radiance. Thefollowing table sets forth the market position and approximate share, based onretail sales, of our products in total and for selected categories within the *masstige* market, as we define it, based onACNielsen(1) data for the 52 weeks ended November 4, 2006:
| ** **    | ** ** | **52 Weeks Ended November 4, 2006** | ** ** |
|---------------|------------|--------------------------------------------------------------|------------|
| ** **    | ** ** | ***Masstige*  ($ Share)**                               | ** ** | **% Change  vs. Prior Year  ($ Share)** | ** ** |
| Total Company |       | 6.9                                                          | %          | 26.0 | % |
|          |       |                                                         |       |   |   |
| Face          |       | 12.7                                                         | %          | 30.0 | % |
| Eye           |       | 5.2                                                          | %          | 16.0 | % |

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(1)                                  ACNielsenis an independent research entity. ACNielsen data does not include Wal-Mart,which is our largest customer.

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## **Seasonality**

Our business, similar toothers in the cosmetic industry, is subject to seasonal variation due to theannual “sell-in” period when retailers decide how much retail space will beallotted to each supplier and the number of new and existing products to beoffered in their stores. For us, this period has historically been fromDecember through April. Sales during these months are typically greater due tothe shipments required to fill the inventory at retail stores and retailers’warehouses. Retailers typically reset their retail selling space during thesemonths to accommodate changes in space allocation to each supplier and toincorporate the addition of new products and the deletion of slow-sellingitems. Our net sales for the three months ended December 31, 2005 were higherthan our net sales for the three months ended September 30, 2005, as a resultof this seasonality. Our quarterly results of operations may fluctuate as aresult of a variety of reasons including the timing of new product introductions,general economic conditions or consumer buyer behavior. In addition, resultsfor any one quarter may not be indicative of results for the same quarter insubsequent years.

**Results of Operations**

The following table setsforth condensed consolidated statements of income for the three and nine monthsended September 30, 2006 and 2005 (dollars in thousands):
| ** **                                          | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **September 30,  2006**     | ** ** | ** **                      | ** ** | **September 30,  2005** | ** ** | ** ** | ** ** | **September 30,  2006** | ** ** | ** ** | ** ** | **September 30,  2005** | ** ** | ** ** | ** ** |
| Net sales                                           |       | $                                | 18,093     |                            | 100.0      | % | $ | 13,976 |   | 100.0 | % | $ | 68,865 |   | 100.0 | % | $ | 57,082 |   | 100.0 | % |
| Cost of sales                                       |       | 8,449                            |       | 46.7                            | %          | 5,481 |   | 39.2 | % | 29,826 |   | 43.3 | % | 22,474 |   | 39.4 | % |
| Gross profit                                        |       | 9,644                            |       | 53.3                            | %          | 8,495 |   | 60.8 | % | 39,039 |   | 56.7 | % | 34,608 |   | 60.6 | % |
|                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Selling, general and  administrative expenses       |       | 7,540                            |       | 41.7                            | %          | 6,988 |   | 50.0 | % | 26,820 |   | 38.9 | % | 23,811 |   | 41.7 | % |
|                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Income from operations                              |       | 2,104                            |       | 11.6                            | %          | 1,507 |   | 10.8 | % | 12,219 |   | 17.7 | % | 10,797 |   | 18.9 | % |
|                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense                                    |       | 1,945                            |       | 10.8                            | %          | 566 |   | 4.0 | % | 5,457 |   | 7.9 | % | 1,623 |   | 2.8 | % |
| Other (income) expense                              |       | (32                              | )          | (0.2                            | )%         | 9 |   | 0.1 | % | (35 | ) | (0.1 | )% | (109 | ) | (0.2 | )% |
| Income before income  taxes                         |       | 191                              |       | 1.1                             | %          | 932 |   | 6.7 | % | 6,797 |   | 9.9 | % | 9,283 |   | 16.3 | % |
| Income tax (benefit)  provision                     |       | (32                              | )          | (0.2                            | )%         | 343 |   | 2.5 | % | 2,527 |   | 3.7 | % | 3,595 |   | 6.3 | % |
| Net income                                          |       | 223                              |       | 1.2                             | %          | 589 |   | 4.2 | % | 4,270 |   | 6.2 | % | 5,688 |   | 10.0 | % |
|                                                |       |                             |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allocation of income to  preferred stockholders     |       | —                           |       | —                          |       | 819 |   | 5.9 | % | — |   | — |   | 2,458 |   | 4.3 | % |
| Net income (loss) available for common stockholders |       | $                                | 223        |                            | 1.2        | % | $ | (230 | ) | (1.6 | )% | $ | 4,270 |   | 6.2 | % | $ | 3,230 |   | 5.7 | % |

 

#### Thefollowing is a discussion of our results of operations for the three monthsended September 30, 2006 and September 30, 2005 and nine months ended September30, 2006 and September 30, 2005.

#### **ThreeMonths Ended September 30, 2006 Compared to Three Months Ended September 30,2005**

*NetSales*. Net Sales increased $4.1 million, or 29.5%, to $18.1million for the three months ended September 30, 2006, from $14.0 million forthe three months ended September 30, 2005. The increase was primarilyattributable to growth in sales of our face and eye makeup products, as wecontinued to broaden our total distribution. Total distribution represents thenumber of stores in which we sell products multiplied by our number of stockkeeping units per store. Total unit volume increased by 1.0 million units, or23.6%, to 5.1 million units for the three months ended September 30, 2006, from4.1 million units for the same period a year ago. Excluding subcontracted unitvolume sold under a manufacturing agreement and license with our former parentcompany Pierre Fabre, which expired on November 2, 2006, our total unit volumeincreased by 1.4 million units, or 36.5%, to 5.1 million units for the threemonths ended September 30, 2006, from 3.7 million units for the three months 

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ended September 30, 2005.New products represented 33% of our net sales for the three months endedSeptember 30, 2006, lower than the same period a year ago when new productscontributed 37% of net sales. Partially offsetting our net sales growth for thethree months ended September 30, 2006 was an increase in our returns provisiondue to higher returns resulting from our retailer customers’ wall displaychanges, an increase in promotional returns and a retailer customer consolidation.Our increase in net sales was also partially offset by an increase in couponexpense as well as trade allowances that were attributable primarily toincremental spending for in-store retailer customer advertising and promotionexpenses. During the three months ended September 30, 2006, our resultsincluded net sales of $1.6 million from our international customers, comparedto $1.1 million for the three months ended September 30, 2005. Internationalsales included subcontracted net sales under the manufacturing and license withPierre Fabre in the three months ended September 30, 2005. There were nosubcontracted net sales for the three months ended September 30, 2006, comparedto $0.1 million for the three months ended September 30, 2005.

*Cost ofSales.*Cost of sales increased $3.0 million, or 54.1%, to$8.4 million for the three months ended September 30, 2006 from $5.5 millionfor the three months ended September 30, 2005. Cost of sales as a percent ofnet sales was 46.7% of net sales for the three months ended September 30, 2006,compared to 39.2% for the three months ended September 30, 2005. The increasein cost of sales as a percentage of net sales was attributable to higherinbound freight costs of $0.6 million resulting from higher fuel surcharges andair freight from our freight carriers, an increase of $0.5 million from thewrite-down of slow selling and discontinued product inventory, and an increasein product costs of $0.3 million primarily due to the outsourcing of productionfor a new product that will be manufactured at a lower cost in-house by the endof 2006 and higher labor costs resulting from overtime associated with meetingsales demand.

*Selling,General and Administrative Expenses.* Selling, general andadministrative expenses increased by $0.5 million, or 7.9%, to $7.5 million forthe three months ended September 30, 2006, from $7.0 million for the threemonths ended September 30, 2005. The increase was principally due toincremental expenses of $0.4 million related to preparing for compliance withSarbanes Oxley requirements, a $0.3 million increase in variable costsconsisting of higher outbound freight costs and warehouse allowances related toour sales growth, and a $0.2 million increase in overhead costs due primarilyto higher distribution expenses and employee compensation. Partially offsettingthese increases was a $0.4 million decrease in marketing and selling expensesdue primarily to the timing of advertising spending as compared to the sameperiod a year ago. Selling, general and administrative expenses decreased to41.7% as a percentage of net sales for the three months ended September 30,2006, from 50.0% for the same period last year, due primarily to higher netsales during the three months ended September 30, 2006.

*InterestExpense.* Interest expense increased by $1.3 million to $1.9million for the three months ended September 30, 2006, from $0.6 million forthe three months ended September 30, 2005. The increase in interest expense wasdue to the increase in average borrowings outstanding on our existing revolvingcredit facility, the increase in our long-term debt as a result of our December2005 recapitalization and an increase in interest rates during the period. Weexpect interest expense to decrease following our initial public offeringbecause we have less debt outstanding upon completion of the offering.

*OtherIncome*. Other income increased by $41,000, or 455.6%, to$32,000 for the three months ended September 30, 2006, from other expense of$9,000 for the three months ended September 30, 2005. Other income for thethree months ended September 30, 2006 was attributable to realized andunrealized gains related to investments held as part of our non-qualifieddeferred compensation plan.

*Provisionfor Income Taxes*. The income tax benefit for the three monthsended September 30, 2006 was $32,000, representing a true up of the provisionto the 2005 tax return with a resulting effective income tax rate of 16.8%. Thisbenefit is compared to income tax expense of $0.3 million, representing aneffective tax rate of 36.8%, for the three months ended September 30, 2005. Theeffective rates differed from the statutory rates due to the effect of varyingstate and local taxes and certain permanent items such as extra territorialincome exclusions.

**NineMonths Ended September 30, 2006 Compared to Nine Months Ended September 30,2005**

*NetSales*. Net Sales increased $11.8 million, or 20.6%, to $68.9million for the nine months ended September 30, 2006, from $57.1 million forthe nine months ended September 30, 2005. The increase was primarilyattributable 

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to continued growth insales of our face and eye makeup products, as we continued to broaden our totaldistribution throughout our sales channels and increase awareness throughincreased marketing spending. Total unit volume increased by 1.7 million units,or 10.6%, to 17.3 million units for the nine months ended September 30, 2006,from 15.7 million units for the same period a year ago. Net sales growth waspartially offset by a reduction in subcontracted unit volume of 1.9 millionunits, or 99.8%, as compared to the prior period. Subcontracted units were soldunder a manufacturing agreement and license with our former parent company,Pierre Fabre, which expired on November 2, 2006. Excluding subcontractingvolume, total unit volume increased 25.6% for the nine months ended September30, 2006 as compared to the same period a year ago. In addition, we sold agreater percentage of higher-priced face powder products this year as comparedto last year. New products represented 38% of our net sales for the nine monthsended September 30, 2006, which was consistent with the same period a year agowhen new products contributed 38% of net sales. Partially offsetting our netsales growth for the nine months ended September 30, 2006 was an increase inour returns provision due to higher returns resulting from our retailercustomers’ wall display changes, an increase in promotional returns, and aretailer customer consolidation. We have experienced an upward trend in therate of returns during 2006. We expect the trend to continue for the remainderof this year. Our increase in net sales was also partially offset by anincrease in trade allowances that was attributable primarily to incrementalcoupon expenses. During the nine months ended September 30, 2006, our resultsincluded net sales of $5.1 million from our international customers, comparedto $4.3 million for the nine months ended September 30, 2005.

*Cost ofSales.*Cost of sales increased $7.4 million, or 32.7%, to$29.8 million for nine months ended September 30, 2006, from $22.5 million forthe nine months ended September 30, 2005. Cost of sales as a percent of netsales was 43.3% of net sales for the nine months ended September 30, 2006,compared to 39.4% for the nine months ended September 30, 2005. The increase incost of sales as a percentage of net sales was attributable to an increase inproduct costs of $1.3 million primarily resulting from the temporaryoutsourcing of production for a new product that will be manufactured at alower cost in-house by the end of 2006 as well as higher labor costs resultingfrom overtime associated with meeting sales demand, higher inbound freightcharges of $1.0 million due to an increase in fuel surcharges and air freightfrom our freight carriers and an increase of $0.4 million from the write-downof product inventory.

*Selling,General and Administrative Expenses.* Selling, general andadministrative expenses increased by $3.0 million, or 12.6%, to $26.8 millionfor the nine months ended September 30, 2006, from $23.8 million for the ninemonths ended September 30, 2005. The increase was principally due to a $1.2million increase in marketing and selling expenses driven by increases inadvertising and promotion, a $0.8 million increase in variable costs consistingof higher outbound freight costs and warehouse allowances related to our salesgrowth, a $0.6 million increase in overhead costs due primarily to higher distributionexpenses and employee compensation, and incremental expenses of $0.4 millionrelated to preparing for compliance with Sarbanes Oxley requirements. Selling,general and administrative expenses decreased to 38.9% as a percentage of netsales for the nine months ended September 30, 2006, from 41.7% for the sameperiod last year, due primarily to higher net sales during the nine monthsended September 30, 2006.

*InterestExpense.* Interest expense increased by $3.8 million, or236.2%, to $5.5 million for the nine months ended September 30, 2006, from $1.6million for the nine months ended September 30, 2005. The increase in interestexpense was due to the increase in average borrowings outstanding on ourexisting revolving credit facility, the increase in our long-term debt as aresult of our December 2005 recapitalization and an increase in interest ratesduring the period. We expect interest expense to decrease following our initialpublic offering because we will have less debt outstanding upon completion ofthe offering.

*OtherIncome*. Other income decreased by $74,000, or 67.9%, to$35,000 for the nine months ended September 30, 2006, from other income of$109,000 for the nine months ended September 30, 2005. Other income for the ninemonths ended September 30, 2006 was attributable to realized and unrealizedlosses related to investments held as part of our non-qualified deferredcompensation plan.

*Provisionfor Income Taxes*. Income tax expense for the nine monthsended September 30, 2006 was $2.5 million, representing an effective income taxrate of 37.2%, compared to income tax expense of $3.6 million, representing aneffective tax rate of 38.7%, for the nine months ended September 30, 2005. Theeffective rates differed from the statutory rates due to the effect of varyingstate and local taxes and certain permanent items such as extra territorialincome exclusions.

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## **Liquidity and Capital Resources**

***Cash Flows***

As of September 30, 2006,we had $24,000 in cash and cash equivalents compared to $20,000 in cash as ofDecember 31, 2005. The low level of cash reflects the use of cash to pay downthe old revolving credit facility on a regular basis. As of September 30, 2006we had $9.8 million of availability under the old revolving credit facility.

*Operatingactivities*. Cash provided by operating activities increased$0.2 million, or 3%, to $6.6 million for the nine months ended September 30,2006, from $6.4 million for the nine months ended September 30, 2005. The netincrease in cash provided by operating activities resulted primarily fromfavorable changes in working capital due primarily to higher collections onreceivables, partially offset by lower net income. Our inventory turnover ratehas been relatively consistent at 1.9 times per year for both 2004 and 2005,but improved to an annualized 2.1 times per year for the nine months endedSeptember 30, 2006. Days sales outstanding increased 2.2 days, to 46.9 days inSeptember 2006 from 44.7 days in September 2005 due primarily to the impact onour receivables of higher sales in the third quarter of this year.

*Investingactivities.* Cash used in investing activities for the ninemonths ended September 30, 2006 was $528,000, which was related to capitalexpenditures for basic replacement and upgrade of machinery and equipment,spending for upgrading tube sealing and filling equipment, and partial paymentsfor our automated assembly line project which is scheduled to be completedduring the third quarter of 2007. Cash used in investing activities for thenine months ended September 30, 2005 of $394,000 was related to capitalexpenditures for basic replacement and upgrade of machinery and equipment.

*Financingactivities*. Cash used in financing activities was $6.1million for the nine months ended September 30, 2006 compared to cash used infinancing operations of $2.0 million for the nine months ended September 30,2005. The increase in cash used in financing activities between periodsprimarily resulted from higher debt service related to the long-term debt, aswell as subsequent repayments of our revolving credit facility for workingcapital needs.

*FutureLiquidity and Capital Needs.* The significant components ofour working capital are cash, accounts receivable and inventory, reduced bybank overdraft, accounts payable and accrued expenses. Net working capitalrequirements are projected to increase by $7.1 million, or approximately 103%,to $14.0 million in 2006, from $6.9 million in 2005. We anticipate that workingcapital will increase during the fourth quarter of 2006, when we typicallyexperience higher inventory levels as we produce new products for shipment inthe first quarter of the following year. We have budgeted capital expendituresof $1.7 million for 2006, compared to $0.7 million in 2005. Capitalrequirements related to manufacturing include a major project to automateproduct assembly lines that are used to assemble products representingapproximately half of our total sales in 2005. We expect this to addapproximately $1.1 million to our normal level of capital expenditures, partlyin 2006 and partly in 2007. We have budgeted capital expenditures of $2.5million for 2007 for several key projects, including completion of ourautomated assembly line, investment in our information technologyinfrastructure and improvements to our warehouse distribution systems. We mayalso need to replace our IBM AS/400 mainframe computer to accommodate futuregrowth at a cost we estimate at approximately $0.5 million, and implementimprovements to our warehouse distribution systems at a cost of approximately$0.4 million. We are currently upgrading tube sealing and filling equipment toimprove product quality. We believe that our cash flows from operations andfunds from our new revolving credit facility will provide adequate funds forour working capital needs and planned capital expenditures for at least thenext twelve months. No assurance can be given, however, that this will be thecase.

***CreditFacilities***

At September 30, 2006,there was $5,162,000 outstanding under the revolving credit facility at aninterest rate of 10.25%. Amounts outstanding under the term loan were due inquarterly payments, starting March 31, 2006, of $1,044,000, and increasing to$2,506,000 through December 2010. The balance outstanding under thesubordinated notes were due on December 16, 2012. The interest rate on the termloan was 9.25% at September 30, 2006.

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On November 14, 2006, PhysiciansFormula, Inc. entered into a new senior credit agreement with a bank that willterminate in 2011and consists of a $15.0 million term loan facility and arevolving credit facility providing for borrowings of up to $20.0 million. Weused the borrowings under the new senior credit agreement and a portion of thenet proceeds of the initial public offering to repay borrowings and accruedinterest under the existing credit agreement. The availability under therevolving credit facility is reduced by outstanding letters of credit. Borrowingsunder the new senior credit agreement are guaranteed by Physicians FormulaHoldings, Inc. and the domestic subsidiary of Physicians Formula, Inc., andborrowings under the new senior credit agreement are secured by liens onsubstantially all of the assets of Physicians Formula, Inc., including theassets of its subsidiary. Amounts outstanding under the term loan facility aredue in quarterly payments, starting December 31, 2006, of $375,000, andincreasing to $562,500 on December 31, 2007, $750,000 on December 31,2008, $937,500 on December 31, 2009 and $1,125,000 on December 31,2010.

Amounts outstanding underthe term loan facility and revolving credit facility bears interest at a LIBOR AdjustedRate (as defined in the new senior credit agreement) plus 2.0% or at a BaseRate (as defined in the new senior credit agreement) plus 0.5%. The revolvingcredit facility is also subject to a commitment fee of one-quarter of 1.0% onany unused commitments.

The new senior creditagreement contains the following financial covenants: a maximum total leverageratio; a minimum fixed charge coverage ratio; a minimum net worth requirement;and a limitation on capital expenditures (which may be no more than $3,000,000per fiscal year).

The new senior creditagreement contains certain additional negative covenants, including limitationson our ability to: incur other indebtedness and liens; fundamentally change ourbusiness through a merger, consolidation, amalgamation or liquidation; sellassets; pay cash dividends or pay for expenses of Physicians Formula Holdings, Inc.,unless certain conditions are satisfied; make certain acquisitions,investments, loans and advances; engage in transactions with our affiliates;enter into certain agreements; engage in sale-leaseback transactions; incurcertain unfunded liabilities; and change our line of business.

The new senior creditagreement requires us to make mandatory prepayments with the proceeds ofcertain asset dispositions and upon the receipt of insurance or condemnationproceeds to the extent we do not use the proceeds for the purchase ofsatisfactory replacement assets.

**Off-BalanceSheet Transactions**

The Company does not haveany relationships with unconsolidated entities or financial partnerships, suchas entities often referred to as structured finance or special purposeentities, which would have been established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes. In addition, the Company does not engage in trading activitiesinvolving non-exchange traded contracts that rely on estimation techniques tocalculate fair value. As such, we are not exposed to any financing, liquidity,market or credit risk that could arise if we had engaged in such relationships.

**Forward-LookingStatements**

This section and otherparts of this Quarterly Report on Form 10-Q contain forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933, as amended andSection 21E of the Secutities Exchange Act of 1934, as amended. In some cases,forward-looking statements can be identified by words such as “anticipates,” “expects,”“believes,” “plans,” “predicts,” and similar terms. Such forward-lookingstatements are based on current expectations, estimates and projections aboutour industry, management’s beliefs and assumptions made by management.Forward-looking statements are not guarantees of future performance and ouractual results may differ significantly from the results discussed in theforward-looking statements. Factors that might cause such differences include,but are not limited to those discussed in Part II, Item 1A, “Risk Factors.”Unless otherwise required by law, we expressly disclaim any obligation toupdate publicly any forward-looking statements, whether as result of newinformation, future events or otherwise.

**Item 3.**                          Quantitativeand Qualitative Disclosures About Market Risk

**(a)****          Foreign Currency Risk**

The Company paysoverseas suppliers and third-party manufacturers in U.S. dollars. A decrease inthe value of the euro and the Chinese yuan relative to the U.S. dollar couldcause our suppliers to raise prices that would result in higher cost of sales. Thevolatility of the applicable rates and prices are dependent on many factorsthat cannot be forecast with reliable accuracy. Our current reliance on foreignsuppliers for many of the raw materials and components used to produce productsmakes it possible that the Company’s operating results may be affected byfluctuations in the exchange rate of the currencies of the suppliers. The Companydoes not have any foreign currency hedges.

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(b)         **Interest Rate Risk**

The Company isexposed to interest rate risks primarily through borrowings under our revolvingloan arrangement and term loans. Interest on these borrowings is based uponvariable interest rates. Our weighted-average borrowings outstanding under therevolving loan arrangement and term loans during the nine months endedSeptember 30, 2006 was $44.8 million and the weighted-average interest rate ineffect at September 30, 2006 was 9.36%. An interest rate collar that we enteredinto in March 2006 mitigates the interest rate risk. This agreement has anotional amount of $21,000,000 and expires in March 2008. The agreementestablishers a floor interest rate of 4.05% and a cap interest rate of 5.6%. Basedon the foregoing, a hypothetical 1% increase or decrease in interest rateswould have resulted in a $336,000 change to interest expense in the nine monthsended September 30, 2006. On December 18, 2006, the Company terminated theexisting interest rate collar agreement at a cost of $7,500.

**Item 4.**                          Controlsand Procedures

The Company maintains disclosure controls andprocedures that are designed to ensure that information required to bedisclosed in its reports pursuant to the Securities Exchange Act of 1934, asamended (the “Exchange Act”), is recorded, processed, summarized and reportedwithin the time periods specified Rule 13a-15 under the Exchange Act, and thatsuch information is accumulated and communicated to the Company’s management, includingits Chief Executive Officer and Chief Financial Officer, as appropriate, toallow timely decisions regarding required disclosure. Management is responsiblefor establishing and maintaining adequate internal control over financialreporting.

As required by Rule 13a-15(b) under the Exchange Act,the Company carried out an evaluation, under the supervision and with theparticipation of its management, including the Chief Executive Officer and theChief Financial Officer, of the effectiveness of the design and operation ofthe Company’s disclosure controls and procedures. Based on the foregoing, itsChief Executive Officer and Chief Financial Officer determined that disclosurecontrols and procedures were effective at a reasonable assurance level as of theend of the period covered by this report.

There has been no change in internal controls overfinancial reporting during the most recent fiscal quarter that has materiallyaffected, or is reasonably likely to materially affect, internal controls overfinancial reporting.

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# **PART II —Other Information**

**Item 1A.**                 Risk Factors

*Investing in our common stockinvolves a high degree of risk. You should carefully consider the followingrisk factors and all other information contained in this prospectus beforemaking a decision to invest in our common stock. If any of the following risksoccur, our business, results of operations and financial condition may bematerially and adversely affected. In that event, the trading price of ourcommon stock could decline, and you could lose all or part of your investment.*

**Risks Related to Our Business andIndustry**

***The high level ofcompetition in our industry could harm our business, financial performance,market share and profitability. Many of our competitors have substantiallygreater resources than we do.***

The business of selling cosmetics is highlycompetitive. This market includes numerous manufacturers, distributors,marketers and retailers that actively compete for consumers both in the UnitedStates and abroad. The cosmetics market is highly sensitive to the introductionof new products, which may rapidly capture a significant share of the market.In addition, our products may be, or are at the risk of becoming, obsolete dueto new product introductions or new technologies. Our competitors may foreseethe course of market development more accurately than we do, develop productsand technologies that are superior to ours, produce similar products at a lowercost than we can or adapt more quickly to consumer preferences. Any of thesedevelopments would harm our operating results.

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We compete in select product categories against anumber of multinational manufacturers, many of which are larger and havesubstantially greater resources than we do. Therefore, these larger competitorshave the ability to spend more aggressively on advertising, marketing andresearch and to grow more quickly through acquisitions. Our largest competitorscurrently sell their products in twice as many stores as we do and havesignificantly more selling space per store than we do. In addition, our currentproduct lines compete in only approximately half of the cosmetics categoriesand we may not be able to compete successfully with companies with broaderproduct offerings.

Our competitors may attempt to gain market share byoffering products at prices at or below the prices at which our products aretypically offered. Competitive pricing may require us to reduce our prices,which would decrease our profitability or result in lost sales. Ourcompetitors, many of whom have greater resources than we do, may be better ableto withstand these price reductions and lost sales. We cannot assure you thatfuture price or product changes by our competitors will not adversely affectour net sales or that we will be able to react with price or product changes ofour own to maintain our current market position.

***We depend on alimited number of retailer customers for a majority of our sales and the lossof one or more******of these customers would reduce our sales and harm ourmarket share and our business.***

We depend on a small number of core retailer customersfor a majority of our sales, including Wal-Mart, CVS, Walgreens and Target.Sales to these four retailer customers accounted for an aggregate of 66% of ourgross sales for the year ended December 31, 2005, with sales to each of thesecustomers accounting for greater than 10% of our gross sales for the year endedDecember 31, 2005. None of our customers is under an obligation to continuepurchasing products from us in the future. The fact that we do not havelong-term contracts with our customers means that we have no recourse in theevent a customer no longer wants to purchase products from us. In the future,retailers in the mass market channel may undergo restructurings orreorganizations, realign their affiliations, close stores or otherwise sufferlosses, any of which could decrease their orders for our products. The loss ofone or more of our customers that, individually or in the aggregate, accountsfor a significant portion of our sales, any significant decrease in sales tothose customers, any significant decrease in our retail selling space in any ofthose customers’ stores, an interruption or decline of our customers’ businessor a successful demand by those customers that we decrease our prices wouldreduce our sales and harm our business.

***Fluctuations inbuying decisions of our retailer customers, the trend toward retailconsolidation and changing******policies and demands of our customers could harm ourbusiness.***

We currently sell our products primarily in the massmarket channel. Consequently, our sales are affected by fluctuations in thebuying patterns of our retailer customers and consumers who shop in the massmarket channel. These fluctuations may result from economic conditions or otherfactors. In addition, with the growing trend towards retail consolidation, weare increasingly dependent upon a few leading retailers, such as Wal-Mart, CVS,Walgreens and Target, whose bargaining strength continues to grow due to theirsize. These customers have demanded, and may continue to demand, increasedservice and order accommodations. For example, for our Mineral Wear products,our customers have demanded new permanent fixtures, which are wallmerchandising fixtures located in retail stores that display products. Ourcustomers have also demanded assistance with installation of new permanentfixtures and resets of our wall displays, which typically requires us to hire athird-party vendor to provide these services. Our customers could also demandincremental trade allowance investments such as cash discounts, markdownallowances, in-store retailer advertising, coupon expense and othermiscellaneous retailer allowances, and could require us to invest in radiofrequency identification, an automatic data capture technology that uses ‘‘smarttags’’ attached to inventory for purposes of inventory control, or sourcetagging, a security tag attached to inventory. Our customers could also demandprice decreases that would negatively impact our margins. As a result, we mayface substantially increased expenses to meet these demands, which would reduceour margins. We also may be negatively affected by changes in the policies anddemands of our retail customers relating to service levels, inventoryde-stocking or limitations on access to wall display space.

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***If our products donot appeal to a broad range of consumers, our sales and our business would beharmed.***

Our success depends on our products’ appeal to a broadrange of consumers whose preferences cannot be predicted with certainty and aresubject to change. If our current products do not meet consumer demands, oursales will decline. In addition, our growth depends upon our ability to developnew products through new product lines, product line extensions and productimprovements, which involve numerous risks. New product launches are essentialto our continued growth. New products have contributed, on average,approximately 30% of our net sales for the last three years and approximately45% of our net sales in 2005. As we grow, our reliance on new products mayincrease. We may not be able to accurately identify consumer preferences,translate our knowledge into consumer-accepted products or successfullyintegrate new products with our existing product platform or operations. We mayalso experience increased expenses incurred in connection with productdevelopment or marketing and advertising that are not subsequently supported bya sufficient level of sales, which would negatively affect our operatingresults. Unsuccessful product launches could also result in increased inventorywrite-downs. Furthermore, product development may divert management’s attentionfrom other business concerns, which could cause sales of our existing productsto suffer. We may not be able to successfully develop new products in the future,and our newly developed products may not contribute favorably to our operatingresults.

***We are a small andrapidly growing company that relies on a few key employees to ensure that ourbusiness******operates efficiently. If we were to lose the services of any of thesekey employees, we would experience difficulty******in replacing them, which wouldaffect our business operations and harm our business and results of******operations.***

Our success depends to a significant degree upon thebusiness expertise and continued contributions of our senior management team ofonly three individuals, any one of whom would be difficult to replace. As aresult, our future results will depend significantly upon the efforts andretention of key employees, such as Ingrid Jackel, our Chief Executive Officerwho is also currently and has historically been responsible for marketing andresearch and development, Jeff Rogers, our President who is also currently andhas historically been responsible for sales, and Joseph J. Jaeger, our ChiefFinancial Officer who is also responsible for operations, human resources andlegal functions. We rely on this group of three individuals, who have anaverage of 19 years of cosmetics industry experience, for managing our company,developing our business strategy and maintaining our strategic relationshipswith our key retailer customers. Because we are a small and rapidly growingcompany, we believe that the loss of key personnel would be more disruptive tous than it would be to a large, multinational manufacturer. Any of theseemployees could, with little or no prior notice, voluntarily terminate theiremployment with us at any time. We only maintain a life insurance policy onIngrid Jackel. The loss of service of any of these key employees would harm ourbusiness and results of operations.

In addition, our senior management team may not beable to successfully manage our company as it grows larger. If they are unableto handle these increased responsibilities and we are unable to identify, hireand integrate new personnel, our business, results of operations and financialcondition would suffer. Even if we are able to identify new personnel, theintegration of new personnel into our business will inevitably occur over anextended period of time. During that time, the lack of sufficient seniormanagement personnel would cause our results of operations to suffer.

***Our initiatives toexpand into new product categories may not be successful and any failure toexpand into******new product categories would harm our business, results ofoperations, financial condition and future growth******potential.***

In order to expand our business, we plan to furtherdevelop products in cosmetics subcategories such as foundation, mascara and lipproducts. We currently offer products in only approximately half of thecosmetics categories, and expansion into new cosmetics categories is a criticalcomponent of our growth strategy. We may not be successful in our expansionefforts in these areas. Each of these product initiatives involves significantrisks, as well as the possibility of unexpected consequences, including:

·      sales of the new products toour retailer customers may not be as high as we anticipate;

·      the rate of purchases byconsumers may not be as high as we or our retailer customers anticipate;

·      returns of new products byretailer customers may exceed our expectations;

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·      our marketing strategies andmerchandising efforts may be ineffective and fail to reach the targetedconsumer base or engender the desired consumption;

·      we may incur unexpectedcosts as a result of the continued development and launch of new products;

·      our pricing strategies maynot be accepted by our retailer customers and/or their consumers;

·      we may experience a decreasein sales of our existing products as a result of introducing new products;

·      there may be delays or otherdifficulties impacting our ability, or the ability of our third-party manufacturersand suppliers, to timely manufacture, distribute and ship products inconnection with launching new products; and

·      attempting to accomplish allof the elements of expansion in multiple product categories simultaneously mayprove to be an operational and financial burden on us and we may be unable tosuccessfully accomplish all of the elements of the expansion simultaneously, ifat all.

Each of the risks referred to above could delay orimpede our ability to successfully expand into new product categories, whichwould harm our business, results of operations, financial condition and futuregrowth potential.

***We may be unable toincrease our sales through new and existing distribution channels which wouldlimit our growth and harm our business, results of operations and financialcondition.***

The mass market channel is currently the onlysignificant distribution channel for our products. Products similar to ours aresold in department stores, door-to-door, on the Internet, through home shoppingtelevision shows, by mail-order and through telemarketing by representatives ofdirect sales companies. Our growth strategy includes entering new distributionchannels such as home shopping television. Any failure to successfully enternew distribution channels could limit our growth. In addition, consumers couldchoose to increasingly purchase cosmetics at department stores, high-endspecialty retailers or in other distribution channels in which we do notparticipate. Our ability to continue to grow and achieve similar profit marginsis dependent on our continued expansion in the mass market channel. Our failureto successfully expand in the mass market channel would harm our business,results of operations and financial condition.

Many of our competitors currently sell to the sameretailer customers that we do, but their products are sold in more of thoseretailers’ stores and they are allocated more shelf space in those stores. Ourgrowth strategy includes increasing store count with these retailers andexpanding the space within the existing stores that currently sell ourproducts. If we fail to increase the number of stores or the amount of spacewithin those stores in which we sell our products, it would harm our business, resultsof operations and financial condition.

***The requirementsassociated with being a public company will require significant companyresources and management attention.***

As a result of the initial offering, we have becomesubject to the reporting requirements of the Securities Exchange Act of 1934,as amended, and the Sarbanes-Oxley Act of 2002. The Exchange Act requires thatwe file annual, quarterly and current reports with respect to our business andfinancial condition. The Sarbanes-Oxley Act requires, among other things, thatwe maintain effective disclosure controls and procedures and internal controlover financial reporting. As a result, we will incur significant legal,accounting and other expenses that we have not incurred as a nonpublic company.We expect that, because of these additional expenses, our general andadministrative expenses will exceed those incurred in 2005. However, we cannotpredict or estimate with certainty the amount of the additional costs that wemay incur, the timing of such costs or the degree of impact that our management’sattention to these matters will have on our business. We currently have hiredone of two full time employees to assist with public company reportingrequirements and Sarbanes-Oxley Act compliance. Hiring and supporting newemployees could result in significant costs to us.

Our current senior management team consists of threeindividuals. The requirements associated with being a public company couldplace a strain on our senior management team. We have hired an investorrelations firm which will increase our costs. Further, management’s attentionmay be diverted from other business 

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concerns, which could adversely affect our business.We have made, and will continue to make, changes to our corporate governancestandards, disclosure controls and financial reporting and accounting systemsto meet our reporting obligations. However, the measures we take may not besufficient to satisfy our obligations as a public company. Our failure toachieve and maintain the adequacy of our internal controls, as such standardsare modified, supplemented or amended from time to time, could harm ourbusiness and operating results. Effective internal controls are necessary inorder to enable us to produce reliable financial reports and prevent financialfraud. Any failure to provide reliable financial reports or prevent fraud wouldharm our business and operating results and cause us to fail to meet ourreporting obligations which would cause our stock price to suffer.

***If we are unable tosuccessfully execute any material part of our growth strategy, our futuregrowth and ability******to make profitable investments in our business would beharmed.***

Our ability to succeed depends on our ability to growour business while maintaining profitability. Introducing new products andexpanding our distribution have contributed significantly to our recentresults, but we must continue to develop new and innovative products and expandour distribution in order to maintain our growth and profitability. We areheavily dependent on new products, which have contributed, on average,approximately 30% of our net sales in the last three years and approximately45% of our net sales in 2005. We may not be able to sustain our growth orprofitability on a quarterly or annual basis in future periods. Our futuregrowth and profitability will depend upon a number of factors, including,without limitation:

·      the level of competition inthe cosmetics industry;

·      our ability to continuouslyoffer new products;

·      our ability to maintainefficient, timely and cost-effective production and delivery of our products;

·      our ability to obtainsufficient production capacity for our products;

·      the efficiency andeffectiveness of our sales and marketing efforts in building product and brand awareness;

·      our ability to identify andrespond successfully to emerging trends in the beauty industry;

·      the level of consumeracceptance of our products; and

·      general economic conditionsand consumer confidence.

We may not be successful in executing our growthstrategy, and even if we achieve targeted growth, we may not be able to sustainprofitability. Failure to successfully execute any material part of our growthstrategy would significantly impair our future growth and our ability to makeprofitable investments in our business.

***We may be unable tomanage our growth effectively, which would harm our business, results ofoperations and******financial condition.***

We have grown rapidly, with our net sales increasingfrom $52.6 million in 2003 to $78.7 million in 2005. Our growth has placed, andwill continue to place, a strain on our management team, information systems,labor, assembly and distribution capacity and other resources. We expect toexperience capacity constraints at our product assembly facility in the fourthquarter of 2006 due to our recent growth. We are currently running two shiftsat this facility, and it is currently operating at 90% of its capacity. Weintend to use outsourced manufacturing in the fourth quarter of 2006 to meetanticipated demand. Outsourcing manufacturing could impact our ability tomaintain our quality standards, which could harm our reputation. We could alsobe forced to add a third shift in the fourth quarter of 2006, which would bemore expensive and would negatively affect our operating margins. We haveleased additional temporary space for manufacturing assembly and componentstorage, which could negatively affect our operating margins. We may experienceadditional constraints on capacity in the future. If we are unable toeffectively address our capacity constraints or manage our future growth, ourfailure to do so would harm our business, results of operations and financialcondition. Our rapid growth also makes it difficult for us to adequatelypredict the expenditures we will need to make in the future. If we do not make,or are unable to make, the necessary overhead expenditures to accommodate our futuregrowth, we may not be successful in executing our growth strategy, and ourprospects and results of operations would suffer. In addition, if retailercustomer 

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demand exceeds forecasts, we could, from time to time,have an inadequate supply of products to meet customer demands.

***If we are unable toprotect our intellectual property our ability to compete would be negativelyimpacted.***

We attempt to protect our intellectual property underthe patent and trademark laws. The market for our products depends to asignificant extent upon the goodwill associated with our trademarks and tradenames. We own the material trademarks and trade name rights used in connectionwith the packaging, marketing and sale of our products. Therefore, trademarkand trade name protection is important to our business. Although we haveregistered or applied to register many of our trademarks in the United Statesand in certain foreign countries, we cannot assure you that all of ourtrademark applications will be approved. We also own design patents that relateto some of our products. The design patents we own could be challenged,invalidated or circumvented by others and may not be of sufficient scope orstrength to provide us with any meaningful protection or commercial advantage.Although we have registered or applied to register additional design patents inthe United States and in certain foreign countries, we cannot assure you thatany of our design patent applications will be approved.

In addition, we do not own any formula patents. Oursuppliers or other third parties hold certain formula patents for themanufacture of our products. If our relationships with our suppliers wereinterrupted or terminated, or if we are unable to use formulas covered bythird-party patents, our business could be harmed and it would negativelyimpact our results of operations. Third parties may also oppose our trademarkand design patent applications, or otherwise challenge our use of ourtrademarks or design patents. We cannot assure you that competitors will not infringeour trademarks or our design patents, or that we will have adequate time andresources to enforce our trademarks and design patents and to protect ourrights through litigation or otherwise, or that we will be successful in doing so.We also face the risk of claims that we have infringed third parties’intellectual property rights. Any claims of intellectual property infringement,even those without merit, could expose us to the following risks, among others:

·      we may be required to defendagainst infringement claims which are expensive and timeconsuming;

·      we may be required to ceasemaking, licensing or using products that incorporate the challenged intellectualproperty;

·      we may be required tore-design, re-engineer or re-brand our products or packaging; or

·      we may be required to enterinto royalty or licensing agreements in order to obtain the right to use athird party’s intellectual property.

Any of these outcomes would negatively impact ourbusiness, results of operations and financial condition.

***We will require asignificant amount of cash, and any failure to generate and raise sufficientcash would impair our ability to support our future growth or operatingrequirements, which would harm our business.***

Our ability to fund working capital needs and plannedcapital expenditures depends on our ability to generate cash flow in thefuture. We estimate that our net working capital requirements will increase by$7.1 million, or approximately 103%, to $14.0 million in 2006 from $6.9 millionin 2005 due primarily to the impact of our sales growth on our receivables andinventory levels. We have budgeted capital expenditures of $1.7 million for2006, compared to $0.7 million in 2005. This increase is due to incrementalspending on several important projects, including the purchase of a new tubefilling machine to improve product quality and partial payment for an automatedassembly line that we expect to install in mid-2007 for our face powder and eyeshadow products. We have budgeted capital expenditures of $2.5 million for 2007due to several key projects, including completion of our automated assemblyline, investment in our information technology infrastructure and improvementsto our warehouse distribution systems. Our ability to generate future cash flowis subject to general economic, financial, competitive, legislative, regulatoryand other factors that are beyond our control. We cannot assure you that ourbusiness will continue to generate cash flow from operations at current levelsor that our cash needs will not increase beyond what we currently anticipateour cash needs to be. If we had to raise additional capital, equity or debtfinancing may not be available at all or may be available only on terms thatare not favorable to us. In addition, certain 

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selling stockholders can require us to registeradditional shares of common stock held by them pursuant to a registrationagreement. A registration and subsequent sale of common stock by our sellingstockholders could result in a decreased market for our equity which would harmour ability to raise additional capital in the equity markets. If we cannotobtain adequate capital on favorable terms or at all, we may be unable tosupport future growth or operating requirements and, accordingly, our business,financial condition or results of operations would suffer.

***Any variation inthe quality of our products or delay in our ability to fill orders would harmour relationships with our retailer customers.***

Our success depends upon our quality control and onour ability to deliver products in a timely manner. If our products are notdelivered according to retailer customers’ delivery deadlines or are found tobe defective or not to specification, our relationships with our customerswould suffer, our brands’ reputation would be harmed and we could lose ourmarket share. We could also experience increased return rates or become subjectto liability claims. These negative results would have a harmful effect on ourbusiness, results of operations and financial condition.

***We may not be ableto successfully implement efficiency improvements or realize cost savings,which would harm our business.***

The automation of our assembly line and any otherefficiency improvements we may undertake could involve substantial investmentsand are subject to significant business, economic and competitive uncertaintiesand contingencies, many of which are beyond our control. Our implementationcosts for the automated assembly line may turn out to be substantially higherthan we currently estimate, and we may not fully achieve our expected costsavings within the anticipated time frame, if at all. We expect to experiencecapacity constraints at our product assembly facility in the fourth quarter of2006, and our failure to successfully implement efficiency improvements andcapacity expansion could result in additional capacity constraints in thefuture. Failure to implement this efficiency improvement would result inincreased costs which would reduce our margins and harm our business.

***We purchasecomponents and semi-finished goods from a limited number of third partysuppliers, which******reduces our control over the manufacturing process and maycause variations in quality or delays in our******ability to fill orders.***

We purchase components, such as plastic compactcontainers or plastic tubes, and semi-finished goods, such as plastic compactcontainers or plastic tubes filled with product, from foreign and U.S.suppliers. We depend on these suppliers to deliver products that are free fromdefects, that comply with our specifications, that meet our deliveryrequirements and that are competitive in cost. If our suppliers deliverproducts that are defective or that otherwise do not meet our specifications,our product failure and return rates may increase, and the reputation of ourproducts and the Physicians Formula brand may suffer. In addition, if oursuppliers do not meet our delivery requirements or cease doing business with usfor any reason, we might miss our retailer customers’ delivery deadlines, whichcould in turn cause our customers to cancel or reduce orders, refuse to acceptdeliveries or demand reduced prices. Even if acceptable alternative suppliersare found, the process of locating and securing such alternatives is likely todisrupt our business and we cannot assure you that we will be able to securealternative suppliers on acceptable terms that provide the same quality productor comply with all applicable laws. Extended unavailability of necessarycomponents or finished goods would cause us to be unable to market one or moreof our products for a period of time. Any of these events would cause our business,results of operations and financial condition to suffer.

***Further increasesin the California or Federal minimum wage would increase our operating costsand harm our profitability.***

We pay the 150 to 250 workers provided to us by athird-party staffing service the California minimum wage, which is currently$6.75 per hour. On September 12, 2006, the State of California adoptedlegislation to increase the California minimum wage. Effective January 1, 2007,the California minimum wage will increase to $7.50 per hour and will increaseto $8.00 per hour on January 1, 2008. In addition, the increase in the minimumwage may lead to an increase in wages to our hourly employees who are currentlypaid 

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above minimum wage. We expect the combined effect ofthese changes in wages to increase our cost of sales by approximately $450,000in 2007 and by approximately $300,000 in 2008.

The Federal minimum wage is currently lower than theCalifornia minimum wage. If the Federal minimum wage were increased to anamount greater than the California minimum wage, we would be required to paythe Federal minimum wage. Further increases in the California minimum wage, orincreases in the Federal minimum wage to an amount higher than the Californiaminimum wage, would increase our operating costs and harm our profitability.

***All of our facilityleases expire on or before December of 2007. If we are unable to renew theseleases on******favorable terms or move to new facilities, our costs could increase,which would harm our business, results of******operations and financial condition.***

The leases for our facilities in Azusa and City ofIndustry expire in December 2007 and our short-term lease for our facility inIrwindale, California expires in April 2007. Whether we lease new facilities orremain in those facilities, we could be subject to increased rental rates. Ifwe lease new manufacturing or distribution facilities, the costs associatedwith moving from our Azusa or City of Industry facilities could be substantial.In addition, any move would be costly and could disrupt our operations andability to meet our obligations to our retailer customers.

***Catastrophic loss,delays in deliveries or other disruptions at any of our facilities wouldnegatively impact our business.***

Substantially all of our products are assembled at ourtwo adjacent manufacturing facilities in City of Industry, California and ourthird facility in Irwindale, California. Significant unscheduled downtime atthese facilities due to equipment breakdowns, fires, power failures, earthquakesand other natural disasters, severe weather conditions or other disruptionswould adversely affect our ability to provide products to our retailercustomers in a timely manner. Although we maintain insurance coverage for ourfacilities, we cannot assure you that our insurance coverage will be adequateto cover all of our losses in the event of a catastrophic loss. Insurance couldin the future become more expensive and difficult to maintain and may not beavailable on commercially reasonable terms or at all.

We operate a facility in Azusa, California, whichserves as our main distribution facility and our corporate headquarters. Ifoperational complications arise with our Azusa facility or if our Azusafacility is severely damaged or destroyed, it would not be able to support ourdistribution needs. Any disruptions at our Azusa facility would adverselyaffect our ability to deliver products to our retailer customers on a timelybasis. If we miss our retailers’ delivery deadlines or if our products fail tomeet their specifications, our relationships with our customers would sufferand our business could be harmed.

All of our facilities are located within 15 miles ofeach other in Southern California. We do not have other facilities in otherregions from which to operate in the event of catastrophic loss, delays indeliveries, other disruptions or natural disasters.

***We are currentlytesting sales of a new brand called*professional formula *on a home shopping television******channel. If our testing is successfuland we begin to sell our products on a regular basis on a home shopping******television channel, wecould lose business from our existing retailer customers, which would harm our******business, results ofoperations and financial condition.***

If we sell products under the *professional formula*brand on a homeshopping television channel, our retailer customers could perceive that we aredirectly competing with them, which could lead them to reduce or eliminatetheir purchases of our products. If any of our existing retailer customersdecide to stop carrying our products or carry a smaller number of products, oursales and profitability would decrease significantly, which would harm ourbusiness, results of operations and financial condition. If we are successfulin selling our products on a regular basis on a home shopping channel, we maynot be able to protect the *professionalformula*name because we have not registered it as a trademark. Ourinability to protect the *professionalformula*name could have an adverse impact on our successfulexpansion into sales on home shopping networks, which could negatively impactour future growth.

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***Regulationsgoverning our industry could have a significant negative effect on ourbusiness, results of operations and financial condition.***

Our business is subject to numerous laws andregulations. The formulation, manufacturing, packaging, labeling, registration,advertising, distribution, importation, storage and sale of our cosmeticproducts are subject to extensive regulation by various Federal agencies,including the U.S. Food and Drug Administration, or the ‘‘FDA,’’ the U.S.Federal Trade Commission, or the ‘‘FTC,’’ the U.S. Environmental ProtectionAgency, or the ‘‘EPA,’’ and by various agencies of the states, localities andforeign countries in which our products are manufactured, distributed and sold.Our City of Industry, California facilities are registered with the FDA as drugmanufacturing establishments, permitting the manufacture of cosmetics thatcontain over-the-counter drug ingredients such as sunscreen. Failure by us orour manufacturers to comply with those laws and regulations could lead toenforcement action and the imposition of significant penalties or claims,resulting in significant loss of sales, and could have a negative effect on ourbusiness, results of operations and financial condition. If we fail to complywith Federal, state or foreign laws and regulations, we could be required tosuspend manufacturing operations, change product formulations, suspend the saleof certain products, initiate product recalls, change product labeling,packaging or advertising or take other corrective actions. Any of these actionscould harm our business, financial condition and results of operations. Inaddition, the adoption of new laws or regulations or changes in theinterpretations of existing laws or regulations may result in significantcompliance costs or discontinuation of products. Our failure to comply withFDA, FTC, EPA or state laws and regulations, or with laws and regulations inforeign markets, that cover our advertising, including direct claims andadvertising by us, may result in enforcement actions and imposition ofpenalties or otherwise materially adversely affect the distribution and sale ofour products and our business.

Under the Federal Food, Drug, and Cosmetic Act, or ‘‘FDCA’’,cosmetics are defined as articles or components of articles that are applied tothe human body and intended to cleanse, beautify or alter its appearance, withthe exception of soap. Cosmetics are not subject to pre-market approval by theFDA but the product and ingredients must be tested to assure safety. If safetyhas not been adequately substantiated, a specific label warning is required.The FDA monitors compliance of cosmetic products through random inspection ofcosmetic manufacturers and distributors to ensure that the products neithercontain false or misleading labeling nor are manufactured under unsanitaryconditions. Inspections also may occur from consumer or competitor complaintsfiled with the FDA. In the event the FDA does find false or misleading labelingor unsanitary conditions or otherwise a failure to comply with FDArequirements, our distribution channel may be affected by a possible productrecall or insufficient product in the marketplace resulting in reduced productsales and revenue to us and increased costs to our operations.

We also are subject to a variety of other laws andregulations in Canada and Australia. Our failure to comply, or assertions thatwe have failed to comply, with these laws and regulations could have a materialadverse effect on our business in a particular market or in general. To theextent we decide to commence or expand operations in additional countries, lawsand regulations in those countries, or the cost of complying with such laws andregulations, may prevent or delay entry into or expansion of operations inthose markets or could have a negative effect on our operating margins forproducts sold in those countries. Regulatory requirements can vary widely fromcountry to country and could further delay the introduction of our productsinto those countries. We may not be able to enter into acceptable agreements tomarket and commercialize our products in international markets.

Our ability to sustain satisfactory levels of sales inour markets is dependent in significant part on our ability to introduceadditional products into those markets. Government laws and regulations in bothour domestic and international markets can delay or prevent the introduction,or require the reformulation or withdrawal, of our products.

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***Inability to obtainregulatory approval for our manufacturing facility or the need to open newfacilities may delay or disrupt our commercialization efforts.***

Our manufacturing facility must be regularly inspectedand approved by the FDA because we manufacture products that containFDA-regulated ingredients. All processes, methods and equipment must becompliant with current Good Manufacturing Practices, or ‘‘cGMP,’’ approved bythe FDA, and cGMP requires extensive audits of vendors, contract laboratoriesand suppliers. The cGMP requirements govern quality control of themanufacturing process, documentation policies and procedures. In complying withcGMP, we are obligated to expend time, money and effort in production, recordkeeping and quality control to ensure that the product meets applicablespecifications and other requirements. If we fail to comply with theserequirements, we could experience product liability claims from customerspurchasing our product and we could be subject to possible regulatory action.If an inspection by the FDA or state or other foreign regulatory authorityindicates that there are deficiencies, we would be required to take remedialactions or our facility may be closed, and we may be subject to additionalenforcement activity.

We may need to develop additional manufacturingfacilities based on expanded product development, FDA regulatory requirementsor other unforeseen market pressures. Preparing a facility for commercialmanufacturing may involve unanticipated delays, and the costs of building afacility in compliance with state, local and FDA regulations may be higher thanwe anticipated.

***The regulatorystatus of our products could change, and we may be required to conduct clinicaltrials to******establish efficacy and safety or cease to market some or all of ourproducts, which would require significant******time and resources.***

The FDA does not have a pre-market approval system forcosmetics, and we believe we are permitted to market our cosmetics and havethem manufactured without submitting safety or efficacy data to the FDA.However, the FDA may in the future determine to regulate our cosmetics or theingredients included in our cosmetics as drugs or biologics. If certain of ourproducts are deemed to be drugs or biologics, rather than cosmetics, we wouldbe required to conduct clinical trials to demonstrate the safety and efficacyof these products in order to continue to market and sell them. In such event,we may not have sufficient resources to conduct the required clinical trials,we may not be able to establish sufficient efficacy or safety to resume thesale of these products, we may not gain regulatory approval of the trialdesign, the clinical trials may be subject to unanticipated delays due to theirtime-consuming nature and the outcome of any clinical trial is uncertain. Anyinquiries by the FDA or any foreign regulatory authorities into the regulatorystatus of our cosmetics and any related interruption in the marketing and saleof these products could severely damage our brand reputation and image in themarketplace, as well as our relationships with retailer customers, which wouldharm our business, results of operations and financial condition.

Some of our foundations and concealers are consideredover-the-counter, or ‘‘OTC,’’ drug products by the FDA. The FDA regulates theformulation, manufacturing, packaging, labeling and distribution of OTC drugproducts pursuant to a monograph system that specifies active drug ingredientsand acceptable product claims that are generally recognized as safe andeffective for particular uses. If any of these products that are OTC drugs arenot in compliance with the applicable FDA monograph, we would be required to(i) reformulate such product, (ii) cease to make certain use claims relating tosuch product or (iii) cease to sell such product until we receive further FDAapproval. If more stringent regulations are promulgated, we may not be able tocomply with such statutes or regulations without incurring substantial expense.In addition, OTC drug products must be manufactured in accordance withpharmaceutical good manufacturing practice regulations. Our OTC drugmanufacturers are subject to ongoing periodic unannounced inspection by the FDAas well as regular and ongoing inspections. In addition, inspections may becommenced as a result of consumer or competitor complaints related to ourproducts. Corresponding state agencies may also inspect our facility to ensurestrict compliance with drug good manufacturing practices and other governmentregulations and corresponding foreign standards. We have minimal control overthird-party manufacturers’ compliance with these regulations and standards. Ifthe FDA finds a violation of drug good manufacturing practices, it may enjointhe manufacturer’s operations, seize products, or criminally prosecute themanufacturer, any of which could require us to find alternative manufacturers,resulting in additional time and expense.

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***Our products maycause unexpected and undesirable side effects that would limit their use,require their removal from the market or prevent their further development.Product liability claims resulting from these undesirable side effects wouldhurt our business. In addition, we are vulnerable to claims that our products arenot as effective as we claim them to be.***

Unexpected and undesirable side effects caused by ourproducts for which we have not provided sufficient label warnings could resultin the recall or discontinuance of sales of some or all of our products.Unexpected and undesirable side effects could prevent us from achieving ormaintaining market acceptance of the affected products or could substantiallyincrease the costs and expenses in marketing new products. We have been, andmay in the future be, subject to various product liability claims resultingfrom those undesirable side effects caused by our products. Product liabilityclaims may result in negative publicity regarding our company, brand orproducts that may harm our reputation and sales. In addition, if one of ourproducts is found to be defective we may be required to recall it, which mayresult in substantial expense, adverse publicity and loss of sales, which wouldsubstantially harm our brand. Although we maintain product liability insurancecoverage, potential product liability claims may exceed the amount of ourinsurance coverage or potential product liability claims may be excluded underthe terms of our policy, which would cause our financial condition to suffer.In addition, we may be required to pay higher premiums and accept higherdeductibles in order to secure adequate insurance coverage in the future.

In addition, consumer or industry analysts may assertclaims that our products are not as effective as we claim them to be. We areparticularly susceptible to these risks because our marketing heavily relies onthe assertions that our products adhere to our founder’s commitment to productpurity and quality, are hypoallergenic and are ideal for women who have skinconditions that can be exacerbated by traditional cosmetics. Unexpected andundesirable side effects associated with our products or assertions that ourproducts are not as effective as we claim them to be also could cause negativepublicity regarding our company, brand or products, which could in turn harmour reputation and our business.

***Our business may besubject to environmental investigation, remediation and compliance costs, whichcould adversely affect our business, results of operations and financialcondition.***

Our operations are subject to a range of Federal,state and local environmental, health and safety laws and regulations,including those governing discharges to air, soil and water, the handling anddisposal of, and exposure to, hazardous substances and the investigation andremediation of contamination resulting from the release of hazardoussubstances. We believe that our business, operations and facilities are inmaterial compliance with all applicable environmental, health and safety lawsand regulations.

Our City of Industry facility was contaminated, andsubsequently remediated, by the former operator of the property. In addition,the facility is located within an area of regional groundwater contaminationknown as the Puente Valley ‘‘operable unit’’ of the San Gabriel ValleySuperfund Site. We, along with many others, were named a potentiallyresponsible party for the regional contamination by the United StatesEnvironmental Protection Agency. We are also one of approximately 25 partiesconsidered potentially liable by a regional water authority for allegedcontamination of the area’s potable water supply. To date, our liability forthese matters has been substantially covered by indemnities and resolved byprior settlements, and borne by prior operators of the facility and thebusiness, one of their successors and one of their insurers. We are, however,attempting to recoup approximately $0.6 million in defense costs from one ofour indemnitors. These costs have been expensed as paid by us and are notrecorded in our consolidated balance sheets. We may be subject to additionalclaims resulting from the historical site contamination and regionalcontamination. We have not established a reserve for additional claims. Failureby one or more of the responsible parties and/or our indemnitors to honor theirobligations could cause us to incur liability which could be material.

***We rely heavily ona staffing service to provide us with workers and could face significantemployment claims******that could harm our reputation, business, results ofoperations or financial condition.***

We have contracted with a staffing service to supplyus with workers. The number of workers supplied by the staffing service variesbetween a minimum of approximately 150, and up to 250, based 

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on seasonal demands for our products. Actions taken bythese workers or the agency that provides them to us could subject us tosignificant liability. An inherent risk of using workers supplied by a third partyis that we may face possible claims of employment of undocumented workers,claims of violations of the National Labor Relations Act, discrimination orharassment, claims under health and safety regulations and other relatedclaims. We may also be subject to claims that these workers should be deemedour employees for ERISA, federal taxation or other purposes. Any of theseclaims could require us to pay substantial fines and monetary damages. Inaddition, we could face negative publicity that would harm our brand. Any ofthese negative consequences would harm our reputation, business, results ofoperations or financial condition.

***Our computer andcommunications hardware and software systems are vulnerable to damage and interruption,which could harm our business.***

Our ability to receive and fulfill orders on a timelybasis is critical to our success and largely depends upon the efficient anduninterrupted operation of our computer and communications hardware andsoftware systems. Our primary computer systems and operations are located atour Azusa facility and are vulnerable to damage or interruption from poweroutages, computer and telecommunications failures, computer viruses, securitybreaches, catastrophic events and errors in usage by our employees and retailercustomers. Systems integration is complex, time-consuming and expensive. Sincewe do not currently have adequate offsite backup systems, if a catastrophicevent occurred at our City of Industry, Azusa or Irwindale facilities, we wouldbe required to purchase back-up computer and communications hardware andsoftware systems, and integrate them with our existing systems, at asignificant cost. During the period in which these new systems are beingintegrated, our business, results of operations and financial condition couldbe harmed.

***Significantincreases in fuel prices would adversely affect our financial results.***

Our freight cost is impacted by changes in fuel pricesthrough surcharges and price increases. Fuel prices and surcharges affect freightcost both on inbound shipments from our suppliers to our assembly anddistribution facilities and on outbound freight from our distribution center toour retailer customers. For example, fuel surcharges from one of our majorfreight carriers increased the outbound freight costs charged by them by 23%for the nine months ended September 30, 2006. We have experienced similarincreases from other carriers. Increases in fuel prices and surcharges andother factors may increase freight costs and thereby increase our cost of salesand selling, general and administrative expenses.

***We are subject to avariety of social, political and economic risks associated with doing businessoutside of the United States.***

For the year ended December 31, 2005, approximately 6%of our net sales were attributable to our business in Canada and Australia. Inaddition, eight of our top 15 suppliers, which includes U.S.brokers thatpurchase raw materials, semi-finished goods and components on our behalf, arelocated in Europe or Asia. These eight foreign suppliers representedapproximately 58% of our purchases of raw materials, semi-finished goods andcomponents in 2005. In particular, we purchase significant portions of ourpowders from suppliers in Italy and our components from suppliers in China. Wemay encounter risks of doing business outside of the United States including:

·      unexpected changes in, orimpositions of, laws or regulatory requirements;

·      fluctuations in foreignexchange rates, which could cause fluctuations in the price of our products inforeign markets or in the cost of certain raw materials purchased by us;

·      delays resulting fromdifficulty in obtaining export licenses, tariffs and other barriers and restrictions,potentially longer payment cycles, greater difficulty in accounts receivablecollection and potentially adverse tax treatment;

·      potential trade restrictionsand exchange controls;

·      differences in protection ofour intellectual property rights; and

·      the burden of complying witha variety of foreign laws and regulations.

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In addition, as we grow, we will be increasinglysubject to general geopolitical risks in foreign countries where we sell ourproducts and purchase our raw materials, such as political and economicinstability and changes in diplomatic and trade relationships, which couldaffect, among other things, retailer customers’ inventory levels and consumerpurchasing, and which would cause our results to fluctuate. These risks arecompounded by the fact that we purchase the majority of our raw materials,semi-finished goods and components from only two countries, Italy and China.Changes within these countries could impair our business, results of operationsand financial condition.

***Our common stockhas only been publicly traded since******November9,2006 and the price of our common stock may fluctuate substantially.***

There has only been a public market for our commonstock since November 9, 2006. Broad market and industry factors may adverselyaffect the market price of our common stock, regardless of our actual operatingperformance. Factors that could cause fluctuations in our stock price mayinclude, among other things:

·      introductions of newproducts or new pricing policies by us or by our competitors;

·      the gain or loss ofsignificant customers or product orders;

·      actual or anticipatedvariations in our quarterly results;

·      the announcement ofacquisitions or strategic alliances by us or by our competitors;

·      recruitment or departure ofkey personnel;

·      the level and quality ofsecurities research analyst coverage for our common stock;

·      changes in the estimates ofour operating performance or changes in recommendations by us or any researchanalysts that follow our stock or any failure to meet the estimates made byresearch analysts; and

·      market conditions in ourindustry and the economy as a whole.

In addition, public announcements by our competitorsconcerning, among other things, their performance, strategy, accountingpractices, or legal problems could cause the market price of our common stockto decline regardless of our actual operating performance.

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**Item 2.Unregistered Sales of Equity Securities and Use of Proceeds**

**Use of Proceeds**

On November 14, 2006, we completed an initial publicoffering of shares of our common stock. The SEC declared the Registration Statement for the initial publicoffering (File No. 333-136913) effective on November 8, 2006, and we filed aRegistration Statement pursuant to Rule 462(b) (File No. 333-138536) onNovember 8, 2006 to register additional shares of common stock in theoffering.  Pursuant to these RegistrationStatements, the Company registered the sale of a total of 8,625,000 shares ofcommon stock, of which the Company sold 3,125,000 shares and the sellingstockholders sold 5,500,000 shares.  The5,500,000 shares of common stock sold by the selling stockholders includes1,125,000 shares sold pursuant to the underwriters’ over-allotment option.  The underwriters exercised thisover-allotment option on November 10, 2006, and the offering closed on November14, 2006.  At a public offering price of$17.00 per share, the aggregate price of the shares of common stock sold by theCompany was $53,125,000, and the aggregate price of the shares of common stocksold by the selling stockholders was $93,500,000.  We did not receive any proceeds from the saleof common stock by the selling stockholders, but we received $29,614 from thepayment by members of our management of the exercise price of options topurchase 296,140 shares of common stock that they sold in the offering.  The managing underwriters for the offeringwere Deutsche Bank Securities Inc. and Citigroup Global Markets Inc.

Our net proceeds from the offering, after accountingfor approximately $3.7 million in underwriting discounts and commissions andapproximately $2.8 million of expenses relating to the offering, wereapproximately $46.6 million.  We used thenet proceeds to reduce outstanding indebtedness, to pay debt issuance costs andto pay IPO completion bonuses.  We usedapproximately $20.9 million of the net proceeds from the offering to repurchasePhysicians Formula, Inc.’s senior subordinated notes and to pay all accrued andunpaid cash and payment-in-kind interest on those notes through the closingdate of the offering.  We used approximately$25.4 million of the net proceeds from the offering, together withapproximately $22.2 million of borrowings under Physicians Formula, Inc.’s newsenior credit agreement, to repay borrowings and accrued interest underPhysicians Formula, Inc.’s existing credit agreement.  We used $270,000 of the net proceeds from theoffering to pay IPO completion bonuses, including a bonus of $250,000 to ourchief financial officer.  Except for theIPO completion bonus paid to our chief financial officer, no net proceeds tous, or expenses, were paid to any of our directors, officers, ten percent orgreater stockholders or affiliates.

**Item4.**                          Submissionof Matters to a Vote of Security Holders

Prior to the completionof our initial public offering on November 14, 2006, we had 10,421,916 sharesof common stock outstanding, 76.8% of which was owned by entities affiliatedwith Summit Partners, 17.3% of which was owned by an entity affiliated withPierre Fabre and the rest of which was owned by our current and former directorsand executive officers.

On August 8, 2006,holders of 10,393,916 shares of our common stock, or 99.7% of ourthen-outstanding common stock, executed a written consent in accordance withour then-existing certificate of incorporation in order to amend thethen-existing certificate of incorporation to change our name from PFI HoldingsCorp. to Physicians Formula Holdings, Inc.

On September 29, 2006,holders of 10,208,916 shares of our common stock, or 98.0% of ourthen-outstanding common stock, executed a written consent in accordance withour then-existing certificate of incorporation in order to amend thethen-existing by-laws to increase the number of directors to serve on the Boardof Directors from four to five and to elect Ingrid Jackel as a director.

**Item 6.**                          Exhibits
| Exhibit  Number | ** ** | **Description** | ** ** |
|-----------------|------------|-----------------|------------|
|            | 3.1        |            |       | Amended and Restated  Certificate of Incorporation of the Registrant. |   |
|            | 3.2        |            |       | Amended and Restated  By-laws of the Registrant. |   |
|            | 10.1       |            |       | Credit  Agreement, dated as of November 14, 2006, among Physicians Formula, Inc., the  lenders party thereto and Union Bank of California, N.A., as administrative  agent. |   |
|            | 10.2       |            |       | Amended  and Restated Stock Option Agreement, dated November 14, 2006, by and between  the Registrant and Ingrid Jackel. |   |
|            | 10.3       |            |       | Amended  and Restated Stock Option Agreement, dated November 14, 2006, by and between  the Registrant and Jeff Rogers. |   |
|            | 10.4       |            |       | Amended  and Restated Stock Option Agreement, dated November 14, 2006, by and between  the Registrant and Joseph J. Jaeger. |   |
|            | 10.5       |            |       | Amended Bonus Potential  Letter by Physicians Formula, Inc. in favor of Joseph J. Jaeger. |   |
|            | 31.1       |            |       | Certification by Ingrid  Jackel, Chief Executive Officer. |   |
|            | 31.2       |            |       | Certification by Joseph  J. Jaeger, Chief Financial Officer. |   |
|            | 32.1       |            |       | Certification Pursuant  to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002. |   |
|            | 32.2       |            |       | Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |   |

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, as amended, the registranthas duly caused this report to be signed on its behalf by the undersignedthereunto duly authorized.
|                                | PHYSICIANS FORMULA HOLDINGS, INC. |
|--------------------------------|-----------------------------------|
|                           |                              |
|                           | /s/ Ingrid Jackel                 |
|                           | By:                               | Ingrid Jackel |
|                           | Its:                              | Chief Executive Officer (principal executive officer) |
|                           |                              |
|                           | /s/ Joseph J. Jaeger              |
|                           | By:                               | Joseph J. Jaeger |
|                           | Its:                              | Chief Financial Officer (principal financial officer) |
|                           |                              |
| Dated: December 20,  2006 |                              |

 

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