**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC  20549**

**FORM 10-Q**

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

**Forthe quarterly period ended March 31, 2007**

**OR**

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

**Forthe transition period from            to            .**

**COMMISSIONFILE NUMBER: 001-33142**

**Physicians FormulaHoldings, Inc.**(Exactname of registrant as specified in its charter)

| **DELAWARE**                                                     | ** ** | **20-0340099**                        |
|------------------------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
| **1055 West 8th Street**                                         | ** ** | **91702**                             |
| **Azusa,  California**                                           |       | (Zip Code)                            |
| (Address of  principal executive offices)                        |       |                                  |

 

**(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 thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x  No o

Indicate by check markwhether the Registrant is a large accelerated filer, an accelerate filer, or anon-accelerated filer. See definition of “accelerated filer and largeraccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

| Large accelerated filer o | Accelerated filer o | Non-accelerated filer x |
|--------------------------------|--------------------------|------------------------------|

 

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

Thenumber of shares outstanding of the registrant’s common stock, par value $.01per share, as of May 10, 2007, was 13,927,055.

 

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**TABLEOF CONTENTS**
| PART I. FINANCIAL  INFORMATION |   | 1                                                                                           |
|--------------------------------|--------|---------------------------------------------------------------------------------------------|
| Item 1.                        |   | Financial Statements                                                                        |   | 1 |
| Item 2.                        |   | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |   | 10 |
| Item 3.                        |   | Quantitative and Qualitative  Disclosures About Market Risk                                 |   | 15 |
| Item 4.                        |   | Controls and Procedures                                                                     |   | 15 |
| PART  II. OTHER INFORMATION    |   | 16                                                                                          |
| Item 1.                        |   | Legal Proceedings                                                                           |   | 16 |
| Item 1A.                       |   | Risk Factors                                                                                |   | 16 |
| Item 6.                        |   | Exhibits                                                                                    |   | 16 |

 

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**PART I.**

**FINANCIALINFORMATION**

**Item 1.**                Financial Statements

**PHYSICIANS FORMULA HOLDINGS, INC.CONDENSED CONSOLIDATED BALANCE SHEETS(unaudited)(dollars in thousands, except share data)**

| ** **                                                                                                                          | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                          | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| **ASSETS**                                                                                                                          | ** ** | ** **         | ** ** |                  | ** ** | ** ** |   |
| CURRENT ASSETS:                                                                                                                     |       |               |       |                  |       | ** ** |   |
| Cash and cash  equivalents                                                                                                          |       | $                  | 21         |                  |       | $ | 26 | ** ** |   |
| Accounts receivable, net  of allowance for bad debts of $364 and $348                                                               |       | 29,009             |       |                  | 26,654     | ** ** |   |
| Inventories                                                                                                                         |       | 21,197             |       |                  | 23,472     | ** ** |   |
| Prepaid expenses and  other current assets                                                                                          |       | 1,601              |       |                  | 1,775      | ** ** |   |
| Deferred income taxes—net                                                                                                      |       | 5,958              |       |                  | 5,139      | ** ** |   |
| Total current assets                                                                                                                |       | 57,786             |       |                  | 57,066     | ** ** |   |
| PROPERTY AND  EQUIPMENT—Net                                                                                                    |       | 2,775              |       |                  | 2,506      | ** ** |   |
| OTHER ASSETS—Net                                                                                                               |       | 1,093              |       |                  | 968        | ** ** |   |
| INTANGIBLE ASSETS—Net                                                                                                          |       | 55,870             |       |                  | 56,311     | ** ** |   |
| GOODWILL                                                                                                                            |       | 17,463             |       |                  | 17,463     | ** ** |   |
| TOTAL                                                                                                                               |       | $                  | 134,987    |                  |       | $ | 134,314 | ** ** |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                      | ** ** | ** **         | ** ** |                  | ** ** | ** ** |   |
| CURRENT LIABILITIES:                                                                                                                |       |               |       |                  |       | ** ** |   |
| Accounts payable                                                                                                                    |       | $                  | 10,468     |                  |       | $ | 12,670 | ** ** |   |
| Accrued expenses                                                                                                                    |       | 1,513              |       |                  | 1,915      | ** ** |   |
| Trade allowances                                                                                                                    |       | 3,791              |       |                  | 3,479      | ** ** |   |
| Sales returns reserve                                                                                                               |       | 10,462             |       |                  | 9,440      | ** ** |   |
| Income taxes payable                                                                                                                |       | 3,656              |       |                  | 378        | ** ** |   |
| Line of credit  borrowings                                                                                                          |       | 2,262              |       |                  | 7,522      | ** ** |   |
| Current portion of  long-term debt                                                                                                  |       | 2,250              |       |                  | 2,063      | ** ** |   |
| Total current  liabilities                                                                                                          |       | 34,402             |       |                  | 37,467     | ** ** |   |
| DEFERRED COMPENSATION                                                                                                               |       | 753                |       |                  | 721        | ** ** |   |
| DEFERRED INCOME TAXES—Net                                                                                                      |       | 21,123             |       |                  | 21,617     | ** ** |   |
| LONG-TERM DEBT                                                                                                                      |       | 12,375             |       |                  | 12,937     | ** ** |   |
| COMMITMENTS AND CONTINGENCIES STOCKHOLDERS’ EQUITY:                                                                            |       |               |       |                  |       | ** ** |   |
| Series A preferred  stock, $.01 par value—10,000,000 shares authorized, 0 and 0 shares  issued and outstanding  |       | —             |       |                  | —     | ** ** |   |
| Common stock, $.01 par  value—50,000,000 shares authorized, 13,927,055 and  13,843,056 shares issued and outstanding |       | 139                |       |                  | 138        | ** ** |   |
| Additional paid-in  capital                                                                                                         |       | 57,506             |       |                  | 57,047     | ** ** |   |
| Retained earnings                                                                                                                   |       | 8,689              |       |                  | 4,387      | ** ** |   |
| Total stockholders’  equity                                                                                                    |       | 66,334             |       |                  | 61,572     | ** ** |   |
| TOTAL                                                                                                                               |       | $                  | 134,987    |                  |       | $ | 134,314 | ** ** |   |

 

See notes to condensed consolidated financial statements.

1

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**PHYSICIANS FORMULAHOLDINGS, INC.CONDENSED CONSOLIDATED STATEMENTS OF INCOME(unaudited)(dollars in thousands, except per share data)**

| ** **                                    | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| NET SALES                                     |       | $                                                    | 35,723     |   | $ | 27,689 |   |
| COST OF SALES                                 |       | 15,102                                               |       | 12,039 |   |
| GROSS PROFIT                                  |       | 20,621                                               |       | 15,650 |   |
| SELLING, GENERAL  AND ADMINISTRATIVE EXPENSES |       | 13,110                                               |       | 9,950 |   |
| INCOME FROM OPERATIONS                        |       | 7,511                                                |       | 5,700 |   |
| INTEREST EXPENSE                              |       | 404                                                  |       | 1,771 |   |
| OTHER INCOME                                  |       | (5                                                   | )          | (22 | ) |
| INCOME BEFORE INCOME TAXES                    |       | 7,112                                                |       | 3,951 |   |
| PROVISION FOR  INCOME TAXES                   |       | 2,810                                                |       | 1,536 |   |
| NET INCOME                                    |       | $                                                    | 4,302      |   | $ | 2,415 |   |
| NET INCOME PER  COMMON SHARE:                 |       |                                                 |       |   |   |
| Basic                                         |       | $                                                    | 0.31       |   | $ | 0.23 |   |
| Diluted                                       |       | $                                                    | 0.30       |   | $ | 0.21 |   |
| WEIGHTED-AVERAGE  COMMON SHARES OUTSTANDING:  |       |                                                 |       |   |   |
| Basic                                         |       | 13,866,389                                           |       | 10,352,892 |   |
| Diluted                                       |       | 14,537,147                                           |       | 11,531,629 |   |

 

See notes to condensed consolidated financial statements.

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**PHYSICIANS FORMULAHOLDINGS, INC.CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)(dollars in thousands)**

| ** **                                                                                                                                                                                       | ** ** | **Three Months Ended March 31,**                                                                 | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                       | ** ** | **         2007         ** | ** ** | **         2006        ** | ** ** |
| **CASH FLOWS FROM OPERATING  ACTIVITIES:**                                                                                                                                                       | ** ** |                                                                                                                 | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Net income                                                                                                                                                                                       |       |                                                                                                                 | $          | 4,302 |   |   |   | $ | 2,415 |   |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:                                                                                                               |       |                                                                                                                 |       |   |   |   |   |   |   |
| Depreciation and amortization                                                                                                                                                                    |       |                                                                                                                 | 669        |   |   |   | 627 |   |   |
| Deferred income taxes                                                                                                                                                                            |       |                                                                                                                 | (1,313     | ) |   |   | (273 | ) |   |
| Provision for bad debts                                                                                                                                                                          |       |                                                                                                                 | 15         |   |   |   | 14 |   |   |
| Amortization and write-off of debt issuance costs                                                                                                                                                |       |                                                                                                                 | 8          |   |   |   | 49 |   |   |
| Recognition of stock based compensation                                                                                                                                                          |       |                                                                                                                 | 452        |   |   |   | — |   |   |
| Changes in  operating assets and liabilities:                                                                                                                                                    |       |                                                                                                                 |       |   |   |   |   |   |   |
| Accounts receivable                                                                                                                                                                              |       |                                                                                                                 | (2,370     | ) |   |   | (517 | ) |   |
| Inventories                                                                                                                                                                                      |       |                                                                                                                 | 2,275      |   |   |   | 1,959 |   |   |
| Prepaid expenses and other current assets                                                                                                                                                        |       |                                                                                                                 | 174        |   |   |   | (611 | ) |   |
| Other assets                                                                                                                                                                                     |       |                                                                                                                 | (88        | ) |   |   | 8 |   |   |
| Accounts payable                                                                                                                                                                                 |       |                                                                                                                 | (2,449     | ) |   |   | 113 |   |   |
| Accrued expenses, trade allowances and sales returns  reserve                                                                                                                                    |       |                                                                                                                 | 932        |   |   |   | 1,875 |   |   |
| Income taxes payable                                                                                                                                                                             |       |                                                                                                                 | 3,278      |   |   |   | (2,347 | ) |   |
| Net cash provided by operating activities                                                                                                                                                        |       |                                                                                                                 | 5,885      |   |   |   | 3,312 |   |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                                                                                                                                       | ** ** |                                                                                                                 | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Purchase of property and equipment                                                                                                                                                               |       |                                                                                                                 | (250       | ) |   |   | (64 | ) |   |
| Net cash used in investing activities                                                                                                                                                            |       |                                                                                                                 | (250       | ) |   |   | (64 | ) |   |
| **CASH  FLOWS FROM FINANCING ACTIVITIES:**                                                                                                                                                       | ** ** |                                                                                                                 | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Paydowns of term loans                                                                                                                                                                           |       |                                                                                                                 | (375       | ) |   |   | (1,044 | ) |   |
| Net paydowns under line of credit                                                                                                                                                                |       |                                                                                                                 | (5,260     | ) |   |   | (1,868 | ) |   |
| Debt issuance costs                                                                                                                                                                              |       |                                                                                                                 | (13        | ) |   |   | (154 | ) |   |
| Bank overdraft                                                                                                                                                                                   |       |                                                                                                                 | —     |   |   |   | (177 | ) |   |
| Exercise of stock options                                                                                                                                                                        |       |                                                                                                                 | 8          |   |   |   | 37 |   |   |
| Cash payment of common stock dividend                                                                                                                                                            |       |                                                                                                                 | —     |   |   |   | (46 | ) |   |
| Net cash used in financing activities                                                                                                                                                            |       |                                                                                                                 | (5,640     | ) |   |   | (3,252 | ) |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                                                                                                                        |       |                                                                                                                 | (5         | ) |   |   | (4 | ) |   |
| CASH AND CASH  EQUIVALENTS—Beginning of period                                                                                                                                              |       |                                                                                                                 | 26         |   |   |   | 20 |   |   |
| CASH AND CASH  EQUIVALENTS—End of period                                                                                                                                                    |       |                                                                                                                 | $          | 21 |   |   |   | $ | 16 |   |   |
| SUPPLEMENTAL  DISCLOSURE OF CASH FLOW INFORMATION—                                                                                                                                          |       |                                                                                                                 |       |   |   |   |   |   |   |
| Cash paid during the  period for:                                                                                                                                                                |       |                                                                                                                 |       |   |   |   |   |   |   |
| Interest                                                                                                                                                                                         |       |                                                                                                                 | $          | 402 |   |   |   | $ | 1,082 |   |   |
| Income taxes—net                                                                                                                                                                            |       |                                                                                                                 | $          | 846 |   |   |   | $ | 4,157 |   |   |
| SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING ACTIVITIES—The Company  had accounts payable of $247 outstanding as of March 31, 2007, relating  to purchases of property and equipment. |       |                                                                                                                 |       |   |   |   |   |   |   |

 

See notes to condensed consolidated financial statements.

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**PHYSICIANS FORMULAHOLDINGS, 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’’), a Delaware corporation, and its wholly owned subsidiary,Physicians Formula, Inc. (‘‘Physicians’’), a New York corporation, and itswholly owned subsidiaries, Physicians Formula Cosmetics, Inc. andPhysicians Formula DRTV, LLC.

The Company develops, markets, manufactures anddistributes innovative, premium-priced products for the mass market channel.The Company’s products include face powders, bronzers, concealers, blushes,foundations, eye shadows, eyeliners, brow makeup and mascaras. The Companysells its products to mass market retailers such as Wal-Mart, Target, CVS,Walgreens and Albertsons.

The accompanying condensed consolidated balance sheetas of March 31, 2007, the condensed consolidated statements of income for thethree months ended March 31, 2007 and 2006 and the condensed consolidatedstatements of cash flows for the three months ended March 31, 2007 and2006 are unaudited. These unaudited condensed interim consolidated financialstatements have been prepared in accordance with U.S. generally acceptedaccounting principles for interim financial information and Article 10 ofRegulation S-X. In the opinion of the Company’s management, the unauditedcondensed interim consolidated financial statements include all adjustments ofa normal recurring nature necessary for the fair presentation of the Company’sfinancial position as of March 31, 2007, its results of operations for thethree months ended March 31, 2007 and 2006, and its cash flows for thethree months ended March 31, 2007 and 2006. The results for the interimperiods are not necessarily indicative of the results to be expected for anyfuture period or for the fiscal year ending December 31, 2007. Thecondensed consolidated balance sheet as of December 31, 2006 has beenderived from the audited consolidated balance sheet as of that date.

These condensed interim consolidated financialstatements should be read in conjunction with the Company’s audited financialstatements and notes thereto included in the Company’s Annual Report on Form 10-Kfor the year ended December 31, 2006.

***Use of Estimates—******The*** preparationof financial 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.   NEWACCOUNTING STANDARDS**

In June 2006, theFinancial Accounting Standards Board (‘‘FASB’’) issued FASB Interpretation No. (“FIN”)48, *Accounting for Uncertainty in IncomeTaxes*. FIN 48 prescribes a more likely than not threshold forfinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. FIN 48 also provides guidance onderecognition of income tax assets and liabilities, accounting for interest andpenalties associated with tax positions, accounting for income taxes in interimperiods and income tax disclosures. The Company adopted FIN 48 on January 1,2007, and did not record any cumulative effect adjustment to retained earningsas a result of adopting FIN 48. Interest and penalties, if any, related tounrecognized tax benefits are recorded in income tax expense. Totalunrecognized tax benefits and interest and penalties were not significant atJanuary 1, 2007. The Company does not expect significant changes inunrecognized tax benefits in the next twelve months. As of 

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January 1,2007, the Company is subject to U.S. Federal income tax examinations for thetax years 2003 through 2006, and is subject to state and local income taxexaminations for the tax years 2002 through 2006.

**3.   NET INCOMEPER SHARE**

Basicnet income per common share is computed as net income divided by theweighted-average number of common shares outstanding during the period. Dilutednet income per share reflects the potential dilution that could occur from theexercise of outstanding stock options and is computed by dividing net income bythe weighted-average number of common shares outstanding for the period, plusthe dilutive effect of outstanding stock options, calculated using the treasurystock method. The following table summarizes the potential dilutive effect ofoutstanding stock options, calculated using the treasury stock method:

| ** **                                             | ** ** | **Three Months Ended March 31,**                                                     | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
| ** **                                             | ** ** | **        2007        ** | ** ** | **        2006        ** | ** ** |
| Weighted-average  number of common shares—basic   |       |                                                                                                     | 13,866,389 |   |   |   | 10,352,892 |   |   |
| Effect of  dilutive employee stock options             |       |                                                                                                     | 670,758    |   |   |   | 1,178,737 |   |   |
| Weighted-average number  of common shares—diluted |       |                                                                                                     | 14,537,147 |   |   |   | 11,531,629 |   |   |

 

**4.   INVENTORIES**

Inventories consist of the following (dollars inthousands):

| ** **                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                    | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| Raw materials and  components |       |               | $          | 10,482                |       |   |   | $ | 11,955 |   |   |
| Finished goods                |       |               | 10,715     |                  |       |   | 11,517 |   |   |
| Total                         |       |               | $          | 21,197                |       |   |   | $ | 23,472 |   |   |

 

**5.**   INTANGIBLEASSETS

Intangibleassets consist of the following as of March 31, 2007 (dollars inthousands):

| ** **                 | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
|----------------------------|------------|---------------------------------|------------|-------------------------------|------------|-----------|------------|
| Trade names                |       |                            | $          | 29,500                        |       |      |       | $ | — |   |   | $ | 29,500 |   |
| Patents                    |       |                            | 8,699      |                          |       |      | 1,982      |   |   | 6,717 |   |
| Distributor  relationships |       |                            | 23,701     |                          |       |      | 4,048      |   |   | 19,653 |   |
| Total                      |       |                            | $          | 61,900                        |       |      |       | $ | 6,030 |   |   | $ | 55,870 |   |

 

Intangibleassets consist of the following as of December 31, 2006 (dollars inthousands):

| ** **                 | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Total** | ** ** |
|----------------------------|------------|---------------------------------|------------|-------------------------------|------------|-----------|------------|
| Trade names                |       |                            | $          | 29,500                        |       |      |       | $ | — |   |   | $ | 29,500 |   |
| Patents                    |       |                            | 8,699      |                          |       |      | 1,836      |   |   | 6,863 |   |
| Distributor  relationships |       |                            | 23,701     |                          |       |      | 3,753      |   |   | 19,948 |   |
| Total                      |       |                            | $          | 61,900                        |       |      |       | $ | 5,589 |   |   | $ | 56,311 |   |

 

Amortization expense was$441,000 for both of the three month periods ended March 31, 2007 and 2006.Amortization of intangible assets for the remainder of 2007 will beapproximately $1,324,000 and for the next five years will be approximately$1,765,000 per year.

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**6.   STOCKHOLDERS’EQUITY**

On November 14, 2006,the Company completed an initial public offering of shares of the Company’scommon stock. In the initial public offering, the Company sold 3,125,000 sharesof common stock and the selling stockholders sold 5,500,000 shares of commonstock, which included 1,125,000 shares of common stock sold by the sellingstockholders pursuant to the underwriter’s over-allotment option. Theunderwriters exercised this over-allotment on November 10, 2006 and theinitial public offering closed on November 14, 2006.

**7.   EQUITY ANDSTOCK OPTION PLANS**

***2006 Equity Incentive Plan***

In connection with theCompany’s initial public offering, the Company adopted the Physicians FormulaHoldings, Inc. 2006 Equity Incentive Plan (the “2006 Plan”). The 2006 Planprovides for grants of stock options, stock appreciation rights, restrictedstock, restricted stock units, deferred stock units and other performanceawards to directors, officers and employees of the Company, as well as othersperforming services for the Company. The options generally have a 10-year lifeand vest over a period of time. As of March 31, 2007, a total of 876,861shares of the Company’s common stock were available for issuance under the 2006Plan. This amount will automatically increase on the first day of each fiscalyear 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) suchlesser number of shares as determined by the compensation committee of theBoard of Directors. On February 6, 2007, the Company granted 300,000 stockoptions under the 2006 Plan to certain employees of the Company.

***2003 Stock Option Plan***

In November 2003, the Board of Directors adoptedthe 2003 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. Theoptions generally have a 10-year life and vest over a period of time. Optionsgranted under the 2003 Plan were originally granted as Time-Vesting Options andPerformance-Vesting Options. The original Time-Vesting Options vest in equalannual installments over a four-year period. In connection with the initialpublic offering, the 713,334 Performance-Vesting Options were amended toaccelerate the vesting of 550,781 of such options, and 296,140 of these optionswere exercised. The remaining 162,553 Performance-Vesting Options wereconverted to Time-Vesting Options that vest in equal monthly installments overa two-year period. Optionsare granted with exercise prices not less than the fair value at the date ofgrant, as determined by the Board of Directors.

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Theequity incentive and stock option plan activity is summarized below:

| ** **                                            | ** ** | **Time-Vesting Options** | ** ** | **Performance-Vesting Options**        | ** **   |
|-------------------------------------------------------|------------|-------------------------------|------------|---------------------------------------------|--------------|
| ** **                                            | ** ** | ** **                    | ** ** | **Weighted-  Average  Exercise Price** | ** **   | **Aggregate  Intrinsic  Value** | ** ** | ** ** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| Options  outstanding—January 1, 2007        |       | 652,053                       |       |                                        | $ 0.11  |   |   |   |   | 254,641 |   |   | $ 0.10 |   |   |   |   |
| Options granted  in February 2007                |       | 300,000                       |       |                                        | 20.75        |   |   | — |   | — |   |   | — |   |   |   |   |
| Options exercised                                     |       | (83,999                       | )          |                                        | 0.10         |   |   | $ 1,555,000 |   | — |   |   | — |   |   |   |   |
| Options outstanding—March 31, 2007          |       | 868,054                       |       |                                        | $ 11.07 |   |   | $ 4,438,000 |   | 254,641 |   |   | $ 0.10 |   |   | $ 4,782,000 |   |
| Vested and  expected to vest—March 31, 2007 |       | 868,054                       |       |                                        | $ 11.07 |   |   | $ 4,438,000 |   | 254,641 |   |   | $ 0.10 |   |   | $ 4,782,000 |   |

 

Thefair value of options granted during the quarter ended March 31, 2007totaled $3,161,000. The Company utilized the Black-Scholes option valuationmodel to calculate the fair value of these options using the followingweighted-average assumptions:

| Risk-free  interest rate |   | 4.9  | %      |
|--------------------------|--------|------|--------|
| Volatility               |   | 52.2 | %      |
| Dividend rate            |   | None |   |
| Life in years            |   | 5.0  |   |

 

The risk-free interest is based-upon the U.S. Treasuryyield curve in effect at the time of grant for periods corresponding with theexpected life of the options. The expected volatility rate is based oncompanies of similar growth and maturity and our peer group in the industry inwhich the Company does business. The dividend rate assumption is excluded fromthe calculation, as the Company intends to retain all earnings. The expectedlife of our stock options represents management’s best estimate based uponhistorical and expected trends.

Thevesting activity for the equity incentive and stock option plans is summarizedbelow:

|                        | ** ** | **Time-Vesting Options**    | ** ** | **Performance-Vesting Options** | ** ** |
|------------------------|------------|----------------------------------|------------|--------------------------------------|------------|
| ** **             | ** ** | ** **                       | ** ** | ** **                           | ** ** | **Weighted-Average** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted-Average** | ** ** | ** ** | ** ** |
| ** **             | ** ** | **Vested and  Exercisable** | ** ** | **Aggregate  Exercise Price**   | ** ** | **Exercise  Price** | ** ** | **Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** | **Vested and  Exercisable** | ** ** | **Aggregate  Exercise  Price** | ** ** | **Exercise  Price** | ** ** | **Remaining  Contractual  Life** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
| January 1, 2007   |       |                             | 246,108    |                                 |       |   | 25,000 |   |   |   |   |   |   |   |   |   |   |   |   |   | 254,641 |   |   |   | 25,000 |   |   |   |   |   |   |   |   |   |   |   |   |
| Vesting during quarter |       |                             | 53,569     |                                 |       |   | 136,000 |   |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   | — |   |   |   |   |   |   |   |   |   |   |   |   |
| Options exercised      |       |                             | (83,999    | )                                    |       |   | (8,000 | ) |   |   |   |   |   |   |   |   |   |   |   |   | — |   |   |   | — |   |   |   |   |   |   |   |   |   |   |   |   |
| March 31, 2007    |       |                             | 215,678    |                                 |       |   | 153,000 |   |   |   | $ 0.71 |   |   |   | 6.9  years |   |   | $ 3,919,000 |   |   | 254,641 |   |   |   | 25,000 |   |   |   | $ 0.10 |   |   |   | 6.7  years |   |   | $ 4,782,000 |   |

 

As of March 31, 2007, the options outstandingunder the 2003 Plan and 2006 Plan had exercise prices between $0.10 and $20.75and the weighted-average remaining contractual life for all options was7.5 years.

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Asummary of the weighted-average grant date fair value of the non-vested stockoption awards is presented in the table below:

| ** **            | ** ** | ** ** | ** ** | **Weighted-Average  Grant Date Fair Value** | ** **  |
|-----------------------|------------|------------|------------|------------------------------------------------------------|-------------|
| January 1,  2007 |       | 405,945    |       |                                                       | $ 6.56 |   |   |
| Vested                |       | (53,569    | )          |                                                       | 7.72        |   |   |
| Granted               |       | 300,000    |       |                                                       | 10.54       |   |   |
| March 31, 2007   |       | 652,376    |       |                                                       | $ 8.30 |   |   |

 

The total fair value of options that vested during thethree months ended March 31, 2007 and 2006 was $413,000 and $4,000,respectively.

As of March 31, 2007,total unrecognized estimated compensation cost related to non-vested stockoptions was approximately $5,276,000, which is expected to be recognized over aweighted-average period of approximately 2.9 years. The Company recorded cashreceived from the exercise of stock options of $8,000 during the three monthsended March 31, 2007. Upon option exercise, the Company issues new sharesof stock.

**8.   COMMITMENTSAND CONTINGENCIES**

***Litigation—******The*** Companyhas been named in various lawsuits in the ordinary course of business. Inmanagement’s opinion, the ultimate resolution of these matters will not resultin a material impact to the Company’s consolidated financial statements.

***Manufacturing—******The*** Companyhas a contractual agreement, for approximately $1,100,000, to automate aproduct assembly line, of which $500,000 has been incurred as of March 31,2007.

***Environmental—******The*** shallowsoils and groundwater below our City of Industry facilities were contaminatedby the former operator of the property. The former operator performed onsitecleanup and we anticipate that we will receive written confirmation from theState of California that no further onsite cleanup is necessary. Suchconfirmation would not rule out potential liability for regionalgroundwater contamination or alleged potable water supply contaminationdiscussed below. If further onsite cleanup is required, the Company believesthe cost, which the Company is not able to estimate, would be indemnified,without contest or material limitation, by companies that have fulfilledsimilar indemnity obligations to the Company in the past, and that the Companybelieves 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 to which,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 Company expects to enter into aconsent decree with EPA and the other PRP that will resolve its liability forthe cleanup of regional groundwater contamination without any payment by us toEPA. Depending on the scope and duration of the cleanup, the Company may berequired to make further payments to the other PRP for regional groundwaterremediation costs. The Company estimates the amount of any such additionalpayments would not exceed approximately $130,000. The estimate is based oncomponent estimates for two distinct contaminants that may require remediation.Those estimates in turn are based on a number of assumptions concerning thelikelihood that remediation will be required, the cost of remediation ifrequired and other matters. Uncertainty in predicting these matters limits thereliability and precision of the estimates. The Company expects any suchadditional payments by the Company to be covered by indemnities given to theCompany by other 

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companies. Those companiesmay contest their indemnity obligation for these payments. The Company believesthe companies are financially able to pay the liability. Because the Companybelieves it is not probable that it will be held liable for any of theseexpenses, the Company has not recorded a liability for such potential 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 liabilityfor these contamination matters and related claims is substantially covered bythird-party indemnities and resolved by prior settlements, and borne by prioroperators of the facility, their successors and their insurers. The Company isattempting to recoup approximately $0.7 million in defense costs from one ofthese indemnitors. These costs have been expensed as paid by the Company andare not recorded in its condensed consolidated balance sheets.

**10.   GEOGRAPHICINFORMATION**

Geographicrevenue information is based on the location of the customer. All of theCompany’s assets are located in the United States. Net sales to externalcustomers by geographic region are as follows (dollars in thousands):

| ** **    | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------|------------|------------------------------------------------------|------------|
| **Customer**  | ** ** | ** **                                           | ** ** | **2007** | ** ** | **2006** | ** ** |
| United States |       | $ 31,131                                        |       | $ 25,810 |   |
| Canada        |       | 4,467                                                |       | 1,835 |   |
| Other         |       | 125                                                  |       | 44 |   |
|          |       | $ 35,723                                        |       | $ 27,689 |   |
|               |            |                                                      |            |  |  |  |  |

 

**11.   SUBSEQUENTEVENT**

***Secondary Equity Offering***

On April 25, 2007, the Company completed asecondary equity offering, by certain selling stockholders, of 5,049,650 sharesof the Company’s common stock, which includes 658,650 shares of common stocksold pursuant to the underwriters’ over-allotment option. The Company did notreceive any proceeds from the sale of the shares but incurred approximately$850,000 of the expenses of the offering.

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**ITEM 2.**                MANAGEMENT’SDISCUSSION AND ANALYSIS 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 Annual Report on Form 10-K for the yearended December 31, 2006.

**Overview of theBusiness**

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 and marketing innovative, premium-priced products forthe mass market channel. Our products focus on addressing skin imperfectionsthrough a problem-solution approach, rather than focusing on changing fashiontrends. Our products address specific, everyday cosmetics needs and includeface powders, bronzers, concealers, blushes, foundations, eye shadows,eyeliners, brow makeup and mascaras.

We sell our products tomass market retailers such as Wal-Mart, Target, CVS, Walgreens and Albertsons. Ourproducts provide above-average profitability for retailers due to their higherprice points and sales per linear foot. Our products are currently sold in approximately26,000 of the 45,000 stores in which we estimate our *masstige* competitors’ products are sold. We seek to befirst-to-market with new products within this channel, and are able to take newproducts from concept development to shipment in less than 12 months. Newproducts are a very important part of our business and have contributed, onaverage, approximately 38% of our net sales for the last three years.

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

Wedefine 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 approximate market share, based on retail sales,of our products in total and for selected categories within the *masstige* market, as we define it, based on ACNielsen(1) data for the 52 weeksended March 24, 2007:

| ** **    | ** ** | **52 Weeks Ended March 24, 2007** | ** ** | ** **                                                             |
|---------------|------------|------------------------------------------------------------|------------|------------------------------------------------------------------------|
| ** **    | ** ** | **Masstige ($ Share)(1)**                        | ** ** | **% Change vs. Prior Year ($ Share)(1)** | ** ** | ** ** |
| Total Company |       |                                                       | 7.3        | %                                                                      |   |   | 22 | % |   |   |
| Face          |       |                                                       | 13.3       | %                                                                      |   |   | 26 | % |   |   |
| Eye           |       |                                                       | 5.3        | %                                                                      |   |   | 11 | % |   |   |

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

**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 from December throughApril. Sales during these months are typically greater due to the shipmentsrequired to fill the inventory at retail stores and retailers’ warehouses. Retailerstypically reset their retail selling space during these months to accommodatechanges in space allocation to each supplier and to incorporate the addition ofnew products and the deletion of slow-selling items. Our net sales for thethree months ended March 31, 2007 were higher than our net sales for thesecond and third quarters of 2006, as 

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a resultof this seasonality. Our quarterly results of operations may also fluctuate asa result of a variety of other reasons including the timing of new productintroductions, general economic conditions or consumer buyer behavior. Inaddition, results for any one quarter may not be indicative of results for thesame quarter in subsequent years.

**Results ofOperations**

Thefollowing table sets forth our condensed consolidated statements of income forthe three months ended March 31, 2007 and 2006:

| ** **                                    | ** ** | **Three Months Ended  March 31, **                      | ** ** |
|-----------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                                                    | ** ** | **2006** | ** ** |
| ** **                                    | ** ** | **(dollars in thousands,  except per share data)** | ** ** |
| **Statement of Operations Data:**             |       |                                                                        |       |   |   |
| Net sales                                     |       | $                                                                           | 35,723     |   | $ | 27,689 |   |
| Cost of sales                                 |       | 15,102                                                                      |       | 12,039 |   |
| Gross profit                                  |       | 20,621                                                                      |       | 15,650 |   |
| Selling, general  and administrative expenses |       | 13,110                                                                      |       | 9,950 |   |
| Income from operations                        |       | 7,511                                                                       |       | 5,700 |   |
| Interest expense                              |       | 404                                                                         |       | 1,771 |   |
| Other income                                  |       | (5                                                                          | )          | (22 | ) |
| Income before income taxes                    |       | 7,112                                                                       |       | 3,951 |   |
| Provisions for  income taxes                  |       | 2,810                                                                       |       | 1,536 |   |
| Net income                                    |       | $                                                                           | 4,302      |   | $ | 2,415 |   |
| Net income per common  share:                 |       |                                                                        |       |   |   |
| Basic                                         |       | $                                                                           | 0.31       |   | $ | 0.23 |   |
| Diluted                                       |       | $                                                                           | 0.30       |   | $ | 0.21 |   |
| Weighted-average common  shares outstanding:  |       |                                                                        |       |   |   |
| Basic                                         |       | 13,866,389                                                                  |       | 10,352,892 |   |
| Diluted                                       |       | 14,537,147                                                                  |       | 11,531,629 |   |

 

The following is adiscussion of our results of operations for the three months ended March 31,2007 and 2006.

***Three Months Ended March 31, 2007 Compared toThree Months Ended March 31, 2006***

*Net Sales.*   NetSales increased $8.0 million, or 28.8%, to $35.7 million for the three monthsended March 31, 2007, from $27.7 million for the three months ended March 31,2006. The increase was primarily attributable to growth in sales of our faceand eye makeup products, as we continued to broaden our total distribution.Total distribution represents the number of stores in which we sell productsmultiplied by our number of stock keeping units per store. Total unit volumeincreased by 1.6 million units, or 24.4%, to 8.4 million units for the threemonths ended March 31, 2007 from 6.8 million units for the same period ayear ago. New products represented 45% of our net sales for the three monthsended March 31, 2007, one percent higher than the same period a year agowhen new products contributed 44% of net sales. Partially offsetting our netsales growth for the three months ended March 31, 2007 was an increase inour returns provision due to higher returns resulting from our retailercustomers’ wall display changes. Our increase in net sales was also partiallyoffset by an increase in markdown expenses for discontinued products. Duringthe three months ended March 31, 2007, our results included net sales of$4.6 million from our international customers, compared to $1.9 million for thethree months ended March 31, 2006.

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*Cost ofSales.*   Cost of sales increased $3.1 million, or25.8%, to $15.1 million for the three months ended March 31, 2007 from$12.0 million for the three months ended March 31, 2006. Cost of sales asa percent of net sales was 42.3% of net sales for the three months ended March 31,2007, compared to 43.5% for the three months ended March 31, 2006. Thedecrease in cost of sales, as a percentage of net sales, was attributable to aslight increase in the recovery of inventory returns of $0.2 million and areduction in the write-down of obsolete inventory of $0.5 million due toseveral initiatives we implemented during 2006 to improve inventory management.These initiatives include identifying slow moving products at retail as earlyas possible to prevent overbuilding of inventories and improving the managementof the sales forecasting and production planning processes. The decrease incost of sales, as a percentage of net sales, was partially offset by anincrease in product costs of $0.3 million resulting from increased wages due toan increase in the California minimum wage and increased overhead as a resultof a short-term lease we entered into for a temporary manufacturing facility inIrwindale, California.

*Selling,General and Administrative Expenses.*   Selling,general and administrative expenses increased by $3.1 million, or 31.0%, to$13.1 million for the three monthsended March 31, 2007, from $10.0 million for the three months ended March 31,2006. The increase was principally due to a $2.1 million increase in overheadcosts resulting from a $0.6 million increase in employee compensationassociated with our growth, a $0.3 million increase in marketing spending, a$0.5 million expense for our stock options awards, and an increase in expensesassociated with being a public company. In addition, there were higher costsassociated with increased sales volumes, including a $0.7 million increase inoutbound freight costs and a $0.3 million increase in export sales commissions.

*InterestExpense.*   Interest expense decreased by $1.4million to $0.4 million for the three months ended March 31, 2007, from$1.8 million for the three months ended March 31, 2006. The decrease ininterest expense was due to the decrease in average borrowings outstanding underour revolving credit facility as we repaid all borrowings under our formersenior credit agreement with the net proceeds of the initial public offeringand borrowings under our senior credit agreement.

*OtherIncome.*   Other income decreased by $17,000, or77.3%, to $5,000 for the three months ended March 31, 2007, from $22,000for the three months ended March 31, 2006. Other income for the threemonths ended March 31, 2007 and 2006 was attributable to realized andunrealized gains related to investments held as part of our non-qualifieddeferred compensation plan.

*Provision for IncomeTaxes.*   The income tax expense for the threemonths ended March 31, 2007 was $2.8 million, representing an effectiveincome tax rate of 39.5%, compared to income tax expense of $1.5 million,representing an effective tax rate of 38.9%, for the three months ended March 31,2006. The effective rates differed from the statutory rates due to the effectof varying state and local taxes, the impact of the change in the deferredcarrying rate and certain permanent items such as extra territorial incomeexclusions.

**Liquidity andCapital Resources**

*Cash Flows*

As of March 31, 2007, we had $21,000 in cash andcash equivalents compared to $16,000 in cash and cash equivalents as of March 31,2006. The low level of cash reflects the use of cash to pay down the revolvingcredit facility on a regular basis. As of March 31, 2007 we had $17.7million of availability under our revolving credit facility. The significantcomponents of our working capital are accounts receivable and inventories,reduced by accounts payable and accrued expenses.

*Operatingactivities.*   Cash provided by operatingactivities increased $2.6 million, or 78.8%, to $5.9 million for the threemonths ended March 31, 2007, from $3.3 million for the three months ended March 31,2006. The net increase in cash provided by operating activities resultedprimarily from favorable 

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changes in working capitaland higher net income due to our growth. Our inventory turnover rate hasslightly decreased to an annualized 2.7 times per year for the three monthsended March 31, 2007, from an annualized 2.9 times per year for the threemonths ended March 31, 2006. Days sales outstanding decreased 0.6 days, to48.5 days in March 31, 2007 from 49.1 days in March 31, 2006.

*Investingactivities.*   Cash used in investing activitiesfor the three months ended March 31, 2007 was $250,000, which was relatedto capital expenditures for the replacement of machinery and equipment and theautomation of an assembly line to accommodate future growth. Cash used ininvesting activities for the three months ended March 31, 2006 of $64,000was related to capital expenditures for the replacement and upgrade ofmachinery and equipment. We spent $250,000 and $64,000 on capital expendituresin the three months ended March 31, 2007 and 2006, respectively.

*Financingactivities.*   Cash used in financing activitieswas $5.6 million for the three months ended March 31, 2007 compared tocash used in financing operations of $3.3 million for the three months ended March 31,2006. The increase in cash used in financing activities between periodsprimarily resulted from higher repayments of indebtedness under our line ofcredit.

*Future Liquidity andCapital Needs.*   The significant components of ourworking capital are accounts receivable and inventory, reduced by accountspayable and accrued expenses. Net working capital requirements increased by$14.7 million, or approximately 169%, to $23.4 million in the three monthsended March 31, 2007, from $8.7 million in the three months ended March 31,2006. We anticipate that working capital will decrease during the second andthird quarters and increase during the fourth quarter of 2007, when wetypically experience higher inventory levels as we produce new products forshipment in the first quarter of the following year. We have budgeted capitalexpenditures of $2.5 million for 2007, compared to $1.0 million in 2006, forseveral key projects, including completion of our automated assembly line,investment in our information technology infrastructure and improvements to ourwarehouse distribution systems. Capital requirements related to manufacturinginclude a major project to automate product assembly lines that are used toassemble products representing approximately 44% of our net sales in 2006. Weexpect this to add approximately $800,000 of a $1.1 million project to ournormal level of capital expenditures in 2007, of which $300,000 was incurred in2006 and $200,000 was incurred during the three months ended March 31,2007. We have completed the replacement of our IBM AS/400 mainframe computer toaccommodate future growth at a cost of approximately $0.3 million. Further, wemay also need to implement improvements to our warehouse distribution systemsat a cost of approximately $0.5 million. We believe that our cash flows fromoperations and funds from our new revolving credit facility will provideadequate funds for our working capital needs and planned capital expendituresfor at least the next twelve months. No assurance can be given, however, thatthis will be the case.

*Credit Facilities*

On November 14, 2006, we entered into a seniorcredit agreement with a bank that will terminate in 2011 and consists of a $15.0 millionterm loan facility and a revolving credit facility providing for borrowings ofup to $20.0 million. At March 31, 2007, there was $2.3 millionoutstanding under the revolving credit facility at an interest rate of 8.75%and we had $17.7 million of availability under the revolving creditfacility. The interest rate on the term loan was 7.36% at March 31, 2007. Theavailability under the revolving credit facility is reduced by outstandingletters of credit. There were no outstanding letters of credit as of March 31,2007.

We used the borrowings under our senior creditagreement and a portion of the net proceeds of our initial public offering torepay borrowings and accrued interest under our former senior credit agreement.Borrowings under our senior credit agreement are guaranteed by PhysiciansFormula Holdings, Inc. and the domestic subsidiaries of Physicians Formula, Inc.,and borrowings under our senior credit agreement are secured by liens onsubstantially all of the assets of Physicians Formula, Inc., including theassets of its 

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subsidiaries. Amountsoutstanding under the term loan facility, which totaled $14.6 million at March 31,2007, are due in quarterly payments currently equal to $375,000 and increasing 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. Theinitial quarterly payment of $375,000 was made on January 1, 2007 and thesecond quarterly payment of $375,000 was made on April 2, 2007.

Amounts outstanding under the term loan facility andthe revolving credit facility bear interest at a LIBOR Adjusted Rate (asdefined in our senior credit agreement) plus 2.0% or at a Base Rate (as definedin our senior credit agreement) plus 0.5%. The revolving credit facility isalso subject to a commitment fee of 0.25% on any unused commitments.

Our senior credit agreement contains the followingfinancial covenants: a maximum total leverage ratio; a minimum fixed chargecoverage ratio; a minimum net worth requirement; and a limitation on capitalexpenditures (which may be no more than $3,000,000 per fiscal year). As of March 31,2007, we were in compliance with these covenants.

Our senior credit agreement contains certainadditional negative covenants, including limitations on the ability ofPhysicians Formula, Inc., our operating subsidiary, to: incur otherindebtedness and liens; fundamentally change its business through a merger,consolidation, amalgamation or liquidation; sell assets; pay cash dividends orpay for expenses of Physicians Formula Holdings, Inc., unless certainconditions are satisfied; make certain acquisitions, investments, loans andadvances; engage in transactions with our affiliates; enter into certainagreements; engage in sale-leaseback transactions; incur certain unfundedliabilities; and change our line of business.

Our 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-Balance SheetTransactions**

We do not have anyrelationships with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes. Inaddition, we do not engage in trading activities involving non-exchange tradedcontracts that rely on estimation techniques to calculate fair value. As such,we are not exposed to any financing, liquidity, market or credit risk thatcould arise if we had engaged in such relationships.

**Forward-LookingStatements**

This section and otherparts of this Quarterly Report on Form 10-Q contain forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended and Section 21E of the Securities Exchange Act of 1934,as amended. In some cases, forward-looking statements can be identified bywords such as “anticipates,” “expects,” “believes,” “plans,” “predicts,” andsimilar terms. Such forward-looking statements are based on currentexpectations, estimates and projections about our industry, management’sbeliefs and assumptions made by management. Forward-looking statements are notguarantees of future performance and our actual results may differsignificantly from the results discussed in the forward-looking statements. Factorsthat might cause such differences include, but are not limited to thosediscussed in Part I, Item 1A, “Risk Factors” in our Annual Report on Form 10-Kfor the year ended December 31, 2006. Unless otherwise required by law, weexpressly disclaim any obligation to update publicly any forward-lookingstatements, whether as result of new information, future events or otherwise.

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**ITEM 3.**                QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

(a)           *ForeignCurrency 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 our operating results may be affected by fluctuations inthe exchange rate of the currencies of the suppliers. We do not have anyforeign currency hedges.

(b)          *InterestRate Risk.*

We are exposed to interestrate risks primarily through borrowings under our revolving loan arrangementand term loans. Interest on these borrowings is based upon variable interestrates. Our weighted-average borrowings outstanding under the revolving loanarrangement and term loans during the three months ended March 31, 2007,was $20.1 million and the weighted-average interest rate in effect at March 31,2007, was 7.55%. A hypothetical 1% increase or decrease in interest rates wouldhave resulted in a $50,000 change to interest expense for the three monthsended March 31, 2007.

**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 Exchange Act is recorded, processed,summarized and reported within the time periods specified Rule 13a-15under the Exchange Act, and that such information is accumulated andcommunicated to the Company’s management, including its Chief Executive Officerand Chief Financial Officer, as appropriate, to allow timely decisionsregarding required disclosure. Management is responsible for establishing andmaintaining adequate internal control over financial reporting.

As required by Rule 13a-15(b) underthe Exchange Act, the Company carried out an evaluation, under the supervisionand with the participation of its management, including the Chief ExecutiveOfficer and the Chief Financial Officer, of the effectiveness of the design andoperation of the Company’s disclosure controls and procedures. Based on theforegoing, its Chief Executive Officer and Chief Financial Officer determinedthat disclosure controls and procedures were effective at a reasonableassurance level as of the end 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 1.**                LEGALPROCEEDINGS

None.

**ITEM 1A.**        RISKFACTORS

There have been nomaterial changes to our risk factors as disclosed in Item 1A. “Risk Factors” inour Annual Report on Form 10-K for the year ended December 31,2006.

**ITEM6.**                EXHIBITS
| Exhibit  Number | ** ** | ** **                                                                                                                                                                                                                                                                                                           | ** ** | **Description** |
|-----------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 10.1            |       | Form of  non-qualified option award agreement for Ingrid Jackel, Jeff Rogers and  Joseph J. Jaeger (incorporated by reference to Exhibit 10.34 to the  Annual Report on Form 10-K for the year ended December 31,  2006 filed by Physicians Formula Holdings, Inc. on March 16, 2007). |
| 10.2            |       | Form of 2007  Bonus Plan (incorporated by reference to Exhibit 10.1 to Form 8-K  filed by Physicians Formula Holdings, Inc. on March 12, 2007).                                                                                                                                             |
| 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**

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly 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: May 10, 2007 |   |                                                          |

 

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