UNITED STATES


SECURITIES AND EXCHANGE
COMMISSION


Washington, DC
20549





FORM 10-Q





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





For the quarterly period
ended September 30, 2009





OR





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





For the transition period
from            to            .





COMMISSION FILE NUMBER:
001-33142





Physicians Formula Holdings,
Inc.





(Exact
name 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
            
            91702Azusa,
      California
            
            (Zip
      Code)(Address
      of principal executive offices)





(626) 334-3395





(Registrant’s
telephone number, including area code)





N/A





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





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes x  No o




Indicate
by check mark whether the registrant has submitted electronically and
posted on its corporate Web site, if any, every Interactive Data File required
to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of
this chapter) during the preceding 12 months (or for such shorter period that
the registrant was required to submit and post such files). Yes o  No o




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting company. See
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act. (Check one):




Large
      accelerated filer o
            
            Accelerated
      filer xNon-accelerated
      filer  o
            
            Smaller
      reporting company x





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




The number of
shares outstanding of the registrant’s common stock, par value $0.01 per share,
as of November 5, 2009, was 13,589,668.















TABLE OF CONTENTS





PART I. FINANCIAL INFORMATION
            
            
            1Item 1.
            Financial
      Statements
            
            
            1Item 2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            
            
            14Item 3.
            Quantitative and Qualitative Disclosures About Market
      Risk
            
            
            21Item 4.
            Controls and Procedures
            
            
            21PART II. OTHER INFORMATION
            
            
            22Item 1.
            Legal
      Proceedings
            
            
            22Item 1A.
            Risk
      Factors
            
            
            22Item 5.
            Other
      Information
            
            
            22Item 6.
            Exhibits
            
            
            23














PART
I.





FINANCIAL
INFORMATION





ITEM
1.  FINANCIAL STATEMENTS





PHYSICIANS FORMULA HOLDINGS,
INC.


CONDENSED CONSOLIDATED BALANCE
SHEETS


(Unaudited)


(In thousands, except share
data)





September
      30,
                      
                      
                      December
      31,2009
                      
                      
                      2008ASSETSCURRENT
      ASSETS:Cash
      and cash equivalents
                      
                      $
                      1,334
                      
                      
                      $
                      620Restricted
      cash
                      
                      
                      51
                      
                      
                      
                      -Accounts
      receivable, net of allowance for doubtful accounts of $669 and
      $838as
      of September 30, 2009 and December 31, 2008, respectively
                      
                      
                      15,016
                      
                      
                      
                      29,186Inventories
                      
                      
                      26,931
                      
                      
                      
                      29,694Prepaid
      expenses and other current assets
                      
                      
                      1,618
                      
                      
                      
                      1,515Income
      taxes receivable
                      
                      
                      2,492
                      
                      
                      
                      -Deferred
      tax assets, net
                      
                      
                      7,327
                      
                      
                      
                      9,224Total
      current assets
                      
                      
                      54,769
                      
                      
                      
                      70,239PROPERTY
      AND EQUIPMENT—Net
                      
                      
                      3,847
                      
                      
                      
                      4,138OTHER ASSETS—Net
                      
                      
                      3,783
                      
                      
                      
                      2,838INTANGIBLE ASSETS—Net
                      
                      
                      34,457
                      
                      
                      
                      36,881$
                      96,856
                      
                      
                      $
                      114,096LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIES:Accounts
      payable
                      
                      $
                      8,411
                      
                      
                      $
                      11,212Accrued
      expenses
                      
                      
                      1,231
                      
                      
                      
                      1,523Trade
      allowances
                      
                      
                      6,525
                      
                      
                      
                      4,580Sales
      returns reserve
                      
                      
                      4,829
                      
                      
                      
                      12,613Income
      taxes payable
                      
                      
                      -
                      
                      
                      
                      1,675Line
      of credit borrowings
                      
                      
                      9,274
                      
                      
                      
                      7,935Related
      party bridge loan
                      
                      
                      4,200
                      
                      
                      
                      -Debt
                      
                      
                      -
                      
                      
                      
                      10,500Total
      current liabilities
                      
                      
                      34,470
                      
                      
                      
                      50,038DEFERRED
      TAX LIABILITIES—Net
                      
                      
                      10,729
                      
                      
                      
                      11,475OTHER
      LONG-TERM LIABILITIES
                      
                      
                      706
                      
                      
                      
                      1,022Total
      liabilities
                      
                      
                      45,905
                      
                      
                      
                      62,535COMMITMENTS
      AND CONTINGENCIES (NOTE 9)STOCKHOLDERS'
      EQUITY:Series
      A preferred stock, $0.01 par value—10,000,000 shares authorized,
      noshares
      issued and outstanding at September 30, 2009 and December 31,
      2008
                      
                      
                      -
                      
                      
                      
                      -Common
      stock, $0.01 par value—50,000,000 shares authorized, 13,589,668
      and13,577,118
      shares issued and outstanding at September 30, 2009 andDecember
      31, 2008, respectively
                      
                      
                      136
                      
                      
                      
                      136Additional
      paid-in capital
                      
                      
                      59,783
                      
                      
                      
                      58,968Accumulated
      deficit
                      
                      
                      (8,968
                      )
                      
                      
                      (7,543
                      )Total
      stockholders' equity
                      
                      
                      50,951
                      
                      
                      
                      51,561$
                      96,856
                      
                      
                      $
                      114,096


See notes
to condensed consolidated financial statements.




-1-





PHYSICIANS FORMULA HOLDINGS,
INC.


CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS


(Unaudited)


(In thousands, except share
data)


Three
      Months Ended
                    
                    
                    Nine
      Months EndedSeptember 30,
                    
                    
                    September 30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008NET
      SALES
                    
                    $
                    14,230
                    
                    
                    $
                    20,254
                    
                    
                    $
                    55,453
                    
                    
                    $
                    85,791COST
      OF SALES
                    
                    
                    7,773
                    
                    
                    
                    8,431
                    
                    
                    
                    26,425
                    
                    
                    
                    39,696GROSS
      PROFIT
                    
                    
                    6,457
                    
                    
                    
                    11,823
                    
                    
                    
                    29,028
                    
                    
                    
                    46,095SELLING,
      GENERAL AND ADMINISTRATIVE EXPENSES
                    
                    
                    6,614
                    
                    
                    
                    9,878
                    
                    
                    
                    29,259
                    
                    
                    
                    38,377INTANGIBLE
      ASSET IMPAIRMENT
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    1,100
                    
                    
                    
                    -(LOSS)
      INCOME FROM OPERATIONS
                    
                    
                    (157
                    )
                    
                    
                    1,945
                    
                    
                    
                    (1,331
                    )
                    
                    
                    7,718INTEREST
      EXPENSE, NET
                    
                    
                    367
                    
                    
                    
                    147
                    
                    
                    
                    1,046
                    
                    
                    
                    731OTHER
      (INCOME) EXPENSE, NET
                    
                    
                    (29
                    )
                    
                    
                    113
                    
                    
                    
                    (17
                    )
                    
                    
                    220(LOSS)
      INCOME BEFORE (BENEFIT) PROVISION FOR INCOME TAXES
                    
                    
                    (495
                    )
                    
                    
                    1,685
                    
                    
                    
                    (2,360
                    )
                    
                    
                    6,767(BENEFIT)
      PROVISION FOR INCOME TAXES
                    
                    
                    (193
                    )
                    
                    
                    (1
                    )
                    
                    
                    (935
                    )
                    
                    
                    2,044NET
      (LOSS) INCOME
                    
                    $
                    (302
                    )
                    
                    $
                    1,686
                    
                    
                    $
                    (1,425
                    )
                    
                    $
                    4,723NET
      (LOSS) INCOME PER COMMON SHARE:Basic
                    
                    $
                    (0.02
                    )
                    
                    $
                    0.12
                    
                    
                    $
                    (0.10
                    )
                    
                    $
                    0.33Diluted
                    
                    $
                    (0.02
                    )
                    
                    $
                    0.12
                    
                    
                    $
                    (0.10
                    )
                    
                    $
                    0.32WEIGHTED-AVERAGE
      COMMON SHARES OUTSTANDING:Basic
                    
                    
                    13,589,668
                    
                    
                    
                    14,105,999
                    
                    
                    
                    13,581,669
                    
                    
                    
                    14,099,367Diluted
                    
                    
                    13,589,668
                    
                    
                    
                    14,620,427
                    
                    
                    
                    13,581,669
                    
                    
                    
                    14,604,105
  See notes
to condensed consolidated financial statements.





-2-





PHYSICIANS FORMULA HOLDINGS,
INC.


CONDENSED CONSOLIDATED STATEMENTS OF
CASH FLOWS


(Unaudited)


(In thousands)


Nine
      Months EndedSeptember 30,2009
                                    
                                    
                                    2008CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      (loss) income
                                    
                                    $
                                    (1,425
                                    )
                                    
                                    $
                                    4,723Adjustments
      to reconcile net (loss) income to net cash provided by operating
      activities:Intangible
      asset impairment
                                    
                                    
                                    1,100
                                    
                                    
                                    
                                    -Depreciation
      and amortization
                                    
                                    
                                    2,909
                                    
                                    
                                    
                                    2,240Exchange
      rate loss
                                    
                                    
                                    69
                                    
                                    
                                    
                                    106Deferred
      income taxes
                                    
                                    
                                    1,151
                                    
                                    
                                    
                                    (554
                                    )Provision
      for bad debts
                                    
                                    
                                    (169
                                    )
                                    
                                    
                                    (141
                                    )Amortization
      of debt issuance costs
                                    
                                    
                                    215
                                    
                                    
                                    
                                    24Stock-based
      compensation expense
                                    
                                    
                                    807
                                    
                                    
                                    
                                    1,836Tax
      benefit on exercise of options
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (45
                                    )Changes
      in assets and liabilities:Accounts
      receivable
                                    
                                    
                                    14,270
                                    
                                    
                                    
                                    16,299Inventories
                                    
                                    
                                    2,812
                                    
                                    
                                    
                                    617Prepaid
      expenses and other current assets
                                    
                                    
                                    168
                                    
                                    
                                    
                                    901Accounts
      payable
                                    
                                    
                                    (2,823
                                    )
                                    
                                    
                                    (6,109
                                    )Accrued
      expenses, trade allowances and sales returns reserve
                                    
                                    
                                    (6,131
                                    )
                                    
                                    
                                    (2,349
                                    )Income
      taxes payable/receivable
                                    
                                    
                                    (4,209
                                    )
                                    
                                    
                                    (3,673
                                    )Other
      long-term liabilities
                                    
                                    
                                    2
                                    
                                    
                                    
                                    -Net
      cash provided by operating activities
                                    
                                    
                                    8,746
                                    
                                    
                                    
                                    13,875CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment
                                    
                                    
                                    (649
                                    )
                                    
                                    
                                    (823
                                    )Other
      assets
                                    
                                    
                                    (1,916
                                    )
                                    
                                    
                                    (414
                                    )Restricted
      cash
                                    
                                    
                                    (51
                                    )
                                    
                                    
                                    -Net
      cash used in investing activities
                                    
                                    
                                    (2,616
                                    )
                                    
                                    
                                    (1,237
                                    )CASH
      FLOWS FROM FINANCING ACTIVITIES:Paydowns
      of term loans
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (2,250
                                    )Net payments
      on line of credit
                                    
                                    
                                    (9,161
                                    )
                                    
                                    
                                    (8,191
                                    )Borrowings
      from related party bridge loan
                                    
                                    
                                    4,200
                                    
                                    
                                    
                                    -Debt
      issuance costs
                                    
                                    
                                    (456
                                    )
                                    
                                    
                                    -Repurchase
      and retirement of common stock
                                    
                                    
                                    -
                                    
                                    
                                    
                                    (1,178
                                    )Tax
      benefit on exercise of stock options
                                    
                                    
                                    -
                                    
                                    
                                    
                                    45Exercise
      of stock options
                                    
                                    
                                    1
                                    
                                    
                                    
                                    10Net
      cash used in financing activities
                                    
                                    
                                    (5,416
                                    )
                                    
                                    
                                    (11,564
                                    )NET
      INCREASE IN CASH AND CASH EQUIVALENTS
                                    
                                    
                                    714
                                    
                                    
                                    
                                    1,074CASH
      AND CASH EQUIVALENTS—Beginning of period
                                    
                                    
                                    620
                                    
                                    
                                    
                                    -CASH
      AND CASH EQUIVALENTS—End of period
                                    
                                    $
                                    1,334
                                    
                                    
                                    $
                                    1,074SUPPLEMENTAL
      DISCLOSURE OF CASH FLOW INFORMATION:Cash
      paid for interest
                                    
                                    $
                                    809
                                    
                                    
                                    $
                                    772Cash
      paid for income taxes
                                    
                                    $
                                    2,121
                                    
                                    
                                    $
                                    6,269SUPPLEMENTAL
      DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:The
      Company had accounts payable of $119 and $27 outstanding as of September
      30, 2009 and 2008, respectively,relating
      to purchases of property and equipment.On
      March 30, 2009, the Company replaced its previously outstanding
      borrowings of $10,500 under its term loans withborrowings
      underthe
      revolving credit facility in connection with the fourth amendment to the
      senior credit agreement.In
      May 2009, a non-cash distribution of $375 was made to an executive officer
      from the Company's 1999 NonqualifiedDeferred
      Compensation Plan.
 See notes
to condensed consolidated financial
statements.





-3-





PHYSICIANS FORMULA HOLDINGS,
INC.


NOTES TO CONDENSED CONSOLIDATED
FINANCIAL STATEMENTS


(Unaudited)





1.  ORGANIZATION AND BASIS
OF PRESENTATION




The
accompanying unaudited condensed consolidated financial statements include the
accounts of Physicians Formula Holdings, Inc., a Delaware corporation (the
“Company,” “we” or “our”), and its wholly owned subsidiary, Physicians
Formula, Inc., a New York corporation (“Physicians”), and its wholly owned
subsidiaries, Physicians Formula Cosmetics, Inc., a Delaware
corporation, and Physicians Formula DRTV, LLC, a Delaware limited liability
company.




The Company
develops, markets, manufactures and distributes innovative, premium-priced
cosmetic 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 Company sells its products to mass
market retailers such as Wal-Mart, Target, CVS, and Rite Aid.





The
accompanying condensed consolidated balance sheet as of September 30, 2009,
the condensed consolidated statements of operations for the three
and nine months ended September 30, 2009 and 2008 and the condensed
consolidated statements of cash flows for the nine months
ended September 30, 2009 and 2008 are unaudited. These unaudited
condensed consolidated interim financial statements have been prepared in
accordance with accounting principles generally accepted in the United States of
America (“GAAP”) for interim financial information and Article 10 of
Regulation S-X. In the opinion of the Company’s management, the unaudited
condensed consolidated interim financial statements include all adjustments of a
normal recurring nature necessary for the fair presentation of the Company’s
financial position as of September 30, 2009, its results of operations for
the three and nine months ended September 30, 2009 and 2008, and its
cash flows for the nine months ended September 30, 2009 and 2008. The
results for the interim periods are not necessarily indicative of the results to
be expected for any future period or for the fiscal year ending December 31,
2009. The condensed consolidated balance sheet as of December 31, 2008 has been
derived from the audited consolidated balance sheet as of that
date.





These
condensed consolidated interim financial statements should be read in
conjunction with the Company’s audited financial statements and notes thereto
included in the Company’s Annual Report on Form 10-K for the year ended December
31, 2008.





Significant
Developments—From the year
ended December 31, 2004 through the year ended December 31, 2007, the
Company experienced rapid revenue growth and increased demand
for its products.  During this period, the
Company significantly increased its production capacity, warehouse
space and inventory levels in an effort to meet demand.  This pattern
changed in 2008.  As a result of deteriorating economic conditions,
the Company experienced lessened demand for its products and tightening of
inventory levels by its retail customers. The Company’s net
sales moderated in the second half of 2008 and declined during the first nine
months of 2009.  Net sales declined 35.3% during the nine months ended
September 30, 2009 compared to the same period in 2008, which was attributable
in large part to deteriorating economic conditions, which significantly lowered
consumer discretionary spending and tightening of inventory levels by
our retail customers.  The Company incurred a net loss of $1.4
million during the nine months ended September 30, 2009 and may incur
additional losses through the remainder of 2009.  The Company continues to
reevaluate its operating plans for the next twelve months and has implemented
cost controls to address the potential for continued decreases in
sales.  The Company implemented a company-wide salary reduction plan,
eliminated cash bonuses in 2009, implemented cost controls, reduced capital
expenditures and is reevaluating various non-strategic marketing and
administrative costs.  The Company reduced its workforce by 15%, or 24
positions, during the nine months ended September 30, 2009 in an effort to
reduce costs.


As more fully
described in Note 7, on September 4, 2009, Physicians entered into a sixth
amendment to its senior credit agreement with Union Bank, N.A. (“Union Bank”)
and obtained a bridge loan (“Bridge Loan”) from Mill Road Capital, L.P. (“Mill
Road”).  As more fully described in Note 12, on November 6, 2009,
Physicians terminated its senior credit agreement with Union Bank and replaced
it with a new asset based revolving credit facility with Wells Fargo Bank, N.A.
(“Wells Fargo”) and repaid the Bridge Loan using proceeds from the issuance of a
new senior subordinated note (“Senior Subordinated Note”) to Mill
Road.
  Concentration of
Credit Risk —Certain financial
instruments subject the Company to concentrations of credit risk.  These
financial instruments consist primarily of accounts receivable.  The
Company regularly reevaluates its customers' ability to satisfy credit
obligations and records a provision for doubtful accounts based on such
evaluations.  Significant customers that accounted for more than 10% of
gross sales are as follows:  Three
      Months Ended
                          
                          Nine
      Months EndedSeptember 30,
                          
                          September 30,2009
                          
                          2008
                          
                          2009
                          
                          2008Customer
      A
                          
                          
                          37
                          %
                          
                          
                          30
                          %
                          
                          
                          29
                          %
                          
                          
                          22
                          %Customer
      B
                          
                          
                          17
                          %
                          
                          
                          15
                          %
                          
                          
                          19
                          %
                          
                          
                          16
                          %Customer
      C
                          
                          
                          15
                          %
                          
                          
                          12
                          %
                          
                          
                          13
                          %
                          
                          
                          11
                          %Customer
      D
                          
                          
                          0
                          %
                          
                          
                          10
                          %
                          
                          
                          7
                          %
                          
                          
                          15
                          %
  -4-


Fair Value
Measurements—The Company's financial
instruments are primarily composed of cash and cash equivalents, restricted
cash, accounts receivable, accounts payable and debt.  The fair value of
cash and cash equivalents, restricted cash, accounts receivable, accounts
payable and related party bridge loan closely approximate their carrying value
due to their short maturities.  The fair value of debt is estimated based
on reference to market prices and closely approximates its carrying value.


Fair Value
Measurements are based upon observable and unobservable
inputs.  Observable inputs reflect market data obtained from independent
sources, while unobservable inputs reflect internal market assumptions. 
These two types of inputs create the following fair value
hierarchy:




▪ —Quoted prices in active markets
for identical assets or liabilities.




▪  —Observable inputs other than
Level 1 prices such as quoted prices for similar assets or liabilities; quoted
prices in markets that are not active or other inputs that are observable or can
be corroborated by observable market data for substantially the full term of the
related asset or liabilities.




▪  —Unobservable inputs that are supported by
little or no market activity and that are significant to the fair value of
assets or liabilities.








Goodwill and Intangible
Assets), indefinite-lived assets are not amortized and are
tested for impairment annually or whenever events or circumstances occur
indicating that they might be impaired.  Indefinite-lived intangible assets
consist exclusively of trade names.  As a result of testing the trade
names for impairment in the second quarter of 2009, trade names with a carrying
amount of $13.6 million were written down to their fair value of $12.5 million,
resulting in an impairment charge of $1.1 million, which was included in the
operating results for the nine months ended September 30, 2009.  The fair
value of the trade names was determined using a projected discounted cash flow
analysis based on the relief-from-royalty approach.  The principal factors
used in the discounted cash flow analysis requiring judgment were projected
net sales, discount rate, royalty rate and terminal value assumptions (Level 3
inputs).  The royalty rate used in the analysis was based on transactions
that have occurred in the Company's industry.  If the Company's net sales
or other estimated factors are not achieved at or above the forecasted level,
the carrying value may prove unrecoverable and the Company may incur additional
impairment charges in the future.




Use of
Estimates—The preparation of
financial statements in conformity with GAAP requires management to make
estimates and assumptions that affect the amounts reported in the condensed
consolidated financial statements and accompanying notes. Actual results could
differ from those estimates.
  Subsequent
Events—Management
evaluated all events or transactions through the filing of this quarterly report
on Form 10-Q on November 9, 2009.  No events or transactions occurred
subsequent to September 30, 2009 requiring adjustments to or disclosure in the
condensed consolidated financial statements other than those discussed in Notes
1, 7 and 12.
 
 2.  NEW
ACCOUNTING STANDARDS
 
 In April 2009, the
FASB issued ASC 825-10-65-1 (formerly FASB Staff Position FAS 107-1
and APB 28-1, Interim Disclosures about Fair
Value of Financial Instruments). ASC 825-10-65 requires disclosures
about the fair value of financial instruments whenever a public company issues
financial information for interim reporting periods. ASC 825-10-65 is
effective for interim reporting periods ending after June 15, 2009. The
Company adopted ASC 825-10-65 upon its issuance, and it had no
material impact on the Company's condensed consolidated financial
statements.
 
 In June 2009, the
FASB issued ASC 855 (formerly SFAS No. 165, Subsequent Events). ASC
855 incorporates the subsequent events guidance contained in the auditing
standards literature into authoritative accounting literature. It also requires
entities to disclose the date through which they have evaluated subsequent
events and whether the date corresponds with the release of their financial
statements. ASC 855 is effective for all interim and annual periods
ending after June 15, 2009. The Company adopted ASC 855 upon
its issuance, and it had no material impact on the Company's condensed
consolidated financial statements.
 
 In July 2009,
the FASB confirmed that the FASB Accounting Standards
Codification will become the single official source of authoritative GAAP
(other than guidance issued by the Securities and Exchange Commission),
superseding existing FASB, American Institute of Certified Public Accountants
(“AICPA”), Emerging Issues Task Force (“EITF”), and related literature. After
the Codification became effective (interim and annual periods ending on or after
September 15, 2009), only one level of authoritative GAAP now exists. All
other literature will be considered non-authoritative. The Codification does not
change GAAP; it introduces a new structure that is organized in an easily
accessible online research system. The adoption of the Codification had no
material impact on the Company's condensed consolidated financial
statements.




-5-





3.  NET
(LOSS) INCOME PER SHARE




Basic net
(loss) income per common share is computed as net (loss)
income divided by the weighted-average number of common shares outstanding
during the period. Diluted net (loss) income per common share reflects the
potential dilution that could occur from the exercise of outstanding stock
options and is computed by dividing net (loss) income by the
weighted-average number of common shares outstanding for the period, plus the
dilutive effect of outstanding stock options, if any, calculated using the
treasury stock method. The following table summarizes the potential dilutive
effect of outstanding stock options, calculated using the treasury stock
method:




Three
      Months Ended
                    
                    
                    Nine
      Months EndedSeptember 30,
                    
                    
                    September 30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Numerator:Net
      (loss) income (in thousands)
                    
                    $
                    (302
                    )
                    
                    $
                    1,686
                    
                    
                    $
                    (1,425
                    )
                    
                    $
                    4,723Denominator:Weighted-average
      number of common shares—basic (in thousands)
                    
                    
                    13,590
                    
                    
                    
                    14,106
                    
                    
                    
                    13,582
                    
                    
                    
                    14,099Effect
      of dilutive stock options (in thousands)
                    
                    
                    -
                    
                    
                    
                    514
                    
                    
                    
                    -
                    
                    
                    
                    505Weighted-average
      number of common shares—diluted (in thousands)
                    
                    
                    13,590
                    
                    
                    
                    14,620
                    
                    
                    
                    13,582
                    
                    
                    
                    14,604Net
      (loss) income per common share:Basic
                    
                    $
                    (0.02
                    )
                    
                    $
                    0.12
                    
                    
                    $
                    (0.10
                    )
                    
                    $
                    0.33Diluted
                    
                    $
                    (0.02
                    )
                    
                    $
                    0.12
                    
                    
                    $
                    (0.10
                    )
                    
                    $
                    0.32
 
 Stock options
for the purchase of 1,113,889 and 662,000 shares of common stock
were excluded from the above calculation during the three and nine months
ended September 30, 2009 and 2008, respectively, as the effect of those
options was anti-dilutive.


4.  INVENTORIES





Inventories
consisted of the following (in thousands):




September
      30,
                      
                      
                      December
      31,2009
                      
                      
                      2008Raw
      materials and components
                      
                      $
                      12,880
                      
                      
                      $
                      17,655Finished
      goods
                      
                      
                      14,051
                      
                      
                      
                      12,039Total
                      
                      $
                      26,931
                      
                      
                      $
                      29,694
  5.  OTHER ASSETS Other assets
consisted of the following (in thousands):
  September
      30,
                              
                              
                              December
      31,2009
                              
                              
                              2008Capitalized
      debt issuance costs, net of accumulated amortization of
$80
                              
                              $
                              -
                              
                              
                              $
                              116Restricted
      investments
                              
                              
                              222
                              
                              
                              
                              540Deposits
                              
                              
                              360
                              
                              
                              
                              284Income
      tax receivable
                              
                              
                              312
                              
                              
                              
                              312Retail
      permanent fixtures, net of accumulated amortization of $624 and $0,
      respectively
                              
                              
                              2,889
                              
                              
                              
                              1,586Total
                              
                              $
                              3,783
                              
                              
                              $
                              2,838
 
 Restricted
investments represent a diversified portfolio of mutual funds held in a Rabbi
Trust, which fund the nonqualified, unfunded deferred compensation plans (the
“Deferred Compensation Plans”).  These investments, which are
considered trading securities, are recorded at fair value.
Unrealized gains related to these investments were $29,000 for
the three months ended September 30, 2009 compared to unrealized
losses of $113,000 for the same period in 2008.  For
the nine months ended September 30, 2009, the unrealized gains
were $17,000 compared to unrealized losses of $220,000 for the same period
in 2008. On May 7,
2009, the 1999 Nonqualified Deferred Compensation Plan was terminated
and $375,000 was distributed to an executive officer. The balance remaining
in restricted investments relates to the 2005 Nonqualified Deferred Compensation
Plan, which is still in effect.
  During the third quarter
of 2008, we implemented a key project of creating new permanent
fixtures ("retail permanent fixtures") for the display
of the Company's products which began being delivered to certain
retail customers in 2009.During the three and nine
months ended September 30, 2009, the Company incurred costs of $110,000 and
$1.9 million, respectively, for retail permanent fixtures, compared to
$396,000 for each of the three and nine months ended September 30,
2008.  These retail permanent fixtures are being placed in
service in connection with the retail customers' resets of selling
space, are recorded at cost and these costs will be amortized over a period
of three years. Amortization expense was $257,000 and $624,000 for
the three and nine months ended September 30, 2009,
respectively. Amortization of retail permanent fixtures is expected to
be approximately $241,000 for the remainder of 2009, $963,000 for
2010, $963,000 for 2011 and $722,000 for
2012.
  -6-


6.  INTANGIBLE
ASSETS





Definite-lived
intangible assets consisted of the following (in thousands):




September 30, 2009
                            
                            
                            December 31, 2008Gross
                            
                            
                            Accumulated
                            
                            
                            Net
                            
                            
                            Gross
                            
                            
                            Accumulated
                            
                            
                            NetAmount
                            
                            
                            Amortization
                            
                            
                            Amount
                            
                            
                            Amount
                            
                            
                            Amortization
                            
                            
                            AmountPatents
                            
                            $
                            8,699
                            
                            
                            $
                            (3,432
                            )
                            
                            $
                            5,267
                            
                            
                            $
                            8,699
                            
                            
                            $
                            (2,997
                            )
                            
                            $
                            5,702Distributor
      relationships
                            
                            
                            23,701
                            
                            
                            
                            (7,011
                            )
                            
                            
                            16,690
                            
                            
                            
                            23,701
                            
                            
                            
                            (6,122
                            )
                            
                            
                            17,579Total
                            
                            $
                            32,400
                            
                            
                            $
                            (10,443
                            )
                            
                            $
                            21,957
                            
                            
                            $
                            32,400
                            
                            
                            $
                            (9,119
                            )
                            
                            $
                            23,281





Amortization
expense was $441,000 in each of the three month periods
ended September 30, 2009 and 2008 and $1.3 million in each of
the nine month periods ended September 30, 2009 and 2008. Amortization
of intangible assets for the remainder of 2009 will be approximately $441,000
and will be approximately $1.8 million in each of the next five
years.





The
changes in the carrying amounts of indefinite-lived intangible assets as
of September 30, 2009 and December 31, 2008, are as follows (in
thousands):


September
      30,
                    
                    
                    December
      31,2009
                    
                    
                    2008Trade
      namesBalance—beginning
      of period
                    
                    $
                    13,600
                    
                    
                    $
                    29,500Impairment
      charge
                    
                    
                    (1,100
                    )
                    
                    
                    (15,900
                    )Balance—end
      of period
                    
                    $
                    12,500
                    
                    
                    $
                    13,600
 
 The Company evaluates
its indefinite-lived intangible assets for impairment in the second quarter
of each fiscal year or whenever events or circumstances occur that potentially
indicate that the carrying amounts of these assets may not be
recoverable. Due to the significant downturn in the economy and the
deterioration of the market price of the Company's common stock during the
fourth quarter of 2008, management tested indefinite-lived intangible
assets for impairment. Based on this analysis in 2008, a non-cash
impairment charge of $15.9 million was recorded to write-down the carrying value
of trade names to their fair value and a non-cash impairment charge of $16.8
million was recorded representing the entire amount of previously recorded
goodwill. During the six months ended June 30, 2009, the downturn in the
economy continued which significantly lowered consumer discretionary
spending, and therefore lowered demand for the Company's products.
Additionally, the market capitalization of the Company continued to decline. As
a result of testing the trade names for impairment in the second
quarter of 2009, the Company recorded a non-cash impairment charge of
$1.1 million to write down the carrying value of trade names to their
fair value.  The Company did not identify any triggering events that would
require completion of an impairment analysis as of September 30,
2009.


In order
to test the trade names for impairment, the Company determines the fair value of
the trade names and compares such amount to its carrying value. The Company
determines the fair value of the trade names using a projected discounted
cash flow analysis based on the relief-from-royalty approach. The principal
factors used in the discounted cash flow analysis requiring judgment
are projected net sales, discount rate, royalty rate and terminal value
assumptions. The royalty rate used in the analysis is based on transactions
that have occurred in the Company's industry.
 
 The
Physicians Formula trade name has been used since 1937 and is a recognized brand
within the cosmetics industry. It is management's intent to leverage the
Company's trade names indefinitely into the future. The
Company will continue to monitor operational performance measures and general
economic conditions. A continued downward trend could result in our recognizing
an impairment charge of the Physicians Formula trade name in connection with a
future impairment test.
  7.  FINANCING
ARRANGEMENTS
 
 As more fully
described below, on September 4, 2009, Physicians entered into a sixth amendment
to its senior credit agreement with Union Bank and obtained a Bridge Loan from
Mill Road.  As more fully described in Note 12, on November 6, 2009,
Physicians terminated its senior credit agreement with Union Bank and replaced
it with a new asset based revolving credit facility with Wells Fargo and repaid
the Bridge Loan using proceeds from the issuance of a new Senior Subordinated
Note to Mill Road.
  Senior Credit
Agreement
 
 On March
30, 2009, Physicians entered into a fourth amendment to the senior credit
agreement with Union Bank (the “fourth amendment”) which converted the
entire facility, which previously consisted of an amortizing term loan and a
revolving credit facility, into an asset-based revolving credit facility, and
the outstanding term loan was replaced with borrowings under the revolving
credit facility. The fourth amendment to the senior credit agreement,
among other things, eliminated the minimum fixed charge coverage ratio and the
maximum total leverage ratio covenants and replaced them with a minimum
interest coverage ratio and a minimum EBITDA (as defined by the senior
credit agreement) covenant and amended the minimum tangible net worth
covenant, all of which are financial maintenance covenants.
 
 The
maximum amount available for borrowing under the revolving credit
facility was equal to the lesser of (i) $20.0 million or (ii) a
borrowing base formula equal to the sum of (a) up to 65% of the book value
of eligible accounts receivable, (b) the lesser of (1) up to 15% of
eligible inventory or (2) $5.0 million, (c) the balance of
certain foreign currency accounts denominated in Canadian dollars (the
“Canadian Pledged Accounts”), and (d) the orderly liquidation value of eligible
equipment not to exceed $1.0 million, all as determined in accordance with the
fourth amendment. The applicable interest rate under the revolving credit
facility was equal to a percentage equal to the lender’s reference rate
plus 3.00%.  The senior credit agreement required Physicians to
pay a commitment fee on unused commitments of 0.50%.
  -7-





Under the
senior credit agreement, all revenue received by Physicians and its subsidiaries
in Canadian dollars was required to be deposited into the Canadian Pledged
Accounts, which were pledged to the agent to secure borrowings under the
revolving credit facility.  Physicians could use the balance in
the Canadian Pledged
Accounts to repay borrowings under the revolving credit facility, or, if the
Company demonstrated availability under the borrowing base of at least $1.5
million and other conditions were met, Physicians could make monthly
transfers from the Canadian Pledged Accounts to a Canadian disbursement account
in an amount that would not cause the balance of the Canadian disbursement
account to exceed CDN$500,000, and, if other conditions were met,
Physicians could use the Canadian disbursement account to pay amounts due
to its Canadian vendors in the ordinary course of business. On July 8,
2009, restricted cash of $6.5 million was used to repay borrowings
under the revolving credit facility.  As of September
30, 2009, the Canadian Pledged Accounts had a balance of $51,000, which is
recorded as restricted cash in the accompanying condensed consolidated balance
sheet.
 
 On July 29,
2009, Physicians entered into a fifth amendment to the senior credit
agreement.  Pursuant to the fifth amendment, the lender reduced its
revolving loan commitment from $25.0 million to $20.0 million and amended the
definition of eligible accounts receivable for purposes of the borrowing base to
increase the maximum percentage of eligible accounts receivable from any one
customer (the “customer concentration threshold”) from 25% to 35% (except with
respect to certain customers).  The lender also agreed to waive an
event of default resulting from the failure of the Company to repay an
overadvance of $1.8 million outstanding as of July 1, 2009 within the five day
grace period permitted by the senior credit agreement. The overadvance
was a result of the decrease in the maximum eligible inventory under the
borrowing base from $8.0 million to $5.0 million on July 1, 2009. Further,
due to the reduction in second quarter sales to a customer that is in the
process of discontinuing the sale of our products, another customer was placed
above the 25% customer concentration threshold, causing the portion of accounts
receivable associated with sales above the 25% customer concentration threshold
to be excluded from the borrowing base calculation as of July 1, 2009. In
addition, the amendment required the Company to hire a management
consultant on or before July 31, 2009 to conduct an assessment
of Physicians Formula's financial performance, including the business
plan, cost structure and liquidity.  In connection with the fifth
amendment, the Company paid a fee of $50,000 and related
expenses.  After
 The senior
credit agreement required the Company to comply with a minimum interest coverage
ratio, a minimum EBITDA (as defined in the senior credit agreement) covenant and
a minimum tangible net worth covenant.  As of September 30, 2009, the
Company was in compliance with these covenants in the senior credit
agreement. The
senior credit agreement required the Company to make mandatory
prepayments with the proceeds of certain asset dispositions and upon the receipt
of insurance or condemnation proceeds to the extent the Company did
not use the proceeds for the purchase of satisfactory replacement assets in
accordance with the terms of the senior credit agreement.
  
 
  Bridge Loan
  
  -8-


8.  EQUITY AND STOCK OPTION
PLANS





2006 Equity Incentive
Plan


In
connection with the Company’s initial public offering in November 2006, the
Company adopted the Physicians Formula Holdings, Inc. 2006 Equity Incentive Plan
(as amended, the “2006 Plan”). The 2006 Plan provides for grants of stock
options, stock appreciation rights, restricted stock, restricted stock units,
deferred stock units and other performance awards to directors, officers and
employees of the Company, as well as others performing services for the Company.
The options generally have a 10-year life and vest in equal monthly installments
over a four-year period. As of September 30, 2009, a total of 883,776
shares of the Company’s common stock were available for issuance under the 2006
Plan. This amount will automatically increase on the first day of each fiscal
year ending in 2016 by the lesser of: (i) 2% of the shares of common stock
outstanding on the last day of the immediately preceding fiscal year or (ii)
such lesser number of shares as determined by the compensation committee of the
Board of Directors.
 
 2003 Stock Option
Plan
  In
November 2003, the Board of Directors adopted the 2003 Stock Option Plan (the
“2003 Plan”) and reserved a total of 2,500,000 shares for grants under the 2003
Plan. The 2003 Plan provides for the issuance of stock options for common stock
to executives and other key employees. The options generally have a 10-year life
and vest over a period of time ranging from 24 months to 48 months. Options
granted under the 2003 Plan were originally granted as time-vesting options and
performance-vesting options. The original time-vesting options vest in equal
annual installments over a four-year period. In connection with the
Company's initial public offering during 2006, the 713,334
performance-vesting options were amended to accelerate the vesting of 550,781 of
such options, and 296,140 of these options were exercised. The remaining 162,553
performance-vesting options were converted to time-vesting options that vested
in equal monthly installments over a two-year period through November
2008.
 
 Options are
granted with exercise prices not less than the fair value at the date of grant,
as determined by the Board of Directors, which subsequent to the
Company's initial public offering is the closing price on the grant
date.
  The 2006
Plan and 2003 Plan activity is summarized below:
 Time-Vesting
      Options
                          
                          
                          Performance-Vesting
      OptionsNumber
      of Shares
                          
                          
                          Weighted-Average
      Exercise Price
                          
                          
                          Aggregate
      Intrinsic Value
                          
                          
                          Number of
    Shares
                          
                          
                          Weighted-Average
      Exercise Price
                          
                          
                          Aggregate
      Intrinsic ValueOptions
      outstanding—January 1, 2009
                          
                          
                          1,075,758
                          
                          
                          $
                          9.04
                          
                          
                          
                          
                          
                          
                          136,681
                          
                          
                          $
                          0.10Granted
                          
                          
                          25,000
                          
                          
                          
                          1.83
                          
                          
                          
                          
                          
                          
                          -
                          
                          
                          
                          -Exercised
                          
                          
                          (12,550
                          )
                          
                          
                          0.10
                          
                          
                          $
                          19,000
                          
                          
                          
                          -
                          
                          
                          
                          -Cancelled
                          
                          
                          (63,714
                          )
                          
                          
                          13.56
                          
                          
                          
                          
                          
                          
                          
                          -
                          
                          
                          
                          -Forfeited
                          
                          
                          (47,286
                          )
                          
                          
                          16.45
                          
                          
                          
                          
                          
                          
                          
                          -
                          
                          
                          
                          -Options
      outstanding—September 30, 2009
                          
                          
                          977,208
                          
                          
                          $
                          8.32
                          
                          
                          $
                          (5,394,000
                          )
                          
                          
                          136,681
                          
                          
                          $
                          0.10
                          
                          
                          $
                          369,000Vested
      and expected to vest - September 30, 2009
                          
                          
                          977,208
                          
                          
                          $
                          8.32
                          
                          
                          $
                          (5,394,000
                          )
                          
                          
                          136,681
                          
                          
                          $
                          0.10
                          
                          
                          $
                          369,000


-9-








Nine
      Months EndedSeptember 30,2009
                  
                  2008Risk-free
      interest rate
                  
                  
                  2.0
                  %
                  
                  
                  3.3
                  %Volatility
                  
                  
                  58.6
                  %
                  
                  
                  50.7
                  %Dividend
      rate
                  
                  None
                  
                  
                  NoneLife
      in years
                  
                  
                  5.6
                  
                  
                  
                  6.5


The
risk-free interest rate is based-upon the U.S. Treasury yield curve in effect at
the time of grant for periods corresponding with the expected life of the
options. The expected volatility rate is based on companies of similar growth
and maturity and the Company's peer group in the industry in which it
does business. The dividend rate assumption is excluded from the calculation, as
the Company intends to retain all earnings. The expected life of the
Company's stock options represents management’s best estimate based upon
historical and expected trends in the Company's stock option
activity.




The
vesting activity for the 2006 Plan and 2003 Plan is summarized
below:
  Time-Vesting
      Options
              
              Performance-Vesting
      OptionsWeighted-Average
              
              
              
              
              
              
              
              Weighted-AverageVested
      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 ValueJanuary
      1, 2009
              
              
              637,759
              
              $
              3,793,000
              
              
              
              
              
              
              
              
              136,681
              
              $
              14,000Vested
              
              
              127,196
              
              
              1,653,000
              
              
              
              
              
              
              
              
              -
              
              
              -Exercised
              
              
              (12,550
              )
              
              (1,000
              )
              
              
              
              
              
              
              
              -
              
              
              -Forfeited
              
              
              (47,286
              )
              
              (778,000
              )
              
              
              
              
              
              
              
              -
              
              
              -September 30,
      2009
              
              
              705,119
              
              $
              4,667,000
              
              $       6.62
              
              5.6
      years
              
              $ (2,694,000
              )
              
              136,681
              
              $
              14,000
              
              $      0.10
              
              4.1
      years
              
              $    369,000
 As
of September 30, 2009, the options outstanding under the 2003 Plan and
2006 Plan had exercise prices between $0.10 and $20.75 and the weighted-average
remaining contractual life for all options was 6.0 years.
  A summary
of the weighted-average grant date fair value of the non-vested stock option
awards is presented in the table below:
  Weighted-AverageNumber
                          
                          
                          Grant
      Dateof Options
                          
                          
                          Fair ValueJanuary
      1, 2009
                          
                          
                          437,999
                          
                          
                          $
                          7.04Vested
                          
                          
                          (127,196
                          )
                          
                          
                          6.72Cancelled
                          
                          
                          (63,714
                          )
                          
                          
                          7.07Granted
                          
                          
                          25,000
                          
                          
                          
                          0.99September
      30, 2009
                          
                          
                          272,089
                          
                          
                          $
                          6.62
 
 The total
fair value of options that vested during the nine months
ended September 30, 2009 and 2008 was $855,000 and $2.0 million,
respectively.
  As
of September 30, 2009, total unrecognized estimated compensation cost
related to non-vested stock options was approximately $1.8 million, which is
expected to be recognized over a weighted-average period of
approximately 1.9 years. The Company recorded cash received from the
exercise of 12,550 stock options of $1,255 during the nine months
ended September 30, 2009 and issued 12,550 new shares of common
stock.
  The Company recognized $865,000 and $1.9 million of pre-tax non-cash
share-based compensation expense for the nine
months ended September 30, 2009 and 2008,
respectively.  Non-cash share-based compensation cost of $58,000 was a
component of cost of sales and $807,000 was a component of selling,
general and administrative expenses in the accompanying condensed consolidated
statement of operations for the nine months ended September 30,
2009. Non-cash share-based compensation cost of $85,000 was a component of
cost of sales and $1.8 million was a component of selling, general and
administrative expenses in the accompanying condensed consolidated statement
of operations for the nine months ended September 30, 2008. The
Company recognized a related tax benefit of $354,000 and
$748,000 for the nine months ended September 30, 2009 and 2008,
respectively.  The Company capitalized non-cash share-based
compensation expense of $49,000 and $88,000 in inventory for the nine
months ended September 30, 2009 and 2008,
respectively.
 
 Excess
tax benefits exist when the tax deduction resulting from the exercise of options
exceeds the compensation cost recorded. The cash flows resulting from such
excess tax benefits are classified as financing cash flows.
 
 The stock
options exercised and forfeited during the nine months ended September
30, 2009 resulted in a reduction in a deferred income tax asset because the
share-based compensation cost previously recognized by the Company was greater
than the deduction allowed for income tax purposes, based on the price of
the stock on the date of exercise.  This reduction in the deferred
income tax asset was in excess of the Company's additional paid-in capital pool
by $192,000.
  -10-





9.  COMMITMENTS AND
CONTINGENCIES
 
 Litigation—The Company
is involved in various lawsuits in the ordinary course of business. In
management’s opinion, the ultimate resolution of these matters will not result
in a material impact to the Company’s condensed consolidated financial
statements.
 
 Environmental—The
shallow soils and groundwater below the Company's City of Industry
facilities were contaminated by the former operator of the property. The former
operator performed onsite cleanup and the Company anticipates
that it will receive written confirmation from the State of California that
no further onsite cleanup is necessary. Such confirmation would not rule out
potential liability for regional groundwater contamination or alleged potable
water supply contamination discussed below. If further onsite cleanup is
required, the Company believes the cost, which the Company is not able to
estimate, would be indemnified, without contest or material limitation, by
companies that have fulfilled similar indemnity obligations to the Company in
the past, and that the Company believes remain financially able to do
so.





The facility
is located within an area of regional groundwater contamination known as the
Puente Valley “operable unit” (“PVOU”) of the San Gabriel Valley Superfund Site.
The Company, along with many others, was named a potentially responsible party
(“PRP”) for the regional contamination by the United States Environmental
Protection Agency (“EPA”). The Company entered into a settlement with another
PRP at the site, pursuant to which, in return for a payment the Company has
already made and that was fully indemnified and paid by a second company, the
other PRP indemnified the Company against most claims for PVOU contamination. A
court has approved and entered a
consent decree between the other PRP, the Company and the
EPA that resolves the Company's liability for the cleanup of
regional groundwater contamination without any payment by the Company to
EPA.Depending on the scope and duration of the cleanup, the
Company may be required to make further payments to the other PRP for regional
groundwater remediation costs. The Company estimates the amount of any such
additional payments would not exceed approximately $130,000. The estimate is
based on component estimates for two distinct contaminants that may require
remediation. Those estimates in turn are based on a number of assumptions
concerning the likelihood that remediation will be required, the cost of
remediation if required and other matters. Uncertainty in predicting these
matters limits the reliability and precision of the estimates. The Company
expects any such additional payments by the Company to be covered by indemnities
given to the Company by other companies. Those companies may contest their
indemnity obligation for these payments. The Company believes the companies are
financially able to pay the liability. Because the Company believes it is not
probable that it will be held liable for any of these expenses, the Company has
not recorded a liability for such potential claims.




The Company’s
liability for these contamination matters and related claims is substantially
covered by third-party indemnities and resolved by prior settlements, and borne
by prior operators of the facility, their successors and their insurers. The
Company is attempting to recoup approximately $0.7 million in defense costs from
one of these indemnitors. These costs have been expensed as paid by the Company
and are not recorded in its condensed consolidated balance sheets.




10.  GEOGRAPHIC
INFORMATION
 
 Geographic
revenue information is based on the location of the customer. All of the
Company's assets are located in the United States and Canada. The Company has
total assets of $1.7 million located in Canada, or 1.8%, of the Company's total
assets, including approximately $285,000 of retail permanent
fixtures, which are classified in other assets on the accompanying
condensed consolidated balance sheet as of September 30, 2009. Net
sales to unaffiliated customers by geographic region are as follows (in
thousands):
  Three
      Months Ended
                        
                        
                        Nine
      Months EndedSeptember 30,
                        
                        
                        September 30,2009
                        
                        
                        2008
                        
                        
                        2009
                        
                        
                        2008United
      States
                        
                        $
                        12,935
                        
                        
                        $
                        17,070
                        
                        
                        $
                        48,853
                        
                        
                        $
                        73,245Canada
                        
                        
                        1,135
                        
                        
                        
                        2,881
                        
                        
                        
                        6,127
                        
                        
                        
                        11,925Other
                        
                        
                        160
                        
                        
                        
                        303
                        
                        
                        
                        473
                        
                        
                        
                        621$
                        14,230
                        
                        
                        $
                        20,254
                        
                        
                        $
                        55,453
                        
                        
                        $
                        85,791
  11. 
RELATED PARTY BRIDGE LOAN
 
 On September 4, 2009, Physicians entered into
an agreement for a second-priority senior secured bridge loan facility with Mill
Road in the amount of $4.2 million.  See Note 7 for a description
of the related party bridge loan.  Based on a Schedule 13D/A filed by
Mill Road on March 11, 2009, Mill Road is the beneficial owner of
approximately 18% of the Company’s outstanding common stock.  Interest
expense related to the related party bridge loan totaled $47,000 for the
three and nine months ended September 30, 2009.  As of September 30, 2009,
$47,000 of accrued interest related to the related party bridge loan was
included in accrued expenses in the accompanying condensed consolidated balance
sheet.




12.  SUBSEQUENT
EVENTS
  Stock Option
Grant
  
  New
Senior Revolving Credit Facility
 
 On November
6, 2009, pursuant to a new senior credit agreement (the “New Senior Credit
Agreement”) between Physicians and Wells Fargo, Physicians entered into a new
asset-based revolving credit facility (the “new revolving credit facility”) and
terminated its previous asset-based revolving credit facility (the “old
revolving credit facility”) with Union Bank.  Approximately $9.3
million of the proceeds of the new revolving credit facility were used to
repay outstanding borrowings under Physicians’ old revolving credit
facility. The current available cash, cash equivalents and restricted cash of
approximately $1.6 million in the Union Bank account and will be transferred to
the Wells Fargo operating account.  The new revolving credit facility
is scheduled to mature on November 6, 2012.




-11-





The maximum
amount available for borrowing under the new revolving credit facility is equal
to the lesser of $25.0 million and a borrowing base formula equal to: (i) 65% or
such lesser percentage of eligible accounts receivable as Wells Fargo in its
discretion as an asset-based lender may deem appropriate; plus (ii) the least of
(1) $14.0 million and (2) the sum of specified percentages (or such lesser
percentages as Wells Fargo in its discretion as an asset-based lender may deem
appropriate) of each of the following items of eligible inventory (as defined in
the New Senior Credit Agreement): (A) of eligible inventory consisting of
finished goods that are fully packaged, labeled and ready for shipping, not to
exceed 65% of such eligible inventory, (B) eligible inventory consisting of
semi-finished goods which are ready for packaging and shipping, not to exceed
$4.0 million, (C) eligible inventory consisting of raw materials, not to exceed
$1.5 million, (D) eligible inventory consisting of blank components, not to
exceed $1.0 million and (E) eligible inventory consisting of returned items, not
to exceed $0.75 million; plus (iii) the cash balance in a certain Canadian
concentration account; less (iv) a working capital reserve of $1.0 million as
such amount may be adjusted by Wells Fargo from time to time and a borrowing
base reserve that Wells Fargo establishes from time to time in its discretion as
a secured asset-based lender; less (v) indebtedness owed to Wells Fargo other
than indebtedness outstanding under the new revolving credit facility.
Availability under the new revolving credit facility is reduced by outstanding
letters of credit.
  Floating rate
borrowings under the new revolving credit facility accrue interest at a daily
rate equal to the three-month LIBOR plus 3.5% and fixed rate borrowings accrue
interest at a fixed rate equal to the three-month LIBOR plus 3.5% on the date of
borrowing. Interest on floating rate borrowings is payable monthly in arrears
and interest on fixed rate borrowings are payable upon the expiration of the
fixed rate term, subject to minimum monthly interest payments in the amount of
$25,000. Under the New Senior Credit Agreement, Physicians is required to pay to
Wells Fargo an unused credit line fee equal to 0.5% per annum and various other
fees associated with cash management and other related services. Physicians may
reduce the maximum amount available for borrowing or terminate the facility
prior to the scheduled maturity date at any time by paying breakage fees equal
to 3% of the maximum amount of the new revolving credit facility or amount of
the reduction in the credit facility, as applicable, decreasing to 1.5% after
November 6, 2010 and decreasing to 0.5% after November 6,
2011.
  Under the New
Senior Credit Agreement, all payments to Physicians and its subsidiaries are
required to be deposited into a lockbox account provided by Wells Fargo, except
that payments in connection with the Company’s Canadian operations may be
deposited into a lockbox account with Royal Bank of Canada. Any amounts
deposited into a lockbox account with Wells Fargo will be swept to a collection
account to be applied to repay the outstanding borrowings under the new
revolving credit facility. If the balance in Physicians’ restricted Canadian
account exceeds Canadian $2.0 million at any time, Physicians must within 10
days after such occurrence transfer the excess amount to the collection account
to repay borrowings under the new revolving credit facility. In addition, at any
time, Physicians may transfer amounts out of the restricted Canadian accounts to
repay borrowings under the revolving credit facility or so long as no event of
default exists, pay costs and expenses incurred in connection with the Company’s
Canadian operations from its Canadian operating account.
  The New
Senior Credit Agreement requires the Company to comply with a monthly minimum
book net worth covenant and a quarterly minimum adjusted EBITDA covenant.
In addition, the Company is required to comply with certain negative covenants,
including limitations on its ability to: incur other indebtedness and liens;
make certain investments, loans or advances; guaranty indebtedness; pay cash
dividends from Physicians, except in an amount up to $0.1 million to allow the
Company to pay ordinary course expenses; sell assets; suspend operations;
consolidate or merge with another entity; enter into sale-leaseback
arrangements; or enter into unrelated lines of business or acquire assets not
related to our business; and make capital expenditures in excess of $6.0 million
for the year ending December 31, 2009 and $5.5 million for the year ending
December 31, 2010 (subject to up to a $600,000 carryforward from the prior
year). The financial covenants for the year ending December 31, 2011 and
thereafter will be agreed upon between Physicians and Wells Fargo no later than
April 30, 2010.  The New Senior Credit Agreement also contains
customary events of default, including a change of control of
Physicians.
  Borrowings
under the new revolving credit facility are guaranteed by the Company and the
domestic subsidiaries of Physicians and are secured by a pledge of the capital
stock of Physicians and its subsidiaries and substantially all of the assets of
the Company and its subsidiaries.
  Physicians
paid a closing fee to Wells Fargo equal to $250,000 and agreed to pay all
expenses incurred by Wells Fargo in connection with the new revolving credit
facility.
  In order to
retire the old revolving credit facility and pay other fees and expenses, on
November 6, 2009, the Company borrowed $10.4 million under the new revolving
credit facility, and immediately thereafter had $1.3 million in availability for
future borrowings under the new revolving credit facility, net of certain
specified reserves totaling $3.1 million at closing. When combined with the net
cash proceeds of the Senior Subordinated Note from Mill Road of
$3.0 million and cash on the balance sheet of $1.6 million, the Company had
approximately $6.0 million of liquidity available to it, which was previously
disclosed as the expected availability under the Wells Fargo line of
credit.
  New Senior
Subordinated Note
  On November 6, 2009,
pursuant to a Senior Subordinated Note Purchase and Security Agreement between
Physicians, the guarantors named therein and Mill Road (the “Note Agreement”),
Physicians issued a new Senior Subordinated Note to Mill Road in an aggregate
principal amount equal to $8.0 million.  Physicians used $4.3 million
of the proceeds to repay in full the principal of $4.2 million and interest
of $107,000 outstanding under its Bridge Loan from Mill
Road.  The Company intends to use the remaining proceeds for capital
expenditures and general corporate purposes. The Senior Subordinated
Note is scheduled to mature on May 6, 2013 and accrue interest at 19% per
annum, with 15% per annum payable in cash monthly in arrears on the first day of
each calendar month and 4% payable in kind with quarterly compounding on the
first day of each calendar quarter.
 Subject to
the terms of the new revolving credit facility, the Senior Subordinated Note may
be redeemed in whole or in part prior to November 6, 2010 at an amount equal to
105% of the aggregate principal amount of the outstanding Notes, decreasing to
104% if redeemed on or after November 6, 2010 and prior to November 6, 2011,
decreasing to 102% if redeemed on or after November 6, 2011 and prior to
November 6, 2012, and decreasing to 101% if redeemed on or after November 6,
2012. In addition, Physicians must make an offer to redeem the Senior
Subordinated Notes upon a change of control of Physicians at the then applicable
redemption price.


-12-




The Company
is required to comply with substantially the same covenants under the Note
Agreement that it is required to comply with under the New Senior Credit
Agreement and events of default under the Note Agreement are substantially
the same as the events of default under the New Senior Credit
Agreement.




The Senior
Subordinated Note is guaranteed by the Company and Physicians’ subsidiaries
and are secured by a first lien on certain intellectual property and a second
lien on substantially all of the other assets of the Company and its
subsidiaries and pledges of the stock of Physicians and its
subsidiaries.  The value of the collateral subject to these liens is
limited to the lesser of 10% of the value of the assets of Physicians Formula
Holdings, Inc. and its subsidiaries and 10% of the value of all outstanding
common stock of Physicians Formula Holdings, Inc. as of November 6, 2009 (the
“10% Cap”).




Pursuant to
an Intercreditor Agreement entered into between Physicians, Mill Road and Wells
Fargo in connection with the New Senior Credit Agreement and Note Agreement, the
Senior Subordinated Note is subordinate in right of payment to the prior
paying of all obligations under the New Senior Credit Agreement and the liens
securing the obligations under the Notes Agreement are junior and subordinate to
the liens securing the obligations under the New Senior Credit Agreement (except
for first liens on certain intellectual property). In addition, the
Intercreditor Agreements prohibits certain amendments to the Note Agreement
without the consent of Wells Fargo and prohibits certain amendments to the New
Senior Credit Agreement without the consent of Mill Road.




Physicians
paid a closing fee to Mill Road equal to $160,000 and agreed to pay all expenses
incurred by Mill Road in connection with the issuance of the Senior Subordinated
Note and the transactions described below.




Based on a
Schedule 13D/A filed by Mill Road on March 11, 2009, Mill Road is the
beneficial owner of approximately 18% of the Company’s outstanding common
stock.  In connection with the issuance of the Senior Subordinated
Note, the Company agreed that, upon the
earlier to occur of the mailing of the Company’s proxy statement for the annual
meeting of stockholders in 2010 and June 30, 2010, and for so long as the Senior
Subordinated Note is outstanding, Mill Road has the right to nominate one
individual to serve as a member of the Company’s board of directors (the
“Board”), and the Company agreed to recommend to the Company’s stockholders that
Mill Road’s designee be elected to the Board at the Company’s annual meetings of
stockholders for as long as the Senior Subordinated Note is
outstanding.  In addition, Mill Road agreed that until September 30,
2010, it would not acquire more than 35% of the Company’s common stock or seek
to elect any directors to the Board (other than the one director it is entitled
to nominate while the Senior Subordinated Note is outstanding), in each case,
without obtaining the prior written consent of the Board.  These
restrictions will be released if the Company receives a bid for the acquisition
of the Company (other than from Mill Road or its
affiliates).





In connection
with the Note Agreement, the Company agreed to hold a special meeting of
stockholders to vote on a proposal to approve the issuance to Mill Road of
warrants to purchase the Company’s common stock and an amendment to the Senior
Subordinated Note with Mill Road.  The Company will be seeking
stockholder approval to comply with the Nasdaq shareholder approval requirements
and to satisfy Section 203 of the Delaware General Corporation Law, because Mill
Road is an “interested stockholder” for purposes of the
statute.  Because Mill Road is an interested stockholder, the Company
will be required to obtain the vote of 66 2/3% of the outstanding common stock
not owned by Mill Road to approve the transactions.





If
stockholder approval is obtained and the warrants are issued, Mill Road has
agreed to reduce the interest rate on the Senior Subordinated Note from 19% per
annum (15% payable in cash monthly and 5% payable in kind with quarterly
compounding) to 14% per annum (10% payable in cash monthly and 4% payable in
kind with quarterly compounding), and extend the maturity of the Senior
Subordinated Note from May 6, 2013 to November 6, 2014.   The
prepayment premium for an optional redemption would be amended so that if the
Senior Subordinated Note is redeemed on or after November 6, 2011 and prior to
November 6, 2012, the prepayment premium would be 102%, decreasing to 101% if
redeemed on or after November 6, 2012 and prior to November 6, 2013, and
decreasing to 100% if redeemed on or after November 6, 2013.  If
stockholder approval is obtained, Mill Road would be entitled to a number of
warrants equal to the product of (i) $2.028 divided by the Company’s 30-day
average stock price and (ii) 700,000, calculated on November 5, 2009 or the date
of the amendment to the Senior Subordinated Note, whichever is
greater.  The warrants would have an exercise price equal to $0.25 and
would mature on the seventh anniversary of the date they were
issued.  If the warrants are issued, the Company will agree to file a
registration statement under the Securities Act of 1933, as amended, to register
the resale of the shares underlying the warrants pursuant to a registration
rights agreement to be entered into with Mill Road.









-13-





ITEM
2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS





General





This
discussion should be read in conjunction with the Notes to Condensed
Consolidated Financial Statements included herein and the Notes to Consolidated
Financial Statements and Management’s Discussion and Analysis of Financial
Condition and Results of Operations included in our Annual Report on Form 10-K
for the year ended December 31, 2008.





Overview of the
Business





We
specialize in developing and marketing innovative, premium-priced cosmetic
products for the mass market channel. Our products focus on addressing skin
imperfections through a problem-solution approach, rather than focusing on
changing fashion trends. Our products address specific, everyday cosmetics needs
and include face powders, bronzers, concealers, blushes, foundations, eye
shadows, eyeliners, brow makeup and mascaras.
 
 We sell
our products to mass market retailers such as Wal-Mart, Target, CVS and
Rite Aid. Our
products are currently sold in approximately 29,500 of the 45,000 stores in
which we estimate our masstige
competitors' products are sold.  Our products will be sold in
approximately 23,700 stores after one of our customers completes its process to
discontinue selling our products. We seek to be first-to-market with
new products within this channel, and are able to take new products from concept
development to shipment in less than 12 months. New products, which are
primarily introduced during the first and fourth quarters, are a very
important part of our business and have contributed, on average,
approximately 44.1% of our net sales from 2006 to 2008.
 Significant Developments
  From the
year ended December 31, 2004 through the year ended December 31, 2007, we
experienced rapid revenue growth and increased demand for our premium-priced
products.  During this period, we significantly increased our
production capacity, warehouse space and inventory levels in an effort to meet
demand.  This pattern changed in 2008.  As a result of
deteriorating economic conditions, we experienced lessened demand for our
products and tightening of inventory levels with our retail customers. Our net
sales moderated in the second half of 2008 and declined during the nine months
ended September 30, 2009. Net sales declined 35.3% during the nine
months ended September 30, 2009 compared to the same period in 2008, which
was attributable in large part to deteriorating global economic conditions and
tightening of inventory levels with our retail customers.
We incurred a net loss of $1.4 million in the nine months
ended September 30, 2009 and may incur additional losses through the
remainder of 2009.  We continue to reevaluate our operating plans for
the next twelve months and have implemented cost controls to address the
potential for continued decreases in sales. We have implemented a
company-wide salary reduction plan, eliminated cash bonuses in
2009, implemented cost controls, reduced capital expenditures
and are re-evaluating various non-strategic marketing and
administrative costs. We have reduced our workforce by 15%, or 24
positions, during the nine months ended September 30, 2009 in an
effort to reduce costs.
  Late in the
first quarter of 2009, one of our largest retail customers informed us
that, as a result of a change in strategy, the customer intended to reduce its
space allocated to the entire color cosmetics category in its stores in
2010.  In April 2009, this customer informed management of its
decision to completely discontinue selling our products in 2010 rather than
implementing only a reduction in the number of our products sold in the stores.
This customer began to reduce its inventory levels of our products to
prepare for the 2010 discontinuation during the second quarter 2009, which had a
material negative impact on the our net sales. We did not
have any sales to this customer during the third quarter and do not expect to
have any sales to this customer in the future. This
change eliminated our distribution in approximately 5,800
stores.  This customer accounted for 7% of gross sales for
the nine months ended September 30, 2009.  For the year
ended December 31, 2008, this same customer accounted for 16%
of our gross sales.
  As more fully
described in “Liquidity and Capital Resources—Credit Facilities”, on September
4, 2009, Physicians entered into a sixth amendment to its senior credit
agreement with Union Bank, N.A. (“Union Bank”) and obtained a $4.2 million
bridge loan (“Bridge Loan”) from Mill Road Capital, L.P (“Mill
Road”).  As more fully described in “Liquidity and Capital
Resources—Credit Facilities”, on November 6, 2009, Physicians terminated its
senior credit agreement with Union Bank and replaced it with a new asset based
revolving credit facility with Wells Fargo Bank, N.A. (“Wells Fargo”) and repaid
the Bridge Loan using proceeds from the issuance of a new senior subordinated
note (“Senior Subordinated Note”) to Mill Road.
 
 Overview of U.S.
Market Share Data  Based on
retail sales data provided by ACNielsen, the Company’s approximate share of the
masstige
market, as defined below, was 7.7% for the 52 weeks ended October 3,
2009 compared to 8.0% for the same period in the prior year. This
represents a 4% decrease in dollar sales and a 3.8% decrease in the
Company’s share of the masstige
market.  The overall dollar sales for the masstige market remained unchanged during this
period.
 The Company
defines the masstigemarket as products sold in the mass market channel under the
following premium-priced brands: Physicians Formula, Almay, L'Oreal, Max Factor,
Neutrogena, Revlon, OPI, Borghese and Iman. ACNielsen is an independent research
entity and its data does not include retail sales from Wal-Mart, the Company’s
largest customer, and Canada. In addition, ACNielsen data is based on sampling
methodology, and extrapolates from those samples, which means that estimates
based on that data may not be precise. The Company’s estimates have been based
on information obtained from our customers, trade and business organizations and
other contacts in the market in which the Company operates, as well as
management's knowledge and experience in the market in which the Company
operates.
  Seasonality
 
 Our business,
similar to others in the cosmetic industry, is subject to seasonal variation due
to the annual “sell-in” period when retailers decide how much retail space will
be allotted to each supplier and the number of new and existing products to be
offered in their stores. For us, this period has historically been from
December through April. Sales during these months are typically greater due
to the shipments required to fill the inventory at retail stores and retailers’
warehouses. Retailers typically reset their retail selling space during these
months to accommodate changes in space allocation to each supplier and to
incorporate the addition of new products and the removal of slow-selling
items. For example, our net sales for the second and third
quarters are generally lower than the net sales for the first and
fourth quarters of the year, as a result
of this seasonality. Our quarterly results of operations may also fluctuate as a
result of a variety of other reasons including the timing of new product
introductions, general economic conditions or consumer buyer behavior. In
addition, results for any one quarter may not be indicative of results for the
same quarter in subsequent years.
  -14-


Critical
Accounting Policies
 
 Our
condensed consolidated financial statements have been prepared in accordance
with accounting principles generally accepted in the United States of America,
which require management to make estimates and assumptions that affect the
amounts reported in the condensed consolidated financial statements and
accompanying notes. Actual results could differ from those estimates. Critical
accounting policies represent the areas where more significant judgments and
estimates are used in the preparation of our condensed consolidated financial
statements. A discussion of such critical accounting policies, which include
revenue recognition, inventory valuation, goodwill and other intangible assets,
share-based compensation and income taxes can be found in our Annual Report on
Form 10-K for the year ended December 31, 2008. There have been
no material changes to these policies as of this Quarterly Report on
Form 10-Q for the quarterly period ended September 30,
2009.





Results of
Operations





The
following table sets forth our condensed consolidated statements
of operations for the three and nine months ended September
30 , 2009
and 2008:




Three
      Months Ended
                      
                      
                      Nine
      Months EndedSeptember 30,
                      
                      
                      September 30,2009
                      
                      
                      2008
                      
                      
                      2009
                      
                      
                      2008Net
      sales
                      
                      $
                      14,230
                      
                      
                      $
                      20,254
                      
                      
                      $
                      55,453
                      
                      
                      $
                      85,791Cost
      of sales
                      
                      
                      7,773
                      
                      
                      
                      8,431
                      
                      
                      
                      26,425
                      
                      
                      
                      39,696Gross
      profit
                      
                      
                      6,457
                      
                      
                      
                      11,823
                      
                      
                      
                      29,028
                      
                      
                      
                      46,095Selling,
      general and administrative expenses
                      
                      
                      6,614
                      
                      
                      
                      9,878
                      
                      
                      
                      29,259
                      
                      
                      
                      38,377Intangible
      asset impairment
                      
                      
                      -
                      
                      
                      
                      -
                      
                      
                      
                      1,100
                      
                      
                      
                      -(Loss)
      income from operations
                      
                      
                      (157
                      )
                      
                      
                      1,945
                      
                      
                      
                      (1,331
                      )
                      
                      
                      7,718Interest
      expense, net
                      
                      
                      367
                      
                      
                      
                      147
                      
                      
                      
                      1,046
                      
                      
                      
                      731Other
      (income) expense, net
                      
                      
                      (29
                      )
                      
                      
                      113
                      
                      
                      
                      (17
                      )
                      
                      
                      220(Loss)
      income before (benefit) provision for income taxes
                      
                      
                      (495
                      )
                      
                      
                      1,685
                      
                      
                      
                      (2,360
                      )
                      
                      
                      6,767(Benefit)
      provision for income taxes
                      
                      
                      (193
                      )
                      
                      
                      (1
                      )
                      
                      
                      (935
                      )
                      
                      
                      2,044Net
      (loss) income
                      
                      $
                      (302
                      )
                      
                      $
                      1,686
                      
                      
                      $
                      (1,425
                      )
                      
                      $
                      4,723





The
following is a discussion of our results of operations for the three
and nine months ended September 30, 2009 and 2008.




Three
Months Ended September 30, 2009 Compared to Three Months
Ended September 30, 2008
 Net
Sales.  Net sales decreased
$6.1 million, or 30.0%, to $14.2 million for the three months ended September
30, 2009, from $20.3 million for the three months ended September 30,
2008.  The decrease was primarily attributable to a decrease in sales of
our makeup products and an increase in our provision for returns,
partially offset by a decrease in our trade spending.  The decrease in
sales of our makeup products resulted from the
loss of a major customer, lower Canadian sales and sales of higher-priced
promotional kits that were featured in 2008. The loss of a major customer contributed $2.1 million
to our decrease in net sales for the three months ended September 30, 2009
compared to the same period a year ago.  Our provision for returns
increased by $98,000, or 1.6%, to $6.1 million for the three months ended
September 30, 2009, from $6.0 million for the three months ended September 30,
2008 due to increased returns from our retailers.  Trade spending with
retailers decreased by $74,000 for the three months ended September 30, 2009
compared to the same period a year ago, which includes a decrease in our
provision for cooperative advertising of $552,000 and a decrease in our
provision for markdowns of $9,000, offset in part by an increase in our
provision for coupons of $350,000 and an increase in our provision for cash
discounts and miscellaneous allowances of $137,000. During the three months ended September 30, 2009, our
results included net sales of $1.3 million from our international customers,
compared to $3.2 million for the three months ended September 30, 2008. 
The decrease in sales to international customers was primarily due to our
Canadian business, which has experienced softness due to the poor economy. 
Other factors contributing to the decrease in Canadian sales were lower
prepack sales and timing of promotional programs.  For information on
our sell through performance, please see "U.S. Market Share
Data".
  Cost of
Sales.  Cost of sales decreased $658,000, or 7.8%, to $7.8
million for the three months ended September 30, 2009, from $8.4 million for the
three months ended September 30, 2008.  The decrease in cost of sales
resulted primarily from a decrease in product costs of $1.3 million due to a
decrease in sales of our makeup products and a decrease in the provision for obsolete and slow
moving inventory of $920,000, offset in part by a decrease in actual and
estimated inventory recoveries from retailers (inventory returns by customers
deemed to be resalable) of $1.6 million. Cost of sales as a percentage of net sales was 54.6%
for the three months ended September 30, 2009, compared to 41.6% for
the three months ended September 30, 2008.  The increase in cost of
sales as a percentage of net sales was primarily due to an increase in our
product costs and a decrease in inventory recovery from
retailers, partially offset by a decrease in the provision for
obsolete and slow moving inventory.
  Selling,
General and Administrative Expenses.  Selling, general and
administrative expenses decreased $3.3 million, or 33.3%, to $6.6 million for
the three months ended September 30, 2009, from $9.9 million for the three
months ended September 30, 2008.  The decrease was primarily due to a
$798,000 decrease in corporate administrative costs, a $501,000 decrease in the
allowance for doubtful accounts, a $471,000 decrease in freight and warehouse
costs, a $397,000 decrease in stock-based compensation expense, a $381,000
decrease in marketing expense, a $339,000 decrease in realized and
unrealized foreign currency exchange losses, a $251,000 decrease in sales force
and sales administrative expenses and a $126,000 decrease in distribution
costs.




-15-


Interest
Expense-Net.  Interest expense-net increased $220,000, or
149.7%, to $367,000 for the three months ended September 30, 2009, from $147,000
for the three months ended September 30, 2008.  The increase in interest
expense was due to an increase in average borrowings outstanding under our
credit facility and Bridge Loan and an increase in interest rates on our
borrowings for the three months ended September 30, 2009 when compared to the
same period for the prior year.
  Other (Income)
Expense-Net.  Other income for the
three months ended September 30, 2009 was $29,000 compared to other expense of
$113,000 for the same period in 2008, which consisted of unrealized gains and
losses related to investments held as part of our non-qualified deferred
compensation plans.
  (Benefit)
Provision for Income Taxes.  The provision (benefit) for
income taxes represents federal, state and local income taxes.  For the
three months ended September 30, 2009, the benefit for income taxes was
$193,000, representing an effective income tax rate of (39.0)%.  The
effective tax rate differed from the statutory rate for the three months ended
September 30, 2009, primarily due to fluctuations in permanent differences
between book and taxable income.  For the three months ended September 30,
2008, the benefit for income taxes was $1,000, representing an effective
tax rate of (0.06)%.  The effective tax rate differed from the statutory
rate for the three months ended September 30, 2008, primarily due to our change
in filing position in various state tax jurisdictions, changes in federal and
state tax estimates and, to a lesser extent, fluctuations in permanent
differences between book and taxable income, which collectively decreased our
income tax provision by approximately $0.6 million.
 Nine Months
Ended September 30, 2009 Compared to Nine Months Ended September
30, 2008
  Net Sales.  Net sales decreased $30.3
million, or 35.3%, to $55.5 million for the nine months ended September 30,
2009, from $85.8 million for the nine months ended September 30, 2008.  The
decrease was primarily attributable to a decrease in sales of our makeup
products offset by a decrease in our provision for returns and a decrease in
trade spending.  The decrease in sales of our makeup products was primarily
due to the loss of a major customer, lower Canadian sales, sales
of higher-priced promotional kits that were featured in 2008 and tight inventory
control by retailers leading to destocking, which reduced the pipeline orders
for new products during the nine months ended September 30, 2009 when compared
to the same period a year ago.  The loss of a major customer contributed
$9.5 million to the decrease in our net sales for the nine months ended
September 30, 2009 compared to the same period a year ago.  At the same
time, our provision for returns decreased by $4.2 million, or 21.8%, to $15.0
million for the nine months ended September 30, 2009, from $19.2 million for the
nine months ended September 30, 2008 due to decreased returns from our
retailers.  Lower returns are expected as a result of the loss of a major
customer, from which we no longer expect to receive returns, and the
higher-priced promotional kits that were only sold in 2008, and are no longer
being sold, that had a significantly higher return rate than our other
products.  Trade spending with retailers decreased by $1.4 million for the
nine months ended September 30, 2009 compared to the same period a year ago,
which includes a decrease in our provision for cooperative advertising of $3.1
million and a decrease in our provision for cash discounts and miscellaneous
allowance of $435,000, partially offset by an increase in our provision for
coupons of $1.4 million and an increase in our provision for markdowns of
$752,000.  During the nine months ended September 30, 2009, our results
included net sales of $6.6 million from our international customers, compared to
$12.5 million for the nine months ended September 30, 2008.  The decrease
in sales to international customers was primarily due to our Canadian
business, which has experienced softness due to the poor economy.  Other
factors contributing to the decrease in Canadian sales were lower prepack
sales and timing of promotional programs.  For information on our
sell through performance, please see "U.S. Market Share
Data".
  Cost of
Sales.  Cost of sales decreased $13.3 million, or 33.5%, to
$26.4 million for the nine months ended September 30, 2009, from $39.7 million
for the nine months ended September 30, 2008.  The decrease in cost of
sales resulted primarily from a decrease in product costs of $15.1
million due to a decrease in sales of our makeup products, offset in part
by an increase in the provision for obsolete and slow moving inventory of
$371,000 and a decrease in actual and estimated inventory recoveries from
retailers (inventory returns by customers deemed to be resalable) of $1.4
million. Cost of sales as a percentage of net sales was 47.7%
for the nine months ended September 30, 2009, compared to 46.3% for the nine
months ended September 30, 2008.  The increase in cost of sales as a
percentage of net sales was primarily due to an increase in the provision for
obsolete and slow moving inventory and an increase in product costs, offset
by an increase in inventory recovery from
retailers.
 
 Selling,
General and Administrative Expenses.  Selling, general and
administrative expenses decreased $9.1 million, or 23.7%, to $29.3 million for
the nine months ended September 30, 2009, from $38.4 million for the nine months
ended September 30, 2008.  The decrease was primarily due to a $2.3 million
decrease in marketing spending, a $1.9 million decrease in freight and warehouse
costs, a $1.4 million decrease in corporate administrative costs, a $1.1 million
decrease in sales force and sales administrative expenses, a $1.1 million
decrease in stock-based compensation expense, a $959,000 decrease in
realized and unrealized foreign currency exchange losses, and a
$360,000 decrease in distributions costs.
  Intangible Asset Impairment.  Duringthe
nine months ended September 30, 2009, we recorded a non-cash charge of $1.1
million for the impairment of our trade names.  We evaluate our intangible
assets for impairment in the second quarter of each fiscal year and when events
or circumstances occur that potentially indicate that the carrying amounts of
these assets may not be recoverable.  This non-cash impairment charge does
not impact our overall business
operations.
  Interest
Expense-Net.  Interest expense-net increased $315,000, or
43.1%, to $1.0 million for the nine months ended September 30, 2009, from
$731,000 for the nine months ended September 30, 2008.  The increase in
interest expense was due to an increase in average borrowings outstanding
under our credit facility and an increase in interest rates for the nine
months ended September 30, 2009 when compared to the same period a year
ago.
  Other
(Income) Expense-Net.  Other income
for the nine months ended September 30, 2009 was $17,000 compared to other
expense of $220,000 for the same period in 2008, which consisted of unrealized
gains and losses related to investments held as part of our non-qualified
deferred compensation plans.
  (Benefit)
Provision for Income Taxes.  The (benefit)
provision for income taxes represents federal, state and local income
taxes.  For the nine months ended September 30, 2009, the benefit for
income taxes was $935,000, representing an effective income tax rate of
(39.6)%.  The effective tax rate differed from the statutory rate for
the nine months ended September 30, 2009, primarily due to permanent
differences between book and taxable income such as tax benefit deficiencies on
stock options exercised and forfeited and research and development
credits.  For the nine months ended September 30, 2008, the provision for
income taxes was $2.0 million, representing an effective income tax rate of
30.2%.  The effective tax rate differed from the statutory rate for the
nine months ended September 30, 2008, primarily due to our change in filing
position in various state tax jurisdictions, changes in federal and state tax
estimates and, to a lesser extent, fluctuations in permanent differences between
book and taxable income.
  -16-
 Liquidity and Capital
Resources





Cash Flows





As
of September 30, 2009, we had $1.3 million in cash and cash equivalents and
$51,000 in restricted cash compared to $0.6 million in cash and cash
equivalents as of December 31, 2008. The increased level of cash reflects
cash inflows provided by our operating activities. As of
September 30, 2009, we had $9.3 million outstanding and $1.4 million of
availability under our revolving credit facility.  The significant
components of our working capital are accounts receivable and inventories,
accounts payable, trade allowances, income taxes, sales returns
reserve, related party financing and line of credit
borrowings.





Operating
Activities.Cash provided by operating activities decreased by
$5.2 million, or 37.4%, to $8.7 million for the nine months
ended September 30, 2009, from $13.9 million for the nine months
ended September 30, 2008. The net decrease in cash provided by operating
activities resulted primarily from our net loss and unfavorable changes in
accounts receivable, sales returns reserve, prepaid expenses and other
current assets and income taxes. The net decrease in cash provided by operating
activities was offset by favorable changes in accounts payable
and inventories.  Our inventory turnover rate decreased to an
annualized 1.6 times per year for the nine months ended September
30, 2009, from an annualized 1.8 times per year for the nine months
ended September 30, 2008. Days sales outstanding increased by 5.1
days, to 52.8 days for the nine months ended September 30, 2009
from 47.7 days for the nine months ended September 30,
2008.





Investing
Activities.Cash used
in investing activities for the nine months ended September 30, 2009
was $2.6 million, which was primarily related to investments in retail
permanent fixtures and capital expenditures for the replacement of machinery and
equipment and improvements to our warehouse distribution systems.Cash
used in investing activities for the nine months ended September 30,
2008 of $1.2 million was primarily related to capital expenditures for the
replacement of machinery and equipment and the automation of the assembly
line.





Financing
Activities.Cash used in financing activities was $5.4
million for the nine months ended September 30, 2009 compared
to cash used in financing activities of $11.6 million for
the nine months ended September 30, 2008. The decrease in
cash used in financing activities was primarily due to proceeds
received from the bridge loan and stock repurchases in 2008, offset in part
by higher net payments on our revolving credit facility and payments for debt
issuance costs.




Future Liquidity and Capital
Needs.  Our net working capital decreased by $9.6
million, or approximately 32.1%, to $20.3 million as of September 30, 2009,
from $29.9 million as of September 30, 2008. We anticipate that
requirements for working capital will increase during the fourth quarter of
2009, when we typically experience higher inventory levels as we produce new
products for shipment in the first quarter of the following year. We have
budgeted capital expenditures of $5.7 million for 2009 for several key projects,
including $4.7 million in investments in retail permanent fixtures (classified
as other assets in the accompanying condensed consolidated balance
sheets which are excluded from our capital expenditure covenant under our
old senior credit agreement with Union Bank), $443,000 in improvements to other
manufacturing and distribution equipment, $290,000 to upgrade a product assembly
line, $209,000 in improvements to our information technology infrastructure and
$58,000 in improvements to our research and development equipment.  We
expect capital requirements related to fixture infrastructure to total $6.2
million for the period from September 2008 (inception of the project) to
December 2009, of which $3.5 million was incurred as of September 30,
2009.  Approximately half of the capital spending for retail permanent
fixtures will occur during the fourth quarter of 2009 in conjunction with the
new 2010 fixture systems.  Capital requirements related to
manufacturing include an upgrade to a major project undertaken in 2007 to
automate a product assembly line that is used to assemble products that
represented approximately 24.5% of our total sales in 2008.  We expect the
aggregate capital requirements of this project to total $1.7 million for the
period from August 2008 (inception of the project) to December 2009, of
which $1.6 million was incurred as of September 30, 2009.  We spent
$649,000 for capital expenditures and $1.9 million for investments in retail
permanent fixtures for the nine months ended September 30, 2009.  We
believe that our cash flows from operations and funds from our financing
arrangements entered into during November 2009 will provide adequate funds for
our working capital needs and planned capital expenditures for at least the next
twelve months.  No assurance can be given, however, that this will be the
case.




Credit
Facilities
 As described
below, on September 4, 2009, Physicians entered into a sixth amendment to its
senior credit agreement with Union Bank and obtained a $4.2 million Bridge
Loan from Mill Road. As also described below, on November 6, 2009,
Physicians terminated its senior credit agreement with Union Bank and replaced
it with a new asset based revolving credit facility with Wells Fargo and repaid
the Bridge Loan using proceeds from the issuance of a new Senior
Subordinated Note to Mill Road.
 
 Senior Credit Agreement.  On March 30,
2009, Physicians entered into a fourth amendment to the senior credit agreement
with Union Bank (the “fourth amendment”) which converted the entire
facility, which previously consisted of an amortizing term loan and a revolving
credit facility, into an asset-based revolving credit facility, and the
outstanding term loan was replaced with borrowings under the revolving credit
facility. The fourth amendment to the senior credit agreement, among
other things, eliminated the minimum fixed charge coverage ratio and the maximum
total leverage ratio covenants and replaced them with a minimum interest
coverage ratio and a minimum EBITDA (as defined by the senior credit
agreement) covenant and amended the minimum tangible net worth covenant,
all of which are financial maintenance covenants.
  The
maximum amount available for borrowing under the revolving credit
facility was equal to the lesser of (i) $20.0 million or (ii) a
borrowing base formula equal to the sum of (a) up to 65% of the book value
of eligible accounts receivable, (b) the lesser of (1) up to 15% of
eligible inventory or (2) $5.0 million, (c) the balance of
certain foreign currency accounts denominated in Canadian dollars (the
“Canadian Pledged Accounts”), and (d) the orderly liquidation value of eligible
equipment not to exceed $1.0 million, all as determined in accordance with the
fourth amendment. The applicable interest rate under the revolving credit
facility was equal to a percentage equal to the lender’s reference rate
plus 3.00%.  The senior credit agreement required us to pay
a commitment fee on unused commitments of 0.50%.
  Under the
senior credit agreement, all revenue received by Physicians and its subsidiaries
in Canadian dollars was required to be deposited into the Canadian Pledged
Accounts, which were pledged to the agent to secure borrowings under the
revolving credit facility.  Physicians could use the balance in
the Canadian Pledged
Accounts to repay borrowings under the revolving credit facility, or, if the
Company demonstrated availability under the borrowing base of at least $1.5
million and other conditions were met, Physicians could make monthly
transfers from the Canadian Pledged Accounts to a Canadian disbursement account
in an amount that would not cause the balance of the Canadian disbursement
account to exceed CDN$500,000, and, if other conditions were met,
Physicians could use the Canadian disbursement account to pay amounts due
to its Canadian vendors in the ordinary course of business. On July 8,
2009, restricted cash of $6.5 million was used to repay borrowings
under the revolving credit facility.  As of September
30, 2009, the Canadian Pledged Accounts had a balance of $51,000, which is
recorded as restricted cash in the accompanying condensed consolidated balance
sheet.




-17-




On July
29, 2009, Physicians entered into a fifth amendment to the senior credit
agreement (the “fifth amendment”).  Pursuant to the fifth amendment,
the lender reduced its revolving loan commitment from $25.0 million to $20.0
million and amended the definition of eligible accounts receivable for purposes
of the borrowing base to increase the maximum percentage of eligible accounts
receivable from any one customer (the “customer concentration threshold”) from
25% to 35% (except with respect to certain customers).  The lender
also agreed to waive an event of default resulting from our failure to
repay an overadvance of $1.8 million outstanding as of July 1, 2009 within the
five day grace period permitted by the senior credit agreement. The overadvance
was a result of the decrease in the maximum eligible inventory under the
borrowing base from $8.0 million to $5.0 million on July 1, 2009. Further,
due to the reduction in second quarter sales to a customer that is in the
process of discontinuing the sale of our products, another customer was placed
above the 25% customer concentration threshold, causing the portion of accounts
receivable associated with sales above the 25% customer concentration threshold
to be excluded from the borrowing base calculation as of July 1, 2009. In
addition, the amendment requires us to hire a management consultant on
or before July 31, 2009 to conduct an assessment of Physicians Formula's
financial performance, including the business plan, cost structure and
liquidity.  In connection with the fifth amendment, we paid a fee of
$50,000 and related expenses.
    The senior credit
agreement required us to comply with a minimum interest coverage ratio, a
minimum EBITDA (as defined in the senior credit agreement) covenant and a
minimum tangible net worth covenant.  As of September 30, 2009, we were in
compliance with these covenants in the senior credit agreement.  The senior
credit agreement contained certain additional negative covenants, including
limitations on our ability to: incur other indebtedness and liens;
fundamentally change its business through a merger, consolidation,
amalgamation or liquidation; sell assets; make restricted payments; pay
cash dividends from Physicians Formula, Inc. 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 its affiliates; enter into certain agreements; engage in
sale-leaseback transactions; incur certain unfunded
liabilities; change its line of business; and make capital
expenditures in excess of $2.0 million per year. The
senior credit agreement required the Company to make mandatory
prepayments with the proceeds of certain asset dispositions and upon the receipt
of insurance or condemnation proceeds to the extent the Company did
not use the proceeds for the purchase of satisfactory replacement assets.
  Borrowings
under the senior credit agreement were guaranteed by Physicians
Formula Holdings, Inc. and the domestic subsidiaries of Physicians Formula, Inc.
and borrowings under the senior credit agreement were secured by a
pledge of the capital stock of Physicians Formula, Inc. and its equity interests
in each of its subsidiaries and substantially all of the assets Physicians
Formula, Inc. and its domestic subsidiaries. At September 30, 2009, there
was $9.3 million outstanding under the revolving credit facility at an
interest rate of 6.25%. At December 31, 2008, there was $7.9 million
outstanding under the revolving credit facility at an interest rate of 3.50% in
addition to the outstanding term loan of $10.5 million with an interest rate of
3.39%.
    Bridge Loan.
 -18-
       New Senior
Revolving Credit Facility. On
November 6, 2009, pursuant to a new senior credit agreement (the “New Senior
Credit Agreement”) between Physicians and Wells Fargo, Physicians entered into a
new asset-based revolving credit facility (the “new revolving credit facility”)
and terminated its previous asset-based revolving credit facility (the “old
revolving credit facility”) with Union Bank.  Approximately $9.3
million of the proceeds of the new revolving credit facility were used to
repay outstanding borrowings
under Physicians’ old revolving credit facility. The current available
cash, cash equivalents and restricted cash of approximately $1.6 million
remained in the Union Bank account and will be transfered to the Wells Fargo
operating account.  Our new revolving credit facility is scheduled to
mature on November 6, 2012.
  The maximum amount
available for borrowing under the new revolving credit facility is equal to the
lesser of $25.0 million and a borrowing base formula equal to: (i) 65% or such
lesser percentage of eligible accounts receivable as Wells Fargo in its
discretion as an asset-based lender may deem appropriate; plus (ii) the least of
(1) $14.0 million and (2) the sum of specified percentages (or such lesser
percentages as Wells Fargo in its discretion as an asset-based lender may deem
appropriate) of each of the following items of eligible inventory (as defined in
the New Senior Credit Agreement): (A) of eligible inventory consisting of
finished goods that are fully packaged, labeled and ready for shipping, not to
exceed 65% of such eligible inventory, (B) eligible inventory consisting of
semi-finished goods which are ready for packaging and shipping, not to exceed
$4.0 million, (C) eligible inventory consisting of raw materials, not to exceed
$1.5 million, (D) eligible inventory consisting of blank components, not to
exceed $1.0 million and (E) eligible inventory consisting of returned items, not
to exceed $0.75 million; plus (iii) the cash balance in a certain Canadian
concentration account; less (iv) a working capital reserve of $1.0 million as
such amount may be adjusted by Wells Fargo from time to time and a borrowing
base reserve that Wells Fargo establishes from time to time in its discretion as
a secured asset-based lender; less (v) indebtedness owed to Wells Fargo other
than indebtedness outstanding under the new revolving credit facility.
Availability under the new revolving credit facility is reduced by outstanding
letters of credit.
  Floating rate
borrowings under our new revolving credit facility accrue interest at a daily
rate equal to the three-month LIBOR plus 3.5% and fixed rate borrowings accrue
interest at a fixed rate equal to the three-month LIBOR plus 3.5% on the date of
borrowing. Interest on floating rate borrowings is payable monthly in arrears
and interest on fixed rate borrowings are payable upon the expiration of the
fixed rate term, subject to minimum monthly interest payments in the amount of
$25,000. Under the New Senior Credit Agreement, Physicians is required to
pay to Wells Fargo an unused credit line fee equal to 0.5% per annum and various
other fees associated with cash management and other related services.
Physicians may reduce the maximum amount available for borrowing or terminate
the facility prior to the scheduled maturity date at any time by paying breakage
fees equal to 3% of the maximum amount of the new revolving credit facility or
amount of the reduction in the credit facility, as applicable, decreasing to
1.5% after November 6, 2010 and decreasing to 0.5% after November 6,
2011.
  Under the New
Senior Credit Agreement, all payments to Physicians and its subsidiaries are
required to be deposited into a lockbox account provided by Wells Fargo, except
that payments in connection with the our Canadian operations may be deposited
into a lockbox account with Royal Bank of Canada. Any amounts deposited into a
lockbox account with Wells Fargo will be swept to a collection account to be
applied to repay the outstanding borrowings under the new revolving credit
facility. If the balance in Physicians’ restricted Canadian account exceeds
Canadian $2.0 million at any time, Physicians must within 10 days after such
occurrence transfer the excess amount to the collection account to repay
borrowings under the new revolving credit facility. In addition, at any time,
Physicians may transfer amounts out of the restricted Canadian accounts to repay
borrowings under the revolving credit facility or so long as no event of default
exists, pay costs and expenses incurred in connection with our Canadian
operations from its Canadian operating account.
  The New
Senior Credit Agreement requires us to comply with a monthly minimum
book net worth covenant and a quarterly minimum adjusted EBITDA covenant.
In addition, we are required to comply with certain negative covenants,
including limitations on our ability to: incur other indebtedness and liens;
make certain investments, loans or advances; guaranty indebtedness; pay cash
dividends from Physicians, except in an amount up to $0.1 million to allow the
Physicians Formula Holdings, Inc. to pay ordinary course expenses; sell assets;
suspend operations; consolidate or merge with another entity; enter into
sale-leaseback arrangements; or enter into unrelated lines of business or
acquire assets not related to our business; and make capital expenditures in
excess of $6.0 million for the year ending December 31, 2009 and $5.5 million
for the year ending December 31, 2010 (subject to up to a $600,000 carryforward
from the prior year). The financial covenants for the year ending December 31,
2011 and thereafter will be agreed upon between Physicians and Wells Fargo no
later than April 30, 2010.  The New Senior Credit Agreement also
contains customary events of default, including a change of control of
Physicians.
  Borrowings
under the new revolving credit facility are guaranteed by Physicians Formula
Holdings, Inc. and the domestic subsidiaries of Physicians and are secured by a
pledge of the capital stock of Physicians and its subsidiaries and substantially
all of the assets of the Company and its subsidiaries.
  Physicians
paid a closing fee to Wells Fargo equal to $250,000 and agreed to pay all
expenses incurred by Wells Fargo in connection with the new revolving credit
facility.
  In order to
retire the old revolving credit facility and pay other fees and expenses, on
November 6, 2009, we borrowed $10.4 million under the new revolving credit
facility, which was less than originally expected, and immediately thereafter
had $1.3 million in availability for future borrowings under the new revolving
credit facility, net of certain specified reserves totaling $3.1 million at
closing. When combined with the net cash proceeds of the Senior Subordinated
Note from Mill Road of $3.0 million and cash on the balance sheet of $1.6
million, we had approximately $6.0 million of liquidity available to it, which
was previously disclosed as the expected availability under the Wells Fargo line
of credit.
 
 -19-
 
 New Senior
Subordinated Note. On
November 6, 2009, pursuant to a Senior Subordinated Note Purchase and Security
Agreement between Physicians, the guarantors named therein and Mill Road (the
“Note Agreement”), Physicians issued a new Senior Subordinated Note to Mill Road
in an aggregate principal amount equal to $8.0 million.  Physicians
used $4.3 million of the proceeds to repay in full the principal of $4.2 million
and interest of $107,000 outstanding under its Bridge Loan from Mill Road. We
intend to use the remaining proceeds for capital expenditures and general
corporate purposes. The Senior Subordinated Note is scheduled to mature on
May 6, 2013 and accrues interest at 19% per annum, with 15% per annum payable in
cash monthly in arrears on the first day of each calendar month and 4% payable
in kind with quarterly compounding on the first day of each calendar
quarter.
  Subject to
the terms of the new revolving credit facility, the Senior Subordinated Note may
be redeemed in whole or in part prior to November 6, 2010 at an amount equal to
105% of the aggregate principal amount of the outstanding Notes, decreasing to
104% if redeemed on or after November 6, 2010 and prior to November 6, 2011,
decreasing to 102% if redeemed on or after November 6, 2011 and prior to
November 6, 2012, and decreasing to 101% if redeemed on or after November
6, 2012. In addition, Physicians must make an offer to redeem the Senior
Subordinated Notes upon a change of control of Physicians at the then applicable
redemption price.
 
 We are
required to comply with substantially the same covenants under the Note
Agreement that we are required to comply with under our New Senior Credit
Agreement and  events of default under the Note Agreement are
substantially the same as the events of default under our New Senior Credit
Agreement.
  The Senior
Subordinated Note is guaranteed by Physicians Formula Holdings, Inc. and
Physicians’ subsidiaries and are secured by a first lien on certain intellectual
property and a second lien on substantially all of the other assets of
Physicians Formula Holdings, Inc. and its subsidiaries and pledges of the stock
of Physicians and its subsidiaries.  The value of the collateral
subject to these liens is limited to the lesser of 10% of the value of the
assets of Physicians Formula Holdings, Inc. and its subsidiaries and 10% of the
value of all outstanding common stock of Physicians Formula Holdings, Inc. as of
November 6, 2009 (the “10% Cap”).
  Pursuant to
an Intercreditor Agreement entered into between Physicians, Mill Road and Wells
Fargo in connection with the New Senior Credit Agreement and Note Agreement, the
Senior Subordinated Note is subordinate in right of payment to the prior
paying of all obligations under the New Senior Credit Agreement and the liens
securing the obligations under the Note Agreement are junior and subordinate to
the liens securing the obligations under the New Senior Credit Agreement (except
for first liens on certain intellectual property). In addition, the
Intercreditor Agreements prohibits certain amendments to the Note Agreement
without the consent of Wells Fargo and prohibits certain amendments to the New
Senior Credit Agreement without the consent of Mill Road.
  Physicians
paid a closing fee to Mill Road equal to $160,000 and agreed to pay all expenses
incurred by Mill Road in connection with the issuance of the Senior Subordinated
Note and the transactions described below.
  Based on a
Schedule 13D/A filed by Mill Road on March 11, 2009, Mill Road is the
beneficial owner of approximately 18% of our outstanding common
stock.  In connection with the issuance of the Senior Subordinated
Note, we agreed that, upon the
earlier to occur of the mailing of the proxy statement for the annual meeting of
stockholders in 2010 and June 30, 2010, and for so long as the Senior
Subordinated Note is outstanding, Mill Road has the right to nominate one
individual to serve as a member of our board of directors (the “Board”), and we
agreed to recommend to our stockholders that Mill Road’s designee be elected to
the Board at our annual meetings of stockholders for as long as the Senior
Subordinated Note is outstanding.  In addition, Mill Road agreed that
until September 30, 2010, it would not acquire more than 35% of our common stock
or seek to elect any directors to the Board (other than the one director it is
entitled to nominate while the Senior Subordinated Note is outstanding), in each
case, without obtaining the prior written consent of the Board.  These
restrictions will be released if we receive a bid for the acquisition of our
company (other than from Mill Road or its affiliates).
 
 In connection
with the Note Agreement, we agreed to hold a special meeting of stockholders to
vote on a proposal to approve the issuance to Mill Road of warrants to purchase
our common stock and an amendment to the Senior Subordinated Note with Mill
Road.  We will be seeking stockholder approval to comply with the
Nasdaq shareholder approval requirements and to satisfy Section 203 of the
Delaware General Corporation Law, because Mill Road is an “interested
stockholder” for purposes of the statute.  Because Mill Road is an
interested stockholder, we will be required to obtain the vote of 66 2/3% of our
outstanding common stock not owned by Mill Road to approve the
transactions.
 
 If
stockholder approval is obtained and the warrants are issued, Mill Road has
agreed to reduce the interest rate on the Senior Subordinated Note from 19% per
annum (15% payable in cash monthly and 5% payable in kind with quarterly
compounding) to 14% per annum (10% payable in cash monthly and 4% payable in
kind with quarterly compounding), and extend the maturity of the Senior
Subordinated Note from May 6, 2013 to November 6, 2014.   The
prepayment premium for an optional redemption would be amended so that if the
Senior Subordinated Note is redeemed on or after November 6, 2011 and prior to
November 6, 2012, the prepayment premium would be 102%, decreasing to 101% if
redeemed on or after November 6, 2012 and prior to November 6, 2013, and
decreasing to 100% if redeemed on or after November 6, 2013.  If
stockholder approval is obtained, Mill Road would be entitled to a number of
warrants equal to the product of (i) $2.028 divided by our 30-day average stock
price and (ii) 700,000, calculated on November 5, 2009 or the date of the
amendment to the Senior Subordinated Note, whichever is greater.  The
warrants would have an exercise price equal to $0.25 and would mature on the
seventh anniversary of the date they were issued.  If the warrants are
issued, we will agree to file a registration statement under the Securities Act
of 1933, as amended, to register the resale of the shares underlying the
warrants pursuant to a registration rights agreement to be entered into with
Mill Road.





Off-Balance
Sheet Transactions
 
 We do not
have any relationships with unconsolidated entities or financial partnerships,
such as entities often referred to as structured finance or special purpose
entities, which would have been established for the purpose of facilitating
off-balance sheet arrangements or other contractually narrow or limited
purposes. In addition, we do not engage in trading activities involving
non-exchange traded contracts that rely on estimation techniques to calculate
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-Looking
Statements
 
 This
section and other parts of this Quarterly Report on Form 10-Q contain
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934,
as amended. In some cases, forward-looking statements can be identified by words
such as “anticipates,” “expects,” “believes,” “intends,” “plans,” “predicts,”
and similar terms. Such forward-looking statements are based on current
expectations, estimates and projections about our industry, management’s beliefs
and assumptions made by management. Forward-looking statements are not
guarantees of future performance and our actual results may differ significantly
from the results discussed in the forward-looking statements. Factors that might
cause such differences include, but are not limited to those discussed in Part
I, Item 1A, “Risk Factors” in our Annual Report on Form 10-K for the year ended
December 31, 2008 and Part II, Item 1A, “Risk Factors” in this quarterly report
on Form 10-Q. Unless otherwise required by law, we expressly disclaim any
obligation to update publicly any forward-looking statements, whether as result
of new information, future events or otherwise.




-20-





ITEM
3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK





(a)  Foreign Currency
Risk.





The Company
sells to Canadian customers in Canadian dollars and pays overseas suppliers and
third-party manufacturers in U.S. dollars. An increase in the Canadian dollar
relative to the U.S. dollar could result in lower net sales and higher selling,
general and administrative expenses. Additionally, the Company holds
Canadian dollars in a cash account, which could result in higher
unrealized foreign currency exchange losses due to a decrease in the Canadian
dollar relative to the U.S. dollar. Further, a decrease in the value of the Euro
and the Chinese Yuan relative to the U.S. dollar could cause our suppliers to
raise prices that would result in higher cost of sales. The volatility of the
applicable rates and prices are dependent on many factors that cannot be
forecasted with reliable accuracy. Our current sales to Canadian customers and
reliance on foreign suppliers for many of the raw materials and components used
to produce products make it possible that our operating results may be affected
by fluctuations in the exchange rate of the currencies of our customers and
suppliers. We do not have any foreign currency hedges.





(b)  Interest Rate
Risk.





Since
November 9, 2009, we are exposed to interest rate risks primarily through
borrowings under our New Senior Credit Agreement (and previously under our old
senior credit agreement). Interest on these borrowings is based upon variable
interest rates. Our weighted-average borrowings outstanding under our old
senior credit agreement during the nine months ended September 30,
2009, was $19.5 million and the interest rate in effect at September
30, 2009, was6.25%.
A hypothetical 1% increase or decrease in interest rates would have resulted in
a $146,000 change to interest expense for the nine months
ended September 30, 2009.





ITEM
4.  CONTROLS AND PROCEDURES





The
Company maintains disclosure controls and procedures that are designed to ensure
that information required to be disclosed in its reports pursuant to the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in Rule 13a-15 under the Exchange Act, and that such
information is accumulated and communicated to the Company’s management,
including its Chief Executive Officer and Interim Chief Financial Officer, as
appropriate, to allow timely decisions regarding required disclosure. Management
is responsible for establishing and maintaining adequate internal control over
financial reporting.





As
required by Rule 13a-15(b) under the Exchange Act, the Company carried out an
evaluation, under the supervision and with the participation of its management,
including the Chief Executive Officer and the
Interim Chief Financial Officer, of the effectiveness of the design and
operation of the Company’s disclosure controls and procedures. Based on the
foregoing, the Company's Chief Executive Officer and Interim Chief Financial
Officer determined that disclosure controls and procedures were effective at a
reasonable assurance level as of the end of the period covered by this
report. 
 There has
been no change in internal controls over financial reporting during the most
recent fiscal quarter that has materially affected, or is reasonably likely to
materially affect, internal controls over financial reporting.


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PART
II.


OTHER INFORMATION





ITEM
1.  LEGAL PROCEEDINGS





The
Company is involved in various lawsuits in the ordinary course of business. In
management’s opinion, the ultimate resolution of these matters will not result
in a material impact to the Company’s condensed consolidated financial
statements.




ITEM
1A.  RISK FACTORS





There
have been no material changes to our risk factors as disclosed in Item 1A. “Risk
Factors” in our Annual Report on Form 10-K for the year ended December 31, 2008,
except as follows:
 
 We
depend on a limited number of retailer customers for a majority of our sales and
the loss of one or more of these customers would reduce our sales and harm our
market share and our business.
 
 We depend on
a small number of core retailer customers for a majority of our sales, including
Wal-Mart, CVS, Target and Rite Aid. Sales to these four retailer
customers accounted for an aggregate of 57.9% of our gross sales in 2008. None
of our customers is under an obligation to continue purchasing products from us
in the future. The fact that we do not have long-term contracts with our
customers means that we have no recourse in the event a customer no longer wants
to purchase products from us. In the future, retailers in the mass market
channel may undergo restructurings or reorganizations, realign their
affiliations, close stores or otherwise suffer losses, any of which could
decrease their orders for our products. The loss of one or more of our customers
that, individually or in the aggregate, accounts for a significant portion of
our sales, any significant decrease in sales to those customers, any significant
decrease in our retail selling space in any of those customers’ stores, an
interruption or decline of our customers’ business or a successful demand by
those customers that we decrease our prices would reduce our sales and harm our
business. In the first quarter of 2009, one of our largest retailer
customers informed us that as a result of a change in strategy, the
customer intends to reduce the space allocated to the entire color
cosmetics category in its stores in 2010. In April 2009, this customer informed
us of its decision to discontinue selling Physicians Formula products. This
change had a material negative impact on our net sales beginning in the
second quarter of 2009 as the customer reduced its inventory levels of
our products.  We did not have any sales to this customer in the third
quarter and we do not expect to have any sales to this customer in the
future. This change eliminated our distribution in approximately 5,800
stores.  This customer accounted for 7% of our gross sales for
the nine months ended September 30, 2009 and 16% of our gross
sales for the year ended December 31, 2008.
 
 Our
business and results of operations have been adversely impacted by the severe
downturn in the U.S. economy and will continue to be impacted by general
economic conditions.
 
 Our
operations and financial performance are directly impacted by changes in the
U.S. economy.  The significant downturn in the U.S. economy during the
first quarter of 2009 significantly lowered consumer discretionary spending,
which lowered the demand for our products.  Reduced consumer
discretionary spending may cause us to lower prices, increase our trade spending
or suffer significant product returns from our retailer customers, any of which
would have a negative impact in our gross margins. Additionally, a
continued weakened consumer environment may create additional declines in the
Company's market capitalization relative to its net book value resulting in a
potential impairment of intangible assets, including trade names.
 
 Current
economic conditions could also have a negative impact on the financial stability
of our retailer customers.  A small number of our customers account
for a large percentage of our net sales and accounts receivable.  If
any of our significant retailer customers is unable to finance purchases of our
products or defaults on amounts owed to us, it would have an adverse impact on
our results of operations and financial condition, including our
liquidity.  It is uncertain if economic conditions or consumer
confidence will deteriorate further, or when economic conditions or consumer
confidence will improve.  If there is a prolonged recession, reduced
consumer spending could have a material and adverse effect on our business,
results of operations or financial condition, including recognizing an
additional impairment charge of the Physicians Formula trade
name.
 
 ITEM
5.  OTHER INFORMATION
 
 (a)
 
 Refinancing.
On November 6, 2009, Physicians terminated its senior credit facility with Union
Bank of California, N.A. and replaced it with a new asset-based revolving credit
facility with Wells Fargo Bank, N.A. and repaid a bridge loan from Mill
Road Capital, L.P. (“Mill Road”) using proceeds from the issuance of a
new Senior Subordinated Note to Mill Road. See Note 12 to the accompanying
unaudited condensed consolidated interim financial statements and Exhibits
10.10 through 10.22 for additional information. Descriptions of the new
revolving credit facility and the Senior Subordinated Note are qualified by
reference to Exhibits 10.10 through 10.22 filed
herewith.
  -22-


ITEM
6.  EXHIBITS





Exhibit
              Number
            
            
            
            Description10.1
            
            Fifth
      Amendment to Credit Agreement, dated July 29, 2009, by and among
      Physicians Formula, Inc., the several banks and other lenders from time to
      time parties to the Credit Agreement and Union Bank, N.A., as
      administrative agent (incorporated by reference to the registrant's
      Current Report on Form 8-K filed on August 4, 2009).10.2
            
            Term
      Loan Agreement, dated as of September 4, 2009, between Physicians Formula,
      Inc., as borrower, and Mill Road Capital, L.P., as lender (incorporated by
      reference to Exhibit 10.1 to the registrant's Current Report on Form 8-K
      filed on September 11, 2009).10.3
            
            Term
      Note, dated as of September 4, 2009, by Physicians Formula, Inc., in favor
      of Mill Road Capital, L.P. (incorporated by reference to Exhibit 10.2 to
      the registrant's Current Report on Form 8-K filed on September 11,
      2009).10.4
            
            Security
      Agreement, dated as of September 4, 2009, by Physicians Formula, Inc. and
      the subsidiaries of Physicians Formula, Inc. party thereto, in favor of
      Mill Road Capital, L.P. (incorporated by reference to Exhibit 10.3 to the
      registrant's Current Report on Form 8-K filed on September 11,
      2009).10.5
            
            Pledge
      Agreement, dated as of September 4, 2009, by Physicians Formula Holdings,
      Inc., in favor of Mill Road Capital, L.P. (incorporated by reference
      to Exhibit 10.4 to the registrant's Current Report on Form 8-K filed
      on September 11, 2009).10.6
            
            Intercreditor
      and Subordination Agreement, dated as of September 4, 2009, by and among
      Mill Road Capital, L.P., Physicians Formula, Inc., Physicians Formula
      Holdings, Inc., the subsidiaries of Physicians Formula, Inc. party thereto
      and Union Bank, N.A., as administrative agent (incorporated by reference
      to Exhibit 10.5 to the registrant's Current Report on Form 8-K filed on
      September 11, 2009).10.7
            
            Sixth
      Amendment to Credit Agreement, dated as of September 4, 2009, by and among
      Physicians Formula, Inc., the several banks and other lenders from time to
      time parties to the Credit Agreement and Union Bank, N.A., as
      administrative agent (incorporated by reference to Exhibit 10.6 to the
      registrant's Current Report on Form 8-K filed on September 11,
      2009).10.8
            
            Pledgor
      Guarantee, dated as of September 4, 2009, by Physicians Formula Holdings,
      Inc. in favor of Mill Road Capital, L.P. (incorporated by reference to
      Exhibit 10.7 to the registrant's Current Report on Form 8-K filed on
      September 11, 2009).10.9
            
            Subsidiary
      Guarantee, dated as of September 4, 2009, by the subsidiaries of
      Physicians Formula, Inc. party thereto, in favor of Mill Road Capital,
      L.P. (incorporated by reference to Exhibit 10.8 to the registrant's
      Current Report on Form 8-K filed on September 11,
2009).10.10
            
            Credit
      and Security Agreement, dated as of November 6, 2009, Physicians Formula,
      Inc. and Wells Fargo Bank, National Association, acting through its Wells
      Fargo Business Credit operating division.10.11
            
            Revolving
      Note, dated as of November 6, 2009, by Physicians Formula, Inc., in favor
      of Wells Fargo Bank, National Association, acting through its Wells Fargo
      Business Credit operating division.10.12
            
            Continuing
      Guaranty, dated as of November 6, 2009, by Physicians Formula Holdings,
      Inc. to Wells Fargo Bank, National Association.10.13
            
            Continuing
      Guaranty, dated as of November 6, 2009, by Physicians Formula Cosmetics,
      Inc. to Wells Fargo Bank, National Association.10.14
            
            Continuing
      Guaranty, dated as of November 6, 2009, by Physicians Formula DRTV, LLC to
      Wells Fargo Bank, National Association.10.15
            
            Security
      Agreement, dated as of November 6, 2009, between Physicians Formula
      Holdings, Inc. and Wells Fargo Bank, National
  Association.10.16
            
            Security
      Agreement, dated as of November 6, 2009, between Physicians Formula
      Cosmetics, Inc. and Wells Fargo Bank, National
  Association.10.17
            
            Security
      Agreement, dated as of November 6, 2009, between Physicians Formula DRTV,
      LLC and Wells Fargo Bank, National Association.10.18
            
            General
      Security Agreement, dated as of November 6, 2009, by Physicians Formula,
      Inc. to and in favor of Wells Fargo Bank, National Association, acting
      through its Wells Fargo Business Credit operating
  division.10.19
            
            Senior
      Subordinated Note Purchase and Security Agreement, dated as of November 6,
      2009, among Physicians Formula, Inc., as the borrower, the guarantors
      party thereto and Mill Road Capital, L.P.10.20
            
            Senior
      Subordinated Note, dated as of November 6, 2009, by Physicians Formula,
      Inc., in favor of Mill Road Capital, L.P.10.21
            
            Guarantor
      Security Agreement, dated as of November 6, 2009, by and among Physicians
      Formula Holdings, Inc., Physicians Formula Cosmetics, Inc., Physicians
      Formula DTRV, LLC and Mill Road Capital, L.P.10.22
            
            Intercreditor
      Agreement, dated as of November 6, 2009, by and among Wells Fargo Bank,
      National Association, acting through its Wells Fargo Business Credit
      operating division, Mill Road Capital, L.P. Physicians Formula, Inc. and
      the guarantors party thereto.31.1
            
            Certification
      by Ingrid Jackel, Chief Executive Officer.31.2
            
            Certification
      by Jeff Berry, Interim 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.




-23-


SIGNATURES





Pursuant
to the requirements of the Securities Exchange Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





Physicians
      Formula Holdings, Inc./s/
      Ingrid JackelDate: November
      9, 2009
            
            By:
      Ingrid JackelIts:   Chief Executive
      Officer
              (principal executive officer)/s/
      Jeff BerryDate: November
      9, 2009
            
            By:
      Jeff BerryIts:   Interim Chief Financial
      Officer
              (principal financial officer)








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