Rather than focusing on the upside, value investors are well advised to look first to the potential downside of an investment. Only upon concluding that the possibility of a permanent loss of capital is small should the focus shift. Consider Parlux Fragrances, Inc (NASDAQ:PARL), a designer, manufacturer and distributor of celebrity fragrances. PARL is a company that has been a favourite of value investors for quite some time and for good reason – it has persistently traded well below its NCAV for more than two years. The stock has had quite a run-up over the last three months, gaining 45%, but it still trades well below its NCAV. Does it still make a good investment? Let’s first look at the downside potential.
Generally, a company’s NCAV is a reasonable price for its minimum liquidation value, since it ignores intangibles that are not included in current assets, and usually the value of the Net PP&E will more than offset any losses on inventory liquidation and A/R defaults. In PARL’s case there are a few red flags. First, its A/R balance has been increasing, and it appears to be due to its largest client, Perfumania (NASDAQ:PERF). PERF’s A/R balance grew 70% this past quarter, from $10.5m to $17.7m. PERF’s own operations appear to be in jeopardy, with sales and earnings in decline along with CFO (I imagine this would be a difficult thing to do when you are barely paying suppliers!). Even worse, the company is making no allowance for credit loss from its A/R balance with PERF. Let’s assume for our worst-case scenario that PERF goes bankrupt and none of these receivables are collected upon (an unlikely scenario, given that PERF’s debt balance is relatively low and the liquidation of its assets would hopefully cover those debts with something left over for trade creditors). If that is the case, PARL’s revenues will immediately decline by approximately 25% (PERF is its largest customer) and $17.7m of its A/R would be wiped out. With PARL only marginally profitable as it is, a reduction in revenues of this level would easily lead to losses. Let’s further assume for our worst case scenario that PARL is no longer a going concern (not outside the realm of possibility). In this situation, we look to PARL’s adjusted liquidation value, and we see that the company would still have NCAV of approximately $2.69 (I also made an adjustment of a 50% loss on the inventory, which may be generous). This is essentially where the stock has been trading recently, so we see that in the absolute worst case scenario – liquidation – the company should be worth approximately what it is trading at today.
Now that we recognize there is little reason for the company’s liquidation value to decline (after all, the company is profitable and has been growing revenues this year), we can consider the company’s earnings power. Unfortunately, from a look through the company’s recent SEC filings, we see that there are several reasons for ignoring EPV simply because it is not possible to accurately assess its future earnings. First, as already mentioned, the company is highly reliant on two clients – Perfumania and Macy’s – which together account for nearly 50% of its revenues. As discussed in past posts, relying on past earnings to project future earnings in a situation where the loss of a single client would have massive effects is sheer speculative folly. Especially so in a situation where at least one of those major clients is performing poorly. Second, PARL is extremely reliant on certain brands it carries. It used to be highly reliant on the Guess and Paris Hilton fragrances, until Guess decided not to renew its contract, causing a 28% drop in revenues last year. Now, the company is reliant on its Paris Hilton branded products for 68% of its sales. Would you invest in a company that derives 2/3 of its revenues from the public’s fickle fascination with a specific celebrity?
The end result is that the company is trading at a fair price relative to its adjusted NCAV, and that any expectation of growth beyond this amounts to speculation as to the improving fortunes of PARL, PERF and Paris Hilton together. I’ll save my treble bets for the horses and wait for PARL to once again trade for a fraction of its adjusted NCAV.
Author Disclosure: No position.