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Elizabeth Arden Shares Smell Sweet

By Howard Choe Will Britney Spears and Jeff Gordon each have a banner year in 2005? Maybe not on the record charts or at the stock car oval, but Elizabeth Arden (RDEN

; recent price, $25) is counting on them to help deliver results at the fragrance counter.

While the company's newest celebrity-themed fragrances may lack the old-time glamour of its department-store mainstays -- Elizabeth Taylor and Elizabeth Arden -- Standard & Poor's thinks its future growth is likely to come from consumers' channel shift to mass retail, along with new fragrances, acquisitions, and growing distribution.

SCENTS ARE BIG CONTRIBUTORS. We consider Arden a growth stock in a mature industry that investors can purchase at a reasonable price. The company's strong execution, coupled with improving stature in the fragrance and cosmetics industries, will help manufacturers and celebrities look to Arden as an attractive partner, we believe. Its executive team is adept at managing growth profitably and building shareholder value, in our view. The stock carries S&P's highest investment recommendation of 5 STARS, or strong buy.

Arden is a global business with an extensive portfolio of prestige fragrance, skin care, and cosmetics brands. The outfit sells its beauty products in more than 65,000 separate retail locations in the U.S. (67% of sales) and internationally (90 countries), including department stores, mass retailers, and international retailers.

Net sales of fragrance and ancillary products were $623 million in fiscal 2004 ended June, about 76% of the total. Skin care and cosmetics accounted for 15% and 9% of net sales, respectively, in fiscal 2004.

YOUNGER CELEBRITIES Arden owns and licenses about 50 fragrance brands and distributes more than 250 scents under brands manufactured by others, mainly to mass retailers. Over the years, the business has developed or acquired an extensive list of popular fragrance brands such as Elizabeth Taylor's White Diamonds, Elizabeth Arden, Geoffrey Beene, and Halston.

Indeed, Arden had 18 of the 25 top-selling prestige fragrances in the U.S. mass retail channel in 2003, according to the NPD Group and company sources. Elizabeth Taylor's White Diamonds fragrance was the No. 1 selling box set during the holidays for the sixth year in a row.

And Arden appears to be getting some juice from celebrities of a more recent vintage. We think the Britney Spears' Curious fragrance, introduced in the September, 2004, quarter, has been a great success. As a result, the fragrance's distribution has been extended to international markets, with plans to launch a second Britney Spears fragrance this fall.

DIVERGENT GROWTH. The popularity of fragrances such as Curious is advantageous for Arden, given that it's a licensed brand. Owned or licensed brands generate higher profit margins than distributed brands. We believe Arden will enhance the Halston brand. The company recently signed top stock car driver Jeff Gordon to endorse the Halston Z-14 fragrance for men in an effort to appeal to the swelling NASCAR fan base.

In our view, Arden is benefiting from the consumer shift to mass-retail channels, which has affected most product categories, including fragrances and cosmetics. With 51% of the company's sales generated at mass retailers, this channel shift has helped Arden increase sales at a compounded annual growth rate (CAGR) of 31% over the past decade.

With respect to scents, which account for over 75% of Arden's sales, the channel shift has caused divergent growth in sales of prestige fragrances, which have been flat or declining at traditional department-store locations but increasing at double-digit rates in the mass-retail channel in recent years.

MASS APPEAL. Given its strong mass-channel presence with large retail customers such as Wal-Mart (WMT) and Target (TGT), we believe fragrance manufacturers also look to Arden as a leading distributor for their brands. We believe fragrance growth will remain strongest in the mass-retail channel, and the company will continue to benefit from this trend.

Arden has said its business strategy is to enhance brand performance, expand the prestige fragrance category with its retail partners, improve profitability and working capital efficiencies, expand selection of distributed fragrance brands, and acquire control of additional prestige names.

We believe the company will continue to deliver strong results for at least the next several years. It appears well positioned in the growing mass-retail channel for fragrance and cosmetic sales and well disciplined operationally and financially to increase profits.

PROVOCATIVE WOMAN. With our projection of nearly 9% average growth in sales and 28% in earnings over the next two fiscal years, we view the stock as undervalued. On a relative price-to-earnings and p-e to growth basis, the shares trade at a meaningful discount to the company's peers. Should Arden reach our $31 target price over the next 12 months, shareholders would experience over 20% appreciation from current levels.

We project that revenues will increase 9% in fiscal 2005, driven by new fragrances and an exclusive skin-care line for Wal-Mart, called skinsimple. In addition to the Britney Spears and Halston/Jeff Gordon fragrances, the company is launching a new brand, Provocative Woman.

We expect Arden to experience some distribution gains, but sales growth should be broad-based across distribution channels. We see operating income increasing 18% in fiscal 2005, with expectations for significantly wider gross margins than in the prior year and a marketing spending boost to support new products.

IMPROVING EARNINGS QUALITY? We think Arden could realize cost savings from plant consolidation and improved distribution capabilities. We expect operating margins of about 8.9% for the current fiscal year, modestly higher than in fiscal 2004. After expected lower interest expense and a higher effective tax rate, we project fiscal 2005 earnings per share to increase to $1.29, up 36% from 95 cents in fiscal 2004.

Due to a large impact from stock options, we view the quality of Arden's earnings as below average. However, with lower option expenses in the first half of fiscal 2005, we think indications point to improved earnings quality.

In the third quarter of 2004, Arden changed its fiscal year-end to June, from January. In its previous recorded fiscal 2004, Arden's variance to operating earnings came from stock options.

ATTRACTIVE SHARES. After adjustments made to earnings from continuing operations (on a generally accepted accounting principles, or GAAP, basis) and before extraordinary items to conform to S&P's Core Earnings methodology, we believe the company's fiscal 2004 net income per share of 97 cents would be reduced by 22%, to 76 cents. This doesn't compare favorably to the 16% negative variance of the S&P 500 companies recorded in 2003.

For fiscal 2005, we are projecting S&P Core Earnings of $1.20, only a 7% reduction from our operating EPS estimate of $1.29. The reduction for option expense accounts for 100% of the difference, as Arden does not have a pension plan. Given that the level of stock-option expense has declined significantly in the first half of fiscal 2005, we are projecting at this rate for the full year.

We view the shares as attractive at a recent level of 17 times our calendar 2005 EPS estimate, a 17% discount to our personal-care universe and an 11% discount to its small-cap peers. On a current and forward p-e to growth (PEG) basis, Arden trades at a multiple of 0.6 times current and 0.9 times forward earnings, compared to respective multiples of 1.4 and 1.3 for its peers.

POTENTIAL RISKS. Our 12-month target price of $31 is 18.5 times our calendar 2006 EPS estimate. Arden's peers currently trade at a p-e of 18, and we believe the stock should trade at about this level 12 months from now. A $31 intrinsic value derived from our

discounted cash-flow model provides further support to our target.

Risks to our recommendation and target price include low consumer acceptance of new products, increased competition in the mass channel, and negative geopolitical events that could affect consumer spending and travel-related purchases. Analyst Choe follows shares of consumer products companies for Standard & Poor's Equity Research Services

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