Description

This is a straightforwad idea! Del Laboratories is a successful producer and marketer of cosmetics and OTC pharmaceuticals. Partially because the company principally sells to mass marketers, which are gaining market share vs. department stores, Del’s revenues grew by 15% last year – and management has stated that “despite the continued challenging economic environment …..we believe that the strength of our brands will continue to enable us to maintain our positive momentum in 2003”. Yet, the company’s shares are selling at only 8.4X estimated current year EPS of $2.30 (in 2002 recurring EPS were $1.99). Good quality cosmetics and pharmaceutical companies have typically been selling at 15-20X earnings. If Del sells at 17X earnings, its shares would currently be worth $39.
In our opinion, there are three key reasons why Del Lab’s shares are deeply undervalued: (1) they are not closely followed by any brokerage analyst; (2) the two largest shareholders have been selling some of their shares (this is discussed below); (3) the company’s earnings were weak in the 1998-2001 period because the company altered its product line in order to provide for stronger growth and earnings in future years.
Del Labs was founded in 1961 by Martin Revson, a member of the family that founded Revlon. Martin Revson (now 91 years of age) remains a director and owns 1.15 million shares (or 13.2% of the outstanding shares). For the past twelve years, Del’s Chairman and CEO has been Mr. Dan Wassong (age 71), who currently owns 2.60 million shares (or 29.9% of the outstanding shares).
In 2002, cosmetics accounted for about $295, or 84% of Del’s $350 million of revenues. The Sally Hanson line of nail care products (nail polish, polish remover, and various treatment products such as nail strengtheners and cuticle care implements) is the backbone of Del’s cosmetics business. Sally Hanson focuses its marketing on the mass merchandisers. WalMart and Target are key customers (note – WalMart accounts for roughly 23% of Del’s total revenues). Because Sally Hanson has been gaining market share and has been introducing new products (including foot and hand moisturizers), the brand’s sales have been growing rapidly. According to Del’s Q3 10Q, Neilsen reports that Sally Hanson is the brand leader in the “nail category” with a strong 26% market share.
Del’s less important cosmetics brands include CornSilk (face make-ups), La Cross (beauty implements), Naturistics (color cosmetics) and N.Y.C. New York Color (color cosmetics). In late 1998, management decided to de-emphasize and repackage Naturistics, which was not doing well. At that time, the decision was made to launch a new brand of color cosmetics, which was called N.Y.C. New York Color. Del allowed retailers to return unsold Naturistics products. The costs of the returns, inventory write-downs, repacking, and introducing the new N.Y.C. New York Color brand depressed Del’s earnings from late-1998 through most of 2001. EPS fell from $1.56 in 1997 to $1.34 in 1998, and to a loss (as a result of write-downs) of $.48 in 1999. Earnings started to recover in 2000 – and reached $1.99 per share last year (Del reported EPS of $2.16, but this included a $.17 gain from the sale of excess real estate).
In 2002, Del’s other business, OTC pharmaceuticals, accounted for about $55 million, or 16%, of Del’s total revenues. The company’s key pharmaceutical product line is Orajel, which has a 27% share (up from a recent 21%) of the oral analgesic market. Over the years, the Orajel brand has grown at a moderate pace and has been quite profitable (exact numbers are not disclosed). In total, Del’s pharm business has been growing at a 7-10% annual rate and has experienced average annual operating profit margins of about 17%.
As noted above, Del’s two major shareholders frequently have sold small quantities of shares. I have been told that the sales have either been to pay taxes on exercised options and, more often, to provide needed income in lieu of income form cash dividends. Instead of paying cash dividends, Del has been paying a 5% stock dividend annually. The two major shareholders have been selling part of their stock dividends. I note that both major shareholders currently own more shares than they did five years ago. In December, Mr. Wassong owned 2.60 million shares vs. 2.24 million in April 1997 and Mr. Revson owned 1.15 million vs. .94 million.
In 2002, Del’s revenues grew by 15%. Looking ahead, we believe that revenues can continue to grow at a 10+% rate as the company continues to gain market share and extend its product lines into new areas (such as moisturizing creams). Profits should grow faster than revenues because of leverage on fixed costs and because the company will materially reduce manufacturing costs once a new plant in North Carolina replaces an older plant on Long Island. Our best guesstimate is that Del’s EPS will grow at a 15% annual rate.
As an aside, a former cosmetics industry executive who knows Del told us that, in his opinion, the company’s cosmetics business is worth 1-1.5X revenues and its pharmaceutical business is worth at least 2-2.5X revenues. If this person is correct, Del’s shares today would be worth $38-56 (net of debt and based on 2002’s revenues). I note that the Wall Street Journal recently reported that P&G has been in talks to purchase Wella (a “hair-care” company) for 1.5+X revenues.
The writer of this recommendation owns shares in Del Laboratories. The opinions expressed in this report reflect the author’s current views, which may change in the future. The author has no obligation to update this recommendation should his opinions or views change – and, at any time, the author may decide to buy or sell shares in Del Laboratories for any reason, including: price, fundamentals, personal needs, or personal desires. (note: I have included this disclaimer on advice of counsel.)

Catalyst

Del is a relatively unknown company whose shares are mispriced. Our experience is that mispricings eventually are corrected becasue investors eventually discover a company's earnings, growth, and strenghts.