Description

We’re short shares of Revlon (REV).

Historically, the Revlon bull case has revolved around:

1.  A sale of the company given Ron Perelman’s 78% stake

2. Something akin to if I buy a 1,200 square foot condo in Pittsburgh, and it rerates to Manhattan prices, the stock trades much higher

We think the recent acquisition of Elizabeth Arden kills both theses and leaves Revlon as a random hodge-podge of subpar assets thrown together by at least three different management teams in leveraged transactions over the past five years.  The Arden transaction takes a sale off the table for the time being, and indicates a lack of interest in Revlon from strategic and financial sponsors, while the low quality Arden business means the company won’t re-rate to “peers” like Estee Lauder and L’Oreal.

Revlon reports under three divisions – Consumer, Professional, Other - the latter two of which are made up of companies acquired since the middle of 2013.

The Consumer division consists of the company’s legacy business of color cosmetics, hair color, hair care and men’s grooming and anti-perspirant deodorants.

The Professional division houses the 2013 acquisition of The Colomer Group, and markets products to hair and nail salons as well as professional salon distributors.

The Other division is made up of fragrance and beauty products acquired in the 2015 purchase of CBBeauty.

We’re just past the midway point of 2016 and it has been an active one for Revlon.  After years of rumors that Revlon would be sold, the company announced that it would consider strategic alternatives in late January sending the stock higher.   A month later, CEO Lorenzo Delpani resigned further fueling M+A speculation.  Delpani was CEO of The Colomer Group at the time of the Revlon acquisition, and was supposed to be the architect of a long-awaited turnaround at Revlon.  While you might not want to invite him to a dinner party of your most diverse set of friends, (lawsuit: http://jezebel.com/lawsuit-claims-revlons-ceo-is-racist-as-hell-1677071783) he had an impressive background and investors rightfully had high hopes for his tenure at Revlon. 

In late March, Revlon announced the hiring of Colgate-Palmolive executive Fabian Garcia as its new CEO ending hopes of an immediate Revlon sale.

On June 16, Revlon announced an all-cash offer for - the struggling and levered - Elizabeth Arden (RDEN) of $14 / share in an $870 enterprise value deal.

It’s hard to imagine that when Revlon announced strategic alternatives plan 1A was to further lever-up to purchase Elizabeth Arden.  Arden’s sales, much like its stock price, have been in freefall since 2013 as its celebrity fragrance business collapsed and the company hemorrhaged cash the past two years.  Fragrances make up 75% of Arden’s business and the company rode a wave of successful celebrity perfumes like Justin Bieber’s “girlfriend” in the early part of the decade.  The celebrity perfume fad peaked in 2013 and it has been a rough ride down for shareholders ever since.  Arden management claims to be at an inflection point in the business but accepted an all cash deal.

Our best guess is no strategic wanted the low quality collection of Revlon assets, and the company was already too leveraged for financial buyers to show an interest.  The company pivoted, hired a new CEO, and further levered-up to buy a low quality, levered business.

There’s been a revolving door at the CEO position during Perelman’s 30 years of ownership.  New CEO Fabian Garcia, a 13 year Colgate veteran, appears well-respected and a decent fit for the job, but the same and more was said about their previous CEO Lorenzo Delpani.  Delpani was CEO of The Colomer Group which Revlon acquired for $664.5 million in cash in 2013 - he was the first product and marketing focused CEO in over a decade, following a string of finance-types in the CEO role.  At private equity owned The Colomer Group, Delpani led a successful turnaround, divested lower quality brands and cut costs.  When Revlon acquired Colomer, they were not only getting a business they previously owned, but a successful CEO with a perfect ten of a background.  It shouldn’t come as a shock that there might not be a ton of fat to cut and additional revenue opportunities available when purchasing a business after 13 years of PE ownership – but Delpani’s flame-out, lawsuits and resignation were disappointing for shareholders.  Today we’re in a similar situation – a new CEO with a slightly less relevant background (past experience in the industry, but most recently in pet food, at a well-run Fortune 500 company) looking to lead an operating turnaround at Revlon. 

The $870 million Arden transaction combines two of the last independent publicly traded cosmetic brands.  The rationale for transaction mostly centers around cost cutting via duplicate operations, distribution networks and purchasing power.  Much like your last single friend, the last independent cosmetic brand might not be the pick of the litter, and that’s certainly the case with Arden.  RDEN lost nearly $400 million over the last two years and was underinvesting in the business, so in theory there should be some benefit to the financial strength of Revlon.  Arden’s business is primarily fragrances and perfumes, with smaller skincare and make-up units. 

Both brands have seen better days – but you might not know that from looking through the acquisition slide deck.  Slide 17 – “Revlon’s Strong Financial Trajectory” shows a 2012-2016 sales CAGR of 10.1% and an EBITDA CAGR of 8.3%.  These numbers might mean something if the growth was organic, but Revlon has been on a debt fueled acquisition binge.  In the 2012-2016 timeframe Revlon made a small acquisition of Pure Ice in 2012 (later written down), a “transformative” acquisition of Colomer for $664.5 million in 2013 (CEO since left company), bought CBBeauty for $48.6 million, as well as 2 small acquisitions in 2015, and an additional $30 million acquisition in 2016.  Netting out currency headwinds which have negatively impacted revenue, and estimating M&A benefits and increased promotional spend, it appears the top-line has barely grown despite a decent economy and increased scale through acquisitions.

The smoke and mirrors didn’t stop there as management expects Net Debt / Adjusted EBITDA of 4.2x by year end 2016 - assuming full achievement of $140 million in multi-year synergies and cost reductions.  Given that the deal is likely to close late in 2016, and the cost synergies are middle-loaded in a 3-5 year plan, they are essentially just adding $140 million to EBITDA or providing a 2019 EBITDA number.  Also there has been no comment on the upfront costs to achieve the later year cost and synergy targets.

Pro-forma, the company will have sales of $3 billion and EBITDA of $420 million plus $140 million of synergies down the road.  Revenue will be 49% Revlon consumer, 17% Elizabeth Arden brand, 17% Revlon professional and 21% fragrances.  Brands will include both namesakes, Almay, Mitchum, American Crew, Juicy Couture, John Varatos, and Britney Spears amongst others.  Sales will be 57% North America, and 43% International – Arden has a presence in China, and Revlon will attempt to re-enter the market following its 2013 exit due to years of losses.

We think the integration of Arden is going to be more challenging than the market is anticipating, and think investors are underestimating the challenges and strategic issues involved with merging two companies in turnaround mode under a CEO who has been on the job for only a few months.  The combined company seems to be aware of this and instead of giving a Presidential “you’re fired” to RDEN’s CEO who has overseen the destruction of the business / stock price in the last two years, they are keeping him on as an advisor and making him Vice Chairman of the Board.

            Analysts on the call were asking questions that implied they thought all of Arden’s SG&A could be eliminated, but the lack of overlap in the businesses mean that RDEN needs to maintain a salesforce for the prestige products channel as well as management to oversee the continued transition; brand marketing expenses for the prestige channel will also remain.

            The combined company will still lack scale as it is a diverse group of businesses that now combines prestige brands with mass market brands, consumer products with professional products, a broad range of price points and distribution through 130+ countries globally through a plethora of channels.  Arden’s strengths in prestige distribution and travel retail have little overlap with Revlon’s strengths in the mass market and professional channel. 

The cost cutting here seems achievable but there doesn’t seem to be much other strategic benefit.  Pro-forma, 36% of sales are to common customers – about half of that will be to Walmart.  It’s unlikely the REV-RDEN marriage will enable the company to head down to Bentonville, Arkansas and push better terms, the same goes for other mass merchants like Target and CVS.  Of the 64% of non-common customers, much of that can be attributed to different channels and we think management’s guidance for no revenue synergies is likely to be more accurate than conservative.

            Revlon’s strategy has been to focus on fewer, bigger and better innovations but now with the acquisition of RDEN they will fund new products that RDEN didn’t have enough cash to fund.  The fewer, bigger and better strategy adds a hits driven element to a levered balance sheet.

Valuation and Price Target

The stock trades at a ~$1.8 billion market cap, debt will be $2.65 billion post acquisition.  The company has $186 million in cash, most of which should be eaten up in closing costs, debt issuance costs, and cash costs to achieve the $140 million in integration synergies.  There is also a $175 million pension plan deficit.

Guidance for the year is $420 million before cost synergies; $560 after synergies but that won’t be achieved until probably sometime in 2019.  The company will exit the year levered close to 6x.  Revlon was trading around 9x EBITDA before the Arden acquisition which arguably had some M+A juice in the multiple.  After the Arden acquisition this is a lower quality business with more leverage and is less likely to be acquired.  At 8x (for a no to low-growth, non-cyclical company levered 5x+) what is likely a 2019 EBITDA number the stock looks pretty fairly valued here on an undiscounted basis.  It’s worth noting that the Adjusted EBITDA figures have $20-30 million in annual severance and restructuring costs – it seems likely these will persist from now until eternity, and this will be a Kodak-like situation in its consistency of 1x restructuring costs. 

We think the recently appointed, first-time CEO, has been dropped into a difficult situation, and there will be hiccups integrating the merger of a troubled company with Revlon’s own turnaround far from complete.  Revlon is getting buzz as a platform company, but it is standing on the weak legs of multiple transactions completed by multiple management teams with little strategic overlap.  We think the strategic alternatives process wrapping up with the all-cash purchase of a company in the midst of a turnaround is a red flag, and that it will be tougher to massage revenue numbers with tuck-in M+A at the new $3 billion run-rate revenue figure.

Risks

Leverage cuts both ways, so does a low float

After a series of new CEO’s Fabian Garcia might be the right hire at the right time

Catalyst

Integration issues with Arden, poor Arden results, lack of strategic rationale for transaction

Slow revenue growth for legacy Revlon

Market realization of business quality

Rising interest rates