Description

Revlon’s stock price has dropped from $34.05 just before its last earnings report on March 3rd, 2017, to $25.70 today, April 24th, 2017. That Q4 2016 report revealed an accelerated rate of decline for Revlon’s North American consumer sales, which account for 31% of total sales ($882M pro-forma 2016 sales out of $2,859M total).  Despite the very weak result from that segment, growth in international sales and their professional segment led to a 2016 annual report of total pro-forma net sales of -0.6%, and +1.4% on a constant currency (XFX) basis.   We believe that the market is overreacting to what should prove to be surmountable domestic headwinds, while ignoring impressive international sales growth, and that Revlon continues to trade at an unwarranted discount to its peers.  It also remains an obvious takeover candidate that would likely yield a significant valuation premium in the event its controlling shareholder, Ron Perelman, elected to sell the company.  We suspect that he may have tried to do just that when his holding company, MacAndrews & Forbes, announced it was exploring “strategic alternatives” for its 77% stake in Revlon in a press release on January 16, 2016.  That he perhaps failed to find a buyer willing to pay his price at that time doesn’t mean that he won’t eventually be successful in that effort, so we speculate that after owning Revlon since 1985, Perelman, now 74, might be edging closer to selling.

Our minimum fair value estimate for Revlon of $65 is based on an EV/EBITDA multiple of 13.5x estimated 2017 adjusted EBITDA of $450M which is EV of $6.08B, minus $2.47B net debt, minus $184M pension deficit, equals $3.42B equity value, divided by 52.6M shares outstanding equals $65 per share, and a market cap/FCF multiple of 23x estimated $150M in normalized (ex-restructuring charges) free cash flow for 2017.  13.5x EBITDA is the multiple Coty (COTY $17.83) paid for its $12.5B purchase of Procter & Gamble’s beauty brands (including Cover Girl) in October 2016, and Coty itself, at nearly a 52-week low now, is still trading at 13.3x EBITDA based on calendar 2017 consensus estimate of $1.42B, despite performing much more poorly than Revlon in their U.S. mass market business during 2016.

Revlon is a global (42% of sales from outside North America) purveyor of cosmetics to the mass market (Wal-Mart, drug stores like Rite Aid, Walgreens Boots, etc.) with significant market shares in key product categories of color cosmetics (#1 market share in lipstick, foundation, eye liner, and lip liner), nail polish, hair color, and beauty tools.  The company entered the prestige market with its recent acquisition of Elizabeth Arden (RDEN), for which it paid about $900M upon closing on 9/08/16, funded entirely by debt.  Due to Elizabeth Arden’s subpar profitability, Revlon was able to acquire it at a bargain valuation of just under 1x sales (RDEN did $966M revenue in 2016), whereas most cosmetics firm takeovers happen at 2.5x sales.  Revlon expects to achieve huge cost savings in the merger, and recently increased their initial target of $140M in annual cost synergies to $190M, to be realized in 3 to 4 years, at an incremental cost of $250M in cumulative restructuring costs, integration costs, and integration-related cap-ex, also spread out over 3 to 4 years.  That would imply Revlon is paying only 4.9x EBITDA post synergies for RDEN ($900M initial cost, plus $250M in costs to achieve synergies = $1,150M total cost, / $235M in 2020 EBITDA ($45M in 2016 + $190M in annual synergies).   For example, moving RDEN’s outsourced manufacturing into Revlon’s under-utilized (one million sq. ft.) factory in Oxford, North Carolina will account for a significant part of the cost savings.

Revlon’s business is highly recession-resistant, with historically resilient EBITDA and FCF to support its highly leveraged balance sheet (net debt = 5.5x our $450M estimate for adj. EBITDA in 2017, and 6x 2016’s pro-forma adjusted EBITDA of $409.4M), a leverage ratio we expect to drop as the company  pays down debt from free cash flow.

Revlon is an iconic brand with decades of resonance across multiple generations of consumers.  The addition of Elizabeth Arden, a 107-year old brand rebounding now (2016 RDEN pro-forma sales +0.4%, +1.8% XFX) after a fall from grace, opens up new channels for growth, particularly in Asian markets where RDEN is growing fast.  The concept of merging mass market brands with prestige brands under one roof has been achieved successfully by Revlon's peers (L'Oreal bought Maybelline for 14.7x EBITDA in 1996; Coty also has both prestige and mass market brands) so Revlon is not pioneering an unproven strategy in that regard.

New Revlon CEO Fabian Garcia took the helm in April 2016 with extensive cosmetics experience at Procter & Gamble, Chanel, and more recently was COO and in charge of Global Innovation at Colgate-Palmolive.  He appears to be the most qualified CEO to run Revlon in the past nearly 32 years since Perelman took control.  Garcia recently stated a goal of $5B in sales in 5 years (from $2.86B  pro-forma sales in 2016), implying an ambitious 12% CAGR versus the 5% long-term industry average, a goal that we think will require further successful M&A activity to achieve. https://www.bloomberg.com/news/articles/2017-01-17/revlon-sees-long-term-growth-with-revitalized-brands-marketing.   

That goal seems even more bold in light of the recent category headwinds afflicting large mass market cosmetic players in the U.S.  such as Coty and Revlon, as well as the shrinking department store sales base weighing on a large chunk of Elizabeth Arden’s prestige business.  Those two components of weakness combined caused 51% of Revlon’s total sales in 2016 to decline (Revlon’s N.A. consumer sales at 31% ($882M) pro-forma 2016 sales out of $2,859M, and Elizabeth Arden’s N.A. sales at 20% ($573M) pro-forma 2016 sales out of $2,859M, while the other 49% of total sales (Revlon’s international sales (consumer + professional) at $805M (28% of total sales), Elizabeth Arden’s international sales at $393M (14%), and Revlon’s North American professional / salon (hair care and nail polish) at $205M (7%),  grew fast enough in 2016 to offset the declining segments (on an XFX basis).   Even if these trends remain unchanged for some time, it appears that the company can still achieve some degree of organic growth, particularly if recently increased marketing spend and innovative new product launches underway prove effective.  And with the USD finally weakening a bit in Q1 2017, the international business should get an added boost from that, so that more of their strong foreign sales growth benefits the company on an actual basis, not just when viewed XFX.

The explanation for the adverse trend in Revlon’s North American consumer mass market business is primarily that for the past few years, there has been a shift in sales in the U.S. cosmetics industry away from the mass market channels (drug stores, WalMart, Target, etc.) to specialty stores (Ulta and Sephora) and with that shift, a trend towards premiumization, meaning consumers are paying up for prestige products such as Urban Decay (owned by L’Oreal), MAC (owned by Estee Lauder), and Benefit Cosmetics (owned by LVMH), while leaving behind cheaper mass market brands like Revlon, Coty (Rimmel and Cover Girl), and Maybelline.  So instead of paying $5.00 for Revlon lipstick (where Revlon maintains a #1 market share), many defecting customers are paying $20 for Urban Decay lipstick and comparable prestige brands at Sephora and Ulta.  We think Revlon’s answer to this challenge, at least in part, is to bring more feature rich (lipstick infused with natural oils, etc.) product line extensions into those growing channels such as Ulta at higher price points, which Revlon appears to be doing, in a sense meeting the customer half way with a $10 lipstick in Ulta competing against $20 lipsticks, but $10 is significantly more than their base $5 lipsticks sold in the drugstore chains.  The answer also lies in further innovation (like the company did with Shellac nail polish, a category killer when it came out in 2010), as well as more recent innovations in product features and form factors, albeit less impactful so far.  However, they need to accelerate their time to market for new launches, and the new CEO, Fabian Garcia, has a good track record with innovation as his previous job was COO: Global Innovation & Growth, at Colgate-Palmolive, a position to which he ascended after running their Asia business since 2003, and Latin America since 2007.  He also ran Chanel’s Asia Pacific business from 1996 to 2001, so we think they’ll do better in that regard (innovation) starting now.  

In addition, the online sales channel is taking share away from the traditional mass market outlets and Revlon has yet to perfect their online strategy, although the newly acquired Elizabeth Arden has done much better in online penetration and Revlon hopes to adopt some of their best practices in that critical area.    

The shift away from the mass market channel accelerated throughout 2016, with Revlon’s North American consumer sales -0.5% in Q1 2016, -1.3% in Q2 2016, -5.3% in Q3 2016, and -9.0% in Q4 2016 (again, not only a Revlon issue, as Coty did much worse in the N.A. mass market channel last year) and seems to be continuing in Q1 2017, albeit at a moderating rate  which looks like -6% in Q1 2017 judging from the Nielsen’s trailing 12 week data as of 03/25/17.

Some of the sales decline in Revlon’s N.A. consumer segment are also due to competition within the mass market channel, such as the recently IPO’d e.l.f. (ELF $27.44), which has been taking share in the mass channel by accepting a lower gross margin using manufacturing outsourced to China and undercutting on price, and using a highly effective internet / social media advertising strategy to gain awareness and shelf space. 

And yet according to IRI, Revlon still occupies the top spots in foundation, lipstick, lip liner and eyeliner.  And although barriers to entry have fallen and a proliferation of new niche competitors has eaten away at the bigger players in the mass channel (Maybelline, Revlon, Cover Girl primarily), it remains to be seen which of these new brands will have staying power.  For example,  The Body Shop was once the hot up-and-comer from 1990 to 2001, before stagnating in the early 2000s, and now L’Oreal is trying to sell it after buying it in 2006 at 12x EBITDA.  Or Richard Branson’s Virgin Cosmetics line, which only lasted from 1997 to 2009.  It should also be noted that the prestige brands don’t do so well during recessions, while the mass market brands usually show impressive resilience.  So while Estee Lauder (EL) saw a 7.3% decline in sales in 2009 during the Great Recession, Revlon saw a 3.8% decline (all due to currency), with EBITDA and FCF actually increasing in that year.  Thus the trend toward premiumization as traditional mass market buyers shift their spending upmarket might reverse if we ever encounter another recession, as the value proposition of the traditional mass market brands might see renewed appeal amidst a likely shakeout amongst the recent flood of new entrants as most of these smaller brands face their first test of staying power.

But rather than waiting for a recession, Revlon should find that their plan to increase brand support and innovation will have significant positive effects on sales.  In 2014, Revlon increased brand support by 10.8% (+$38.1M) versus 2013, from 18.5% of sales in 2013 to 20.01% of sales in 2014, and that appears to have boosted N.A. consumer sales significantly in both 2014 and 2015, before the 2016 decline began.  We guesstimate (the company wouldn’t provide a specific number here when asked) that marketing spend will increase from about 20% of sales in 2015 to 22%, an increase of $57M (the large legacy players in cosmetics generally spend 20% to 30% on advertising and promotion) consuming much of the cost savings we expect them to realize in 2017 from the Elizabeth Arden acquisition.  But if history is any guide, that should give sales a noticeable boost of some multiple of the incremental dollar amount spent.

More on the Elizabeth Arden acquisition:  While two segments of Elizabeth Arden’s (RDEN) business have been in sharp decline, the rest has been growing fast enough to offset that decline.    RDEN’s 2016 pro-forma adjusted sales were up 1.8% XFX to $966M, with growth in skin care and color cosmetics offsetting a decline in celebrity fragrances, and international sales growth  (+6.6% XFX) on 41% of RDEN’s total sales offsetting North American weakness (-1.4% XFX) on 59% of RDEN’s total sales.  So, RDEN, misperceived by some as a dying dinosaur, as a whole clearly does not appear to be dying.

The part of Arden’s business that may actually be “dying” is the “young celebrities” fragrance business (Justin Bieber, Taylor Swift, and others whose fragrances exhibited fleeting popularity), which imploded over the past few years, dragging RDEN’s overall sales down 28% over the past 3 years from $1.34B in FY 06/30/2013 (adj. EBITDA $162M) to $967M in FY 06/30/2016 (adj. EBITDA $24M).  That aspect of RDEN had always been a significant risk, and was a common reason for bears to avoid investing in RDEN, as it just seemed obvious that the celebrity fragrance lines were problems waiting to happen.  But Revlon swooped in after that portion of the business had already been reduced to rubble, and it now represents only 5% of RDEN’s total sales.  RDEN has other celebrity fragrances beyond the “young” ones that had been the main problem, but those are with older celebrities like Elizabeth Taylor, Christina Aguilera and Britney Spears which seem to have a more stable sales profile due to the iconic status of the celebrity.  RDEN also has a substantial designer fragrance business, which has been growing nicely with names like John Varvatos and Juicy Couture, doing particularly well in Asia.

It’s also important to note that RDEN was not alone in terms of suffering in the fragrance business during that time frame.  For example, New York, NY-based Inter Parfums Inc. (IPAR) saw its sales drop from $654M in 2012 to $469M in 2015 (a 28% drop, same as RDEN’s), before rebounding 11% in 2016.  And IPAR at $35.45 today trades at an enterprise value of 2x sales and 12x EBITDA with a 15% EBITDA margin.   

As discussed above, Revlon paid less than 1x sales for RDEN.  Of course, not all sales are created equal.  RDEN was terribly managed prior to the acquisition with a bloated cost structure, and barely profitable, with adjusted EBITDA of only $24M in RDEN’s FY ended 06/30/16, a paltry 2.5% EBITDA margin in an industry that typically does not achieve less than a 15% EBITDA margin.  That metric implies that Revlon paid an obscene 38x EBITDA if one uses that trailing 12 month measure.  But for calendar year-end 2016, RDEN’s EBITDA was $45M, so now the EV/EBITDA multiple appears to be closer to 20x, before synergies; still too high.  But as previously mentioned, if they achieve targeted cost savings and adding one-time costs to achieve them into the purchase price, Revlon will have paid only 4.9x EBITDA post synergies for RDEN ($1,150M total cost / $235M in 2020 EBITDA ($45M in 2016 EBITDA + $190M in annual synergies)).

Looking beyond just trailing twelve months, or the immediately prospective twelve months, rather than overpaying, Revlon appears to be getting RDEN at a very low valuation that should be hugely accretive to Revlon’s intrinsic value per share.  Even if we only look at 2017, if we add Revlon’s low-end expectation for the portion of the total $190M in annual cost savings on RDEN to be realized in 2017, that is $45M, plus RDEN’s $45M in EBITDA for 2016 presumed flat in 2017, totaling $90M in EBITDA for RDEN in 2017, for which Revlon will have paid just over 10x.  As a reference point, Inter Parfums is trading at 12x EBITDA today, and Coty at $17.83 trading at 13.3x calendar 2017 EBITDA est., and Coty is currently performing more poorly than any of these businesses.  So again, rather than overpaying as a cursory look might lead one to believe, Revlon’s opportunistic buy-out of RDEN looks like an unusually accretive deal.  And Revlon was uniquely positioned to do that deal given it’s huge manufacturing facility in North Carolina has the excess capacity to bring much of RDEN’s outsourced manufacturing back to the U.S., saving a lot of EBITDA margin in the process.

The other declining segment of RDEN’s business is their North American department store sales (due to store closures by Macy’s and the like), which is the bulk of their North American sales (vs. their online sales which are growing in N.A. and spa and specialty store sales (Ulta, Sephora) also doing better), and N.A. sales are the bulk (59%) of RDEN’s total sales.  But if RDEN’s international sales (41% of total sales) keeps growing at 6.6% as in 2016, and N.A. sales keep shrinking at 1.4% as in 2016,  that’s still 1.8% annual growth rate overall, improving each year as international sales would overtake N.A. sales in 5 years if such annual rates persist.  Obviously either trend could get worse or better, but that’s the risk we take, and at a valuation of 9x normalized FCF for Revlon right now, and less than 9x EBITDA, it remains a good risk / reward ratio.

In addition, Coty has performed much worse in each of the last two quarters than Revlon.  Revlon’s Q4 2016 had sales -4.5% (-2.7% XFX), but much better than Coty (COTY) which reported a few weeks prior at -7% (-4% XFX) in the same period.  And looking at just their consumer (mass market) business, although they don’t break out N.A., overall (globally) Coty was down -11% XFX, versus -3.3% XFX for Revlon’s global consumer segment in Q4 2016.  And yet Coty at $17.83 today is at 13.3x EBITDA for CY 2017 and 20x FCF, multiples that if applied to Revlon today would put the stock at $57 to $63, more than double today’s price of $25.70.

Some history about our investment in Revlon:

We started buying Revlon at $10 in December 2010.   Today the stock is near its 52 week low of $24.70, down from an interim peak of $41.67 in April 2015.  Revlon’s stock is highly volatile, and recently moved from approximately $27 to $37 before this recent weakness.  The small float allows short term swings in sentiment to weigh on the shares more than it likely would for a more liquid stock.

In terms of sales and FCF trends, sales in 2010: $1,321M.  EBITDA in 2010: $257M.  Free cash flow: $82M.  Sales in 2016: $2,859M (pro forma).   EBITDA in 2016: $409M (pro forma, adjusted).  Free cash flow: $140M (excluding $80M non-recurring expenses related to acquisition of Elizabeth Arden and associated restructuring).

That is a total of 6 years (24 quarters) that have been reported during the course of our ownership, and sales have been down in 8 of the 24 quarters, so 35% of the time Revlon showed a decline in quarterly sales, and 65% of the time they showed increasing sales on quarterly basis. 

And while almost all of Revlon’s net growth has been through acquisitions, the two major acquisitions (Colomer Group in 2013, Elizabeth Arden in 2016) have been done at very attractive multiples (sub 9x EBITDA) and highly accretive to intrinsic value per share in our estimation, both funded entirely with debt.  There should be opportunities for further such accretive deals in the coming years as a shakeout of some magnitude is likely the reaction to this recent surge in new brands over the past few years.

Even if sales for the overall company remain relatively flat in 2017, EBITDA and FCF should grow significantly as cost savings from the Elizabeth Arden merger are only partially consumed by increased marketing spending.  And the international growth story is really overlooked here, as the opportunities for Revlon to further penetrate in Asia and Latin America in particular are significant and near term.  And while Elizabeth Arden may be considered “your grandmother’s cosmetics company,” by many in the U.S., in Asia it’s considered much differently.

Today Revlon is $25.70, near its 52-week low, representing an equity market cap. of $1.35B against $140M in TTM FCF.  A 10x FCF multiple in an industry that’s 20x to 25x.  And $25.70 is an EV of $4B, less than 10x TTM EBITDA. There is no sell-side research coverage of Revlon’s stock (although their debt is followed by a few firms), so we believe that is part of the reason for the valuation disconnect.  Another reason is that billionaire Ron Perelman owns 77.4% of the stock and has controlled Revlon since 1985.  Perelman, now 74 years old, has a history of achieving premium valuations when selling major holdings.  Unfortunately, he also has a history of abusive behavior towards minority shareholders, which is likely a lingering fear that some investors harbor, and keeps some potential investors away from the stock.  It is important to remind those investors that Perelman already attempted to effectively steal Revlon at the seemingly magnanimous offer of around $5 after the stock had crashed to $2.30 in early 2009 during the Great Recession, only to be rebuffed by a Delaware court, a court he would likely be forced to return to if he attempted force out minority shareholders at an unfairly low valuation again.  We believe it would be almost impossible for Perelman to justify the purchase of Revlon from remaining minority shareholders at anything other than the lowest end of the current comp values, which would represent a price of $57 to $63, more than a double from current price.   

Revlon was #1 in lipstick in 1957, 60 years ago, and it remains #1 in lipstick today, as well as other key product lines, despite intense competition from much larger and smaller entities for decades now.  It is the definition of a durable franchise, and its global potential for growth seems very attractive.

In summary, we see the recent stock price weakness as an over-reaction to the recent weak trends in Revlon’s N.A. consumer business, while ignoring the offsetting strength in their international sales, and the scarcity value of the last remaining major U.S player in cosmetics with global scope that has yet to be acquired by a giant.  The stock is fairly illiquid and prone to outsized volatility of this sort.  We think we’ll see double and eventually triple the current price within a reasonable investment timeframe, with or without a takeover.

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We are long REV and may buy or sell additional shares at any time. This is not a recommendation to buy or sell securities. Please conduct your own research and reach your own conclusion.

We do not hold a position with the issuer such as employment, directorship, or consultancy.

Catalyst

We see the recent stock price weakness as an over-reaction to the recent weak trends in Revlon’s N.A. consumer business, while ignoring the offsetting strength in their international sales, and the scarcity value of the last remaining major U.S player in cosmetics with global scope that has yet to be acquired by a giant.  We think we’ll see double and eventually triple the current price within a reasonable investment timeframe, with or without a takeover.