Description

Company:  Revlon, Inc.

Security: $500MM of 5.75% Senior Notes due 2021

Recommendation: Long

Current Price: 78c / 7.4% CY / 15% YTW

EV (through MV of bonds): $2.7BN (assume secured debt at par and unsecured at MV)

TEV (through equity): $3.9BN

Executive Summary

I am recommending a ‘tactical’ trade in Revlon’s 5.75% Senior Notes due 2021 (‘21s) with a ~25% expected return over the next year on the thesis that the company needs to term out is debt maturity schedule and improve its liquidity profile while implementing a turnaround of its underlying operations and preserving Ron Perelman’s equity value. This is the only security in Revlon’s highly levered capital structure that I think is worth investing in as a profitable outcome for the ‘21s is not contingent on a successful turnaround of the company’s underperforming businesses.

Until 2015/16, Revlon generated solid growth and free cash flow with a stable of historically iconic brands. Operating performance has suffered in the last 1-2 years due to dynamic shift in the competitive landscape from online channel disruption and more innovative new entrants. As such, I believe there is very limited visibility into Revlon’s earnings power over the next few years and I am not recommending an investment in the equity. For more background on the company (and the bull thesis), it is worthwhile reading mimval’s post in April 2017.

Thesis

1. Liability management: in my view three things need to coalesce to have conviction that management will look to refinance the ‘21s in short order:

• Capacity / transfer of assets: similar to my experience and investment in J.Crew, I believe there is sufficient wiggle room in Revlon’s debt covenants to enable the company to raise secured debt and move assets around the corporate structure and offer the bondholders of the ‘21s an attractive collateral package to exchange into longer-dated secured paper.

• Timing: Revlon could face liquidity constraints in 2H2019/1H2020 if performance continues to decline and negative working capital trends persist; also the company needs to address the ‘21s 91 days prior to maturity or risk acceleration on their ~$1.8 billion Term Loan (due 2023) to Q4-2020.

• Incentives: at the risk of oversimplifying the game theory dynamics, with a ~$770MM equity at risk, Perelman would seem incentivized to extend the liquidity runway (i.e. move value around the corporate structure per the carveouts) in order to preserve the restructuring option.

2. Turnaround plan: Due to disappointing performance over the last few years (that continued in the most recent quarter) against a backdrop of solid growth in the global cosmetics market, the company has embarked on a turnaround strategy to strengthen the brand portfolio, expand access to brands and develop a sustainable cost structure. Progress has been slow but there are some signs of growth, particularly in the Elizabeth Arden assets that may form the basis of a secured exchange for the ‘21s.

3. Valuation – through the market value of the ‘21s, the company trades at ~1x LTM revenue and 13.2x LTM Adj. EBITDA with a YTW of +15%. This compares to 1.9x sales and 13x EBITDA for Revlon’s closest peer Coty (admittedly a better business currently with positive topline growth and higher margins).

The obvious risk with this trade is that the company pursues an alternative (and in all likelihood suboptimal) strategy to address its near term liquidity needs and the bonds remain outstanding as an unsecured claim (and potentially further subordinated behind additional secured debt).

What we know: The Basics

Brief Description

Revlon is a US-based multinational cosmetics company focused on skin care, fragrance and personal care. The company was founded 85 years ago and was acquired by Ron Perelman and his investment firm MacAndrews & Forbes (M&F) in 1985 for $2.7 billion. Perelman/M&F currently own 84.4% of the equity. In 2016, Revlon completed the acquisition of Elizabeth Arden for $870MM (0.9x revenue).

Effective January 1, 2018, the company began reporting its results under its four brand-centric operating segments:

• Revlon (41% of Q1-2018 revenue): comprised of the company’s flagship Revlon branded products that are sold mainly through the mass retail channel, large volume retailers, chain drug and food stores, department stores and specialty cosmetic/beauty retailers in the US and internationally; main brands include Revlon, ColorSilk and Professional.

• Elizabeth Arden (‘EA’, 19%): sells fragrances, skin care and color cosmetics principally to prestige retailers, department and specialty stores, boutiques and mass retail as well as through direct to consumer channels; main brands include Ceramide, Prevage, Superstart, 5th Avenue and Red Door.

• Portfolio (24%): includes skin, hair, nail and other grooming products not included in the Revlon and Elizabeth Arden segments; main brands include Almay, Vinylux, Cutex and Crème of Nature.

• Fragrances (16%): includes the development, marketing and distribution of owned and licensed fragrances; brands include Juicy Couture, John Varvatos, La Perla, Elizabeth Taylor, Christina Aguilera, Giorgio Beverly Hills and Jennifer Aniston.  

In 2017, the company generated $2.69BN in revenue, $258MM in Adj. EBITDA and ($139MM) in cash flow from operations. It is clear that besides Elizabeth Arden’s International sales, the company is experiencing significant revenue pressure.

Key Issues Impacting Revlon

In my view, two primary and interrelated industry forces have caused disruption in the cosmetics business and Revlon has failed thus far to adapt accordingly:

1) Channel disruption – not a huge surprise given the trends in the overall retail space over the last few years. By way of background, the US cosmetics market can be separated into two segments: prestige and mass market. Prestige products are characterized by higher quality/price points and account for ~40% of US cosmetic retail sales. Mass products, which generates the other ~60%, are generally more affordable than prestige but lack the quality and innovation. Most of the company’s Revlon products are considered mass while the Elizabeth Arden franchise has greater exposure to prestige customers. Until recently, prestige and mass were sold through distinct channels – department/specialty retailers (like Sephora) for prestige and drugstores/large volume merchandisers (such as Walmart, Target, Walgreens) for mass. The advent of innovative specialty retail concepts, such as Ulta Beauty, and social media platforms and have served to disrupt the historical distinction and lowered the barrier to entry for new entrants. Ulta, which offers +20,000 prestige and mass products from ~500 well-established and emerging beauty brands, has blurred the lines between the historically distinct markets and offered new brands a “level playing field” to compete on value and convenience. Revlon has thus far been underrepresented in retailers like Ulta. On the online front, social media influencers are key to brand recognition and development, especially among younger consumers, and Revlon is currently a more recognized brand in +45 year age cohort.

2) Brand fragmentation – historically, sales in the cosmetics industry have been concentrated among a few large consumer products companies such as L’Oreal, Estee Lauder, Procter & Gamble, Revlon and Shiseido. Since 2015, channel disruption has enabled smaller companies to enter the market with new brands and customized product offerings. In an interview with Women’s Wear Daily in late 2017, Revlon management acknowledged that some of its products, including Almay, “struggled to retain retail shelf space given heightened competition from newcomer brands such as Elf Cosmetics and NYX Cosmetics”.

Revlon’s performance has been disproportionately impacted by soft sales in the US (51% of the company’s revenue is generated in North America), and management has attributed the decline to “continued migration of consumers to specialty retailers, online purchasing and inventory reductions among several mass retail partners”.

Capital Structure

During Q2-2018 the company received a short-term 8% $50MM unsecured credit line from the equity sponsor, and in July Revlon secured a €77MM Euro Asset-Backed Term Loan. After giving effect of these transactions, the company’s available liquidity as of July 31 was $164MM.

Corporate Structure

Why is the situation interesting? Why are the 5.75% ‘21s mispriced?

As I mentioned, the ‘21s are “time senior” in the capital structure and the thesis is based the company’s ability to offer the ’21 bondholders an attractive collateral package in exchange for an extended maturity.

Thesis:

1)  Liability management

• Capacity: Based on my read of the covenants and carveouts in the credit facilities (Revolver and Term Loan B), particularly the incremental/general baskets and general liens, Revlon has significant capacity for additional secured debt, in the $600-700MM range. The ‘21s are the most restrictive security (less than $300MM secured debt capacity) which provides some protection for the bondholders in the event the company attempts to layer the notes. Specifically:

Revolver and Term Loan Facilities: The facilities carry essentially the same covenants and are covenant-lite (no maintenance covenants). Secured debt capacity is ~$600MM for the revolver and ~$700MM for the term loan:

Ø  Limitation on liens: substantial – access to $200MM (revolver) to $300MM (term loan) general basket not subject to total leverage test

Ø  Investment basket: significant - “unlimited” for intellectual property under both facilities; in addition, general basket of ~$495MM for the revolver and ~$695MM for the term loan

Ø  Restricted payments: “unlimited” if conditions are met (net total leverage test)

5.75% ‘21s and 6.25% ‘24s Senior Notes: The ‘24s appear to have much more secured debt capacity than the ‘21s. Secured debt capacity is ~$300MM for the ‘21s and ~$850MM for the ‘24s:

Ø  Limitation on liens: limited (based on ratio and basket) for the ‘21s, substantial for the ‘24s

Ø  Investment basket: “unlimited” for intellectual property for both notes; in addition, ~$300MM for the each if the notes and +$100MM carveout for Joint Ventures

Ø  Restricted payments: limited for ‘21s (subject to general and builder basket restrictions), more room (+$350MM) under the ‘24s

• Transfer of assets: As in J.Crew, it seems clear that the company has very few limitations in the types of assets in can move or invest in unrestricted subsidiaries. Based on my read, the company has unlimited capacity to move IP assets and provide an attractive collateral package to the ‘21s.

Actionable Transaction:

- Move IP and/or other assets to “IPCo” (incl. Elizabeth Arden international assets)

- Exchange the ‘21s into a New Note that is secured by $500-600MM of IPCo assets and matures in 2024; the new notes would have a 1st lien on the IPCo

assets and potentially 8-10% coupon with a springing maturity (ahead of the ‘24s)

- Assuming the bonds are exchanged at 90-95c, the company could potentially raise additional secured debt at IPCo to provide some more liquidity cushion.

Benefits:

- Comprehensive solution: terms out the capital structure, only revolver matures in 2021.

- Potential discount capture on exchanged bonds.

- Removes 2020 springing maturity of term loan.

- Potential to add incremental liquidity.

• Timing: At 14.7x book leverage (LTM Adj. EBITDA) through the unsecureds, Revlon’s capital structure is clearly stretched. Alongside seasonal Q3 capital needs and persistent negative free cash flow over the last 18 months, the prospect of mounting liquidity concerns is clear and crunch time to address the capital structure appears to be fast approaching. While management has stated that it is “not considering material asset transfers”, Revlon is still burning cash on an operating basis and will have to consider all possible avenues to improve liquidity in in 2019/20, address the ‘21s and avoid the acceleration of the term loan:

• Incentives: Given the challenging dynamics, high leverage and negative free cash, Perelman is clearly incentivized to focus on two things: 1) give the company as much time as permissible/feasible to effectuate a restructuring plan, and 2) by extension preserve his equity value. Due to the aforementioned loose covenants in the credit facility and tighter restrictions in ‘21s, it behooves the company to extend the maturity wall of the capital structure by exchanging the ‘21s into a longer dated security and tapping the incremental secured debt capacity.

2) Turnaround plan

Revlon’s earnings remain under pressure due to category headwinds and loss of market share, and there is no quick turnaround in my view. The big drag continues to be the Revlon branded products which account for 42% of revenue and were down 6% and ~11% in Q1-2018 and Q2-2018 year on year, respectively. The company has embarked on implementing several new initiatives to transform Revlon’s portfolio of brands and improve its market position. While it is too early to determine whether any of these strategies will be successful in reversing Revlon’s trajectory, particularly during a time when the company is tight on liquidity and burning cash, there are some reasons to be constructive:

• Management change – in May 2018, Revlon appointed Ron Perelman’s daughter Debra as President and CEO; Debra Perelman has served as COO since January and a Board Member since 2015. She was previously a senior executive at M&F. We can look at her appointment from two perspectives: 1) the skeptical view is obvious – combination of nepotism, Revlon’s unwieldy capital structure and inability to attract a ‘real’ guy due to the perceived low likelihood of a successful turnaround (all valid concerns); 2) a less negative signal is Perelman’s continued commitment to the company and the preservation of his equity which has, in the past, resulted in creative capital structure solutions and direct lending during periods on financial distress. In the early 2000s and in 2008, Perelman supported the company with credit availability, subordinated term loans, debt-for-equity exchanges and participation in rights offerings. Perelman has already intervened post his daughter’s appointment with an unsecured credit line from M&F.     

• “Flesh” – Flesh is a new, in-house incubated brand being sold through Ulta Beauty. The brand was created by Linda Wells, Revlon’s Chief Creative Officer and former editor of Allure magazine for 25 years. Flesh is a prestige makeup line and has apparently generated a lot of excitement due to broad range of ‘shade-inclusive’ products, “40 shades of foundation….this news is not only huge, it’s a change in the right direction” according to Women’s Wear Daily.

• Elizabeth Arden – the brand continues to perform well, particularly in China and other international markets which account ~75% of segment sales. In Q2, International was up 9.9% and total segment revenue increased ~5% year over year. EA’s skincare products have been especially strong in Europe, the Middle East and Asia. In North America, sales declined year-on-year due to store closures and weakness in certain areas of color cosmetics.

• Non-recurring system issues – In February, Revlon implemented a new SAP enterprise resource planning software system and has experienced issues since then. The disruption has mainly occurred in the fulfillment levels at the company’s Oxford, NC plant which has resulted in YTD lost sales and EBITDA of $50MM and $32MM, respectively. According to the Q2 press release, “Adjusted EBITDA was $36.7MM, compared to $61.5MM in the prior year period, primarily driven by approximately $30MM in reduced net sales associated with the SAP service level disruptions”. The company stated that although the facility is back to full production, they are still cycling through the complexity of those SKUs and expect some issues to linger in Q3.

• Positive industry growth backdrop – The global cosmetics market has grown at an annual rate of ~4% for the last 15 years with the exception of 2008 and 2009 when it grew 2.9% and 1.0%, respectively. The industry has generally been resistant to economic downturns having posted positive growth during the last several recessionary periods. Over the last decade or so, expenditure on cosmetics, perfume and bathing products has increased ~12% in the US from ~$150 per consumer unit in 2007 to ~$170 in 2016. The US remains the largest beauty and personal care market in the world, with China and Brazil rapidly growing.

For prestige products, the US is still the predominant growth area while for mass beauty, Asia (principally China and India) and Latin America (Brazil) are expected to be the fastest growing markets going forward.

3) Valuation

On a valuation basis, the ‘21s trade at 13.2x MV on LTM Adj. EBITDA. For a cosmetics company that generates 8-10% margins, it is hard to argue that the ‘21s are attractive on a fundamental basis unless you have conviction in a turnaround and EBITDA/cash flow will be significantly higher in a few years. Revlon’s arguably closest comp, Coty (although significantly bigger), has a TEV of ~$17.4bn and is expected to generate $1.3bn in EBITDA in 2018. As such, Coty’s equity trades at 1.9x revenue and 13x EBITDA which could be justifiable as it generates ~14% margins and is growing topline.

The thesis for the ‘21s is a ‘move up’ in the capital structure. Assuming the company uses the IPCo structure to effectuate the exchange with the ‘21s, and the Elizabeth Arden assets form the basis of the collateral (up to the secured debt capacity), then the valuation could be compelling for the 21s.

Catalyst

• Liability management/exchange offer