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Shares of Revlon (REV) jumped up in Monday's trading session after the cosmetics company announced the acquisition of The Colomer Group. I am quite surprised by the enthusiasm among investors. Given the significant build up in leverage following the deal, and the premium valuation multiples being paid, I am not convinced that this is a good deal. In case economic conditions or Revlon's core business deteriorate, investors should be wary of the dilutive risks involved by taking on this kind of leverage.

The Deal

Revlon announced that it has signed a definitive agreement to acquire privately held The Colomer Group. Revlon will pay $660 million in cash of the beauty care company, which is focused on professional salons. The company was previously owned by CVC Capital Partners, which funny enough boosted the business from Revlon back in 2000.

The deal supports Revlon's strategy to increase its overall brand portfolio, distribution channels, and global reach. The deal is complementary to Revlon's professional hair care business and its nail business. The Colomer Group generated roughly half of its revenues in Europe, 40% in the U.S., and the remainder in the rest of the world. CEO Alan Ennis commented on the rationale behind the deal:

This acquisition, which we expect to be accretive to cash flow and earnings in the first year, represents a significant and logical strategic step forward for Revlon as it complements our core business, expands our distribution into new channels, and provides meaningful cost synergy opportunities.

The deal is expected to close in the fourth quarter of 2013 and is subject to normal closing conditions, including regulatory approval. Revlon expects to finance the deal with loans provided by Citigroup Global Markets. The deal is expected to be cash flow and earnings accretive within the first year after closing.

Valuation

Revlon ended its second quarter with $141.3 million in cash and equivalents. The company operates with a total debt position of around $1.23 billion, for a net debt position of $1.1 billion. Just last week, Revlon released its second-quarter results. Net sales fell by 2.0% to $350.1 million, driven by unfavorable currency movements. Thanks to impressive cost cuts, net income more than doubled to $24.7 million.

At this pace, full-year revenues could come in around $1.4 billion. Based on analysts estimates, full-year earnings could come in between $80 million and $90 million. Factoring in the 7% gains following the announcement of the deal, with shares exchanging hands at $26, the market values Revlon at $1.4 billion. This values the firm's equity at 1.0 times annual revenues and 16-17 times annual earnings. Revlon does not pay a dividend at the moment.

Some Historical Perspective

Shareholders in Revlon have seen very poor returns over the past decade. Shares traded in the mid-$30s back in 2005 and fell to lows of $2 in 2009. Shares have bounced back to $26 at the moment. Still, the returns are extremely poor considering that Revlon does not pay a dividend. Between 2009 and 2012, Revlon has increased its annual revenues by 10% toward $1.43 billion. Net earnings stagnated around the $50 million mark in the meantime.

Investment Thesis

Investors in Revlon reacted with enthusiasm to the deal, which will add quite a bit of leverage to Revlon's balance sheet. To finance the $660 million deal, Revlon will obtain $1.52 billion in loans to assume Colomer's outstanding debt. But the activities are not completely unknown to Revlon. Thirteen years ago, it sold the Spanish beauty care company to CVC for $315 million. CVC has built out the operations in recent years, boosting annual revenues of The Colomer Group to $538 million. With the deal, Revlon gets a renewed access to the professional cosmetics business, the highest margin business within the makeup industry. The Colomer Group already markets Revlon's hair care products under a license deal.

The price tag of the equity of The Colomer Group values the activities at 1.2 times annual revenues. The deal will add roughly 40% in annual revenues, but more than double the net debt position of the firm. Combined, the activities will report revenues approaching the $2 billion mark. Net earnings should be able to come in around $100 million, accounting for the profitability of the business and the increased financing costs. This would bring Revlon's valuation down to 0.7 times annual revenues and roughly 14 times annual earnings, while the net debt position would increase to $2.5 billion.

While the market has reacted favorably to this increase in leverage, it does incur some future risks -- especially as Revlon is seeing flat revenue growth, despite new initiatives, on softness in its Almay brand. I am not convinced at all by the deal. While the company stresses the strategic rationale, it is paying a premium valuation to acquire assets while incurring much higher leverage. That leaves the company and shareholders severely exposed if Revlon's core business comes under more pressure.

Source: Revlon - Leverage Increase Following Colomer Deal Is Worrying