Previously, in November of 2013, we wrote a positive article about Revlon (NYSE:REV). In that article, based on a conservative analysis, we valued REV at $35/share. Since November, in the notable absence of any sell-side coverage on Revlon (although one favorable story in Barron's featuring the third-largest shareholder), we have sharpened our pencils further, incorporating margin expansion from synergies with The Colomer Group (TCG), as well as the company's exit from China.
Using a rigorous, conservative approach, we estimate REV fair value to be between $49/share (63% upside based on a DCF analysis) and $54/share (80% upside based on comps) in public markets, assuming ongoing controlled ownership by Ron Perelman, with upside to $68/share (127% upside) in a private market transaction.
To be clear, Revlon is not worth $68/share today in public markets, due primarily to its controlled ownership (78% by Perelman) and the relatively illiquid level of the stock due to the small float (63,910 shares traded per day over last 12 months). However, both of these factors are merely technical, and could be remedied in one fell swoop if a certain prominent New Yorker wished to make himself $1.6B [$1,580M*0.78*($68/$30-1)] and willed it to be so. Even if Perelman does not will it to be so anytime soon, the stock has 63% to 80% upside based on fundamental improvements following various restructuring and integration initiatives.
One non-technical factor depressing valuation could be a "wait-and-see" approach by the market to Revlon's synergy and cost-savings projections, as well as a new product initiative strategy (discussed further below). As the market incorporates Revlon's cost savings and higher margins into its numbers, REV shares will reveal themselves to be worth materially more than their current market price, sale or no sale.
Note that outside of a control premium for our $68/share price (with probability of M&A being relatively high), we are not explicitly including any synergies from an acquisition in our private market estimates, even though a strategic buyer such as Unilever or LG Household (following its dropped interest in Elizabeth Arden after RDEN announced a restructuring plan) would be the best fit for Revlon. Hypothetically, and solely for the purpose of this analysis, we shall "cede" all synergy benefits to an acquirer in exchange for terminating the liquidity and controlled company respective, but related discounts. In other words, we're going to keep the analysis simple and conservative.
Future Potential Synergies
Before discussing valuation, Lorenzo Delpani must be complimented for his early efforts as the new CEO. Delpani previously ran TCG before Revlon acquired it. Early indications suggest Perelman made a wise choice in appointing him to lead the company. The Italian has an extensive consumer products marketing background, and is revamping Revlon's new product initiative strategy through the self-described personal motto of "fewer, bigger, better", which will allow for more marketing spend per product. The suggestion in implementing this new strategy is that Revlon had been spreading an equivalent amount of dollars across too many products, diluting the effect of each campaign.
Delpani is also cutting out the regional management layer from the previous global/regional/local management structure, thus streamlining decision-making while cutting expenses. Finally, he is overseeing the migration of Revlon's "complex and multiple" IT systems to SAP, which he says will be critical for "working future potential synergies".
Wait a minute… "future potential synergies"? Those sound like different kind of synergies than the previously identified $35M targeted from the TCG and Revlon integration. He may have simply meant as of yet unidentified synergies between Revlon and TCG, but it's not clear that Delpani would put Revlon through a complex IT migration for an uncertain amount of internal synergies without providing an estimate of future savings, when he's done so for the other integration synergies.
A second interpretation is that Delpani meant between Revlon and other companies with whom there may "potentially" be "future" M&A discussion, including relevant "synergies". You know -- future potential synergies. This interpretation could explain why Revlon did not provide any numbers around the IT migration benefit, despite highlighting it as a project - the benefit depends on who the future potential synergies are with!
Also, despite (and in part because of) the TCG acquisition, with net leverage now, based on our estimates, set to remain above 2.5x through 2018, the 71-year-old, financially motivated Perelman is more likely a seller than a buyer. Age may not even be a factor, as Perelman could very well remain chairman for five, ten, or maybe fifteen more years if he wanted. More importantly, comp multiples are highs, REV is trading at a big discount to peers with similar financial profiles, and there is an opportunity to be had in M&A.
At What Price?
Cosmetics and consumer staple company comps trade at a median '14E EBITDA multiple of 12.5x, with a range 10.2x for Natura Cosmeticos (NATU3 BZ), a Brazilian company with a similar direct selling model as Avon minus the restructuring issues, which has '14E EBITDA margins of 23%, to 15.6x for L'Oreal (OR:FP) with '14E EBITDA margins of 21%.
In comparison, at $30.10/share (close on 6/27/14), REV trades at 9.1x 2014E adjusted EBITDA of $364M, despite EBITDA margins in 2013 that were 18%, in line with the group median. If it were to trade in line with comps on 2014E adjusted EBITDA, REV would be worth $55/share (see comps table).
Source: Bloomberg, Armored Wolf
The future is much brighter for Revlon than its valuation suggests, and 2014 marks a critical inflection point in the company's integration efforts with TCG and savings realization from the China exit. We estimate Revlon's adjusted EBITDA margins (adding back one-time restructuring expenses) will improve from 18.3% in 2013 to 19.3% in 2014 and 20.6% in 2015 (and 20.8% in 2016), which would put the company's profitability on par with L'Oreal, which trades at a comparable company universe-leading 14.5x 2015E.
For the sake of conservatism, applying a 13x EBITDA multiple on REV's 2015E adjusted EBITDA implies a fair value of $68/share. Not conservative enough? At an 11x multiple, REV would be worth $53/share. Looking at comps, it's very difficult to justify lower multiples when projecting out Revlon's margin improvement over the next 18 months. Yes, leverage of 4.9x is higher than the group average of 0.3x, but the company's unsecured bonds are yielding less than 5% (indicating the bond market recognizes that Revlon is a high-quality credit), cash flow is robust and stable, and the company has $350M of liquidity.
EV/EBITDA is not the only metric on the comp sheet that one might think was an error at first glance due to its divergence with peers. REV's price-to-sales ratio of 0.9x versus a group average of 2.5x is evidence of the extreme distortion of REV's basic valuation metrics. This gap is likely to narrow over time as Revlon's margins increase and/or an M&A catalyst occurs.
We don't think the market can continue to penalize Revlon to this extent for being a controlled, relatively illiquid stock -- especially when the probability of a sale increases substantially over the next two years as the company fully realizes benefits from recent strategic and restructuring initiatives.
It's what on the in(trinsic)side that counts
No offense to Revlon's patrons, but its free cash flow is best presented au naturel. There's no need to apply lipstick, foundation, nail polish, BB, or CC cream to Revlon's financials to justify a $68/share valuation. The unlevered free cash flow generation (EBIAT + D&A - capex, including purchases of permanent wall fixtures - changes in net working capital - pension contribution), at a 12.5% yield in 2015E, speaks for itself.
Running an adjusted present value (appropriate for a de-levering capital structure such as Revlon's) DCF model utilizing our base operating assumptions (discussed in more detail below) and conservative inputs, we arrive at $54/share, nearly the same value per share that the implied comps yielded.
Unlevered beta of 0.61 is based on a 2-year beta (one could argue it should be lower, based on comps, which would result in a lower discount rate and higher valuation). The U.S. 10-year treasury, matching the duration of REV's cash flows better than a 30-year treasury, provides our risk-free rate, 2.53%.
Our model's equity risk premium (ERP), which determines the discount rate by which we discount the cash flows (again, a higher rate is more punitive), is composed as the sum of various components: 5% as a U.S. equity risk premium, 4.5% as a small cap premium, and a 3% controlled-company risk premium, for a total ERP of 12.5%. Some may ask, what about the illiquidity premium? It is included, imprecisely, through a combination of the more precise small cap and controlled company premiums.
Our terminal value is based on a conservative 11x exit multiple, and composes 72% of firm (enterprise) value. Net operating losses of $211M contribute $83M of firm value on a present value basis.
When valuing Revlon, one should first back out the transitory risk factors before considering upside arising from a change of control premium and potential synergies. With a 12.5% ERP, our public market target valuation is $49/share, which assumes Perelman holds on to his 78% ownership and there is no change of control. Removing the 3% controlled company premium for Perelman's 78% ownership (for example, if Perelman were to sell stock in a series of secondary sales), our target valuation jumps to $54/share. Applying a 25% change of control premium once the controlled ownership overhang has been removed (1.25*$54/share) results in a valuation of $68/share, or 127% upside.
Another thing, for the sake of conservatism. Those "adjusted" EBITDA numbers we discussed earlier, while they make sense for our multiple-derived valuation, are relegated to a "memo" line in our APV/DCF, because we're attempting to model actual cash flows. While our model rightly penalizes REV over the next couple of years for its restructuring and TCG integration initiatives, the company's valuation eventually receives the benefit of higher margins in years 1.5 (2015) through 5.5 (2019), as well as through its terminal value.
We project that Revlon de-levers to 4.9x net debt/EBITDA (not adjusted) this year, 3.9x by FYE 2015 and 3.3x by FYE 2016. For that reason, we see limited room for acquisitions. With net debt of $1.7B (mostly bank debt) and market cap today of $1.6B, REV is not only a digestible target for an acquirer, but at the current valuation level, an absolute steal.
A Closer Look at Projections
For sales, we project only 1.5% to 2.0% (including foreign exchange) through 2019, despite Q1 2014 sales growth of 4.4% (6.4% excluding FX).
Margin expansion at Revlon will be driven by 1) $30M of synergies with TCG (we haircut management's estimate of $35M of synergies, noting that upside to margins will be realized if the CEO and his team succeed in hitting their stated target); and 2) $11M of savings from exiting China, nearly all of which was expensed in fiscal year 2013, with only $1.1M of the $22M exist costs being expensed in 2014.
Our 2015 estimate is based on 2014E unadjusted EBITDA of $338M, originating from $348M of 2013 EBITDA with 1.6% sales growth, $10M of synergies, $8M of cost savings from China, $33M in one-time restructuring expenses from the TCG acquisition, and $1.1M of one-time China exit expenses.
Our 2016 estimate is based on 2015E unadjusted EBITDA of $392M, originating from $338M of 2014 EBITDA with 1.5% sales growth, $20M of synergies, $3M of cost savings from China, and $12.5M in one-time restructuring expenses from the TCG acquisition.
Source: Armored Wolf
We didn't just "make up" this price target
When conducting a thorough comparable company or a rigorous DCF/APV analysis, what becomes obvious is that REV trades at a deep discount to its peers and what a rational investor should consider fair value. We think that without any M&A, there is 63% to 80% upside as Delpani and his team execute. A change of control catalyzed by Ron Perelman's decision to sell, or an interested party coming forward as a buyer, unsolicited, could cause the stock price to soar even higher to as high as $68, for upside of 127%. Over a three-year period (although it need not take that long), if REV eventually traded to $54/share or $68/share, annualized returns would be 25% or 31%, respectively.
Brands like REV don't come along very often at such large discounts to fair value, and we would not be surprised to see a limited window during which investors, or acquirers, can take advantage of such a compelling disconnect.
Disclosure: The author is long REV. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Armored Wolf is currently long REV on behalf of its clients. In addition, the author owns shares of REV in his personal account.