Revlon: Positive Operating Trends and a Low Valuation

| About: Revlon, Inc. (REV)

Revlon (NYSE:REV), the well-known maker of beauty products, recently announced earnings of 20 cents per share for the first quarter of 2011, as compared to 4 cents per share last year. The market seemed to cheer this news, sending the share price up 6.7% to $17.45 as of Thursday's close. Upon further investigation of Revlon's earnings history for the last few years, I conclude that these latest results are the continuation of a general trend of improvement that has been going on for the last few years, and that despite the strong reaction to earnings, Revlon is still attractively priced.

Revlon produces a full range of cosmetics, including makeup, nail polish, lipstick, eye makeup, and skin care products, as well as fragrances and deodorants. In the United States the company focuses on large retailers and drugstores, while overseas the company's outlets also include department stores and specialty stores. Non-U.S. sales for 2010 accounted for 45% of Revlon's total sales, up from 42% in 2008, and non-U.S. sales, particularly in Latin America, have been Revlon's major source of sales growth, offsetting occasional declines in U.S. sales. Revlon's five largest overseas countries for sales are South Africa, Australia, Canada, the United Kingdom, and Venezuela, which collectively accounted for 25% of total sales in 2010. This characteristic may make Revlon of interest to U.S. investors seeking to expand their exposure to non-US economies.

Revlon is 78% owned by Ron Perelman, who acquired the company in 1985 in a leveraged buyout, and has been deeply involved in Revlon's financing since that time. In October of 2009 Perelman attempted to acquire all the remaining outstanding shares, but a series of lawsuits forced him to change his offer into an offer to exchange common shares for preferred shares with a limited lifespan. Perelman has also lent money to Revlon from time to time; his latest loan was for $170 million lent in 2008, of which $58.4 million remains outstanding at an interest rate that now stands at 12%. The terms are obviously ungenerous, but it may be comforting to know that Revlon appears to have a lender of last resort. I shall say more about Revlon's debt situation below.

Turning now to the figures, I would first like to address the issue of excess cash. Readers of my other articles may recall that I consider a company's cash to be "excess," and therefore capable of being considered separately from the company that owns it, to the extent that current liabilities are covered by noncash current assets. Applying this method to Revlon, I would normally find that Revlon's $61 million in cash would be considered excess. However, owing to Revlon's significant indebtedness and the fact that the company is required to redeem $48.1 million in preferred stock in October of 2013 if it has the funds legally available to do so, I am forced to conclude that Revlon's cash should not be considered excess and therefore should not be taken into account separately in performing a valuation.

In terms of earnings and free cash flow, in 2010 Revlon had sales of $1321 million and reported operating income (taking into account foreign exchange effects) of $194 million. The company also recorded excess depreciation charges, which are a noncash expense, of $42 million, which brings operating cash flow to $236 million. Interest expense was $90 million, producing an interest coverage ratio of 2.6x. This leaves $146 million in pretax cash flow, which, at a tax rate of 35%, leaves $95 million in estimated after-tax earning power. $6 million of that amount goes to the preferred stockholders as adividend, leaving $89 million in free cash flow to common shareholders. Based on Revlon's current market cap of $905 million, this is a price/free cash flow ratio of 10.2, which is attractive for a company that is still expanding its market.

I should point out that the above calculation treats excess depreciation as taxable when in fact it is tax free, which would improve 2010's results by an estimated $15 million. Furthermore, Revlon has accumulated $754 million in net operating loss carryforwards ($457 million U.S.-based and $279 million non-US-based), which should serve to shelter Revlon's incomefrom taxes for several years into the future. Taking these carryforwards into account, Revlon's valuation appears even more attractive.

In 2009, Revlon's sales were $1296 million, operating income apart from restructuring expenses was $183 million, and excess depreciation was $46 million, producing operating cash flow of $229 million. Interest expense was $92 million, leaving $137 million in pretax cash flow, or $89 million after taxes. Revlon's preferred stock was issued in October of that year, but to render the figures comparable with those of 2010, the $6 million in preferred dividends should be deducted, particularly because the preferred stock was issued in exchange for common stock. This makes the comparable free cash flow to common shareholders $83 million.

In 2008, Revlon's sales were $1347 million (Revlon discontinued certain noncore operations in 2008, hence the decline in sales in 2009), and reported operating income of $147 million. Excess depreciation came to $67 million, producing operating cash flow of $214 million. Interest expense was $120 million, leaving $94 million in pretax cash flows, which comes to $61 million after taxes, or $55 million on a comparable basis.

In 2007, Revlon's sales were $1367 million and reported operating income before restructuring charges was $132 million. Excess depreciation was $76 million, producing operating cash flow of $208 million. Interest expense was $136 million, leaving $72 million in pretax cash flows, or $47 million after taxes, which produces $41 million in comparable cash flows to common shareholders.

2010 2009 2008 2007
Sales 1321 1296 1347 1367
Reported Operating Cash Flow 194 183 147 132
Excess Depreciation 42 46 67 76
Operating Cash Flow 236 229 214 208
Interest Expense 90 92 120 136
Pretax Free Cash Flow 146 137 88 72
After-tax Free Cash Flow to Common (Comparable) 89 83 55 41

The first quarter 2011 results are a continuation of the positive developments at Revlon. Sales increased in every region: 2.3% in the US, 8.9% in Asia, 11.2% in Europe, the Middle East and Africa, 34.5% in Latin America, and 11% in Canada, making a 7% increase overall (these growth figures discount currency movements; measured in U.S. dollars sales grew 9.1%). Sales were $333 million and reported operating income was $45 million. Excess depreciation came to $13 million, producing operating cash flow of $57 million. Interest expense for the quarter was $23 million, leaving $34 million in pretax cash flows, or $22 million after taxes. After preferred dividends this leaves $20.5 million in cash flow to common shareholders. This compares favorably with the figures for first quarter 2010, where the free cash flow to common shareholders was $19.5 million.

1Q2011 1Q2010
Sales 333 305
Reported Operating Cash Flow 45 42
Excess Depreciation 13 11
Operating Cash Flow 57 53
Interest Expense 23 21
Pre-tax Cash Flow 34 32
After-tax Cash Flow to Common 20.5 19.5

Now, offsetting the low free cash flow multiple and general trend of improvement at Revlon is the company's debt situation. Revlon's long-term debts include approximately $800 million in term loans, $330 million in 9.75% bonds, $58 million of the loan from Ron Perelman's company at 12%, plus the $48 million in 12.75% preferred stock that is due to be redeemed in October 2013. The interest rate on the term loans is 6%, or the Eurodollar rate plus 4%, whichever is higher, and as LIBOR is less than 30 basis points as of this writing, Revlon has not locked in a rate using swaps, although it may wish to in future. The bonds are rated B by Standard & Poor's; nonetheless, they trade at a premium to par and a yield to maturity of 7.2%. The credit agreement and the bonds both fall due in 2015, and will most likely have to be rolled over, in whole or in part, at that time. As I stated above, the interest coverage ratio is 2.6x based on 2010's earnings, which is low enough to be considered sub-investment grade and is consistent with a B rating.

However, as I suggested before, Revlon may be somewhat insulated from an inability to roll over its debts by the presence of Ron Perelman, who owns 77% of the company and would no doubt prefer not to put his position at risk because of defaults. He could, if the situation requires it, ride to the rescue as a lender of last resort, although, as the 12% rate on his existing loan would suggest, his assistance would be expensive. However, it would be better than a default. At any rate, Revlon's current capacity to generate free cash flow provides the resources to chip away at its debt load, making such an extreme measure unlikely, although progress on this front is not as fast as I would like to see.

In the last few years, Revlon seems to have found direction in its operations, which has produced psoitive developments in its cash flow generating abilities, particularly in the area sales growth outside of the United States. Furthermore, the company is still selling for an attractive price, especially when the operating loss carryforwards are taken into account. I remain cautiously optimistic on the debt situation as well. Therefore, I can suggest Revlon as a candidate for portfolio inclusion.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.