Revlon (REV) announced that it would acquire Elizabeth Arden (RDEN) in order to create a greater beauty player. While Revlon is promoting the deal, I have some real problems with the transaction. For starters it is the fact that Elizabeth Arden is posting large losses, as Revlon defends the rationale by pointing towards the very high synergy estimates.
I think that the synergy estimates are not very realistic, which could result in higher leverage ratios going forward. Leverage concerns could actually become a problem if the integration does not go smoothly. The potential leverage concerns down the road as well as the aggressive synergy estimates make that I am very cautious, not joining the current momentum run higher.
Deal Terms & Rationale
Revlon is acquiring Elizabeth Arden for $14 per share, which values the company at $870 million including debt. Arden was too small to operate in the global beauty market. The company's sales have fallen from $1.3 billion in 2013 to less than $1 billion, resulting in large losses.
Elizabeth Arden's losses and increasing debt load made that the company had few options to survive as a stand-alone business. The $14 per share sales price will make recent investors happy, as shares actually traded at lows of $5 at the start of the year. While the premium looks nice based on recent share price developments, a lot of investors will see large losses given that shares traded in the $40s in 2012/2013.
Revlon is mostly pursuing this deal in order to achieve scale. Arden's strength in licensed fragrances, skin care and color cosmetics will be combined with Revlon's hair care, men's grooming and deodorants. With the deal, Revlon aims to offer the broader product line to an increased number of vendors, creating improved diversification across sales channels and geographical areas.
Revlon is very upbeat on the financial benefits resulting from the increase in scale. All in all, it anticipates cost synergies of some $140 million per year from improved manufacturing as well as selling synergies.
The Performance Of Revlon's Business
Alongside the deal announcement, Revlon reiterated a favorable outlook for this year. Sales for the stand-alone business are seen at $2.0 to $2.1 billion, with adjusted EBITDA seen at $400-$420 million.
Revlon ended the first quarter with nearly 52 million shares outstanding. At $32 per share, this values equity of Revlon at $1.66 billion. The company operates with $182 million in cash and $1.80 billion in debt. This gives Revlon an enterprise valuation of nearly $3.3 billion, excluding pension-related obligations of $181 million.
This means that Revlon is trading at roughly 1.6 times forward sales and 8 times the projected EBITDA for 2016. Back in 2015, when Revlon posted adjusted EBITDA of $377 million, it actually reported operating profits of $216 million and net profits of $56 million. Given that EBITDA is anticipated to improve by $33 million in 2016 (at the midpoint of the guidance range), I see operating profits come in around $250 million.
After subtracting interest costs of $85 million and a 35% tax rate, earnings might actually come in around $100 million for the stand-alone business. This anticipated jump in net profit is explained by improving margins as well as the fact that 2015's earnings were impacted by some one-time items.
Based on potential earnings of $100 million, equity in Revlon trades at a relatively attractive 16-17 times multiple. While that looks pretty attractive, remember that Revlon has a huge debt load, equivalent to roughly 4 times adjusted EBITDA.
The Contribution Of Elizabeth Arden & Pro-Forma Business
The $870 million purchase to acquire Elizabeth Arden will contribute roughly $950 million in annual sales based on the current run rates. That suggests that Revlon pays a 0.9 times sales multiple, marking a steep discount to the 1.6 times sales multiple at which the company itself is trading.
The reason is simple as the discount can be explained by the lack of margins at Arden. Having license deals with pop stars such as Britney Spears, Taylor Swift and Justin Bieber might seem nice, but the high licensing fees take away all the potential profits. Even on an adjusted EBITDA basis, Arden managed to only break even in 2015, as operating losses increased to $189 million.
The combined entity is on track to post sales of roughly $3 billion going forward. With a flattish adjusted EBITDA contribution of Arden, EBITDA is seen around $410 million. If we include the multi-year run rate of $140 million in synergies, adjusted EBITDA might improve to $550 million.
Revlon's net debt load of $1.62 billion will increase to $2.5 billion as a result of the deal. While Revlon's stand-alone leverage ratio of 4 times will only increase slightly to 4.2 times the projected adjusted EBITDA, the situation might be riskier than it sounds on paper. This projected leverage ratio relies on the realization of $140 million in synergies. I find this projection quite aggressive, given that Elizabeth Arden adds roughly $950 million in sales. That suggests that the synergies come in around 15% of the added revenues, being simply a very high percentage.
I can understand why Revlon could be compelled to acquire Elizabeth Arden. For a 0.9 times sales multiple, it can add nearly a billion in sales at a 40-50% discount compared to the sales multiple at which the company is trading itself.
The deal could theoretically make a lot of sense. If Revlon could turn Arden into a business which is as profitable as itself, Elizabeth Arden could be worth $1.5 billion at a 1.6 times sales multiple. Given the purchase price of $870 million, some $630 million in value could theoretically be created going forward, equivalent to roughly $11 per share for Revlon.
The reality is that Arden's revenues are shaky and that it is actually posting high losses. Those losses are a concern given that Revlon is actually operating with a fairly elevated debt load at the moment. While it is true that leverage can be contained to 4.2 times adjusted EBITDA if synergies are being realized, I am doubtful that these synergies will be achieved. If half the projected synergies are realized, leverage ratios increase to roughly 5 times adjusted EBITDA.
While I saw some potential for Revlon as a stand-alone business, I do not really like the purchase. The deal can be justified if synergies are achieved, however I have some doubts. These doubts and the elevated leverage ratios make that Revlon has actually gotten riskier in my eyes, with very few benefits to show for in the short to medium term.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.