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Thursday, May 6, 1999

An Investment Opinion
by Dale Wettlaufer

Open Letter to Chairman Lauder

Mr. Leonard Lauder
Estee Lauder Companies
767 Fifth Ave.
New York, NY 10153

Dear Mr. Lauder,

I cover cosmetics companies for The Motley Fool and wanted to bring an idea to your attention. Before I do, though, I wanted to congratulate you and everyone at Estee Lauder (NYSE: EL) on your successes since coming public. I especially applaud the Aveda and jane acquisitions and appreciate the work being put into the development of those brands.

I don't know if you've heard this idea, but I suspect you have. The idea that I'm proposing is that Estee Lauder acquire Revlon (NYSE: REV). Sure, at first it sounds like a bad fit. Estee Lauder is the number one prestige cosmetics company, while Revlon is a self-select (or drugstore brands) company. In their respective categories, however, they're both well-known, worldwide brand names.

In looking at Revlon, I've come to the conclusion that it's not the products, brands, or business model that are unattractive. To me, there's no getting around the fact that the interests of common shareholders are not being served well by the majority owners of the company. The company is currently leveraged with high-interest rate debt and long-term economic value is being sacrificed for the sake of servicing that debt and cutting operating costs.

For instance, Revlon has made the mistake of cutting operating expenses out of its sales organization, subsuming the goal of serving the wholesale customer to the goal of increasing operating income. I know you take a personal approach to dealing with customers, and having read your mother's autobiography, I'm pretty sure where that approach comes from. It has always been the backbone of Estee Lauder's attitude towards its sales efforts, as far as I can tell.

Revlon is currently the leader in self-select cosmetics with cosmetics and skincare brands such as Revlon, Almay, Ultima II, and regional brands. In fragrances, the company's staples are Charlie and Fire & Ice. In addition, Revlon has a significant lineup of personal care and professional products.

Through the first quarter of 1999, these products generated $2.2 billion in net sales over the last twelve months, with gross margin of 65.5% and operating earnings of $143 million, or 6.5% of net sales. For fiscal 1998, Revlon spent 89.3% of gross profits on sales, general, and administrative expenses while Estee Lauder spent 84.2% of gross profits on SG&A. Not that you would be able to get much help from the company in performing due diligence, but that extra 500 basis points of gross profits are going somewhere.

Revlon isn't currently covering its cost of capital, and that has been distorted by some of the sell-in troubles the company has had with its customers. Sure, mass merchants want to keep reasonable amounts of inventory on hand, but a company with Revlon's and your resources can work with those customers to arrive at the best possible way of doing things under that system. Even if Revlon's long-term operating margin goals are lower than Estee Lauder's 14-15% long-range target, this is a business model where you can turn over capital a little more quickly and still generate 20% returns on invested capital (ROIC).

At present, return on invested capital (ROIC) is 7.6% versus just under 20% for Estee Lauder. In the near-term, Revlon would need some work in dealing with your intermediate customers, your wholesale partners, who will then be more receptive to working well in marketing the product to your retail customers. I don't think you can make this company stand on its head immediately, but I believe with the right leadership from Estee Lauder, Revlon can get back to health again.

At $29, an approximately 30% premium to today's closing price, Estee Lauder would be paying 2.6 times invested capital, a significant discount to Estee Lauder's current 7.2 multiple of enterprise value to invested capital and 12.5 times at Avon. On an enterprise value to sales ratio basis, Revlon would be priced at 1.44x, while Estee Lauder is priced at 3.15x, and Avon is priced at 2.78x.

I would estimate potential earning power at Revlon at 15% of current invested capital, which would yield pre-tax operating earnings of $272.8 million. At an enterprise value of $3.15 billion with the 30% takeover premium, the company would be priced at 11.6 times pre-tax operating earnings. That's compared with 24.3x for Avon and 27.2x for Estee Lauder.

I'm not suggesting Revlon is a good idea on its own. I am suggesting that it is selling well beneath the intrinsic value that could be realized with Estee Lauder as the company's parent. As such, for every dollar of capital deployed to acquire the company, the market would accord Estee Lauder at least $1.50 in extra enterprise value. I don't see any channel conflicts with your company, as you've already entered the self-select category with the acquisition of Sassaby and the jane brand. I hear MegaBites is going well, by the way.

I don't believe a little internal competition in overlapping brands is ever a horrible thing for a well-managed company, either. There are probably some vestigial names where value could be better realized elsewhere. And one major brand could be sold, as Almay could provide just too much of an internal conflict with Clinique and to a lesser extent, Origins. You would be a much better judge of it than I.

I'm not sure what Estee would say about the idea, but if I could ask her, I'd love to get her thoughts. I've never been afraid to be the one asking the stupid question and maybe that's the response I would get out of your mom. But I would bet her instincts would be pretty good on this matter. In the meantime, the initial numbers look interesting, Revlon's products still occupy a very valuable market segment, and its employees' talents could be fully realized under the kind of leadership Estee Lauder Companies would provide.

If we can be of help in compiling additional data or performing due diligence for Estee Lauder on this matter, I'd love to hear from you.

Sincerely yours,

Dale Wettlaufer

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