Has This Makeup Company's Deep Value Vanished?

In the land of cosmetics, few companies have a bigger brand than Revlon (NYSE: REV  ) . It's a great business in that it sells a high-margin product that can be marketed as a premium good, yet it's priced competitively enough with peers that it was able to weather the financial crisis with only minimal revenue drops. Moreover, the company has recently emerged from a reorganization that started a few years ago with a new CEO and a plan to trim costs and boost margins.

There are some concerns, though, including limited liquidity resulting from a major insider shareholder and a recent 60% gain in stock price. With major hedge fund interest and an attractive intrinsic business, should you make up your portfolio with Revlon?

Another Mittleman position
Lately, I've been highlighting some of the businesses owned by hedge fund Mittleman Brothers. I'm not trying to be a mouthpiece for the fund, but I am intrigued by many of its picks. Mittleman has identified several high-moat businesses that have traded at a discount to their peers. Last year, the fund held a 10% stake in Revlon.

The good
Makeup is a consistent business -- it doesn't ever go out of vogue. It's an industry with near-steady demand that can easily be forecasted many years out. Revlon is a leading name in makeup and has been proved capable of keeping its name in the upper echelons of the industry for decades.

Like other cosmetic companies such as L'Oreal, Revlon has great EBITDA margins -- averaging around 20%. This has helped create attractive, meaningful cash flow in recent years. For all of 2012, the company generated $83.2 million in free cash flow. That compares with $74.1 million in 2011, and $82 million in 2010. The company does have a significant amount of long-term debt, as it was the subject of a leveraged buyout offer from billionaire Ronald Perelman; however, with the healthy cash flows and a recent recapitalization, I don't find debt to be a pressing issue for the company.

Revlon trades at a discount to its peers, such as L'Oreal, on a EBITDA basis. In its most recent year, adjusted for non-recurring costs, the company brought in $254 million in EBITDA. At an enterprise value of $2.3 billion, that's a multiple of 9.05. On a free cash flow-to-market cap basis, the company trades at a multiple of just 13.94. For comparison, L'Oreal trades at 16.7 times EV/EBITDA. Investors need to keep in mind, though, that these comparative metrics should not suggest that Revlon and L'Oreal are 1-for-1 in risk and profitability over time.

The not-as-good
While top-line sales have grown nicely over the past couple of years, Revlon's net income and EPS have wavered. The company is a fraction of the size of L'Oreal ($1.16 billion versus $93.88 billion) and does have the same track record of consistent growth. Revlon is also majority owned by its LBO partner, billionaire Ronald Perelman's firm MacAndrews and Forbes. Given the less-than-friendly shareholder decisions by private equity firms in the past, Perelman's stake in Revlon could be viewed as a risk.

Given that large stake, the stock is not particularly liquid, trading at an average volume of 80,000 shares per day.

By no fault of the company, the stock has risen nearly 60% in three months. Clearly, the market found this deal before I did. Sitting near its 52-week high, and with valuations closer to that of its peers, Revlon's deep value has virtually vanished. I believe the company will continue to improve as the turnaround effort yields its long-awaited fruits. With two recent bolt-on acquisitions that further the company's exposure to the profitable nail-polish segment, sales should grow at a decent clip in coming quarters. As I mentioned earlier, the company recently recapitalized its debt at a more favorable rate and pushed debt maturities further down the line.

At $23 per share, Revlon probably offers some upside potential in the range of 10%-15%, depending on how close the valuation gap between it and its peers can get. However, there is also considerably more downside potential now, since the company has dug itself out of the deep value territory.

For those interested in a company with a bulletproof brand and successful restructuring under its belt, Revlon may be a good long-term pick. For the bargain-hunters in the group, however, this ship may have just sailed. Mittleman may agree, as the fund's most recent 13F shows that just a 1.8% stake remains.

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