What happened

Shares of iconic makeup company Revlon (REV) rose just over 28% at one point in trading on Nov. 5. By about 3:30 p.m. EDT they were holding on to most of those gains, sitting at a nearly 25% advance. The big story was earnings, which presented some major positive news. However, there are also some negatives here about which investors need to be wary.

So what

Revlon's sales were up 9.2% year over year, hitting $521.1 million in the third quarter of 2021. There was strength across all four of the company's business segments. Gross profit increased 23.5% with gross profit margin expanding by 670 basis points. Operating income went from a loss of $9.7 million in the third quarter of 2020 to a profit of $34.1 million this year. So far so good. But the company lost $0.99 per share in the quarter, which was worse than the per-share loss of $0.83 in the same quarter of 2020. What's going on?

A person applying eyeshadow.

Image source: Getty Images.

First off, the company's business-level results are definitely showing improvement, so management is doing something right and it deserves credit for that. In fact, the only place where there was sales weakness was in the international component of Revlon's portfolio division (this segment basically houses the company's makeup brands other than Revlon and Elizabeth Arden), which was off by 5.5%. But that weak spot was more than made up for by the rest of the company's business across both domestic and international markets. The really worrying problem is that Revlon's balance sheet is carrying a huge $3.3 billion in long-term debt. Shareholder equity, meanwhile, is negative $2 billion so the debt-to-equity ratio is so bad it's basically meaningless. Leverage is, essentially, eating Revlon up right now. 

But let's put a number on that. Operating income was $34.1 million in the third quarter, with interest expense of $63.1 million. Basically, despite the improvement, the business didn't generate enough money to cover its interest expenses. Looking further down the income statement, the net loss was $53.1 million. If you back out the interest expense from the net loss, the company would have had a roughly $10 million profit. But financial statements don't work like that and the interest burden here is just as real as the underlying business improvement that's taking shape. And that's a problem investors shouldn't ignore.

Now what

Revlon is in turnaround mode and it appears to be making progress at the business level. Investors are right to be pleased by that. However, at some point it needs to deal with its debt-heavy balance sheet. Until management finds a way to do that most investors will probably be better off watching this name from the sidelines even as the stock posts massive gains. Revlon is really only appropriate for more aggressive investors willing to bet on special-situation stocks.