Despite Debt, Revlon Should Spend on Branding Color Cosmetics

For many women Revlon (NYSE:REV) is synonymous with lipstick, nail polish, and eye mascara. It then comes as no surprise that the company is one of the leading manufacturers of color cosmetics with almost a 20% market share in the US, which itself makes up for over 18% of the world’s color cosmetics market. Revlon also manufactures hair color, skin care, fragrances and deodorants and sell them through chain drug stores such as Walgreens (NYSE:WAG) and CVS Caremark (NYSE:CVS) and through mass retailers such as Wal-Mart (NYSE:WMT) etc. Revlon competes with the likes of L’Oreal (PINK:LRLCY), Avon Products (NYSE:AVP) and Estee Lauder (NYSE:EL) among others.

We estimate that the color cosmetics segment constitutes over 61% of our $9.58 Trefis price estimate for Revlon, which is close to market prices.

What also characterizes Revlon’s business is its heavy indebtedness. This and its relatively small size with $1.3 billion in sales leaves it with much less money to spend of marketing and advertising compared to L’Oreal’s $24 billion and even Estee Lauder’s $7.9 billion in sales. Revlon’s limited R&D budget at 1.7% of sales amounting to $24 million, is a drop in the bucket compared to L’Oreal’s budget of $667 million at 3.7% of its sales. This disadvantage is part of the reason we forecast modest market share declines going forward.

In our last article (Revlon: What’s the way ahead?), we explored Revlon’s possible option of focusing the limited available R&D and advertising budget on its color cosmetics segment while phasing out from skin care and fragrances, and we estimated this could lead to potentially 27% upside to our current Trefis price estimates of its stock.

Revlon’s focus on paying down its debt to get its fiscal house in order makes it a more attractive as an acquisition candidate but might come at the expense of market share. We believe that upside exists from spending its additional resources on initiatives to maintain its brand value, especially in the color cosmetics where it possesses a strong market presence and has a good chance of defending its current market share.

What makes Revlon attractive for acquisition?

High debt levels typically make a business unattractive for an acquisition as acquirers have difficulty raising additional debt against the business, thereby reducing the possibility of a leveraged buyout by a private equity player. Leverage also makes the target’s earnings more volatile and increases the risk associated with the cash flow forecast. This raises the cost of capital for the funds needed to acquire such a business.

However as Revlon pays its down its debt, we believe it could become a takeout target given its strong brand name in the personal care industry. Also given the relatively cheap credit currently available, big players such as Procter & Gamble and Unilever are exploring options of inorganic expansion by pursuing acquisitions of smaller players and have already made a few acquisitions like Unilever’s acquisition of Sara Lee’s personal care business and European laundry business (Unilever’s European Expansion Lifts Stock). Since these do not already operate in color cosmetics and hence are not likely to face antitrust issues, Revlon could be a good fit for one of these companies.

Assuming Revlon wants to stay independent, we believe that in the current low interest environment Revlon could take advantage of reduced interest payments to focus on building its brand to better compete with its bigger peers. Revlon could sustain its current debt levels while investing in R&D and marketing so as to gain – or at least defend -its current market share.

We currently estimate Revlon’s share of color cosmetics to decline from close to 3% in 2010 to 2.80% by the end of the forecast period. If however, Revlon maintained its leverage and invested behind color cosmetics, we can reasonably expect the market share to rise to its historical levels of close to 3.25% in the coming years, leading to a 30% potential upside to our current $9.58 Trefis price estimate of its stock.

You can drag the graph below to see the impact of Revlon’s stock price.

You can see our detailed analysis of $9.58 Trefis price estimate of Revlon’s stock here.

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