Armored Wolf Sees $1.3B of Inner Beauty in Perelman’s Revlon

Beauty is in the eye of the beholder, and Bradd Kern, Managing Director at Armored Wolf LLC, a hedge fund based in Newport Beach CA, sees something beautiful in cosmetics supergiant Revlon, Inc. (NYSE: REV).

Kern originally posted a long recommendation on Revlon to SumZero back in late 2013, a position which has since appreciated 43%. Recently Kern doubled down on Revlon after noticing a situation that could lead to shares appreciating another 80%. The key to unlocking this value lies in the hands of billionaire Ron Perelman, owner of almost 80% of Revlon stock. We sat down with Kern to discuss the incentives, economics, and potential profits behind this special situation.

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SumZero: What about Revlon initially caught your attention as a value investor. What was the market missing at the time?

Bradd Kern, Armored Wolf: There were a couple of compelling aspects with Revlon. First, it has an incredible history as a consumer company. Charles Revson started the company in 1931, and it’s grown into one of the most well recognized brands in cosmetics globally. The quality of the brand speaks to the staying power of the cash flows within an already stable consumer staple profile business. Second, the company trades at a massive discount to its intrinsic value and to industry peers when comparing enterprise value-to-EBITDA, beyond any justification on a fundamental basis. Revlon has similar EBITDA margins to much more richly valued cosmetics companies, such as Estee Lauder, Coty, and L’Oreal. Yet investors are so paranoid about Ron Perelman’s presence through his 78% controlling ownership position that the market has failed to recognize anything close to the stock’s intrinsic value. In essence, Revlon is a high quality business deeply undervalued for a non-fundamental reason that is identifiable, unreasonable, and not necessarily permanent.

SumZero: Revlon has been a repeat position for you. You first recommended Revlon on SumZero back in late 2013. In your view, how well is your original thesis materializing?

Bradd Kern, Armored Wolf: The original thesis has worked well, in that the stock has appreciated due to underlying improvements in the company’s revenue growth profile and strategic direction under their new, product and marketing-focused CEO, Lorenzo Delpani. There was a high margin of safety because of the valuation discount, yet that discount persists which means that despite great performance due to underlying fundamental support from the business, the original thesis remains intact. In fact, the gap relative to comparable beauty industry companies has actually widened.

SumZero: Early this year, you recommended Revlon again for our FactSet Best Special Situations contest (and won an Honorable Mention). How has the situation changed between the two Revlon pitches?

Bradd Kern, Armored Wolf: Version 1.0 was a passive thesis. We thought the market was overly concerned about Ron Perelman and the company’s balance sheet (since Revlon has a high level of indebtedness), despite strong cash flow. Not only could the stock appreciate on the merit of growth in cash flows, but that there was a valuation gap too large to ignore relative to intrinsic value and comparable companies. Version 2.0, however, was an active thesis where we revisited the controlled ownership discount, but this time we went a step further and assumed the role of a Revlon adviser. We realized that there was a way to exploit the valuation arbitrage in a major way, but to do it, your name needed to be Ron Perelman. So rather than doing a typical, boilerplate write-up, the submission to the FactSet Best Special Situations contest was actually an open letter and presentation that we also delivered to Perelman’s holding company, MacAndrews & Forbes (M&F). In it we explained the favorable economics of a tender for the remaining 22% of the company M&F doesn’t already own. We calculated a $1.3B arbitrage opportunity, net of tender costs, that Perelman is uniquely positioned to capture. That’s real money, even for a billionaire.

SumZero: Can you talk about the suggestions you recommended and the implications to the both Perelman and common shareholders?

Bradd Kern, Armored Wolf: What we suggested MacAndrews & Forbes should do is take a hard look at tendering for the remaining 22% of the shares they don’t already own through what’s known as a “squeeze-out” or “freeze-out” merger. This would work as follows:

First, Perelman could tender for the remaining 22% of REV shares. Under Delaware law, if just 12% of REV shares tender (which would bring M&F ownership to 90%) M&F can effect a “freeze-out” merger and pay the remaining 10% of holdout shareholders the final price paid that raised M&F ownership to 90%. This gets M&F to full 100% ownership.

By eradicating the minority “share class” along with its distorted share price, potential acquirers will no longer be anchored to an inappropriately low value. Valuations thereafter can only focus on comps and intrinsic value, both of which imply >$60/share, even though the stock currently trades around $35/share.

What we didn’t advertise to M&F is that the average premium in a freeze-out merger has been about 20%, with an average bump of another 10% or so, for a 30% premium overall. That’s a very attractive proposition for shareholders. The beauty of the deal is, both parties would win. Perelman would not only make money on the slug of shares he tendered for, but he could monetize the remaining 78% of the shares he already owns for full intrinsic value once the distorted “public stub” share price was banished from the face of the earth, never to be referenced again as representative of Revlon’s value by potential acquirers.

SumZero: Are there any companies that would potentially acquire Revlon should Perelman go through with this plan?

Bradd Kern, Armored Wolf: There are global conglomerates like Unilever that might one day be interested in acquiring Revlon, but it's not likely to happen in the near term because Perelman is currently focused on growing market share, profitability, and free cash flow. In the meantime, the company's been sacrificing some margin to grow market share. Ultimately the value of Revlon will be higher, but Perelman treats Revlon like a private company, in that he doesn't care about tightly managing earnings. Although Perelman is not known for being a patient person, he's a smart businessman and has clearly instructed Revlon's CEO to do what is best for the company over the medium and long term. If Perelman wants to set the company up for a potential sale down the road, he should tender today for the shares while they are still cheap. It’s kind of the best of both worlds for us at Armored Wolf, because we’ve experienced appreciation, and are thus getting paid to wait for Perelman to take Revlon private, as he already did once many years ago.

SumZero: So this is common situation, and Perelman has done this before?

Bradd Kern, Armored Wolf: Typically when concentrated ownership exists in a public company, it will trade at some discount to comps and intrinsic value-- even if the ownership is not a proper controlling stake-- because that large ownership can have so much technical influence over the share price, and because so many of the votes are spoken for by one constituent, which is not ideal with respect to corporate governance. A similar situation with an influential billionaire shareholder taking a controlling stake private was with David Murdoch and Dole Foods in 2003 and 2013. Technically Murdoch was a minority shareholder, but he owned 40% and many believe he essentially controlled the board.

Controlling shareholders like Perelman are the extreme case. Perelman tendered for Revlon in 1987, ultimately paying a 36% premium for the shares he didn't own, a sliver of which he took public again in 1996 to help pay down some debt. Perelman took the company public for a purpose. Today, Revlon's balance sheet is healthy, the company's bonds yield about 6%, and Revlon's public status is merely a distraction for management.

SumZero: In your open letter to Perelman, you also warned that a consortium of minority investors could block the freeze-out merger by taking control of at least 10% of shares. Then they could refuse to sell in the event of a tender, driving prices even higher. Has the idea of a minority consortium to block takeover gained any traction among shareholders of Revlon?

Bradd Kern, Armored Wolf: We approached a number of Revlon shareholders, which are mostly mutual funds, but didn’t receive much interest. Part of it is ego—this would be an interesting, high profile maneuver, and these more seasoned, institutional investors would want to be the one spearheading this group if the initiative were to ever materialize. I used to work at a large mutual fund, and unlike at hedge funds, which seem to like to hunt in packs, cooperation with other funds to accomplish activist investing goals is generally not in the mutual fund playbook; it’s not the style. Anyone that brushes off the idea of a consortium though by saying they are already well compensated for the risk, is essentially saying that they agree there is a large premium that could be extracted if the risk were to be mitigated. From that perspective, there seems to a complacent passive stance held by the Revlon shareholder base. We still believe a minority consortium would help reduce the discount in Revlon shares, and we would be happy to lead or follow any effort to that effect.

SumZero: Revlon’s price spiked almost 20% in March 2015 but has since come down somewhat. What’s behind the recent volatility?

Bradd Kern, Armored Wolf: While there’s been some noise around a potential acquisition of Procter & Gamble’s CoverGirl and Max Factor assets, recent volatility in Revlon stock is due mostly to inconsistent earnings reports – one great, one bad. The company had a fantastic quarter in 4Q14 driven by strong underlying sales and profitability growth in both their consumer and professional beauty segments. Part of the success was due to management integrating and realizing synergies from their 2013 acquisition of The Colomer Group. However 1Q15 was a disappointment (and announced just two months later since results came in a bit late), due to temporarily high promotional spending in order to win new customers, as well as a couple of very specific but likely temporary issues in the professional segment. The company is addressing those issues, and we think the back half of the year will be much better than extrapolating the first quarter numbers would suggest.

SumZero: Is Revlon still attractive to buy at today’s prices?

Bradd Kern, Armored Wolf: Revlon is one of the most attractive holdings in our equity strategy today. We think the shares are worth $65, which equates to upside of 80%.

SumZero: What key metrics should investors be paying attention to as your thesis matures?

Bradd Kern, Armored Wolf: There are probably four key metrics investors should keep an eye on with Revlon. The first is enterprise value-to-EBITDA, which is now 10x, while comps sit at 14x. The second is leverage, or net debt-to-EBITDA, since Revlon has a high level of indebtedness. As the company pays down debt with free cash flow, this should help the multiple expand, since when debt declines, the equity becomes better protected in adverse scenarios and receives a larger portion of free cash flow. Leverage is currently at 4.8x net debt-to-EBITDA and we expect it to decline from that level. The third metric is sales growth, excluding the volatility of currency movements, since “ex-FX” growth indicates how well the core sales are doing, whether the products are gaining market traction, and whether management’s recent marketing initiatives are paying off. Finally, EBITDA margin, which is currently at about 18%, should tick back up closer to 19-20% as the recent promotional spending winds down. The closer that margin is to 20%+, the easier it is to make the argument that Revlon can be compared to comps.

SumZero: Is this thesis representative of the Bradd Kern and Armored Wolf investing style?

Bradd Kern, Armored Wolf: The Revlon thesis is very representative of my investing style and the kinds of ideas you’ll find in the Armored Wolf equity strategy, because it combines a fundamental view of the business, a heavy dose of valuation, and a special situation component. There’s a unique wrinkle that creates this huge arbitrage opportunity. While we don’t consider ourselves activists, we are not afraid to proactively share a view with management when we have one. In my former career at PIMCO and here at Armored Wolf, I was and continue to be instilled with the values of a meritocracy and the notion that the quality of ideas comes above all else. The one way the Revlon thesis is not as representative of Armored Wolf’s style is that many of our ideas are strongly informed by macroeconomic views, which is not as present in this Revlon thesis by virtue of the fact that it’s a consumer staple that lacks a high level of cyclicality other than some exposure to increased discretionary spending.

SumZero: Where else do you see value in the market today?

Bradd Kern, Armored Wolf: From a high level, there continues to be a large valuation discrepancy between cyclical and non-cyclical stocks. Investors are skeptical about the ability of the U.S. economy to recover. The industry best positioned to capitalize on a more optimistic view of the U.S. economy are the legacy airlines, which trade extremely cheaply and will be growing EPS while multiples expand as the market recognizes their new, more stable earnings profile. Delta, for example, has a forward P/E of 9x that’s approximately half that of the S&P industrials index, with a free cash flow yield of 12%. The airlines are also being more shareholder return focused than the market is giving them credit for, with more aggressive capital return programs, healthy balance sheets, and a macro benefit from the global glut of oil. A lot of investors view airlines the same way they view Ron Perelman; they just won’t get involved, they have a knee-jerk aversion. We underwrite risk in those select cases, and expect we will be compensated for picking the right risks to take through a superior market return.

SumZero: Tell me about your investing background and investing mentors/heros.

Bradd Kern, Armored Wolf: My introduction to value investing came from reading Benjamin Graham’s The Intelligent Investor and following Warren Buffett. I spent several years at PIMCO analyzing high yield credits, including through the financial crisis, which is where I learned how to size up the financials and business conditions of leveraged companies. In 2008-2009, I watched how quickly a business cycle can turn, taking defaults and equity valuations along with it, which reinforced my belief that macro matters, contrary to the beliefs of many fundamental investors. I also previously worked for a fund of hedge funds, and had the opportunity to observe how great investors like David Tepper managed their portfolios through the European sovereign debt crisis, and the types of opportunities they looked for across a capital structure to generate alpha.

At Armored Wolf, I’ve worked with our CIO, John Brynjolfsson, to develop a risk-adjusted approach to hedged equity portfolio management that supplements the most important piece of the puzzle, security selection. Finally, I’m a big fan of Carl Icahn’s toughness and the initiative he’s taken with the Shareholder Squaretable to advocate for better corporate governance. If you combine all of those influences together in some sort of kosher sausage, you get the investing ideal that I strive towards. Each experience and mentor has contributed to my style.

SumZero: How has your approach evolved over the years?

Bradd Kern, Armored Wolf: I’ve always had a value-oriented approach to investing, so that hasn’t changed. What’s different is that a few years ago, I was investing more in a mix of cyclical, beta-driven theses than special situation, alpha-driven names, but I’ve always done both. To some extent, that reflected a high directional conviction in U.S. equity markets, as well as the opportunity set at the time. There’s a critical balance for an investor between flexibility around the opportunity set and staying in your lane. With U.S. equity index valuations at more full levels in today’s environment, I’m focusing much more on targeting alpha through special situations and targeted macro views.

A special situation can be as simple as a company divesting non-core assets and using cash to buy back undervalued shares, such as Assurant (AIZ), or as complicated as a startup holding company like Philip Falcone’s HC2 (HCHC). I’ve also become more willing to engage with management as I’ve matured and realized that I can add value to certain holdings.

SumZero: What advice would you give to someone interested in pursuing investing?

Bradd Kern, Armored Wolf: There’s no one path, but reading helps you build a personal database of knowledge, which then sets the stage for pattern recognition and ability to react more quickly to opportunities. Read Benjamin Graham’s The Intelligent Investor to understand value investing. Study how great investors have honed their craft-- but don’t just read about other investors your whole life. That would be like trying to become a great hitter by watching Miguel Cabrera at-bats from your couch. Watch Tigers games, but take batting practice as well-- test your mettle by managing a personal account. When you have a meaningful amount of skin in the game, it is much more motivating. Read the Wall Street Journal and The Financial Times every day to learn about market and industry dynamics, and Barrons on the weekends so you get a sense for the breadth of stock theses out there. If possible, find a mentor as well to talk about investing and business.

Finally, create models and write-ups so you have something to show people when you have a job interview or have a successful pick. Early in your career, employers care a lot about your investing framework, the quality of your thought process, and your willingness to work hard, more than the actual outcome of your picks. Having a few thoughtful write-ups on hand for job interviews or when reaching out to a networking contact is some of the best evidence you can present that you’re passionate about investing.

SumZero: All very sound advice. Finally, on a lighter note, where does the name Armored Wolf come from? We see a lot of hedge fund names and have decided they are almost always a person name, place name, or occasionally a reference to greek mythology. Armored Wolf seems to be breaking the mold unless I’m forgetting my mythology.

Bradd Kern, Armored Wolf: Your theory about hedge fund names remains intact, as far as we’re concerned. Armored Wolf is the Icelandic translation of Brynjolfsson, the last name of our founder and CIO John Brynjolfsson, which translates as “Armored Wolf”. As a dog lover, wolves are one of my favorite animals because of their intelligence, adaptability, and beauty. So I enjoy the name.

SumZero: Bradd, thanks for you time and for shedding some light on this very interesting Revlon situation. Best of luck with this position to you and Armored Wolf going forward.

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