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Mittleman Brothers 1Q17 Letter – Revlon & International Game Technology

Mittleman Brothers Investment Mangement 1Q17 Commentary, May 1, 2017

Performance

  • Gained 5.4% in 1Q17 vs. 6.1% in S&P 500 and 2.5% in Russell 2000
  • Top 3 contributors were Jardine Strategic Holdings (+27%), KB Financial Group (+25%), and Intralot S.A. (+22%)
  • Top 3 detractors were International Game Technology (-7%), Revlon (-5%), and Gazprom (-12%)

International Game Technology (IGT)

  • #1 lottery and #2 slot machine business in the world
  • Reported 4Q16 results that were slightly worse than expected and offered guidance for 2017 of adjusted EBITDA of $1.68B to $1.76B (vs. consensus expectations of $1.78B to $1.82B)
  • Main cause of the weakness was their social gaming division (paying real money for virtual chips on various online casino games on social media websites) – this small subsidiary called DoubleDown Interactive was 5% of total IGT sales
    • Acquired in 2012 for $500 million in cash
    • After losing market share and poorly performing, IGT announced in April that it is selling DoubleDown Interactive for $825 million cash (10.5x EBITDA) to a South Korean company called DoubleUGames
    • Selling their worst performing business for 10.5x while IGT trades at 7.5x seems like a highly accretive maneuver
  • Continue to like IGT because of its global leadership in lottery business, immense barriers to entry, high EBITDA margins (34% in 16), and very predictable cash flows
  • Italy’s lotto concession will run for another 9 years and their top 20 North American contracts have an average remaining life of 8.5 years
  • In the US alone, $70B is spent annually on lottery tickets industry-wide; lottery ticket sales drive about 25% of total sales for convenience stores like 7-11
    • It seems strange that market awards convenience store chains like Couche-Tard and Casey’s General Stores with 10x EBITDA multiple on their 7% EBITDA margin business while IGT, the largest facilitator of a key product for those chains, with a 34% EBITDA margin, wallows at 7.5x EBITDA
  • Estimated fair value of stock at $32 – we arrive at $32 by applying the same EV/EBITDA at which SGMS trades (8.5x) to our estimate of IGT’s 2017 EBITDA of $1.65B which is an EV of $14.03B, minus net debt of $6.97B, minus minority interest of $580M, equals equity value of $6.48B or $32/share
    • Market value is 16x our estimate of IGT’s normalized FCF at $400M
    • 4% dividend yield and 35% upside potential
  • Slot machine business which was the weak spot in 2015 seems to have stabilized and may grow again – gambling and lotteries are a source of incremental revenue for over-leveraged state governments
    • Japan is legalizing casinos and we think legal sports betting is coming to the US at some point
  • Also have confidence that Marco Drago of De Agostini private equity fund of Italy will continue to push toward maximizing shareholder value

Revlon (REV)

  • 4Q16 report showed an accelerated rate of decline for Revlon’s North American consumer sales; however, growth in international sales and their professional segment led to total net sales of -0.6%, and +1.4% on a constant currency basis
  • Lowered our estimate of EBITDA to $450M and FCF to $150M for 2017 and fair value estimate to $65/share
    • $65/share based on 13.5x EV/EBITDA and a market cap/FCF multiple of 23x; 13.5x is what Coty paid for its purchase of P&G’s beauty brands in October 2016 and Coty itself is trading at nearly a 52-week low of 13.3x
  • Explanation for the adverse trend in North American consumer mass market business is primarily that for the past few years, there has been a shift in sales in the US cosmetics industry away from the mass market channels (drug stores, Wal-Mart, Target) to specialty stores (Ulta and Sephora) and with that shift, a trend towards premiumization
    • In addition, online sales channel is taking share and Revlon has yet to perfect their online strategy
  • Addition of Elizabeth Arden, a 107-year old brand rebounding now after a fall from grace, opens up new channels for growth, particularly in the Asian market
  • New CEO, Fabian Garcia, recently stated a goal of $5B in sales in 5 years, implying an ambitious 12% CAGR versus the 5% long-term industry average
  • Although barriers to entry have fallen and a proliferation of new niche competitors has eaten away at the bigger players, it remains to be seen which of these new brands will have staying power
    • Body Shop was once the hot up-and-corner from 1990 to 2001 before stagnating in the early 2000s and now L’Oreal is trying to sell it after buying it in 2006 at 12x EBITDA
    • How long until reality TV star Kylie Jenner’s $300 million cosmetics sales in 2016 revert back to established players?
  • Revlon’s business is highly recession-resistant, with historically resilient EBITDA and FCF to support its highly leveraged balance sheet (5.5x net debt)
  • Trend towards premiumization might reverse if we encounter another recession – but rather than waiting for a recession, Revlon should find that their plan to increase brand support and innovation will have significant positive effects on sales
  • Even if sales for overall company remain relatively flat in 2017, EBITDA and FCF should grow significantly as cost savings from Elizabeth Arden merger are only partially consumed by increasing marketing spending
  • We started buying Revlon at $10 in December 2010; stock was $27.85 on 3/31/17 down from an interim peak of $41.67 in April 2015
    • Mere parity with Coty’s current 52-week low valuation would be $57 to $63, more than double the current price
  • Billionaire Ron Perelman owns 77.4% of the stock and has controlled Revlon since 1985
    • May have tried to sell his stake in January 2016 when his holding company, MacAndrews & Forbes announced it was exploring “strategic alternatives”; he perhaps failed to find a buyer willing to pay his price at that time does not mean that he won’t eventually be successful
  • Revlon was #1 in lipstick in 1957 and it remains #1 in lipstick today as well as other key product lines – despite intense competition from much larger and smaller entities for decades now, it is the definition of a durable franchise
    • We see the recent price drop as an over-reaction to the recent slide in North American business, while ignoring the offsetting strength in international sales, and the scarcity value of the last remaining major US player in cosmetics with global scope that has yet to be acquired by a giant
Image Source: Bloomberg
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