B. Riley’s Equity Raise: Peak Leverage Or Unsustainable Dividend (NASDAQ:RILY)

Funding Thesis

Within the earlier article on B. Riley Monetary (NASDAQ:RILY), I arrived at a cautious ‘Maintain’ score for the controversial California-based funding financial institution, balancing a number of dynamics at play: the cyclicality of the corporate’s core operations, speculative-grade funding portfolio, and reputational dangers related to its deal with financially-distressed companies. These issues have been counterbalanced by RILY’s historic outperformance, administration’s unwavering dedication to shareholder returns, and its notably low valuation.

Nevertheless, current developments, together with RILY’s inventory rally prior to now few weeks, have prompted me to revisit this middle-of-the-road stance. The valuation speculation that backed the ‘Maintain’ score within the earlier piece now not seems legitimate. Moreover, a deeper dive into the efficiency of the non-core operations suggests they may not be residing as much as expectations, prompting a contemporary analysis of the corporate’s general outlook.

Final week’s determination to boost capital via a brand new fairness providing whereas concurrently paying dividends highlights an unconventional capital allocation coverage that both alerts an unsustainable dividend coverage or a battle with excessive leverage.

Within the earlier article, I provided a complete overview of RILY’s working segments, honing in on income drivers and tendencies. Nevertheless, regardless of this thorough evaluation, there wanted to be extra dialogue of RILY’s property underpinning their income drivers. Furthermore, RILY experiences $6.6 billion in whole property, creating a picture of a sturdy scale that means alternatives to leverage its dimension for extra income and market share. Nevertheless, upon nearer examination, this notion appears deceptive.

This piece makes an attempt to rectify this disadvantage, providing a complete overview of RILY’s asset accounts, from the most important to the smallest.

Large Asset, Tiny Returns

Practically half of RILY’s $6.6 billion property fall underneath the ‘Securities Borrowed’ account. Property underneath this account represent the shares RILY borrows from numerous monetary establishments to assist its securities lending operations. For instance, if a buyer needs to borrow a share for a brief place, RILY will procure this inventory from one other entity earlier than lending it to its buyer.

The Securities Lending operations and the corresponding ~3 billion in property on RILY’s steadiness sheet have some key traits that undermine their worth.

Collateralization: RILY maintains a ‘matched ebook’ ledger to facilitate its securities lending operations whereas neutralizing publicity to market fluctuations. Property underneath the ‘Securities Borrowed’ are collateral to liabilities underneath the ‘Securities Loaned’ account. Thus, the ~$3 billion property underneath the ‘Securities Borrowed’ account is NOT freely obtainable for different makes use of as they’re tied to corresponding liabilities as collateral.

Slender Margins: For Q1 2023, the income from securities lending rounded to a powerful $37.2 million. That is the cash that RILY collects from its clients for its securities lending service. Nevertheless, after accounting for the curiosity expense to unique securities house owners, a mere $4.8 million stays because the gross margin. Thus, whereas RILY experiences a sturdy steadiness sheet, with Whole Property exceeding $6.6 million, almost half of this steadiness is expounded to low-margined securities-lending and brokerage operations.

Restricted Indicator of Creditworthiness: This ‘matched ebook’ construction reduces its relevance as a measure of RILY’s creditworthiness. It is just like a brokerage agency allowing its retail buyers to have interaction in margin buying and selling with out conducting a credit score verify. The exercise is collateralized, with a steadiness between property and liabilities.

These little nuggets of knowledge present a actuality verify to the preliminary awe impressed by the large scale of RILY’s property.

The Damaged Promise of Extraordinary Returns

RILY has undertaken a diversification technique, branching into various sectors, from dial-up web, laptop computer equipment, and most not too long ago, European Trend, with the acquisition of Scotch & Soda in Might.

This technique has been marketed to buyers as a pathway towards extraordinary returns. For instance, commenting on the BR Manufacturers acquisition, RILY acknowledged that it has:

established a model funding portfolio which aligns with the Firm’s technique of pursuing sturdy free money movement funding alternatives to generate accretive recurring income for the B. Riley platform.

This pitch means that these acquisitions, regardless of working in sectors riddled with technological challenges and aggressive pressures, can yield vital returns on invested capital. On the floor, this narrative appears interesting, with the picture of RILY unearthing discarded property which are, in reality, useful gems that promise excessive returns on invested capital.

Nevertheless, a more in-depth have a look at the monetary outcomes unveils a contrasting narrative. The corporate’s diversification efforts, which started with the acquisition of United On-line ‘UOL’ in 2016 to the newest acquisitions, together with Targus and Scotch & Soda, generated an EBIT of $220 million. When bearing in mind curiosity and tax expense, this whole barely offsets the $170 million outlay solely for the United On-line acquisition in 2016, to not point out the remaining acquisitions, which in whole, quantity to greater than $830 million, most of which is recorded on the steadiness sheet as Goodwill and Intangibles, representing 14% of RILY’s whole property.

Under is a listing of a few of RILY’s non-core acquisitions, listed together with combination acquisition worth.

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*Creator’s estimates. The Lingo acquisition deal contains further 200,000 share warrants with a strike worth of $26.24 per share, exercisable at numerous dates.

28% of Whole Property within the Stability

RILY has traditionally demonstrated a concentrated deal with distressed firms inside its funding portfolio, a technique that has been a explanation for concern for a lot of buyers. It maintains an inherently high-risk, high-reward portfolio, mandating rigorous scrutiny and urge for food for threat.

Sadly, RILY operates with a sure degree of opacity, protecting public disclosures to a minimal. This amplifies the chance for these drawn to the high-risk, high-reward alternatives it provides.

A case level of RILY’s lack of transparency is its 2014 reverse merger with Nice American Group, which introduced it to the general public markets. Buyers have been provided solely a fleeting look at RILY’s previous, with only a single 12 months’s price of historic information featured within the prospectus, whereas typical mergers usually embrace a number of years of efficiency historical past. Regardless of its existence since 1996, I wasn’t in a position to pin down public information of RILY previous to its merger. This opacity extends to RILY’s funding portfolio.

However this obscurity, we are able to acquire some perception into RILY’s funding portfolio from its steadiness sheet, which reveals its portfolio structured round two primary accounts.

1. Securities and Different Investments Owned: $1.05 billion (15% of whole property)
2. Loans Receivables: $0.77 billion (11.5% of whole property)

Securities and Different Investments Owned

The ‘Securities Owned’ account consists of stakes in numerous asset courses, together with publicly-traded shares, personal fairness, personal debt, company loans, and others.

There is not a whole file of RILY’s funding portfolio. The one accessible file is a partial one, discovered within the Type 13-F filings, which, whereas useful, falls wanting being complete. This disclosure represents solely 38% of the property underneath the ‘Securities Owned’ account, permitting us to establish $382 million out of the $1.05 billion reported on the steadiness sheet assertion. Included on this incomplete record are investments in 46 firms, together with a number of SPACs during which RILY is both main or appearing as a book-runner. Under is a listing of the highest twenty of those 46 firms, which collectively symbolize 99% of the $382 million grand whole on the 13-F type.

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*Particular Function Acquisition Firm ‘SPAC’

Whereas a few of these investments could also be a by-product of RILY’s underwriting actions, the substantial stakes in a few of these entities counsel a deliberate technique to carry a large market place in these firms. Notable investments embrace possession of round 30% of Babcock & Wilcox Enterprises, 21% of The Enviornment Group Holdings, 18.5% of Alta Tools Group, 15% of FaZe Holdings, 14% in Synchronoss Applied sciences, along with stakes ranging between 3 – 11% in a number of different entities.

Though ‘Securities and Different Investments’ account for under 15% of whole property, fluctuations on this account have traditionally created vital volatility for RILY’s earnings. Many of the firms are rated ‘Maintain’ or ‘Promote’ by Searching for Alpha Quant System, indicating a cautious outlook, with protection by analysts being notably restricted.

Loans Receivables: Strategic Loans

RILY’s mortgage technique is not nearly excessive yields from financially struggling firms. It is extra subtle. RILY guides these debt-ridden corporations towards issuing new fairness to repay loans. In doing so, and by stepping in as an underwriter, RILY is not simply getting its mortgage a reimbursement but additionally pocketing underwriting charges as properly.

Reflecting again three years in the past, I recall writing an article about Exela (XELA), warning widespread fairness holders about dilution threat and what I imagine is an elaborate scheme by administration to stay its sturdy debt invoice to widespread fairness holders.

On the time, RILY was a small firm, and I did not put an excessive amount of thought into its fairness underwriter or lenders. All I knew was that XELA amassed enormous debt within the again places of work of funding bankers slicing and dicing the corporate earlier than dumping it to the general public market via a SPAC deal. Now, with hindsight, I see the larger image and notice that XELA wasn’t a one-off incident. It was a part of RILY’s strategic enterprise mannequin to supply bridge loans to financially pressured firms earlier than passing the debt to a different investor, on this case, fairness buyers, which has, as predicted, considerably diluted shares.

An identical state of affairs performed out with Greenidge Era Holdings Inc. (GREE). In March 2022, RILY prolonged a $26 million promissory notice to GREE, secured by a mortgage lien on GREE actual property properties. Regardless of dealing with compensation difficulties, GREE was obligated via an amended mortgage settlement to make use of 65% of any fairness proceeds in direction of clearing RILY’s debt. On the identical time, RILY, appearing because the underwriter, collected a 4% payment on the proceeds, together with different adjustments, on high of the curiosity revenue on the debt.

Not all offers are the identical, however they share a theme of RILY excreting affect and management on troubled companies. For instance, in 2018, as an alternative of in search of debt compensation, RILY transformed its mortgage to Bebe shops to a 30% fairness stake. In November 2020, it transformed its loans to Lingo right into a 40% stake earlier than buying a further 40%. One other instance is RILY’s $60 million debt to Harrow Well being, which was dropped at gentle by Wolfpack Analysis earlier this 12 months. It’s price noting that since Wolfpack’s article, Harrow Well being has repaid RILY’s debt in full, along with curiosity. Harrow funded RILY’s debt compensation by borrowing from Oaktree Capital Administration, the exterior supervisor of Oaktree Specialty Lending (OCSL), and Oaktree Strategic Earnings (OCSI). RILY nonetheless has publicity via a ten.9% $100 million credit score facility that expires in 2025, which as of the time of this writing, stays undrawn.

These examples make clear RILY’s strategic maneuvers: offering mortgage help to struggling firms and transitioning into an fairness underwriter function by excreting management and implementing stringent debt covenants. RILY calls for accelerated compensation or encourages further fairness choices within the occasion of a covenant breach, thus securing an advantageous place. For that reason, whereas these loans have attracted probably the most scrutiny, I imagine that RILY’s technique to mitigate threat assuages a few of these fears.

As of Q1 2023, RILY’s steadiness sheet confirmed $722 million in mortgage property, accounting for roughly 11.7% of whole property. A good portion of that is associated to the W.S Badcock 2021 receivables deal, which entailed the acquisition of $531 million in W.S Badcock receivables for $400 million, successfully making RILY a creditor to W.S clients. In 2022, RILY bought a further $168 million of W.S receivables. As RILY collects these receivables, a portion is recorded as curiosity revenue. As of Q1 2023, RILY reported $324 million in mortgage property associated to W.S. It’s price noting that earlier this 12 months, RILY bought a controlling curiosity in Franchise Group, the mother or father firm of W.S Badcock.

Excluding W.S, the mortgage portfolio presently consists of 14 firms with a complete worth of $448 million, with a median mortgage dimension of $34 million, in response to administration.

Pay as you go Bills and Different Property: 7.5% of Whole Property, with SPACs within the Combine.

Yesterday’s fee hike by the Fed and the anticipated tightening by the European Central Financial institution, and probably different components of the world, sign continued tightening, though it appears we could also be nearing the tip of this part, as many pundits agree. Nonetheless, the financial coverage at this time is stricter than it was in 2021 when the funding banking sector benefited from ultra-accommodative Fed insurance policies.

RILY sponsors or serves because the book-runner of a number of SPACs, a lot of which have raised capital however are but to discover a goal firm. Probably the most consequential is B Riley 250 Merger Corp (BRPM), which raised $150 million however has did not discover a goal firm. Given the controlling curiosity of RILY in BRPM, its property are consolidated on the steadiness sheet underneath the ‘Pay as you go bills and different property’ account for Q1 2023 quarterly report as proven under:

In Q2 2023 quarterly report, the property of BRPM will likely be written off from RILY’s steadiness sheet, on condition that the deadline for RILY to discover a goal firm has handed. Earlier in Might, RILY introduced it was redeeming all BRPM shares and paying again $10.15 per share to shareholders. Wolfpack Analysis tried to domesticate negativity surrounding this matter, asserting that there can be a 176 million lower in property in Q2 2023. Nevertheless, that is solely a bit of the larger image. Because it stands, RILY carries a legal responsibility steadiness of $176 million associated to BRPM. Following the redemption of BRPM’s property, this legal responsibility may even be erased, thereby leaving the Internet Asset Worth “NAV” intact.

RILY can be the bookrunner of a number of SPACs that reached the deadline with out discovering a goal firm in Q2 2023. For instance, AltEnergy Acquisition Corp, which RILY owns 149,000 shares valued at $1.6 million, handed its deal deadline. AltEnergy will seemingly redeem RILY’s shares for the precise quantity, which can seemingly be mirrored in Q2 or Q3 2023 13-F and the ‘Securities Owned’ account. The identical goes for ArrowRoot Acquisition Crop and Deep Drugs Acquisition, during which RILY is each an investor and the bookrunner, assuming no extension for these deadlines.

Different examples embrace the Anzu Acquisition, whose deadline is on September 30, 2023, and the Forest Street acquisition of December 2023, during which RILY can be the bookrunner and investor.

Leverage

RILY has proven sturdy historic efficiency, with its income growing six folds since its IPO. This progress can be mirrored in its income per-share metrics. Nevertheless, once we dig deeper, we will not discover clear proof of natural progress. Take the public sale and liquidation enterprise, for instance. Since its acquisition in 203, gross sales have remained comparatively inside the identical vary. As an alternative of driving natural progress, RILY has been boosting its numbers via monetary leverage, taking up extra debt to fund acquisitions. So, whereas the corporate’s funds may look good at first look, a more in-depth look reveals a unique story.

A good portion of RILY’s debt was invested in dangerous property, together with industries with slender financial moat, resembling Targus, or enterprises within the declining part, resembling United On-line.

RILY’s notes are traded on public exchanges, and their excessive yield has attracted curiosity amongst retail revenue buyers. Nevertheless, I imagine that at this stage, there’s some monetary threat, given the high-interest burden that presently stands at about $200 million yearly.

Taking part in With Fireplace: RILY’s Capital Allocation Technique

Final week, RILY introduced that it was elevating 115 million via a brand new fairness providing. On the identical time, the corporate additionally declared a dividend of $1 per share, which might quantity to an annual dividend run fee of roughly 120 million or ~$30 million per quarter. These choices spotlight an uncommon capital allocation technique.

On the floor, it seems as if RILY is getting ready to fund subsequent 12 months’s dividends via the fairness increase, a transfer that contradicts administration’s acknowledged intention of supporting dividends via operations. But, even when the management succeeds in fulfilling dividend funds via working money movement, the capital increase means that the group perceives a excessive degree of leverage inside the firm.

Within the face of excessive leverage, issuing further shares is a viable answer. Given RILY’s excessive leverage, the current determination to boost capital via fairness will be interpreted in two methods. It may both signify that the corporate’s dividend coverage is unsustainable or that the corporate is contending with excessive leverage.

How I May Be Flawed

In the newest reporting durations, RILY recorded losses on its investments. The first driver was a difficult macroeconomic surroundings. Nevertheless, because the newest reporting interval via the quarter ended June 2023, a lot of RILY’s fairness portfolio has rebounded, together with the broader market.

For instance, RILY’s holdings in Lilium NV, which has been an underperformer in 2022, and Q1 2023, almost tripled in worth in Q2 2023, including $10 million in capital positive factors. Equally, LifeMD shares greater than doubled in Q2, including $2.5 million in capital positive factors within the interval (assuming RILY hasn’t modified variety of shares held).

Thus, buyers ought to anticipate a optimistic contribution from investments when RILY experiences its Q2 ends in the approaching weeks. Extra importantly, these dynamics present the complexity of assigning a constant valuation to RILY, undermining the Promote score on this evaluation.

Abstract

Over the previous few weeks, I have been analyzing RILY from numerous angles, diving into the intricate and sophisticated layers of its monetary efficiency and asset high quality. The corporate’s diversification technique, which guarantees a excessive return pathway, hasn’t fairly lived as much as expectations. For instance, the EBIT from RILY’s almost $1 billion price of acquisitions within the Communications and Manufacturers phase barely covers the preliminary 2016 capital outlay for United On-line alone. Return ratios fall deeper within the crimson when including curiosity expense on the debt funding these acquisitions.

Whereas RILY’s income progress is spectacular, taking pictures up sixfold since its IPO, a more in-depth look reveals that this progress is predominantly fuelled by monetary leverage and acquisitions quite than natural enterprise growth.

The corporate’s current fairness increase means that both RILY has reached its peak leverage, with the corporate now’s now trying into the fairness market to revive the steadiness on its sheet, or that its dividend coverage is unsustainable.

Editor’s Word: This text covers a number of microcap shares. Please concentrate on the dangers related to these shares.