RILYP - B. Riley's Confrontation With Market Headwinds And Internal Struggles

2023-03-30 10:48:13 ET

Summary

• RILY is facing challenges both from external factors, such as rising interest rates and market selloffs, and internal issues, such as decreased investment banking activity and sluggish growth.
• The financial performance across segments is mixed, with an adjusted segment income of $128 million, enough to cover interest expense and overhead costs but not sufficient for sustaining dividend payments.
• There is no immediate threat to RILY's business model, but this is an evolving situation, with reputational damage from high-risk asset exposure possibly causing asset withdrawals and decreased confidence.

Investment Thesis

In the midst of an intricate web of challenges, B. Riley Financial (RILY) is seemingly entangled, facing a tumultuous descent driven by the convergence of internal strife and external pressures that culminate in an all-too-perfect storm.

The overall market has been witnessing turbulence due to a confluence of unfavorable events; rising interest rates, the war in Ukraine, and persistent inflation have all contributed to the market's downturn. As RILY is not immune to these broader trends, its share price has felt the impact.

Furthermore, the financial services sector, which includes RILY, has been facing a particularly challenging environment in the aftermath of the Silicon Valley Bank collapse, with the sector bearing the brunt of the market's recent decline, adding to the woes of RILY's shareholders.

Digging deeper into the company's performance, we find that RILY has encountered its fair share of internal obstacles. A noticeable decrease in investment banking activity and a sluggish loan growth rate have raised concerns about the company's prospects.

Moreover, RILY has been under fire for the alleged adoption of high-risk lending practices. These criticisms have undoubtedly tarnished the company's reputation and may have deterred potential investors, further contributing to the decline in its share price.

Generally speaking, I believe the current market downturn presents a buying opportunity as many of the external challenges affecting the stock market are likely to be temporary in nature. However, it is important to note that RILY is grappling with additional internal issues that may elongate its recovery. The increased scrutiny surrounding the company's practices adds another layer of complexity to its situation. Consequently, while I am inclined to capitalize on this market dip, I acknowledge that the road to recovery for RILY shares may be a long and arduous one.

The Evolution of B. Riley Financial: Embracing Diversification and Seizing Opportunities

Over the years, RILY has carved out a niche for itself as an investment bank, "IB," catering to the needs of Small and Medium Enterprises, "SMEs," and high net-worth individuals. However, in an era marked by constant change, the company has been undergoing a remarkable transformation, broadening its horizons by morphing into a holding company and expanding its reach beyond the financial services sector.

This strategic shift has seen RILY adopting an opportunistic approach, actively acquiring businesses outside its traditional realm of expertise. For example, the company recently bought BullsEye Telecom to complement its communications business, which includes United Online, Lingo, and magicJack.

This move can be seen as an attempt to diversify its revenue streams and hedge against potential downturns in the financial services industry. In doing so, the company aims to insulate itself from market volatility and industry-specific risks than can hamper growth.

RILY's propriety trading and investment accounts have snowballed in the past few years, expanding both organically and through acquisitions by 67 folds from $17 million in 2016 to $1.3 billion in 2022, while its loans receivable increased from $33 million in 2017 to more than $700 million in 2022. Yet, the ambiguity that exists between the securities held for market making, investment banking, and propriety investments raises concerns. It is this very lack of clarity that underscores the material weaknesses recently exposed in the company's internal controls, compelling a restatement of financial statements for the past years. As observers and stakeholders, we must question whether these blurred lines are symptomatic of deeper issues within the organization.

Navigating the Ebb and Flow: A Closer Look at B. Riley Financial's Segment Performance

RILY reported varying results across its diverse business segments in recent years, as shown by its restated financial reports earlier this month. As the company continues to evolve into a holding company and opportunistically acquire businesses outside the financial sector, it is essential to examine the performance of its various segments.

The Capital Markets segment is the largest contributor to revenue and net income. It includes underwriting fees, commissions on brokerage services for institutional investors, and interest from loans. It also includes trading income and loss, which has been the center of management internal control investigations, as the company found it difficult to differentiate between this item, and another balance under the account "Realized and unrealized gains (losses) on investments." Generally, results from the trading activities are recorded in revenue (whether gain or loss), while Realized and unrealized gains (losses) on investments are recorded in a separate line item below operating results.

In the past three years, the Capital Markets segment witnessed fluctuating revenues, with a significant dip in 2022, compared to the previous year. Despite the setback, the segment management generated substantial income in all three years. Net interest income remained strong, driven by interest on loans and, from my understanding, interest on covered options.

The Wealth Management segment, which oversees $23 billion in assets spawning high net-worth individuals, non-profits, and retirees, saw a decline in income, with a notable loss in 2022. The segment's net income margins have historically been low. This, combined with its cyclicality, might indicate the need for the company to reassess its strategies or bolster its position in the wealth management space.

The Auction and Liquidation segment, although relatively small, has experienced a stable income, with notably high earnings during periods of economic instability, offering a counter-cyclical exposure. The segment includes revenue from operations such as the closure of unproductive retail stores and the disposition of assets.

The company's Financial Consulting business reported consistent income in the past few years, showcasing the company's ability to maintain its core competencies and deliver value to its clients. The company's focus on troubled assets gives it an edge over its peers in the bankruptcy consulting services segment, which contributes to a meaningful part of the company's consulting operations.

The communication business, which includes subscription revenue from its magicJack VoIP services and United Online dial-up internet, and associated devices revenue, saw a surge in 2022 after the company acquired BullsEye Telecom, a provider of cloud-based services. Overall, management expects the communication segment to see a decline as demand for DSL connections becomes obsolete.

Finally, the Brands segment includes licensing fees and royalties collected. It is a cyclical business line, as demonstrated by the decline in net income in 2020 and the subsequent surge in 2021 and 2022. Brands included are

• Catherine Malandrino
• English Laundry
• Joan Vass
• Kensie Girl
• Limited Too
• Nanette Lepore

From the tables above, RILY's financial performance reveals a blend of ups and downs, reflecting the challenges faced by many in these uncertain times. While the company's consolidated segment net income of $128 million might not be dazzling, it comfortably covers the combined interest expenses and overhead costs, which totaled around $72 million last year, providing an adequate cushion for its bondholders; ( RILYG ) ( RILYK ), ( RILYL ), ( RILYM ), ( RILYN ), ( RILYO ), ( RILYP ), ( RILYT ), and ( RILYZ ). The same can't be true for dividends, which, as many know, will fluctuate according to economic conditions.

It is also hard to overlook the precarious nature of RILY's investment portfolio, which is heavily concentrated in troubled high-risk assets. These unrealized losses, which we might usually dismiss as temporary setbacks, have the potential to become lasting scares on the company's financials.

Adding to these concerns, RILY's operating cash flow of a mere $6 million in 2022 leaves much to be desired, falling short of the necessary funds to maintain any dividend payments. Yet as I delve deeper into the financials, I'm optimistic that with prudent cash flow and credit management, RILY can overcome these challenges and chart a course toward stability.

Summary

RILY stock performance appears to be caught in a whirlwind of adverse market conditions and internal challenges. With an unpredictable market and growing scrutiny over the company's practices, the road to recovery for RILY shares is fraught with obstacles and might take longer than anticipated.

Despite these concerns, it is important to note that there is no clear evidence to suggest that the company's business model faces immediate challenges, at least for now, notwithstanding the reputational damage caused by its exposure to high-risk assets. For these reasons, I will pass on this ticker but would consider buying its publicly-traded notes.

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