RILY - B. Riley: Short Covering Could Lead To A Massive Squeeze

2024-01-05 08:30:00 ET

Summary

• B. Riley Financial, Inc. is a financial services provider with a diverse portfolio and a focus on middle-market investments.
• Insiders have consistently bought shares, but short interest in the company reached significantly high levels in mid-December.
• The recent recovery in B. Riley Financial stock suggests a possible rotation in the market toward small caps, potentially benefiting the stock in 2024.
• B. Riley's constructive price action suggests the worst is likely over, as it bottomed out in November 2023.
• I highlight why a further recovery above the $24.5 level could drive a massive short squeeze as bearish investors bail.

B. Riley Financial, Inc. ( RILY ) is a financial services group with a diverse portfolio spanning several financial service segments. Its business is split into six operational segments, with capital markets as its most important revenue driver. The company believes its success is based on its " unique strategy in middle-market investments, often using their balance sheet to facilitate transactions."

As a result, it highlights its "buy-side" thesis, underscoring its "principle of owning stocks they recommended," a significant deviation from sell-side analysts in general. In other words, B. Riley wants investors to know that the B. Riley chefs eat their own cooking, bolstering the company's approach. In addition, I gleaned that insiders have consistently bought into their shares over the past year, highlighting the confidence in their approach and valuation. Notably, B. Riley's insiders reportedly own more than 44% of RILY's outstanding shares.

Despite that, RILY's short interest as a percentage of float reached nearly 57% in mid-December 2023, as it was battered toward its November 2023 lows. The mid-November margin call of B. Riley Securities CEO Andy Moore added to its bearish sentiments during that month, as investors were likely concerned about the overall exposure of the company's insiders. That caution is justified, given the significant exposure by the company insiders. As a result, RILY has turned out to be a battleground between insiders and short sellers committed to inflicting more punishment.

While it could be challenging to pinpoint the exact underlying thesis behind the short sellers' conviction in RILY, I believe its negative GAAP earnings metrics likely attracted them. Accordingly, B. Riley reported negative GAAP net income in the third quarter, which was attributed mainly to unrealized investment losses. "These losses were attributed to changes in mark-to-market valuations on its equities portfolio." Management stressed that these losses reflected the challenges in small caps, as they underperformed relatively. Despite that, the company raised $115M in an equity offering in July 2023, "indicating the company’s ability to attract equity investment." Given the company's middle market investments, it could remain susceptible to perceived volatility in the small-caps space if the volatility continues.

However, could the worst be over, with RILY showing signs of bottoming out in December and the recovery stretching further into the first week of January? Morningstar highlighted in a recent piece that small caps exposure in 2024 could be worth a consideration, as they are undervalued relative to mid and large caps. As a result, I believe the recent recovery in RILY over the past two months isn't a coincidence, suggesting the market has likely rotated. The selloff in the Nasdaq (COMP.IND) and the S&P 500 (SP500) to start 2024's trading year lends credence to my observation, as RILY outperformed.

Furthermore, investors must consider that B. Riley's operational adjusted EBITDA remains solidly profitable when excluding certain items, including the mark-to-market investment losses. With an operational adjusted EBITDA margin of about 23% in Q3, B. Riley's underlying business seems to remain sound, even as the short sellers would like you to think otherwise. It's also important to consider that the Franchise Group's internal investigation " revealed no connections with Prophecy Asset Management, whose co-founder is implicated in a securities fraud case." As a result, it has likely underpinned the market's confidence in B. Riley management, who supported the embattled company.

However, B. Riley's affiliation with Franchise Group had battered RILY in November, suggesting market sentiments remain uncertain. Despite that, I gleaned that if RILY could continue to recover from its crucial support level, the worst seems priced in. As a result, it could encourage more dip buyers to return, lifting RILY's recovery momentum further.

RILY's valuation remains favorable relative to its 10Y average, notwithstanding its recent recovery. Accordingly, RILY last traded at a trailing revenue multiple of 0.5x, well below its 10Y average of 1.5x.

As seen above, RILY's price action indicated a capitulation that resulted from a steep selloff that likely shook out weak hands in November 2023, including B. Riley's Andy Moore (who received the margin call notice). The consolidation has been constructive over the past two months, suggesting the possibility of accumulation and short-covering. Although its short interest was nearly 57% in mid-December, further covering has likely occurred based on its recent price action.

If RILY's dip buyers could decisively lift its upward momentum further above the $24.5 support level, it could spur more bearish investors to cover their shorts in a hurry to protect their positions/profits, leading to a possible short squeeze.

I see the risk/reward as favorable for B. Riley Financial, Inc. dip buyers at the current levels, in line with a more favorable market environment for small caps in 2024. Given my expectation that RILY bottomed out in November, I believe it's apt to lean bullish, albeit as a speculative rating.

Rating: Speculative Buy. See the additional disclosure section below for important notes accompanying the Speculative/Cautious Buy rating presented.

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