Why The Outlook is Bleak
I am pessimistic about B. Riley Financial, Inc. (NASDAQ:RILY) due to a risky solvency position and the company’s negative tangible book value vis-à-vis its trading value.
- RILY’s core business is in a risky solvency position.
- The company has a negative tangible book value yet is trading above book value.
- Short interest is high, but I believe a squeeze is unlikely until new lows are made.
My assessment underscores the balance sheet risks in B. Riley, which overshadow the claims of equity investors, preferred equity investors, and debt security investors. Hence, the viewpoint applies to all the different listed instruments under the RILY umbrella (RILY) (NASDAQ:RILYP), (NASDAQ:RILYL), (NASDAQ:RILYO), (NASDAQ:RILYM), (NASDAQ:RILYG), (NASDAQ:RILYK), (NASDAQ:RILYN), (NASDAQ:RILYZ), and (NASDAQ:RILYT).
The Peril of RILY’s Business Solvency
RILY’s standard interest coverage ratio (computed as EBIT/Net Interest Expense) is already low at 1.26x. However, the headline EBIT figure includes volatile revenue streams that may not be part of core operations:
- Capital markets trading and mark-to-market on loan revenues
- Auction and liquidation sale of goods revenue
- Wealth management trading and mark-to-market on loan revenue
The material volatility in these revenue streams is evident in their historical contribution to the overall revenue mix.
The Capital Markets trading and mark-to-market revenues have exhibited substantial swings in the last 11 quarters, indicating significant volatility.
Similarly, the Auction and Liquidation sale of goods revenues show sizable volatility in the revenue mix over the same period.
Although Wealth Management trading and mark-to-market revenues have made insignificant contributions, they share the characteristic of being volatile.
Excluding such highly volatile revenue streams from the solvency analysis reveals that the company is unable to fund net interest expenses from its core operating earnings, leading to a negative core net interest coverage ratio of -0.17x.
This negative coverage stems from negative core EBIT, excluding the impact of the highly volatile revenue streams and associated cost of goods sold.
As of Q3 FY23, the company has $4.23 million in liquidity, insufficient to cover the annualized core EBIT loss of $8.76 million. While core EBITDA is positive at +$23.59 million as of Q3 FY23, the high net debt to core EBITDA ratio of almost 10.6x is cause for concern.
The Dismal State of Tangible Book Value
RILY has a negative net assets ex-goodwill situation of -$30 million as of Q3 FY23.
This disturbing picture is compounded by the fact that RILY is trading above its book value despite these glaring financial weaknesses.
RILY Stock: A Structural Decline Looms
RILY’s Balance Sheet Woes
RILY’s financial health is facing dire straits. With a negative net assets ex-goodwill figure and trading above book value, the stock is seemingly amiss on its true valuation. The inclusion of $333.6 million in intangible assets in the net assets calculation, despite recent impairments, casts further shadows on the company’s stability.
Short Interest and Squeeze Potential
Short interest in RILY is high at 32.25%, signaling widespread market skepticism. However, the likelihood of a short squeeze seems diminished after a recent surge in late January 2024. Fresh lows below $15.93 might be the trigger for a new set of short sellers to emerge.
Positioning Before Q4 Earnings
Beyond the surface, RILY’s core business is undergoing significant challenges. EBIT losses and a frail liquidity position reflect a worrying financial predicament, possibly impeding the company’s ability to cover net interest expenses. These predicaments could influence the stock’s valuation, highlighting the potential for further de-rating.
The forthcoming Q4 results on 22 Feb 2024 are unlikely to spur a sustainable reversal, given the deeply entrenched headwinds facing RILY.
Shorting Perspectives and Past Lessons
Despite the high short interest, the potential for short squeeze mitigation rests on the stock’s performance dipping to record new lows. Furthermore, the bearish sentiment is driving annual short borrow fee rates to an exorbitant 49.64%, effectively dissuading fresh short positions.
Drawing on prior experience with Medical Properties Trust (MPW), a cautious approach is recommended. Recognizing the asset quality risks early but failing to capitalize due to risk aversion underlines the importance of proactive decision-making. Consequently, a more resolute rating is advised for RILY, given its structural decline and looming external challenges.
Rating: Strong Sell
In accordance with these findings, a Strong Sell rating is warranted for RILY.
Interpreting Ratings
Understanding the ratings systems, the Strong Sell designation conveys an expectation of underperformance relative to the S&P 500, backed by an above-average level of confidence.
The foreseeable time horizon for this view is several quarters to around a year, with an openness to altering the stance as informed by potential updates.
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