Wednesday, October 5 2022

Diego Thomazini

B. Riley Financial (NASDAQ:RILY) is a diversified financial services company that I have touted as a good buy at various times in the past.

The company derives its revenue from investment banking and capital markets advisory services as well as small cap equity research, wealth management, restructuring advisory, retail liquidation, real estate advisory, fixed income advisory, ownership of multiple retail brands and communications companies, and own portfolio of investment.

RILY was a big winner in 2021 as low corporate bond yields and a booming stock market presented the company with plenty of opportunities to offer its investment banking services. But this year, as the stock market slumped and bond yields surged, RILY’s core capital markets advisory business declined.

More recently, investors witnessed this disturbing press release regarding RILY’s second quarter 2022 results:

Publication of RILY Q2 2022 results

Looking for Alpha

Negative $4.36 earnings per share? This is obviously a very bad sign, if it accurately reflects RILY’s profitability. If RILY generates deeply negative earnings and burns cash, the company won’t survive long – let alone the annual dividend of $4 per share!

Fortunately, the negative EPS number above does not accurately reflect RILY’s financial position or results. Rather, it is the result of accounting measures surrounding its equity and debt investment portfolio that significantly distort its results.

So let’s dive into RILY’s second quarter results to assess the company’s outlook as well as the safety of its 7.2% dividend.

1. Accounting measures skew results

As briefly mentioned above, RILY has its own investment portfolio consisting of publicly traded stocks, corporate bonds and other investments. When a public company holds a portfolio of stocks and bonds, the change in the market value of these securities must be taken into account in order to arrive at an accurate valuation of the company as a whole.

Therefore, we find that while RILY’s operating revenue and EBITDA held up even after the 2021 boom ended, “investing” revenue and EBITDA turned negative as the market values ​​of its stocks and bonds have fallen this year.

RILY Adjusted EBITDA

Introducing RILY

The investment segment refers to capital gains or losses (mainly unrealized) on RILY’s investments and loans based on fair value adjustments. It also includes trading income or losses, but the transactions are relatively small compared to the large swings in value of its investment portfolio.

As CEO Bryant Riley explained during the Q2 2022 conference call, these downward fair value adjustments “are mostly unrealized and correlated to market contraction.” In other words, they don’t so much indicate weak performance for RILY in particular, but rather weak performance for the stock and bond markets in general.

As you can see from the image below, most of the decline in the fair market value of securities comes from RILY’s equity portfolio. Second, a decline in the fair market value of RILY’s corporate bond portfolio also added to RILY’s unrealized investment losses.

RILY Cash

Introducing RILY

Although total debt increased by 2% and total cash and investments decreased by 12.2% between the first and second quarters, it is important to note that total cash, marketable securities and other investments on the balance sheet still exceed the total debt by $61.5 million.

In other words, even assigning zero value to the financial services segment (RILY’s main revenue generator!), shareholders would still walk away with $61.5 million, or about $2.19 per share, of value in a full liquidation scenario. As recently as the end of 2021, RILY’s liquidation value was above $21.50 – again without assigning any value to the financial services part of the business.

Moreover, after two consecutive quarters of negative results, note that the total debt only increased by 4.1%.

Here is a clearer breakdown of RILY’s investment assets:

RILY Assets

Introducing RILY

Combining RILY’s cash position, marketable securities and other investments, the company has not report debt. It’s impressive to see a company with no net debt generating the kind of operating EBITDA that RILY achieves.

2. Revenue is down but not exhausted

Revenue from RILY’s core financial services business segment, which includes investment banking, financial advisory and real estate advisory services, decreased from $266.1 million in the second quarter of 2021 to 200, $9 million in Q2 2022. The bulk of this decline in Services revenue came from the Capital Markets segment, which saw Services and Fee revenue roughly half of Q2 2021.

RILY Revenue Breakdown by Segment

Introducing RILY

This should come as no surprise, given that financial conditions in capital markets were much worse in the second quarter of this year than they were in the second quarter of last year. Public companies do not issue as many shares because stock prices are lower. They also don’t issue as much debt because interest rates are much higher.

From the start of the year to the end of June, the S&P 500 (SPY) lost 20% of its value, while BBB corporate interest rates roughly doubled from just over 2, 5% to more than 5%.

Chart
SPY data by YCharts

This environment was obviously not conducive to strong activity on the capital markets!

But the second quarter may have marked the bottom for financial markets, as the Federal Reserve showed signs of being near a pivot and the stock market rebounded. Riley commented on the conference call:

Being able to generate the operating results that we achieved in another quarter without capital markets is extremely gratifying for us. And since the end of the quarter, we have recovered some of the investment losses that we had reported, because the market has recovered a little.

3. The dividend remains safe – for now

RILY’s quarterly dividend of $1 per share was just over $28 million in the second quarter.

Omitting unrealized investment losses, I calculate RILY’s second quarter operating profit to be approximately $76 million. Taking out $31.7 million in interest expense at the business level, I then get $44.3 million in pre-tax profit. Due to investment losses and other tax deductions, RILY will have no income tax due for the second quarter.

Thus, I estimate RILY’s second quarter cash profit to be approximately $44 million, which is more than enough to cover the $28 million dividend while leaving approximately $16 million available for investment. in the investment opportunities RILY’s management team deems most attractive.

This includes share buybacks, which RILY has been committed to all year. The weighted average number of diluted shares outstanding decreased from 28.67 million in the second quarter of 2021 to 28.05 million in the second quarter of 2022.

Additionally, as RILY continues to grow its less cyclical business segments, it should continue to generate a stable, recurring cash flow base to support the dividend. Here’s Bryant Riley from the Q2 conference call:

The relative contribution of our less cyclical and less episodic businesses increased significantly, with the entire Riley platform generating $366 million in operating EBITDA in the last 12 months, compared to $114 million in operating EBITDA operating in 2019. With increasing contributions from less cyclical and less episodic companies exceeding the capital needed to sustain our dividend, we continue to have the ability to invest across our businesses. To that end, we are pleased to pay our shareholders a dividend of $1 for the quarter.

Additionally, if and when capital markets become friendlier, both cash profit generation and RILY’s dividend will have a significant upside. It’s important to remember that bear markets, like the one we’re currently in, only happen about 5% of the time. The other 95% of the time, bull markets rule. And during those times, RILY should thrive.

Here’s Riley again:

Looking ahead, we are encouraged by the possibility of increasing this dividend [as] capital markets are coming back and normalizing and they will normalize. We have seen cycles like this many times over the 25 year history of B. Riley and each time we have come out the other side [more] strongly than before.

Conclusion

RILY is one of my favorite financial stocks, not least because founder and CEO Bryant Riley has so much skin in the game. The vast majority of Riley’s wealth (not to mention his name!) is tied to RILY, and his leadership proved adept as the company swallowed up many other financial services companies to form the diverse company that RILY is today.

Complicated accounting creates a somewhat misleading picture, leading investors to perceive at first glance that RILY is losing money and burning money – that it is not profitable at all. While operating profit from RILY’s core revenue-generating business is certainly lower this year than it was last, the company is still profitable.

The overall negative earnings number is the result of the decline in the fair market value of RILY’s holdings of securities, but this does not necessarily represent a permanent loss. Just as with your own investment portfolio, a paper (unrealized) loss on a stock or bond does not represent an actual loss unless it is realized by selling it for less than its cost base.

The dividend remains secure for now, although market conditions could certainly deteriorate enough to threaten the quarterly $1 per share payout.

As such, RILY and its 7.2% dividend yield look attractive to the income investor willing to accept slightly above average risk.

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