B Riley ($RILY) — Initiation (10/30/20)

This is an incredible business that has created a ton of value and looks well positioned to continue doing so...

There are multiple elements to this business but we’ll start with the quick pitch…

Quick Pitch

Heavily-insider-owned “merchant bank / operating business” combination doing some interesting things in activist investing, capital markets, and wholly-owned operating businesses.

Call it a merchant bank or call it a conglomerate. At first glance you might think it’s a “financial” or broker-dealer… but no, it’s more than that. It’s very easy for investors to overlook this company given the collection of disparate businesses here (yet they all seem to work together).

Insiders have been buying like crazy for months now (including the largest shareholder, CEO Bryant Riley), the valuation is still cheap while the business has grown considerably for years now. Revenue is up nearly 6x from 2015-2019.

Riley has and continues to create value for themselves and shareholders with more opportunity to come (and likely from unforeseen areas).

Here are some of the other elements…

CEO Bryant Riley took the company public via reverse merger in 2014 with then-public Great American Group (GAG), the current auction/liquidation segment.

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The company prides itself on being a combination of cyclical or lumpy streams of cash flow augmented by stable / recurring cash flow streams. The 5-year financial summary tells the story pretty well at 10,000 feet… Revenue is up 6x from $112m to $652m. (Yes, they’ve added debt and share count during that period but they’ve improved the business as well.) Net income is up 6x as well from $12m to $81m.

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So there are elements of episodic revenue and steady revenue. I like this setup. You have the recurring and stable pieces of the business keeping the lights on and earning you a base level of cash flow. Your episodic pieces of the business contribute spurts of lumpy income. This is the classic Buffett situation of taking a lumpy 15% return over a steady 12% return any day.

As far as actual segments go… we have:

  • Capital Markets — All things brokerage, investment banking, research, investment management, advisory, etc.
  • Auction and Liquidation — Great American Group, participating in the liquidation of bankrupt retail businesses for the most part. They’ve completed some high profile work such as Bon-Ton and Toys R Us.
  • Valuation and Appraisal — “provides Valuation and Appraisal services to financial institutions, lenders, private equity firms and other providers of capital. These services primarily include the valuation of assets (i) for purposes of determining and monitoring the value of collateral securing financial transactions and loan arrangements and (ii) in connection with potential business combinations.” This is a neat business and very stable.
  • Principal Investments — Wholly owned operating businesses on the B Riley balance sheet and some other equity method investments — United Online, magicJack, bebe stores
  • Brands — The newest segment and a competitor to bebe… Acquire and own mostly retail brands in exchange for licensing income.

Good luck modeling this thing… you’ll have some base level of earnings with periods of supernormal profitability — the liquidation business earned $40m+ in 2016 EBIT but lost $25m in 2019.

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They key to this collection of businesses in my mind — Riley has built an incredible deal flow machine with each segment feeding off one another. For example: The appraisal business helps the liquidation business better understand the inventory values in a bankruptcy situation. The liquidation business allows brands/principal investments to get a good look at the defunct brand names to scoop up. The capital markets segment (and activist investing done therein) help funnel ideas to wholly own via principal investments — each major PI business was/is publicly traded: United Online, Magicjack, bebe.

I hate this concept of a flywheel but dang it looks like these pieces all move in motion with each other…

Here’s how they describe it in their own words…

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Last item to note — 2020 has not been a bad year for Riley…

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Strip out the trading gains/losses from each year and you have $158m in 2020 EBIT vs. $86m in 2019 — nearly 2x growth!

Capital Markets

Investment banking and brokerage are likely the most cyclical / sporadic of the businesses inside this division. It also encompasses a fairly large wealth management business managing $10bn in client assets at ~$85m in revenue.

This segment was cobbled together through acquisitions of FBR and Wunderlich at bargain prices which added significantly in wealth management, securities lending, and research/banking.

Within the Capital Markets segment — banking represents the largest share of revenue followed by wealth management and then commissions. This year has seen an uptick in banking / transaction activity which may not be a good read on a “normal” period.

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Small-cap banking peers like COWN, GHL, PIPR, and OPY have historically traded at 0.3-1x sales and small-cap asset managers (DHIL, PZN, HNNA) in the 2-4x sales range.

Trading gains and losses make historical segment results difficult to read into…

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Let’s ignore the securities lending business for now, say investment banking is worth 1x sales, wealth management 3x sales, and brokerage/other at 0.25x… this would mean ~$440m in value at the mid-point of those valuation metrics.

Liquidation

This is the Great American Group. When retailers go out of business and have final store closing sales, that’s GAG. There are 2 types of fee structure in this business:

  1. GAG is paid a fee for services; or
  2. GAG buys inventory/assets from the defunct business using capital from their own balance sheet and attempts to sell for a profit

This can obviously be pretty lumpy depending on the size or timing of any bankruptcies.

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There were 2 years of losses from 2014-2019 — in total, GAG has generated $65m in EIBT during that 6-year period.

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Why the losses in 2019?

GAG advanced money to buy assets in a retail liquidation during Q4 2019 and the process wound up with a lower recovery than anticipated, causing a big loss for the year. This is the primary risk in this business — poor underwriting. There will not be a lack of opportunity in the future.

It’s hard to emphasize just how well known this business is in the field… All major wind downs or store closures typically get a look by GAG.

There are no good comparables for this business. If we simply take a DCF at 10% with no growth using the same figures from FY14 through 3Q2020 then I get roughly $115m in value for this segment.

Appraisal

This is probably the most stable of the B Riley business lines…

Having generated a very consistent and growing $30-40m per year in revenue and $8-10m per year in operating income with virtually no capex requirements.

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They provide valuation and appraisal reports mainly for banks that have inventory-based (i.e. retail) borrowers. The banks use these appraisals to validate inventory levels in determining a borrowing base for asset-backed lines of credit.

Most of this business is driven by financing activity — the need for credit from banks. Given the nature of retailing in general (whether it comes from brick and mortar or online sales), this business should see plenty of growth.

I used a 12x EBIT multiple (which might be low!) on $10.5m average EBIT as this has been a remarkably stable / growing business for years now… This gets me to $125m in value for this segment.

Operating Businesses (called “Principal Investments”)

It all started with the purchase of United Online for $33m in 2016 and then magicjack for $90m in 2018.

United Online was formerly known as NetZero / Juno. It’s an old dial-up / DSL internet access business which is in secular decline. At the time B Riley made the acquisition, United Online had 389k paying subscribers at just shy of $11/month.

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At a reasonable purchase price even a declining business can be a great value proposition. Riley has already recouped their investment and then some in United and it still generates cash for them.

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Magicjack is already looking like a similar setup after paying $90m for the VoIP operator. Prior to being acquired, magicjack generated $12m in EBIT during the first 9 months of 2018… Like United Online, this is still a business in decline — magicjack revenue fell from $143m in 2013 to $88m in 2017 and was down another 11% through 9 months of 2018.

This segment is tough to value. Putting a multiple on these businesses is probably not the right approach here. Another complicating factor — cash flows have lasted longer than anticipated (and could continue to do so).

I’ll use a 4x multiple (25% cap rate) on trailing EBIT of $35m for a total value of $140m.

Brands

This is officially a new segment in 2019… Riley has partnered with Bluestar Alliance (a company with which they have a long history) to own and operate brands and trademarks for licensing.

Our brand investment portfolio focuses on generating revenue through the licensing of trademarks. The Company holds a majority ownership interest in BR Brand, which owns the assets and intellectual property related to licenses of six brands: Catherine Malandrino, English Laundry, Joan Vass, Kensie Girl, Limited Too and Nanette Lepore as well as an investment in the Hurley Brand with Bluestar Alliance LLC (“Bluestar”). The Company intends to grow licensing revenue from the brand holdings in partnership with Bluestar by leveraging its extensive relationships and strategic partnerships in the retail sector. The Company intends to pursue future acquisitions of consumer brands, intellectual property, trademarks and licenses, and participate in select transactions as an equity owner.

Here are the brands currently owned and operated by Riley/Bluestar:

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I was surprised to see Riley invest $116m in this business in 2019. It certainly hasn’t yet generated decent returns on that capital but perhaps it could get to the 10%+ mark?

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Backing out the impairment charge of $12.5m gets to $6.7m in EBIT so far in 2020 — about $9m annualized operating income. Let’s just say this is worth what Riley paid for it less the impairment charge = ~$100m in value (rounded down).

Investments

Riley essentially operates an activist investment fund using its own balance sheet — taking positions in small and microcap stocks while effecting change at those businesses, getting them sold, or buying them outright.

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They have a sizable cash balance at Q3.

The investment portfolio of stocks, bonds, and partnership interests is $410m net of short sales outstanding.

Loans receivable are valued at $330m — these are all high interest (typically 10%+) loans to mainly related party entities (i.e. they own common stock or have management / board representation) — Franchise Group, B&W, etc.

Equity investments probably shouldn’t be considered cash but I think they’re worth full value or $58m.

Call the net result of this piece worth $80m or so.

How the businesses work together…

Think of this as one giant deal flow machine capable of funneling the best ideas or insights in-and-out of each segment…

For instance, the appraisal business performs inventory valuations for banks for the purpose of lending against retailer inventory / assets as collateral. The appraisal business has a good understanding as to the value of that inventory or perhaps may sense a situation where things are going sour. Liquidation business steps in… Using the inventory valuation data from the appraisal business, they now have a good sense for what they can get in a liquidation sale of retail inventory, allowing them to place the best bid to acquire inventory from the bankrupt retailer. The liquidation is complete but the liquidation team senses the retail brand may have some lasting value… Principal investments group can now get involved to make a bid in bankruptcy to acquire the defunct brand and partner with others to license the brand name…

Riley also invests money for others via funds and through their own balance sheet / prop trading. They’ve taken some large stakes in public companies that have often led to workouts or control situations… In past cases, they’ve even acquired entire businesses (United Online and magicjack).

I liken this side of the business to operating their own “activist” hedge fund. Buying cheap stocks, sometimes effecting change, other times taking outright control or acquiring.

  • Franchise Group $FRG — common stock position and as lender
  • Babcock & Wilcox $BW — common stock and lender — Ken Young, CEO of BW, is also the CEO of B Riley Principal Investments
  • National Holdings $NHLD — controlling common stake >45%
  • bebe stores inc $BEBE — controlling common stock >30%

Other Odds and Ends

I’ve mentioned insiders have been buying and Bryant Riley owns a huge amount of stock (18%+).

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Also, the company has been buying back a decent amount of stock — racking up $38m so far this year.

Lastly, they have a great dividend policy with a smaller base dividend and larger variable payouts depending on business performance. In total they’ve paid $2.26 per share in regular + special dividends = 8.5% payout over 7 quarters

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Wrapping Up

Take each of the pieces I’ve reviewed above and you get the following:

Capital Markets $440mLiquidation $115mAppraisal $125mPrincipal Investments $140mBrands $100mNet Cash / Investments $80m

= $1bn

We still need to back out some capitalized corporate costs which are running at $33m per year. Call that a $150m offset (~5x)… This nets to $850m in equity value or $32-33 per share.

This might still undervalue the business considerably…

There are ~27m shares outstanding and a $25 share price = $675m market cap. We’ve established net cash is about $80m but let’s say enterprise value is really $675m (the net cash / net debt aspect of equity / loan interests is debatable).

Some high level figures below show results for the past few years…

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Remember that 2019 included some large trading gains and 2020 still has ~$36m in trading losses. Regardless, we have trailing EBITDA of $164m (4.1x multiple) and EPS of $2.22 (11.3x). This is an inexpensive and well diversified business!

From a Cash Flow Standpoint…

Can’t forget my sources and uses of cash analysis!

Operating cash flow from a GAAP perspective is extremely misleading here. The company characterizes securities purchased (stocks, bonds, etc.) for their own balance sheet as an operating cash flow item when these really represent investments.

Backing out these figures from working capital, I get free cash flow of $132m ($4.88 per share) in 2019 and $122m ($4.50 per share) so far in 2020.

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Cumulatively since 2015 — Riley has generated $380m in free cash flow (virtually no capex at $12m for the entire 5.75 year period). They borrowed an additional $880m and deployed those $1.3bn funds in the following way:

  • $412m invested in securities via RILY balance sheet
  • $268m in acquisitions
  • $304m in loans made
  • $39m in share repurchases
  • $120m in dividends

You may not love the public security investment strategy but Bryant Riley considers himself an investor and this side of the business has turned into a few lucrative ownership opportunities.

From a valuation standpoint if we simply use a 10x multiple on the “average” free cash flow over the past 3 years ($90m), we get $900m or $33 per share. If we used 10x on the 2019-2020 amounts, we would have a valuation closer to $1.3bn or $48 per share.

My guess is there will be a few more changes / surprises in the coming quarters and years. But this is a shareholder friendly management team looking to create value anywhere they can find it…