March 27, 2023 - 7:11pm EST by
Ray Palmer
2023 2024
Price: 23.00 EPS 0 0
Shares Out. (in M): 8 P/E 0 0
Market Cap (in $M): 200 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0 0

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The whole financial sector has been smashed by the SIVB / SBNY / SI failures, but one area that has been hit particularly hard is the financial sectors preferred stocks. 

Lots of banks have issued perpetual preferred stock, and I think investors are starting to look at these as a "tails I lose, heads I don't win" situation. The perpetual preferreds have low dividends payments and are generally non-cumulative (so any skipped dividends do not need to be made up). With banks looking to shore up liquidity and capital, investors are selling prefs and asking questions later, and likely for good reason: if the banks go under, the prefs will likely be zero'd. If they don't go under, the banks might look to retain capital by skipping pref dividends. And, if they continue paying dividends, a perpetual low or mid-single digit yield on par doesn't look that attractive in a world of mid-single digit interest rates.

So something like WAL's 4.25% preferreds strikes me as a brainer. It's currently trading at ~$13/share versus a $25/share face. If contagion spreads and WAL goes under, these are a likely zero. If WAL proves to be just fine, these were trading for ~$21 before the crisis so maybe they go back there? But what happens if WAL is fine but decides to preserve liquidity and not pay dividends for a few years? 

As I said, a brainer.

However, a few banks have issued publicly traded "baby bonds." These generally show up on Bloomberg as preferred stocks; there aren't a ton of them out there, but these have seen some sell-off alongside the preferred / financial stock sell-off. Most of them are issued by banks that seem unlikely to go under, making the sell of an interesting place to go hunting for value. In particular, I think RILY's 6.75% baby bonds due May 2024 are undervalued and catalyst rich given the just over one year to maturity. You can find the bonds prospectus here, the bonds marketing deck here, and the 8-k with the bond contract here.

I'll break down a few points, but the high level thesis is quite simple: the 2024 notes are RILY's next bonds that are due. There's only $200m of them outstanding (table below from RILY's 10-K). 

Is it possible RILY doesn't pay off the bonds? Sure. But, again, they're RILY's "next up" bonds, and RILY has enough cash on their balance sheet to just pay them off in cash (and that assumes they couldn't roll them / refi them; in addition, RILY has had several loans payoff since Q4 which should increase their cash balance).

RILY's insiders have been aggressively buying RILY stock, not just since the SIVB swoon but for all of the past year. Again, anything's possible at any time, but I struggle to believe RILY is going to file for BK because they couldn't roll / payoff a $200m bond when they have more than enough liquidty on their balance sheet to do just that and insiders have been buying as recently as ten days ago.

So my bet is simply that RILY will be able to payoff this bond in one way, shape, or form. If they simply pay it off at maturity in May 2024, that would be a >15% IRR from today's prices. However, the real kicker would come if they chose to call the bond before it's due. The call pricing on the bond steps down to par this May, and I expect RILY will look to roll the bond in some way once credit markets stabilize. If they do that right when the bond is up to get called in May, the IRR on the trade will be over triple digits. If they waited till, say, the end of October, this would still be a >25% annualized return. I don't think it's crazy to think RILY will want to roll these as soon as they can; these guys are bankers, they know how to get deals done and I doubt they want a $200m liquidity drain when they could be using their balance sheet to invest in deals / get risky deals done. They also have a history of calling notes early; they called their 2023 notes in 2021 when they still needed to pay a small premium. Obviously interest rates and the market were much different then, but I point it out just to show a history of rolling and retiring notes.

That's the very high level set up. Let's talk about asset value and downside protection here.

RILY's value comes from two places; there's the value of their operating businesses, and then there's the value of their assets / balance sheet.

If you just pull up a bloomberg or something, you might not see the value of RILY's operating business. 2022 was a relative disaster for the type of smaller / growthier / more speculative stuff RILY tends to invest in, and the losses their balance sheet / investments generated roughly offset the money their operating businesses made.

However, that accounting quirk / masking does not change the fact that RILY's core businesses spit off a decent bit of cash. I would not call any of these the best businesses in history, but they're all reasonably capital light businesses the generate excellent cash flows (though several are in terminal decline). I'd also note the runrate earnings from these businesses is probably a little too low, as RILY acquired Targus for $250m in late October and that's barely showing up on the income statement.