Description

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.

If you read RILY's Q4'22 call, Bryant Riley talks about how RILY's EBITDA "run rate is somewhere in the low 300s and my upside's in the high 300s" while noting "none of those businesses require a lot of CapEx. They are cash flow generative." and further upside to earnings "if capital markets comes back or if liquidation comes back." He also notes that, even at the lowest end, those operating earnings would cover all fixed costs and RILY's dividend, leaving them some extra cash for capital allocation.

Anyway, as mentioned above, the value of RILY comes from two places: their balance sheet, and their operating businesses. Their balance sheet almost completely covers the value of their debt, and while their operating businesses aren't the best in the history of the world they produce tons of cash flow and are reasonably consistent. More importantly, because we're buying the 2024s, we're just betting that there's enough cash / value at the company to pay off and/or refinance then bonds over the next ~year. Given the insider buying, the asset value, and the cash generation here, it's really hard to see how that wouldn't be the case.

There are three other things worth noting before wrapping this up.

First, RILY's been hammered over the past month. I'd guess a large part of that is due to all financials getting thrown out with the SIVB bath water. While RILY does have a capital markets segment, they don't have exposure to customer deposits (so they don't have huge run on the bank risk and we don't have to worry about future net interest margin compression).

Second, there is a RILY short thesis floating around. It was published by Wolfpack, and the timing proved excellent (early Feb. was a grerat time to go short anything financials!). There's also a follow up from late Feb. While I think the short report does make some good points, there are also some mammoth issues with it. For example, the report suggests that RILY's SPAC, BRIV, failing to find a deal will cause "a $175m hit." That's either intentional clickbait or a fundamental misunderstanding of how SPACs work; if you look at p. 117 and 131 of RILY's 10-k, you can see that the SPAC funds are held in trust and have a corresponding pre-paid expense held against them. If the SPACs liquidate, RILY will lose their sponsor investment but nothing more. Another big part of the short thesis is that RILY is using their weath management franchise to stuff baby bonds on to their clients. I have no view on that accussation, but if it's true it would actually be good for this thesis as RILY would easily and quickly be able to refiance these bonds by stuffing new bonds into their unsuspecting clients. The final part of the short thesis is that RILY has made some shitty investments and took huge write offs in 2022; that's absolutely true, but RILY fair values their balance sheet and you can see their large equity positions in their 13-F. As of this afternoon, I have RILY's equity portfolio down ~$25m in Q1'22; not great, but also pretty small against a 13-F that includes ~$445m of equities. In addition, the short report came out before RILY's Q4 earnings were reported, and many of the problem loans the short report focused on were revealed as repaid or addressed on RILY's Q4 earnings (I'd encourage you to listen to their Q4 call to hear them address some of the issues with their assets / loan book that the short thesis raised! For example, their $41m sorrento loan was repaid in full before the company filed)).

Third, It's worth noting that RILY bought Targus in October 2022 for $250m. $59m of that $250m was in the form of the 6.75% 2024 notes I am recommending. Targus's CEO sat on RILY's board until the deal close (at which time he stepped down from RILY's baord given that obvious conflict of interest). Again, none of this is to say RILY can't go bankrupt, but someone who was on the board and is now the CEO of a major RILY subs got >20% of the proceeds from selling is company in these bonds. The incentives are very stacked for these bonds to get paid off / insiders clearly believe in them.

The major risks here are obvious: for this idea to work, we just need them to refi or payoff $200m of bonds in the next ~12 months. RILY has >$2B in liquid-ish assets and generates >$300m/year in EBITDA, so asset prices and the economic environment would need to get materially worse (and quickly) for refinincing these bonds to begin to pose a problem. Probably your biggest risk is that RILY's debt facility with Normua has some covenants (>$135m in operating EBITDA and a net asset value at the guarantor of $1.1B; see 10-k p. 136); if RILY somehow tripped those, getting the capital structure under control could be a mess. However, as mentioned earlier, RILY does >$300m/year in EBITDA and the Q4 call noted that net asset value at the guarantor was >$2B, so things would have to get pretty bad before the capital structure really became a refi issue.

However, if we do get into a bankruptcy, these are publicly traded baby bonds; the covenants are awful, and in a true downside scenario I'd guess other pieces of RILY's capital structure can easily outmanuver the baby bonds. Again, I don't expect it to come to that, but something to keep in mind.

A key stock to watch is Babcock (BW). RILY owns >30% of them, worth $150m at current prices, and RILY has also guaranteed $100m of BW's bonds. If BW exploded, RILY would still have plenty of asset value to cover/refinance everything, but obviously it would get a little closer / more dicey. However, if BW does well, that gives a lot more equity value to cover debt / refinancing. With that in mind, I'd note a lot of insider buying at BW recently (including from RILY), and that BW issued a very positive Q4'22 earnings release / 2023 guide (backlog and billings well up, adjusted EBITDA to grow from just over $70m in 2022 to >$100m in 2023)

Anyway, I'll wrap it up here. This is ultimately a pretty simple idea: insiders seem aligned, and even if you believe the short report, it's hard to see how these bonds aren't getting paid off / refinanced in the near future given RILY's cash flows and asset value. With just over a year until these bonds mature, we will get a good IRR if RILY simply pays them off at maturity, but I'm expecting and hoping for a fantastic IRR if and when RILY refi's them early.

Catalyst

early Refi

payoff at maturity