Description

For a better formatted version of this write-up, please follow this link:  https://www.dropbox.com/s/lf4bvhy8t4kvtvm/RILY%20VIC%20Write-up%20v1.pdf?dl=0

Situation Overview

B. Riley Financial (ticker:  RILY) is an uncovered, unfollowed mini-conglomerate, led by a sharp capital allocator who owns 21% of the Company and has been buying sizeable amounts of stock in the open market as recently as June, paying a 5% dividend and trading at a steep discount to intrinsic value.  The Company is an amalgamation of several different businesses reported in three segments, including the namesake small-cap broker-dealer, an appraiser and liquidator of retail inventory, and the recently acquired assets of United Online.  Though unrelated, the businesses are complementary in that they provide offsetting cyclicality to one another and serve as funding sources for opportunistic M&A.  With intrinsic value between $23 and $30 compared to a current share price of $15.93, RILY offers compelling upside, with limited downside, providing investors with a compelling risk/reward on the core business and free optionality on the retail liquidation business.

Business Description

• B. Riley & Co. (reported as Capital Markets):  As a broker-dealer and investment bank, B. Riley & Co., the namesake business within the publicly-traded holding company, provides equity research, sales & trading, capital markets, advisory, and other services to companies and clients focused on the small-cap space.  While traditional broker-dealer businesses broadly have been challenged by the shift of investible assets into passive ETFs and shrinking commission rates, we believe B. Riley & Co. is positioned for growth despite those and other secular headwinds.  On June 1st, RILY completed the acquisition of FBR & Co. (ticker:  FBRC), a regional broker/dealer best known for its Financial Services, Real Estate, and Energy practices, and on July 5th the Company closed on the purchase of Wunderlich Securities, another provider of investment banking, capital markets, and sales & trading services, that brings with it a solid wealth management platform as well.  These acquisitions will broaden the reach and scale of RILY’s business at a time when other small-cap broker-dealers are retrenching, creating an opportunity for RILY to consolidate market share and become the go-to partner for institutional and buyside clients alike.  RILY paid $160m in cash and stock for the two businesses, or 7.4x LTM Adj. EBITDA, adjusted for $15m in expected cost synergies as of the time of the Wunderlich announcement.  In reality, that figure drastically understates the opportunity to rationalize costs, as evidenced by comments made by CEO Bryant Riley on the recent earnings call – the first since the FBR deal closed – in which he announced that RILY had already cut $28m in compensation costs, reducing FBR’s breakeven revenue level from ~$120m to $92m per year.  With that figure in mind, RILY paid a combined 4.6x EBITDA for the two businesses.

Beyond the traditional broker-dealer side of the business, this segment also includes GA Capital Partners, a direct lending business created to provide senior secured loans to middle market public companies in an effort to leverage RILY’s expertise in inventory valuation (discussed below).  RILY closed its first fund with $155m in commitments, including an anchor investment by Corporate Capital Trust, a KKR Credit Advisors-managed BDC, in April 2015, and has since delivered 13%+ annualized returns.  The Company is now beginning to raise a second fund with as much as $500m in capital.  I estimate the current fund generates $1.6m in management fees and double that in performance fees.  If fully subscribed, the second fund would generate an incremental $7.5m in fees.  Additionally, following the close of the Wunderlich deal, RILY now has a wealth management platform with close to $11bn under management which earns $71m a year in revenue.  Together, these businesses provide RILY with a growing base of recurring fee revenue to balance out the more cyclical market-facing elements of its financial services platform.

• Great American Group:  Though RILY now goes by the B. Riley name, the public entity came into existence as Great American, and remained as such until its 2014 acquisition of B. Riley Financial, which resulted in Bryant Riley running the combined company.  However, despite the change in name, Great America remained the largest piece of the business prior to the recent acquisitions.  The subsidiary has several lines of business, reported in two segments:

• Valuation & Appraisal:  In its Valuation & Appraisal business, RILY provides various types of financial institutions and lenders with estimates of liquidation value for a variety of assets, including retail and commercial inventory, real estate, and intangible assets, on a periodic basis.  This is a fee-based business with stable, recurring revenue that has grown at a high single-digit CAGR since 2007 and has EBITDA margins around 28%.  More importantly, the analysis done for clients, which spans 1,200+ appraisals each year, is leveraged by the Company to inform its Auction & Liquidation and Direct Lending businesses, which depend on knowing the valuation floors of the assets in question.

• Auction & Liquidation:  When a retailer chooses to close stores, be it a small group of unprofitable stores or an entire chain being liquidated in bankruptcy, it is left with a significant amount of inventory that needs to be cleared out at the best price possible.  Great American is one of the few providers with the capability to step in and handle that process, which often includes taking over the management of the stores themselves.  Most of the time, the Company will evaluate the inventory in question and submit a bid with a minimum recovery rate stipulated; RILY then captures any upside value.  In other situations it will collect a fee for service while bearing no primary risk.  This business pairs very well with the Valuation & Appraisal business, which routinely conducts valuations of retailer inventory, as the two inform one another’s appraisal values and bidding parameters.  Because of the minimum guarantees involved, RILY must at times put up large amounts of capital to back its bids.  There are only a small handful of other players in this market, and on very large projects, they will often partner with one another to spread the capital required.  Revenue and profitability in this business are subject to large swings – when big retailers go out of business, RILY sees large surges in profits – but the business has rarely lost money (a $6.3m loss in 2014 was the only down year in the last 10) owing to the small (fewer than 10) team of full-time employees; when RILY wins a big piece of business, it adds temporary labor to supplement the core team.  Following a strong $30m profit in 2016, there are plenty of reasons to believe this business will continue to grow as numerous headwinds pressure retailers big and small, leading to round after round of store closings or outright bankruptcies.

  RILY also operates a much smaller industrial auction business in which it disposes of a wide variety of industrial assets including construction, transportation, and manufacturing equipment via live or online auction processes.  This business is 50% owned by RILY and is de minimis in size.

• United Online:  In July of 2016, RILY completed the acquisition of United Online (ticker:  UNTD) for $71m in cash and stock.  Historically United Online had been a compilation of a number of assets, however, at the time of the acquisition, the only remaining business was a consumer facing dial-up Internet access business operating under the NetZero and Juno brand names.  Why might RILY, a company that already owned two disparate businesses acquire an unrelated dial-up business in terminal decline?  The answer is simple:  CEO Bryant Riley saw an orphaned asset he could opportunistically buy at a steep discount to intrinsic value.  Though declining, United Online throws off $30m+ a year in EBITDA with few reinvestment needs.  This value had long been masked by UNTD’s other businesses and steep corporate cost structure.  By acquiring just the Communications segment and cutting out the excess corporate expense, RILY was able to add a stable cash flow-generating asset to its portfolio for roughly 2x EBITDA, which it can now utilize to fund the more strategic deals it is doing in the financial services space.  The Company has made clear that to the extent it finds similar opportunities, it won’t hesitate to pursue additional such “principal investments.”

Thesis

With no sell-side research coverage, four disparate businesses – one of which is subject to large revenue swings and the other of which is in decline – it’s easy to see why investors might be overlooking the Company’s value.  But when one takes the time to understand the various pieces, we think a compelling opportunity becomes apparent.  As we see it, RILY is an undervalued Company with a financial services platform that is becoming increasingly dominant in its space and has a significant opportunity to cut costs and cross-sell as it integrates the recent acquisitions; a stable and growing Valuation & Appraisal business; an Auction and Liquidation business that might be the single biggest beneficiary of the much-talked-about restructuring of the retail landscape; and a strong cash-flow generating asset, acquired for next to nothing, that provides management with the capital to invest in organic and M&A-fueled growth, all of which is led by a founder/owner who controls 21% of the stock and has been buying more at prices above today’s as recently as June.

In the table below, we lay out the LTM earnings of the Company, fully adjusted for the acquisitions of FBR (LTM figures include just one month) and Wunderlich (LTM figures include no data), as well as the $28m of annualized cost savings already realized.  There are two key takeaways here:  1) Pro forma Adj. EBITDA is well north of LTM reported Adj. EBITDA; and 2) You’ve got to do a bit of work to understand the earnings power.  This isn’t hard work – RILY has released pro forma figures for FBR in an 8K and has given some insight into Wunderlich – but investors do need to take more than a casual glance at the stock to understand the opportunity.  And with no sellside analysts drumming up interest in the stock, few buyside investors have yet chosen to do so.

We value the business using the sum-of-the-parts analysis shown below.  One note, for the purposes of the analysis we include stock-based compensation and other add-backs directly into the Corporate EBITDA figure.

Looking at the components of the business, Capital Markets is the biggest driver in light of the recent acquisitions.  We ascribe a multiple of 8x to 10x pro forma Capital Markets EBITDA, which includes the $28m of realized synergies, for a total value of $390m to $487m, or $14.25 to $17.80 per share.  We think these multiples are reasonably conservative given the earnings profile of the business, increasing scale within its market, growing base of recurring fee-based revenue, and opportunities for revenue synergies across its many verticals.  As a reference point, comps such as Raymond James and Stifel Financial trade for 14x to 15.5x earnings, which correspond to our 8x to 10x EBITDA multiples).  Our Downside valuation of $272m applies 8x to the legacy B. Riley Capital Markets business and adds to it the $160m paid for FBR and Wunderlich, ignoring any synergies.

It is difficult to pinpoint normalized earnings for the Auction and Liquidation segment given the large swings in Liquidation revenue, so we take an average of profitability going back to 2007 and exclude the banner 2016 year, which gives us an average of just over $11m per year of EBITDA.  Note:  actual LTM Adj. EBITDA was $36.3m.  Given the strong pipeline and deteriorating retail landscape, RILY should earn supernormal profits in this business for at least the next year or two, if not much longer; we could very easily see as much as $30m+ a year in Adj. EBITDA in each of 2017 and 2018, if not more.  However, rather than capitalize these supernormal earnings, we instead value the business by applying a 4x to 6x multiple to the $11m of “Normalized” Adj. EBITDA, for a total value of $55m to $96m ($2.00 to $3.50 per share).  We then make a separate adjustment in our Upside case which adds in the incremental value from two years’ in which we assume RILY earns $25m each in excess of the “normalized” earnings power of the business, taxed at 35% and discounted at 10%.

Valuation and Appraisal is a very predictable, growing business.  We apply a multiple of 10x to 13x, a haircut to the multiples ascribed by the market to Moody’s and S&P, two businesses with similarly steady cash flow characteristics.  The total value for this piece is $90m to $120m, or $3.35 to $4.35 per share.

United Online is a declining business but will generate significant free cash flow over the coming years.  We believe 3x to 4x LTM Adj. EBITDA, for a total value of $88m to $117m ($3.23 to $4.30 per share) is a reasonable multiple for such a business.  For our Downside case, we assume a value of $71m, the same figure RILY paid to acquire the business.  We view this figure as conservative given that in the year it has owned the business, RILY has grown EBITDA from $26.7m at the end of 2015 to $29.4m at June 30, 2017.

Putting it all together, we believe shares of RILY have a very favorable risk/reward, and should trade somewhere between $23 and $30 per share, offering upside of 45% and 90%, with very minimal downside.  Most importantly, our valuation isn’t based on projections from two years out that assume growth across the business and magical margin improvement; instead it is predicated on LTM numbers, adjusted to reflect the recent acquisitions and cost-cuts already realized, and reasonable valuation multiples.  With both the FBR and Wunderlich deals now officially closed, it is just a matter of time before their contributions (and those of the synergies) start to work their way into reported results and give investors a clear picture of the true earnings power of the business.  When this happens, we expect shares to re-rate accordingly.

Risks

• Disruption to Capital Markets:  The acquisitions of FBR and Wunderlich are clearly a bet by the Company that 1) they can operate the assets more efficiently than their prior owners (which already seems to be the case), and 2) that the small-cap investment banking and broker/dealer business can be a vibrant one going forward.  As investors focused solely on the small-cap space, we readily see the value in the platform RILY is putting together.  But regardless of the merits of the strategy, the business would still be negatively affected by a major sell-off, economic recession, or any event that makes it more challenging for small-cap companies to raise capital.  And because of the modest size of the business, a half dozen deals a year can have a material effect on profitability.

• Increasing complexity:  In most of the situations we invest in, we are looking for companies that are becoming increasingly simple, usually by exiting non-core businesses or otherwise streamlining operations.  RILY is the opposite, as evidenced most clearly by the acquisition last year of United Online.  Even the purchase of Wunderlich, which has meaningful overlap with the existing Capital Markets segment brings with it several new businesses, including a material wealth management platform.  The cobbling together of disparate business is often a red flag for investors, but in this case, we are comfortable with the strategy, largely because of our confidence in Bryant Riley as a capital allocator.  We’d much prefer to have as a steward of our capital someone who, when faced with a compelling investment opportunity, pursues it to our benefit rather than passes it over simply because it doesn’t fit some pre-determined set of arbitrary parameters.

• Accelerated revenue declines at United Online:  Revenue at United Online has been declining in the neighborhood of 25% year-over-year for the last few years.  RILY has managed to grow profits despite this headwind by keeping fixed costs low and matching variable expenses to revenue declines.  Our discussions with management give us confidence that this business should continue to generate profits for many years to come, but at some point the business will reach a level at which profitability starts to decline.  

Catalyst

The obvious catalyst is the recent closure of RILY's recent acquisitions.  Once these flow into the financial statements the undervaluation should be more apparent to anyone paying attention.