Quarterly Update After Earnings Part III: $RILY

Diving into the Wreck

“The wreck is not a beautiful thing.

It is not a pretty thing.

There is no myth.

It is important to learn it.

You learn it

in the opening of the jaw.

The long familiar cry.

The wreck is not a beautiful thing.

It is not a pretty thing.” - Adrienne Rich

Welcome back to part III of the quarterly update. Today I will discuss RILY, and tomorrow VTNR.  

Those stonks have some real stink on them.

B Riley Financial (RILY) had its market capitalization cut in half today, from $500 million to $240 million.  The earnings call had two major points, the first on the slowing consumer, a decline in EBITDA from $80 million two quarters ago to $50 million today, and a suspension of the dividend, and the second on management receiving subpoenas to be interviewed by the SEC in relation to the take private transaction of the Franchise Group with Brian Kahn. 

For the last year or so, I have been digging into RILY, and that included reading the arguments of the short sellers.  I found the arguments of the short sellers to be weak, and frequently provably wrong.  This gave me a false confidence, because this particular type of short seller was not interested in finding undervalued businesses, they were interested in finding manipulable businesses, and shame on me for not realizing this earlier.  Every time the shorts moved the goal posts and made up a new claim, the stock fell.  

A list of false claims and moved goalposts can be found here:

https://www.reddit.com/r/RILYStock/comments/1cxbxy2/rily_long_list_of_short_seller_claims_debunked/

An example of a later proven false short attack which caused a 7% stock price drop can be found here:

More Problems at B. Riley (RILY)

As a value investor, prices moving in the wrong direction don’t bother me, I know that eventually value will win out.  But earlier this year there was something that should have stood out to me more, while RILY was undergoing a voluntary 3rd party audit to see if any wrongdoing had been done by management in the Franchise Group take private transaction, they filed their 10-K late, and while noncompliant, lost potential underwriting business in the meantime.  I should have paid closer attention at that time to the fact that uncertainty created by short seller accusations, even when false, can hurt RILY’s business.  

The short sellers are actively telling wealth management clients that they should transfer out funds, actively harassing employees to try and get them to switch firms, and any potential capital markets client with a quick attempt at due diligence will find that the words RILY are in the same tweet as fraud far too often for comfort.  I was so interested in trying to find the truth, I missed the fact that in many instances, short sellers can cause the destruction of the company they are shorting.  Even though the short sellers of Medical Properties Trust (MPW) are using the same bad arguments and the same tactics, they can’t hurt MPW’s revenue as those hospital leases are fixed.  But every bond underwriting, IPO, or seasoned equity issuance that RILY doesn’t get actually hurts their business.  Shame on me for not seeing this sooner. 

Yes, it is true that the SEC sent subpoenas to interview RILY management.  The shorts are bragging that this is because they didn’t stop writing letters to the SEC until they agreed to do it. How much business will RILY lose just because of the Bloomberg headline?  Probably not a trivial amount. 

Some aspects of RILY are insulated from this, Hurley won’t sell any fewer swim trunks, Targus won’t sell any fewer laptop cases, and as a market maker, nobody knows who they are buying a stock from.  But the sale of Vitamin Shoppe is probably hopeless under this fog of war, and while RILY has a manageable $1.6 billion in debt around 6%, the Franchise Group has $2 billion of debt with $600 million at SOFR +10%, and the sale of Vitamin Shoppe to retire debt really could mean the difference between Franchise Group surviving to get the next boom part of their cyclical business or not.

I think RILY is a fantastic business, built over the course of 27 years by its founder.  But the darned thing is that might not matter, because John Hughes of Prophecy Asset Management committed fraud in telling clients their money was diversified across several portfolio managers, when in reality he had only one, Brian Kahn, CEO of the Franchise Group.  Brian Kahn maintains he was a victim of the whole affair, and remains unindicted, although I believe he had settled a civil claim against him for around $70 million.  RILY had no relationship with John Hughes at Prophecy, and the entity of the Franchise Group is legally distinct from its former CEO, Brian Kahn.  Even after Sullivan & Cromwell, the fourth most profitable law firm per partner in the world, performed an audit and found no wrongdoing, if there somehow was a crime committed, how much could the damages possibly be?  And would those damages even affect RILY, or would they affect Bryant Riley personally instead?  If Brian Kahn settled his liability for $70 million, the best thing that could happen to RILY today is if the SEC would fine Bryant Riley $30 million and consider the matter closed.  Otherwise, RILY can look forward to years of struggling to keep and acquire clients amidst an unprovable and neverending fog of accusations from short sellers.

https://www.sec.gov/newsroom/press-releases/2023-231

I am still long RILY, but I don’t recommend you follow me on this one anymore.  Perhaps short term there might be a bounce after such a drop in share price yesterday, but the dividend was the force anchoring RILY’s share price near $20.  Without the dividend, it can get whipsawed around much more now.  RILY’s quarterly EBITDA of $50 million is enough to support their $170 million annual interest payments, but not much more than that.  There would probably need to be some sort of asset sale to retire debt if management’s newfound focus on profitability doesn’t yield results.  We would know if RILY is under any real stress based on the price of those asset sales.  If RILY sold Hurley, for example, for 10x EBTDA, it would be an opportunistic sale, but if it came in at 6x EBITDA, it would be an indication of a financial duress.

The Franchise Group’s debt level is much higher, and at higher interest rates.  EBITDA from 2022 for Vitamin Shoppe, Buddy’s, American Freight, and Pet Supplies Plus was a combined $300 million to compare against an interest expense of around $240 million.  With RILY commenting on the deteriorating consumer, the earnings are likely somewhat less, but we have no way of tracking this inside RILY’s black box.  

Everything I wrote previously about the market not understanding the mark to market effect of third party write downs is still true and still applies.  But it is a different ball game if rampant character defamation can scare away clients and lenders.  The only thing that will put the short argument to rest is time, earnings, and the return of capital to shareholders.  With the fog of accusations preventing asset sales and hampering RILY’s core business revenue, the road ahead is bumpy and uncertain.