Heritage Global (NASDAQ:HGBL) Q3 2020 Earnings Call

0:01 Good afternoon, ladies and gentlemen, and welcome to the Heritage Global Inc. Third Quarter 2020 Earnings Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this call may be recorded. I would now like to turn the conference over to Michael Kim, Investor Relations. Please go ahead, Michael. Thank you and good afternoon, everyone. Before we begin, I'd like to remind everyone that this conference call contains forward-looking statements based on our current expectations and projections about future events and are subject to change based on various important factors.

0:48 In light of these risks, uncertainties, and assumptions, you should not place undue reliance on these forward-looking statements, which speak only as of the date of this release. For more details on factors that could affect these expectations, please see our filings with the Securities and Exchange Commission. Now I'd like to turn the call over to Heritage Global's Chief Executive Officer, Mr. Ross Dove. Ross? Thanks, Michael, and good afternoon, everyone. Welcome to Heritage Global's first earnings conference call. As you may know, we recently uplisted our shares to the NASDAQ stock market, and successfully completed a public offering of our common stock which I'll discuss in more detail a bit later. So as part of our effort to enhance investor relations we wanted to provide the investment community with a forum to discuss quarterly results as well as review why we believe the company is positioned to increasingly leverage our differentiated diversified business model.

1:53 Heritage Global is an asset liquidation services company specializing Thank you for joining us. of 2019 and adjusted EBITDA of 1.8 million, equating to a 28% growth over the third quarter of 2019. Focusing on industrial assets, Heritage Global advises enterprise and financial customers on the sale via auctions of industrial assets, mostly from surplus and sometimes distressed circumstances, while acting in a range of roles, including as an agent A guarantor or a principal. During the quarter, we continue to capitalize on rising demand for the re-commerce of used surplus equipment as companies increasingly look to source more affordable machinery. As a result, we benefited from strong growth in online auction volumes and related revenue.

3:16 In addition, auctions represent a key source of market intelligence for our valuation business. Thank you very much. Remember, NLEX provides liquidity to issuers of consumer debt that are looking to monetize charged-off loans which creditors have written off as uncollectible. Second, Heritage Global Capital continues to ramp up its business of providing specialty financing solutions for businesses, small and medium-sized investors in charged-off and non-performing asset portfolios.

4:11 We're currently excited about deploying a portion of the capital we raised from our recent equity offering to fund secured loans to financial debt buyers. That capital is expected to generate attractive returns with upfront fees, interest income, ongoing fees, and back-end participation. Looking ahead, we remain focused on driving sustainable growth by increasing capitalizing on several powerful drivers. First, a more challenging economic backdrop typically drives increased supply of surplus and distressed assets and rising demand for liquidation services via brokered asset sales, which bodes well for auction volumes. Related to that, ongoing social distancing as a result of COVID-19 pandemic enhances the relative attractiveness of Heritage Global's online auction model.

5:03 Second, we believe rising charged off consumer loan sales, as indicated by banks significantly increasing their loan loss reserves, will drive expanding volumes and commissions for MLEX, particularly given the continued growth of digital and other non-bank lending platforms. Third, with conventional lenders continuing to tighten underwriting standards to manage credit losses through the cycle, we believe Heritage Global Capital remains well-positioned to capitalize on rising demand for capital by debt buyers. Fourth, the additional working capital from our recent stock offerings Thank you very much. With that, I'll now pass it over to our Chief Financial Officer, Scott West, for a deeper dive into our financials. Thank you.

6:18 Thanks, Ross. For the third quarter of 2020, total revenue increased 14% year over year to $7.6 million, reflecting strong growth in services revenue, which were up 16%, as well as higher asset sales. Importantly... We maintain multiple revenue streams across businesses including brokered asset sales, principal auctions, sales commissions, and advisory and secured lending fees on top of recurring forward flow contracts with industry leading customers reinforcing the sustainability of our top line growth. Gross profit or total revenue, less cost of services revenue and asset sales totaled $5 million for the third quarter of 2020 compared to $5.3 million in the prior year quarter. With a modest decline, mostly a function of timing and activity of asset liquidation transactions as well as a mixed shift between financial assets and industrial assets.

7:20 Operating income grew 27% to $1.6 million. Thank you for joining us. We believe that tailwinds going forward will include a favorable mixed shift toward higher contribution businesses and fee structures as well as rising operating leverage as economies of scale increasingly build within businesses and across platforms.

8:10 We remain focused on managing expenses both at the corporate level and across business units and increasingly leveraging synergies across processes and systems to drive further operational efficiencies. and as mentioned earlier, net income totaled $1.3 million or $0.04 per share for the third quarter of 2020 and adjusted EBITDA was up 28% year-over-year to $1.8 million from $1.4 million in the prior year quarter reinforcing the building earnings power of our model. Net income and EPS were essentially flat year-over-year reflecting lower tax expense for the year-ago quarter with pre-tax income up 28%. At September 30, 2020, the company had aggregate tax net operating loss carry forwards of approximately $82 million, including $62 million of unrestricted net operating tax losses and approximately $21 million of restricted net operating tax losses. Substantially, all of the net operating loss carry forwards expire between 2024 and 2037. Stepping back, increased principal versus agency revenue, more predictable event and transaction flow, and rising contribution from our specialty lending division all bode well for a smoother forward trajectory for revenue and earnings, thereby driving improving EPS visibility and growth over time.

9:41 Finally, turning to our financial position, the company maintains a strong and growing balance sheet with stockholders' equity of $16 million, as of September 30, 2020, up 35% from the end of 2019 and net cash of $5.7 million. Importantly, our $5 million credit facility remains untapped and we raised $8.7 million of net proceeds from the company's common stock offering that closed on October 6, 2020. With that, we'll open up the call for questions. Operator? Thank you. We will now begin the question and answer session. To join the question queue, you may press star then one on your telephone keypad. You will hear a tone acknowledging your request.

10:28 If you're using a speakerphone, please pick up your handset before pressing any keys. To withdraw your question, please press star then two. We will pause for a moment as callers join the queue. The first question comes from Mark Argento from Lake Creek Capital Markets. Please go ahead. Hey, Ross. Hey, Scott. Congrats on a solid quarter. Just wanted to dig in a little bit kind of in the environment we have right now. It's kind of a unique environment. You got parts of the economy doing really well. Starting to see maybe a little distress on the consumer credit side. Do you maybe just talk us through some of the things that you guys are focused on in terms of identifying opportunities and then in particular on the financial assets side, is there a backlog they're building in terms of assets that some of these institutions need to get off their books?

11:25 All right, so I'll take it from here and Scott can add on. This is Ross and great to hear from you, Mark. So really what you're looking at right now is what I would call a pent-up demand by the buyers of non-performing loans. They've all raised a lot of capital and they all look to borrow a lot of capital in this marketplace where it's available from people like us. But at the same time, there has not been enough product released yet. So they're looking at the loan loss reserves from the nation's lenders. They're looking at increased fintech assets that they think are going to become available very soon. There is obviously the new category of the buy now pay later assets that are about to come on market too. So there's a general enthusiasm that there's going to be a lot of product.

12:17 But I would say honestly that that product we're probably looking at not hitting until next year. We think with the election just finishing and everybody still kind of being careful that you're really looking at a next year and a year after increase. Yeah, I agree with that, Ross, and hi, Mark. It's kind of like the floods, the rains are pouring, the water is building up behind the dam. We know the volume is increasing, but we just haven't seen as much as we expect to see in the coming quarters and years. So on the flip side, Mark, in our industrial assets group, we've seen record attendance at our auctions and record pricing. right now the supply chain on new equipment has slowed down the ingress and egress globally hasn't been what it was before COVID and even at this current point in time used assets are bringing a premium in most of the sectors we're in and demand is very high because you're able to get those assets and purchase them real time so we expect that to continue over the next year and it will continue getting record crowds in a very high prices on used equipment.

13:36 Yeah, no, that's super helpful. And then I know, you know, pharma is an area that you guys have built kind of an expertise in, you know, from the, you know, continued M&A activity in that space. Are you guys seeing continued activity there? And is that going to be a focus for you guys going forward? Yes, I mean, if you look right now, we have three assets currently on the book for Pfizer. Everybody who read the world-class great announcement today that we're moving towards a vaccine, we think that not only bodes well for the world, but we think it's going to free up a lot of redundant assets as pharma companies across the world retool and as the governments put leverage on all of them to cooperate in rolling out these vaccines. You're going to see A strong purchase of new equipment, and you're going to see a lot of secondary equipment get to the marketplace, which is much needed by the smaller companies now. So we think it bodes well not just for the country, but we think it bodes well for the people that can take advantage of used equipment increasing in volume.

14:49 That's great. And then just, Scott, just turn into the P&L here. It looks like you guys have some pretty nice leverage in the model here as incremental revenues kind of build. Maybe talk to you a little bit about how you think about how this model scales and in particular kind of thinking about it in terms of incremental margin. Sure. Yeah, happy to, Mark. So As a services-based business, our primary operating costs are our people costs. And so in terms of the fixed costs, in addition to the people costs, we have some rents and things like that. But our overall fixed operating costs are about $10 million a year, and so that's about $2.5 million per quarter. And as you know, we're broken into the two divisions of industrial assets and financial assets, right? On the financial asset side, for every $1 of incremental revenue, once we've covered our fixed operating costs, then that drops about 75 cents to the bottom line. And then on the industrial asset side, for every incremental dollar of revenue, it drops about 40 to 45 cents to the bottom line.

16:12 The model is very scalable. I was going to say, I hope we can put that NOL to use and shield some good earnings here. It looks like you've got some nice margins or nice incremental margins there. Just one last one for me, maybe for Ross. In terms of M&A opportunities, what's the high-level criteria that you guys are really focused on there? Thanks. So when we look hard at M&A right now in what I would call a very transitionary marketplace where there's really two different segments, in both segments, M&A would be what I would call probably more of a niche play of a bolt-on of a specialty entity. On the industrial asset side, it could be somebody with expertise in global arbitrage of medical equipment, It could be somebody that has a special understanding of hospitality equipment as the world changes.

17:15 So they would be both on. And on the financial asset side, we think that there's just a ton of room for de novo organic growth and that the current plan is to go greenfield. So the capital we raised primarily wasn't raised as M&A capital. The capital we raised was really primarily organic growth capital. We always have our eyes open, Mark, but it's not on our current plan. It's not at the forefront. Great. Thanks, guys. Appreciate it. Thank you for listening in. Thanks, Mark. The next question comes from Michael Diana from Max and Ruth. Please go ahead.

18:01 Hey, Ross, Scott. First of all, thanks for having the call. I think the calls are a really good idea for you to tell your story in your own voice. In Scott's remarks, he mentioned a favorable mix shift, and I think when he was just talking about the scalability of the financial side versus the industrial side, maybe he partly answered that question, but could one or both of you talk about The thing that really we're most excited about is that we built this business so that we didn't need both businesses to do great at the same time.

18:49 There were different times in different financial marketplaces where there's a lot of non-performing loans, but there's a tightness in the amount of surplus industrial asset available and vice versa. So the good news is right now we see tailwinds for very logical reasons in both businesses at once. And when both businesses at once synergistically are growing, it puts us in the best spot we could be in. Why is that happening? It's happening because there's a pent-up demand of non-performing loans, and it's very unlikely that non-performing loans magically become performing loans. So generally speaking, once they're non-performing, whether they're getting sold now or getting sold in the future the supply is growing and simultaneous to that there's a growth in the supply of industrial assets coming on the market that has nothing really to do with COVID. COVID created a huge buyer demand but the seller demand is because there's now going to be lots of technological advances as we move forward that are creating excess surplus assets so The favorable mix shift is really the fact that what Scott is looking at is we believe we can get a higher contribution with the capital we raised, meaning we can act more as a principal, or generally speaking, when we're a principal and a guarantor on the industrial asset side,

20:20 there's greater margin than just fee-based, and we have more free capital there, and simultaneously, Thank you very much. Thank you, Ross. Hi, Mike. With the generation of good profits, good cash flows, good EBITDA, what that does, it creates more opportunities for us.

21:12 As you know, we have on the industrial auction side the various options of a fee-based auction system. Thanks very much. Fair enough, Michael. And when Scott says it's excess cash, it's my job as the CEO to make sure it doesn't stay excess and make sure we deploy it. Okay. All right. Well, I like the 36-month part you mentioned.

22:02 The longer the better. Especially for a young guy like me. Thank you. Any other questions, Mike? No. No. Thank you, sir. The next question comes from John Bickthorn from Dialectic Capital. Please go ahead. Hi, John. Hi. Thanks for taking my question and nice job on the quarter. Just looking out at next year at any point in time in the future that you're comfortable talking about with this pent-up demand, could you talk about the capital intensity or cap structure, however you guys think about it, of the two different lines of business? and like how much more capital you're going to need to grow one of them out relative to the other one and what you think you might need to do.

22:53 How do you balance capital need versus revenue growth really? So there's a very different dynamic between the industrial assets division and the financial assets division. The reason is in the industrial assets division, there's a fairly rapid return on capital. So even if we bought transactions for $5, $10, $15 million, generally speaking, within 45 to 60 days, we can do an auction sale because most of what we're doing on the industrial asset side is really date certain sales. So it's not like a brokerage where you're buying it, putting it on the market, and waiting. We're pretty much marking the market. We're trying to be a principal and get it at the right undervalued price and then mark the market rapidly.

23:39 So there's a constant return of capital, and because of the recycled capital, we have enough in the short run that we don't feel intense pressure. Now the flip side is on the lending side. When our clients come up to us and they want to buy a non-performing loan portfolio, they're generally speaking going to collect the money over two to four years. So our capital is tied up for two to four years. and many more. Thank you very much.

25:02 Frankly, it's a surprising statement. Given the idea of pent-up demand for next year, which I fully buy into, and I keep hearing stories of this kind of wall of NPL that's going to hit the universe next year, it would seem to me like there's no way you're going to generate enough cash flow to recycle it into satisfying that demand. But maybe the cap structure is such so that the equity you have to put up is relatively low or there's a first loss feature or or whatever else it just seems. There is a first loss feature and we have over $100 million in relationships and current commitments from large hedge funds that have already underwritten us and back us. The reason for that is that we are a market maker in these kind of assets and that they're very comfortable that we know the right borrowers and that we can underwrite What an auto portfolio or a fintech portfolio or a credit card portfolio this tertiary is worth.

26:04 So we're comfortable that we're going to be able to leverage those relationships, grow new relationships, and if combined between those relationships that we currently have and others we're working with, that we can leverage their capital along with our capital and keep growing. At least that's our next two-year plan. And as we need more capital... Capital is being raised every day for distressed debt, and we think that capital is going to rely upon knowledgeable domain expertise operators like us. That's great. Thank you. And my last quick kind of random question is, what's the most surprising thing you think we'll see from your markets? What's the thing that surprised you over the last three months as you look out, either in terms of sector that's doing better or worse, or Just whatever kind of surprising change you've seen in the market over the last few months that you think would be valuable to us to understand where your business is headed.

27:05 I think, to me, I think that unfortunately, and I don't want to be the grim reaper in any way, but I think unfortunately a lot of plants that were closed in the short term because they thought that COVID was the reason they're closing... I think are going to find out and maybe it's not so much of a surprise to me as I think it's going to be to them that the world has changed and when this pandemic is long over again there are certain things that we experienced that are really going to change commerce for many many years to come I think it's going to have an impact on the hospitality industry an impact on the travel industry and an impact on the aircraft industry and I think that the service contractors that are supporting those industries have many plants that may not reopen. They're going to have to be monetized and the assets transferred to other plants. If there's any surprise, I would say it is the resilience of the secondary market that when it looks like an industry may be struggling, there are entrepreneurs and other industries that have figured out how to really utilize re-commerce and buy those assets. So when we first worried about the impact of the pandemic on surplus assets, My surprise was the resilience of the secondary market and how those assets continue to sell at high prices and continue to get reutilized and continue to get absorbed, which really I think says a tremendous amount about the entrepreneurship in America and the fact that these idle

28:38 assets are all going to have a second life and that we're going to come out of this stronger than ever. Yeah. Hey, John, this is Scott. I agree with what Ross just said. To me, the most surprising thing was just the speed in which the industrial assets division with the auctions at which the buyers came in in record numbers and the prices that were achieved. You know, we had a slowdown in March when most of the country and the world closed close down, but by the second quarter, we were seeing record attendance at our auctions, and we were seeing record prices on the assets that we were selling, just in a very short window. So that's what I was most surprised by.

29:25 Great. That's fascinating. Thanks a lot, guys, and good luck in the next quarter. Thank you. Thanks, John. The final question comes from Mike Schliske from Collier Securities. Please go ahead. Go ahead. Good afternoon, guys. Hi. Hey, Mike. Hey there. I wanted to start off maybe by asking a little bit about the pent-up supply in the financial assets business and a little bit more about the cadence of how this might play out whenever the dam will be opened. Do you think you're going to have one gigantic quarter where everything kind of comes on at once, or is there going to be kind of a more, you know, measured approach, not just a place The banks let the assets come out that way, but also because there's only so much that the market can actually handle. Just some sense as to how this might look whenever we do see the assets that come to the market grow.

30:24 So it's a little bit not about the liquidity. We believe that the liquidity is there in the buying community and that the capital is there. It's really about the lenders' basically different appetites. So some of them are going to test the market, see the pricing and watch for others. And some of them are going to want to get out early and sell the assets that they've had pent-up demand in. So we think that there may be a faster growth in the amount of assets that come out of non-bank lenders, that come out of fintech lenders, that come out of buy-now-pay-later lenders, that come out of different various lenders that are not FDIC-chartered institutions. and even though they have the loan losses in the FDIC Trotter institutions, we think that could be a process of the next year or two of those loans coming out.

31:13 I don't want to say dripping out, but I think that in the end, you're not going to see much change this year. You'll see volumes beginning to increase in Q1 and increasing, and we estimate, for the next two, three years. Every time we've seen... the country going to increase non-performing loans in the past going back all the way to the S&L crisis in the FDIC days through the 2008 financial stresses. We saw that it was a two or three year period to rationalize the non-performing loans and get the levels under control. So we're bullish on there being activity but we're not looking for some massive one quarter or two quarter Get Rich Quick Windfall, we're looking at a steady two- to three-year supply increase.

32:09 Yeah, I agree with that as well. I think the analogy back to the dam is I think the dam will start to open up, but I don't think it will come crashing down all at once. So I don't think there will be a huge influx in any one quarter. But we have seen that these lenders do kind of – operate in tandem. So I do expect that when it does turn and opens up, I think there's going to be an increased flow that we'll see for multiple quarters and years, actually, in light of what's been happening across the macro economy. Great. And just to follow up there, on your household capital business, do you feel like what you just raised, and actually you have a pretty solid cash balance as of the end of the third quarter, but By the way, does the cash you've got available to you, does that allow you to follow that kind of multi-year tailwind or do you have to probably get some more capital after the first, I don't know, year or two?

33:12 We have a very strong belief that with our performance and our ongoing and continuous performance that the $5 million credit line that we have with our incumbent lender will be expanded. We haven't really pursued big expansion yet because it's been untapped. But as we tap it and show that we're using it in an accretive fashion and as we're growing the business, we believe that we'll be able to increase our debt position based upon our profits. So we're not anticipating going out to the marketplace for more capital right away. Will I make a promise that we never will? No, I can't make that promise. It's nothing we're currently working on. It's not on our plate. It's not on our agenda. We are actively negotiating with our capital partners to also expand our alliance there. And anytime we can, obviously, drive down our costs with all of our capital partners.

34:08 But we feel pretty good that over the next 18 months, we've got visibility that we can put out enough money to make a big, big difference in our earnings. As we all know, the best time to ask for increased capacity on a line of credit is when you don't need it. We're real pleased, obviously, with the profits we're generating, the cash flow from operations, EBITDA, et cetera, in our cash position. Hope that helps me. Sure, yeah. I mean, obviously, when you raised capital this past time, you did it with much greater... The term profiles in mind, that's probably well beyond the cost of capital.

34:54 So kudos to you for that. You wouldn't ask for the money if you didn't have good, you know, possible use for it, of course. Correct. Can you maybe also just, I have two more here. Can you maybe give us a sense as to the growth rate that you've got in your business that deals with some of the fintech lenders out there? Is it above the company, you know, run rate or is it below at the current time? So about half the non-performing loans we sell, I mean, FinTech's a pretty, pretty broad category, but about half the loans, I would say digital commerce loans, and the other half are basically old school auto loans and credit card loans and bank loans. So it's about half digital commerce.

35:41 Going forward, we think it's going to be maybe 60% to 65% digital commerce over the next 24 months. It's hard for us to know How many of the larger banks and money center banks are going to use a third-party broker to sell their assets versus sell them direct on their own? We think there's a much more growing cadre of digital commerce clients who are new to the business who are going to want the open sea and the transparency of using somebody like us who's got a large built-in base of buyers. So if that's a fair answer, a best guess would be maybe getting up to eventually two-thirds non-bank fintech and one-third traditional banks.

36:28 Got it. Maybe one last one from me here. Do the results of last week's elections, does it change the environment for you in any way from a regulatory standpoint, do you think, and will it be for the positive or for the negative? We're not going to pretend that we're CNN versus Fox News here at Variety. So this is the one question I'm happy to say. I'm clueless and don't know. And you're not going to trick me into guessing. Fair enough. Okay. I'll pass it along. Thank you. You're the analyst, not me. I'm just an operator. Wait, wait. It's... Whoever won, it's not going to change the fact that the volume of the assets that we sell are increasing.

37:20 That's right. Got it. Thank you very much. You got it. I have a great day, and I'd like to thank everybody and end the call by saying that this is our first live earnings call, and we're extremely appreciative to have the opportunity to get this. Tell our story to get to speak with you all. And we're grateful and thankful for those of you who dialed in and wanted to pay attention and those of you who listened later. And we're going to do everything we can here at Heritage to bust whatever you bust in order to really make sure that we perform and make you all proud. So thank you very much. Thank you. This concludes today's conference call.

38:08 You may disconnect or line up. Thank you for participating and have a pleasant day.